A note to young investors part 1: Why you should rethink investing in index funds

If you’re a younger investor, you’ve likely heard about – and even possibly invested in – index funds, whose promoters argue it’s easier, cheaper, and wiser to stick to investing in broad benchmarks such as the S&P/ASX100 or 200.

How do index funds work?

The great thing about index funds is they give you the benefit of instant diversification across different sectors. But this could be at the expense of growth. And I’d argue that it’s growth that young investors should be seeking.

Apart from index investing, many young investors have taken to using novel apps and digital investing services – often promoted by influencers.

Some of these apps and influencers stick to offering general advice, and promoting index funds, to avoid the more rigorous academic and experience qualifications required for a retail investment adviser license, which would allow the promotion of more appropriate direct investments.

In other words, you might be sold the merits of index investing simply because the person doing the promoting doesn’t have a license that allows them to promote something much better for accumulating long-term wealth.

Meanwhile, many of these index funds are being marketed as safe, fool-proof repositories to diversify your investments. And while it is true that diversification is an essential component of portfolio construction, many who are attracted to the major Australian index funds could be missing out on an important aspect of investing – growth.

The best time to lose money is when you’re young

If you are young, you have a very long runway for becoming wealthy. Most importantly, your youth means you can afford to make a few mistakes, and you will still do well.

The best time to lose money is when you are young – when the balances are relatively small. You have time, and income growth, ahead of you. You will recover the losses, and more importantly, you will learn incredibly valuable lessons to help guide you when the balances you are dealing with are more meaningful.

Think of your beginning investment portfolio as a snowball. Because you have a very, very long slope (life) ahead of you, setting that snowball off down the hill early will ensure it will grow to be an enormous snowball as you journey through life.

Are blue chip stocks safe?

Now, back to those index funds – those funds that seek to track the major indices. These indices are dominated by the bigger ‘blue chip’ stocks, and many incorrectly believe blue chip stocks are safe.

Research shows, however, that blue chip ‘investing’, could be anything but safe.

You see, activist investors in large companies have been very successful at insisting the companies they own shares in, distribute their earnings through dividends. As the Chairman of Blackrock noted back in 2014, “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their own companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”

All over the world, company boards are acquiescing to shareholder demands for dividends. According to a Commonwealth Bank report a decade ago, three-quarters of all companies surveyed maintained or increased dividends even though revenue growth was flat and aggregate net profits fell.

A 2015 study by Goldman Sachs noted $122 billion of free cash flow was generated by non-financial firms between 2010 and 2014 but those same companies returned $177 billion to shareholders through dividends and buy-backs.

When companies pay out more than they earn, they don’t grow. Ben Graham, the intellectual dean of Wall Street and Warren Buffett’s early mentor, observed the market is a ‘voting machine’ in the short term but a ‘weighing machine’ in the long-run. So, it should be no surprise that if a company doesn’t grow, neither does its share price.

The need for growth

Remember that snowball you set off down the slope? Well, investing in companies that don’t grow is like setting your snowball on flat ground. There is no slope for it roll and accumulate more snow!

This may not be the best outcome for young investors. Even older income investors need growth. Why? Because without growth in earnings, there can be little growth in dividends and without growth in dividends, your income and purchasing power will be eroded by inflation.

And you may have heard it said that ‘time in’ the market is more important than ‘timing’ the market. Well, that is only true if you are invested in quality growing businesses. The longer you are invested in companies that aren’t growing, the more expensive your mistake will be.

Take the S&P/ASX100 (XTO) index. It is made up of the 100 biggest listed companies in Australia. There is no focus on quality nor on value. You are just getting the 100 biggest. The price they are trading at compared to their value is irrelevant and there are as many, if not more, mediocre companies in the list than there are high quality growth companies. It is any surprise then that the index is up just 10.9 per cent over the nearly 16 years from October 2007 to today?

Look at the performance of high-quality growth companies like ARB Corporation (ASX:ARB), Cochlear (ASX:COH), CSL (ASX:CSL), Promedicus (ASX:PME), and Reece Limited (ASX:REH) – all companies selected from the 2007 edition of Martin Roth’s Top Stocks booklet; these companies are up 647 per cent, 229 per cent, 742 per cent, 4607 per cent and 210 per cent, respectively. And for both examples, note that I have excluded the reinvestment of dividends, which would favour the growth companies even more.

Warren Buffett once said, “your job as an investor is to purchase at a rational price, a part interest of an easy-to-understand business, whose earnings you are virtually certain will be materially higher in five, ten twenty years from now.”

That’s the snowball.

Buffett went on to say: “put together a portfolio of businesses whose earnings march upwards over the years, and so will the value of the portfolio.”

And that’s the slope.

This really is the mantra young investors should be adopting.

But how can you do it?

Well, that’s the subject of Part 2 of this letter to young investors.

To be continued…