Further to my recent post on sell disciplines we have had a poor set of results from Centrica today. I'll not go into detail on the figures as I'm sure there will be metres of pixels written about it today.
The key disappointment for an income investor was the slightly unexpected, but not wholly surprising dividend cut of 30%, starting with the final dividend. This meant that the full year dividend was down by around 20% overall to 13.5 pence. This compared to forecasts of a small rise in the dividend for this year to 17.5 pence, although a small 3% or so cut was being forecast for 2015 to 17 pence. So the 30% reduction will take this number down from the forecast 17 pence and this years actual 13.5 pence to around 12 pence. At the pixel time price this morning of around 258 pence this will be a yield of 4.65%. Given the further fall of earnings that they are flagging for the current year I estimate this will leave the earnings cover at about 1.4 to 1.5x still only just about acceptable.
So based on my sell disciplines I would sell it given the dividend cut and the poor outlook for this year plus the heightened political risk over the election. I am pleased to note that this one had a Compound Income Score of 20 (stocks are scored 100 to 0 with 100 being best) yesterday ahead of these numbers putting it just in in the bottom quintile showing that the Compound Income Scores can be a good guide to point you in the direction of better income stocks and away from the weaker ones. Talking of which I updated the Scores again yesterday and added one new column in response to a readers comment on Saturday's video post, where you can see the comment and my reply at the end by clicking comments if that is of interest to you.
So the new column attempts to calculate a sustainable growth rate for each company to compare with their current growth rate and the 5 year compound dividend growth. This is based on the theory of the Plowback ratio which can be used to calculate the sustainable growth rate by multiplying the retention rate by the ROE. If a company is growing faster than this rate then they will need extra finance over and above the retained earnings. For this reason and because ROCE will tend to be lower than ROE I have chosen to use the 5 year average ROCE * retained earnings % to calculate this figure to be conservative and also so it takes into account the current financing arrangements, but you could obviously calculate the ROE based one if you prefer.
After my post last week titled Market Ratings & Sell Discipline I thought I would add some further thoughts on this which can be one of the hardest things for an investor to get right. Certainly in my experience it is almost impossible to get it right all the time. I would just add that last time I was talking there about an upper limit on valuations that I use as a sell trigger.
As I mentioned in that post in passing, that on some stocks you will probably have a view of a full valuation for their type of business and financial metrics based on their past trading history which may well lead you to consider selling at lower valuation level than the 2% & 20x that I mentioned.
However, it is important to try and stay disciplined which being a quantitatively driven income investor helps with, so what other factors does that lead me to look at for sell triggers?
Summary and Conclusion
So all of this follows on from constantly monitoring your portfolio and potentially leads to turnover which is something that I have had varying views on over the years. In my early days I was much more active as I was building a portfolio from a low capital base and therefore I tended to trade more aggressively for quick gains and then repeat, although even back then I did run some positions for longer periods.
As my portfolio grew and compliance regimes which I was subject to at the time became more onerous one had to be more investment rather than trading orientated. In recent years as I have become free to invest as I like, I have generally adhered to that longer term investing type philosophy allowing my dividends and gains to compound although with some trading around the edges too.
However, more lately as the market has started to flatten out and returns have been harder to come by I have been trying to become more proactive again, despite my natural reservations about turnover and the potential costs involved as it always pays to keep a very close eye on the cost. However, with fixed price, low cost on line dealing, this really should not be a problem unless you are dealing in very small amounts, as a £5 commission is equivalent to 0.1% on a £5,000 transaction for example, although you do also have to factor in the spreads and the evil 0.5% stamp duty (but not on AIM stocks these days).
Any way I'll leave it there as I have waffled on for ages already but if like me you are a bit worried about doing too much turnover then have a read of this piece titled Portfolio Turnover–A Vastly Misunderstood Concept by John Huber at Base Hit Investing - you may even have an epiphany, but still beware of over trading for the wrong reasons.
As I mentioned in yesterday's post about Reckitt Benckiser which I feel is expensive, I have had a few questions about low medium & high PE valuations and my sell discipline which is based on 20x PE and 2% dividend yield. I have written about this before and you can see my original post here.
