Good reads from around the Web.

When I were a lad in the late 1990s, it was common for 20-somethings to put £500 into shares of some tech company or another that we felt we knew something about – or perhaps even knew somebody working at.

Our parents were mostly still to get onto email. It was easy to feel you had an extra insight into the dotcom boom.

As it happens, my colleagues and friends and I probably did know something about the ‘new economy’. But we knew very little about investing.

And we all know how that turned out.

These days the stock market is about as fashionable as fondue parties and donkey rides at Blackpool, so there’s not much need to warn anyone of the dangers of investing. Few have spare cash, anyway. While young people are rich in many ways, in 2012 it’s certainly not in terms of the folding stuff.

Some of the new generation are drawn to the markets, however. One young UK blogger, Rob, looked this week at investing on a salary of £18,000, for example.

I would never want to put anyone off investing, but be sure you have a sense of proportion. Putting £50 a month into an ISA to get a feel for market fluctuations while cash is tight I’d heartily endorse. But trying to invest your way to wealth on this level isn’t a great strategy, simply because it’s going to be decades before this sort of money moves the dial. You’d do better to focus on a side income.

As it happens Rob thinks he can save and invest thousands of pounds a year, thanks to low living costs in the North and great budgeting. If so, investing early could make a big difference to his future life.

But many young people will do better to focus on the basics at this stage of their life – which means growing their income and cutting their spending.

As TheZikmoLetter put it this week:

There are other ways you can achieve high returns on your excess cash, without incurring the fees and risks of Wall Street.

You often will not hear these options recommended by anyone who gets paid based on transactions, fees or a percent of assets, but they often offer the best risk-adjusted returns, net of fees, taxes and inflation.

Its suggestions – pay off debt, cut spending, build an emergency fund, and invest in yourself – will be familiar to Monevator readers, but still seem to be novel in the wider world. One reader of Mr Money Mustache reported this week that following sensible money management techniques did more for his net worth than doubling his salary.

As the Mustached mister writes:

… until you see it applied to a real life like this, where the graph of your wealth takes a sudden bend and your mandatory work career is suddenly chopped in half, it can be hard to convince people of just how useful it is to understand your spending, instead of just endlessly chasing more income.

Investing from an early age is an excellent habit to adopt for long-term wealth.

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Once we’ve employed a share screener to create a shortlist of potential high-yield portfolio candidates, we can begin to research each company more deeply.

We need to look behind the numbers thrown up by the rough-and-ready share screen to determine which companies might be worth investing in for income, and which are not.

We’ll tackle valuation in another article. Today we’ll focus on financial statement analysis specific to high-yield shares, which we’ve previously determined to be those shares yielding at least 1.2x the FTSE All-Share average.

Remember: There’s usually good reason a share is trading with a high-yield. The share price and yield have an inverse relationship, so a high-yield share often has a depressed share price.

The stock market doesn’t always efficiently price shares, but it’s usually not far off, especially with larger companies that attract more investor interest. As such, when researching high-yield shares, our top job is to identify and fully understand why the share is in fact high-yield.

Sometimes the reasons for a high dividend yield are benign, but other times there are good reasons to stay away.

Sustainability first

When we invest in a high-yield share, we’re typically looking to generate above-average income from the investment.

As such, we first want to make sure that the dividend is sustainable. Can the company continue to pay at least this amount to shareholders going forward?

Traditional dividend cover metrics are earnings-based, but I prefer to measure dividend cover using free cash flow. The reason is that earnings are not cash, and since dividends are cash flows, it makes more sense to measure them against net cash flows to the company after it has reinvested in the business.

So how do we measure free cash flow? There are various ways to go about it, but the simplest definition (and therefore the best place to start) is to take cash flow from operating activities and subtract purchase of property, plant, and equipment (sometimes called ‘capital expenditures’ or ‘capex’).

To illustrate, we’ll look at the magazine and bookseller WH Smith. The snapshot below is from page 41 of the company’s 2011 annual report:

Fortunately for us, we can also find the gross dividend paid on the cash flow statement, making free cash flow cover fairly easy to calculate.

