The following guest post is by Todd Wenning, author of Keeping Your Dividend Edge. Todd’s writing has often featured in our Weekend Reading links, and his excellent new book continues where his blog left off. For this article, Todd candidly admits what he got wrong with his investment in Tesco and considers the lessons we can learn.

Britain’s largest grocery chain, Tesco, was long considered a core holding of UK-based dividend investors. It was once one of mine, as well.

In its 2011 financial year for example, Tesco increased its dividend by 10.8% – marking an impressive 27 consecutive years of dividend increases.1

At the time, respected long-term investors like Neil Woodford and Warren Buffett held considerable positions in Tesco, suggesting the company passed their well-regarded filters.

In addition, Tesco’s UK market share was over 30% and its domestic dominance appeared safe.

More reasons to invest in Tesco

A further prong to my initial thesis on Tesco was that the company’s mistimed expansion in the US (known as Fresh & Easy) would eventually stabilize and rebound as the North American economy recovered – particularly in the Western US states where the stores were located.

I also thought Tesco’s investments in China would fuel earnings and dividend growth for years to come.

Finally, I believed the UK market would continue to produce plenty of cash flow to support international growth.

But the wheels began to fall off one at a time.

Tesco starts to tumble

My US turnaround thesis soon fell flat. In April 2013, Tesco announced it was exiting the US market and Fresh & Easy filed for bankruptcy protection. All of this resulted in over a billion dollars in trading losses and impairments.2

That in itself should have been a sign to sell. I rationalized, however, that with the Fresh & Easy chapter finally shut, Tesco could better focus on its other global operations.

Strike one.

Tesco also never figured out how to turn a steady profit in China. Ultimately, it entered into a joint venture with a large Chinese retailer who actually knew how to run a retail business in China. So much for the region fueling dividend growth!

Strike two.

With Tesco’s focus on its struggling international operations, it began losing ground to competitors in its home market. Indeed, a space race and pricing war simultaneously erupted between Tesco and other UK grocers like Sainsbury’s and Morrisons. Meanwhile discounters and higher-end specialized grocers alike feasted on the opposite ends of the pricing spectrum.

Even though Tesco seemed best-suited to survive this war of attrition, profit margins suffered. This put further strain on both free cash flow and earnings-based dividend cover.

In response, Tesco held its dividend flat starting with the interim dividend paid in December 2012. Then, in February 2014, it abandoned its long-held profit margin target in an effort to better defend its market position.3

Strike three.

Cut to the chase

While some warning signs were present – including that aforementioned long-time owner Neil Woodford bailing on Tesco in early 2012, and laying out a solid rationale for his exit – the combination of Tesco’s distinguished dividend track record, its vast real estate holdings, and its leading share of the UK grocery market seemed to me compelling reasons to hold and hope for a dividend turnaround.

Yet the numbers didn’t lie.

Tesco’s dividend health slowly worsened while its dividend yield steadily increased to more than twice the UK market average – usually a sign that something has gone wrong.

Prelude to the dividend cut: Tesco’s annual results

	2014	2013	2012	2011	2010
Free cash flow coverage	0.59	0.18	0.59	0.66	1.78
Earnings coverage	1.61	1.17	2.51	2.57	2.41
Dividend per share	14.76p	14.76p	14.76p	14.46p	13.05p
Interest coverage	5.89	4.92	6.65	6.10	4.77

Financial years ending February. Source: Company filings, Morningstar.com

It was only a matter of time before Tesco’s board needed to make some tough decisions, and in August 2014, Tesco announced it would cut its interim dividend by 75%.

A month later, it disclosed it had overstated its profit forecast for the year.4 In January 2015, Tesco canceled its dividend for the following fiscal year. 5

Lessons learned

This was truly a brutal end to what initially appeared to be a high-quality dividend investment. But in the spirit of learning from our mistakes, what lessons can we takeaway?

Management changes matter

When a very successful CEO retires or leaves a company for non-obvious reasons (e.g. he or she isn’t 65 or older and looking to retire, say), it’s time to reassess your investment thesis.

In June 2010, well-regarded Tesco CEO Terry Leahy, who during his 14-year tenure more than quadrupled Tesco’s sales and pre-tax profits, took many by surprise6 by announcing his retirement as of March 2011 at the still-young age of 55 and while the company still had a number of unfinished projects overseas.7

With the benefit of hindsight, this was an early red flag that changes were afoot and that all may not be well. Though a major management change in itself may not be a good reason to sell your position, an important change like this during a critical time should prompt you to monitor the company closely in the coming quarters for any signs of trouble.

