Terry Smith says investing for income useless

[Clitheroekid]

I've a lot of time for Terry Smith, and his Fundsmith fund has been a stellar performer. He makes some interesting points regarding the merits of income funds - http://citywire.co.uk/money/terry-smith ... r/a1097563

Of course the bull market is bound to favour his strategy over that of an income fund. It will be interesting to see how he fares if, as appears possible, that bull market has finally hit the buffers.

[Lootman]

Pretty much. After all, a purely income investor would never have invested in Berkshire Hathaway, or Apple (until recently) or Google, or Amazon, and thereby missed out on billions in stock market growth,

Dividend policy is a totally different issue from growing a business. Indeed, it may be a sign that growth is not anticipated and therefore investors need to be bribed with their own money.

[paulnumbers]

Pretty much. After all, a purely income investor would never have invested in Berkshire Hathaway, or Apple (until recently) or Google, or Amazon, and thereby missed out on billions in stock market growth,

Dividend policy is a totally different issue from growing a business. Indeed, it may be a sign that growth is not anticipated and therefore investors need to be bribed with their own money.

That seems a perfectly reasonable way to be bribed.

[Itsallaguess]

Pretty much. After all, a purely income investor would never have invested in Berkshire Hathaway, or Apple (until recently) or Google, or Amazon, and thereby missed out on billions in stock market growth,

Dividend policy is a totally different issue from growing a business. Indeed, it may be a sign that growth is not anticipated and therefore investors need to be bribed with their own money.

This, a thousand times this.

Choosing stocks on the basis of their yield is dumb, dumb, dumb. Total return is king: whether that is via dividends, buy-backs or reinvestment in strengthening the business, it matters little. Choose the best business, not the highest yield!

The problem is that many, many growth stocks don't go on to do as well as Apple, Google, or Amazon. Yes, they are clearly stellar examples of that investment arena, but I don't see a list of similar-sphere tech-growth companies that have dwindled on their vine during the same period. They clearly exist, and there's a good chance some of them may have been chosen as growth investments.....

The general idea behind mega-cap dividend-players is that they have often 'survived' the growth-phase of their development, and whilst they continue to invest in their business to develop and grow organically to some extent, it's generally thought that they generate enough returns on top of that to be able to pay out good levels of dividends for investors to use as income.

Whilst high-yield investing still clearly comes with some level of risk, the general idea is that because many of the companies are very well-established, they may be less likely to 'stumble', but on top of that, if they do 'stumble' then they are often large enough and experienced enough to be able to play their way out of trouble.

Both of those situations (likelihood of stumbling, and likelihood of surviving when they do stumble ...) are clearly much higher risks to high-growth companies, which are often likely to hit both buffers, even multiple times, during their development phases, especially with regards to tech companies operating in the arena's similar to the companies you've listed.

Growth investing is still risky, and this should be clearly acknowledged here. Granted, a wide net will catch some stumblers, but it will also catch some others that go on to survive in a way that rewards some of the risks of catching the other duds, but I'm not seeing much in the way of guidance as to how that might be achieved, or long-term histories of clear and detailed growth-strategies that are likely to achieve a good total-return over many years, and have been used by investors here.

Telling other investors to stop looking at high-yield companies, and to simply 'Choose the best business' is fine, but can you perhaps give some more details as to how that's to be carried out?

Cheers,

Itsallaguess

[Dod101]

Itsallaguess has basically made the point. We all love the Amazons etc of the world, but how often do we actually find them. I found Tullow in its earlier incarnation when I bought it for £1 or so and sold at what turned out to be about its peak of around £14 at the end of 2012 but luck played a lot in that both in terms of the purchase and the sale, and I long ago decided that if you find a decent payer of dividends (rather easier to find) then you can usually rely on at least these arriving in your bank.

The trouble is (and it is a worry to me) dividends can be very expensively bought as any holder of the tobaccos for instance are finding out. How much of that is down to the market in general and how much is stock specific I do not know, but a lot of steady income payers are ex growth and so to that extent Terry Smith is right. It is why I try to ensure a mix of lower yielders as well as the higher yielders are in my portfolio.

