Terry Smith warns income investors about companies that ‘over-distribute’ profits in dividends and fail to invest in themselves

8th January 2013

Fund management firm Fundsmith run by outspoken City entrepreneur Terry Smith is not shy about challenging established wisdom.

Much of Mr Smith’s fire has turned on the Government’s handling of the financial crisis and the deficit as you can see from his Straight Talking blog , but he also frequently questions the assumptions and practices of the fund management industry too.

This morning Mr Smith is warning investors not to take the wrong approach to investing for income by picking a fund purely on the level of income it offers without much regard to what is happening to the capital invested. He suggests, for example, that investing in the highest dividend yielding stocks can mean you are investing in stocks that not investing adequately in the business. He warns they may be guilty of 'over-distributing'.

He also criticises how rival fund managers take their fees from the capital not the dividends thus preserving the headline rate of income offered but eroding the underlying fund. He calls this sleight of hand. As we say, he doesn't mince his words.  

Now, of course, some of this is for public relations reasons. The firm has a fund to promote and its new regular withdrawal facility will allow investors to use it for taking income. Put it another way the firm is gunning for the market served by income funds.

We’ll be testing these opinions with other market experts when we have canvassed their views later this week.

Nonetheless we think his arguments are well worth a read.

The firm says: “Investing in the highest dividend yielding companies in the market can deprive investors of the potential to compound the value of their capital. We know of virtually no business that can grow without reinvestment. It is important to us that the companies in our portfolio reinvest at least a portion of their cash flow back into the business to grow. The companies in the Fundsmith Equity Fund all generate a high return on reinvested cash. Over time, this should compound shareholders’ wealth by generating more than a pound of stock-market value for each pound invested. On the other hand, investing in high dividend yield companies risks the likelihood that the company is over-distributing (paying out most or all of their earnings as dividends) and cannot reinvest to compound value.

Funds which promote a high level of income are often charging their management fees to capital and so the total return is obscured. In the Fundsmith Equity Fund dividends are received as income, from which the costs of running the fund are deducted and the residual figure is available as a dividend to shareholders. Our analysis of the IMA Equity Income Sectors shows that the vast majority of income funds charge their costs against capital. This “sleight of hand” allows them to boast about a high level of yield whilst at the same time depleting the value of your capital. Charging costs to capital is tax inefficient as income is currently taxed in the UK at a higher rate than capital gains and, unlike Income Tax, Capital Gains Tax can be deferred by not releasing gains thus allowing value to compound on, what is in effect, an interest free loan from the taxman.

As we said, we'll do more on this later this week but it is certainly food for thought as investors increasingly seek to maintain their income. 

 

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