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The false hope of equity income funds

Tuesday, Jan 18 2011 by
10
The false hope of equity income funds

Everyone wants income these days. On top of that they want to preserve their capital at a time, where in the UK, inflation is eroding the value of cash at 3% a year. The obvious answer is to buy high yielding equities. That way you get the dividend yield of the market and the capital growth from owning equities as well as the inflation beating increases in dividends over the years. The ever popular Equity Income Sector is testament to the appeal of the concept to investors. However, the logic is deeply flawed.

Most market aphorisms are rubbish. This one though has the ring of veracity to it.

“Any share yielding 10% isn’t yielding 10%”

The market has priced the shares to yield that because, collectively, the corpus of knowledge about it indicates that the dividend is not sustainable.

While that may be an extreme example it does tell us that any stock that offers a yield in excess of the current market yield of 3%, for the FTSE 350, is regarded as likely either to cut its dividend or grow it more slowly than its peers.

The logic is brutal, but equity income funds cannot offer high income and capital growth. At best they can do one or the other and, at worst, they might not deliver either.

Consider this. The current constituents of the FTSE 350, excluding investment trusts, are forecast to pay out £68 billion in dividends next year. At the current valuation of £1,850 billion that indicates the market has a prospective yield of 3.7%. If we exclude the possibility of polluting this universe of 300 stocks by including foreign shares and bonds, as many equity income funds do, how could we increase the yield from this collection of stocks? Any pure UK equity fund has to, and can only, draw from this universe. The index can therefore be viewed as one large fund.

The first thing to point out is that the income from this group cannot be increased. That figure of £68 billion is derived by aggregating all the forecasts from all the analysts covering this universe. That is not to say it will be right, but it is the best estimate from the available data.

So if the income cannot be increased the only way to increase the yield is to reduce the amount of capital needed to buy that income. Instead of paying £1,850 billion to buy £68 billion of income we can try and get the same income for less money. The obvious first step is to eliminate all shares that are not forecast to pay a dividend. In total these 75 shares are worth £74 billion. So removing these shares reduces the cost to £1,776 billion and increases the yield to 3.8%. That is hardly much of an improvement, especially when it removes shares like Cairn Energy that could potentially be significant dividend payers in the future. So the lower price comes with a risk that the smaller universe may not grow as much in the future as the untainted original.

To make a significant increase in the yield of a fund replicating the FTSE 350 it is clear that the only way to do it is to reduce the capital by more than the income. In other words reduce the size of the portfolio so that the capital is, say, 10% smaller but the income is only 5% less. Taking the argument to its logical conclusion you would end up trimming all low yielding stocks until you were eventually reduced to one super high yielding share. All very well except for the massive risk of a BP, Royal Bank Of Scotland (LON:RBS), HBOS type event and seeing the dividend cut.

It is clear from this mental exercise in taking the argument to its extreme that there is a simple trade-off between income and risk. Sure, you can increase yield, in the short term, but at the expense of potentially missing out on future dividend increases and long term capital growth. The smaller the subset of the universe you choose the higher risk of your capital underperforming the index.

While the market might not be 100% efficient it is pretty good at getting the bulk of it right; eventually. Trying to get more of that return through income and assuming high yield stocks are mispriced is a recipe for disappointment in the long term. Dividends can only be increased if the company grows at least as fast as the payout, if not more rapidly. The converse of that, to have rising dividends from an unchanged capital base, would lead to the ridiculous situation of small stocks with massive yields.

In reality the only benchmark for an equity fund is the total return of the index. The category of equity income is a nonsensical and should be relabelled as a multi-asset category, such as cautious growth, to allow it to include bonds.

The equity income label for funds is misleading. The IMA should bury it.


Filed Under: Value Investing,

About the Author's Fund Management

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VT Maven Smart Dividend UK Fund

The VT Maven Smart Dividend UK Fund, formerly The Munro Dividend Fund seeks to buy the UK market in proportion to the forecast dividend of its constituents and in this way provide the returns of the asset class at lower volatility. ...read more or visit website »


Disclaimer:  

Past performance is not a guide to future returns. The value of investments and the income from them may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. For risks relating to specific products, please refer to the relevant documentation for that product.


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34 Comments on this Article show/hide all

ChristopheBassons 19th Jan '11 1 of 34
6

Sorry, most of this is pure conjecture without any basis in reality. This is the crux of the issue:

"The market has priced the shares to yield that because, collectively, the corpus of knowledge about it indicates that the dividend is not sustainable.

While that may be an extreme example it does tell us that any stock that offers a yield in excess of the current market yield of 3%, for the FTSE 350, is regarded as likely either to cut its dividend or grow it more slowly than its peers."