Taking numbers from the statement above:

	2011	2010
Net cash inflow from operating activities	£118m	£104m
Less: Purchase of property, plant and equipment	£36m	£24m
= Free cash flow	£82m	£80m
Divided by: Dividends paid	£29m	£26m
= Free cash flow dividend cover	2.82x	3.08x

Source: WH Smith

This is very good cover. What it’s saying is that for each £1 paid out as dividends, the company generated £2.82 and £3.08, respectively, in free cash flow in fiscal years 2011 and 2010.

Note: Firms with free cash flow cover closer to one times should be approached with caution from a dividend sustainability standpoint.

We can also see from the cash flow statement that WH Smith has used most of its leftover free cash flow on share repurchases (that’s ‘Purchase of own shares for cancellation’ on the statement). This is reassuring – if the company has a tough year or two, it might be able to slow down its repurchasing activity whilst maintaining the dividend.

WH Smith dividend payout looks solid from a cash flow perspective, in my opinion. What’s likely keeping the yield high is not its present circumstances, but rather the company’s (arguably) limited potential for growth given the increasing digital competition for traditional books and magazines, as well as wider concerns about spending on the High Street.

Get a longer perspective: Income investors should look at free cash flow cover trends over a number of years – at least seven, if possible – to notice any trends and to monitor interim results.

Balance sheet health

Companies with too much debt often end up putting the interests of their creditors ahead of the shareholders.

One way you can tell this might be the case with a company you’re considering is if its management heralds creditor-focused metrics such as EBITDA (earnings before interest taxes depreciation and amortisation) in its periodic statements, and doesn’t spend much time speaking about shareholder-focused metrics such as net income.

There is such a thing as a healthy amount of debt. All else being equal, companies with stable businesses and strong cash flows should have more debt than highly cyclical businesses, as it can lower the company’s cost of capital (due to the tax deductibility of interest expense) and enhances company value.

Bearing this in mind, we want to compare a company’s debt ratios such as net gearing ((debt-cash)/equity) against its peers and not necessarily on an absolute basis.

If the company has a good amount of debt, it also likely has a credit rating from one of the major agencies that we can consider. However we don’t want to completely rely on someone else’s opinion here. We want to do our own work, too.

We’ll use Imperial Tobacco’s statement as of 30 September to calculate net gearing:

To calculate net gearing, we add current and non-current borrowings (£1,234 + £8,333) and subtract cash and cash equivalents (£631) to arrive at net debt (£8,936). We then divide net debt by net assets (£8,936 / £6,084) to get a net gearing ratio of 147%.

Now that we have that information, let’s see how Imperial Tobacco stacks up against its global peers:

Company	Net Gearing	S&P Credit Rating
Philip Morris International	N/A	A (stable)
British American Tobacco	128%	A- (stable)
Reynolds American	45%	BBB- (stable)
Altria	302%	BBB (stable)
Imperial Tobacco	147%	BBB (stable)

Source: Public filings, as of most recent report. PMI has negative shareholder equity.

As you can see, there’s some variance in net gearing across the global tobacco industry, but Imperial Tobacco is not an outlier.

Other factors may also be influencing the S&P credit ratings including litigation risk, pension deficits, different leverage ratios, and the outlook for each company’s tobacco volumes.

Management

A high-yield share may check out on free cash flow and balance sheet metrics, but we’re also interested in management’s track record of allocating capital and its attitude toward dividends.

To start, we want to see how effectively management has allocated capital between acquisitions, share repurchases, and dividends. At the very least, we want to be able to answer the following questions:

• What’s the company’s dividend track record?  Does it have a stated dividend policy?

• How many acquisitions has the company made in the past five years? How large were they? Has the company been forced to take impairment charges subsequent to those acquisitions?

• Has the company repurchased shares at opportune times, or does it simply repurchase shares when it is flush with cash?

Ideally, we want to find companies that have at least a five-year track record of paying dividends and those with a stated dividend policy tied to either earnings per share or free cash flow. The reason for this is we want to be sure that dividends are ingrained in the corporate culture and important to the shareholder base.

