On my own blog, YMB, we’ve been getting steadily more interested in the concept of investing for millennials who have saved up a bit but feel frustrated by the returns on their savings accounts. My New Year’s resolution for the Financial Times was to start investing this year and I have made a start – I can’t say where or how, because my picks might not suit you and I don’t want to “advise” y’all. But it’s panning out alright so far – miracle or miracles!
The big stumbling block that all young people face when starting out in investing is what the financial industry likes to ridiculously call “an asymmetry of knowledge”. This means, in a nutshell, that you’ve understandably been thinking about things other than macro-economics over the past 20 – 30 years and that now you’re interesting in investing, there are a whole bunch of options that may or may not work for you, but you lack the in-depth knowledge to really understand this landscape. Conversely, there are a legion of financial advisers and indeed so-called “robo-advisers” out there who have “The Knowledge” and who could advise you very well indeed, but equally some who will just shove you into a mediocre fund because that’s how their business is structured and make you pay hand over fist for the privilege.
The other big turn-off for would-be investors is the industry’s obsession with the future. What will markets do in the year ahead? Which five shares will shoot the lights out? What will the hot sectors be, and which ones may lag? I have to say, journalists are partly to blame; many try simply to educate the public so they can take their investments into their own hands, but others pore over the minutiae in a way that is seldom helpful for those trying to stay in markets for the long-term.
This obsession with the future is also, to some extent, one big irrelevance given the inherent unpredictability of the world we now live in. For instance, Barclays, Goldman Sachs and Morgan Stanley all predicted the FTSE-100 would close 2015 soaring above the 7000 mark – but by the end of 2016, the index had drooped to 6242. Over 90 per cent of investment company managers had wrongly predicted a rise. D’oh!
That sobered them and a year ago only 60% predicted a rise for 2016. Fast forward to today and the FTSE-100 has been having the most momentous run on record, smashing the 7000 ceiling for the first time. Against most expectations, a portfolio evenly split between stocks and government bonds last year would have returned 4.4% – not too shabby given everything that happened. And economists were gloomy even while predicting that we would remain in the EU and that Hillary Clinton would be pant-suiting her way around the White House at this very moment. Lord knows what they would have thought had they known what was to unfurl in the big ’16.
It just goes to show that commentators, driven as much by human sentiment (if not more) than economic fundamentals, have a tendency to overreact to past events – and get things wrong in the process.
So the big question that a young investor, starting out for the first time, is asking is…what should I really be looking for in my investments? Should I be handpicking shares or funds that I can buy, hold and sell up in a few years time? Or do I count on certain steady dividend-paying investments to give me an income that will surpass what I will earn in my bank account?
Unsurprisingly, investors of all ages tend to plump for option B once they see the lie of the land. Because it is so hard to pick the shares or funds that will do well – after all, past performance ain’t no guide to the future – investors understandably gravitate towards an income-generating portfolio of certain defensive shares that will help them top up their income. One fund manager recently told me that his investors actually rely on dividend-paying funds and shares to pay the leccy bills!
But that doesn’t mean income-generating funds and stocks are less impervious to the ups and downs of the market – far from it, actually. So while we should take what economists say with a pinch of salt, investors can’t abdicate all responsibility for their portfolios. Even if they choose fund managers, they still have an obligation to understand what the global background MIGHT mean for the key asset classes we all invest in through our portfolios: stocks, bonds and property.
Indeed, most young people should probably take at least a passing interest in this subject, given their workplace pensions (i.e. the money that will eventually pay for their chairlift, SAGA cruises and Viagra subscriptions) are invested in these key asset classes as well.
If your investment goals include producing some regular income, rather than being happy to wait for long-term capital growth, then dividends are your bread and butter. How have they done?
In the second quarter of 2016, in the run-up to the EU referendum, UK companies paid out a record £28.8bn in dividends. But the total was flattered by no fewer than 22 big blue-chip companies paying out one-off special dividends. The underlying trend was a 3% fall in normal pay-outs. The reason? The cash buffers of many of our key dividend-payers are running low, as shown in falling ratios of dividends to profits.
In the second half of this year, the Brexit vote came to the rescue (even if most young people don’t see it that way!). As the value of sterling crashed, dividends paid by the likes of Shell and BP soared in value by £2.5bn. These dividends, paid in dollars, translated into pumped-up levels in sterling. Even stripping out special dividends, payments were up 2.6%. But if you take away the currency effect, the outlook is not so rosy: dividends have continued to fall this year.
Why do dividends matter so much? Real returns from equities are always calculated with dividends reinvested, whereas the return for an index (like the FTSE-100) reflects only the capital growth (if any) as shown in the share price.
In the UK, the top 15 businesses pay three-fifths of all dividends. For long-term investors, it is dividend growth – not the current headline yield being paid – that really matters.
In 2016, fears intensified over weak operating performance and rising pension deficits among the UK’s largest companies. The cost of meeting distant pension promises has been ratcheted ever higher as gilt yields – the return on pension funds’ key assets – have slipped ever lower. The aggregate deficit of the FTSE-350 pension funds has soared to £150bn.
Almost all the uplift in dividend pay-outs this year has come from the sub-100 tier of businesses, the midcaps. In the third quarter, their payments rose by 4.9%, while the FTSE-100 blue-chips managed only 0.9%. The other big worry looking ahead is that special dividends are just that: one-offs which cannot be repeated the following year. Wealth managers are on red alert for ‘smokescreen’ windfalls, where companies are using low interest rates to pay out borrowed money to shareholders, rather than investing it or disbursing genuine surplus cash that a healthy business has built up.
Why do they do it? Because shareholders, in the shape of fund managers, are always pressing companies to maintain dividends. Aberdeen Asset Management is now reporting a whopping 6.8% yield – 3 percentage points over the FTSE 100 yield.
But the bottom line is that the so-called ‘search for yield’, the holy grail of investing in recent years, will become even more tricky. Firms which have continued to pay out generous dividends from an increasingly rocky base may be forced to backtrack and cut their pay-outs. And the timing could scarcely be worse given that inflation is projected to hit 3%, which will erode the value of our cash and put the onus on us to make our money work even harder.
Should companies start cutting their dividends en masse, this will affect their share prices and ripple across portfolios that are targeting capital growth. So it’s not a case of either/or. Portfolios need both dividends and capital growth to keep investors (broadly) happy.
So should the shaky outlook for dividends be keeping you awake at night? I’m not so sure. Much may depend on sentiment around Brexit and the value of sterling. A continuing low pound may be enough to paper over the dividend cracks for now. And there is a silver lining: businesses with strong balance sheets, pricing power and healthy cash-flows won’t just maintain dividends year-on-year, they’ll increase them.
Those businesses are out there – it’s down to clever fund managers and stock pickers to find them. Should they succeed, investors can expect both a steady income and reasonable capital growth from their portfolios in years to come – despite everything that’s going on in the world economy. And you have a decent shot of finding those opportunities if you diversify, hold your investments for the long-term and refuse to get caught up in the short-term upsets that are…well, just part of the deal, innit?
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