Last Updated June 1, 2012
Having share prices in your face 24/7 is like having a giant red sign on top of your house constantly flashing the price that everyone else (on average) thinks your house is worth.
Do you want grey hair? Just go outside and watch the price on that sign as it ticks up and down by hundreds, if not thousands of pounds every day.
Like the future, the news and people’s opinions, that price would move around essentially at random and often to an alarming degree.
Share price gazing can be hazardous to your wealth
Imagine you’re a buy-to-let landlord and you’ve picked up a nice house for £500,000 cash. The tenants pay £2,000 a month to give you a more or less 5% income.
The reason you chose to invest in property as opposed to the much easier bond route is because you expect both the income and the capital value to go up more or less with inflation while bond coupons are fixed, which sounds sensible enough.
You’d wake up one morning a year later and the sign is flashing:
Great, it’s up 10k in a year, just what you expected and then some. Add in the rental income and you’ll be retired in no time.
But hang on, the man on the news says the US might lose its triple A rating; “oh no it’s the end of the world!!!” you cry. Most people agree with you and the next morning the sign flashes ominously:
At this point your other half throws some toast at you for being such an idiot not seeing this coming. You’ve just lost £200,000 in ONE DAY! That completely wipes out the meagre rent income of £25k that you’ve had so far, almost by a factor of 10!
After you return from work sobbing about the extra years you’ll have to work to make up for that loss, you hear on the radio that the AAA rating is going to stay, and more than that the Euro zone has finally got its act together and has decided to become the United States of Germany.
Of course you always knew they’d sort it in the end. The next morning your red flashing sign says:
You really are a genius after all. Your other half begs you to sell and realise the profit but of course you think it might go up a bit more as you think there could be some good news coming out of Chinese Pork Bellies (or something).
Such is the life of the speculator.
Ignore the day to day noise and concentrate on what really matters
So what did actually change? Probably not very much other than the manic opinions of a lot of people you are never going to meet.
Your old pal, Boring Bob, who bought an identical house down the road, maintains the same zen-like tranquillity as always. Bob unplugged his red flashing sign when he bought his house and he doesn’t watch CNBC.
Bob’s total return: Exactly the same as yours.
Bob’s total stress: About 1 million percent less.
Of course you know that I’m going to say ignore the short term moves. I might even stretch it a bit and say that nobody really has any idea where share prices are going, certainly not in the next five years, and maybe not even the next ten.
The point is that if you’re going to step away from the comfort of fixed rate investments (where you put your money in, you get a fixed return, and then you get back your initial investment back at the end) then you really should have a sound argument as to why you’re taking on all this risk.
And there is a huge amount of risk, especially if you take the difficult road of stock picking rather than index investing.
Everything about fixed rate investing goes out the window. The income is uncertain (if there is any), you may not ever get back what you invested and you may get back a big fat zero if the company goes bust.
And it’s not just the risk of not knowing what the income will be, or of whether you’ll get your money back; it’s the risk that prices will crash and you’ll be scared out of equities at the bottom and completely miss any subsequent rally leaving you with that worst case scenario: the permanent loss of capital.
Following the cash trail
So is it possible to move from fixed rate investing to the quicksand of equities and have a sound reason for doing so?
I think it is. Imagine £100 put into a fictional 5% bond with a five year term.
That’s simple enough; a fixed 25% return over five years. So how does that compare to the FTSE 100 today at 5,500?
|Year||2012||2013||2014||2015||2016||Capital growth||Zero return||Zero return yield|
In this case the current yield is 3.5% and the dividend growth rate is 6% (perhaps optimistic but it’s historically average). If the level of the FTSE 100 stayed at 5,500 until 2016 for a zero percent capital gain, you’d get a 19.73% return from the dividends which is not great given all the extra risks.
If the yield stayed the same, i.e. the index went up in line with the dividend increases then you’d get a 45.98% return (the Capital growth column). That’s much better of course, IF it goes up in line with the dividend.
But what about those risks? What is the chance of getting a zero return, losing hope and slinking back to the safety of a savings account and of course, missing the subsequent rally?
