It’s a new year and so once again it’s time to dust off my model portfolio and review (and then try to improve) its performance.
This year I’m going to look at performance, sales, purchases, mistakes made and lessons learned.
Short-term results are not so good, long-term results are okay but could be better
2018 was not exactly a record year for the UK stock market, with the FTSE All-Share and my model portfolio falling by 9% and 13% respectively.
Underperforming the market index in a year is mildly disappointing, but as a long-term investor what matters to me is long-term performance, not performance over a single day, week, month or year.
And over the long-term the portfolio is still ahead of its All-Share benchmark, although not by as much as I’d like:
Ideally I’d like to be ahead of the market by 3% per year on average, which would put my target annualised return at 10% compared to the market’s expected return of 7% (based on historic returns).
In reality the margin of outperformance has, so far, averaged 1.6%, so I think there’s plenty of room for improvement.
Dividend income is ahead of the market, but again, by less than I’d like
As stock market investors we are investing in companies, so the performance of those companies is, in the long-term, much more important than the ups and downs of the emotional Mr Market.
For me, the best way to measure the performance of the companies I’m invested in is to look at their dividends.
That’s because dividends are a concrete return from investing which is not subject to any of the ‘adjustments’ or other accounting tricks which can be used to massage a company’s earnings or even its revenues.
Dividends aren’t a perfect measure though, especially if you’re looking at a single company.
But if you add up the dividends from a portfolio of 20 or 30 companies then the long-term growth of that aggregate dividend should be a pretty good guide to the growth of the intrinsic value of your portfolio.
For example, here’s a chart showing the annual dividends from both the model portfolio and its All-Share benchmark:
The total annual dividends from both portfolio’s have marched upwards, reasonably progressively.
In fact, the All-Share tracker has managed to grow its dividend faster than my model portfolio, with their 2012-2018 annualised growth rates at 11.2% and 6.7% respectively.
To be honest, I think the 11.2% dividend growth rate of the All-Share is a bit of a short-term anomaly. It’s probably a recovery from the immediate post-crisis years, and the index is very unlikely to keep growing its dividend at 11% per year.
As with total returns, I’d expect dividend growth in an accumulative All-Share tracker (i.e. one that reinvests dividends) to be around 7% or so over the long-term.
As for my portfolio’s 6.7% dividend growth rate, it’s below the market’s expected 7% growth rate. That’s probably due to the fact that my defensive value strategy has changed slightly since 2012, moving away from ‘value’ stocks and more towards ‘quality’ stocks.
As I’ve made this shift, the portfolio’s holdings have moved from high yield low growth companies towards lower yield higher growth companies, and this has probably held back the portfolio’s dividend growth.
That sounds like an excuse, but it isn’t, and I’m happy to be judged on my portfolio’s performance over the next five years, where the balance between quality stocks and value stocks is likely to stay about the same.
Companies sold in 2018
As usual I followed my process of monthly trades, alternatively selling a holding one month and replacing it with something (hopefully better quality and or value) the following month.
In January I sold BP. After almost seven years in the portfolio, BP was no longer the sort of company I was looking to invest in.
It isn’t a growth company, it isn’t a defensive company, it has low margins and low returns on capital and its main products are all commodities, where sellers have virtually no pricing power.
None of these are attractive features, but when I bought BP in 2011 I was more interested in value than in growth, profitability or consistency.
Over the years my views have changed and I now prefer to invest companies with more pricing power, more growth opportunities and less need for massive ongoing investment in expensive physical assets.
BP wasn’t a complete disaster though, having produced a reasonable 6% annualised return over almost seven years.
In March I sold AstraZeneca for an annualised return of 11% over two and a half years. AstraZeneca’s share price had held up well, but its results were flat-lining and I was concerned about the company’s use of ever-more debt to fund its massive research and development needs.
In May I sold Beazley, a leading insurer. This sale was based mostly on valuation as I still very much like the company. The share price increased by 80% in less than three years, massively reducing the margin of safety between the company’s market value and its intrinsic value.
When the margin of safety is reduced, the investment becomes more risky. That’s because we can never actually know what the intrinsic value is, hence the need for a margin of safety between the market price and what we think the intrinsic value is.
If that margin of safety disappears, as I think it did with Beazley, then you may be left with an asset which is worth less than its current market value. And if that’s the case, selling at the current market price is probably the most sensible course of action.
In July I sold BHP Billiton (now BHP Group). Like BP, this was another old holding, purchased in 2011 when I was much more interested in ‘value’ than defensiveness.
The end results were far from reasonable, with an annualised return of just 2% per year over almost seven years. The main cause of the investment’s low returns was an excessively high purchase price.
This is a lesson I have long since learned (which I first mentioned after selling Braemar Shipping in 2017) and these days I’m much more cautious about investing in highly cyclical commodity companies.
In fact, my maximum purchase valuation for highly cyclical companies is now three-times lower than that of other companies (specifically, a PE10 and PD10 ratio of 10 and 20, respectively, instead of 30 and 60 for defensive and somewhat cyclical companies).
Towards the end of the year I was somewhat sad to sell two excellent companies, Senior and Victrex, both on valuation grounds.
I sold Senior in September for a total return of 48% in just over two years.
This excellent result is of course mostly down to luck. Yes, the company performed well during its short time in the portfolio, but most of the returns were down to a mood change from Mr Market, where he decided (entirely unpredictably) that this company was worth much more than he’d previously thought.
