Good reads from around the Web.

There are many reasons to be a passive investor, but guaranteed returns is not one of them.

Is passive investing most people’s best chance of capturing the expected returns?

Definitely.

But you can’t bank on expected returns.

This was illustrated nicely by Motley Fool columnist Morgan Housel in an article this week on how long it takes to prove yourself as an active investor.

Morgan was discussing how some lauded active investors might just have been born at the start of a good run for their asset class – and wondering how long you’d have to invest for in order to know your returns weren’t simply down to luck.

But the graph that illustrates his piece might interest passive investors, too.

It shows how US stocks did over various 20-year periods, which Morgan suggests would reflect the key years in an investor’s life (35-55, he says):

Source: Motley Fool

From eyeballing the graph we can see that, for instance, the 20 years following 1910 were an awful lot easier to find gains in than the 20 years from 1930.

Lies and statistics

Now before anyone in any particular camp starts having a go in the comments, this is just one way of looking at a particular slice of data and it’s designed to make a particular point.

So yes, plenty of caveats.

For a start we nearly all invest regularly over many years, not just in a one-off lump sum.

Also, sensible passive portfolios are diversified – rather than just being all-in US stocks or any other asset class.

Indeed, rather than being pessimistic or misleading, Housel’s graph of US stock market returns reminds us why geographical diversification is important.

The evidence is that a wide variety of very simple well-diversified and rebalanced passive portfolios will deliver solid positive returns over the long-term (though nothing is ever certain!)

Finally, active investing is always a zero sum game. So to extend on Morgan’s comments, this means that an active investor in a good market may find it easier to put up impressive sounding numbers, but on average they will still lag tracker funds that follow the same benchmark.

Careful what lessons you learn

I suspect we will all take what we want to find from such graphs.

Passive investing skeptics will ignore my points about geographic diversification and regularly investing over a lifetime – and Morgan’s point about lucky fund managers – and say this is why you can’t rely on trackers for your returns.

And before I scoff at them too loudly, I must admit I did think to myself that this data shouldn’t really scare me, because as an active investor – for my sins – I flit about territories and individual stocks like a butterfly on a buddleia bush.

But it would be wrong (and ironic) to take away the message that passive investing is a flawed strategy from an article that is trying to show how the perception of an active manager’s success could just be down to when their parents happened to get jiggy with it.

(Again, read my zero sum game article if you don’t understand why.)

The active fund industry will always use the fact that shares go up and down and markets sometimes disappoint to play on people’s feeling that passive investing feels wrong.

But those feelings are not a good guide to the reality.

Certainly we need to be alert to the potential pitfalls, such as not being diversified or falling prey to sequence of returns risk.

And I do still hear too many new-ish passive investors saying things like “I can expect to get 5% from shares over the next few years”.

No you can’t, not over five-years.

You can hope to – but remember that average returns are not normal.

You know what you’ve got to do

I know these warnings and caveats are all a bit relentless, particularly if you’re new to investing.

I’m tempted to write that investing is like an onion, and that every time you peel away a layer you find a new layer and another complication.

But really it’s more like a childhood cut that turns into a scab.

You know what is happening and what you need to do – which is leave it alone – but you can’t resist picking and poking at it.

And if you do it may just start to bleed again!

The principles of investing – regular savings, compound interest, diversification, rebalancing, time horizons – were all worked out long ago.

Investors will experience very different markets depending on when they were born, but the principles don’t change.

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Whilst high-yield shares have been receiving most of the attention in this low interest rate environment, dividend growth shares should also be considered for any income-based portfolio designed to stand the test of time.

Investors wanting to maximise current income may feel content with a portfolio built solely with high-yield shares. But because today’s higher-yielding shares are also likely to be in the slower growth stage of their life-cycles, it’s important to also consider which shares might provide inflation-beating dividend growth in future years.

And that’s where dividend growth shares can play an important role.

That said, dividends that might be paid to us five-to-ten years from now are much less assured than the dividends we’re going to receive next year, so knowing how to make conservative growth forecasts is critical to dividend growth success.

As with high yield share research, healthy balance sheets and free cash flow cover remain important, so as you research dividend growth shares, keep those important factors in mind.

Today though we’ll focus on measuring dividend growth potential. Once we’ve estimated a company’s sustainable growth rate, we can better gauge the opportunities we’re presented and weigh them against alternative investment choices.

History may rhyme, but it doesn’t repeat

The first place many investors look when determining dividend growth rate potential is the dividend track record. But whilst momentum may play a role in future dividend growth – few companies growing their payouts at 15% per annum suddenly flatline the next year – it’s dangerous to presume that past is prologue.

In other words, don’t use the past five-year growth rate as your five-year forecast.