It turns out that to wipe out your dividend return the index would have to drop by that same 19.73% to 4,400 giving you a capital return upon sale of £80.27 (the Zero return column). At that level the dividend yield on the FTSE 100 in 2016 would be 5.5%. That’s a lot, but it is possible. I don’t think it would yield that much for long but it doesn’t take long to scare people into quitting the stock market and selling at the bottom.
If the FTSE 100 today seems a bit so-so, how does this experiment pan out from a known bubble price like the year 2000?
If you were putting in a lump sum of £100 (or 100k if you want to make it more exciting), would the FTSE 100 have been a sensible place to put it, without the benefit of 20/20 foresight?
|Year||2000||2001||2002||2003||2004||Capital growth||Zero return||Zero return yield|
Between 2000 and 2004 you would have a 11.84% dividend return if the index stayed at around 7,000, which is where it was back then. If the index went up at 6% then you’d have a 38.09% return and you’d be ahead of the bond alternative. But if it fell 11.84% to about 6,200 you’d have zero return.
Could the market drop from 7,000 to 6,200? I think we all know the answer to that one. When it did the yield, in this example, would have been around 3% which is very easily attainable and a level that can stick around for years. So investing in the FTSE 100 in 2000 at the level of 7,000 was a really high risk, low return strategy.
That was obvious at the time and it’s even more obvious now, so what about when the FTSE 100 was cheap and future returns good?
Back in 2009 the index was at 4,500 with a yield of 4.3%. The future guestimate then looks like this:
|Capital growth||Zero return||Zero return yield|
The table shows a starting yield of 4.3% and a final yield on the original investment of 5.43%, so that’s a better yield from equities at the end of the period than from bonds (assuming the dividend grows at 6% a year which, as always, is an educated guess).
The total return if the index stays at 4,500 is 24.24% which sort of matches the bond return. If the index goes up by 26.25% to keep the yield at 4.3% (so the index would be at 5,670 which is kind of where we are now) then total return to 2013 would be 50.49%, double the bond return.
Finally, to get a zero return the index would have to drop by 24.24% to about 3,400 which would give a final yield of 7.17%. How likely is it that the index will be at 3,400 in 2013 with a yield of over 7%? Very unlikely I think, and if it were then the investment case would be outstanding from a historic perspective.
The same thinking can be applied to individual companies. The question is:
If this investment were a bond and the price remained static, what would a reasonable estimate of the yield look like in 5 years?
Let’s have a look at Vodafone (which is actually a bad example because of the Verizon dividend, but I’ll ignore that for simplicity):
|Year||2012||2013||2014||2015||2016||Capital growth||Zero return||Zero return yield|
The starting yield is 5.5%, with growth assumed to be 10% which is of course a guesstimate (growth in the last 10 years has been around 12%).
At the end of the period the payout is £8.05, which is an 8% yield on the initial investment, which is a good start because if things panned out like that then at the end of the period the shares would be yielding more than the bond alternative. In this case dividends would provide a 33.58% gain in total.
If the yield remained static and the share price rose we’d see a 66.14% gain; that’s the best result so far but again is reliant on an increasing share price.
Finally, to get a zero return the shares would need to drop by 34% to negate the dividend income, which would give a yield of 12.1% on the 2016 dividend.
Assuming all this panned out as expected (which of course it won’t), how likely is it that Vodafone will be yielding over 12%, and if it was yielding 12% on a sustainable dividend then would it be an investment worth holding?
Of course the answer would very probably be yes because a) the yield is great and b) it’s very likely that the share price will be pushed back up eventually as investors pile in to get that yield.
Don’t speculate to accumulate
While it’s all very exciting to look at share prices and talk about the market going up and down and round and round, all you’re really talking about is the market as a Voting Machine. Everyone puts in their vote on what they think a company is worth and the share price is the result. If everyone is pessimistic the price is down. If optimism rules then the price is up.
The long term investor on the other hand, would do better to focus on the actual cash return an investment provides today and what it can reasonably be expected to return over the next few years.
If the investment case is based on income and appears to be sound, the capital gains should take care of themselves.