I still like Senior and would happily reinvest, but only if its share price declines enough to restore a healthy margin of safety.
In November I sold Victrex for 2018 best result, which was a 93% return in just over two years.
Like Senior, I still like Victrex and think it’s a very good company, but the price just skyrocketed during 2018, continuing a run which took the price from 1400p in 2016 to more than 3400p at its 2018 peak in October. Unfortunately I missed the peak price by a month, finally selling at 2750p, but I can’t complain.
Victrex has since continued to perform well as a company, and has continued to decline as a stock, which has reopened the margin of safety. With a bit of luck, the margin of safety will widen enough for me to reinvest in 2019.
Companies purchased in 2018
As for new investments, there were the usual six, purchased one month after each sale, using a mixture of proceeds from the preceding sale as well as any cash from dividends floating about in the account.
These six new holdings include leading companies from various markets, such as retail, food services, distribution and insurance. I expect to hold all of them for several years at the very least, depending on how the companies perform and how well their margins of safety are maintained.
One (reasonably) big mistake
Most investors are bound to make a mistake of one kind or another each year, and in 2018 I made one mistake which stands out.
One of the new companies purchased this year, an innovative and disruptive high tech company, has already cut its dividend and downgraded its expected results significantly.
Because I’m a fan of diversification, the portfolio only had 4% or so invested in this company, so this isn’t the end of the world.
However, investing in this company was definitely a mistake.
But it wasn’t a mistake because it’s a basket case, because I don’t think it is. And it wasn’t a mistake because the investment’s total returns were bad, because I haven’t sold yet so I don’t know what the total returns will be.
It was a mistake because the company didn’t have the sort of repeatable track record of success that I like to see. Its track record was too heavily based around a single ‘big win’ from a single product in a single market. Once that ‘big win’ was over, it wasn’t repeatable and the company has been downsizing ever since.
As with all mistakes the best course of action is to a) admit it and b) make sure you don’t do it again.
Which leads me onto the topic of lessons.
Lessons learned in 2018
Having literally written the book on defensive value investing, you might think the strategy was now set in stone. But nothing could be further from the truth.
I’m always on the lookout for ways to improve what I do, although I prefer incremental evolution over dramatic revolution. So here are my main lessons from 2018:
The dividend cutter mentioned above was an example of a ‘big win’ company.
Although it does generate lots of profit from recurring service revenues and ongoing new sales, a very large portion of its profits over the last decade came from a single product, sold into a single market, where that market has now reached saturation point (perhaps somewhat similar to Apple and the peak iPhone phenomenon, but on a much smaller scale).
AstraZeneca and GlaxoSmithKline are also examples of companies that rely on ‘big wins’. In their case, the big win is the development of a new blockbuster medicine which can then be patented and used to produce reliable fat profits over the following 20 years or so.
When those patents run out, these companies need new big wins in the form of new blockbuster medicines to replace the old big wins, but that’s easier said than done as their performance over the last decade shows.
That’s partly why I sold both of those companies this year (Glaxo’s post-sale review is coming soon).
I have traditionally preferred normalised or adjusted earnings because they’re supposed to reflect the performance of the core business by excluding one-off incomes or expenses.
But sometimes adjusted earnings give an unrealistically positive view of a company.
This lesson was driven home by the second dividend cutter of 2018, a retail business which is struggling to cope in an online-first world.
This company’s adjusted earnings handsomely covered the dividend, but those adjusted earnings ignored the cash cost of transforming the business into an online-first retailer.
The reason for excluding these costs from adjusted earnings is that they were a one-off expense, and not part of the core business.
That makes sense and it’s fine if the one-off expense lasts for a single year, perhaps two at the most. But in this case the adjustment has lasted for three years and has grown larger with each passing year.
At some point a one-off ‘exceptional’ expense is no longer ‘exceptional’ and instead becomes a normal part of the company’s operations, and I think that’s the case here.
The only constant is change, as they say, and long-running transformation-related expenses shouldn’t be called ‘exceptional’ or ‘non-core’.
That’s partly why I’ve been writing about free cash flows recently. I want to tighten up my stock screen‘s ability to spot potential dividend cutters, and free cash flows and reported earnings are one step in that direction.
Another lesson is the importance of decent gross margins.
In the past, I’ve focused primarily on return on capital employed as a measure of profitability, and I think it’s worked quite well.
However, there is a fairly clear pattern: Companies in the model portfolio today that are struggling tend to have gross margins of less than 20% and sometimes less than 10%.
This pattern is also visible in three of the six loss-making investments I’ve made since 2011:
- Serco: Has gross margins of around 10% to 15%
- Tesco: Has gross margins of around 5% to 10%
- Morrisons: Has gross margins of around 5%
The other three loss-making investments were more to do with 1) excessive debt-fuelled acquisitions, 2) balance sheet weakness and 3) paying too much for a highly cyclical company.
So in my experience weak gross margins are a major source of corporate problems, and companies with thin gross margins are probably best avoided.
To 2020 and beyond
So that’s my summary of what went on in 2018. It was an interesting if slightly negative year, in many ways.
But one year is merely a single step on the road to retirement, financial independence or whatever it is you’re investing for.
In my case I’m focusing on 2041. If my model portfolio has reached £1 million by then I’ll be happy, but it will take annual returns of around 10% or so to get there, so it won’t be easy.
That’s a long way in the future, possibly beyond my lifetime, but it’s that sort of long-term target that makes it easier to ride out the rough patches and bumps in the road, of which Brexit will be just one of many.