Julian wrote:If you end up with a share that invokes your last sentence then, if you have long timescales i.e. looking for decades of reliable income, I would sound a note of caution.
I realise this is a sweeping generalisation but I fear that in the modern fast-moving and highly competitive world there is no company with a moat so robust as to protect it against future changes in its markets. Even the most solid-seeming companies need to re-invest money to either stay competitive or to gradually reposition themselves out of declining businesses. I really don't think there is a company where the management can sit happy in their boardrooms thinking "we've found a good thing here, all we need to do is distribute all our profits to shareholders" because there will almost certainly be an expiry date on those profits.
If one really is invested in one or more companies that are predominantly milking an existing fairly static business model for income with little investment in the future then I think that the investor him/herself needs to be mindful of that future and be prepared to jump ship before going down with it. ...
Yes and no, because there are two things wrong with that.
The first is simply that the investor might well not care if the company clearly has more decades left than the investor does!
The second is that as long as the company has long enough left and is paying a high enough yield, it can still be a worthwhile investment. For example, imagine that you had an occasionally-working crystal ball, and that on one of those occasions it showed you the future of a company whose shares are currently paying a dividend of 12p. That future is that it will go on paying a dividend of 12p for the next 25 years, at the end of which its business would collapse (maybe a competitor will manage to invent and patent a far superior product round then) and it would soon go bust, never paying a dividend or anything else again. It's not a public company and it's normally impossible to buy the shares, but an existing shareholder makes a private offer to you: you can buy some of her shares for 100p each (so you'll get a 12% yield on your investment). The snag is that she'll only do that if you legally commit yourself to
only sell them to her in the future. No commitment to sell: she doesn't have an option over them, but if you want to sell in the future, you can only do so if she and you can arrive at a mutually agreeable price. Otherwise you're stuck with them.
Also suppose you are young and healthy enough to have a very high chance of getting the benefit of all 25 years of those dividends. Should you accept the offer? Your argument suggests you shouldn't: the ship is doomed to go down in the future, and you
cannot jump ship before it does... (At least, assuming the seller refuses to offer you enough to make it worthwhile for you.)
But I would accept the offer, because it would be equivalent to giving me about 11.15% on my money. Specifically, if I could find a bank account offering an interest rate of 11.15% and I invested say £10k in it, then withdrew £1,200 at the end of each year, it would decline to a balance of about zero (*) over 25 years. At first quite slowly - at the end of year 1, it would be worth £10,000 + £1,115 - £1,200 = £9,915 - but accelerating as the balance declined and earned less interest.
So what's the resolution of that disagreement? The answer is basically revealed by that declining balance of a bank account that would deliver the same performance: the income from the investment needs to be treated as partly 'real' and available to pay living costs, buy extra luxuries or whatever else you want to do with it, and partly as 'jumping ship', i.e. supplying you with the capital to invest elsewhere.
That example is clearly very artificial, but its lesson is real: long, slow declines are not something to be frightened of as such - if a high dividend can be relied upon a long time into the future, treat it as jumping ship for you. In essence, the directors of such a company are saying "We can't find anything we can do with this money that fits in with our existing business and is sufficiently profitable, so you, the shareholders should have it back and look more widely for something else you want to be invested in."
There is however a danger associated with long, slow declines: as for anything else long-term, they're very hard to forecast. Companies that look to be headed for them may find a new lease of life from somewhere - e.g. oil & gas producers and tobacco companies both seem to face long-term declines in their primary markets, but may well find new leases of life from renewable energy and vaping respectively, and I at least would have had no idea that vaping even existed as an idea ten years ago, let alone seen it as a potential new lease of life for tobacco companies. And on the flip side, declines can accelerate: a long, slow decline can become anything but long and slow, especially if the company uses accounting sleight-of-hand to try to hide its real speed...
