What caught my eye this week.

I have a soft spot for income investing. I haven’t actually (naughtily, actively) invested with a focus on income since the financial crisis, though.

(Why not? That’s a whole other story.)

I still expect to live off investment income when I’ve had enough of spinning the wheel on my net worth (and of work, of course). But it’s been more than a decade since replacing my salary with the readies from a growing collection of income-producing assets guided my portfolio.

Thinking back, when I began investing I feel it was the aim of most serious private investors I came across to someday live off dividends, bond coupons, interest on cash, and perhaps a buy-to-let or two.

But that’s not the case any longer.

Obviously, the utter squashing of fixed income yield hasn’t done income investing any favours, although those who owned such inflating assets enjoyed a lucrative ride on the way to today’s miserly yields. And interest on cash is a bygone luxury.

More recently dividends have gotten the chop. It all adds up!

But I believe wider cultural influences are at work beyond the numbers.

Imported Americana

When my co-blogger The Accumulator began talking about his planned drawdown strategy – to sell a certain amount of capital every year, with the aim of running it down to near-zero by death – it sounded foreign to me.

And I mean that very specifically.

I was familiar with such strategies – although newer investors would be shocked how rarely you heard terms like ‘safe withdrawal rate’ 20 years ago.

But to me the plan sounded American. I associated it with the American market, which taught different lessons from those I picked up from the curmudgeonly band of 30- and 40-something dotcom bust survivors who frequented the UK investing landscape at the turn of this century.

In contrast The Accumulator was schooled by Bogleheads at the Temple of Vanguard. I sensed he found my income-fantasies atavistic.

I believe he’s made his peace with the concept – writing numerous articles on the intricacies of the safe withdrawal rate will show anyone that all strategies come with their own mental and practical fudges – but he still definitely wouldn’t advise it.

To him, income-investing as a drawdown strategy is at best a retirement hobby for rich people. Like raising alpacas.

You say milllionaire, I say million-a-year

The US market hasn’t yielded much by the way of income for many years. I always assumed that was the main reason for the disinterest in income.

There are big tax disadvantages to dividends in the US, too, although this is also true in the UK nowadays outside of ISAs and SIPPS.

But I was interested to read a post on The Rational Walk blog suggesting there were deeper cultural habits at work, too. Only this author is American, looking in the UK’s direction:

I find the British manner of thinking about wealth much more satisfactory for several reasons that are worth exploring in greater depth.

He believes we still focus on income. The following section from a famous investing book, Where Are The Customer’s Yachts, is fingered for this trans-Atlantic supposition…

Have you ever noticed that when you ask a Britisher about a man’s wealth you get an answer quite different from that an American gives you?

The American says, “I wouldn’t be surprised if he’s worth close to a million dollars.”

The Englishman says, “I fancy he has five thousand pounds a year.”

The Englishman’s habitual way of speaking and thinking about wealth is of course much closer to the nub of the matter.

A man’s true wealth is his income, not his bank balance.

…which does indeed sound familiar, but only to those who’ve read the likes of P.G. Wodehouse, Somerset Maugham and their contemporaries, not to today’s British investing forums.

Because as dedicated investing nerds all know, author Fred Schwed published Where Are The Customer’s Yachts in 1940!

It’s still a timeless read, mind you. Even if I think that this British/American distinction is more dated than many of its other observations. (It’s funny, too, so check it out if you’ve never had the pleasure.)

Also be sure to read that Rational Walk post: What’s Your Magic Number?

Who knows? You might just find some of your native income-seeking spirit rekindled, after all!

Have a great weekend.

[continue reading…]

Anyone cited by Warren Buffett as a super-investor is worth knowing more about. Walter Schloss is one such man.

Walter Schloss was born in 1916. He began working on Wall Street at aged 18, while the stock market was still recovering from the Great Crash.

Schloss took investing classes from Benjamin Graham, who also taught Warren Buffett. He went on to work for Graham’s fund (where he met Buffett) before setting up his own partnership in 1955.

