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Lower your expectations

Our reader needs to adjust his expectations
July 13, 2017, David Henry and Roy Kaitcer

Jack is age 50 and hopes to create a portfolio that will yield around £30,000 a year without the need for asset sales by the time he is 55. He has an index-linked pension that is forecast to pay out approximately £9,000 a year from when he is 65, and about £120,000 in cash for a future house move. His children have left home, he has no debt and his mortgage is paid off.

Reader Portfolio
Jack 50
Description

Sipp, Isas and cash

Objectives

Create a portfolio that will generate £30,000 a year

Portfolio type
Investing for income

“I should be able to top up my self-invested personal pension (Sipp) by another £40,000 in the next financial year,” says Jack. “But I am self-employed, and as my income is dependent on a trade deal and free movement of goods with Europe, Brexit could have a huge impact on my income. Therefore I would like to plan for no further contributions as a worst-case scenario, and I will only take a lump sum from my Sipp if I need it to use my annual individual savings account (Isa) allowance [currently £20,000].

“I am in no rush to invest my cash because many investment areas are looking very toppy. I am happy to sometimes invest in areas on which sentiment is poor, safe in the knowledge that I have the cash to drip-feed into any further falls. I have been investing for five years, and as I am starting to build up a pension pot late on, a substantial correction in the general market would be a good opportunity to invest my cash.

"I could not resist buying supermarkets when they got battered. Although Tesco (TSCO) is still under water, the timing of my purchases in WM Morrison (MRW) and J Sainsbury (SBRY) means that overall the return has been positive. 

“I also think falling markets are good if you are investing in strong dividend-paying companies – even if the current prices are pricing in possible cuts to the dividend. 

"We have quite a large holding in HSBC (HSBA) because my wife took advantage of share options when she worked there. She bought these very cheaply and the dividend yield on this company is too big to warrant any reduction in the holding.

“Over the long term I would prefer my portfolio to be mainly composed of investment trusts, and to reduce my holding in funds, as I prefer the way investment trusts are structured.

"I like renewable energy infrastructure investment trusts and hold three, after buying into them when they were trading at discounts to net asset value (NAV). 

I am thinking of investing in PRS Reit (PRSR) Redefine International (RDI) and funds which offer exposure to the private rental sector, as well as looking out for opportunities to top up existing holdings in investment trusts.

"Low cost trackers might be also be a good long-term option after a market correction.

 

Jack and his wife's portfolio

HoldingValue (£)% of portfolio
BlackRock Gold & General (GB00B99BDY18)9902.141.73
First State Global Listed Infrastructure (GB00B24HJL45)7401.811.29
Jupiter Strategic Bond (GB00B2RBCS16)6823.841.19
Stewart Investors Asia Pacific Leaders  (GB0033874768)4102.20.72
AEW UK REIT (AEWU)4042.750.71
AstraZeneca (AZN)9334.321.63
Aviva (AV.)5836.871.02
Barclays (BARC)7284.531.27
BHP Billiton (BLT)75501.32
BP (BP.)7999.551.4
Carillion (CLLN)4860.230.85
Centrica (CNA)3304.290.58
Epwin Group  (EPWN)4537.030.79
F&C UK Real Estate Investments (FCRE)4814.550.84
Galliford Try (GFRD)6162.651.08
GlaxoSmithKline (GSK)13218.882.31
Lloyds Banking Group (LLOY) 9089.241.59
WM Morrison Supermarkets (MRW)7083.961.24
Next (NXT)44000.77
Regional REIT (RGL)6093.441.07
Rio Tinto (RIO)12080.632.11
St Modwen Properties (SMP)6094.581.07
Standard Life Investments Property Income Trust (SLI)4585.810.8
Telford Homes (TEF)6772.651.18
Vodafone Group  (VOD)6803.021.19
Watkin Jones (WJG)6800.341.19
Aberforth Smaller Companies Trust (ASL)4706.240.82
BlackRock World Mining Trust (BRWM)  10488.281.83
Bluefield Solar Income Fund (BSIF)5913.681.03
British Empire Trust (BTEM)7595.941.33
CQS New City High Yield Fund (NCYF)15656.862.74
Ecofin Global Utilities & Infrastructure Trust (EGL)5364.270.94
European Assets Trust (EAT)7805.051.36
Fidelity China Special Situations (FCSS)6626.591.16
Henderson Far East Income (HFEL)5604.720.98
Henderson Opportunities Trust (HOT)9172.771.6
Henderson Smaller Companies Investment Trust (HSL)74061.29
Herald Investment Trust (HRI)8883.861.55
International Biotechnology Trust (IBT)3229.030.56
John Laing Environmental Assets (JLEN) 5748.961.01
JPMorgan European Investment Trust (JETG)5277.820.92
JPMorgan European Smaller Companies Trust (JESC)10771.191.88
JPMorgan Japan Smaller CompaniesTrust (JPS)8290.081.45
JPMorgan Japanese Investment Trust (JFJ)6712.211.17
Oakley Capital Investments (OCL)3742.720.65
Renewables Infrastructure Group (TRIG)6199.351.08
TwentyFour Income Fund (TFIF)3523.480.62
TwentyFour Select Monthly Income Fund (SMIF)4163.040.73
Utilico Emerging Marktes (UEM) 10399.421.82
Witan Investment Trust (WTAN)12475.742.18
HSBC (HSBA)38569.546.74
National Grid (NG.)43620.76
Royal Dutch Shell (RDSB)16818.612.94
Tesco (TSCO)5279.470.92
U and I Group (UAI)4712.260.82
City Natural Resources High Yield Trust (CYN)8210.251.44
McCarthy & Stone (MCS)6564.381.15
J Sainsbury (SBRY)5001.510.87
BlackRock Commodities Income Investment Trust (BRCI)7317.191.28
Cash12239821.4
Total571969.82 