So I thought I would expand on the thinking behind those metrics and why they were chosen as they were not simply plucked out of the air. They are based on years of experience and knowledge of financial market history. This suggests that it is usually not a good idea to buy markets / equities when ratings go over 20x, think back to the dot com peak in 1999. While this seemed like an exciting time to invest, the overall index in the UK which was on well over 20x at the time and has gone sideways since then, only offering the dividend yield by way of return in the subsequent 15 years as the overvaluation has been worked off.
That's not to say you couldn't have made decent returns over that period as I did by focussing on value stocks in the early 2000's when the highly rated technology stocks were collapsing. But it did mean that if you bought an index fund your returns have been disappointing and probably well below the long term expected real (after inflation) return of 5 to 6% from equities. Which just goes to show the importance of the starting valuation when you are buying stocks / the market.
At the other end of the scale it is usually a good idea to get more exposure to equity markets when valuations reach single figures as they did back in the UK in 2009 after the financial crisis. Any one who was brave / wise enough to have bought shares in that period will have in all probability done very well and earned above average returns versus the long term average, as the market has recovered its poise and ratings have increased again. As a result the FTSE 100 for example has nearly doubled as it has recovered from around 3500 back towards its 1999 peak close to 7000.
Thus when the market is priced around the mid teens in between these two extremes you could say that the market is fairly valued and should provide average real returns although in the long term this will depend on whether the market re-rates upwards or downwards from there. So lets look at some evidence of what these types of rating mean for returns.
I'm going to cheat a bit here and stand on the shoulders of a giant John Mauldin, who I have mentioned before. Below are four key graphics from a post he featured back in 2010 looking at this which you can read here via the Market Oracle site. These show the forward 10 year real returns based on different PE & Yield ranges.
These show that as you would expect as you go up the valuation scale in terms of PE and down in terms of yield the average real returns tend to decline with the >20x and <2% returns falling below the average long term 5 to 6% real returns.
Now while this is US data a similar pattern would be seen in the UK. Indeed it used to be that whenever the yield on the UK market went below 3% in seemed to signal a reversal in the market, although in recent years the market has on occasions been prepared to run with lower yields. The other reason that markets have perhaps been prepared to entertain lower yields on some occasions is not only the falls we have seen in interest rates and inflation but also the increasing use of share buy backs (SBB). Indeed some suggest that Total Shareholder Yield which includes not only dividends but SBB's and in some cases debt repayments, but I'll have more on that for you soon.
The markets propensity to accept lower yields can be more prevalent for individual stocks but nevertheless I tend to try and use a 3% minimum yield for new purchases. This is why I then use a lower 2% threshold as selling trigger to allow for re-ratings and the benefit of the Company trading well and growing its dividend strongly. However once it goes below a 2% yield I tend to look to exit, although I will judge each stock on its merits and some may warrant a sale before they reach that level if, the fundamentals of the business or the facts change as not every stock will be able to justify a 2% yield.
I therefore think in general if the 2% & 20x ratings signal poor returns for an index it seems sensible to apply the same thinking to individual stocks, although obviously some can go onto much higher PE's and have little or no yield, but as a value investor I'm not interested in playing those types of stocks myself and would rather rotate into better value stocks.
Of course some businesses may never be successful or robust enough to justify such lofty valuations in the first place.
Meanwhile in the piece I referenced earlier John Mauldin mentioned secular bull and bear markets and the roughly 17 year cycle, there is some great research on this and the importance of avoiding the downside if you can in secular bear markets. This come from Crestmont Research website.
In the UK we have been going sideways since 1999 on the back of the extended valuations back then and the start of secular bear market. Since then I have had pencilled in my calendar 2016 as the year to look out for the start of a new 17 year secular bull market. But I guess you can never be that precise about these long term cycles but here's to hoping 2016 might be the year that FTSE finally breaks above 7,000 if it doesn't manage it this year. However it does seem as though we might still need one more big sell off at some point to take valuations back down again before the next secular bull market can begin - I guess time will tell.
Finally if you want to read more about the long term real returns you might expect from equities see the Global Returns Year Book from Credit Suisse.