Pay attention to dividend growth trends

The fact that Tesco slammed the brakes on its dividend growth rate after years of solid increases was a sign that management and the board were growing concerned about the underlying business.

Highly cyclical companies like materials, energy, and semiconductor companies may prudently hold their payouts flat for a year or two during a down cycle, but this generally shouldn’t happen at companies in more defensive industries like food retailing, consumer goods, or utilities.

When it does, something’s up.

Free cash flow can tell a different story to earnings cover

As the above table shows, Tesco’s dividend looked well covered by earnings, but it wasn’t covered by free cash flow. Instead, Tesco supported its dividend through real estate monetization (i.e. sale and leaseback arrangements and the like) and not by free cash flow generated through operations.

Put simply, that’s not a sustainable strategy. It took me too long to recognize the problem with my own investment in Tesco.

Bottom line: if the company isn’t covering its dividend with free cash flow, you at need to ask tough questions about how the company plans to afford its payout going forward.

Watch out for big capital investment misses

When companies make large investments that ultimately fail, it can cause the board to reevaluate its dividend policy. Tesco’s board may have, for instance, increased the dividend in prior years under the assumption that the investments in North America and China would work out.

A big swing and miss may also require the board to reprioritize cash flows to pay down debt incurred to fund the investments.

Todd is an equity analyst based in the US. His opinions here and in the book are his own and not those of his employer. Keeping Your Dividend Edge is available from Amazon, at a bargain £1.99 on Kindle or £9.99 in paperback.

1. Source: Tesco plc. 2011 Annual Report. http://www.tescoplc.com/files/pdf/reports/tesco_annual_report_2011.pdf [↩]
2. Source: Sonne, Paul and Evans, Peter. “The $1.6 Billion Grocery Flop: Tesco Poised to Quit U.S.” WSJ. December 6, 2012. http://www.wsj.com/articles/SB10001424127887324640104578160514192695162 [↩]
3. Source: Wood, Zoe. “Tesco Abandons Space Race and Invests Resources in New Price War.” The Guardian. February 25, 2014. http://www.theguardian.com/business/2014/feb/25/tesco-supermarket-price-cuts-profit-forecast [↩]
4. Source:Reed, Stanley. “Tesco Says It Overstated Profit Forecast.” NY Times. September 22, 2014. http://www.nytimes.com/2014/09/23/business/international/tesco-shares-slide-on-news-that-it-overstated-profit-guidance.html [↩]
5. Source: Tesco plc. “Trading Statement for 19 Weeks Ended 3 January 2015.” January 8, 2015. http://www.tescoplc.com/index.asp?pageid=188&newsid=1127 [↩]
6. Source: Sibun, Jonathan and Fletcher, Richard. “Surprise as Sir Terry Leahy Resigns from Tesco.” The Telegraph. June 8, 2010. http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/7812463/Surprise-as-Sir-Terry-Leahy-resigns-from-Tesco.html [↩]
7. Source: Tesco, Annual Review, 2011.https://www.tescoplc.com/files/pdf/reports/tesco_annual_review_2011.pdf [↩]

Saving hard can hurt, but you can turn it into a psychically sustainable experience by aligning your budget with your values.

True, if you have the values of a Russian Oligarch or the cast of The Only Way Is Essex, then this prescription is not going to work.

But if like 95% of the human race you know that bling is not the bedrock of true happiness, then you stand half a chance.

Frugality is the fastest route to our financial goals for most of us. Yet many who are not natural savers think that cutting back is impossible, or will be the end of life as they know it.

Not so. You can make huge savings by experimenting with lifestyle shifts that enable you to live a fulfilling life for less.

In such a scenario, disposable income is laser-focussed upon the areas of life that really matter to you. All frippery is cut. The cash you save is diverted to meeting your financial goals without daunting sacrifices.

Once your budget is harnessed to your well-being, it can perform a new and vital function. It becomes a beacon that guides your quality of life. Overspending becomes a warning signal that you’re losing sight of what really matters, and financial discipline becomes a way of staying true to yourself.

And that’s a more powerful incentive to stay the course than saving a few quid will ever be.

Saving yourself

Discovering what your values are in this context is a personal journey that requires reflection. In the Accumulator household, all spending is viewed through the following lens:

• We spend on the essentials.
• We spend on things we really enjoy.
• We spend on things that really make a difference.
• We don’t spend on things just because we want them.

I want so many things! A fancy new TV, a new bathroom, a faster car, a fine dining experience every night.

