December proved to be a positive month for the UK market as a “Santa Rally” finally arrived despite the on going concerns in the UK & elsewhere about the spread of the new variant of the Corona virus. It seems that although it has spread rapidly & become the dominant variant it doesn’t, as I hoped, seem to be as severe in terms of the illness that it causes. While some existing vaccine booster shots seem to reduce the risks of hospitalization further and new pills for treatment are either imminent or on the horizon. Thus it seems it was right, in the short term, not to panic last month.
As we entered the New Year traders seemed to be bidding up travel and leisure stocks which seems to indicate that the general consensus is thinking along those lines on Covid. Hopefully we might be through the worst of the latest bout by Spring / Summer without too many more restrictions and learn to live with it longer term thereafter. What follows is a review of the performance for the year & over the longer term for the Compound Income Portfolio and a few outlook comments.
If you are pushed for time you can skip the the Summary and Conclusion which tries to sum it all up briefly.
The UK market as measured by the FTSE All Share index (which I use as a benchmark) produced a total return of +4.68% in December and +18.32% for the year. The Compound Income Portfolio underperformed this month with a 3.66% return but did still have a terrific outcome for the year of +29.9%. I calculated the returns that could have been had from just holding the same portfolio from the end of last year and also one selected from the Top Scoring Stocks alone. Both of these returned around 20% for the year, so still a modest outperformance, but it does suggest that this year at least, the process of monthly screening have added value – which is what I have found in the past too So I’ll stick with that again for the year ahead.
Big winners during the year included Ashtead (AHT), Airtel Africa (AAF) and IMI which have all grown to become top 10 holdings. While Renew Holdings (RNWH) which enjoyed a re-rating and Ultra Electronics (ULE) which received a bid were also big contributors although they have since exited the portfolio. Another former position that did well was Dotdigital (DOTD) which I managed to run quite successfully by relaxing my normal value tendencies to sell on valuation ground until such time as the rating and growth rating did not marry up for me. While a risk control reduction of Sylvania Platinum (SLP) at 130p also helped as they subsequently slumped to under 100p.
Talking of slumping, spread betting company CMC (CMCX) disappointed as lockdowns lifted and subsequently sold. I regretted selling Ultra Electronics early in the bid timetable to buy Qinetiq (QQ.) as they came up with some disappointing contract news and Hikma Pharmaceutical (HIK) proved to be worthy but dull and therefore drifted off despite performing reasonably well as a business. Finally some exposure to other precious metals miners like Polymetal (POLY) and Caledonia Mining (CMCL) & the more diversified Rio Tinto (RIO) failed to pay off in price terms but they did pay good dividends which they continued to pay and increase.
Dividend / Income Commentary
Here it was encouraging to see that the income from the portfolio bounce back strongly this year after the Covid inspired cuts seen last year. The income from the portfolio increased by 125% from the 2020 figure which had fallen by 31%. This meant it was up by around 56% from the level of income achieved in 2019 & 2018 pre Covid. This represented a yield of 5.1% on the starting value of the Portfolio – so a bit better than the suggested income yield of 4.5% which expected from the Portfolio at the start of 2021. Obviously it does reflect some changes to stock positions along the way as I’m not comparing a static portfolio and there were also a few large special dividends included in that which will have boosted the total. So I wouldn’t be surprised if the headline total were to decline a little next year if some of those are not repeated.
On these dividends, it is worth pointing out that I don’t target a particular yield from the portfolio. It tends to be a residual result from the stocks selected from the top decile and held along the way, although obviously the process does direct me towards dividend paying stocks and no zero yielders are held. That’s just the way the process is managed, although others may wish to target a certain level of income or yield and try to increase that each year. Personally I do like to see my income rising each year and try to keep it up with or ahead of inflation in the medium term, which I have managed to do generally over the years.
It is worth noting that the RPI Index has grown at 3% per annum since 1989. So assuming the Government / Bank of England are not trying to inflate away all the debt that has been taken on before and during the pandemic then it might be worth factoring in inflation of at least 2.5% to 3% to your run rate calculations for real returns. It is also worth remembering that UK equities have generally returned around 5% per annum in real terms (after inflation) - so you would probably need a total return of around 7.5% to 8% to maintain the real value of your portfolio in the long term.
Fortunately that was not so difficult this year as dividends bounced back strongly as inflation came roaring back & the market was strong in capital terms. The coming year may be more difficult if inflation remains elevated and various cost pressures such as energy, labour and supply chain issues cause Companies to be more cautious on the dividend front.
