Good reads from around the Web.

Even though I think most people are best off passive investing, I don’t think most fund managers are duplicitous, misleading, or stupid. (The industry they work in is another matter).

In fact, I have a few favourites who I try to learn from. Warren Buffett, obviously, but also in the UK the Buffett-like Nick Train, who runs The Linsell Train Investment Trust.

I’ve followed this trust for years without owning it, mainly because I missed my chance to buy when it went to a rare discount in the wake of the financial crisis. Train’s approach is different – he holds far fewer companies than most managers, he rarely trades, and he seeks Buffett-style consumer brands and moats.

He also charges a hefty fee for doing so, which is why I prefer to keep an eye for bargains among his holdings rather than pay him to hold them for me!

Nevertheless, in my view this manager is a class act – and that is underlined not by the sky-high premium over assets being applied to his trust, but by Train’s response to it in his latest update to investors:

The other development is the sharp rise in the Trust’s share price that has resulted in it trading at a 21% premium to NAV. The Trust traded at a premium of this magnitude in the past, at the end of 2001. Two years later the share price was at a 15% discount.

A shareholder who had bought shares in December 2001 suffered a whopping 28% quotational loss of value, whilst the NAV had fallen by just 10%  It took until June 2005, three and a half years later, for the investment to show a notional profit.

As a result we would advise investors to think carefully before buying shares at such a steep premium to NAV.

You might argue that Train can afford to be magnanimous when his trust is enjoying such acclaim from investors – even as rivals like the mighty RIT Capital languish on a discount.

But having read his updates for years, I take it at face value and applaud him for it – especially when he goes on to write:

It would be wrong also for existing investors to celebrate such a high price that results from a large premium. Remember that Manager’s annual and performance fees are calculated on the market capitalisation of the Trust not the NAV. Hence a high premium leads to the accrual of a larger performance fee which in turn depresses the NAV.

Having the fee calculated on the market capitalisation was designed to align the Manager’s interests with shareholders, recognising that most of the time investment trusts trade at discounts, but in the current circumstances this is not the case.

No doubt some shareholders will look to take advantage of this misalignment with the result that the price and the NAV should be brought back in line with each other in due course.

Mr Train is basically trying to talk down the share price of his own trust, and that will reduce his own income if he manages it!

Again, a cynic might say that’s easy if he knows his fans will ignore him. Some of them do think the trust’s hefty holding in the Lindsell Train business itself is worth the premium, but for his part Train refutes this.

Either way, the premium is still over 20% as I write, according to Trustnet.

That is certainly a ludicrous mark-up on most of the fund, which is invested in very liquid shares like Diageo and A.G. Barr

I’m not saying they’re not good companies – again, I like Train’s style – but the fact is you or I could go and buy these shares on Monday without paying a penny over the asking price.

So why pay £1.21 for every £1 of them?

[continue reading…]

Despite what you might hear from the financial media who have been quick to talk about dividend-paying shares as if they were a separate asset class, dividend-paying shares are not a monolith. They don’t trade in lockstep with each other any more than do two shares that use buybacks instead of dividends, or a gilt and non-investment grade bond.

Indeed, a share that trades with a 2% dividend yield probably has very little in common with a share that yields 6%. All else being equal, the two companies are likely at different stages in their growth cycles, have different risk profiles, and different dividend policies.

The simplest way to start classifying dividend-paying shares is to find the market average yield (we’ll use the FTSE All-Share), which is currently 3.5%, and call everything above the average ‘high yield’ and everything under it ‘low yield’.

Yet even that classification can be misleading, though, as there are extremes on both sides to consider, as well.

Four types of dividend shares

I reckon we can use four yield categories to establish a reasonably accurate matrix for understanding the spectrum of dividend-paying shares.

Yield category	Dividend yield range	Translation
Afterthoughts	<2%	Likely a company in a growth phase; yields are so low that dividends are likely not a part of your main investing thesis.
Dividend growth	2% to 1.2x market average	Likely a company in the mature growth phase; expectation that the share will provide a higher income in 5-10 years.
High yield	1.2-2x market average	Likely a company growing near the GDP rate; your expectation is to harvest high levels of current income.
Stratospheric	>2x Market Average	Likely a company in decline or in financial trouble; higher risk of dividend cuts.

Yield ranges as of 10/10/2012.

These are generalisations, of course, and there are always exceptions, but it’s still helpful to see that dividend yields can usually tell us quite a lot about a share.

Perhaps most importantly, it helps set expectations. You shouldn’t buy a share in the high-yield category, for example, expecting 15% annualised dividend growth. It’s simply not likely.

Avoid the extremes

We can set aside ‘afterthoughts’ for our discussion here. Investors primarily interested in dividend-paying shares for income won’t likely waste their time with such low yields.

To see why, consider the following chart tracking income in three scenarios over a decade:

• 1% yield growing at 15% annualised
• 3% yield growing at 9% annualised
• 5% yield growing at 4% annualised

As you can see, even after a decade of 15% annualised growth – a very high growth rate – the share yielding 1% today will still produce far less than the annual income of the other two yield scenarios. Consequently, the low-yielding ‘afterthoughts’ are just not of interest to dividend-minded investors.