When I hear "corpus of knowledge" and "regarded [by the market]" I think straight away herding and under/overshooting. Yes, a numberof poor companies with unsustainable payouts will have (justifiable) high yields. The key question is, however, in aggregate will market opinion on those companies be likely to be wrong or right? The likelihood is that the market will tend to be overly pessimistic and overpay for the good prospsects.

Couple this to a number of sound reasons why dividend payers might be fundamentally better investments: dividend payment forces a sharp focus on positive cashflow; managers are poor allocators of capital, because they're incentivised by things other than pursuit of profit; non-profitable/non-cash-generative companies are filtered out.

It's been a while since I read the book, but what about Dreman's studies?

McEssex, have I got confused by something too? Aren't you involved in a high-income fund? Aren't you undermining the own investment rationale behind that fund?

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McEssex 20th Jan '11 2 of 34
1

The rationale of the fund I run is based around dividend income, not yield.

Taking share price out of the construction process gives a very different picture of the market.

The highest yielding share is not the same company that pays out the most in dividends.

Fund Management: VT Maven Smart Dividend UK Fund
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emptyend 20th Jan '11 3 of 34
2

In reply to McEssex, post #2


The highest yielding share is not the same company that pays out the most in dividends.

Would you care to expand on that?

If you have £1000 to invest amongst companies that pay £40, £50 or £60 per year (per thousand), then the one with the highest yield is the one that pays the highest dividend. Under what circumstances is that not true?

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marben100 20th Jan '11 4 of 34
2

In reply to emptyend, post #3

Must admit, I think the original article could be rather confusing.

Without wishing to pre-empt him, I think the point McEssex is trying to make is that quoted yields don't necessarily represent likely future yields (even where the quoted yields are forward ones, estimated by the "herd" of analysts).. So, some stocks with high quoted yields won't necessarily be the highest payers in the future.

AIUI the thrust of McEssex's article is aimed at high yielding funds with simplistic strategies.

Now that I am focussing a proportion of my portfolio on an income generating strategy, I do find that quite a few of the "high yielding" stocks I look at are heavily indebted/geared, which does ring alarm bells for me. However, there are others, like Royal Dutch Shell B (LON:RDSB) and Glaxosmithkline (LON:GSK) where I feel pretty comfortable that the divvy is likely to be at least maintained going forward (barring unforeseen shocks - the Avandia payout looks like a blip to me, rather than anything with major long-term implications).

It is a bit of minefield and, IMO and IME, simplistic strategies don't work. When looking for income, you have to judge the likely sustainability of what's on offer on a case-by-case basis.

 

Speaking of GSK, I found this analyst comment posted this morning rather amusing:

0803 GMT [Dow Jones] Societe Generale downgrades European healthcare to underweight from neutral, to finance its move last week to upgrade banks to overweight. "Given attractive valuation, we are not expecting outright declines in pharma names but see a number of reasons why they should underperform in the next few months." Notes a lack of cyclicality and dollar exposure, and says growth is weak but margin expectations are high. Says margin expansion will be difficult to achieve, given that governments - which remain major buyers of drugs - recently voted healthcare reforms which exert pressure on pricing. At the same time, EPS growth will be limited by a weak drug pipeline and by upcoming patent expiries, the so-called 'patent cliff,' adds SocGen.

I.E. switch from something with a relatively transparent and pretty safe yield but unexciting growth prospects (debatable) to something with (IMO) crazy risks!

The consequent price fall offers a good buying opportunity to those sharing my views and seeking income.

Cheers,

Mark

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emptyend 20th Jan '11 5 of 34
2

In reply to marben100, post #4

Without wishing to pre-empt him, I think the point McEssex is trying to make is that quoted yields don't necessarily represent likely future yields (even where the quoted yields are forward ones, estimated by the "herd" of analysts).. So, some stocks with high quoted yields won't necessarily be the highest payers in the future.

Obviously I'm entirely happy with things put like that - but that certainly WASN'T what McEssex was trying to say.....unless his ability to use language has taken an unprecedented dip!

As you know, I spent a long while elsewhere a few years back trying to alert others to the folly of jumping blindly into LLOY simply because it had a historic yield of 8% (or whatever the figure was). Even those who didn't understand the point at the time certainly understand it now!

rgds

ee

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McEssex 21st Jan '11 6 of 34
2

Perhaps this will help.

HSBC is forecast to pay out £5 billion in dividends next year making it the largest dividend payer in the UK market.

However, its current yield of 3.2% is nowhere near the the highest yielding stock in the FTSE 350.

Does that make sense?

