The way the Munro UK Dividend Fund is constructed is unique as far as we know and we think it will help investors to read an explanation of how we do it. In essence we have six principles that guide us and this short section explains them and how they are used to construct the portfolio.
Firstly, we believe that the market is pretty efficient. It always eventually gets the right answer to the eternal question of what a company is worth. All we are aiming to do is discover it just a little bit quicker than the majority of the market.
Our second belief is that we are aware of what we know and what we don’t know. We know that the people with the best knowledge of the prospects of any company are the analysts that follow them day in and day out. We are going to use their estimates as the basis of our portfolio without embellishing them with our views on whether we think they are too optimistic or too pessimistic. In the absence of inside information, which is illegal, there is a level playing field of published knowledge about listed companies. That means it is very hard to beat everyone else consistently. But by using this published data in a systematic manner we will eliminate the emotional bias and removes one level of risk.
What we don’t know is what interest
rates, exchange rates, oil prices or any of the other variables that
are important to profits will be. So we don’t try and predict them.
Others might be able to, but we simply don’t know what the price
of oil will be next year so we are not going to try and pretend that
we do. Instead, we use those consensus forecasts that represent the best
available knowledge in the market. When they change, we change our portfolio.
Our third belief is that to capture the return of the market we have to be invested in every stock in the market. There is so much going on in each and every company that could result in additional value creation, but that we don’t know about, that the only way to be sure of capturing it is to hold shares in all of them.
Normally, that is via a tracker, also known as an index fund, but that process has the disadvantage of being obliged to follow valuations up and down regardless of the individual merits of each company. That is best illustrated by the activity at each review of an equity index when some companies are added and some are rejected solely on the basis of their market capitalisation. By holding shares in every company that is forecast to pay a dividend we ensure that we don’t miss out on returns from companies where we don’t know what we don’t know about them.
Our fourth investment principle is to recognise how biased the market is to a handful of global companies. The top ten companies on the London Stock Exchange account for 37% of the total market value. More significantly, these ten companies make up 46% of the dividend income of the whole market. So this fund only invests in the largest half of the market.
Companies suddenly don’t become fantastic investments overnight. Equally, they don’t normally transmute into awful businesses over a weekend; although there are rare exceptions. Companies are like people who evolve and change as they react to or anticipate features in their business environment. This is a gradual process and it is often hard to detect the first signs of when a company is doing well or is facing a more difficult future. One thing is for sure is that by the time a company’s success or problems have reached the front pages of the newspapers it is too late to react and the share price will have already incorporated that element into the valuation.
Because our approach is to hold all the shares in the market that meet our criteria we do not have to take a brutal decision to buy or sell a share. Instead, our process picks up those gradual changes in sentiment towards a company, expressed in earnings and dividend forecasts from the brokers, and incrementally changes the allocation of each stock in the portfolio. This is a rather mechanical exercise and is repeated every month so that we capture all the news flow whether good or bad. This means that as a company is forecast to do better brokers will raise their forecasts of its earning and dividends. If that increase is larger than that expected for the rest of the market then the weight of that stock in the portfolio will be increased when the fund is rebalanced.
Conversely, a company that is not expected to do well, or is not expected to raise its dividend as fast as its peers, will have a lower weight the next time the portfolio is rebalanced. It is these small, gradual changes every month that keeps the portfolio focussed on the largest dividend payers and should enable the fund to outperform the benchmark. Both the market and the fund get the right answer in the end. It is just that the fund should get there that little bit quicker because it is scanning the whole market every month.
This is not rocket science. In fact it is rather tedious, but it is why we review the market every day in our market comment to make sure we know what the companies are saying about their business. Knowing that we can enables us to review the forecasts from the broker with a degree of understanding and appreciate why they are changing.
Finally, the measure we use to construct the portfolio is, as far as we know, unique to us. We calculate the total amount paid out in dividends by the largest companies in the London Stock Market. Then we divide each company’s individual contribution by the total to calculate that company’s size in the portfolio. That’s the theory. In practice there are many adjustments that have to be made to get these numbers.
The two most significant are for currencies and for share buybacks and the whole process is repeated every month so that all the numbers are up to date. Our process means that we don’t include companies that don’t pay out, or are not forecast to pay, dividends. That is a defect we are prepared to live with. In reality excluding these companies, and investment trusts, reduces our the universe of stocks to a very limited extent. Not only are dividends a good way to compare companies the long running Barclays Equity Gilt study consistently proves their value in long term investing. The 2006 study illustrates the point by comparing £100 invested in equities in 1945. Without reinvesting the dividends, i.e. relying solely on capital growth, that £100 would have grown to £7,373 by the end of 2005. But the same £100, with dividends reinvested, would have risen to £107,487 over the same period.
So this is what we do with your money. We don’t claim to be geniuses and able to second guess the market. All we are doing is processing the available data in a logical way and on a regular basis. We think this is the best way to ensure that the fund is always looking to be invested in those companies that will generate the largest amount of free cash flow in the next financial year. Our underlying thought is that in ten years time the largest companies in the stock market will still be those that are paying out the largest amount of dividends.