You Need Income
By David Potter, Former Deputy Chairman Investec Bank UK and CEO Guinness Mahon Group

The only time the word dividend was used was when "special dividends" were paid. This is code for either "we have run out of ideas about how to invest your money" or "here is a good way to pump the share price up for the next deal".

The Venture Capital and Private Equity Industry has mushroomed in the last twenty years without the word "dividend" in the lexicon.

These are the most obvious manifestations. Deeper problems lurk with companies and their bankers who believed that life was all about financial engineering, gearing, mergers and acquisitions. If there was any cash left over they bought back shares. The justification of buy backs being that this gave investors the option to take their return. In truth it was more a method of keeping the share price moving ever upwards to facilitate the next deal. Thus one of the basic corporate disciplines of generating cash, getting it to the bottom line and paying rising dividends was being lost. Investors ceased worrying about this as stock markets kept rising. The words "covered dividend" disappeared from the writings of analysts and journalists.

The long period of inflation (that has now come to an end) reinforced the capital appreciation aspect of total return. At the individual level of perception this was not surprising, due to the huge appreciation in their principle asset of property, magnified by the gearing that was increasingly offered by Banks and Building Societies and the CGT exemption. It will not be long before the regulators start telling Estate Agents and Banks to have the “prices can go down as well as up” warnings on their literature. They should also add, “past performance is no guide to the future”.

Rental yields on houses have declined dramatically. Analysts should now pay more attention to this aspect when speculating on the future movement of prices. How often do we see analysis of the relationship between Gilt yields and rentals income on houses?

Now that we are entering a non-inflationary period, where the risks of deflation mount daily, all of this will need to be re-examined. Most people have forgotten that up to 1959 the dividend yield on equities was higher that that on government bonds. Why? Because when there is no inflation to bail you out, the market realises that equities are more risky than bonds or cash. Secondly, the market understood that the only way companies could grow was by making and selling better goods or services. In the same period house prices barely moved; if you sold a house in the 1950s for the same as you paid 25 years before your attitude was "fantastic, we have lived rent free for 25 years". Some of us may remember our parents or grandparents saying this.

When the Government hops onto a financial bandwagon it is generally best to get off. When index linked Gilts were first issued only institutions could buy them. The day the general public were allowed to buy them marked the absolute peak of the inflation cycle. As the Trustee laws are changed to permit Charitable Foundations to work on a total return basis, you know the party is over for capital growth alone. Beware of ignoring income. I fear that charitable foundations that adopt this approach will end up "eating the huskies".

As the global deflation gathers pace, and signs of falling prices multiply, the dangers of forgetting income are becoming clearer. Most prices are already falling and stock exchanges have been recognising this. We are most of the way through the third year when equity portfolios have declined or moved sideways at best. The large reduction in annuity rates is at last causing pension plan holders to wake up to the importance of income.

Many investors are suffering from another great inflation driven total return delusion. They are still sitting on substantial capital gains, despite recent market setbacks. They say,  “I can’t sell my XYZ shares because I have too big a CGT bill”. Once people realise that prices don’t go on rising forever they will wake up to another basic economic truth. “Give me the gains and I will pay the tax”. Whenever you sell appreciated stock you still retain 60% of the profit (plus the benefit of indexation relief or more recently the benefit of taper relief). Once investors realise that cash can appreciate in value when other prices fall, they may become more willing to sell their appreciated stock and pay the tax from the proceeds. This is a further downside risk for equity markets today.

It is not just individuals who are in danger from missing these simple economic basics. Companies have also become slaves to “total return” and in so doing have progressively abandoned basic financial discipline. The fundamental goal of a company to generate real cash earnings, get them to the bottom line and pay their shareholders cash dividends has been abandoned in favour of mergers and acquisitions, financial engineering, and borrowing at the expense of rising cash dividends. (BT, Marconi and Vodafone are recent examples). As we enter the new world of no inflation to bail out over-borrowed companies, their investors will realise that growth, and growth in share price, will only be achieved from making better products or providing better services and generating enough margin to pay rising cash dividends.

None of this "income blindness" is terribly surprising. We have had nearly 50 years of inflation. No one is around who knows how to manage or invest in a zero inflation or deflationary world.  The Japanese have been at it for ten years and have made no progress. They are discovering that deflation is harder to control than inflation. Perhaps every company should employ a Japanese director.

We therefore have to look to the lessons of history for pointers. There are strong parallels between what is happening now and what happened (more slowly, because of poorer communication) after the Industrial Revolution. The latter ushered in decades of zero inflation to mild deflation with low interest rates. It was a good time for creating new businesses. Many of the "old economy" global companies trace their roots to this period. (Auto, Chemicals, Consumer Products, Retailers, Engineering and Construction). They built their business on creating new products and new markets. Most built slowly and many stayed private for years relying on cheap Bank finance and reinvested (cash) profits for growth.

The evolution of "buy to rent mortgages" is an interesting pointer. In times of no inflation (or mild deflation) rental property has been a basic investment, and indeed in the late 19^th century one of the main investment classes alongside Government Bonds. A reading of the Victorian novels demonstrates this. The key thing to remember is that the rental yield drove the price.

The result of this is that there will be a strong and growing demand for dividends from the gathering army of investors and personal pension fund holders who have seen annuity values plummet. They know that income matters. They will increasingly invest in companies who attend to this fundamental economic basic and pay attention to the yields on property investment. They may have already noticed the defensive benefits of investment in those few companies who do pay, and intend to go on paying, dividends. Companies who recognise this will prosper, and so will their shareholders.
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David Potter spent his early years in the money market, joining White Weld, the predecessor company to CSFB, in 1969. He remained at CSFB as a Managing Director to 1981, becoming involved in the rapidly growing euro markets, corporate finance and asset management and also serving as Chairman of CSFB Asia in Singapore. He then joined Samuel Montagu to head its newly created Capital Markets division. In 1986 he moved to the parent company Midland Bank (now HSBC) as Managing Director of its Global Corporate banking Division, leaving in 1989 to join the board of its subsidiary Thomas Cook as a non-executive director and also of Tyndall PLC. During the following year, prior to his appointment as CEO of Guinness Mahon Group, he worked as a consultant to a number of major corporations including GEC, House of Fraser and BAT. From 1991-98 he led the recovery of Guinness Mahon, its emergence as a significant force in new media and its eventual sale by The Bank of Yokohama to Investec of South Africa. He remained Deputy Chairman of Investec Bank UK until 1999 when he joined the Board of the Rose Partnership, the leading City Head Hunters.

Since early 2001 David has developed a plural life as Chairman of InfoCandy, DictaScribe and Eon Lifestyle Ltd and as a non-executive director of Noble Group, WMC Communications, New Media Spark, FCS and Omega UK. He is also Hon. Treasurer of Kings College London and a Trustee of The UK Friends of The Nelson Mandela Children’s Fund, Worldwide Volunteering for Young People and The National Film and TV School Foundation.

Reproduced by permission of David Potter.