Longer Term Performance – 5 years in a row and 6 out of 7 years of outperformance.
The performance for the year and the last two, three and five years and since inception back in April 2015 is shown in the Bar Chart at the start of this post above, which are more meaningful periods of time to look at rather than one month or year to date figures. It is also pleasing to note that the portfolio has now outperformed for five years in a row (a pretty rare event in itself) & six out of seven years since inception in April 2015 so that one wasn’t a full year. This line graph at the top also shows that this and that the portfolio has now almost made it back to almost to an all time high value it reached this summer and significantly outperformed all the main UK Indices. While the table below shows most of that in numbers form.
The table above shows performance year by year has been somewhat volatile, with good years for harvesting returns followed by fallow drought type years for returns. So with that in mind, given the strong returns that the Portfolio and the market have delivered recently I can’t help thinking, along with most commentators probably, that 2022 may be a more difficult year for investors than 2021 was. This is especially so given that Central Banks seem to have started tightening and draining liquidity. While investors have gone all in with US individual investor stock holdings at record highs and the inflows into US equities in the last 12 months having matched those seen in total in the previous 19 years! (Source:Merrill Lynch). Breadth has also been poor with the FAANG stocks mostly driving the headline indices, where the ratings look to be towards the top end of their range seen at previous frothy occasions like 1999 / 2000. While margin debt over there is close to all time highs, although has come of a little recently, which can apparently also be a bearish signal.
Thus I think you couldn’t rule out a rougher ride for the market in the first half with a possible normal type correction if rising rates, slowing economic growth, Corona virus issues and continued inflation hit sentiment. Aside from that the economic indicators that I follow for flagging a recession and a more serious setback in economies & markets are all in positive territory, as are the market timing indicators that I compile. So while I might be a bit more cautious short term, beyond that I think we should be OK provided the Central Banks don’t lose control & have to overdo the tightening. In the absence of that they will probably come back in yet again if things do cut up rough.
Having said that though looking at the Portfolio valuation it shows that at the end of the year it had a weighted average one year forward PE of 14.4x which is around the long term average for the market I would say. While on the yield front the forecast yield for the portfolio for the year ahead is 3.8% with forecast dividend growth of 9.5%. This suggests that hopefully I’m being too pessimistic about the outlook as in the absence of a re-rating either way the portfolio could return around 13% which is not far off the 15.2% per annum achieved since inception in April 2015. Given that the UK market overall continues to look reasonable value compared to some other international market, maybe the UK could buck the trend even if things turn out less favourable elsewhere, but as ever I guess time will tell on that.
Summary & Conclusion
So a better month for markets and although this month the Compound Income portfolio didn’t manage to outperform, it did achieve another year of outperformance against the FTSE All Share. This make it 5 years in a row now that it has outperformed and 6 out of 7 years since inception. Compounded annual total returns since then have been 15.2% versus the 5.7% from the broader market.
Income from the portfolio bounced back well to more than double from the Covid induced cuts last year and represented a 5%+ yield on the portfolio value at the start of the year versus the 4.5% that was expected. This did include a number of special dividends which may not be repeated next year and it is most unlikely that the income will double again in 2022, indeed it could drop back a little if there are fewer specials and as I do not specifically target a level of income when constructing the portfolio.
The outlook for the market looks a bit less auspicious this year, especially in the US perhaps. There private investor seem to have gone all in at a time when valuations look stretched and the market has been led by a few big tech giants. While headwinds abound in the shape of the US Federal reserve aiming to raise rates and drain liquidity to deal with high and rising inflation as the economy maybe slowing a little from its rapid Covid induced bounce back.
While in the UK the authorities and the markets face similar issues in terms of inflation and rising interest rates. While the UK market looks more reasonably valued, having lagged the US and other markets for the last few years and private investors seem less enthused. Being heavily exposed to more commodity type sectors like oil and miners may also help the UK market to perform better if commodities continue to be strong in the inflationary environment. Of course though, an economic slow down and any restrictive measures from the Chinese government could of course undermine that view with a likely dampening effect on commodity prices.
Having said all that the Compound Income Portfolio looks reasonably well placed to weather some volatility if we see it this year. As the PE is around the long term average for the market at 14x and the dividend yield close to 4% based on high single digits suggests it might be able to deliver returns close to its longer term average of around 15% per annum in the absence of any dramatic change in ratings. Thanks for your attention and persistence if you got this far or just skipped to this bit and may I wish you good luck with your investments in the year ahead no matter what markets and the Covid virus throw at us.