Schloss was an excellent investor:

• His fund achieved an average compound return of 15.5% a year until he closed it in 2000.

• The S&P 500 returned 10% a year over the same period.

If you had been able to invest $10,000 in the S&P 500 in 1955, then by 2000 you’d have had:

• $729,000

Not bad – but $10,000 given to Walter Schloss in 1955 would have grown to:

• $5,388,000

Nice returns if you can get them!

How Walter Schloss managed money

Most super-successful investors must change their tactics as their funds get larger. Schloss invested for fewer than 100 clients. He was therefore able to invest in small companies and special situations throughout his career.

His investing style was pure Benjamin Graham. In Warren Buffett’s 1984 essay, The Superinvestors of Graham and Doddsville, Buffett wrote:

Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again.

He owns many more stocks than I do — and is far less interested in the underlying nature of the business.

I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.

By age 80, Schloss hadn’t changed much, according to Buffett’s biography, The Snowball:

Walter Schloss still lived in a tiny apartment and picked stocks the same way he’d always done.

A few chapters on we find Schloss playing tennis at 90. That definitely qualifies him for the Great Old Investor club!

The rules of Walter Schloss

If you’d like to follow in the footsteps of Walter Schloss – to try to beat the market rather than ‘merely’ tracking it – then you’ll want to know how he invested.

As a pupil of Benjamin Graham and a fellow traveller of Warren Buffett, Schloss was obviously a value investor. Your first port of call should therefore be Ben Graham’s The Intelligent Investor.

Like all investors who do achieve the very difficult – but not impossible – and beat the market, Walter Schloss had his own quirks though.

In 1994 Schloss typed them up onto a single sheet of paper. No book, no speaking tour – just 16 bullet point guidelines.

And here they are, near-verbatim.

Factors needed to make money in the stock market: Walter Schloss

1. Price is the most important factor to use in relation to value.
2. Try to establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper.
3. Use the book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity. (Capital and surplus for the common stock).
4. Have patience. Stocks don’t go up immediately.
5. Don’t buy on tips or for a quick move. Let the professionals do that, if they can. Don’t sell on bad news.
6. Don’t be afraid to be a loner but be sure you are correct in your judgement. You can’t be 100% certain but try to look for weaknesses in your thinking. Buy on a scale and sell on a scale up.
7. Have the courage of your convictions once you have made a decision.
8. Have a philosophy of investment and try to follow it. The above is a way that I’ve found successful.
9. Don’t be in too much of a hurry to sell. If the stock reaches a price that you think is a fair one, then you can sell but often because a stock a goes up say 50%, people say sell it and button up your profit. Before selling try to reevaluate the company again and see where the stock sells in relation to its book value. Be aware of the level of the stock market. Are yields low and P-E ratios high? Is the stock market historically high? Are people very optimistic etc?
10. When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think it attractive. Three years before the stock sold at 20 which shows there is some vulnerability to it.
11. Try to buy assets at a discount [rather] than to buy earnings. Earnings can change dramatically in a short time. Usually assets change slowly. One has to know much more about a company if one buys earnings.
12. Listen to suggestions from people you respect. This doesn’t mean you have to accept them. Remember it’s your money and generally it is harder to keep money than to make it. Once you lose a lot of money it is hard to make it back.
13. Try not to let your emotions affect your judgement. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.
14. Remember the work of compounding. For example, if you can make 12% a year and reinvest the money back you will double your money in six years, taxes excluded. Remember the rule of 72. Your rate of return [divided] into 72 will tell you the number of years to double your money.
15. Prefer stocks over bonds. Bonds will limit your gains and inflation will limit your purchasing power.
16. Be careful of leverage. It can go against you.

Sounds straightforward, doesn’t it?

It’s not! The alchemy of super-rare successful active investing is simple but not easy.

That’s why Schloss’ rules have aged so well. I’d say rule three – to favour book value as a foundation of value – is the only one that’s (arguably) out of date.

