A win, but only just

It doesn’t help that the striker who was bought in the January window to bang in those vital goals turns out to be a complete donkey and he was the one who scored for the opposition with a spectacular own goal. Still, the final whistle blows to end the misery and afterwards the gaffer faces the cameras – ‘ashen-faced’, naturally – and says: “The boys are all very low in that dressing room. We scraped by today, but we know we have to do better next time.”

And that – in a caricature – is roughly speaking how I feel about the performance of the Bearbull income portfolio in 2017. It was a win, but it should have been better and it was very much – to maintain the footballing metaphor – a year of two halves.

In the first half, the income portfolio recorded a 5.7 per cent gain, comfortably ahead of the 3.3 per cent return posted by its benchmark index, the FTSE All-Share. In the second half, however, the portfolio’s gain slipped to just 1.1 per cent while the All-Share maintained its pace – up 3.5 per cent. Those two halves fed through to a year-on-year capital gain for the portfolio of 6.8 per cent. In addition – and importantly – dividends received (and distributed onwards) generated a 4.8 per cent yield on the portfolio’s average value during the year. Added together, those two components produced a total return of 11.6 per cent, compared with 10.6 per cent from the All-Share (see Chart 1). That is very close to the average total return that the income portfolio has generated in the 18 years for which there is a full year-on-year comparative. By contrast, the average total return produced by the All-Share over the same period is just 5.9 per cent.

At this point I must throw in a caveat – Christmas and New Year printing schedules mean I am writing this on 20 December, so the relative performance could change. The market may continue bounding ahead, elated by the belated realisation that the global economy is growing nicely and boosted by the prospect of lower taxes in the US (while, incidentally, sidestepping the concern that the US economy may soon overheat, causing US interest rates to rise faster than expected). Simultaneously, the Bearbull income portfolio could be hit by further stock-specific shocks of the type that undermined its performance earlier last year. Yet most likely the final result will be pretty much as shown in the chart and the portfolio’s year-end value will be close to that shown in Table 1. If the out-turn is substantially different, I will update readers later this month.

One vital ingredient that won’t change is the amount that the portfolio distributed (Table 2). The distribution for the second half of 2017 was 6 per cent higher than the previous year, even though timing differences meant that one particular dividend that the fund received late in 2016 was missing from 2017 (it has strayed into the new year). For the full year, the payout passed £15,000 for the first time.

That amount is worth putting into context because it demonstrates, first, the importance of dividends in equity investing and, second, the wonder of investing in equities for the long term in stable liberal democracies where property rights are both clearly defined and well respected; these are factors – privileges, even – that are in danger of being taken for granted more than they are defended.

Anyway, take the following as an example of the wonder of equities: back in 1999, the first full year of its operation, the Bearbull income portfolio distributed £3,860. If that amount had risen in line with inflation since then – even the variety measured by the Retail Prices Index, whose underlying maths will always produce a bigger number than the officially-favoured Consumer Prices Index – then the payout would have been £6,364 in 2017. Thus the income portfolio delivered an extra £8,995, or 2.4 times what inflation-linking would have generated. We can also assume that the portfolio would be wrapped within an individual savings account (isa), thus the income would have been tax-free. And the point is that returns such as these are hardly unique to the Bearbull portfolio, but are available to pretty well anyone who takes the trouble to build a diversified portfolio of shares in mostly good quality companies that were bought at sensible prices.

The importance of dividends is also illustrated by their contribution to total returns. From its starting capital of £100,000 back in September 1998, the Bearbull portfolio has now produced almost £392,000 of added value, of which as much as 45 per cent has come from dividends received (the monetary split is £176,000 in dividends and £216,000 in capital gains). For funds whose performance is not that good, the importance of dividends is likely to be even greater. In that context, over the 18 years that the income portfolio’s total return has averaged 11.4 per cent, the 5.9 per cent average return from the All-Share index owes more to dividends (3.3 per cent) than to capital gains (2.6 per cent).

The impact of the winning and losing holdings is shown in Table 3. What stands out is that the contribution of the three big winners reflects the success of companies that are being borne aloft by the heat of global growth. Aircraft maker Boeing (US:BA) reported that core earnings rose 85 per cent year on year to $6.3bn (£4.7bn) in the first nine months of 2017, while orders for its work-horse airliner, the 737, rose from 10,655 at the start of 2017 to 11,015 at the end of September. Fortunes at Vesuvius (VSVS), which supplies consumables to foundries, depend heavily on global demand for steel, which consistently exceeded forecasts in 2017. As Vesuvius’s profits are a geared play on that demand, the success of its share price was a logical consequence. And even a small player in the transport industry, aircraft broker Air Partner (AIR), is likely to benefit when demand to find spare aircraft warms up.

Meanwhile, the major losses are company specific. Last week I discussed both Inmarsat (ISAT) and Empiric Student Property (ESP) – see Bearbull, 29 December 2017 – so there is nothing further to say about these two except to make clear that, metaphorically speaking, Inmarsat is that donkey of a striker who put through his own goal; just as soon as the shares were bought, they proceeded to lose over 35 per cent of their value. Still, blame the manager for making the purchase.

However, the biggest loss was sustained in May when I held off from selling the portfolio’s holding in energy industry contractor Petrofac (PFC) as it got dragged into an investigation by the UK’s fraud buster, the Serious Fraud Office (SFO). A couple of weeks later the SFO’s probe turned vicious, bringing existential threats to Petrofac. That was the cue to quit and nothing has happened since then to make me think that was a bad call.

Against that, the fund escaped lightly when I sold its holding in civil engineer Carillion (CLLN) last January. It sustained just an 11 per cent loss, but had I stuck around it would now be suffering a further £16,000-worth of damage as Carillion’s shares have fallen another 93 per cent – enough to have wiped out four-fifths of the portfolio’s capital gains for the year.

As to why I escaped the worst at Carillion, but am still taking it on the chin from Inmarsat, the obvious factor is that I had profits to defend at Carillion, where the earlier success of the portfolio’s holding meant that the stop-loss trigger had been adjusted upwards. So when the share price drifted and drifted and eventually dropped through the stop-loss level it became a relatively straightforward decision to sell, particularly as it was becoming more difficult to value the group’s erratic cash flows. At Inmarsat, I have no such help. It is a new holding, which started heading south at an alarming rate almost from day one.

So where does this leave the portfolio? There are two especially tired holdings in there – GlaxoSmithKline (GSK) and SSE (SSE), Glaxo in particular. The pharma giant keeps trundling out its dividend, which will generate a 6 per cent yield this year, but – not for the first time – one wonders for how much longer? The impact of its newish chief executive has so far underwhelmed the market and it is time, once more, to take a critical look at GSK.

However, on average, the income portfolio looks in decent shape. Put it this way, it is rated on an average PE ratio, weighted by the market value of its component companies, of 14.8 compared with 20.8 for the All-Share index and its dividend yield is 4.7 per cent, compared with 3.6 per cent. Granted, I should look critically at those averages. In addition to Glaxo’s, the payouts from Inmarsat and Empiric, which has already been cut, look under threat. At the other extreme, I can ask whether it’s justifiable to keep Boeing and Vesuvius in the portfolio when the yield on their shares is now down to 2.4 per cent and 2.9 per cent, respectively. The answer may be to further tighten the stop-loss levels on these two. That would allow me to take any additional near-term upside that the market gives and to exit with most of my profits. Then there is the perennial problem – when one looks for alternative high-yield candidates, the same old culprits crop up with dismal predictability. Maybe I should search overseas more or pay more attention to the Alternative Investment Market. Whatever, we press on.