Dividends vs. drawdowns

Dividends vs. drawdowns
I read this Terry Smith article some time ago (also available on the FT site here), and thought I should finally get around to digging into it a bit more. I think you can question the merits of using price to book as an appropriate metric, particularly with low capital companies who generate cash with few physical assets. I’m sure you could also disappear down a rabbit hole attempting to analyse retained earnings for a bunch of companies, particularly a disparate collection such as those in Fundsmith. But I am most interested in the distinction between using dividends for an income stream versus selling fund units (or one’s shares) as a means to generate income - to quote the article:

"The need to get spending money from your investments once you've retired is obvious. But why does it have to come from dividends?"

If I had an investment that paid out 4%, something like a FTSE 100 tracker, how would taking the 4% dividend compare to selling units to generate the same income? The FTSE 100 hasn't performed particularly well over recent years compared to other indices, whereas in terms of capital growth Fundsmith has been one of the better places to park your cash. It's only a small sample, but comparing these two investments, let's see how Mr Smith's assertion stacks up.

Income dilemma

I’m starting from a position that I need my investments to provide me with some income. There are two ways I can generate this:

• Have an investment that pays out a steady dividend
• Sell a slice of my investments at regular intervals

I’m going to take the FTSE 100 as my initial virtual investment – or more precisely a couple of iShares index funds to compare, one an accumulation fund that automatically reinvests dividends, one a distribution fund that pays out dividends quarterly.

I begin with an imaginary £100000 (just because it's a nice round number). I have wound back the clock to January 2010 when the accumulation fund I’ve chosen was started, and tracked performance forward from there until the end of June 2019. To make life easier I’m ignoring fees.

The capital of the distribution fund will remain untouched, and the dividends are not reinvested. For the accumulation fund I will sell as many units as I need to generate the same income provided by dividends from the distribution fund. I will also sell these units in the same months as the dividends are paid out.

Lets start with some stats showing how the trackers performed before I sell any units.

FTSE 100 accumulation tracker:

• Starting value January 2010: £100000
• End value June 2019: £200829
• Total return % change: 101% increase
• Total return: £100829

FTSE 100 distribution tracker:

• Starting value January 2010: £100000
• End value June 2019: £140647
• Capital % change: 41% increase
• Dividends paid: £43941
• Total difference (capital + dividends): 85% increase
• Total return: £84588

As might be expected, dividends being reinvested automatically into the accumulation fund, and the wonders of compounding provide for a much better performance. The additional 16% that the accumulation fund provides sounds a little abstract, but an additional £16k in the bank certainly isn’t.

But I need an income, so how does the accumulation tracker compare as an investment if I need to sell off quarterly slices in order to pay the bills?

Accumulation tracker:

• Starting value January 2010: £100000
• End value June 2019: £141389
• Capital % change: 41% increase
• Total value of units sold: £43941
• Total difference (capital + dividends): 85% increase
• Total return: £85330

In other words, generating an income through dividends, or taking a slice of the fund gives pretty much the same result. Changing the timing of unit sales would affect the returns, but if this was my income I wouldn’t necessarily be able to delay paying bills to wait for a favourable price at which to sell units.

This also doesn’t take into account fees, for the two funds I’ve chosen the ongoing charges are the same, but depending on the platform in which you choose to invest, transaction fees would nibble away at the small advantage that the accumulation fund offers. There is also the hassle of having to sell the units etc. not a big deal maybe, but compared to simply receiving a quarterly dividend in your bank account, it’s an effort that can be avoided.

So it doesn't look like the assertion from the article above holds much water in this particular example. At the time of writing the FTSE 100 ETF has a yield of 4.4%, and as can be seen here, aside from the financial crash years around 2009, the current yield is at the upper end of it's historic range. Fundsmith Income fund has a much lower yield of around 1.5%. Lets see how the Fundsmith accumulation fund would fare providing the same income as the FTSE 100 tracker, if I had to sell off units of Fundsmith.

Mr Smith vs the index
Fundsmith launched in November 2010, 10 months or so after the launch date of the iShares accumulation fund above, so I will adjust the unit sales to match. Basic stats as above to start with:

Fundsmith accumulation:

• Starting value November 2010: £100000
• End value June 2019: £453020
• Total return % change: 353% increase
• Total return: £353020

Now if I sell units to provide for the same dividend income as the FTSE 100 distribution tracker above we get the following:

• Starting value November 2010: £100000
• End value June 2019: £360616
• Capital % change: 261% increase
• Total value of units sold: £41444
• Total difference (capital + dividends): 302% increase
• Total return: £302060

Even when Fundsmith has to pay out an additional few percentage points in income to match the FTSE 100 ETF the differences are pretty stark. Selling the units would give the same income as the tracker, but the capital is up over 260% compared to the 41% of the tracker. Using this second example, the approach outlined in Mr Smith's article appears convincing.