Modern companies’ greatest strengths are often intangible assets that aren’t accurately reflected by book value. Think of today’s technology giants, for instance.

Perhaps Schloss would just ignore those. There are still plenty of companies where old-school value investing metrics are relevant. If you’re turning over thousands of stones looking for a few gems – and trading your portfolio rather than aiming to buy and hold the next Microsoft – then valuing hyper-growth tech firms is someone else’s problem.

According to Smart Money, Walter Schloss was still running his own portfolio as of April 2009, aged 95. Schloss passed away on 19 February 2012.

Would you pay a bank to store your money in their laser-guarded vaults? Ideally not, but that’s the reality for some as negative interest rates have spread from Japan to take hold in Europe – and now lap the shores of the UK.

What are negative interest rates?

Negative interest rates mean that a central bank has cut one of its main interest rates below 0%. Instead of the central bank paying interest to commercial banks, the relationship is turned upside down and now those banks must pay a charge to keep their cash on deposit. The idea is to force commercial banks to loan out money and stimulate the wider economy instead of hoarding cash when a major recession looms.

When faced with negative rates, a bank is theoretically better off making even a 0% loan rather than losing money on cash stashed with the central bank.

Needless to say, negative interest rates are a bad sign – a desperate call for all-hands on the money pump when the economy looks like an extra from Dawn Of The Dead.

Negative interest rate policy (NIRP) has also been used by central banks to weaken demand for their currencies in a bid to protect their country’s export industries.

Countries with negative interest rates

Countries with negative interest rates include:

• Switzerland: -0.75% (SNB Policy Rate)
• Denmark: -0.6% (Nationalbanken CD rate)
• Eurozone countries: -0.5% (ECB Deposit Facility Rate)
• Japan: -0.1%

The Danes went below zero in 2012 (they hit a low of -0.75), the Eurozone in 2014, and Japan in 2016. The Swedish central bank rate also went negative in 2015 and dipped as low as -0.5%. But the Swedes had tunneled back up to zero by January 2020.

The main central bank interest rate in the UK is the Bank Of England’s Bank Rate (or Base Rate).

Bank Rate currently clings on to positive territory at 0.1%.

What do negative interest rates mean for savings accounts?

The great fear with negative rates is that you’ll have to pay your bank to park cash with them. That would erode the value of your savings as surely as water wears down soap. You could be better off stuffing your cash into the proverbial mattress.

And indeed this appears to have happened.

There are reports of German customers putting physical notes in home safes and bank vaults as an alternative to paying charges on deposits of more than €100,000. Physical storage spares customers the charge they’d incur if their money was lodged with the ECB.

Multiple Swiss banks also started charging high net worth customers a 0.75% fee on saving balances over two million Swiss Francs (CHF). That means it’d cost you 7,500 CHF per year for the pleasure of saving three million CHF in your account (tiny violins).

As you can imagine, business customers are hit by this, too. It’s hard for a law-abiding small business to make their cash magically disappear.

A case for cash? Negative interest rates would be easier to impose more widely on a cashless society because its citizens wouldn’t have the option to divert notes from the maw of a negative rate account to a box in their basement instead. Could the spectre of negative interest slow down the adoption of payment apps? At least we wouldn’t have to worry so much about grandad not being able to buy groceries because he never remembers to charge the smartphone he doesn’t know he has.

Imposing negative interest rates on wider swathes of society isn’t inevitable and is highly charged politically. The outcry in the UK would likely reverberate like the death of Alderaan if we’re ever stung for a percentage of our savings. And imagine the headlines the first time a pensioner’s biscuit tin was stolen – their life savings gone because of some banker’s negative interest rates.

It’s possible for central banks to shield consumers from the pain of sub-zero rates. For example, the ECB doesn’t charge on the first-tier of a bank’s deposits.

The local banking market also matters. Do banks rely on deposits as their chief source of funding? Is there a competitive market that empowers people to switch banks in a mad hunt for a few tenths of a percent of interest? If so banks could be reluctant to put off their customers with negative rates.