So while I don't think that long, slow declines are something to be frightened of
as such, provided they're accompanied by sufficiently high dividend yields (**). But they are very hard to forecast reliably, in both directions, and therefore risky. But then, is there a method of selecting shares to invest in that isn't risky? To name but one example, companies like Unilever with respectable but a bit below-market-average yields that they're growing very respectably are often suggested. But in 2008, Tesco was in that sort of position: a 10.9p dividend on a share price in roughly the 300-450p range (depending on when during the year one was considering it) gave it a yield of very roughly 3%, and it had grown its dividend by about 13% that year and by about 11% per year on average over the preceding ten years. Someone who invested then at a yield of 3% (a share price of roughly 363p) will have received a bit under 25% of their investment back in dividends, despite them having grown substantially to over the next three years and continued for a total of six, and lost about 40% of their capital, so a decidedly negative rate of return. It will take a
lot of future growth to get them to a position of having had a respectable rate of return overall...
Basically, I don't think there is any method of predicting a company's future that has a sufficient combination of being reliable and long-term to do more than give one a hint about its future returns, a hint that may well turn out to be wrong. One's only real protections against that are to diversify well enough to make the effects of any one failure on one's whole portfolio sufficiently small to be tolerable, and to pay a great deal of attention to the companies one owns to be able to get out quickly if they go wrong without paying too high a price in terms of getting out on 'false alarms'. The latter is quite a difficult test: it's relatively easy (though tedious!) to watch a company for any signs that it might be going wrong and get out if one sees them, but it requires a lot more effort and skill/talent to distinguish reliably enough between real and false signs of going wrong... As a result, applying
both of those protections is likely to be a
lot of work - certainly much more than I'd be happy to face - and so for most income investors, it becomes a question of which they concentrate on, if either: a really well-diversified portfolio, all or most of which they pay little attention to, or a more concentrated portfolio of shares that they pay more attention to, or they do neither and use a smallish basket of investment trusts or other funds, paying their managers to do the work for them.
I'm not saying anything about which of those solutions anyone should adopt, because I don't know! It's a very investor-specific choice... My own choice is basically about 50% in the first solution, in the form of a well-diversified HYP (roughly 40 shares), and 50% in the second, in the form of a more concentrated and more actively managed smallcaps portfolio (roughly 15-20 shares). The first gives me a good level of basic, pretty reliable income and takes up little of my effort; the second is more challenging on effort, but also more interesting to me, and some years it gives me a good amount of bonus income - occasionally it's even exceeded my HYP income for the year, but it's definitely not very reliable income! And by the way, my posting on TLF (and TMF before it) does
not reflect the effort I put into them well - e.g. in the past couple of months, I'm certain that of the effort I've put into investment-related posts on TLF, nearly 100% was either HYP-specific or general investment stuff and almost none smallcaps-specific, but well over 90% of the effort I've put into actually managing my investments has been smallcaps-specific! That last percentage is unusually high, because one of my smallcaps, which was already my largest shareholding, has taken off recently to the point where I find continuing to just 'run my winner' too risky, so I need to trim it, and that's rather complex because it really is a smallcap, making market liquidity an issue, and also because it realises capital gains big enough to be a significant CGT problem... Those are problems I'm entirely happy to have, of course! - but they do require a very noticeable amount of effort on my part to manage them.
But I'm
not recommending that solution to people - among other things, it requires one to be entirely happy with the HYP income on just half of one's investable capital, and to be willing and able to put in that sort of burst of effort when required.
(*) Actually £50.08 according to the spreadsheet calculation I've done, but that clearly comes nowhere near another year's £1,200 withdrawal. It's due to rounding errors in the 11.15% calculation - if taken to three decimal places, it's actually 11.145% that's needed, but that ends up with a balance of -£0.82. Or to four decimal places, it's 11.1451%, but that still ends up with a nonzero balance of £0.20. And so on.
(**) The 12% in my example is overkill in that regard, chosen to make the example very clear - a 9p dividend for 25 years and nothing more is still an effective 7.54% rate of return, which is perfectly respectable.
Gengulphus
so we don't have to pay tax on income within the wrapper. Of course if, like Terry and Warren, you are worth 100s of millions, this tax issue is a tad more important.