Investing for income of course has its place for Doris and others like me who need to live off their investments. It is not risk free; no investing is but it is relatively hassle free. Terry Smith is typically forthright in his pronouncement but then he is being judged on his Total Returns and so like Nick Train and the sainted Buffett, looks at the underlying capital growth and presumably ignores income.

Dod

[GeoffF100]

Lootman wrote:
Pretty much. After all, a purely income investor would never have invested in Berkshire Hathaway, or Apple (until recently) or Google, or Amazon, and thereby missed out on billions in stock market growth,

Dividend policy is a totally different issue from growing a business. Indeed, it may be a sign that growth is not anticipated and therefore investors need to be bribed with their own money.

That seems a perfectly reasonable way to be bribed.

You give the company your money, they pay it back to you, and the government tales 7.5%. Rather you than me.

We can obtain performance data for the FTSE350 Lower Yield Index (LIX) and the FTSE 350 Lower Yield Index (LIX), over the past 15, years from This is Money:

http://investing.thisismoney.co.uk/char ... AY1&type=2

During these 15 years, LIX has risen from 2162.8 to 3940.93, i.e. by a factor of 3940.93 / 2162.8 = 1.822.

HIX has risen from 3588.8 to 3585.15, i.e by a factor of 3585.15 / 3588.8 = 0.9990.

This is a relative rise of 1.822 / 0.9990 = 1.824.

On an annualised basis, this is 1.824 ^ (1/15) = 1.041, i.e. the LIX has outperformed HIX by 4.1% pa over the last 15 years, in capital terms.

We can obtain the current yields from Stockopedia:

https://www.stockopedia.com/index-price ... -FTSE:LIX/

https://www.stockopedia.com/index-price ... -FTSE:HIX/

The current LIX yield is 2.2%, and the current HIX yield is 4.8%, a difference of 2.7%. It looks as though LIX has been the winner over the past 15 years. Judging from the popularity of the HYP board and high yield funds, I would not be at all surprised if high yield shares are overpriced, and underperform. Dividends are also now less attractive than they were because of the dividend tax. Hopefully, we will see more companies buying back their shares, rather than paying dividends.

[Lootman]

Itsallaguess has basically made the point. We all love the Amazons etc of the world, but how often do we actually find them.

Not often, but the point is more that you don't need to find them that often. Anyone who bought Amazon in 2000 or Apple in 1990 or Berkshire or MicroSoft in 1980 could have afforded to have also bought dozens of other bright prospects that failed. One winner that you let run can go up far more than a loser goes down because that loss is limited to the original investment.

The key is to look at where the stock market wealth is now. For instance Apple is well placed to be the first trillion dollar market cap company. If you didn't hold Apple (because historically it never paid dividends) then it is almost inevitable that you will have under-performed the global index. (And by the way, it now pays a healthy dividend).

If you don't hold Apple, Google, FaceBook and Amazon then that is over 2 trillion in stock market wealth that you had no stake in (unless you hold funds anyway). And that is fine if you value a pound of dividend as more than a pound of capital, but that personal preference does not challenge the point that Smith is making.

I like dividends as well. But I would never rule out a holding just because its yield is low or zero IF I otherwise like the story.

[Dod101]

I agree entirely Lootman. Fortunately I have held Scottish Mortgage for a long time and have done very well out of it by its exposure to the sort of shares you are referring to. Could always have done better though by accepting more risk and held one or two individually.