We can also set aside stratospheric yielding shares for now. These are shares yielding more than 8% in today’s market – or roughly twice the average. Such ultra-high yields are a special case unto themselves, and they require a distinct analysis. The alluring high levels of current income the stratospheric yielders appear to offer is likely to be unsustainable in the medium-term, and as such investors should approach them with the utmost caution and not purchase them for yield alone.

Having eliminated the two extremes, we can focus on the sweet spot of the dividend yield spectrum – the ‘dividend growth’ and ‘high yield’ categories.

I believe an investor looking to build a portfolio that generates a sustainable and growing stream of income is best served by focusing on these two categories. You should find plenty of selection here without taking undue risk.

Dividend growth shares

What we’ll generally find with dividend growth shares – which in today’s environment are shares yielding between 2% and 4% – are companies that have passed their high-growth stages but continue to retain a significant percentage of their earnings to reinvest in the businesses.

In this space, dividend cover ratios are usually at least 1.8-2 times.

A few classic dividend growth examples today might include Domino Printing Sciences (DNO), London Stock Exchange (LSE), and Diageo (DGE).

The trick with dividend growth shares is, well, the growth part!

Since you’re forgoing a little jam today in hope of more jam tomorrow, you want to feel confident that there will in fact be more jam in a few years’ time. After all, a share yielding 3% and growing its annual payout below the rate of inflation won’t do an income-seeker much good.

Ideally, you want dividend growth shares to offer at least three percentage points above inflation. With RPI inflation coming in at 2.9% in August, for example, that means you’ll want to target at least 6% annualised dividend growth from shares in this category.

In future posts, we’ll discuss more tools for analysing dividend shares, but one way to get a better idea of a share’s dividend growth potential is to determine the company’s sustainable growth rate (SGR).

To arrive at the SGR, take the five-year average return on equity and multiply it by the most recent retention ratio (1 – dividend payout ratio).

What the SGR is telling you is the maximum rate the company can grow without changing its financial leverage (increasing/decreasing debt, etc.)

For example, if the company’s average return on equity has been 15% and it is retaining 50% of its earnings, the sustainable growth rate is 7.5%.

If you’re researching a share in this category, one of the things you want to ensure is that SGR is above your annualised dividend growth threshold. Certainly there are other factors to consider before making a buying decision, but SGR is an important one.

High yield shares

Investors who prefer their jam today will likely focus on the high-yield area of the market, which as I write ranges from around 4% to 7%.

For a real-life example of such a portfolio, check out The Investor’s demo HYP here on Monevator.

Companies that fall into the high yield category have likely passed their above-average growth days and have now settled into growing more or less at the rate of the broader economy.

Classic high-yield mainstays in today’s market include SSE (SSE), Vodafone (VOD), and AstraZeneca (AZN).

When analysing high yield shares, it’s critical to keep a few things in mind. First and foremost, your focus shouldn’t be so much on growth potential, but sustainability of the dividend. As such, more emphasis should be placed on the strength of balance sheet and free cash flow cover.

To gauge balance sheet strength, I recommend considering the quick ratio ((current assets-inventory)/current liabilities) for short-term liquidity analysis and the interest coverage ratio (EBIT/interest expense) and debt-to-EBITDA ratios for longer-term credit analysis.

A company with a strong balance sheet will typically have a quick ratio above 1 times, interest coverage above 3 times, and debt-to-EBITDA below 2 times. For free cash flow cover, look for at least 1.5 times.

Slight variance around those figures is fine and it’s important to compare these ratios with competitors’ ratios, as well. Most utilities will have debt-to-EBITDA ratios above 2 times and free cash flow cover close to 1, for instance, but that doesn’t mean they all have terrible balance sheets or unsustainable dividends. The regulated nature of some utility operations allows for a little more leverage. In cases like this, focus your attention on shares with the best relative metrics to the industry average.

Second, it’s important to determine how a company entered the high-yield area of the market. Because yield and share price have an inverse relationship, it’s often the case that a high yield share was a dividend growth share whose yield increased as the result of a depressed share price and not a more generous dividend policy. If this is the case, be sure you understand why the market sold off the share.

Third, there tends to be a limited number of ‘quality’ high-yield shares and they tend to be concentrated in just a few sectors. Investors should be careful not to overload their portfolios in just a few shares or sectors to maximise yield. Diversification is always important.

Finally, since high yield shares tend to be slow-growers, management teams at these companies may opt to make silly and large acquisitions in order to jump-start growth. This strategy usually means bad news for shareholders — the company overpays, can’t achieve its synergy goals, etc. — and the dividend could be at risk if the move turns out to be particularly bad. Be extra cautious around companies with the habit of making sizeable acquisitions to fuel growth.

Roll your own dividend investing strategy

One of the nice things about building an income-focused portfolio is that you can mix dividend growth and high yield shares to meet your specific goals.

If you’d like a little more current income, for example, but still have a longer-term time horizon, you might put 70% in high yield shares and 30% in dividend growth shares. The possibilities are endless.

