Key Post Terry Smith FT article: Why investing for income is not a good idea

[Brendan Burgess]

A very interesting article by Terry Smith.

Busting the myths of investment: who needs income?

The topic has been discussed here a few times.

Terry Smith argues that an investor who needs income gets a better return by investing in companies which do not pay dividends. When they need income they should just sell some shares.

But why do people want income from equities in the first place? The need to get spending money from your investments once you’re retired is obvious. But why does it have to come from dividends? Surely the right approach is to invest for the maximum total return you can achieve and then redeem whatever units you have to provide for your spending needs.
...
Yet most investors seem to regard this idea of redeeming part of the capital sum to provide income as the road to perdition.

A key part of his argument, is that and investor gets a much higher total return from a company which does not pay dividends than from a company which does pay dividends where the investor reinvests the net dividend to buy shares in the market.


If it pays out a dividend of €100
The recipient pays tax at 32.5% (This is a UK article)
So the investor buys new shares worth €67.50
But the average UK company's market value is 3.5 times its book value.
So you are getting €19 worth of assets. (67.5 / 3.5) by reinvesting dividends.

In comparison, if the company retains the profits and does not pay out dividends, you are getting the full €100

He illustrates this by comparing the actual return on Berkshire Hatahaway which does not pay a dividend. The annual return since 1977 has been 19%, If they had paid out half the profits in dividends and the shareholder reinvested it, the return would have been 14%.


I am surprised I had not heard the argument before.

First of all the comparison of €100 with €19 overstates it as the €100 is still in the company and would be subject to tax when the shareholder sells his shares.

Secondly it assumes that the company will reinvest the retained profits at the same rate of return as they are getting on existing capital.

Thirdly, is the 3.5 times market to book value normal?

Brendan

 

[spanners]

I have read similiar thoughts from Terry Smith before and I remain more inclined to dividend investing.

Whilst I understand the argument I think it is a bit misleading to compare fictitious ACME plc's €100 dividend reinvested at 3.5x book value versus actual return from Berkshire Hathaway. I would have thought very few companies, dividend paying or not, would come off favourably in a long term comparison to Berkshire Hathaway.

I think the no dividend pure growth strategy is all good and well during a rampant bull market. Not dissimiliar to the tiger cubs investing in property purely for capital growth, ignoring the negative cash flows. The paper returns look fantastic and it would be great if it lasted forever.

However it is far easier to weather a downturn and stomach the fall in the asset value if you're earning some sort of return from it during a bear market.

That average 3.5 times book value seems quite high to me.

 

[Brendan Burgess]

I think it is a bit misleading to compare fictitious ACME plc's €100 dividend reinvested at 3.5x book value versus actual return from Berkshire Hathaway.

That is not what he is doing.

He is comparing the actual Berkshire Hathaway with itself if it had paid 50% of its earnings each year in dividends and if the shareholder had bought more shares with the proceeds.

Brendan

 

[Gordon Gekko]

It’s a legitimate school of thought; many people, perhaps rightly, think that a dividend is just an admission of failure on the part of a company. They can’t do something better than pump the profits out to the shareholders.

 

[cremeegg]

I am sorry but any possible tax considerations aside, this whole argument is a red herring. No one can tell in advance wether paying a dividend is a companies best use of cash.

If the company has opportunities to reinvest the money in projects that offer a higher rate of return than the opportunity cost for the shareholder then they should not pay dividends. Otherwise they should pay dividends until only sufficient cash remains to fund, in the most tax efficient manner, such opportunities.

In general a company with a culture of not paying dividends is likely to see high return opportunities where in fact none exist.

The need to pay a dividend keeps management rooted.

 

[spanners]

That is not what he is doing.

He is comparing the actual Berkshire Hathaway with itself if it had paid 50% of its earnings each year in dividends and if the shareholder had bought more shares with the proceeds.

Brendan

Fair point, I see that now.

But whilst I get his argument, I still think it is misleading to use Berkshire Hathaway as an example to illustrate it.

 

[Brendan Burgess]

I still think it is misleading to use Berkshire Hathaway as an example

Yes, he does say in his article that it assumes that the company continues to get a good return on capital.

But his main point is comparing retained profits vs paying it out in dividends and buying new shares so I think it holds, whatever the return.

Of course, if I own shares in a company whose share price is declining , then I am better off taking dividends and keeping them.

Brendan

 

[spanners]

The reason I think it is misleading is because Berkshire Hathaway is unique in that it's run by two of the best investors in history who have a very wide scope of how and where to invest the capital for returns. They're in the business of investing capital, rather than running a department store or drilling for oil etc.

It's not quite so clear that the board of Next for instance will find a better investment opportunity in the retail business for their retained profits than the investor who takes the income.

Not every income investor automatically reinvests dividends into same company.

If Terry Smith's main point is in a single company comparing retained profits vs paying it out in dividends and buying new shares in that company, well it seems pretty obvious that retained profits will provide a better return over the long run (assuming the directors are as capable/sensible as Buffett and Munger).

He says: But why do people want income from equities in the first place? The need to get spending money from your investments once you’re retired is obvious. But why does it have to come from dividends? Surely the right approach is to invest for the maximum total return you can achieve and then redeem whatever units you have to provide for your spending needs.
...
Yet most investors seem to regard this idea of redeeming part of the capital sum to provide income as the road to perdition.

I think is the right approach if you're certain you'll be enjoying a good bull market in retirement. As most people cannot be certain of that I understand the appeal of income investing.