Frequently asked questions

The latest issue is published as soon as it’s ready, which is usually somewhere during the first week of the month.

The latest issue is email to all subscribers, so you won’t have to log in to read it.

The stock screen doesn’t show every company listed on the London Stock Exchange. There are a few criteria that must be met.

The company must:

• Be a member of the FTSE All-Share Index (so foreign shares and AIM-listed companies are excluded)
• Have an unbroken record of dividend payments going back at least ten years
• Have produced a net profit, in aggregate, over the last decade
• Have positive capital employed
• Be a ‘trading business’ and not an investment trust or real estate investment trust

If a company meets those criteria and you can’t find it on the stock screen then please let us know and we’ll give you a definitive answer.

Dividends are not automatically reinvested back into the original dividend payer. Instead, they end up in the portfolio’s cash balance, along with the proceeds of any recent sales.

That cash is then used to invest in new holdings rather than top up existing holdings.

The main reason for this approach is simplicity.

It’s much easier to track the performance of individual holdings if each investment has a single buy trade and a single sell trade. If holdings are repeatedly topped up, either from their own dividends or from other sources of cash, tracking performance becomes much more complicated.

Of course, in the real world an investor’s portfolio is likely to have cash inflows from savings and cash outflows for expenses, so therefore holding in the real world may be topped up or part-sold.

However, for the model portfolio there are no cash inflows (other than dividends) or cash outflows, so topping up existing holdings is not necessary.

They key variable in portfolio building (assuming the underlying investment strategy is the same) is the time taken to build the portfolio. In other words, should the portfolio be built quickly over several days or weeks, or slowly over several months?

There is no single “best” timescale for portfolio construction. Instead, there are pros and cons to both fast and slow approaches and which is best will ultimately depend on individual investor preferences.

For example:

• Fast pros:
  • The portfolio benefits from more time in the market as it’s fully invested sooner.
  • The task of building the portfolio is out of the way and the investor can settle into the easier maintenance phase.
• Fast cons:
  • There is less time for a detailed analysis of each holding.
  • If you settle into the maintenance phase immediately after building the portfolio, then in month 2 you would sell a holding that you only bought a month or so before, which doesn’t make much sense (this is because one holding is bought or sold on alternating months if you’re following the “defensive value” strategy closely).
  • You build an entire portfolio with an investment strategy that you’re new to, so you may be uncomfortable with that and you may make novice mistakes in your analysis, but multiplied across the many stocks that you bought so quickly.
• Slow pros:
  • There is more time to analyse each potential investment.
  • The early investments get time to “mature”, i.e. to pay dividends and generate capital gains. When you eventually move into the maintenance phase, perhaps a year after the construction phase began, selling those early investments will make much more sense than it did under the fast construction approach.
  • You get more time to learn about the strategy and to become familiar and comfortable with it and better at applying it.
• Slow cons:
  • It’s more boring (or less exciting) than the fast approach.
  • It takes more patience to methodically add one new holding every week or two, rather than just going out and buying one or more a day until you have a full set of 20 or 30.
  • The portfolio will lose time in the market, as it might have a very high cash weighting for much of the first year.

Much of this comes down to personality. Some people just want to get something done, so they’ll want to build their portfolio in a few days or weeks at most. Others like to plod methodically and they’ll want to buy one stock every week, or every other week.

Personally I’m not 100% strict with my investment rules. In my book (The Defensive Value Investor) I refer to my rules as “rules of thumb” for exactly that reason. They are rules, but they don’t have to be set in stone.

For example, I bought Domino’s Pizza when its PE10 ratio was 34, which breaks the “rule” that PE10 should be below 30 for all purchases. However, I thought Domino’s PE10 was high but reasonable because:

1. Domino’s had grown rapidly, leading to low profits a decade ago (and therefore a higher PE10 ratio)
2. Domino’s pays out most of its earnings as a dividend because it’s ‘capital light’ (i.e. does not require much in the way of capital investment), so dividends were quite high relative to dividends and therefore the PD10 ratio wasn’t especially high.

So while you could stick 100% to the rules, I prefer to think of them as an aid to decision making, rather than as commandments to be followed.

Running UK Value Investor as a purely UK-focused service keeps us very busy, so although it would be nice to replicate this service for EU and US stocks, it’s unlikely to happen anytime soon.

There are lots of great books out there, but if I had to narrow it down to a small number of books that gave the biggest bank for the buck, I’d have to say read this blog post:

39 Lessons from my 3 favourite investment books

And of course my book, The Defensive Value Investor.

There are two main reasons:

1) Companies go from good to bad. I don’t want to artificially lock myself into a “forever” holding period if a previously high quality business loses its way or sees its core market decline. I’d rather have the option of selling if a company is going nowhere or worse.

2) Shares go from cheap to expensive. I don’t want to be locked into holding a company’s shares if those shares are no longer cheap. If a rapid price increase leads to a low dividend yield and high valuation, then the risk is that future returns will be lower (because of that lower yield) and riskier (because of the risk of high valuations falling to historic averages).

In summary, I prefer to have the option of exiting an investment, typically after one to ten years, if (and only if) the company is no longer high quality and/or the shares are no longer cheap.

Cutting your losses and letting winners run is a popular tactic, but I prefer to rebalance “winners” for risk control reasons. For example, let’s say you’ve invested about 3% of your portfolio in Victrex.

• If your portfolio stays flat but Victrex doubles in the first year then by the end of the year it will be from 6% of your portfolio.
• If Victrex then doubles again in the following year, and you let it run, then by the end of year two it will be 12% of your portfolio (assuming that once again your overall portfolio stays flat).
• If Victrex doubles again by the end of year three and your portfolio stays flat then Victrex will be 24% of your portfolio.