 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You've got a good bias towards defensive stocks such as Royal Dutch Shell (RDSB), utilities and pharmaceuticals, and a decent cash holding which protects you from many risks.

But to generate £30,000 a year income in five years’ time without running down your capital would require some capital appreciation, and/or extra savings. I appreciate that both these options could be tricky. But many people in a position like yours have two extra margins of adjustment. 

You could work a little longer, or run down your wealth in retirement and leave a smaller bequest. If you’re willing to do these, your objective should be achievable unless there’s serious bad news.

My second issue is with your hope of buying into a market correction, as there are several dangers here. Such a correction might not come, and maybe you’ll buy too high. Many investors did this during the late 1990s tech bubble. And if the market does fall it might well continue to. The saying “never try to catch a falling knife” is often true. And when shares are at rock-bottom you won’t feel like buying because you’ll be surrounded by negative sentiment, which can affect even the most thick-skinned people. We know, but only in retrospect, that shares were a great bargain in the spring of 2009. But very few investors who were out of the market piled in then.

One way to guard against these conflicting dangers is to have an asset allocation you are content with now. Being fully invested can make you jumpy, but so can holding cash. So think of your cash as protection against a market fall – not just something you’re itching to invest.

A second protection is to follow rules rather than rely on fallible judgment. For example, don’t buy when prices are below their 10-month or 200-day average. Following this rule means you’ll not buy at the bottom, and also that you’ll avoid a protracted bear market. 

Watch investment trust discounts. When these are large relative to their history it can be a sign that sentiment is too depressed and that there are bargains to be had. 

These rules will sometimes conflict, but you don’t have to go all in. You can drip-feed cash into the market when one of these lights is signalling green.

Your focus on fat dividends has had a good effect in that it’s directed you towards some defensive stocks that have what Warren Buffett calls economic moats – brand power or high capital requirements, which protect a company from potential rivals. But a search for dividends can lead us astray, simply because a good yield can be a sign of extra risk. Banks, for example, are on nice yields to compensate for the risk that they would be first in the line of fire if there was increased danger of a financial crisis. And miners’ yields are compensation for their cyclical risk. 

Although your focus on fat dividends has paid off well recently it won’t continue to do so indefinitely. Many investors take comfort in the likelihood that dividend income is safe. But I’ve always thought this is a false comfort: big capital losses are possible even if dividends aren’t cut. So be wary of non-defensive yielders. 

 

David Henry, investment manager at Quilter Cheviot, says:

Using the current yield on the FTSE All-Share of about 3.6 per cent as a guide, the portfolio would need to grow to just under £835,000, ie a total return of approximately 46 per cent over five years, to meet your desired £30,000 annual gross draw from natural yield alone. While your personal experience over the past five years will have been of strong returns for risk assets, there appear to be fewer obvious value opportunities at this stage of the cycle. 