Instead, use dividend history to understand what has been driving the growth rate. Was it due to an expanding payout ratio, for instance, or was it completely due to earnings growth?

A firm that’s been driving dividend growth by paying out a greater percentage of its earnings will not likely be able to repeat that performance. You should adjust your forecast accordingly.

Focusing on the fundamentals

Rather than look just at dividend history to determine future growth potential, we can use the financial statements to calculate a sustainable growth rate (SGR) – that is, the maximum growth rate the company can sustain without increasing its financial leverage:

SGR = (1 – payout ratio) x return on equity

Where:

Payout ratio = dividends per share/earnings per share
Return on equity (ROE) = net income / shareholder equity

To illustrate, let’s assume a share is paying out £1 in dividends for every £3 in earnings (a payout ratio of 33%) and has a return on equity of 15%.

SGR = (1 – 33%) x 15%

SGR = 10%

This SGR calculation assumes that the company takes the £2 in earnings that it isn’t paying out in dividends and reinvests in the business at a 15% return. Assuming the company’s payout ratio and ROE doesn’t change much in the next five years, then, it’s reasonable to assume that the company’s five-year dividend growth rate should approximate 10%.

To see how the SGR can change based on ROE and payout ratio, you might consider the following table:

Note: SGR is rounded to one decimal place

Ah, but if it were only so simple!

Payout ratios and ROEs can change year-to-year, especially with cyclical companies. It’s extremely risky, for instance, to use the most recent payout and ROE figures for a commodity company in a peak year. You’ll come out with a very low payout ratio and a very high ROE, and thus an unrealistic SGR.

A workaround to this is to use a normalised payout ratio and ROE assumption by taking the averages over the most recent business cycle of 5-to-7 years. Even if you normalise the figures, however, the SGR results may still not make practical sense.

For example, let’s assume a large-cap company with an ROE near 30%. We’ll also assume £1 dividends per share and £2 earnings per share for dividend cover of two times (a 50% payout ratio). The share is also trading with a 3% yield and carries a £33 per share price.

If we used those figures to determine SGR, we would get:

SGR = (1 – 50%) x 30%

SGR = 15%

A 3% yield plus potential for 15% annualised dividend growth is a very attractive proposition, but it’s probably too good to be true. Large-cap shares with this type of dividend growth potential simply don’t escape the notice of institutional investors.

Buybacks and dividend growth

Large companies generally are not able to reinvest the majority of their earnings back into the business to earn 30%-plus returns. As the company gets bigger, the absolute amount of high-return opportunities doesn’t usually keep pace.

This is why more mature companies usually engage in dividend and buyback programmes and engage in more acquisition activity – they need something to do with their excess cash.

To illustrate, let’s assume the company can reinvest 20% of its earnings (£0.40 per share) at the 30% return on equity. This implies a more earthly 6% sustainable growth rate in earnings and leaves £1.60 per share remaining for dividends and buybacks.

In a perfect world, this company might pay out all £1.60 per share in dividends, resulting in a 4.8% dividend yield. In today’s markets, however, buybacks are frequently employed alongside dividends, so we’ll assume the company is using the remaining £0.60 per share (£2 EPS – £0.40 reinvested – £1.00 dividends) for buybacks.

Knowing that the company is trading for about £33 per share, we can see that £0.60 per share going to buybacks should eliminate approximately 1.8% of shares outstanding (£0.60/£33). We can then add this 1.8% to the 6% adjusted SGR result and estimate that earnings can grow at 7.8% and provide underlying support to dividend growth.

This isn’t to say that the buybacks will necessarily enhance shareholder value in any way – only that they can support dividend growth by reducing the number of shares the company needs to pay dividends to in a given period.

Don’t be afraid to forecast

As you can likely surmise by this point, forecasting dividend growth is not an exact science. If it were, we active stock pickers could all set up complex equations to automate our investment decisions and build our dividend portfolios, and turn our attention elsewhere.

Some market watchers may therefore see forecasting as a futile task, but when you purchase any share you are nevertheless making an implicit assumption about future growth – that is, the growth that’s currently assumed in the share price. I’d much rather explicitly state my underlying assumptions and hold myself accountable than make like an ostrich.

Forecasting growth is a probabilistic task. Your original assumptions may be a good baseline, but also consider alternative scenarios and see how they might affect your interest in the share.

Finally, you can be more confident with your forecasts, all else being equal, the stronger the firm’s competitive advantages. In contrast if the company is engaged in selling commodity products and has no clear advantage over competitors, it’s important to consider a wider range of possible outcomes and demand a larger margin of safety before purchasing the share.

Read all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

Good reads from around the Web.

One of the big frustrations of the ‘priced-out’ generation – which is fast becoming anyone under 35 in the South East, or at least those without access to Feudal leg-ups from their parents – is that older generations really don’t get how tough it is to buy a house under your own steam now.