The Analyst owns shares of SSE and AstraZeneca. You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

The passive investors who frequent Monevator love cheap funds like teenage boys love cheap dates. So it was with a certain frisson that I greeted the news that HSBC have fired their incredible shrinking ray at their index fund Total Expense Ratios (TER).

The TERs or Ongoing Charge Figures (OCF) have shrivelled as follows:

HSBC C Class Fund	Old TER/OCF	New TER/OCF
FTSE 100 Index	0.27%	0.17%
FTSE 250 Index	0.29%	0.19%
FTSE All Share Index	0.28%	0.18%
American Index	0.30%	0.20%
European Index	0.35%	0.25%
Japan Index	0.33%	0.23%
Pacific Index	0.46%	0.36%
UK Gilt Index	0.28%	0.18%

That’s Vanguard beating form.

So if you’ve already got a portfolio full of HSBC index funds (as many Monevator readers do), you’ll be reaping the reward of the lower cost shortly, right guys?

C no evil

Yeah, no. The weeny OCFs only come with a new spin-off version of the fund – the so-called C class.

The C class funds are clones of the familiar retail share class index funds used in the Slow & Steady portfolio.

The holdings are the same and the roles played in a portfolio are the same. The only differences are the 0.1% snipped off the price tag, limited availability and the backflips you need to do to calculate whether these funds are actually a good deal. We’ll come back to that in a minute.

You can spot a C class fund in your broker’s listings by the telltale C it will have in its name. For example:

HSBC FTSE All Share Index C

The ISIN numbers are different from the retail versions of the HSBC index funds so, if you want to convert to C class, you’ll need to order your broker to make the switch.

C no funds

But your broker may not stock the C class funds.

The back story is that these funds are not primarily intended for retail investors. They’re designed for the likes of Independent Financial Advisors (IFAs) who need to be squeaky clean about charges once the RDR regime kicks in on January 1.

Listings by execution-only brokers seem pretty haphazard, so far I’ve found the C Class on:

• Clubfinance
• Interactive Investor
• Commshare
• Cavendish Online

The common link is Cofunds. Cofunds is a generic fund investment platform that is rebadged by brokers wishing to offer their own service. It’s a bit like discovering that all the cosy country pubs in your area are run by the same mega-brewery.

Not every Cofunds-backed broker is stocking the C class yet and HSBC are supplying other platforms too. My best advice is to call your favourite broker to see what they can do.

Sadly, the choker is that you’re unlikely to get the C class funds without having to pay extra platform charges. And these charges will wipe out the cost advantage for most investors.

C no difference

HSBC slashed the cost of the C Class by stripping out the 0.1% platform fee that is bundled up in the OCF paid for the retail versions.

Vanguard refused to pay this fee from the beginning which is the main reason why their funds weren’t sold on many platforms. It’s also why you’ll always pay a dealing fee or a platform fee (or both) to own Vanguard funds on top of the OCF.

So let’s face it, no platform that wants to stay in business is going to offer us HSBC C class index funds for free.

Platforms are going to levy an additional fee to put the C class on their shelves. The difference is that you’ll know what you’re paying, to whom and why, and that’s the whole point of RDR.

Sadly, the out-of-the-closet platform fees are considerably more painful than the hidden ones of old that nobody talked about.

Returning to our C class listing brokers:

Clubfinance – said the funds were listed by mistake. When they are made available then they will cop the following extra charges:

• £40 annual fee
• 0.29% on the first £100,000
• 0.26% on the next £150,000
• And so on, up the tiers until you’re paying a mere 0.15% after the first million
• This is known as the Cofunds Explicit Charging Structure
• 0.1% Clubfinance platform fee

Interactive Investor – we know all about thanks to their price rise car crash earlier in the year:

• £80 p.a. platform fee
• £10 dealing fee on funds
• Some free trades available and regular purchases are £1.50

Commshare – the staffie I spoke to didn’t know anything about additional charges, but I’ve since found this on their website:

We can arrange investments in No-Trail Funds in return for a fee (typically 0.25% p.a. of the value of your No-Trail funds) charged to your CommShare Cash Account.

Cavendish Online – again, the support staff got a ‘computer said “no”’ on platform charges but the website makes it clear that investors will be hit by Cofund’s explicit charging.

Best case scenario

Most small investors are clearly better off sticking with the regular retail HSBC index funds and a no-fee broker.

The C Class funds only work if you can reduce the explicit platform fees to less than 0.1% of your assets.

So if you’ve got over £90,000 in HSBC index funds and can restrict your trading fees to £10 per year then the C Class will just edge it at Interactive Investor.

Where the C Class index funds butt up against Vanguard there’s now very little difference in OCF. The game essentially comes down to who can offer the cheapest platform fees.

There is another one

HSBC themselves offer the only faint hope of a clear cut winner, if they decide to sell the C class funds directly to investors sans platform fee.

Monevator reader and MSE forum Sensei, Snowman, has been tipped off that this could happen from mid November.

I tried to confirm this with HSBC but was told only that the C Class would be made available through their Global Investment Centre by January 1 and that charges are still being worked out.

So who knows? Not the HSBC frontline staff, anyway.

Take it steady,

The Accumulator