With interest rates, yields and growth in general remaining at subdued levels, you may need to adjust your expectations for this capital, potentially reducing the amount that you draw per year from the portfolio in five years’ time, or accepting that you will have to eventually eat into the capital base   to meet your requirements.

It would not be sensible to chase return excessively over the next five years, given your concerns regarding the ongoing security of your self-employed income. Your cash position, at over 20 per cent of the portfolio, will serve to defend the capital value in a market sell-off and provide liquidity. 

However, cash earns very little so an allocation to US government inflation linked bonds – Treasury Inflation Protected Securities (TIPS) - would provide a useful inflation hedge in a geography where unemployment is low. The dollar exposure could also help the portfolio in a risk-off environment.

 

HOW TO IMPROVE THE PORTFOLIO

David Henry says:

Around 30 per cent of your invested portfolio is allocated to domestic operators or companies whose fortunes are greatly exposed to the UK economy. Given the negative read-across that a disruptive exit from the European Union would have on UK property, construction and consumer confidence, it would be beneficial to have even more of an international focus than you currently have – especially given your exposure to the unknowns of Brexit via your business. 

Focusing on yield as a metric for identifying good investment opportunities is a mature approach, in the sense that you can take less notice of the temporary capital value of a share if you are happy with the ongoing dividend. However, as the majority of your holdings are held within tax wrappers you can afford to be a little more flexible with regard to how you generate return, combining income yield and capital growth to best effect. 

By only focusing on high-yielders you may pick up some very able companies at a discount, but also fall into value traps. You have invested in supermarkets which, despite having rebased their dividends at various points for several years, we think are best avoided given inflationary pressures on disposable income and fast-growing discount competitors. 

The position in HSBC, which accounts for almost 7 per cent of your portfolio, looks excessive. Financials will benefit from the recent rise in bond yields, so consider adding to Lloyds (LLOY) and Barclays (BARC) with the proceeds of any reduction in HSBC.

 

Roy Kaitcer, investment manager at Redmayne-Bentley, says:

Your portfolio is quite well spread, although 60 individual holdings are maybe too many for a portfolio of this size. 

I don’t blame you for having 21 per cent of your assets in cash. It is generally difficult to find value in the markets, with price/earnings (PE) ratios being historically high. However, having so much cash reduces the income generated from your portfolio, and a cash allocation of around 5 per cent would normally be more appropriate for similar-sized portfolios.

Although your holding in HSBC is large I am comfortable with it if it’s for the longer term because the shares currently offer an attractive yield. This is also the case with Royal Dutch Shell, which I regard as a core holding for many portfolios.

Your recent purchase of Tesco looks well founded, and its most recent trading statement would vindicate that, although I am not sure about Next as I would expect to see continued pressure on the consumer.

Also consider adding to Vodafone (VOD). The shares offer a yield approaching 6 per cent and Vodafone has indicated that its free cash flow would be more than sufficient to cover this year's dividend, and grow it slightly. However, the yield has been around this level for some time and the outlook suggests that a dividend yield of around 6 per cent for next year also looks achievable. 

I would question your holdings in Carillion (CLLN) and Centrica (CNA) as they are so small you could dispose of them.

You have about 4 per cent allocated to Europe, but could add a further fund such as BlackRock Continental European Income (GB00B3Y7MQ71) which has a solid track record.

You do not have any direct exposure to North America, and one could argue that US markets have risen over the last six months so that the scope for immediate growth is not apparent. However, a portfolio of this size should have an allocation of approximately 15 per cent to North America, so consider adding the Fidelity American Special Situations (GB00B89ST706) and Old Mutual North American Equity (IE00B42HQF39) funds.

It might not be a bad idea to increase your fixed income weighting to nearer 10 per cent, which you could do with the addition of a fund such as Henderson Diversified Income Trust (HDIV).

Also consider Kames Diversified Monthly Income (GB00BJFLR106) which has a broad spread of investments across multiple asset classes  and pays its income monthly. International Public Partnerships (INPP), meanwhile, is a globally diverse infrastructure fund with a good long-term track record, offering exposure to inflation-linked cash flows. Both of these are fairly defensive, and putting £10,000 into each would not be over the top.