Even without negative rates in the UK, savings rates have been slashed as Bank Rate has sunk to just 0.1%.

It’s not hard to imagine a world in which savings earn nothing.

Negative interest rates: mortgages

What about mortgages? The dream is a bank would pay you to take its money, you’d buy a Scottish Castle, never pay a penny back, and the debt would melt like a snowman.

But that’s probably not going to happen.

There were some excitable reports that the Danish Jyske Bank had offered the world’s first negative interest rate mortgage. But the less exciting reality was that customers were still paying the bank after it had slapped on various fees.

A few lucky punters thought they’d hit the negative interest mortgage jackpot in the UK in 2009.

They were on two-year tracker mortgages that offered the Bank Rate minus a slice¹. But the banks never did pop them a cheque in the post. Instead those blessed borrowers got a 0% interest rate for a short while – which is still free money. On a house!

After that fright, the banks tightened up the small print so that they will never pay you to borrow. Many inserted ‘collars’ that mean your mortgage rate won’t fall below a certain level.

Still, as with saving accounts, you can expect negative interest rates to push mortgage rates downwards. Which sounds great until we start fretting about potential unintended consequences:

• Reduced mortgage competition and choice because lending is less profitable for banks near-zero.

• House price inflation as happy borrowers go large in the face of historically low rates.

• House prices collapse if interest rates rebound and the once-happy borrowers go bust.

Negative interest rates: negative consequences

The concern has always been that once you start experimenting with NIRP psychedelics you can’t go back to the old normal.

It’s not hard to find authors of articles from the 1990s poking fun at Japanese zero rates like they were Chris Tarrant sneering at the gameshow Endurance.

And yet here we are, with near-zero rates abounding.

As sci-fi author William Gibson once said: “The future is already here – it’s just not evenly distributed.”

It’s easy to understand why central banks have slashed rates around the world.

Their first priority is to stop a biblical recession that would make even Friedrich Hayek blush.

But beyond that, the discourse is ablaze as to whether the habitual use of negative rates is good for anything apart from maiming banks, jeopardising pensions, and distorting markets.

Nobody knows for sure – the experiment is still coursing through our system – but here’s a potted tour of sub-zero anxieties:

Reverse psychology

Negative interest rates are widely seen as ‘weird’. They unsettle people and seemingly spooked some consumers and corporates in Japan because they believed that such extreme measures signalled that the Bank of Japan knew something awful was coming.

Hobbling the banking system

The Bank of England reportedly rejected negative rates during the Global Financial Crisis because it feared they would push tottering banks and building societies into bankruptcy. As if things weren’t bad enough.

Negative interest rates narrow bank profit margins, which could ironically reduce their capacity and willingness to lend.

One of the lessons of the financial crisis is that we like our banks to be safe and boring. You know – the kind of stuffy old prudentials that maintained massive cash buffers because they’d only lend you money if you were an earl or married to the bank manager’s daughter.

Another sub-zero misgiving then is that negative rates could erode the very cash buffers that are meant to safeguard the system in times of financial stress.

Stymied stimulus

If negative rates squeeze banks’ profit margins to the extent they rein in their lending to consumers and businesses, then would-be easy money policy has gone from stimulating growth to strangling it. Financial nerds call this the ‘reversal rate’. (Because what’s a bit more interest rate jargon when we’re having fun? Or a depression?)

Mis-selling scandals

It’s been a while since we’ve heard about our friendly local bank forcing its staff to adopt the kind of high-pressure sales tactics that belong in a boiler room.

Flog a loan, a structured bond, a credit card (would you like PPI with that?) – anything so long as the boss got his bonus.

But the rush to get money off the books in sub-zero Denmark has been blamed for banks pushing risky products onto unsuspecting customers. The regulator called in the police to investigate Danske Bank over the affair.

So much for hygge.

