For­get divis and just cash in your cap­i­tal gains? This is why Questor dis­agrees

A pop­u­lar school of thought is that it’s bet­ter to aim for a to­tal re­turn and sell a few shares when you need in­come. For us, this method has one ma­jor flaw

The Daily Telegraph - Business - - Business - RICHARD EVANS

DOES an in­come port­fo­lio such as ours ac­tu­ally need div­i­dends from its stocks? It may sound like a daft ques­tion but there are many, pro­fes­sion­als and DIY in­vestors alike, who say there is no such need.

You are just as well off – bet­ter off, in fact – own­ing in­vest­ments geared to growth and sim­ply sell­ing a small pro­por­tion of them when you need money, the ar­gu­ment goes. Questor has come across fi­nan­cial ad­vis­ers and fund man­agers who take this view and has seen it ex­pressed many times by readers who com­ment on these ar­ti­cles on­line. But this col­umn does beg to dif­fer. Here is why. Let’s imag­ine an ide­alised com­pany that makes £100m in prof­its a year. The board has a choice: it can hand those prof­its to share­hold­ers in the form of a div­i­dend or rein­vest them in the busi­ness. (There are other choices, such as a mix­ture of the two or buy­ing back shares, but we will sim­plify things.) All else be­ing equal, by re­tain­ing the prof­its in the busi­ness we in­crease its value by £100m. There­fore, a share­holder can with­draw his share of that £100m if he wants by sell­ing the ap­pro­pri­ate num­ber of shares and still re­tain enough shares to have the value of his orig­i­nal cap­i­tal.

Let’s look in more de­tail at how this might work.

We’ll imag­ine that the com­pany is at the out­set, be­fore the £100m of profit is made, worth £1bn and has 1bn shares in is­sue, so each is worth 100p.

The £100m of prof­its is then made. Keep­ing things sim­ple, we as­sume for the mo­ment that the value of the com­pany in­creases by £100m or 10pc, which means that the share price goes up by 10pc to 110p.

Let’s now imag­ine that one par­tic­u­lar share­holder owns 1,000 shares (one mil­lionth of the com­pany), orig­i­nally worth £1,000 in to­tal and now worth £1,100.

He wants to get his hands on that £100 in ex­tra value, which rep­re­sents his share of the £100m in prof­its, so he sells enough shares to do so.

At a share price of 110p he needs to sell 91 shares to do so (this ac­tu­ally re­alises £100.10 – we can over­look the pence for the sake of our ex­am­ple). His re­main­ing 909 shares are worth £1,000 so he has £1,100 in to­tal, as you would ex­pect.

We note in pass­ing that he now owns slightly less than his pre­vi­ous one mil­lionth of the com­pany, but he is happy with this be­cause the com­pany has be­come more valu­able: he has a smaller slice of a big­ger pie.

But now let’s look at what hap­pens if the share price does not sim­ply rise in line with the ex­tra £100m in value that the firm gains from those prof­its. Let’s imag­ine that some­thing – a global stock market crash, say – sends the shares down by 30pc to 70p.

If our share­holder still wants to get his share of the £100m in prof­its he has to sell more shares to do so: 143 (to the near­est round num­ber) in fact.

Now we imag­ine that the stock market re­cov­ers and that this com­pany’s share price too re­gains its for­mer level of 110p. Our in­vestor now has 857 shares so his hold­ing is worth £943 (to the near­est pound). He also has his £100 from the sale of the 143 shares so in to­tal he has £1,043.

Now let’s imag­ine that the com­pany had cho­sen to use all its £100m in prof­its to pay a div­i­dend in­stead. The same in­vestor gets his £100 share of the prof­its and, al­though the pa­per value of his shares falls by 30pc when the bear market strikes, he loses noth­ing be­cause he sells no shares. When the share price re­cov­ers to 100p (not 110p be­cause the prof­its have all been dis­trib­uted in div­i­dends), he has 1,000 shares worth £1,000. Add his £100 in div­i­dend in­come and he has £1,100 in to­tal – £57 more than if the com­pany had re­tained the prof­its and he had had to sell some of his hold­ing to get his £100 share of those prof­its.

The key point: when you take in­come by sell­ing shares the share price mat­ters. It doesn’t mat­ter if a div­i­dend

is paid.

Now, there are nu­mer­ous counter ar­gu­ments that in­volve the gen­eral up­ward di­rec­tion of mar­kets, cash “buf­fers” and tax con­sid­er­a­tions but for this col­umn, at least, the fact that div­i­dends al­low you to take in­come with­out share prices mat­ter­ing is para­mount.

Up­date: Low­land

This in­vest­ment trust de­clared on Tues­day a third in­terim div­i­dend of 15p, un­changed from last year. Hold.

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