Imagine conducting extensive pre-purchase due diligence on a local business that generated $1,500,000 in net profit last year. Now, imagine you acquire it for $10 million, concluding the purchase price is neither a bargain nor unreasonably high. Finally, you hire managers and staff to oversee its day-to-day operations, allowing you to collect distributions without actively running the enterprise.
Fast-forward one year: the company has delivered an outstanding performance, generating 33% growth in net profit to $2,000,000 – a yield of 20%. You take home the $2,000,000 as a dividend and anticipate further growth, thanks to a nearby competitor’s failure. You also test the market for a possible business sale and receive three offers. Despite the business’s improving profitability and growth, these are all below your original $10 million purchase price.
Naturally, you decline.
Another year passes, and the growth rate of the company’s profits accelerates to 50%, and profits rise to $3,000,000. The yield on your original purchase price is 30%, and a few prospective buyers have knocked on the door, offering to buy your business for less than the $10 million you originally paid.
How do you feel about the business’s market value being less than you paid?
I imagine, as you read this, you are thinking the buyers are either idiots or ‘bottom feeders’ and that their proposed valuations are irrelevant. And you would be right to reach those conclusions. It should be abundantly clear that the external valuations are irrelevant when the business is healthy, growing, and delivering a substantial, increasing cash flow every year.
Why do our conclusions change with listed companies?
So why do our conclusions change when the business in question is listed on the stock market? Why is it that even if the business is growing its profits, we fret over every small daily move in the share price? Why do we fear a crash in the share price of these businesses?
The reason is complex. We might consider the collective wisdom of markets as superior to our own – the market may know something we don’t. However, we may also have retirement-related obligations to sell some of the securities each year, and if the share prices collapse, we will be forced to sell more securities than we would otherwise have to in meeting our pension payment obligations.
The aim of investing in equities
In equities, our aim should be to acquire a portfolio of outstanding businesses that continually increase their free cash flow and reliably pay - and grow - their dividends. Alternatively, we will do equally well, and perhaps even better, over the long term, buying businesses that have the capability of increasing their dividend payments, even if they retain their profits to reinvest at very high rates of return.
When you own such enterprises, day-to-day market fluctuations should be far less concerning. And while you can rely on the businesses’ dividend streams, rather than fretting over fluctuating share prices, the fluctuations can have adverse impacts.
Mitigating sequencing risk
Sequencing risk - the danger that poor returns early in retirement can rapidly deplete a portfolio when combined with withdrawals - can only partly be mitigated by owning high-quality stocks with predictable, growing dividends.
If the dividend income from a share portfolio is insufficient to meet retirement income stream obligations, you will be forced to sell shares. And if the portfolio has been impacted by a stock market correction caused by geopolitical or macroeconomic shifts (outside of your control) the result is fewer remaining shares to do the heavy lifting of recouping the losses.
From the age of 65 to 74, superannuation income stream beneficiaries must currently withdraw 5% of their retirement account balance (as at the 2023/24 financial year).
Minimum percentage factor for certain pensions and annuities (indicative only) for each age group
|
Age
|
Under 65
|
65-74
|
75-79
|
80-84
|
85-89
|
90-94
|
95 or more
|
|
2023-24 onwards
|
4.0%
|
5.0%
|
6.0%
|
7.0%
|
9.0%
|
11.0%
|
14.0%
|
Note: These withdrawal factors are indicative only. To determine the precise minimum annual payment (especially for market linked income streams), refer to the pro-rating, rounding and other rules in the Superannuation Industry (Supervision) Regulations 1994. Source: www.ato.gov.au
If the yield on an equity portfolio is 3%, the difference – 2% – needs to be achieved by selling some of the shares. There is nothing to worry about if the stock market has risen by circa 10% as the S&P/ASX200 has done over the last 12 months. But if the market falls 20%, more shares need to be sold at lower prices to achieve the required payment.
This is why, occasionally, the Government reduces the minimum withdrawal amount required for account-based pensions and annuities to mitigate the adverse impact of lower prices, as it did between 2020 and 2023.
Is there an alternative to equities?
But what if there was an asset class that offered yields of 7-10% each year, paid cash income every month, had a long track record of never posting a negative month and exhibited very low volatility in its unit price?
By way of example, suppose your portfolio was hypothetically invested in a spread of private credit funds that eschewed lending to property developers altogether, yielded 7 or 8%, paid a mix of monthly and quarterly income and has historically offered substantially less volatility than public equity markets.
For retirees aged 65 to 74, they could withdraw their 5% super income stream and reinvest the remaining 2 or 3% into the private credit funds, diversify into equities or pass the funds to kids and grandkids for much needed school fees, for example.
From the age of 75 to 79, retirees are required to withdraw 6%, from 80 to 84, 7%, and from 85 to 89, 9% (refer to table above). Hypothetically, if invested in a diversified portfolio of private credit funds paying 8%, retirees would not need to draw down on their capital until they reached the age of 85 – a full 20 years after retirement.
Of course, there are risks with any asset class, and that’s where financial advisers are worth their weight in gold. They can help assess whether private credit aligns with your financial goals, risk tolerance, and income needs. The point, however, is that there are now alternatives to equities that may offer more desirable cash flow characteristics for retirees.
The bigger picture
While 2023 and 2024 provided the backdrop of rising equity markets – something we predicted and wrote about extensively - 2025 and 2026 may offer investors an opportunity to reflect on the virtues of diversifying into private credit. Especially if investing $10 million into an unlisted local business growing its net profit by 50% per year is not an option!
Roger Montgomery is the Chairman of Montgomery Investment Management and an author at www.RogerMontgomery.com. This article is for general information only and does not consider the circumstances of any individual.