The fund manager’s home truths about income investing look right on the nail, says David Prosser.
Fund manager Terry Smith has a habit of pointing out uncomfortable truths. It is almost 30 years since Smith was fired by a leading investment bank for publishing Accounting for Growth, his book lifting the lid on the dodgy accounting techniques employed by a string of well-known businesses that had gone bust in spectacular fashion. The City was not pleased back then to see its dirty linen washed in public – and it is a fair bet that today’s financial establishment is none too happy with what Smith has been saying about investing for income.
To be precise, in April, as financial markets began to wake up to the potential impacts of the Covid-19 pandemic, Smith penned a column in the Financial Times warning that “no one should invest in equities for income”. Given the enormous industry that exists to persuade investors to do exactly that – the Investment Association’s UK Equity Income sector alone consist of more than 70 funds collectively worth almost £42 billion – it was not a palatable message.
Since April, however, Smith’s warning has looked ever more prescient, as companies have cut their dividends to protect balance sheets ravaged by the pandemic. Even before BP (LSE:BP.) cut its dividend in early August – a huge blow given that the oil giant is traditionally the UK’s most generous dividend payer – the flow of income from UK companies had slowed to a trickle. UK Plc paid out £16 billion in the second quarter of the year, 57% less than in the same period a year ago, according to Link Group’s regular Dividend Monitor report.
“The second quarter was truly a record-breaker - not by a whisker, nor by a nose, but by a mile,” says Susan Ring, chief executive officer of corporate markets at Link, who warns of more pain ahead. “The whole of 2020 will, without doubt, see the biggest hit to dividends in generations,” she says.
If you are invested directly in equities to generate income, you will have noticed these reductions, which have been equally dramatic in international equity markets. Nor has the diversification offered by collective funds provided much protection, with the honourable exception of those investment trusts able to draw on dividend reserves to smooth out income distributions.
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So much so that the Investment Association has suspended for 12 months the yield requirements that funds in the UK Equity Income sector must normally meet to qualify for inclusion.
Clearly, Covid-19 is a black swan event. But Smith’s argument about the suitability of equities as a tool for generating income is that the dividends to which investors became accustomed in recent years were not sustainable. He believes that even as conditions normalise, companies will not return to the payouts they offered previously – because their generosity has been hampering their ability to retain earnings for investment in future growth.
All of which, in retrospect, feels like common sense. But it also begs a bigger question. For years, we have been told that the secret to maximising stock market returns over the long-term lies in reinvesting dividends – that the lion’s share of the outperformance with which we associate equity investment comes from ploughing our income back into our portfolios. Was that wrong all along?
The short answer is no. The latest Barclays Equity Gilt Study, the bank’s annual report into the long-term performance of leading asset classes, could hardly be clearer. Had you invested £100 in equities on the very first day of the 20th century, you would have had £17,339 in nominal terms by the end of 2019, if you’d chosen to draw down all the income you earned over the subsequent 120 years – or just £193 after adjusting for the effects of inflation. Reinvesting all your dividend income, by contrast, would have helped your £100 grow to a nominal £3,216,855, or £35,790 in real terms.
To see why, consider Barclays’ long-term analysis of dividend growth. Since 1945, UK equities have delivered a positive five-year average annual dividend growth rate in all but three years, the Equity Gilt Study shows. For most of that period, dividend growth has averaged in excess of 5% - and has often been well above 10%.
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In other words, the conventional argument that dividend income plays an absolutely crucial role in helping equity markets outperform over the longer term looks unassailable. If you are a long-term stock market investor, a great deal of the return you can expect to earn will come from the dividends your portfolio generates.
However, this should not be regarded as undermining Smith’s arguments. For one thing, his point is that equities cannot be relied on to deliver reliable and consistent levels of income – the sort of income you need if, for example, you’re managing an income drawdown portfolio in retirement.
The experience of the past few months has been exactly that. Many investors dependent on equity portfolios for income have suddenly found themselves coming up short. And while the pandemic has been an extreme example in the breadth and depth of its impacts, the truth is that companies can – and do – cut dividends at any time for a whole variety of reasons. If you were depending on those dividends for your retirement income, say, that spells trouble.
The issue here is the difference between investing for income and investing for capital return. Ironically, if it is the former that you are engaged in, the stock market may not be the best place to look. While if it is the latter, the evidence of the past at least has been that reinvested dividends will give you an enormous boost. Dividend income may rise and fall – rendering shares more risky for those needing dependable yield – but over time, it is a crucial part of the growth picture.
So, where does that leave investors in the current environment? Well, genuine income seekers face a real problem, warns Philippa Gee, managing director of Philippa Gee Wealth Management. “I see equity income funds deflating, as dividends are cut both in the UK and globally, so investors certainly should not rely on dividend funds,” she warns.
“However, there will also be a pressure on fixed-interest holdings, as some companies cannot stay operating and the potential problems mount up, so a new approach is required.”
In practice, says Gee, that new approach is likely to include a tactic that many investors consider to be an anathema. “I would suggest that investors use any potential growth achieved, where possible, to facilitate income payments, so that you are letting the investments stand up for themselves,” she says.
“Using capital rather than income may sound contrary, but it could have the potential of creating better opportunities than relying on investments which may prove unattractive for now.”
If your objective is maximising growth, meanwhile, the data shows that over the longer term, income-focused equity investment hasn’t always outperformed. The average UK Equity Income fund returned 34% over the seven years to 30 June, Morningstar data shows, against 45% from the average UK All Companies fund. That could be, for example, because companies paying out higher dividends have less to invest in future growth, which hampers their long-term performance – the very issue Smith warned about.
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Equally, there may be tactical reasons to consider an equity income strategy right now. “In the current market environment, the majority of high-yielding stocks are massively under-appreciated, while at the same time large-cap growth is overcrowded and not necessarily mirroring companies’ fundamentals,” argues Teodor Dilov, a fund analyst at interactive investor.
“Should value perform better, as in 2016 when the Global Equity Income sector outperformed its Global counterpart, or 2015 when UK Equity Income delivered more than UK All Companies, income strategies would be in a position to benefit.”
In the end, however, Smith’s home truths look right on the nail. Equities do not deliver the income required by income seekers in a sufficiently consistent manner to be relied on. As for growth, reinvested dividend income may be a crucial element of long-term return, but it does not follow that investment styles focused on maximising dividend income will deliver more growth. Often, the opposite has been true.
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