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The Tippi Hedren rule

What worked for the critical success of The Birds can work for investing, too. Faced with investment’s equivalent of malevolent sea gulls, the instinctive response is to do something – anything – because flailing somehow seems an acceptable way of failing. However, staying calm and doing nothing can often be better.

Thus, by doing nothing the Bearbull income portfolio enjoyed its best month-on-month performance for over eight years when it recorded a 6 per cent gain in January. Clearly one month’s performance alone has no significance, but it served as a reminder that, despite 2018’s losses, putting together a portfolio of good-quality, high-yield stocks has, on average, produced monthly gains three times those of the FTSE All-Share index over a 20-year period, and with much less volatility than the All-Share’s returns.

Yet there are exceptions to every rule and the Tippi Hedren rule is no exception to that one. So the question arises, should the income portfolio’s holding in FTSE 100 energy group SSE (SSE) fall under the Hedren rule or be an exception?

In the past 12 months SSE’s bosses have shown a boundless capacity to disappoint and they were true to form in an update last week. They revealed that earnings for 2018-19 would be approaching 10 per cent lower than they estimated with the first-half results only 12 weeks ago. Nor did it help that the board’s timing turned out to be especially poor. Had the directors waited just another day before announcing half-year results in November, they could have factored in the effect of a ruling from the European Court of Justice (ECJ) on the UK’s convoluted and distorted market in wholesale electricity and, in so doing, saved themselves their third profit warning in six months.

The ECJ froze the UK’s so-called ‘capacity market’, the aim of which is to ensure electricity supply during peak demand. The court ruled that, back in 2014, the European Commission did not satisfactorily investigate whether the market’s structure broke EU rules that limit state aid to the commercial sector.

For SSE, the immediate effect is that it won’t be able to recognise at least £60m of capacity-market payments in 2018-19, with the effect that earnings per share (EPS) will be a maximum 69p compared with the previous estimate of 75p. Despite that, SSE’s bosses reckon that the UK government’s payments will readily resume, which “should make this income-recognition issue a matter of timing only”.

That assessment might be too optimistic by half. Like so much else in Europe’s energy markets, the UK’s capacity market is compromised by a weird mixture of idealism and greed, which prompts the feeling that someone is being ripped off.

It emerged from the government’s 2013 ‘Electricity Market Reform’ paper, which conflated conflicting aims, such as supporting the generation of low-carbon electricity, phasing out dirty generating plant and ensuring security of supply. The capacity market offers government subsidies to those generators that can guarantee supply during peak demand on winter evenings. Alternatively, subsidies are available for users who can guarantee to limit their demand.

Already the government has awarded £5.6bn-worth of contracts and small payments have been made. However, the big money was due to roll this winter – almost £1bn-worth. These payments will now be frozen until – most likely – the European Commission conducts the full inquiry into the capacity market that it should have done back in 2014.

That could yet be compromised by the mess of Brexit – although probably not if the UK actually leaves the European Union on agreed terms. In addition, it is debatable whether the UK needed – or needs – a capacity market. It was driven by an unhealthy combination of politicians scared of headlines about blackouts, generators wanting to eke out life from their dirty coal-fired plant and contractors wanting to build shiny new gas-fired plant.

Meanwhile, prices for guaranteed supply have fallen fast – from £22.50 per kilowatt from the first auctions where generators committed to supply four years in advance down to just £6 per kilowatt for the latest one-year-in-advance auctions. Whether this means there was more capacity than originally thought or that the market delivered a wonderfully efficient solution may depend on your vested interest.

Whichever, it does not help SSE. The group has a declining retail arm, SSE Energy Services, that it is determined to get shot of; a networks business coming under increased pressure from its industry regulator and a diminishing ability to pay dividends – the payout will be cut by 18 per cent in 2019-20. But it’s not all bad. With the share price down to 1,182p, the reduced dividend will still yield 6.8 per cent. Then there is the promise of a small buyback programme yielding the equivalent of 1.7 per cent and the possibility that some value will be generated from disposing of the retail supply arm. Just about enough to apply the Tippi Hedren rule – at least until I can find something better that yields almost as much.