Fund Management: VT Maven Smart Dividend UK Fund
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peterg 21st Jan '11 7 of 34
2

In reply to McEssex, post #2

The rationale of the fund I run is based around dividend income, not yield.

Taking share price out of the construction process gives a very different picture of the market.

The highest yielding share is not the same company that pays out the most in dividends.

Hi McE,

I'm afraid that your clarification about HSBC and the amount they will pay out leaves me just as confused. Are you saying that you select stocks on the basis of total dividends paid without consideration of market cap, number of shares in issue or share price? On that basis you will always pick HSBC, BP etc simply because they are vast, so in reality all you would be doing is selecting the largest mcap stocks in the index, provided they pay out at least something in dividends. It may work, but the rationale is not clear.

Peter

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McEssex 21st Jan '11 8 of 34
1

'm afraid that your clarification about HSBC and the amount they will pay out leaves me just as confused. Are you saying that you select stocks on the basis of total dividends paid without consideration of market cap, number of shares in issue or share price? On that basis you will always pick HSBC, BP etc simply because they are vast, so in reality all you would be doing is selecting the largest mcap stocks in the index, provided they pay out at least something in dividends. It may work, but the rationale is not clear.

No, you are not confused, that is exactly what we do. We ignore valuations to construct the model and then populate the fund according to the model.

So if 7% of the income of the market comes from Vodafone Group (LON:VOD) the fund puts 7% into it regardless of price. If the stock goes up the next day, and the market doesn't so its position rises to 7.5% we trim it back and lock in the gain.

So, yes the fund is overweight the megacaps.

Fund Management: VT Maven Smart Dividend UK Fund
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snaj 21st Jan '11 9 of 34
1

Surely the stock price going up the next day relative to the market is irrelevant to it's contribution to total market dividends, so why would you trim it?

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McEssex 21st Jan '11 10 of 34
1

Surely the stock price going up the next day relative to the market is irrelevant to it's contribution to total market dividends, so why would you trim it?

To keep the fund in line with the model and manage risk.

If the model says hold 7% of HSBC (LON:HSBA) then the fund should hold that amount all the time. Not just when you construct it.

Otherwise you get unbalanced and risk a bigger loss if the stock suddenly corrects.

Fund Management: VT Maven Smart Dividend UK Fund
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dodge1664 21st Jan '11 11 of 34
1


Whilst I accept that the aims of equity income funds might lead to some confusion, I don't agree with some of the points made in the article.

Firstly, there is the assumption that the market is close to being 100% efficient at least over the long term. On the other hand numerous studies have shown that the total return on a sufficiently large portfolio of high yielding stocks tends to beat the market by a significant margin over the long run. Perhaps those studies produced freak results, perhaps not, no one can say for sure. But there are good reasons why it might be true, and some of those were covered by another poster above. Its just a form a value investing after all. Certainly those results cannot just be ignored.

Secondly, even if you accept that the market is more or less efficient, an equity income fund could plausibly offer an above market yield plus at least some capital growth. The total return might end up being less than the whole market, but then that wasn't what was promised. An investor might even be happier with that result if the volatility of returns is lower.

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hannibal 21st Jan '11 12 of 34
10

Not too interested in the specifics of the article. Though even at a cursory glance it represents the top down logic of academics and economists, who squeeze reality to fit the way they have framed an issue, as opposed to changing their frame to fit reality. These same people will tell you that Warren Buffet is just lucky: that it is impossible to beat the market consistently no matter how hard you research, and that share prices follow a random walk.

Importantly, I agree with ChristopheBassons: not only are managers poor allocators of capital, they are often hopeless alocators of capital.

Though I have no data at hand, I beleive it is well known that the dividend payout ratios of privatley owned companies far exceed those of listed companies. In fact, if you study the cashflows of major blue and mid caps, you will find companies with owner earnings sufficient to easily support yeilds of 10% after capital expenditure and retentions for cyclical downturns.

There is also a cultural explanation: we have come to accept 3% dividends on companies generating 20% ROE and willingly allow them to go empire building at our expense. As an aside, any large cap that goes on a buying spree is admitting that it can no longer generate a high enougth return through its own operations. How much less the waste in capital if all such imperialists simply returned the cash to their shareholders and let them decide what to do with it.

It is also interesting that in say Dubai, where shareholders are known to forcefully harrang management at AGMs about dividends, there are much higher payouts: their market average yeild is 9%! Obviously, double taxation on dividend income doesn't help - how criminal that profits that have already had corporation tax deducted must then be subjected to taxation at the personal level!!!!!!!!!!! Trully criminal!!!!!!!!!!!