Saw the Q4 Dividend Monitor Update from Link Asset Services yesterday. This confirmed previous projections that UK dividends were down last year by around 44% or 38% underlying if you exclude special dividends. More significantly they updated their best case scenario for dividends in 2021 in light of the latest lock down. Within the document which you can see a summary of and obtain from here they said:
Currently with FTSE trading at 6740 that leaves us pretty much in the middle of my suggested range. If however you are of a more bullish persuasion then if the FTSE 100 should trade down to or on the basis of a 3% yield then it might be possible for it to trade between 7800 and 8600 or thereabouts, but I wouldn't bet the house on that happening.
There you go steady as she goes on the dividend front but slightly depressing that dividends might not now bounce back as quickly as previously expected and that it might take until 2025 for the market to get back to where it was in 2019 in income yield terms. It is also worth noting that the Link report suggests that the UK market despite cuts from some of the larger paying stocks and sectors last year, still seems to be prone to concentration risk in terms of where the income is generated. Worth bearing in mind if you are investing in a UK tracker fund.
Personally I'd expect to get back to 2019 levels of income much sooner than that given that our portfolios avoided the worst of the dividend cuts by not being as exposed to concentration risk as the headline indices and thanks to our investment trust holdings. Mind how you go out there and in the market.
Having mentioned the dividend flows in the market and for the Compound Income Scores Portfolio in the September / Q3 update, I thought I'd provide an update having read the latest Link Asset Service Dividend monitor recently.
For the portfolio it looks like things are looking up on the dividend front this month with 9 holdings having gone or are due to go Ex Dividend, which is two times more than last year and the totals received are also over double. So as I said in the last update the large fall in year to date income, whilst no doubt reflecting the trends in the market, also reflects some stock and timing differences this year too.
As for the Link Asset Services I'll not try and regurgitate too much of the detail here but offer a few key takeaways and observations plus a link to the full document if you missed it and should wish to download a copy and read it for yourself. Below is their Executive summary with my thoughts thereafter.
Thoughts and Observations
Personally I find it somewhat surprising that Mid and Small Caps have cut more both in number and in quantum as these indices have gone onto outperform the FTSE. Then again perhaps I shouldn't be as Mid and Smaller Companies may be more vulnerable to effects of the virus / shut downs etc. and dividends are not really driving returns this year or any other year for that matter.
In terms of the outlook they seem to think we are through the worst of the battle on the dividend front as we have seen some Companies starting to reinstate or make up for missed dividends in some cases. As a result they see the underlying dividends falling by around 39% for the year and by about 45% if one includes specials. So this is not far off the 30 to 50% falls that were talked about earlier in the year.
While for next year they are expecting some modest bounce back in dividends and tentatively suggest growth of 6% to 15% on a worst case to best case scenario. On this basis they see the current prospective yield being between 3.3% and 3.6% which they suggest leaves UK Equities looking fair value.
Thinking about that and the Ready Reckoner I presented back in the Spring that would be at the bottom end of the yield range of roughly 3.5% to 4.5% that we have seen for FTSE in recent years. With dividend having been cut back to more sustainable(?) levels then may be it makes sense for the market to trade towards the bottom of the range on a yield basis, perhaps. This is especially so given the fall in interest rates, bond yields, property rents and talk of negative rates by the Bank of England.
For what it is worth I present an updated version of the FTSE Ready Reckoner with two new rows reflecting Links latest thinking versus my original 33% to 50% cuts estimates and the original 3.5% to 4.5% range. Thus far the market seems to have operated on the basis of a 30 to 40% cut priced off of 3.5% or 5800 - 6400 roughly speaking.
Summary & Conclusion
So hopefully the worst is over on the dividend front for the UK market with a fall of 40 to 45% or thereabouts in dividends still foreseen, although this may have been discounted if investors are prepared to price those dividends off of a 3.5% yield. If not or if dividends were to fall a bit more then a re-test of the March 5200-5,000 lows on FTSE still can't be ruled out.
Indeed that leaves it looking pretty bedraggled and war torn with the chart trending down below its moving averages. Not great, as we head towards BREXIT but hopefully some resolution or last minute deal there and better news on the Virus front if a Vaccine should become available in the not too distant future might help sentiment. Failing that it seems we are in for a long hard winter as greater lock downs seem to be creeping around the Country and spreading South and Eastwards from the North and Wales!
