Equity funds are fine for accumulating wealth over one's working life, offering convenience, diversification, and professional management. However, they're not very good at generating income. Fees that didn't seem so large in a long-term, total-return context can stand to eat up one third or more of your current income potential. And let's face it--few fund managers' interests truly align with those of the income seeker.
Investing is a tough business, and most of us don't learn it in school. I can understand why the overwhelming majority of investors farm the tasks of asset allocation and stock selection out to the pros, however highly compensated they may be, in exchange for a little peace of mind. But with a dividend-oriented strategy in mind, I can make a strong case for owning individual stocks directly--cutting out the middlemen who want a piece of your investment profits.
Certainly there's a case for recruiting the expertise of a manager when it comes to investing in areas that you don't necessarily have expertise in yourself--international equities, for example, and emerging markets in particular. It's often easier to evaluate the average emerging market equity manager than the average emerging markets stock.
Similarly, I'd rather buy a superbly managed real estate investment trust than become a landlord myself (inevitably with plunger in hand). I can't compete with the specialised knowledge these managers can offer, and their records largely speak for themselves.
But when it comes to buying domestic equity--especially well-known, large-cap blue chips--I'm sceptical that investment managers as a group can offer an edge on performance commensurate with their cost. If your strategy simply seeks the best companies in the UK, inserting a fund manager (or worse yet, a fund manager and an overpriced financial planner or broker) between yourself and the actual cash generated by the business will act as a big drag on your returns.
And consider this: If your equity-income fund has a net expense ratio of 1.5% and your fund offers a yield equivalent to, say, 3%, then of actual income being collected, nearly half is carted off in fees.
Going It Alone--and Going Strong
Investing in stocks directly, however, can be a very low-cost proposition. Of course, managing a portfolio of individual stocks does require an investment of your time. Yet even in today's incredibly competitive markets, I believe an individual stock-picker--armed with a few basic principles--can earn attractive returns over the long run.
Take the long-term view. With City careers hinged on short-term performance, it's the rare professional who can take the long-term view even if he or she wants to. But this conveys one of the few advantages available to the independent investor: You need not "fire yourself" for lagging the market over a month or a quarter. When you're being paid to own the stocks, you can afford to be patient. Most of the pros simply can't.
Focus on economic moats. Competitive advantages are rarely, if ever, the centre of the City's focus. Why should the sell-side analyst or hedge fund manager concern himself or herself with long-run competitive dynamics when the goal is to pick the next company to beat or miss one quarter's earnings per share estimate? Changes in economic moats rarely play out in such short time frames.
Yet it's overlooked that the long-term competitive advantages inherent in the business are what permit earnings to be recorded at all. Armed with a long-term view and the knowledge that competitive standing plays a critical role in future earning power, we can compete with other investors on our own, superior terms. Click here for a comprehensive explanation of how Morningstar measures moats.
Buy only with a margin of safety. The pros all know who Ben Graham was, and what he had to say about investing in stocks. They're also aware of Graham's own investment prowess and the fortunes built by proteges like Warren Buffett. (I suggest looking up Buffett's 1984 speech on the topic, "The Superinvestors of Graham-and-Doddsville," which is available in several different locations on the Internet, including here.)
Relatively few pros, however, follow Graham's most critical advice: Always have a margin of safety. By obtaining a margin of safety--purchasing a stock at a discount to its intrinsic value--the investor reduces risk (providing room for error in valuation) and increases his or her profit potential should that valuation estimate turn out to be correct.
Let dividends be your guide. The dividend record contains more information about the true state of a company--its financial condition, capacity to grow, and willingness to share any success with owners--than any quarterly earnings figures.
The theme behind each of these four principles is this: Don't invest on the City's terms. Keep those transaction and management costs in your pocket and let them compound to your advantage over time.
This is an edited version of an article that originally appeared on Morningstar.com on September 8, 2006.