Delinquent debt

We won’t be paid to swipe our credit cards, buy a Tesla on HP, or to live in our dream house, but negative interest rates are at least meant to make it easier to get the loans to do such things. Reckless lending in NIRP world isn’t so much a moral hazard as a patriotic duty. But the risk of burying the system under a collapsing Jenga tower of bad debt is obvious.

Asset price bubbles

Another source of disquiet since the financial crisis is that easy money just flows straight through our fingers and into assets like equities.² Instead of stimulating the real economy, the money might exacerbate income inequality, prop up zombie companies, and turn the stock market into a giant Ponzi scheme. Such accusations remain unproven but the dread is only amplified by negative interest rates.

Unfair on savers and pensioners

The effect of negative rates spills over onto savings, bonds, and annuities, with painful implications for those who rely on low-risk returns to maintain their standard of living.

The ECB had to change the rules to prevent Dutch pension funds cutting their payouts, for example, while Swedish insurers have apparently increased their exposure to equity markets in a titanic reach for yield.

Stretching for yield on a personal level is an obvious threat as retirees head into riskier asset classes in a bid for return – think junk bonds, emerging market debt, volatile risk factors, and, god forbid, leveraged products. The danger of people getting in over their heads and panicking if it goes wrong is clear and present.

Currency war

Most of the central banks who’ve gone negative have done so in part to devalue their currency and increase the competitiveness of their export industries. If other central banks choose to tit-for-tat then we could end up in a beggar-thy-neighbour spiral. That didn’t turn out so well in the 1930s.

Does it even work?

The general narrative is that negative interest rates seem to work in the short-term to ward off deflation and stimulate the economy.

But many argue that sub-zero is addictive and doesn’t facilitate recovery in the long-term.

Only Denmark popped its head back above the zero bound for a few months in 2014 before going back under. Sweden made it back to zero in the first few months of 2020 and then the coronavirus hit.

Negative interest rates: UK

Most of the dangers listed above were contaminating our financial system long before NIRP. I make no claim to know whether they are really exacerbated by negative interest rates.

Perhaps there wasn’t much choice anyway, but everything I’ve read on the subject suggests you wouldn’t want to start from here.

So do we face the same negative rate future in the UK?

All we have to go on are the gnomic utterances of Bank of England officials. Former governor Mark Carney took sub-zero rates off the table, only for new guv Andrew Bailey to put them firmly back on the table again.

Bailey didn’t sound keen though when he told MPs:

We do not rule things out, as a matter of principle. That would be a foolish thing to do. But that doesn’t mean we rule things in either.

An alternative to negative interest rates is a Keynesian fiscal stimulus that spurs the economy through massive government spending. That looks like it’s actually happening, given borrowing is being thrown into overdrive courtesy of that arch-Keynesian Boris Johnson.

Truly we live in Bizarro World.

Negative interest rates: bonds and real yields

The negative interest rates imposed by your smiley bazooka-wielding central bank are not the same as the infamous negative bond yields reported in the financial press.

Bonds inflict a negative yield when their asking price outweighs any remaining interest payments, so that investors suffer a loss on the bond if they hold it to maturity.

Negative real yields occur when inflation is higher than nominal interest rates. For example, a 2% cash deposit pays a real yield of minus 1%, if inflation is 3%. The UK is no stranger to this.

Negative interest rates: key takeaways

• Negative interest rates happen when a central bank lowers one of its main interest rates (often the deposit rate) below zero.

• It’s an extreme monetary policy designed to force commercial banks to make cheap loans in order to avoid paying to deposit money at the central bank.

• Negative interest rates are believed to ward off deflation in the short term and to stimulate the economy. There may be negative side-effects in the long term.

Take it steady,

The Accumulator

1. A discount of -1.01% was offered by Cheltenham & Gloucester at the peak of the 2007 mortgage madness [↩]
2. Note from The Investor: Much QE money never actually goes into the real economy to touch our grubby hands at all, but nevertheless by flattening the yield curve it does drive investors into riskier assets – such as shares – which amounts to the same thing. [↩]