Because high-yield shares also tend to have slower growth rates, they can be keen on making acquisitions to boost growth. As such, we want to identify companies that have made logical acquisitions – that is, acquisitions that complement its existing business – and paid good prices for them. If the company has a history of impairment charges, for instance, it may be a sign that it isn’t a good acquirer.

Finally, if a company does engage in share repurchases, we want to see that it has repurchased shares for the right reasons (i.e. the share is undervalued) and not simply because they have extra cash lying around.

Take a look at a company’s annual reports, which tell you how many shares it repurchased and how much it paid for those shares. If they have consistently paid too much, it could be a sign of poor capital allocation skills. Too many value-destructive acquisitions and the dividend could eventually come under pressure.

Do your best

Analysing free cash flow cover, balance sheet health, and management’s capital allocation skill helps us to determine dividend sustainability, which is the key to a strong high-yield dividend share.

We remain, of course, susceptible to luck despite best research efforts. Unexpected things can befall any investment thesis – both good and bad – so it’s important to remain diversified and pay attention to valuation, which we’ll discuss in a future article.

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

One of my favourite investing books is Free Capital. It profiles a dozen successful private investors, with insights into their lifestyles as well as their methods.

Free Capital is unusual in focussing on UK investors. Most investing books are about Americans. At a time when you’re more likely to meet someone in the pub who’d rather smash the system than buy shares in it, it’s nice to know you’re not the only optimistic nutter in the asylum.

As I said in my original review, Free Capital also appeals to me because I dream of achieving financial independence through investing, just like its subjects.

All the investors profiled live off their money. They are free to invest their capital how they like, but they are also free to take the day off to go to the zoo and see the monkeys. They need never do another day in the office, unless they want to.

Given that many people live paycheque-to-paycheque, are wilfully ignorant about managing their money, shun shares, and save little towards their retirement, this drive to achieve financial freedom through the stock market is far less common than it might seem to the typical Monevator reader.

DIY private investors

What else do the private investors in Free Capital have in common?

Most obviously: They made it.

The book’s author didn’t interview a dozen people who failed to invest their way to millions. Survivorship bias looms large.1

This is especially important here, because all the ‘free capitalists’ profiled are active investors, and the academic evidence is clear. Most active share traders will fail to beat the market, and would do better in index funds.

Were the stock pickers in Free Capital skilful or lucky to end up on the right side of the bell curve of returns? Let’s leave that for another day.

In this post I want to focus on the lifestyle choices that enabled them to amass their wealth, which are equally important.

Earning returns of 20% a year makes achieving financial freedom quicker and likelier, no doubt. But without the habit of socking away cash and risking the market’s ups and downs, you’ve got no chance, whether you’re in passive funds or Bolivian small caps.

All the private investors in Free Capital:

• Saved a large chunk of their income instead of spending it.

• Learned about investing and managing money – often via a painful apprenticeship period of losing it.

• Risked their funds in the stock market for superior long-term returns, compared to bonds or cash.

Those are the fundamentals, whether you’re a passive investor, an active investor, or like me some hybrid of the two.

As the Australians say, “You’ve got to be in it to win it!”

What else?

Guy Thomas, the author of Free Capital, says there is no single thread that we can replicate for success. No surprise there.

But there are things that most of his successful investors have in common.

1. Future time perspective

Psychologists have discovered we tend to see our experiences through a past, present, or future time perspective.

People with a present time perspective, for example, might be more interested in making a big salary now (and perhaps spending it!) than in seeking uncertain future gains from the compound interest on their capital.

Most of the successful investors in the book seem to have been born with a forward-looking mindset. Many got interested in making money at an early age. None had big debts to pay off or other bad financial decisions to undo before they started investing

2. Few responsibilities or dependents

Several of the investors achieved financial freedom before they got married or had children. That’s no mean feat given the sums involved, and the fact that people typically pile on responsibility in their 20s and 30s.

I noticed several of the investors remained unmarried, too, even after achieving success.

Children and a non-working spouse are a big drain on anyone’s financial resources, which means less money to invest and compound.

There’s surely also a freedom in being unanswerable to a long-term partner. Given how weird dedicated stock market investing seems to many people these days, the chances of you marrying a like-minded soul are slim.