Dod

[LeMoss]

Terry Smith is right of course.
In fact, Buffett outlined this very clearly in his 2012 annual letter to shareholders via an example

http://www.berkshirehathaway.com/letters/2012ltr.pdf

We’ll start by assuming that you and I are the equal owners of a business with $2 million of net worth. The
business earns 12% on tangible net worth – $240,000 – and can reasonably expect to earn the same 12% on
reinvested earnings. Furthermore, there are outsiders who always wish to buy into our business at 125% of net
worth. Therefore, the value of what we each own is now $1.25 million.
You would like to have the two of us shareholders receive one-third of our company’s annual earnings and
have two-thirds be reinvested. That plan, you feel, will nicely balance your needs for both current income and
capital growth. So you suggest that we pay out $80,000 of current earnings and retain $160,000 to increase the
future earnings of the business. In the first year, your dividend would be $40,000, and as earnings grew and the onethird
payout was maintained, so too would your dividend. In total, dividends and stock value would increase 8%
each year (12% earned on net worth less 4% of net worth paid out).
After ten years our company would have a net worth of $4,317,850 (the original $2 million compounded at
8%) and your dividend in the upcoming year would be $86,357. Each of us would have shares worth $2,698,656
(125% of our half of the company’s net worth). And we would live happily ever after – with dividends and the
value of our stock continuing to grow at 8% annually.
There is an alternative approach, however, that would leave us even happier. Under this scenario, we
would leave all earnings in the company and each sell 3.2% of our shares annually. Since the shares would be sold
at 125% of book value, this approach would produce the same $40,000 of cash initially, a sum that would grow
annually. Call this option the “sell-off” approach.
Under this “sell-off” scenario, the net worth of our company increases to $6,211,696 after ten years
($2 million compounded at 12%). Because we would be selling shares each year, our percentage ownership would
have declined, and, after ten years, we would each own 36.12% of the business. Even so, your share of the net
worth of the company at that time would be $2,243,540. And, remember, every dollar of net worth attributable to
each of us can be sold for $1.25. Therefore, the market value of your remaining shares would be $2,804,425, about
4% greater than the value of your shares if we had followed the dividend approach.
Moreover, your annual cash receipts from the sell-off policy would now be running 4% more than you
would have received under the dividend scenario. Voila! – you would have both more cash to spend annually and
more capital value.
This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on
net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the
S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth.
Both assumptions also seem reasonable for Berkshire, though certainly not assured.
Moreover, on the plus side, there also is a possibility that the assumptions will be exceeded. If they are, the
argument for the sell-off policy becomes even stronger. Over Berkshire’s history – admittedly one that won’t come
close to being repeated – the sell-off policy would have produced results for shareholders dramatically superior to
the dividend policy.
Aside from the favorable math, there are two further – and important – arguments for a sell-off policy.
First, dividends impose a specific cash-out policy upon all shareholders. If, say, 40% of earnings is the policy, those
who wish 30% or 50% will be thwarted. Our 600,000 shareholders cover the waterfront in their desires for cash. It
is safe to say, however, that a great many of them – perhaps even most of them – are in a net-savings mode and
logically should prefer no payment at all.

Terry Smith's approach relies heavily to selecting good businesses.

The alternate strategy of chasing yields regardless of business quality is more risky as it ends up selecting a fair chunk of businesses which are - to quote terry - rubbish.
A company that distributes a large amount of its earnings ( or capital in the case of some oil companies) because it lacks opportunities to generate future growth via reinvestment is not going to survive very long unless there are some really big barriers to entry. Tobacco is the one exception where there are virtually no new entrants in the market and reducing opportunities to use the earnings in marketing and advertising expense.

[Howard]

Itsallaguess has basically made the point. We all love the Amazons etc of the world, but how often do we actually find them.

Not often, but the point is more that you don't need to find them that often. Anyone who bought Amazon in 2000 or Apple in 1990 or Berkshire or MicroSoft in 1980 could have afforded to have also bought dozens of other bright prospects that failed. One winner that you let run can go up far more than a loser goes down because that loss is limited to the original investment.

The key is to look at where the stock market wealth is now. For instance Apple is well placed to be the first trillion dollar market cap company. If you didn't hold Apple (because historically it never paid dividends) then it is almost inevitable that you will have under-performed the global index. (And by the way, it now pays a healthy dividend).

If you don't hold Apple, Google, FaceBook and Amazon then that is over 2 trillion in stock market wealth that you had no stake in (unless you hold funds anyway). And that is fine if you value a pound of dividend as more than a pound of capital, but that personal preference does not challenge the point that Smith is making.

