Sherman Tank
by Doug Brodie
In this blog:
/1. The Magic Money Machine
/2. £90,000 per year, net, for life, inflation adjusted. The aNewuity: when ‘pension’ means ‘income’.
/3. “What were you thinking?”
/1. The Magic Money Machine
This is the Cummins VT8-460 turbodiesel, and it was used to power the M50 Sherman tank, it’s 15.5 litres and was built in Indiana by Cummins. Here’s the tenuous connection to MetroBank: the Magic Money Machine. Clearly to follow Mr Buffet’s advice about passive income we need a Magic Money Machine, and if you ask Mr Google to find one he (they?) come up with the coin counting machines that MetroBank install in their branches, mainly for the youngsters to deposit their sweatily-grabbed coins and watch them being counted. The link to the Sherman tank is that the money counting machines are manufactured by none other than the Cummins-Allison Corporation.
We think the coin machines are not quite suitable for the Magic Money we have in mind. Magic Money, aka passive income, is cash that gets paid while you sleep, 52 weeks per year, whether you’re on holiday in New Zealand, sailing in Vassiliki or climbing cliffs in Madeira. By default, that means you cannot be generating income by selling investment assets, which is just as well because sequence risk will catch you out at some time over your retirement. You can read the explanation in Chapter 13 of our core White Paper, however as a shortcut here’s an excerpt from an academic paper by Javier Estrada at IESE Business School in Barcelona, taking data from the S&P 500. This is real data, and is what ‘index only’ acolytes are buying into in the US, however, you can see that at year 10 the money runs out (and being an index you have no third-party investment manager to blame).
/2. £90,000 per year, net, for life, inflation adjusted.
The aNewuity: when ‘pension’ means ‘income’.
The person who is the subject of this case happened to have recently retired from his investment bank role when he came to see us in 2009. By his own very honest and affirming admission he was of independent means simply by dint of where he worked, not because he’d invented anything or was a quant-investing maths guru. As it happened, in 2009 we were focused on fixed interest (bonds) as the yields were priced in for Armageddon – we didn’t believe that was going to happen, and if it did we wouldn’t need pensions anyway.
People often think we only do investment trusts – not so, we’re income investors first and foremost, and when the dynamics of the market change, so do our income portfolios. Here’s the actual allocation of a £2m portfolio in 2009, one in which the objective was to build to that £90k net income.
If you take a snapshot of the yields then it’s quite clear why:
One of the take-aways from this should be that you can see that we’re quite happy to use other investment assets when relevant, and if we’re running a portfolio for you using trusts that’s because that horse happens to fit your course at this moment.
Now going back to the objective… £90k net, for life, with inflation. We can’t control tax rates or allowances and we knew that £90k was a target – a bit higher or lower was never going to cause a problem. Targeting income and NOT asset allocation meant that in 2010 this was the income statement:
£132,520 of income was very healthy and meant the portfolio had a 6.49% return just from income, completely ignoring capital – what’s not to like? The task for us, however, was to handle the portfolio and make relevant adjustments and selections so that inflation was dealt with appropriately. To do that, as interest rates rolled off and the bonds matured, there were no high yielding bonds to us, and our research then built banks of data on other sources of investment income, through the figures from investment trusts.
Inflation aware, however not linked. ‘Linking’ implies a guarantee and the only way to do that was via index linked gilts (or a tiny amount of corporate bonds, mainly banks). We invest with the mantra of ‘probable’, not guaranteed, as the price paid for that implicit, contractual guarantee is often too high, and ‘probable’ is normally good enough.
The RPI figure from the ONS was 216.9 at the end of 2009, and then 378.0 at the end of December, so the £90k net target had climbed, inflation linked, to £156k per year. That clearly puts the client into the 45% tax bracket so the gross income needed will have climbed to around £260k. For those of you who have been clients for over twelve months you’ll have seen a table like this on the front of your report (however this happens to be our largest income portfolio so I’m afraid it’s not yours!)
/3. “What were you thinking?”
If you’re a regular reader of ours you may have seen this from us before, however, in the week that Nvidia’s market cap has breached $1.7 trillion we think that the words of Scott McNealy, CEO of Sun Microsystems in 2000, remain very pertinent:
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
— Scott McNealy, Business Week, 2002
Valuations are underpinned by earned cashflow, there is maths involved, otherwise is simply a Greater Fool theory – where profit on the investment depends on one thing alone – selling out at a higher price than you paid not getting caught when the price collapses.