2019 Mid-year review

As we’re past the half way point of 2019 I thought I should reflect on how the portfolio has performed and how I’ve progressed against my goals during the first 6 months of the year.

Portfolio performance
So far in 2019 the portfolio has increased in value by 15.1% (including all costs, and dividend payments). This compares to an increase of 13.4% in my benchmark (also including costs – as an accumulation fund dividends are reinvested automatically). I'm obviously pleased by this but a number of larger holdings, such as Unilever, have been performing very strongly of late and I would expect them to take a breather at some point soon.

The dividend yield from my portfolio in 2019 has amounted to 1.84% so far. The dividend yield on my benchmark is 3.79%, if half of this had been paid out in the first 6 months of the year, that would amount to a yield of around 1.9%. So I’m not too far away, however, a larger proportion of dividends tend to get paid out in the first half of the year, so I may drift from this. I would prefer the portfolio yield to be higher, but not at the expense of quality.

The best performer in the portfolio so far this year has been Sage, but this possibly reflects an overdone sell off last year, rather than any stellar turnaround from the business. Worst performer has been Saga, presenting a dire set of results that gave the impression the management had been asleep at the wheel. Whilst there are a few laggards in the portfolio, Saga is the only one at the moment looking like getting the elbow.

Analysis
I’ve been adding to the toolset, but it’s too early to say if this is proving effective. I’ve added in cost of capital calculations, and started to analyse performance metrics in a similar way to Terry Smith in his annual letters to investors in Fundsmith. I now have some weighted average performance metrics, and the median for the same metrics for the portfolio. In this way I can get a view of the portfolio as if it was a business, and how it compares to other businesses and potential investments. So an additional consideration for adding to the portfolio is to invest in companies that have performance metrics that compare favourably to those already in the portfolio, and the portfolio as a whole. Some of the key portfolio performance metrics are below:

Weighted average
roce	gross margin	operating margin	net margin	cash conversion	debt: ebit	cash flow yield
18.7%	47.7%	17.0%	13.4%	46.5%	3.5	2.2%

Median
roce	gross margin	operating margin	net margin	cash conversion	debt: ebit	cash flow yield
17.6%	57.0%	21.0%	16.1%	96.7%	2.8	5.6%

Whilst the above stats are helpful in some respects, using them to evaluate a Real Estate Investment Trust (REIT) is a little tricky as REITs are structured differently to most businesses. So I have excluded BBOX from the above. Also the debt related stats are not necessarily a sound reflection of the distribution of the debt across the portfolio. A number of holdings have no borrowings, it is mostly concentrated in a small number of holdings. Going forward, debt will continue to be an important factor in deciding whether to add something to the portfolio, I will prefer any additions to have low levels of borrowings.

Buying and selling
So far this year I've made the following purchases:

• Tritax Big Box (January)
• Manx Telecom (January)
• Fulcrum Utilities (March)
• Abcam (April)
• Reckitt Benckiser (April)
• Somero Enterprises (June)

These are all new additions to the portfolio, I haven't topped up any existing holdings.

Manx Telecom was acquired shortly after I invested, leaving the portfolio for a 32% profit. I have not sold any other shares.

Goals
My initial investment goals were:

• Capital preservation
• Increase capital by more than the rate of inflation
• Invest in quality dividend paying stocks

And by careful selection of stocks and funds, to outperform the FTSE All Share Index. Ultimately I'd like to be in a position in 20 years to get a steady income from dividends to top up pensions, and a solid portfolio of investments to pass on to sleepy junior, to provide not just a lump of cash, but a revenue stream. So far I'm fairly pleased with performance against these goals, but it's very early days.

Personal finance
No need to access the emergency fund during the first half of the year, and we've added to it slightly. Getting this set up has proved a great foundation for the rest of our finances as we now know that any spare cash is genuinely surplus to requirements.

Mortgage overpayments have continued. Mortgage partA is on track to disappear in around 3 years thanks to maxing out the overpayments. This accounts for about 60% of our mortgage payments, so completing this would free up a nice extra chunk of disposable income. We could then decide whether to put this to work overpaying the remainder of Mortgage partB, to a large extent this will depend on interest rates at the time. We have a bit of cash from bonuses, some of which is going into some work on the house, if this comes in under budget then Mortgage partB might get a little extra too.

Arrival of sleepy junior 2 over the winter will likely take a slice out of the budget, but nothing too dramatic as an attic full of stuff used by sleepy junior 1 can get wheeled out.

Conclusion
Fairly pleased with the start to the year, with a decent performance from the portfolio. I don't expect it to continue throughout the second half the year, as the high performing stocks are going to ease off at some point, macro-economic conditions look wobbly, and Brexit will once again take centre stage in the Autumn.

I've noticed myself prevaricating quite a lot over a number of purchases, and tend to want to get a bit more data, crunch some more numbers. Whilst caution and care is a positive, I think there has been a little too much dithering at times. However, overall, I'm pretty comfortable with the investments in the portfolio.