No Capital Appreciation

Published in Investing on 20 September 2012

Stephen Bland on why capital doesn’t matter.

I'm feeling in a high-yield portfolio (HYP) mood today. For commercial reasons I write here only rarely on the subject these days and don't follow the HYP boards much, either -- although I do stick up the very occasional message when if by chance I read some of more outrageous comments made there about the strategy.

Well, here's the big news: I'm not perfect -- and the HYP strategy is not perfect, either. I'm human, more or less, so that makes me by definition imperfect. HYPs are a risk strategy because they are comprised of shares that are a risk investment, and thus also by definition they are not perfect, either. What I mean is that the aim of a HYP is to deliver a growing income over time, but there can be no certainty that that this will happen. This lack of certainty about delivery is their imperfection. It is not a guaranteed way to derive a growing income, it is a risk way of attempting to do so.

The only guaranteed risk-free way (or nearly so) that I can quickly think of to achieve a growing income is index-linked gilts. But the trade-off for this is a start yield that is minuscule and thus unacceptable to nearly all income investors. The long-term income from ILGs depends on inflation over time, so that if this doesn't happen then the income won't rise, but I don't think we've seen the end of long-term inflation just yet.

Back to HYPs, and inevitably there will be years in recessions when total income falls, and it may then take years to recover if the fall was especially severe, as extremely occasionally it will be. Anyone who can't face that should not invest in them.

HYPers who think they can face this should not therefore be surprised when it happens. Facing it doesn't make it pleasurable, but my point here is that there are little grounds to complain when you get hit in this way because you will have this bad experience at some stage. Further, if you hold your HYP for a long time as intended, you will likely be hit more than once though the depth of income fall will vary, usually in line with the prevailing level of the economic problems that cause the dividend cuts.

And then there's the capital. Probably the oldest HYP argument on the Fool is whether capital matters... well, that and tinkering. Here, I'm not going to comment on the latter.

My stance on this is probably very well known: it is that capital doesn't matter. I've said this right from my introduction of the HYP strategy to the Fool a long time ago now -- back in 2000 -- and I still say it now. To expand on this, what it means is that capital fluctuations don't matter because the strategy is about income.

In an absolute sense, capital obviously does matter in that if it fell to zero because all the shares in a portfolio went bust, then there would be no income so obviously in that way it does matter. You need the shares to have some value in order that they can deliver income. But that is not what I meant by my view. It is as I say above, that the fluctuations are of no consequence and ought to be ignored by the HYPer.

This has been perverted over the years by total return artists to whom capital does matter. People for whom I never intended HYPs. Clearly, if you want a two-pronged return from your portfolio, capital plus income, then it matters a lot how the capital performs. But total return was never an objective of my HYP strategy, that was assumed into it by certain individuals bent on doing so.

What probably has caused some to think of capital and total return from an HYP is that it so happens that the capital appreciation has been outstanding for many longer-running portfolios.

For example, HYP1, the original portfolio that I launched here in November 2000, is at this moment valued at £125,164 against the £75,000 invested. That's a gain of 66.9% over nearly 12 years. In contrast, the benchmark of the FTSE 100 (UKX), from which nearly all of the shares were originally drawn, now stands at 5,852 -- which is actually down 6.7% from the start level of 6,275. That's an outperformance of 78.9%, pretty damn good though I say so myself. And it's not just a snapshot lead that could be ahead or behind depending on where you draw the line; HYP1 has been way ahead of the FTSE and thus index trackers for years.

But despite this great capital result so far, I continue to stress that it was not the aim of the scheme. It would be dead easy for me now with perfect hindsight to switch emphasis with this index tracker trashing gain and claim that HYPs are really as much about capital as income, but I don't. Whatever the capital results achieved to date, my HYP strategy was not and is not concerned with that. The portfolio capital value must fluctuate in some way or other over time, and naturally it is better to fluctuate up than down. But whatever happens to it is a side effect, it does not alter my view on what HYPs are about.

