Tag: income investing

Focus on total returns, not income investing

Focus on total returns, not income investing

This is a sequel to Getting Hurt Chasing Yields – Part 1. Apart from investing in instruments and companies that are unable to sustainably pay out interest and dividends based on their operating cash flow, investors are committing a mistake by solely focusing on investing for income.

Income investing means building a portfolio of interest or dividend-paying common stocks, preferred stocks, and bonds in an effort to generate sufficient income to maintain their desired lifestyle.

Investors should not be fixated on chasing yields. Rather, they should focus on the maximum total return they can derive from their investments. Total return includes both income and capital gains.

“The best way to approach this is to invest for the highest total return you can achieve and sell whatever shares or units you need to provide cash. However, I realise that for many investors, the idea of realising part of their capital to provide income is anathema.”

Terry Smith, CEO of Fundsmith

When investors focus on income-producing stocks, most are focused on stocks that have a high dividend yield. Generally, this would be limited to companies that pay out most of its earnings as dividends such as REITs or mature companies such as Singtel and Comfortdelgro.

These companies do not retain most of their earnings for reinvestment. Largely because they are unable to reinvest at high returns. Cash generated by the business will have to be deployed at other places (e.g. acquisitions) or returned to owners (e.g. via dividends or share buybacks).

Investors focusing on dividend yield alone would miss out on the great compounders – companies that are able to reinvest at a high rate of returns. Instead of paying out a dividend, they would retain most of their earnings for reinvestment. Growing the intrinsic value of their businesses.

Let’s look at an example comparing two businesses and understand which yield a higher total return. The first company, Compounding Corporation. It has the ability to reinvest all of its retained earnings at high returns due to its strong reinvestment moat. As a company that grows at a high ROIC, the market assigns it a higher multiple, at 20x earnings.

The second company, Dividend Corporation. It is a mature and steady business that pays out good dividend yield and trades at 10x earnings.

Assume that, over time, both companies will be valued approximately in line with the market, at 15x earnings. In this case, Compounding Corporation will suffer a multiple derating, while Dividend Corporation will enjoy a multiple expansion.

Let’s observe which company would provide shareholders with higher total returns:

By focusing on companies that provide a high dividend yield, investors would miss out on companies like Compounding Corporation. Although income investing would provide a decent result. The opportunity cost of doing so is huge (total returns of ~700% against ~300%).

The desperate search for yield has led to a number of people choosing to invest in income funds, or in mature companies providing a high dividend yield. On the surface, it might sound sensible, but it is erroneous. It may lead to investors underestimating the risk of investing in high yield instruments. Moreover, what is less obvious is the opportunity cost of focusing on yield only, as opposed to the total returns of a company that is able to compound at a high clip.

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Getting hurt chasing yields – Part 1

Getting hurt chasing yields – Part 1

Some of the most popular asset classes Singaporeans love are REITS, bonds, and stocks that pay a high dividend yield. And understandably so, because we are so sold on the idea of generating consistent, sustainable passive income to cover our expenses. It has almost become like a Singaporean dream to invest for income.

There is nothing wrong with that and it is great that people are taking charge of their financial welfare. But that eagerness has caused many to be blindsided to the risks involved. And many more have been taken advantage of by financial institutions.

In this article, I will discuss bonds and leave the discussion of REITs and high dividend yield stocks for the next articles.

Bonds, must be safe right?

In today’s low-interest rate environment, I find it difficult to comprehend why anyone would subscribe to corporate bonds or perpetual securities when they only offer marginally higher interest than CPF. There are a lot of risks associated with any investments which are often underestimated by retail investors. And it is definitely not what most relationship managers pitch across as “buy and forget instrument”.

High profile defaults such as DBS Lehman Minibonds, Swiber bonds, and Hyflux bonds have caused investors much agony. Especially when many plough their retirement savings into these instruments.

A self-employed man, who wanted to be known only as Mr Jin, said he had invested $500,000 in two Swiber bond issues through DBS. “I was simply following the advice of my relationship manager, who never told me much about the company. I just thought, a bank in Singapore, with this much regulation, would not recommend risky investments,” the 44-year-old said

“Around 34,000 retail investors sank a total of $900 million into Hyflux perpetual securities and preference shares.”

“In all, nearly 10,000 people in Singapore stand to lose over S$500 million ($338 million) due to the collapse of Lehman Brothers Holdings Inc (i.e. DBS Lehman Minibonds), the central bank says.”

Taking a closer look at their financials, we realise that both Hyflux and Swiber had a negative free cash flow (FCF).

The same goes for Swiber, the company was bleeding cash in most years prior to issuing their bonds. The company was making up for its shortfall by borrowing US$736 million from banks, with DBS being its largest creditor.

The point is, the interest for these products was anywhere between 5-7% only. And bond investors do not get to participate in any upside while it has to deal with the risk of total capital loss just like equity investors. The interest payments are fixed, if the company does well it is still going to pay you the agreed-upon interest payment. But if it runs into problems, you will suffer losses just like its shareholders.

When investing in bonds, it would serve investors well to think of it as lending money to their friends. Question you would naturally ask – would they be able to repay me?

And if this friend has been super reliant on credit card for his day to day living, as in the case of Swiber and Hyflux by borrowing from banks, then we better think twice about lending them our money.

There is no easy way out when it comes to investing. If we do not have time to dig deeper, investors are better off putting money into CPF for a guaranteed 4-6% (depending on your current account balance and age) and not reach for an additional 1-2% worth of yield without understanding the risk-reward ratio.

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