In the 1950s, the point of investing was simple. It was, says John Littlewood in his book, The Stock Market: 50 Years of Capitalism at Work, “to provide assets to match as closely as possible the liabilities stretching years into the future over the lifetime of individual policyholders”.
John Maynard Keynes agreed. The ultimate object, he said, of normal institutional investment “is to purchase a reasonably secure annual income year by year over a moderately large number of future years”.
What mattered most to postwar investors was dividends – and only dividends. They were not much concerned with any of the valuation metrics we obsess over today to figure out exactly how much profit a company made, or how much more of a dividend the directors could pay out if they felt like it.
It is quite certain, said financial journalist Harold Wincott at the time, that “it is dividend yields which govern security values”. Nothing else. That led to situations that we would consider completely bonkers today.
In 1952, shares in Glaxo Laboratories were being tipped by stockbrokers Read Hurst-Brown. The firm was paying a dividend that was covered 12 times (its profits were 12 times the dividend it paid out); its earnings yield was 45% and its shares traded on a price/earnings ratio of just over two times.
By modern standards, that is insanely, ridiculously, fortune-makingly cheap. But in the world of the early 1950s, no one saw it like that. Glaxo’s yield of 4.35% was already a little below average – and, given everyone’s view of how long-term investing worked, the rest was considered entirely irrelevant. Oh, for a time machine.
Today, the wheel looks like it has come full circle. After a long period in which equities were judged in a wider kind of a way – mostly as real assets that might protect you from inflation with the yield seen as something of a bonus rather than the entire point – an awful lot of investors seem to be back where we started.
Thanks to quantitative easing, super low interest rates and the need for the pension freedom generation to use the equity income to replicate the annuities they no longer want to pay for, ordinary investors once again judge pretty much everything by the yield that it produces. Every list from every fund supermarket tells us that equity income funds are the best selling in the market.
Not all are totally in step with the 1950s vibe. There is a subsector of investors using the late 1990s as their road map instead – which is why the big US technology ‘Fang’ [Facebook, Amazon, Netflix and Google] stocks still trade on such high valuations.
Even so, most investors are not judging equities by the way they might protect us from inflation over the long term (no one cares about inflation any more, something that makes me very nervous indeed) or by the book value of their assets, but by the cash dividend they pay us.
While today’s investors clearly share their dividend obsession with their 1950s counterparts, the stocks we rely on to pay us the income we demand come with a very very big difference: no cushion.
Dividend cover at 12 times is about as distant as a dream gets. At the beginning of this year, a study from AJ Bell put dividend cover for the firms that make up the FTSE 100 at less than 1.5 times, with the top ten dividend payers having average cover of a mere 1.17 times.
That makes them very fragile indeed. If you are covered 12 times, some really dreadful things have got to happen to your business for you to have to cut your dividend. If you are only covered 1.17 times, one mildly difficult thing will do it.
Worse, half the total dividends paid out from the FTSE 100 this year were forecast to come from just seven firms. To look at it another way around, some 64% of the payout from the FTSE All-Share index comes from just 20 stocks — most of which are grouped into only three sectors (financials, consumer goods and oil and gas).
A study from QuotedData last year spelt out the consequences of that. In 2016, 14 out of the 19 UK equity income funds had at least two of the same stocks in their top ten holdings.
What happens if those companies crash? UK income investors got a hint of the answer to this last week when Provident Financial admitted that its strategy of trying to run a “people business” (doorstep lending) with a computer system that lacked empathy and local knowledge had been an unmitigated disaster — the chief executive resigned, and its shares fell by 65% in one day.
Investors with holdings in some of the UK’s most popular equity income funds would have found this something of a disappointment. Provident Financial’s dividend yield has made it a key holding for equity income fund managers, including Neil Woodford and Mark Barnett.
Provident’s two biggest shareholders are Invesco Perpetual (which owns nearly 30% of the company, according to the latest Bloomberg data) and Woodford Investment Management (which holds just over 18%). Provident is a top five stock in both of Woodford’s income funds, and also features in those run by Invesco’s Barnett.
Following the slump, the size of these stakes are too much to want to keep holding, but too large to sell without making things very much worse.
This is, of course, the key problem with income obsession: over reach and you can pay with your capital. With that in mind, it is worth remembering what Keynes had to say on the matter of dividends. He might have been keen on income, but he knew that guaranteeing a long-term sustainable income from equities without being hugely diversified was a tricky business.
“If we speak frankly”, he wrote, “we have to admit that the basis of our knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory . . . amounts to little and sometimes to nothing.”
Investors have been finding this out one way or another since the 1950s (anyone remember the devastating effect the dividend controls of the 1970s had on the market?). I suspect that those over-invested in UK equity income funds – which in turn, are over-invested in a few big income producers – might be finding this out all over again.
• This article was first published in the Financial Times