Tag Archives: BT rights issue

Inflation beating income: RIRP keeps on winning

Inflation beating income: RIRP keeps on winning

Inflation beating income: RIRP keeps on winning. This is the seventh year I have reported on the performance of the Rising Income Retirement Portfolio, and for the seventh year I am able to report an increase in income significantly greater than inflation, both during the year and since inception, despite a much greater number of disasters on the way than I had anticipated.

The portfolio still contains two shares which paid no dividend last year, one of which never has paid one since I bought it – Lloyds. And my latest disappointment is dear old Sainsbury’s, which has signalled it will cut its dividend this coming year because of the cost of the price war with Lidl and Aldi.  Not what I want to deliver inflation beating income.

According to the original rules I should junk Sainsbury’s and switch into something yielding more, but the fall in its share price means it will probably still yield well over 5% on what the capital is now worth. So partly in the spirit of the season I have decided to leave it in.

Another reason is that the result of undertaking a more detailed review of the past 7 years is the realisation I do not need to work nearly as hard as I did to make up for my early failures.

Inflation beating income - RIRP
How the RIRP produces its inflation beating income

This is the first year during which the fund has been fully invested for the whole period. I am not sure whether it is due to the wisdom that comes with maturity, or a fiscal version of the seven-year itch, but I decided it was time to take a longer view, and introduce a simpler and more transparent way to report the inflation beating income produced by the RIRP results from now on.

Readers may have tired of reading every year that the fund’s rise in income has consistently been more than double the rise in the cost of living. To achieve this both year on year and cumulatively has admittedly required some complicated accounting adjustments to smooth out the distorting effect of one-off special dividends, and to deal with shares on which I have unwillingly had to crystallise a profit or a loss.

Inflation fall is a bonus

The latest bigger-than-expected fall in inflation means I turn out to have overreached myself spectacularly this year, always useful when the objective is inflation beating income. As usual at the start of a year, the table shows the known performance of the fund up to the end of its accounting year in February. It shows dividend rises of 6.3% against a rise in the RPI of a fraction under 2% to November.

That looks – and in cash terms is – terrific, but most of this is in fact due to the huge return of capital by Vodafone, some of it in the form of special dividends, which more than compensated for RSA’s passed dividends.

So I have re-cast the figures. I have removed this year’s and last year’s special dividends to better reflect the underlying income growth over the life of the RIRP.

The small table shows what that really means.

Inflation beating income - RIRP
Rising Income Retirement Portfolio performance

This shows that if I do nothing, dividends in 2015 will be some £800 more than I need to keep ahead of the recent RPI inflation rate: 2% dividend growth only represents a little over £100.

Another way of looking at it is to look at the actual dividend growth since inception in percentage terms. It works out at 44.8% – more than twice the rate of inflation. As above, this figure excludes the special dividends from Vodafone and Direct Line in the current year.

So from now on I propose to ignore special dividends entirely in my computation of the fund’s underlying performance shown in the large table, but to aggregate all such payments in a new line called “Annual Bonus”. This will hopefully be enough each year to more than compensate for any dividend storms ahead.

Up till now the RIRP has not declared by how much it aims to beat inflation – I thought I would be doing well enough just to match it. But in the light of the achievement of the past 7 years, I am making a doubling of the inflation measure my aspiration – at least so long as inflation remains at these historically low levels.

Raising the income target

At the moment, based on recent payouts but factoring in a dividend cut for Sainsbury (and nothing from RSA or Lloyds), the RIRP will produce an income rise of only a little over 1% for the coming year, but we have a year of dividend announcements ahead of us.

I gather that some fund managers are becoming increasingly jittery about the sustainability of dividend growth in future, arguing that dividends cannot continue rising indefinitely faster than wages, even though that is precisely what they have done since incomes started being squeezed in 2010. This may be true in aggregate, but is not necessarily true in individual cases. There is no doubt that Aldi and Lidl will be paying their shareholders more this year, at the expense of Sainsbury and Tesco.