Having said that it is a market of Stocks and there are always opportunities out there for individual stock pickers as demonstrated by some who have still managed to show decent positive returns despite all the problems. in addition UK Equities look pretty unloved and a bit cheap in a global context. So I wouldn't get too bearish and in the long run quality dividend paying equities still seem like a decent way to find a growing yield with potential for capital gains in a low yield environment. If you need help finding these don't forget that's exactly the type of stocks the Compound Income Scores try to identify.
Failing that if you would rather go down the pooled fund route & go active then I'd still recommend Investment Trusts which benefit from their closed end structure, independent boards and the ability to gear which can help to enhance or detract from returns depending on market conditions. They also tend to have revenue reserves and the ability to pay dividends from Capital which can make their dividends more reliable.
Given the bombed out nature of UK Equities it might be worth investigating a few UK Funds like Law Debenture (LWDB) which has solid reserves and benefits from an operating subsidiary which helps fund a fair chunk of its dividend and trades at a 4 to 5% discount with an experienced management team from Janus Henderson and offers a 5% yield.
Or there are a couple on wider discounts of around 10% which are either under new management in the case of Edinburgh Investment Trust (EDIN) or about to be in the case of Temple Bar (TMPL). Of these Edinburgh has increased it dividend and has decent reserves while Temple Bar has had to cut and will use reserves to pay its suggested dividend. But both might be interesting as a source of decent income from diversified portfolios, although you'd have to satisfy yourself that you are happy with the portfolio strategy of their new mangers.
Any way I'll leave it there as this note has already taken me longer than I thought and ended up longer too. So I'll leave you with a picture of the dividend history and outlook to sum up as I continue play some of my old favourites in the Stock market and on Spotify too.
Towards the end of November last year I flagged up Residential Secure Income (RESI) in a post that you can see here if you missed it or can't remember it. It is basically a play on social housing and you get to buy in at a discount to NAV & it offers a decent yield of over 5% which looks reasonably well underpinned which is no bad thing is these days of dividend cuts and suspensions left right and centre.
Any way they put out a COVID-19 update today where they gave an update on the portfolio, financial position and dividend. All seems fine, so check that announcement out if this interests you.
I added to my holding in the 70's during the recent sell off after they announced they had been awarded Investment Partner status by Homes England. Investment Partner status with Homes England extends ReSI Housing's ability to access grant funding to include schemes outside of London and bring forward much needed additional Affordable Housing at national level. So sounds promising in terms of their ability to deliver more homes, given they probably can't issue shares at a discount. i also noted that 4 directors were buying shares around this time too which gave me some reassurance.
It has done a decent job for me as a boring defensive play (see chart below) outperforming by about 20% and looks like it should continue to deliver the dividend too, so two ticks there. I guess there could potentially be some falls in house prices, but given the nature of their properties and the discount I'm not too worried about that.
Finally below the chart see a decent presentation that they did last year which might give you a better understanding of the business if it is of interest to you.
Apologies for the lack of posts recently, have been following all the economic and political fall out from BREXIT but not been doing that much in the market. One thing I did come across recently though was an interesting presentation about the merits of dividend growth investing which as you know is something I believe in.
I attach the presentation at the end of this post and although it is mostly based on US data I believe the findings it highlights are relevant to overseas markets as shown in the graphic from the presentation below which looked at this. As you can see it suggests that focussing on those stocks that pay a growing dividend and avoiding those that pay no dividend is a good idea. Those that offer growing dividends seem to offer higher returns at lower risk which is ultimately what everyone should be aiming for.
Other interesting observations included a look at levels of dividend cover which is something else I also focus on in addition to dividend growth. This found that those with middling levels of cover or the inverse as they looked at payout ratios delivered the best returns. So in terms of payout ratios it was the 3rd and 4th Quintiles which did best while Quintiles 1 (lowest payout ratio) and Quintile 5 (highest payout ratio) did worst. Interesting that those with the lowest payouts did consistently badly - maybe this is to do with them being growth companies and retaining capital which subsequently got wasted perhaps?
While by taking a very long term view and looking at rolling 15 year returns for US stocks they also demonstrate that dividend paying and those that grow their dividends have outperformed 100% of the time, although maybe that is just data mining for marketing purposes? Having said that though I think focussing on this type of stock for the long run will serve you well & don't forget that is exactly the type of stock that the Compound Income Scores seeks to identify.
Finally I saw today that Institutional investors have recently raised cash to record levels and reduced their equity exposure which probably helps to explain some of the volatility we have seen this year. However looking at one final graphic from the presentation suggested that at the end of last year that equities were not that over valued based on dividend yields versus their 20 year history.