Your comments make me smile, Lootman. Anyone, like me, who bought Amazon and other high tech companies in 1999 very soon found that their investment of say £100,000 had turned into less than £10,000 within a year. Some people who invested their pension in a portfolio of high-tech companies and high growth companies at that time faced ruin and I remember reading one or two very sad stories. Luckily, as well as the alleged high growth companies I had the "plodders" which continued paying good dividends and which recovered well.

It's too easy to predict past winners.

For fun, Warren Buffet/Hedge fund style, why don't you predict two companies which will shoot the lights out over the next five years and we'll enjoy comparing them with the performance of an income fund comprised of good dividend payers.

Advocating buying a few high growth companies is a bit like suggesting putting ones pension on Lucky Jim in the 4.30pm race at Sandown Park.

An automotive analogy is arguing that a Ferrari will always out accelerate a Land Rover. Oh! Except in the last few days.

regards

Howard

PS I do have a significant part of my portfolio with Terry. Don't think he holds Amazon or Google though?

[LeMoss]

PS I do have a significant part of my portfolio with Terry. Don't think he holds Amazon or Google though?

He has just started a position in Facebook per his february update.

Actually Terry Smith's approach is not inconsistent with yield seeker but it has a crucial twist. His screening includes a Free Cash Flow Yield figure which is the amount of cash left over after meeting all needs apart from dividends.
I think his minimum FCF yield is about 1% higher than prevailing inflation - around 3.5-4% same as the HYP approach I would say.

Only some of this free cash is paid out in dividends and the businesses he finds deploy the remainder at high ROICs to generate growth at rates a direct investor cannot get ( 25% ROE and above). Ultimately all the cash flow belongs to the shareholder but it is this reinvestment dynamic that creates long term value. The extreme case of this is Berkshire hathaway where none of the free cash flow is distributed as dividend and is all reinvested - most companies like somewhere on the spectrum.

[GeoffF100]

You could not have predicted the out-performance of Apple or Terry Smith's fund in advance. Nobody knows how well they will do in the future. Neither has a better chance of out-performance than their competitors.

If you restrict yourself to high yield shares, you restrict yourself to a subset of a few markets, and usually pay more tax on your return. Restricting yourself to growth shares also restricts your diversification.

When a class of shares does well the market notices it and buys more of it, pushing the price up. The effect then goes away.

If you buy a broadly based low cost tracker, you are guaranteed to finish in the top 10% of funds, or thereabouts. If you buy a managed fund you have only a 10% chance of doing that.

Whatever you do, spread your risk and keep your costs down.

[GeoffF100]

With regard to Buffet, here is an interesting article:

https://www.albertbridgecapital.com/dre ... nwarrented

"He’s underperformed by 16% over the last ten years... Over the last nine years, he’s underperformed by 51%."

[LeMoss]

He’s underperformed by 16% over the last ten years... Over the last nine years, he’s underperformed by 51%."

As someone who has held Berkshire Hathaway over the last 2 decades , that is simply wrong.

The compounded rate between 3rd March 2009 and today for Berkshire is 17.82% per annum - with no tax consequences or frictional costs
The S&p 500 , compounded at 17.96% per annum with all dividends reinvested assuming zero tax and transactional cost.

So not sure where they are getting the "underperformed by 51%" over 9 years from.

[LeMoss]

You could not have predicted the out-performance of Apple or Terry Smith's fund in advance. Nobody knows how well they will do in the future. Neither has a better chance of out-performance than their competitors.

Of course you can't predict in advance.

However you can look at the process followed by different managers and make a judgement on whether it makes sense to you and that you would be happy to have your capital managed that way. I am in that situation with Terry Smith though his charges are rather higher than I would like. To his credit, he lays out his criteria and process very clearly so you know in advance what he will and will not invest in. I feel the same way with Buffett.

I also made a judgement that I was not comfortable with Woodford's process ( income fund ) because his process amounted to "trust me" and he continued to pick businesses with terrible economics, management and headwinds and Mr. Woodford is able to see how it will all turn around. They might but the process and the lack of due diligence bothered me so I parted ways.

