Why Invest? And How Do You Do It?

Foreword from ShareInvestor

This article “Why Invest? And How Do You Do It?” by Cai HaoXiang was first published in The Business Times on 29 Dec 2014 and is reproduced in this blog in its entirety.

Aim for a sustainable stream of income from a diversified portfolio

The unexamined life is not worth living, Socrates famously declared before he was sentenced to death. These words, recounted by his student Plato, were spoken at a trial where he was accused of corrupting the youth of Athens.

As we head into the new year, it is worth reflecting, in a Socratic spirit, on two fundamental issues around investing: the “why” and the “how”.

People often say they want to make some money, or that they want to get some passive income so they can be financially free.

Financial freedom is an attractive thought. We all grow old some day. By then, who knows whether anyone will want to hire us? Who knows whether our children will be in a position to support us? Investing is one of the best ways where we can gain autonomy over our future.

Passive income sounds nice. This refers to income obtained with minimal effort, for example from stocks, bonds, insurance or property. For most young professionals who are not independently wealthy, one thing to aim for is to cover 100 per cent of one’s expenses with passive income streams.

Are you truly financially independent then, at that point in time? Is your passive income really passive? Can you sit back and ignore your portfolio forever?

You might be able to do so if you hold AAA-rated government bonds. If you hold stocks, even blue-chip ones, and get some dividends from them, you still might not be able to relax completely. Investing to get an income is well and good, but many people blindly go for high-yield stocks without considering whether the income streams offered are sustainable.

A cautionary tale is found in New York-listed Seadrill, which provides drilling services to oil majors and buys the oil rigs used in drilling from companies such as Singapore’s Keppel Corp. Seadrill paid out a steadily increasing stream of dividends through the years. Quarterly dividends this year were about US$1 a quarter.

For much of 2014, Seadrill’s shares traded at between US$32 and US$40. This meant that it was trading at a dividend yield of between 10 and 12.5 per cent. As oil prices plunged in the last few months, the stock fell to about US$20. Then, it announced it was suspending its US$1 quarterly dividend. Share prices plummeted further to the low teens, where it is trading at now.

A company having to suspend its dividend payouts is big negative news. Those who bought in at double digit yields will have suffered far more capital losses than they would ever have gained in dividends.

Many investors in Singapore subscribe to a school of investing known as income investing, which means picking stocks that give a decent stream of dividends over time. Dividends form a substantial part of one’s total return from stocks, and can be reinvested accordingly. A bird in the hand is worth two in the bush.

Many investors who claim to invest for income, I noticed, are drawn to conglomerate Keppel Corp. I am no exception, having first bought in during a dip in November 2012.

Over the years, Keppel has grown to become one of Singapore’s most well-known corporate names in the world. Its dividends are generous, typically offering 4 per cent yields or more. I picked up some more shares recently as prices plunged to lows not seen in three years. It was an impulse buy, I admitted immediately to some colleagues right after I matched the “ask” price on my stock trading app. As a business that has many moving parts that are not easy to understand, Keppel sits uneasily within the income theme of my portfolio and the investing mantra that says, buy what you know, buy what you think has a sustainable cashflow.

Keppel’s yield is now about 5 per cent. But can I count Keppel as an income stock? About two-thirds of Keppel’s revenues and profits come from its offshore and marine business, specifically the business of building oil rigs. This is susceptible to booms and busts.

Insufficient Cashflow

If oil prices look like they will stay low for awhile, the oil majors that explore for, produce, refine and sell oil will postpone or cancel some exploration and production projects. This leads to drilling contractors, which are Keppel’s customers, deferring their own purchases of rigs.

In a severe cyclical downturn lasting many years, there is always the possibility that there will be insufficient cashflows from rig sales to sustain Keppel’s currently generous dividends. Keppel’s own payout history has fluctuated through the years, with substantial one-off special dividends in 2007, 2009 and 2012.

Its property division develops residential and commercial properties in mainly Singapore and China. Yet, property earnings tend to be lumpy and cyclical. Its infrastructure division builds waste treatment plants, sells electricity and rents out logistics facilities and data centres.

Utilities sound stable, but the engineering and construction element of its infrastructure division could also contribute to unpredictable cashflows. For example, in 2013, Keppel recorded cost overruns for its UK energy-from-waste plant, as well as its sewage treatment plant in Qatar.

Keppel’s stake in telco M1, and its stake in Keppel Reit that owns the Marina Bay Financial Centre, are more defensive and predictable. However, they do not form a significant part of Keppel’s valuation.

Keppel might be a broadly diversified, financially strong conglomerate. Yet because of the nature of its businesses, an income investor cannot readily assume that its dividends from the previous year will continue indefinitely into the future.

As a relatively conservative investor, I would rather my portfolio contain more so-called defensive assets that give an income even in downturns. Bonds are a natural place to look, especially as the Singapore Exchange (SGX) moves to allow retail investors better access to them next year.

As for stocks, I have a bias towards global giants involved in food and consumer staples. Names in this space that get bandied around are Nestle, Procter & Gamble, Unilever, Coca-Cola, Hershey’s, or McDonald’s. Oil crash or recession, people will be eating Kit Kat chocolate bars, Maggi instant noodles, Pringles potato chips, buying Pampers diapers for their kids, using Persil washing powder, shaving with Gillette razors, drinking Lipton tea, or getting a double cheeseburger with a Coke.

This is not to say these companies do not have risks or competition. Nevertheless, their brands seem to have staying power over time. This is a buffer against bad management and economic downturns.

A number of these stocks are US-listed, where Singapore investors will take a 30 per cent dividend withholding a tax hit. In the UK, where there are currently no dividend withholding taxes, one income stock that’s on my watchlist is Reckitt Benckiser (RB), which owns a number of familiar health and hygiene brands like Dettol, Strepsils, Lysol and Durex.

Another investing mantra around stock-buying is what makes a good business might not be a good investment. These stocks mentioned above are not cheap. Income investors have to evaluate a number of things to decide whether they are paying a fair price, including the company’s earnings ratios against their historical averages, dividend yield, payout ratios and financial health.

For these companies, however, their prices might never drop to a level that investors consider a bargain, except during rare market crashes. In fact, a 20-year analysis shows that many of the stocks mentioned return a double-digit percentage on average every year including reinvested dividends. That beats the S&P 500 index and the Straits Times Index. Perhaps it is best to shut one’s eyes and implement a programme to steadily buy some each year, and more when earnings ratios dip.

After all, daily fluctuations matter little when you focus on long-term returns. Even if you buy them when they are slightly pricey, your income stream might still rise over time – if it is sustainable.

Income investing is just one of many investing strategies. It is one I find attractive. Probing our assumptions behind why and how we invest is not quite a matter of life and death. The exercise, however, is still worthwhile if it can secure your financial future.