“It was equally hard in my day,” some 60-something property millionaire next door will say.

“We ate baked beans for three months and used toxic waste drums for furniture. To get a mortgage I had to marry one of my girlfriends just to look respectable to the bank manager, and she still had to take care of him behind the golf clubhouse to seal the deal. Interest rates were 8%, and I had to sell my LPs.”

Even I’ve underestimated the younger generation’s despair, and I’m not a complacent home owner.

Rather, as a conscientious objector to high house prices in London and hence a deliberate renter, I’m on their side, too.

So I really shouldn’t have opined to some much younger friends over email that their unwanted office relocation out of Central London to Zone 2 at least put them within shooting distance of cheaper property they might eventually buy.

One bombarded me – as is the way of the under-30s now – with animated movie clips of the clinically insane cackling and of cars being deliberately driven off cliffs.

The other emailed: “Twenty three minutes on and I’m still laughing at the idea of ever buying ANYWHERE myself.”

I did the maths. He earns about £35,000 a year. He’s doing okay, by ordinary late-20s standards.

He’s screwed.

The dirty dozen

On this point, The Guardian has come out with some new statistics that show how stretched the market has become:

A homebuyer earning the median salary for their region in 1995 would have had to spend between 3.2 times and 4.4 times their salary on a house, depending on where they lived.

In 2012-13, the last year for which complete data is available, the median house price had risen to between 6.1 times and 12.2 times median regional incomes.

Prices have only pushed higher since 2012-2013.

And as those of us foolish enough to live in London keep reminding everyone else, it really is a madhouse down here:

In 1995, the median income in London was £19,000 and the median house price was £83,000, meaning that people were spending 4.4 times their income on buying a property.

But by 2012-13, the median income in London had increased to £24,600 and the median house price in the capital had increased to £300,000, meaning people were forced to spend 12.2 times their income on a house.

Now, this data does overly exaggerate the escalation in house prices to incomes over the past 20 years.

That’s because prices in 1995 were still in the dumpster due to the last big house price crash.

(Yes, we used to have those, even in London.)

I know that well, because that’s when I first took an interest in London property. The sticker shock of seeing prices well above those lows just 4 or 5 years later definitely discouraged me from buying, even when it was still a sensible thing to do.

Nevertheless that doesn’t change the thrust of the argument.

I’d imagine the median pre-1995 would still only have been around 5 times back to the mid-1980s, and probably lower before that.

But regardless of how much it’s grown, a price to income ratio over of 12 times in London is far in excess of what’s prevailed throughout history.

You’ve got to fight for your right to party walls

So younger people aren’t just moaning like every generation before them when they say that property is almost hallucinogenically expensive.

It is.

The wonder of it is they’re not rioting on the streets every day, like some previous generations would have.

Certainly the baby boomers of the 1960s would have been making their voices felt.

But then, they could afford to take a six months leave of absence to drop out and rabble rouse.

At least as far as the men were concerned, they lived in a world of full employment, free higher education if you could get in, good blue collar salaries if you couldn’t, and social mobility was peaking.

And though the fun wore off in the 1970s, by the 1980s they could begin amassing the property wealth they have today – aided enormously by the right-to-buy and buy-to-let booms that the current Government is only just applying the brakes to.

People obviously weren’t evil in doing this (despite what some bitter Internet warriors say).

They were just trying to improve their lot.

If Monevator had been around in the mid-1990s I am certain many of them would have been reading it – and for that matter I’m sure we’d have been making the case for getting into property for those double-digit yields.

But that was then, and this is now.

We know the consequences of all that, and something has to change.

A European problem, too

For me, it could eventually be the country I live in.

The gulf between what you can buy in the UK and in the great livable cities of Europe is staggering.

True, it helps enormously that I don’t rely on those famed London office-based salaries for my income – and that I’ve saved a fair wodge along the way.

So really all I’ll be doing if I was to move to Spain or Portugal or Italy is arbitraging how far my savings will go.

The indigenous youth of those countries actually think property is a pipedream, too, according to a report in the FT this week [search result]:

The affordability gap has widened so much that 72 per cent of Europeans questioned in the ING survey believe that society would benefit if house prices fell.

This is felt most sharply by renters, with 93 per cent of Spanish, 75 per cent of British and 74 per cent of French tenants citing expensive housing as a block on their path to home ownership.

Of course, in most of those countries a sickening proportion of the young haven’t got jobs at all.

That’s not the cure for high house prices that anyone wants.

You can’t swipe your first flat

Bottom line: If you know a young person, be kind to them.

Yes, they have iPhones, Tinder, and they live in a more tolerant, flexible society.

But the majority of those without wealthy parents foresee no chance of ever owning a place of their own.

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