As a contemporary example, consider EasyJet: its managers speak the language of growth, 'we have the biggest route network in Europe' they say. So important is growth, that they will commence low margin routes just to improve their growth figures. Their famous, vocal and largest stake holder (though unfortunately for him not controlling) understandably has very different priorities.

As a counterexample Ryan Air - where management own 10% of the company - has just paid a whopping 10% one-off dividend and looks likely to offer simmilar large cash returns in future. Good capital allocators? Hell no, nobody throws their own money way do they?

Buy a company with one dominant shareholder and you will almost certainly get screwed . Buy into a company with a dominant but not controlling stakeholder and you can be certain they won't  be complacent about how their precious cash gets spent.

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Daytona 24th Jan '11 13 of 34
2

Rob, how do you explain the difference between the theory and the reality as demonstrated in the following research precised in Tweedy Brown's - The High Dividend Yield Return Advantage -

"In a later paper, entitled Taxes, Dividend Yields and Returns in the UK Equity Market, Journal of
Banking & Finance (1998), Gareth Morgan and Stephen Thomas of the University of
Southampton also found a return premium associated with higher dividend yield securities, but their
data rejected a tax-based explanation since in the UK dividend income is taxed more favorably than
capital gains. Using data from the London Share Price Database (LSPD), they examined the
relationship between dividend yields and stock returns from 1975 through 1993 in the UK.
Database companies were ranked by dividend yield at the end of each month and divided into six
groups, including a zero dividend group (companies that did not pay dividends). In the table below
from page 12 of their study, Messrs. Morgan and Thomas find a strong correlation between the size
of the dividend yield and the average monthly return."

"In a paper entitled Stock Market Anomalies: A Reassessment Based on the U.K. Evidence, Journal of
Banking and Finance, December 1989, Professor Mario Levis, at The School of Management,
University of Bath, United Kingdom, examined a number of anomalies in stock price behavior of
firms on the London Stock Exchange, including the correlation between dividend yield and
investment returns. In a subsequent paper, entitled Market Anomalies: A Mirage or a Bona Fide Way to
Enhance Returns?, Michael Lenhoff of CapelCure Myers Capital Management, used data largely
derived from Professor Levis’ study to illustrate a strong positive relationship between dividend yield
and attractive rates of return. Using a sample of 4,413 companies, all of which were listed on the
London Stock Exchange during January 1955 through December 1988, Lenhoff ranked these listed
companies each year according to dividend yield and sorted the companies into deciles. The 34-year
compounded annual investment returns and cumulative values of an assumed ₤1 million initial
investment in each of the ten groups is shown in the following table, along with descriptive
information concerning each group’s average dividend yield and market capitalization.
In his study, there was almost a perfect correlation in the decile returns between higher
dividend yields and higher annualized returns. The top decile, in terms of high yield, produced an
average annualized return over 34 years of 19.3% versus 13.0% for the Financial Times Actuaries All
Share Index."

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emptyend 25th Jan '11 14 of 34
4

I'm afraid that your clarification about HSBC and the amount they will pay out leaves me just as confused. Are you saying that you select stocks on the basis of total dividends paid without consideration of market cap, number of shares in issue or share price? On that basis you will always pick HSBC, BP etc simply because they are vast, so in reality all you would be doing is selecting the largest mcap stocks in the index, provided they pay out at least something in dividends. It may work, but the rationale is not clear.

No, you are not confused, that is exactly what we do. We ignore valuations to construct the model and then populate the fund according to the model.

So all you are doing is weighting the fund with reference to total dividends rather than (the more normal) weighting by market cap.

Why didn't you say so?

The reference to "dividend income" in your earlier post was misleading - because the phrase is only meaningful if based on a particular amount of capital.  What you mean is the "gross dividend payout", and not "dividend income" or yield.

ee

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About McEssex

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Rob Davies is the Fund Manager of VT Maven Smart Dividedn UK Fund, formerly The Munro Fund.. He worked as a professional geologist in Antarctica and Australia before joining the City as a mining analyst. During his 15 years he worked for a number of brokers and investment banks including Smith New Court, Shearson Lehman Hutton and ING Barings. He was a speaker at the Financial Times Gold Conference in 1997 and worked on a number of capital market transactions in the mining industry. From 1999 to 2001 he was a writer at The Motley Fool and co-wrote “The Old Fools Guide to Retirement”. In 2002 he joined the Private Client Department of Clydesdale Bank as Senior Investment Analyst where he was responsible for writing and maintaining investment policy, selecting securities and portfolio creation until the department was sold in 2006. His experience of the stock market as an equity research analyst, personal finance writer and portfolio construction manager has given him a unique background to draw on in crafting this investment process which he now runs at VT Maven Smart Dividend UK Fund, previously known as The Munro Fund. more »


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