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Loss elimination

Applying that rule to the Bearbull Income Portfolio, where is trouble most likely to be hiding? To answer that, we need a handle on the portfolio’s overall rating. That provides both an indication of whether the whole portfolio might be expensive relative to its market – the FTSE All-Share index – and a point of comparison for the individual holdings.

So think of the portfolio as a single company. Then it would be rated at almost 13 times 2019’s forecast earnings (a bit higher than the All-Share) and offer a 5.8 per cent dividend yield (about 1.3 times the All-Share’s). So there is a fat yield on offer, but not much excess earnings to cover the payout (average cover is about 1.5 times). Meanwhile, this theoretical company would make abnormally wide profit margins (24 per cent) and an acceptable return on equity (14 per cent), both of which are levered by quite a lot of debt in relation to equity.

As a composite for the archetypal high-yield stock, those ratios are plausible. Arguably, however, the key factor is the relationship between the portfolio’s price and its value. This ratio, which is the average of the price-to-value of its components, is currently 0.9, meaning that, if I bought each of the portfolio’s holdings today, I would pay 90p for every £1 of my guesstimate of value.

And the most vulnerable holdings are those where the price/value ratios are highest. That would make US gas pipeline operator The Williams Companies (US:WMB) the most exposed, on a ratio of 1.23 with its share price at $27. Yet Williams is hard to value using conventional methods that capitalise accounting profits or cash flow at required rates of return. That’s a function of its high capital spending, its heavy debt load and especially a corporate restructuring, in which it bought out minority shareholders in a linked partnership. Given these difficulties, at least for a while longer I’ll stick with the growth story that sees Williams stacking up long-term supply contracts to use its pipelines as US consumers – both commercial and domestic – increasingly switch from oil to cheap gas.

Next most vulnerable is foundries’ consumables supplier Vesuvius (VSVS), where the ratio is 1.12 with the shares at 592p. The prevailing tailwind is that Vesuvius will meet City forecasts for £195m of operating profit in 2018 (about 11 per cent higher than 2017) even though foreign exchange losses have knocked about 5 per cent off. That’s largely thanks to global steel production rising over 4 per cent in 2018 and Vesuvius’ sales volumes outperforming the market. However, if global growth falters – as is widely expected – then the factors that have helped will swing into reverse.

Vesuvius is also tougher to value than might be expected for a relatively straightforward industrials operator. That’s for two reasons. First, because it only generates a low return on equity – although that ratio is always difficult to pin down; second, because of the big disparity between its accounting profits and its operating cash flow even though its capital spending is consistently less than its depreciation. This makes for inconsistent figures. Vesuvius’s shares might be fairly priced or might be worryingly expensive. It depends which valuation method you pick.

What is clear, however, is that the shares are too low yielding to be in an income portfolio – just 3.2 per cent on 2018’s likely payout. High dividend cover partly compensates for that. But it’s also clear that I could generate extra income from the capital – 10 per cent of the income portfolio – tied up in Vesuvius. That makes it a candidate to sell.

Yet the holding I currently feel most like selling is insurance industry services group Randall & Quilter (RQIH). That has little to do with missing value, but because Quilter has diluted its existing shareholders with a massive share placing – effectively a one-for-two issue – which increases its share capital by 50 per cent. The placing – at 153p a share against a price of 180p immediately before it was announced – cut existing shareholders’ ownership by over a third and the value of their holdings by 6 per cent. Since then, the market’s underwhelming response to the issue has pushed the price down to 160p, 11 per cent less than before the placing.

True, Quilter’s bosses have done nothing that shareholders have not previously assented to. The move was almost to be expected since the company’s bosses have joined the acquisition binge to hoover up so-called ‘legacy’ insurance operations, where books closed to new business are sold to free up capital. Whether legacy businesses are the wonderful opportunity that Quilter’s bosses assume, time will tell. Even so, it’s no fun to wake up to find a holding has been substantially diluted without compensation, even if it’s in the name of growth. Sure, I’ll stay with Quilter for now, but my intuitive concern is that the group may end up like Charles Taylor (CTR), another acquisition-driven niche firm in specialist financial services where the practice has fallen well short of the theory.