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The fast and the furious – Why income-seekers should slow down and think carefully about yield

26/07/2016

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

Every time I make the drive between London and Manchester to see my family, I will inevitably start thinking about speeds and speed limits – and from there, as a dedicated member of The Value Perspective team, it is only a short jump to the hunt for yield. No, bear with me – we will make the link in a fraction of the time it takes me to get beyond the M25.

Obviously nobody on The Value Perspective would ever dream of speeding but we are led to believe there are plenty of drivers who work on the basis the police will give them a leeway of 10% of the limit or even 10% plus two miles. Apparently the increasing accuracy of measuring equipment means that is no longer a given but, still, let’s go with that idea to make our point.

We will start relatively slowly – with the restrictions imposed on some sections of road that you average no more than 50mph. But let’s say, instead of 50mph, you were to edge it up to 53mph, what good would that do you? Well, if there were speed restrictions for the whole journey, then driving at that speed from London, you would save about 10 minutes reaching Manchester, 14 minutes reaching Newcastle and 27 minutes reaching Edinburgh.

But of course there are longer sections of the motorway where you could – you should not, but you could – go a whole lot faster. Say you chose one day to move from an average 80mph for the whole journey – what one might call a ‘normal’ level of speeding – to the rather more hairy 90mph, what sort of time savings would you make then?

Under those circumstances, you would save 12 minutes on your Manchester trip – or 17 minutes travelling to the most northerly city in England. OK, you can read maybe three or four articles on The Value Perspective in 17 minutes but even we would not suggest that prospect is worth all the stress and angst associated with driving long distances at a steady 90mph.

This all-too-human instinct that ‘more’ should always equate to better is where we reach the hunt for yield – because surely a dividend of 4% has to be better than one of 3.5%, hasn’t it? Well, the 50 basis point uplift may seem quite significant but our experience here on The Value Perspective – and especially in the current environment – is it entails taking on a whole lot more risk.

One important point most investors tend to overlook is that, to achieve that additional 50 basis points of dividend, they are putting at risk their whole initial investment of 100. In other words, assuming the share price stays flat, they are going not from 3.5 to 4 but from 103.5 to 104 – and now the 50 basis point difference between those two numbers does not look so appealing.

Furthermore, it involves the unappetising combination of an increased risk profile and diminishing returns, which we can illustrate by returning to our speeding analogy. As the following table shows, upping your average speed from 60mph to 70mph saves you 29 minutes driving from London to Newcastle while upping it to 80mph and to 90mph saves you 21 and just 17 minutes respectively.

 

London to:

Manchester

Newcastle-upon-Tyne

Edinburgh

Distance

140

200

400

       

Time saved (mins)

     

50 - 53 mph

10

14

27

50 - 60 mph

28

40

80

60 - 70 mph

20

29

57

70 - 80 mph

15

21

43

80 - 90 mph

12

17

33

 

Another motoring-oriented illustration of risk and diminishing returns is offered by the following chart, which shows how far a car generally travels after a driver hits the brakes at different speeds. Move up from 40mph to 50mph, for example, and you need an extra 14m to avoid hitting the car ahead. Move up from 50mph to 60mph, however, and it is an extra 17m. Another 10mph and it is an extra 20m.    

                                            Source: UK Department of Transport                                                                         

At a time when, as we have discussed in articles such as Theory and practice, the IA is consulting on an appropriate yield requirement for UK Equity Income funds and the UK market yield is becoming increasingly concentrated, this matter requires careful consideration. As things stand, however, a lot of people would appear to be hunting for yield without assessing the risks and the rewards of a particular course of action. And, as with driving too fast, it has the potential to end unhappily.

Author

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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