That’s an unlikely scenario, but it shows what can happen when you let winners run. Yes, you portfolio will do better because of the bigger “bet” on a winning stock, but the risks of investing so heavily in one company are huge.

What if one morning it turned out that Victrex had done something very illegal and/or its accounts were fraudulent?

The shares could drop by 50% or more in a single day and within a few weeks they could go to zero. Stranger things have happened. If that happened then 24% of your portfolio would be wiped out from a single mistake, which would be very hard for most people to take, both psychologically and perhaps financially.

So instead of chasing every last drop of performance, I prefer to keep a tight lid on the risk side of things by staying widely diversified, and for me that means regular rebalancing by “top-slicing” winners.

In almost all cases I only make one trade per month and, more specifically, only in the first week of each month. I alternate each trade so if I bought a company in January then I would usually sell an existing holding in February, and so on.

Some people think that this will lead to missed opportunities and I completely agree; it will.

However, I think the benefits of making one trade at a specific time each month – such as developing a disciplined mindset, avoiding over-trading and avoiding ad-hoc knee-jerk decisions – should outweigh the occasional lost opportunity.

If a company has a defined contribution (DC) pension scheme then you won’t see any pension scheme assets or liabilities listed anywhere in the annual results. DC pensions are managed separately from the company and don’t represent a financial risk.

For defined benefit (DB) schemes, you’ll find the surplus or deficit listed on the balance sheet, but not the total assets or liabilities. The surplus or deficit will be called something like Retirement Benefit Obligations or Retirement Benefit Assets respectively, and in the annual report (although not usually the annual results) you’ll see a number indicated the related accounting note (e.g. Note 23).

If you go to the related note you’ll see a huge amount of information about the pension fund, its assets, liabilities and all manner of other things. What you’re looking for is a table listing the scheme’s obligations/liabilities. There are usually rows called Total Value of Scheme Obligations and Total Value of Scheme Assets (or similar), although this may be broken down by business unit, geography or some other category.

Total pension liabilities are more closely related to pension risk than the pension’s deficit or surplus (pension assets minus pension liabilities).

For example, imagine a company with average earnings of £10m and a pension deficit of £10m. The deficit is equal to an average year’s profit and so it would be reasonably easy to pay off that deficit.

However, what matters is not the size of the deficit, but the size of the potential deficit in five or ten years.

If that example deficit of £10m came from £20m of pension assets minus £30m of pension liabilities, then the maximum possible future deficit is likely to be £30m or so, which would occur in the unlikely event that the pension asset value fell to zero.

£30m is only three-times the company’s average profits, so the risk is still quite small even in a worse case scenario.

However, if that £10m deficit came from £200m of pension assets minus £210m of pension liabilities, then the pension risk is much larger. If the pension scheme’s asset value fell to zero (unlikely, but possible) then the pension deficit would balloon to £210m. Given that the company only earns an average of £10m, that’s 21-times the company’s average earnings. In reality it’s unlikely that a company earnings £10m per year could repay a deficit of £210m without a major rights issue.

So defined benefit pension risk is closely related to the maximum potential size of the pension deficit, and that is determined primarily by the size of the pension liabilities, not the size of the current surplus or deficit.

The short answer is no, I do not use stop losses.

The reason is that a stop loss puts the decision to sell into the hands of the market. If a company which you own hits some tough and uncertain times, then the share price may drop considerably. However, this does not mean that the long-term value of the company has dropped because markets do not have perfect foresight. Sometimes, perhaps quite often, the market is wrong.

One example from the model portfolio is Braemar Shipping Services. This was bought in May 2011 at about 480p. By October 2011 it had dropped almost 40% to just over 280p. If I had put in a stop loss at 335p (30% below the purchase price) then the investment would have been ‘stopped out’, resulting in a realised 30% loss.

However, after dropping to 280p the shares subsequently rebounded to 400p. That’s a gain of almost 43% from the low point, and about 19% up from the stop loss.

So In Braemar’s case, since 2011 it has been through some ups and downs but the underlying fundamentals (revenues, earnings, dividends, etc.) didn’t show – in my opinion – that the company had lost 40% of its long-term value.

Instead, the market was spooked by some short-term bad news and decided to sell off. That’s how the stock market works.

One of the reasons that I run a diversified portfolio is so that I can sit and watch an investment drop 40% and not panic. With each holding at around 3% of the whole portfolio, a 40% drop in any one of them makes little more than 1% difference to the portfolio overall.

So in summary, I don’t use stop losses because I like to decide when to sell, rather than letting the market make that decision, and I like to concentrate on what the company’s doing rather than what the share price is doing.

Not directly. I do look at the relationship between earnings, dividends, capex and depreciation, and these are the key components of free cash flow and free cash flow dividend cover.

However, I’m somewhat reluctant to use free cash flow as a primary metric. The main reason is that it’s easy for management to boost free cash flow by reducing capex.

Capex is usually a major driver of future growth, so reducing capex to increase free cash flow increases the risk that management are favouring short-term cash flows at the expense of long-term growth.

In most cases it would take more than a single set of bad results to put me off a company. I realise that capitalism is tough, and even the best companies can sometimes produce bad results for reasons that are outside their control (recessions, pandemics, etc).

However, I don’t want to fall in love with companies and hold them regardless of their performance, so if a company consistently underperformed and seemed to have no obvious path back to consistent growth, then I would be willing to sell up, learn the relevant lessons and move on.

It depends on the specific situation.

If the rights issue is for negative reasons, i.e. to pay down debt or to re-capitalise the business to help fund a turnaround, then I usually won’t get involved. I don’t want to invest in companies that are weak or have been run badly.

However, if the rights issue is for a positive reason, such as a sensible and large acquisition, then I might take up my rights if the portfolio has sufficient cash available.