I’ve seen friends make money despite marrying at an early age and having kids, but invariably it’s been through career success (albeit with some carefully judged risks, including starting their own business).

I suspect throwing your life into your job is more socially acceptable than saving 50% of your income and investing it in the stock market.

3. Not career-minded

One advantage these investors had is they weren’t turning their backs on a great career to start investing.

Just as I wouldn’t say anyone should avoid kids to become rich – not if you really want them – I don’t think anyone who loves their job should quit for investing. (Especially as the evidence is most would do better putting money into a passive portfolio, leaving plenty of time for even the most demanding career).

But how many of us really feel a vocation when the alarm goes off in the morning?

If active investing was a skill you could definitively learn and profit from, I think many would prefer it to the 9-5.

4. Invest for freedom, not consumption

Most investors in Free Capital live unflashy lives. Like a Zen martial artist on the fringes of a Saturday night brawl, they could show off if they wanted to, but they prefer self-determination to sports cars and bling.

It’s important to be honest with yourself. I recently realised that if I made a great deal of money, I’d probably buy a fancier property than I once thought. But otherwise I’m certain I wouldn’t start throwing money about.

Anyone wanting to flash the cash will likely prefer the quick hit of a big salary. Investing your way to £1 million takes time – unless you start with £2 million!

Once you’ve made money the slow way, you’ll probably find spending it is more of a challenge than a temptation.

5. Avoid borrowing to invest

Virtually all the investors profiled avoid leverage – that is borrowing to invest. Even those who use spreadbetting do it without gearing up much.

Again, this is a small sample set, but I’d argue survivorship bias actually teaches us something here. Using debt in volatile markets works until the market turns down and takes all your geared-up capital with it. One severe dislocation can lose you more than you started with, which can’t happen unless you borrow to invest.

There’s a case for running a mortgage alongside a share portfolio. Otherwise I’d avoid borrowing like an England football team avoids World Cup glory.

6. Not team players

All the investors in Free Capital work alone. No great shock. Most people who want to be in with the crowd wouldn’t even think about investing in shares.

The only time investing has been popular in my lifetime was during the Dotcom boom. That it ended with a bust should tell you all you need to know about seeking comfort from others in the stock market.

As Steve Jobs said, “Better to be a pirate than join the navy.”

7. They enjoy investing

Everyone profiled in Free Capital clearly enjoys investing. Some – those spouses you need to avoid, for instance – might even say they’re addicted.

All the featured investors could put their fortunes into passive portfolios and spend their time doing whatever they wanted. However it’s pretty obvious that being in the thick of the markets is exactly where they want to be!

It’s like when people ask why billionaire entrepreneurs keep on working despite having all the money they need. The answer is they weren’t doing it primarily for the money. That’s just a way of keeping score.

I’ve mentioned before that “because I love it” comes far above “because I might make better returns” on the list of reasons why I pick shares rather than solely investing through trackers.

Yet spend time with Monevator’s passive fund hound The Accumulator, and it’s obvious he’s almost as gaga for investing as I am – even though he hands his money over to an index-tracking computer every month.

I can’t tell you to love investing if you don’t, and happily it’s not a prerequisite. By regular investing a chunk of your earnings into a well-diversified portfolio, you should do fine.

However there’s no doubt that loving it makes it easier.

I’ll happily read company reports on my iPad all day, turn to the Business section first in The Sunday Times, and I actually look forward to bear markets for the thrill of securing cheaper bargains.

I could – and do – tell people I invest because it’s intellectually stimulating, and it keeps me engaged with science, technology, and other developments.

But the truth is it’s not even a chore, because I love it.

You can learn more about successful private investors by reading their full profiles in Free Capital. I notice it’s now available on Kindle, too.

1. Survivorship bias is the error and consequence of focussing on winners because the losers are not so visible. For instance, you might go into Waterstones and see thousands of novels available, and conclude it is easy to write a novel and get it published. You are forgetting the hundreds of thousands of rejected novels lying around forgotten in bedroom drawers or on hard drives, because you cannot see them. Also remember that the range of novels in a bookshop is the cream of at least 200 years of novelist output! [↩]