Fund manager Terry Smith has a long history of making uncomfortable arguments that the financial services industry doesn’t want to hear. Almost 30 years ago, following the publication of his book, Accounting for Growth, he was fired from his role at a leading investment bank; his exposure of the accounting techniques used by a bunch of companies that blew up in spectacular fashion is one of the best and most accessible books you’ll read on the City, but it washed rather too much dirty linen in public for some people’s liking.
Today, after a decade of running Fundsmith, the fund management firm he launched in 2010, Smith remains as forthright as ever. The latest target in his sights is the idea of equity income; his Financial Times column last month warned “no one should invest in equities for income”. Yikes.
To offer a little more nuance, Smith’s argument is that even before the Covid-19 crisis prompted so many companies to slash their dividends, the distributions that many of them were making were not sustainable. He expects many companies will take this opportunity to move to smaller dividends in the future.
That may be no bad thing if it enables more companies to retain earnings for investment in growth. But where does it leave investors seeking income, particularly at a time when interest rates are at unprecedented lows and yields on pretty much every asset class look paltry? Interestingly, Smith has two suggestions – both of which play to the strengths of the investment companies industry.
First, he suggests income seekers simply focus on capital growth, investing for the best total return possible; then, he points out, there is nothing to stop them cashing in part of this growth in order to secure an income.
This, of course, is one of the unique attributes of the investment companies sector. Unlike other types of collective investment fund, investment companies have the right, with shareholders’ permission, to pay income from capital, rather than funding all distributions from dividends earned by the portfolio. Effectively, such funds are doing exactly what Smith suggests.
Smith’s second suggestion, made thinking of investors who baulk at the idea of swapping capital for income, is that income seekers should look for companies where there is an opportunity to invest alongside a family that has a controlling shareholding in the business. Often, he points out, these families rely on the dividend income generated by their companies, which helps guarantee its flow.
Where might you find such companies? Step forward the closed-ended fund industry once again. There are a number of long-established and successful investment companies where the shareholder base is dominated by a single family, alongside which the public is free to invest. Leading examples include Caledonia Investment, 44% owned by the Cayzer family, Majedie, where the Barlow family owns a similar-sized stake, Brunner, where the eponymous family remains significantly invested, and Manchester & London, majority-controlled by the Sheppard family.
Investors and advisers sometimes worry about investing in family-owned companies and funds; they may have concerns about governance structures and there may be questions over whether the interests of all shareholders are always aligned. Still, these particular funds have impressive long-term performance track records.
The broader point here though is that in so many other areas, the investment companies industry offers some unconventional solutions for investors worried about income, particularly in the challenging environment in which we currently find ourselves.