I maintain my advice to HYPers existing and potential, that you should be here only for the income and capital doesn't matter.

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Comments

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MunroMan 20 Sep 2012 , 7:51pm

Well said, if you get the income right the capital will follow.

backdated 21 Sep 2012 , 3:39pm

Well said.

If you only ever talk about distribution of profit you only ever discuss the potential positives of investing.

Never the potential negatives......

Luniversal 21 Sep 2012 , 6:47pm

Is Lord Essex back? Good.

Glad Pyad sticks to his guns. Wish he'd come down on the HY boards and lay about the Total Return twerps more often. Then he could duff up those closely associated species, the tinkerers and complexifiers who always know how to make things 'even better'.

Some people cannot see a simple and effective system without wanting to festoon it with bells and whistles. The only one requisite is a margin of safety and an income reserve for the odd 'down' year, and then only if you need income to go up without fail instead of using HYP to supplement a pension.

My derisking method for income would have turned HYP1 into a device for paying up to 4% plus inflation every year since 2000-- and that sure beats a linker gilt.

MunroMan 22 Sep 2012 , 9:17am

He never went away, but is not allowed to play with the big boys on the boards because he upsets them, they complain and he gets banned.

For some reason he can sneak in here though.

Most of the article are hagiographies about Woodie or Buffet but it is good to the occasional gem from pyad.

kempiejon 22 Sep 2012 , 2:50pm

Essex thank you for that.
biography of saints or venerated persons
idealising or idolising biography

ANuvver 22 Sep 2012 , 10:40pm

...from the Greek "hagios" roughly meaning "holy" - as in Hagia Sofia.

Still, the element of proselytising can be forgiven surely? We who've been around here for a bit must bear in mind that there are those who come to this site brand-new. They may think Woodford is too far a journey on the London tube and Buffett is where you get the stale sandwiches from...

goodlifer 23 Sep 2012 , 2:29pm

"The only guaranteed risk-free way (or nearly so) that I can quickly think of to achieve a growing income is index-linked gilts. But the trade-off for this is a start yield that is minuscule and thus unacceptable to nearly all income investors. The long-term income from ILGs depends on inflation over time, so that if this doesn't happen then the income won't rise, but I don't think we've seen the end of long-term inflation just yet."

I don't understand this.
Will index-linked gilts really protect your capital from inflation and provide you with a fair return?

goodlifer 23 Sep 2012 , 2:39pm

"The portfolio capital value must fluctuate in some way or other over time, and naturally it is better to fluctuate up than down."

Not necessarily.
If, like me, you like to reinvest your dividends, the lower the market goes the better.

OTBE.

goodlifer 23 Sep 2012 , 2:58pm

"Despite this great capital result so far, I continue to stress that it was not the aim of the scheme."

Quite so.
But why not opportunistically cash in?

Perhaps I'm not a true-blue HYP, but if one of my stocks ever shoots up to ridiculous heights I'm not too proud to take the money and run.
Provided of course there's a sensible replacement available.

Arborbridge 24 Sep 2012 , 11:50am

Pyad was always a good scribe and an excellent read.


Essex, come home. I miss you - even though your comments can be cryptic. Why should the rest of us lose out because a minority are beastly?

Arb.

Arborbridge 24 Sep 2012 , 11:57am

A more serious comment about this article: was it cut in half? When I got to the bottom, it seemed like PYAD had only just got into his stride. Surely he has more to say than this? What great proofs or points was he about to make when he was cut short? Why mention HYP1 gee-whizz capital, but no mention of how well the income has done?

This article, so well written and a joy to read left me unsatisfied and wanting more. Perhaps that was his plan: is there more to come?

Arb.

MrBearBull888 25 Sep 2012 , 11:58am

Great article

As Arb said (i)This article, so well written and a joy to read left me unsatisfied and wanting more(/i)

Yes I would like more

Bear

MrBearBull888 25 Sep 2012 , 11:59am

Looks like I should have gone to Spec Savers

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