The collapse of Woodford Investment Management was one of the UK’s largest financial services scandals and its aftershocks are still being felt. The causes were multiple and complex, but at its simplest, the word “income” in the company’s flagship fund title was partly to blame.
The presence of that word alone meant investors saw the Woodford Equity Income fund as safe and defensive, but the manager had other ideas. As part of our income special report week, I'm unpacking our obsession with getting paid for owning a financial instrument and why it can lead investors astray.
Laws of the Land
As investors, we grow up knowing time favours those who continue reinvest their dividends – and the arithmetic is impossible to argue with. You can accumulate significant sums over multi-decade investment horizons if you buy and hold – I wrote about the importance of longevity in a column when Queen Elizabeth died last year.
Because of their pivotal role in creating inflation-beating wealth, dividends are revered. Warren Buffett likes them too, as reflected in his large stake in Coca-Cola. My colleague Daniel Noonan, in his recent piece For Dividend Investors, Time Pays, discusses this stock in relation to its unbroken dividend record:
"Dividends are by no means a magical source of returns, but they do provide an edge (or slight advantage) in a portfolio. By extension, slight edges can compound over many decades and end up feeling like magic," he said.
But those focused only on dividends can easily commit some of the seven deadly sins of investing:
• Rear-view mirror investing: a stock with a five-year track record of raising dividends may seem safer, but who knows?
• Overpaying for stocks: income stocks often trade at unjustified premiums over their peers;
• Chasing yields: high inflation means investors will focus more on headline numbers rather than business fundamentals;
• Refusing to sell underperforming investments: good dividends can mask a fundamentally weak business;
• Failure to diversify: a portfolio of reliable income stocks may be riskier than you think;
• Checking your portfolio too much ties you to the quarterly news cycle;
• Home bias: an overseas income portfolio may be much more effective than a domestic one, but you feel more comfortable sticking with what you know.
Do Investors Have the Patience for Dividends?
It’s clear modern consumers of all ages are more time-poor and easily distracted than ever. The short term is certainly noisier and more demanding than ever, so why should investing not reflect this change?
It would be easy to conclude people aged 50 and over are sensible, cautious, and able to wait patiently for quarterly or annual dividends to hit their accounts, while 20-year-olds are trading crypto watching TikTok videos.
But the trading platform CMC reported that in Q1 2023, non-income stock Tesla (TSLA) was the most commonly traded stock among all generations of traders (Amazon and Apple are also commonly bought and sold stocks).
It’s not surprising that that a short-term trading platform would report these figures. But the survey is interesting in what it reveals about investor psychology: many people want to make short-term gains and maybe have some fun (as the GameStop phenomenon taught us). The mainstream financial services industry may not like this. And governments in the Western world won’t either because they want you to build a nest egg.
In The Intelligent Investor, Benjamin Graham asked readers to ask themselves honestly whether they are investors (good) or speculators (bad). In the modern world you can be both. Let the asset managers and pension funds focus on "boring" long-term investing and harvesting dividends to boost total returns. Elsewhere, investors are embracing risk and reward and ditching the conservative mindset. In this sense, long-term dividend investing could become another relic of the analogue age like print newspapers and VHS films.
Last time I wrote an anti-income piece in November 2021 I cited tech, crypto and gold as examples of high-performing investments that don’t pay an income. If you’d bought in to two of these asset classes at this point, you would have been hammered in 2022 during the crypto winter and tech meltdown. But if you’d been brave/foolish enough to buy Bitcoin at the November low, you would have doubled your money.
In terms of tech, shares in Meta Platforms (META) cratered in 2022 but are up 86% in the year to date as growth returns to fashion. As for gold, the original anti-income portfolio stalwart, it fared better in 2022 and is now flirting with record highs in dollar terms. These sorts of gains depend on luck, courage and exceptional market timing – attributes that most retail investors don’t possess (myself included). But this won’t stop some people shunning the more cautious approach, especially with inflation eating into take-home pay.
To these anti-income high achievers, I could add a long list of alternative assets such as art, jewellery, guitars, whisky, wine, handbags, collectible books and comics, as well as classic cars. They don’t pay an income but are fun to own and have a long-term track record.
Breaking the Contract
What about those who depend on dividends to supplement their retirement income? "Why Dividends Matter" is a recent research paper by Paul Shultz at the University of Notre Dame.
Shultz says that "firms use their dividend policy to engage in an implicit contract with shareholders". He continues: "when a firm does cut dividends, it is very bad news. The firm is announcing that it can no longer honour its agreement with shareholders". (My italics)
This betrayal of trust happens more often than investors would think. 2020 was admittedly an outlier year, but the list of companies cancelling or cutting dividends bulged. In the UK this cost investors around £50 billion, or roughly half of the total payouts received in 2020.
Once that sacred contract has been broken, should income investors trust companies not to do this again in another crisis? From Trump’s victory to Covid-19, investors should be continually alert to "unexpected" events that cause dislocations for listed companies. Sod’s law dictates that something will always let you down at precisely the point you need it!
Shultz also touches on the idea that paying dividends reflects a company’s capital discipline, its respect for small investors, and its prudence.
"Paying dividends takes cash out of the firm and prevents managers from using it for projects of dubious value," he says.
This argument is sound. M&A famously enriches intermediaries rather than minority shareholders – but still segregates payers (good, prudent) from hoarders and spendthrifts.
Mining companies have been forced to pay out special dividends rather than embark on new projects – this is now seen as the right approach, but who knows what the long-term effect will be? If we can’t trust companies to use their money sensibly, why should we invest in them at all?
Of course, Apple is the ultimate outlier here: it has $57 billion in cash, but has just declared a paltry $0.24 dividend, meaning it yields around 0.55%. An income mindset would steer you away from Apple towards regulated utilities that increase their dividends every year. Apple is "sitting on cash" but its 20-year share price record speaks for itself.
Home Bias, UK Style
There are cultural factors at work too. Some countries are more "dividend-y" than others.
Morningstar’s Global Investor Portfolio Study from 2022 put this neatly: "building a portfolio that provides natural income to live off is seen by many as a priority. The UK equity market, with its many large dividend names, provides a natural target market for such investors."
As such, it’s hard-wired into the UK investor mindset to "think dividend" – and that has been rewarded. But has that held stifled innovation and risk taking? UK companies have tended to focus more on cash generation than growth and that’s now reflected in our biggest companies (pharma, banks and oil). Indeed, our growth success stories are thin on the ground, as Liz Truss was only too keen to point out last year.
Generational factors are also at work: the UK's income-dependent older investors have been allowed to set the agenda. If pensioners need extra income, it might be worth asking "why?"
The answer is obvious. Apart from for the fortunate few, retirement here is actually pretty precarious. At around £10,000 a year, the UK's state pension is lower than many G7 countries and we retire later than other countries in Europe. A lot of potential productive capital that could be used to build nest eggs also tends to be sucked into the hyperactive residential property market.
Where once investors were taught the acronym "TINA" ("there is no alternative" to stocks and bonds), then, that agenda has come unstuck in the zero and negative bond yield era. Fixed income and cash assets are now luring savers back in their droves.
Bonds have the benefit of capital preservation and income predictability, while cash offers a level of safety that equity income really can’t match. And, when things go wrong, equity investors also find themselves at the bottom of the pile of creditors. Whether it’s Woodford or something else cataclysmic, a financial plan is anything but if it fails to account for worst-case scenarios.
Perhaps dividends aren't as safe as they sometimes look.
