So if active funds are expensive and unreliable and passive trackers don't deliver the goods what is the answer?
Well we think the way the Munro Fund is constructed makes a lot more sense, and here's why. The good thing about tracker funds is that they reduce risk by holding every stock in the index. We think that is a good idea so our aim is to do the same, providing that a company is eligible. However, we don't think that price is the best way to determine how much of a stock to hold in the fund. We want something that reflects the fundamental value of a business, and there is no better measure than the cash it generates and distributes to shareholders as dividends. Others agree. Our process is based on dividend payments not because we like dividends, although we do. It is because they are the most reliable data we can get from a company and they have a solid historical base. Dividends paid in the past cannot be restated like the book value of failed acquisitions. When Vodafone finally accepted in 2006 that it had paid too much for Mannesmann in 2000 it changed the company's accounts by £28b. That is big revision of history by any standard and makes comparison using accounts more complicated. Dividends have the virtue of simplicity, and can easily be compared between sectors and companies.
It is possible to argue that revenue is a better measure, or book value, or reported profits be they profits before tax, net or adjusted. The problem with all those figures is that there is a degree of subjectivity involved with all of them. To a greater or lesser extent a manager, director or an accountant will form an opinion on those numbers to determine if they are valid for inclusion. A dividend cheque is different. An investor knows exactly what it is and how much it is. There is no argument. That is not to say that we don't trust company boards but they do have a conflict of interest. Their main purpose from 9 a.m. to 5 p.m. every day is to increase the value of the company. Warren Buffet discusses this issue on page 17 of his report in 2000. Many of them are incentivised to do this through share option schemes which don't require any capital up front but are very lucrative when the target share price is reached. Warren Buffet has something to say on that too on page 23 of his 2004 report. For that reason they have every incentive to accentuate the positive and minimise the negative aspects of their companies. One little aphorism sums up our attitude to corporate accounts:
- Turnover is vanity
- Profit is sanity
- Cash is reality.
A dividend is the money paid out to shareholders after the company has paid all its suppliers and spent enough on maintaining and growing its business. We think that is a good way of assessing how much it is worth to investors. Normally dividends are assessed in relation to a company's share price by dividing the dividend per share by the share price to give the yield. While that is interesting it gives no indication of size. Effectively it assesses dividends by price not volume. We think the total amount paid out is a better way to rank them because that automatically introduces a quantative element into the process. Larger companies are generally safer than small companies and it also aligns the fund closely to market weightings. Indeed, it is remarkable how this process creates a portfolio that is so similar to that of the traditional index.
It is widely assumed that making money on the stock market is all about picking shares that go up in value. In fact that is not the case as this bar chart from Societe Generale demonstrates
It shows quite clearly that in the longer term the bulk of the return from equities comes from dividends and growth in dividends. Over periods of five years or more only 20% of the return comes from capital appreciation. Dividends are much more important than many people realise.
If you are in any doubt about that take a few minutes to look at this video clip from John Authors of The Financial Times.
What we do is unique. We take the forecast dividends per share and multiply them by the number of shares in issue to estimate how much cash the company will pay out in total in the year following the current one.
Rather than using historic data that may be over a year old we prefer to use forecast data on the basis that being roughly right is better than being precisely wrong. The figures we use are the consensus forecasts as reported by Bloomberg. The theory behind this is that the average of a group of experts is more likely to be right than any individual expert, even if you could identify the best expert. James Surowiecki explains this in more detail in his book The Wisdom Of Crowds. It also makes the process transparent. In today's world of frequent corporate reporting, and full disclosure of material events as soon as they happen, it is hard to find information that genuinely provides an edge over the competition. Many of the routes used in the past are now deemed to be inside trading and are therefore illegal. We don't think we are better placed to make better estimates of what will happen than the analysts who talk to the company every day. Recent history has shown how difficult it is to forecast the future and that was best encapsulated by Donald Rumsfeld, then US Secretary of Defence when he said:
"Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know."
Nassim Taleb has also mused on the limits of our knowledge in his two books, "Fooled by Randomness" and "The Black Swan" Knowing what we don't know, and accepting the limits of our knowledge instead of pretending we know the unknowable, is a key part of our investment philosophy.
In the world of finance we have some certainties, like historic dividend payments. There are also things like oil prices that we can try and forecast. Hardest to cope with of all though are things that come out of the blue like fraud. With so much uncertainty we prefer to take the average of the forecasts of the experts rather than adding our own when we have no additional knowledge that would give us a more accurate forecast. Instead of just being another expert we see our role as assimilating the data from all the experts.
Our work is to take those forecasts convert them into sterling if required and then add them all up to calculate the total. That total is then used as the divisor for each company's contribution to work out what percentage it makes of the whole. It is that figure that is used to determine the weight of the stock in the portfolio. This process is repeated every month so that changes to forecasts, exchange rate and any corporate developments such as takeovers or rights issues are incorporated. Much of the day to day work of the fund is keeping track of share buybacks and equity issues that affect how much the company will pay out in dividends.
We describe the process as using forecast gross cash dividends to determine the weight of each stock.
It is unique, simple, transparent and reliable. It means that it does not depend on our views on the market, exchange rates or the prospects for any industry or sector. It is therefore arithmetically based and is not subjective. Consequently the process will not change if our management changes and means it will be the same in ten or fifteen years time as it is today. In essence we are ignoring the capital value of the shares and view them as a big pot of assets that vary in price in a fairly random manner in the short term. What we are focussing on is the cash that flows out of the pot to us and making sure that we have the right amount of capital invested in each company in proportion to its expected cash generation.