Defensive value portfolio review: 2017 Q1

Another quarter has flown by and so it’s time again for a review of the defensive value portfolio’s progress against its primary goals.

As well as just talking about performance, I’ll try to highlight areas of my approach to investing that you might find useful, especially if you’re interested in dividends and relatively defensive investments.

Clear investment goals

I’m a big believer in the idea that if you aim at nothing that’s what you’ll get. So with that in mind, here are the goals of this model portfolio:

• High growth: The portfolio should generate higher total returns than the FTSE All-Share over any five-year period
• High yield: The portfolio should always have a higher dividend yield than the FTSE All-Share
• Low risk: The portfolio should suffer smaller peak-to-trough declines than the FTSE All-Share

So this is a balanced portfolio, seeking to improve on a passive index-tracking strategy across the three key investment factors of growth, income and risk.

Do you know what your investment goals are? Have you written them down?

If not, then I suggest you think up some sensible goals and make a note of them.

And if you’re new around here, the investment strategy which I use to manage this virtual portfolio (and my real-world portfolio, which holds exactly the same stocks), it’s detailed at length in my first book.

So how has this portfolio done so far in relation to its goals?

More growth, more income, less risk? Yes, yes and yes

The chart below shows how the model portfolio has outperformed a FTSE All-Share tracker portfolio since its inception in 2011 (initially the tracker was the Aberdeen UK Tracker Trust but now it’s the lower-cost Vanguard FTSE UK All-Share Index Unit Trust).

Clearly, this has been a relatively happy time for UK stock market investors as the market has continued to recover from the global financial crisis.

Since 2011, several years have produced double-digit returns with none producing double-digit declines.

The actual growth figures for the two portfolios are:

• Five-year total return: 76.8% for the model portfolio and 59.8% for the All-Share tracker
• Five-year annualised return: 12.1% and 9.8% respectively
• All-time total return: 82.9% and 63.2% respectively
• All-time annualised return: 10.4% and 8.4% respectively

So the model portfolio is comfortably ahead on all counts.

The All-Share tracker’s annualised return from 2011 of 8.4% is well above its expected long-run growth rate of around 5% above inflation. This is largely due to the recovery of asset prices from depressed levels following the financial crisis.

However, I don’t expect the index to continue growing at such a high rate. Instead, in the longer term I expect its growth to moderate towards 7% or so (2% inflation plus the typical 5% real return from equities).

As for the possible longer-term returns from the model portfolio, or any portfolio managed along defensive value lines, I simply don’t know.

All I know is that the model portfolio has produced total returns just north of 10% per year over the last six years, and I think that’s sustainable, but only time will tell if I’m right.

So growth is on track, but what about income?

Here’s a chart of dividend income, which for both portfolios is reinvested to fuel further growth:

As with total returns, the model portfolio has managed to beat the passive index in terms of dividend income on a consistent basis.

2017 is a bit of an anomaly as the Aberdeen tracker trust has already paid out its full-year dividend. That’s because the trust is moving away from its index-tracking mandate, hence my change of benchmark to a Vanguard index tracker instead. This is a one-off though so in the long run it will be irrelevant.

Here are some key dividend stats:

• Current dividend yields: 4.0% for the model portfolio, 3.2% for the All-Share tracker
• Five-year dividend income: Relative to their capital values five years ago, the portfolios have generated total five-year dividend incomes of 31% and 26% respectively

As a potential future dividend retiree, having a good dividend yield is extremely important to me. For example, the current respective yields of 4.0% and 3.2% are the difference between a £500,000 portfolio generating a £20,000 income and the same portfolio generating a £16,000 income.

That’s a 25% increase in income, and I know which I’d rather have in retirement.

So growth has been high, income has been high, but what about risk?

The total return chart above should give you a pretty good idea about which portfolio has been more volatile so far, but just to be more explicit, here’s another chart showing peak-to-trough declines since inception:

Neither portfolio suffered any major declines during the period because there haven’t been any bear markets.

However, the model portfolio has avoided the double digit declines suffered by the All-Share index tracker. It also completely avoided any meaningful decline in the 2015/2016 pre-Brexit slump.

Of course a low risk past doesn’t guarantee anything about the future, but I think there’s a good change the model portfolio’s history of lower risk will be repeated during the next inevitable bear market.

For me, investing in a low risk portfolio is very important because it reduces the stress of investing.

In fact, since pain from losses is felt about twice as acutely as pleasure from gains, the difference in stress caused by these two portfolios could be far greater than the chart suggests.

Because a low risk portfolio should induce less fear, holding a low risk portfolio should make it easier to pick up bargains in the next bear market rather than panic sell at precisely the wrong moment.

So the portfolio has hit all of its growth, income and risk targets, but how does that help you?

Well, hopefully you’ve picked up a few ideas about how you might track your portfolio’s performance relative to a suitable benchmark. You might also want to re-think whether you’ll be able to stomach a major bear market with the current level of risk you’re taking on.

But you’re probably also looking for ideas about stock selection and portfolio construction, so I’ll cover that now.

Defensive value investing = Quality + value + diversity

There are basically four steps to my investment strategy:

1. Find high quality dividend-paying companies
2. Buy them when yields are high and valuations low
3. Use diversification to reduce risk
4. Only sell when points 1 or 2 are no longer true, in order to take profits on winners and weed out losers

In practice this means a defensive value portfolio would:

• Hold around 30 companies, mostly from the FTSE 100 and FTSE 250,
• with unbroken records of dividend payments over at least ten years,
• operating in a wide range of sectors and geographies,
• held on average for five years each,
• with around six holdings sold and replaced each year (leading to a total of just 12 trades a year, or one trade per month).

If you want to have a go at finding these relatively defensive companies trading at low valuations, then you might want to take a look at these investment spreadsheets, guides and worksheets.

As for portfolio diversification, I must admit I am probably a bit obsessed with this topic, and I have a bunch of rules that relate to it, such as:

• Hold 30 companies (so the average position size is just 3.3%)
• Trim back any holdings that grow to more than 6% of the portfolio
• Don’t own more than three companies from the same sector
• Invest primarily in large and mid-cap companies
• Don’t have more than half the portfolio’s total revenues or profits coming from one country (i.e. the UK)
• Don’t have more than two thirds of the portfolio invested in cyclical sector stocks

Here are a few charts showing how the model portfolio currently measures up against those rules:

Sensible investing is a marathon, not a sprint

Another notable aspect of my approach is the “one trade per month” rule, where I’ll sell an existing holding one month and replace it with a new holding the following month.

This takes all of the drama, excitement and stress out of the buying and selling process, which I think is a very good thing indeed.

It also helps me to think of investing as being like a game of chess, with each player only allowed to make one move per month. At that pace the average game would last years, which is the sort of timeframe stock market investors should focus on (rather than days, weeks or months).

Since my last quarterly performance review in January I’ve made just three trades:

• February: Bought a small-cap technology company (small-cap, but it still has a market cap of more than £250m) with a track record of high growth and high profitability. Replaces TP ICAP which was sold in January
• March: Sold Standard Chartered, which made a loss of 33% over two and a half years (the occasional bad investment is inevitable, which is why diversification is so important)
• April: Bought a FTSE 100 life insurance company with a high dividend yield and attractive prospects for the future

In between those trades I do a lot of reading and thinking, primarily looking for ways to improve my strategy, but there certainly isn’t a lot of buying and selling going on.

However, that’s okay because – as Terry Smith, Warren Buffett or Charlie Munger would no doubt say – one of the most important characteristics of a good investor is the ability to do nothing when nothing is the right thing to do.