Investment Heretic

Peter Thornhill is something of an investment heretic, arguing against a key plank in standard portfolio management theory, that investors should diversify between asset classes. Not only that, the reason he doesn’t like it is the reason most managers give for following it: safety.

Thornhill, principal at the Motivated Money group, is an investment industry veteran with a successful career behind him at National Mutual, Perpetual and MLC. These days he’s happily semi-retired but can still be found giving lectures and seminars on investment and selling his book, Motivated Money, through www.motivatedmoney.com. The core of his message is investment in quality dividend-paying industrial shares above all else. Actually, make that investment in quality dividend-paying industrial shares and nothing else.

It’s an unfashionable view when the resources stocks are running, let alone when standard balanced portfolios include a fair whack of property and fixed-interest investments, but he’s happy to stand behind it. He intends to remain firmly entrenched in industrial shares even as he moves from the accumulation to the run-down phase of his own super.

Today’s accompanying video concentrates on the danger Thornhill sees in investors chasing yield on fixed-interest investments over the income stream that builds from dividends. At first it might sound counter-intuitive, but investments offering higher yields finish up providing lower income.

Thornhill identifies holding inappropriate assets as the biggest mistake self-managed super funds make. The second is “fiddling” too much. He calls his own investment style “benign neglect”.

Not in the video is a discussion we had on blue-chip resources stocks. Thornhill argues there is little value-add in digging up dirt and shipping it overseas. He says in the longer term, miners don’t perform nearly as well as industrials. He’s not interested in chasing income by share trading, but in the good old-fashioned capitalist idea of investing for a return. It’s certainly worked for him.

Michael Pascoe: What do you see as the biggest mistake made by DIY superannuants?

Peter Thornhill: Well there’s probably two. One is holding inappropriate assets in their super fund '” the wrong assets '” and, second, often too much fiddling.

Well the first one, inappropriate assets. What do you mean?

By that I mean holding, say, cash or fixed interest. Superannuation is there for the long term and to be honest, holding cash or fixed interest in something that’s going to be there for 20, 30, 40 years is totally inappropriate.

Yet people think cash, fixed interest, that’s safe?

Well that’s based largely on the measure of volatility, which I find very difficult to accept as a measure of risk. Volatility simply measures the liquidity of an asset. Commonwealth Bank is traded daily '” goes up and down in price, but that doesn’t necessarily make it a risky investment; so I don’t consider cash to be a safe investment for the long term because it virtually guarantees that you will not get the result that you want.

You’re talking here about people in the accumulation phase, not necessarily during the run-down phase? Or both?

No, both. I think if you’ve held the best possible assets during the accumulation phase, continue to hold those during the run-down phase as well because ultimately it’s the cash flow from the investments that’s really going to power the thing forward '¦ both accumulation and run down.

Cautious investors look at the yield, particularly when the stockmarket’s running hot and think, 'Well, the yield isn’t what it used to be’.

I understand this and it’s one of the great '¦ not one of the great mysteries, it’s one of the great drawbacks. People take a spot yield; that is they see, say, 5.5% on a term deposit, they see 3.5% or 4% on a share and they chase the highest yield but they don’t understand the implications that time has in this yield equation.

Talk me through that.

OK. What happens is that people always look at the yield on a spot basis. Now that’s no good. What you must understand is that over time, while a yield may not change a great deal the actual quantum of the income is improving. So to give you an example, over the past 20–25 years the yield on industrial shares has remained relatively flat but if you understand that both dividends and share prices have risen over that time, when you keep dividing one number that’s rising into another number that’s rising you get the same yield equation but you are actually getting an increasing cash flow that is vastly superior to virtually every other form of income that’s available.

If you look at the first graph it shows you the two income streams from cash and fixed interest over the last 25 years. If you then look at the second chart it shows you the yield of these two investments and, as I mentioned earlier, the yield on industrials is relatively low and flat but that’s because the dividends and the share prices are rising over time. The most important thing for me as a long-term investor is that the dividends are rising relatively stably. I can therefore live with the ups and downs that the share prices go through from time to time.

I’ve heard you talk about the tragedy of the generation of retirees who retired when interest rates were high and have suffered because of it.

All I have to do is look at my own parents, and from that generation term deposits were considered to be safe. There was and is today, still considerable ignorance related to sharemarket investing and as a result of that people are still fearful. But the sad part was that the income ran out very early for one generation of retirees and they have missed the opportunity that was always available, of investing in a growing cash flow simply because of fear of the price fluctuations.

And this is, 'Look at the stockmarket though’. They see shares going up and down. Companies going broke. They feel risky.

I think the important thing here is diversification. I acknowledge that business is inherently risky. Companies do go broke. Sadly most people remember the ones that go broke; most people do not remember the ones that survive and I think that’s just a factor of human nature. We are 2½ times more sensitive to a loss than we are to a gain so there tends to be a far greater focus but diversification can protect an investor over the long term. The sad thing for me is that people, for fear of one company going broke, will give away the unlimited upside from the rest of the sharemarket. That is a tragedy.

Well your own superannuation. What asset classes are you in?

It’s virtually all shares, as is my portfolio and my wife’s portfolio. In fact, my wife and I are about 120% invested in shares as we are very comfortable gearing and if you refer to the first chart you will see the cash flow from shares over time far outstripping the interest payments that we are making on the loan and as a consequence it makes good sense for us to have modest debt on our personal balance sheets to buy good businesses that produce far greater returns than the net cost of borrowing.

Now you’re still in the accumulation phase. You’re still selling your book. The money’s coming in. Will that asset allocation change when you’re in the run-down stage?

Not at all. The aim for us and I must say the accumulation phase is rapidly coming to a close, for us the asset allocation will remain exactly the same. All we will do is ensure that prior to kicking off the allocated pensions we have at least two years’ cash flow from the dividends sitting in the tin so that as we draw down the cash each year they are replenished by the dividends from the industrial shares so that we will have two years’ again which we then draw down from. So we’ve got a two year buffer of cash, which enables us to sail through any market upturn or downturn bearing in mind that the dividends are far more stable over the long term than the share prices.

You’re obviously not a trader by the sounds of things.

I’m not a trader. My investment style I define as benign neglect.

And that’s what you identify as the second-biggest problem with investors: fiddling around too much.

You can be a share trader and I’m quite comfortable with that, but as a long-term investor I’m there for cash flow. I am not there trying to produce either income or capital gain out of buying and selling assets in an attempt to benefit from fluctuations in prices.