Bearbull Portfolio: Even a poor year has silver linings

The locus of pain was the portfolio’s capital value, which dipped 5.6 per cent. The eponymous income bit, which is paid out in full at the end of June and December rather than reinvested, offered limited compensation. An average fund yield of 4.1 per cent might’ve been worse and might’ve been better. But absent capital growth, on which those dividends eventually come to rely, it’s hard to shake the disappointment.

That brings (or rather reduces) the portfolio’s all-time performance to an average annual return of 9 per cent, split evenly between income and capital appreciation. As if to emphasise that characteristically British duality of ‘equity income’, the FTSE All-Share also saw a perfect balance between income and capital growth in 2023.

Still, to dwell on the portfolio’s long-term positives feels like an exercise in vanity. Faced with an underwhelming recent performance, a more meaningful response is called for.

Bearbull isn’t predisposed to syrupy aphorisms about persistence. But we’re all human. And if the odd bit of pain-prompted reflection helps us to think more clearly about the limits and purpose of what we’re doing, and what we might hope to achieve, then that’s always a plus.

To those silver linings, then. The first concerns volatility, and the challenges that a total-return-based drawdown strategy would have presented an income investor during the portfolio’s past two dud years. Granted, with a standard deviation of less than half the FTSE World or S&P 500 indices during this time, the FTSE All-Share hasn’t been too volatile. But even range-bound markets can add complexity and frustration to the selling process, as the All-Share’s habit of crossing its 50-day simple moving average once a month over the two-year period attests.

By contrast, watching the dividends roll in takes capital values and market timing out of the equation. Therein lies another easily overlooked bonus to the regular coupon clipper. Excluding interest accrued on cash left in the account – now worth a mention despite the multiple free lunches this provides my broker – there were 24 individual dividend payments into the portfolio in the second half of 2023. Despite my twice-a-year withdrawal schedule, these almost-weekly income streams provide both optionality and assurance.

More importantly, the portfolio is on surer footing, following the biggest shake-up in its history. In November, it was recapitalised to the tune of £100,000, to better diversify those income streams. The lion’s share was soon deployed into three overseas funds: JPMorgan Asia Growth & Income (JAGI), JPMorgan European Growth & Income (JEGI) and S&P US Dividend Aristocrats (USDV). Together with the addition of a bona fide US dividend aristocrat in Johnson & Johnson (US:JNJ), I am much happier with the portfolio’s international credentials.

The final point of reflection is to acknowledge those limits referred to above. A perennial tension in the portfolio, if not with all stripes of dividend investing, is achieving a balance between the security of income and the growth required to keep that income relevant over time. Because the return from dividends is measured out in years, there is often a psychological benefit to seeing the fruits of income investing as soon as possible. But it’s all too easy to confuse a desire for the return of capital with the need for a return on capital. They’re not the same: the first is a loan, the second is an investment.

Despite (or maybe because of) this tension, I’m newly determined to avoid viewing the portfolio’s need for income as a separate species of investing. To really focus on ‘yield’, we cannot think only in terms of safety and value, but growth, quality and even momentum.

Appropriately enough, given the portfolio’s somewhat belated internationalisation, we can illustrate this point with Microsoft (US:MSFT). Today, few would look to the $3tn (£2.4bn) software giant as a dividend stock. Despite paying out $20.2bn to shareholders over the past year (on its own enough to buy that stalwart of the UK dividend scene, Legal & General (LGEN)) a sky-high valuation gives the stock a rather meagre yield of 0.8 per cent.

Given the size of his in-tray – from the cloud to AI to gaming and licensing – chief executive Satya Nadella is not short of options for allocating capital. And with a payout ratio of 28 per cent (equal to less than a quarter of available cash), the dividend does not appear a high-ranking priority. Next to stock repurchases, it’s not even the leading source of capital returns.

But let’s put that dividend in context. A decade ago, investors were looking at a cheaper, less evolved Microsoft, but one with multiple, significant growth options ahead of it, and a proven grip on the software market for personal and business computers. Its then-dividend yield of 2.7 per cent (see table), while tempting to income investors, did not scream high-risk. Nor was it too generous, being covered almost three times by earnings and four times by cash.

While the stock’s cumulative payouts since have been dwarfed by its capital gains, the history serves as a reminder that great growth stocks can be great income stocks even when dividends are an afterthought. Thanks to a 168 per cent rise in the quarterly distribution to 75¢, the yield on 2014-bought Microsoft shares is now 8.35 per cent. Apply the 15 per cent withholding tax, and UK investors could still have banked an average 5.6 per cent annual yield across the decade.

Had Microsoft’s earnings growth fared half as well during this time, it isn’t a stretch to assume that the same dividend growth rate could have been easily maintained. 

Similar lessons are available closer to home. Behold, then, a table of London-quoted stocks whose market capitalisations were at least £50mn on 22 January 2014, whose share prices have at least held ground in the decade since, and which have rewarded the faithful with income returns of at least 100 per cent.

If memory (or the spreadsheet equivalent) serves, none of these names has featured in the income portfolio. This column’s 2014 clippings show no crossover, and in some cases, this isn’t a surprise; despite returning more than their capital value via dividends over the past decade, several of these stocks started the period with either a negligible dividend, or none at all.

Others have been more typical of the holdings that have benighted my portfolio: solid income generators let down by tepid capital appreciation. Overextended water utility Pennon (PNN), whose shares have gone nowhere since 2014, is a prime example. City of London Investment (CLIG), while a perennial high-yielder, has also seen its capital treading water.

Another point is that those 2014 yields and payout ratios proved weak predictors of the risk-reward balance to come. It’s tempting to even call it random. With the 2014 class, yields ranged from zero to 9.3 per cent, at an average at 3.7 per cent – not wildly off the average purchase yield within our portfolio (4.2 per cent), though deviation from the mean has been much slimmer. My most recent purchase, that S&P US Dividend Aristocrats fund, is also the only time when I have accepted a yield of less than 2.5 per cent.

That makes trust in the slow miracle of compounding, however hard it may be, a must. With 4 per cent of the portfolio sitting in cash, there are also some decisions to be made in the coming weeks. Here’s hoping it can all spark a happier year.