Jagger and Richards sagely told us that you can’t always get what you want. Harry and Meghan would likely agree, as we suspect, would many investors who signed up for ‘equity income’. Or, to be more precise, a high income derived from equities. This particular corner of the equity market is big business but with many large multinational companies either cutting or scrapping their payouts and numerous ‘star’ fund managers receiving their marching orders, the sector has arrived at a visible fork in the road. And, as Yogi Berra said “when you reach a fork in the road, you should take it”.
It is our view that too many investors have been led to expect a level of both income (and growth in that income) that is, over the longer term, highly unlikely to be delivered. Or, to put it another way, if you want x% growth in income, it is far more realistic to acknowledge it might be better to start with a meaningfully lower yield. To those that believe x% growth is possible from a portfolio offering two or even three times the level of that aforementioned lower yield, you are probably guilty of believing that 1 + 1 = 3.
As, I would argue, was the well known (but no longer employed) fund manager I recall talking to a few years ago. His answer as to why he was buying a FTSE 100 constituent with a very poor return on capital, high debt burden, massive pension fund liability and a clearly challenged business model, was “but the yield is close to 6%”. Mmmm ….. Today, the company doesn’t even pay a dividend and when it eventually does again, it won’t be at anywhere near the previous level. So, when is a 6% yield not a 6% yield? When it’s patently obvious the economics of the business cannot support such a persistent level of over distribution.
Last year we were asked to comment upon a poorly performing charity portfolio, riddled with the kind of stocks outlined above. We made it clear that the notional level of income was a mirage and that before disaster came to pass, a radical restructuring would (pun intended) pay dividends. As we suspected, the trustees declined to act as their body language throughout the meeting suggested a psychological inability to acknowledge reality. They also told us their current adviser expected recovery at some point. Mmmm ….. in the immortal words of Mandy Rice Davies, “Well he would, wouldn’t he?” Heaven knows what the portfolio looks like now.
The above tale illustrates how all too often, so called ‘income investing’ puts the cart before the horse. The dividend distribution policy should play second fiddle to the needs of the business. If the enterprise can reinvest at attractive rates, it makes economic sense to prioritise this, the dividend becoming, if not an afterthought but certainly the junior partner in terms of total return. However, when the dividend takes priority, it so often triggers a feedback loop of bad decisions and false priorities, ultimately leading to misallocation of resources and poor investment returns. Add to this toxic brew, advisers telling clients what they want to hear and the perfect storm is born.
Not only is the extra point or two of anticipated income so often illusory, but there is also a nasty double whammy from the permanent destruction of capital value that accompanies it. Really, there should be no surprise that superior investment returns are likely sourced from better businesses. As Warren Buffett said, “a great business doesn’t always make a great investment but it’s a good place to start looking for one”.
The value of investments and any income from them can go down as well as up and you may not get back the amount originally invested.
This material should not be considered as advice or an investment recommendation. Investors should seek advice from an authorised financial adviser prior to making investment decisions.
John Newsome can be contacted on 01423 705123 or john.newsome@williams-im.com. Williams Investment Management LLP is authorised and regulated by the Financial Conduct Authority.