I can chase all this ephemera to the point of financial ruin or else I can recognise that none of it moves the happiness needle very far, or for very long, or provides anything like the mental nourishment of a long walk in the countryside with the promise of a pub or teashop at the end of it.

Saving in line with your values does not rely on entirely rejecting all status symbols and the consumerist components of your identity. It’s not about living in the boondocks and eating berries for supper (although it can be).

Everyone has their must-have items that are central to their idea of themselves. The plan is to strip those back to an essential core.

For example, I need quality work clothes. It’s important to my sense of self-confidence that I feel that I look the part when operating in a politically charged office space. So I splash out on brands that make me feel good when I buy, and I wince when I drop curry down my front.

But the time is coming when I think I can challenge my lavish expenditure in this arena. Recently someone complimented me on my shirt. It’s years old, from Burtons, and was only pressed into emergency service due to a laundry crisis.

Perhaps all that other fancy stuff isn’t needed at all? Perhaps I’m a victim of the spotlight effect (our innate tendency to overestimate how much others notice us) and no-one else gives a stuff about my nice threads?

Happiness replacement therapy

Once you begin to challenge your notions of what you need to live the good life, you can turn the drudgery of budgeting into a game that replaces the expensive with the inexpensive but similarly fulfilling.

You can apply Money Saving Expert’s downshift challenge to your entire lifestyle.

• I used to race go-karts at the weekend. Now I play football. This substitute is just as much fun but the difference is I’m not burning fistfuls of cash in exchange for the memories.

• Challenge everything you do. Confront especially ritual behaviours that have remained unquestioned for years. There’s a good chance that diminishing returns have long since eroded most of the gratification you once got.

• If you’re wedded to expensive experiences, try halving the frequency and see whether the novelty value boosts your pleasure meter upwards.

• Challenge all your spending that’s for show. If you’re up against the implacable Jones’, then narrow down the number of arenas you feel you must compete in. Win the important battles, don’t try to win every battle.

• Keep a spreadsheet if you need to and rate the alternatives. Just how much fun was that foreign holiday in comparison to a staycation?

Too far, too fast

A word of warning: Don’t try to change too much at once.

Saving is like dieting, only you’re trying to put pounds on. Take a crash course and the pace of change will almost certainly break your resolve.

By taking it slowly, Ms Accumulator and I have managed to up our savings every year – even in the face of inflation and a period of stagnant wages. I’m like a corporate hatchet-man: constantly cutting costs by trying cut-price alternatives.

I still get doubts. At low moments it’s easy to think that the savings being squirreled away are denying me fun I might otherwise be having today. But mostly that’s because consumer society is so strong. It’s constantly trying to put me in a psychic headlock, bullying me into thinking that an iPad is a cure for feeling down.

Regular reflection upon and discussion of our true values are necessary counter-measures to materialistic pressures. This strategy can make a big difference to your saving while maintaining your quality of life.

But first you have to work out the difference between what makes you happy, and what you’re told makes you happy.

Take it steady,

The Accumulator

Good reads from around the Web.

The question of how many active investors and financial intermediaries are needed to make the market go around is becoming less theoretical as passive investing’s popularity grows each year.

This week the blog Philosophical Economics made a great – if theory-heavy – stab at answering it.

The article introduces us to the economy of Indexville – a land where everyone is a passive investor (and Monevator is an even more popular site than Buzzfeed).

The first hurdle for successful equity investing in Indexville is company valuation – in our world a free ride enjoyed by passive investors as a consequence of active investors competing for bargains.

The author’s conclusion is that perhaps 20,000 analysts would be sufficient in a passive-only world to value the equivalent of the entire US stock market.

That’s a cheap wage bill, the piece suggests, compared to the total cost of today’s actively managed funds, where the equivalent fees might be 25-100 times higher.

A bigger problem comes with providing liquidity to investors who want to buy or sell their passive funds, instead of just receiving dividends.

I’ll leave you to read the article for that long discussion.

The author concludes that even in the fantasy-land of Indexville, some percentage of investors would need to be active – but maybe as few as 5%.

Those active investors would be playing a zero-sum game in any speculation.

But by providing liquidity to passive investors, they would also in aggregate earn a small additional return over passives – effectively a fee charged for providing liquidity, and for taking on the risks of doing so.

Axe-wielding passive investing maniacs

Like me you probably won’t agree with every assumption made in the piece, but it’s a fascinating discussion – albeit one for finance nerds, really – and it strips back our bloated financial markets to their bare bones.

It will be fascinating to look back in 20-30 years to see whether the financial services industry did get significantly cut down to size.

[continue reading…]