I feel more comfortable that managers with that focus on quality and consistent process have a far lower chance of losing significant capital than the index hugging lswarm who are very susceptible to the flow of 'hot money'.

[GeoffF100]

I plotted BRK-A against the total return of the S&P 500 on Yahoo:

https://finance.yahoo.com/quote/%5ESP50 ... FydCJ9fX19

The chart looks like that in the paper. Clearly BRK-A under-performed the S&P 500 over this period. The current under-performance over the last 10 years is 122.05 / 152.12 = 0.80233, which is a little larger than the figure quoted in the article at nearly 20%, or about 1% pa. An S&P500 tracker will have costs, but the tracking error should be much less than 1% pa.

The "under-performed by 51%" over 9 years" was "excluding the GFC in 2008". I expect GFC means Global Financial Crisis. I have to say this exclusion is rather artificial though. If you fiddle with the scroll wheel on the chart, you can see that the article's claim is about right.

[GeoffF100]

However you can look at the process followed by different managers and make a judgement on whether it makes sense to you and that you would be happy to have your capital managed that way.

That is not something that can be back-tested. What we can say, is that managed funds that have done well in the past are no more likely to do well in the future than those that did badly, after adjusting for risk.

[Lootman]

Anyone, like me, who bought Amazon and other high tech companies in 1999 very soon found that their investment of say £100,000 had turned into less than £10,000 within a year.

Your problem then was not that you bought the wrong share (you clearly did not) but rather that you made a short-term and emotional reaction to a setback and sold at the bottom. I was not advocating market timing at all. Quite the opposite in fact.

It's too easy to predict past winners.

I wasn't. In fact I clearly stated that I had more losers than winners. The point was more that you only need one runaway success and the rest doesn't matter.

Sure, hindsight is easy. But forecasting the future is impossible and so the past is all we have. And the past says that if you avoided zero-yielding shares in the past decade or two, you under-performed. If you deliberatly avoided the four shares that have created over 2 trillion in stock market wealth then you cannot help but have under-performed.

I do have a significant part of my portfolio with Terry. Don't think he holds Amazon or Google though?

Of course, Smith is more a of a value guy (although Apple and Google are arguably value shares at this point). I invest in a blend of Smith-type mid-yielding value shares and low or no yielding category busters. Maybe it will stop working one day but how many more decades should I give that thesis when nothing supports it?

[Howard]

Your problem then was not that you bought the wrong share (you clearly did not) but rather that you made a short-term and emotional reaction to a setback and sold at the bottom.

I didn’t say I sold at the bottom. I said an investment in Amazon in 1999, like a number of other high tech companies, would have gone down to around 10% of its value by 2000.

I implied you were cherry picking a good time to buy Amazon by writing:

Anyone who bought Amazon in 2000 or Apple in 1990 or Berkshire or MicroSoft in 1980 could have afforded to have also bought dozens of other bright prospects that failed.

From memory Amazon did not recover for years after 1999. I think its share price was still lower 10 years later – so selling some time in that ten year period was hardly a short-term or emotional reaction.

But maybe (as a fellow holder of the shares you mentioned above, but in an Investment Trust) we can agree that it’s worth holding a well diversified portfolio.

From my experience there is a role for income shares too.

regards

Howard

[Dod101]

Whatever the merits of the argument re individual shares and when they were bought, I am happy to get exposure to this type of share through say Scottish Mortgage which I think is a pretty much instant portfolio of the sort of shares usually known as 'Growth'.

As for Berkshire Hathaway, I suspect that once Buffett and Munger have gone we will see a substantial dismantling of the edifice. It is obvious to me that it cannot carry on simply piling up money and yet there is very little to spend it on without, in effect, diluting the brand. Thus, irony of ironies, it will become an income fund or be dismantled along the lines of Hanson Trust.

Maybe it has another Buffett hiding in the wings but these are rare animals and I doubt it. No one should be fooled into thinking that he runs the outfit in the style he projects in public and it takes a very special personality to do what he has done and is apparently still doing.

Dod