More worrying is the renewed fear of deflation. I do not discount the danger entirely, but think the markets are forgetting that much of the current “problem” is caused by a drop in the oil price. Back in the 1980s when Britain was at the peak of its oil exporting history, the Treasury still judged the effect of a falling oil price as on balance benign for the UK, and lower oil prices have always historically been reflationary in their impact on the economies of all except the oil-producing countries.

If deflation were to occur, then if companies were only to cut their dividends by no more than the fall in the general price level, the portfolio would in theory still be delivering its original aim – the preservation of purchasing power through Inflation beating income. But sadly, history suggests this is not what happened last time round.

Although the historical information is far from robust, everything in the best we have, the Barclays Equity and Gilt study, indicates that when prices last fell over a prolonged period in Britain (every year bar one from 1924 to 1932) the dividend payouts from shares fell much faster. But capital values did fall much less than the cost of living, and the value of income shares fell less than the market as a whole, so an equity income strategy still benefited investors.

I think deflation is improbable. I am – so far – only mildly discomforted by the conclusions of a growing body of academics who are claiming that quantitative easing is itself inherently deflationary rather than inflationary, and that is only partly because I lack the patience to follow the economic maths involved.

The RIRP’s approach is based on the premise that the biggest risk to my wealth in retirement is inflation, rather than the fluctuation in capital values inherent in stockmarket investment; and that shares represent the only likely protection against inflation – apart from property, whose management headaches I do not want to get involved in.

Ultimately I believe politicians will choose to inflate away the national debt and its rising interest burden as they always have done in the past, and which Britain will still be able to do so long as we do not join anyone else’s currency union.

How to deal with BT rights issue?

But do not forget the old City warning: “Never forget the 1% chance”. Presumably the only reason for a private investor to hold gilts with taxed redemption yields of under 2% is as insurance against a prolonged period of deflation.

For what it is worth, I am putting my money – or rather someone else’s, and with it my domestic safety – where my mouth is. I have finally convinced my pathologically risk-averse former partner that as his 5-year bank deposits yielding an average of 4.5% mature, the only way to avoid a massive collapse in his income is to embrace the principles of the RIRP.

His income requirements mean I have had to abandon one of the points of the original RIRP – drip-buying over a long period to benefit from pound-cost averaging, which has certainly proved its worth. Instead since November I have been creating a “Son of RIRP” with the additional short-term aim of maximising its underlying income over the coming 12 months.

The editor has suggested that a forward-looking version of this in the next issue could help those subscribers who have joined less than 7 years ago and who fear they might have missed the inflation beating income provided by the RIRP boat.

So with this in mind for April, I am anticipating a period of “masterly inactivity” for the original portfolio: I hope to watch the underlying inflation-busting dividend increases continue to roll in, perhaps supplemented by continuing specials from Direct Line. I hope the only strategic decision I shall have to make will be what to do if BT launches a rights issue to help fund its mobile phone acquisition.

As the RIRP is fully invested I will be forced either reduce my holdings of one or more other shares in order to increase my BT weighting, or to tail-swallow – sell the rights to fund a small take-up. I shall advise my decision on a web update as and when the details are known.

First published in The IRS Report on 10th January 2015.

Dividend cut from RSA

Dividend cut from RSA for RIRP

Dividend cut from RSA. Barely a month after subscribers had been treated to my self-congratulatory New Year review of the Rising Income Retirement Portfolio’s performance, I was rewarded with a nasty dose of hubris.

Despite “solid performance” including a 5% growth in net premiums, a strong balance sheet and a strategy expected to deliver strong premium growth, somehow profits at one of my biggest holdings, RSA, were down a fifth, and the company decided the dividend was unsustainable and cut it by a third.

The effect of the dividend cut from RSA is to knock nearly a couple of hundred pounds off my projected income for the year ahead, and this reduces the projected percentage rise in RIRP income for the year ahead by a couple of percentage points.

In principle there is no place in the RIRP for any share which isn’t earning its keep by paying out more each year. But in practice I have previously found reasons for retaining Lloyds — which has never paid a penny since we bought it — and for not jettisoning United Utilities or Legal and General when they “rebased” (slashed) their dividends.

To an extent this is a luxury resulting from the inflation-beating performance of the rest of the portfolio. But as I described when justifying my maiden purchase of BP, buying into a company which has just cut its dividends can produce a good starting yield with expectations of above-average dividend growth.

This was certainly true with Legal & General, which we happened to start buying just before it announced a dividend cut. As Figure 1 shows it since has delivered some of the fastest dividend growth of any of our holdings, and is now paying out 28% more than it was before the cut, and twice the 2009 payout. Generally speaking the bigger the cut, the bigger the subsequent increases, as Figures 2 and 3 show.

Dividend cut from RSA
Legal and General’s accelerating dividends

Avoiding losses – for now

The argument for retaining a share in which the RIRP is fully invested when it cuts its payout is less easy to justify, as was the case with United Utilities and is with RSA. The problems are compounded when I have a capital loss on the shares, as I do to a small extent with RSA and to a much larger extent with another possible trouble-maker, FirstGroup.

This is a portfolio for investing retirement savings, so my assumption is that we do not have the salary-earners’ luxury of being able to replace investment losses from earned income.

And while capital gains are mostly only of academic interest to me, crystallising a loss causes me grief and might force me to make up my losses by taking some capital profits elsewhere.

I have convinced myself I can avoid these unpleasant choices because two white knights have ridden to the rescue. Firstly Standard Life has said it will pay a special dividend which will almost double its projected income this year, raising the return on the capital I invested in it to double figures, and more than wiping out the loss of income this year afetr the dividend cut from RSA.

I accept that this is completely hypocritical — after all, last year I railed against the special dividends paid by Vodafone and Glaxo on the grounds they artificially inflate income and store up problems for the following year.

My view on special dividends remains the same, but in deciding what to do after the dividend cut from RSA I have to work out what the investment alternatives would be if I cut my losses. The board has made it clear the interim dividend next November will also be slashed by a third, which will cut the return on my investment in the company from nearly 7.5% to just under 5%. So the right way of deciding whether to junk RSA or retain it is to ask what else could I buy yielding nearly 5% with as good dividend growth prospects as RSA.

I am sure some exist, but I suspect RSA’s still relatively new CEO will be keen to outperform in much the same way Legal & General did. On balance I conclude that jettisoning RSA now constitutes a greater risk than the possible lost opportunity of investing elsewhere.

In coming to this conclusion I am also comforted by the projection of an overall rise in income for the RIRP for the year ahead of at least 5%. A lot of this is of course due to the Standard Life special dividend, but also to the 8% increase over previous expectations in the sterling value of our maiden dividend from BP, owing to the weak sterling/dollar rate.

Dividend cut from RSA
RIRP purchases and dividends to date

BP has also announced an $8bn share buyback programme following the sale of its 50% interest in TNK-BP to Rosneft.

This is my least favourite way of “returning cash to shareholders”, since it usually benefits directors on earnings-per-share bonuses rather than dividend-receiving shareholders: I would prefer the cash in dividends, even if they are “special”!

Despite a further $4bn provision against the Gulf disaster — bringing the total to over $42bn — I take this as evidence of the company’s confidence in its future strategy and ability to deliver earnings and dividend growth. So the RIRP makes its second £1,000 BP purchase, which will qualify for the second quarterly dividend payable in June, yielding a little over 5% at the current exchange rate.

I am acutely aware that these are sticking plaster solutions which I cannot hope to be repeated if FirstGroup also makes the dividend cut which the market is expecting. The RIRP’s dividend growth since inception is more than double the near 18% rate of inflation over the same period, which could in theory enable us to suffer some years with below inflation dividend growth. I am keen to avoid such an outcome if I possibly can.

My aim for the portfolio — as for myself — has to be year-on-year increases in the cash generated to keep ahead of inflation, regardless of past over-achievement. This is a challenge which is likely to become increasingly demanding.

I suppose it is some consolation that the longer it takes for the UK to get its annual budget deficit down, the more desperate the government will be to keep the interest rate it has to pay on its sales of gilts as low as possible for as long as possible, which will continue to make shares look more attractive than bank deposits for the longest period since the 1930s.

First published in The IRS Report on 6th April 2013.