With Christmas and New Year in the rear-view mirror, it’s time for investors up and down the land to review their portfolios. As for this particular year-end review, it will be my twelfth annual review of the UK Dividend Stocks Portfolio, so it’s starting to build up a meaningful track record.
As the name suggests, this is a portfolio of UK dividend stocks, so it's benchmarked against the FTSE All-Share and it has the following goals:
- To have a higher dividend yield than the FTSE All-Share
- To generate higher total returns than the All-Share over ten years or more
Note: In the 2023 mid-year portfolio review, I started benchmarking the portfolio against a basket of UK equity income funds. However, I soon scrapped that idea as it lacked the clarity of a simple FTSE All-Share target.
So, how did the portfolio perform in 2023? The portfolio’s core purpose is to provide a high and rising income, so let’s start there.
Does the portfolio still have a high dividend yield?
In terms of dividend yield, there was a clear gap between the portfolio’s yield and the All-Share's yield throughout 2023 and by the end of the year, the portfolio had a dividend yield of exactly 5% compared to the FTSE All-Share’s yield of 3.8%.
As you can see from the chart below, this large yield gap has only existed for a couple of years, and that coincides with a minor strategic tweak in 2021 where I began to actively position the portfolio around higher-yielding stocks.
Turning to dividend growth, the chart below shows the total annual dividend paid by the UK Dividend Stocks Portfolio and an equivalent FTSE All-Share Total Return portfolio.
These portfolios were each set up in 2011 with a virtual £50,000 and it’s important to note that both reinvest their dividends, which of course boosts their dividend growth rate. However, even with that caveat, it’s good to see that both portfolios have more than doubled their dividend since 2012.
It’s also good to see that the UKDS portfolio produced a significantly larger dividend in 2023 (some 42% larger) than its All-Share benchmark, at £5,854 vs £4,109.
Although the portfolio’s long-term dividend growth is ahead of its benchmark, there was a small reduction in the dividend between 2022 and 2023. That was mostly caused by motor insurance firm Direct Line, which suspended its dividend in early 2023. I’ll have more to say on that shortly.
Overall, I’m satisfied with the long-term progress of the dividend, so let’s move on to total returns.
Has the portfolio produced acceptable long-term total returns?
Most investors focus far too much on one-year capital gains and losses, which is a shame because those gains and losses are largely random and contain little or no information about the strength or weakness of a portfolio or its underlying investment strategy. That's why, in this review, I will be focusing as much as possible on the far more important long-term returns.
Since its inception in 2011, the portfolio has stayed ahead of the FTSE All-Share on a total return basis almost all of the time. Having said that, the lead has narrowed since 2018 and it has been very slim in the last year or two.
There are two main reasons for this recent underperformance.
First, the portfolio has a higher exposure to the UK economy than the FTSE All-Share. The All-Share gets about 25% of its revenues from the UK, while the figure for the UKDS portfolio is about 50%. Although I don’t think that level of UK exposure is excessive, it does mean that the portfolio has been more heavily affected by the increasingly negative sentiment that has affected UK stocks since 2018, or thereabouts.
Second, the portfolio is heavily weighted towards financial stocks, with nine out of 24 holdings currently operating in the financial industry.
Although these companies all operate in the same industry, they’re a diverse group that includes asset managers, insurers, banks and brokers, so I think the operational risk from having this many holdings in the financial industry is limited.
However, the entire financial industry seems to be out of favour with investors, so there is a degree of valuation risk and most of these holdings have been a drag on the portfolio's total returns because their share prices have generally lagged behind the market in recent years.
This is clearly visible when you look at the portfolio’s total return over the shorter-term term and in each individual year.
As a general rule, I’m only concerned if the portfolio lags behind its benchmark by 10% or more over any given timeframe. The table’s colour coding makes it easier to spot when this occurs and its rules are as follows:
- Green (a good performance): Above 0%
- Yellow (a weak performance): Between 0% and -10%
- Red (a very weak performance): Below -10%
As you can see from the table, the portfolio has lagged slightly behind its benchmark since the pandemic began, for the reasons I’ve already mentioned. In general, the margin of underperformance is small, so I’m not overly concerned, and I expect the portfolio’s performance to improve as and when the UK and UK financial stocks in particular are no longer the black sheep of the investing world.
The table also highlights one potentially serious area of weakness, which is the portfolio’s -11.4% underperformance over three years. Having reviewed the underlying causes and taking the portfolio’s solid dividend growth performance into consideration, I think this is a short-term issue driven by the same anti-UK and anti-financials sentiment. Again, I expect this negative sentiment to reverse and, if it does, that reversal could provide a significant tailwind for the portfolio.
Overall then, I would say I’m happy with the portfolio’s high yield, good dividend growth and acceptable long-term total returns, but I accept that its recent performance has been less than spectacular.
Let's turn now to the more interesting topic of how the portfolio's holdings performed.
How many holdings raised, maintained, cut or suspended their dividends?
In terms of real-world operational results (as opposed to the somewhat airy-fairy nature of share price gains and losses), 2023 was, in general, a surprisingly good year. Based on their latest interim or annual results, 13 of the portfolio's 23 holdings increased their dividend, seven held their dividend flat and there were two dividend cuts and one suspension.
Given the less-than-inspiring economic backdrop, I’m reasonably happy with that outcome, but it’s important to remember that there will always be problem stocks in any given year, and that was definitely the case in 2023.
What were the high and low points of the year?
The biggest single problem was the inflation shock that hit the motor insurance industry like a wrecking ball in 2022. Inflation for repairs and second-hand cars went through the roof in the pandemic’s wake, and some insurers handled this better than others.
The key point is that insurance premiums are paid in advance while claim expenses appear months or years later, so when claims inflation is higher than expected, policies written one or two years ago can suddenly cause serious losses. That is exactly what happened in 2022 and, to a lesser extent, 2023.
Admiral has an exceptionally impressive track record and it was able to steer its way through this crisis without recording a loss, but it did cut its dividend (although to be fair, Admiral doesn’t have a progressive dividend policy so management has no intention of stubbornly holding the dividend if a cut makes more sense).
Direct Line’s long-term record is less impressive and it failed to raise premiums fast enough to avoid a loss. The balance sheet was also excessively weak and this led to a suspended dividend and a departed CEO. When I reviewed the situation in early 2023 (which you can read here), my opinion was that management must shoulder more of the blame than the business, and that's why the company remains in the portfolio.
The good news is that Direct Line has dramatically increased its premiums for new policies (by more than 20% in many cases) and sold off its broker-based commercial insurance business to repair the balance sheet, and these actions have paved the way for a hoped-for return of the dividend in 2024.
But 2023 wasn't all doom and gloom and some of the portfolio’s holdings had a surprisingly good 2023.
Perhaps the most consistent expectations-beater was Next, the well-known fashion and homewares retailer. Next’s consistently good results are all the more incredible given the recent losses and outright failures among many of its peers, and the company just seems to go from strength to strength.
Over the last year or so, Next's share price has gained about 80%, so I recently trimmed its position to lock in some of those profits and to reduce the portfolio's exposure to acceptable levels. However, Next is still one of my favourite companies and I hope it remains in the portfolio for many years to come.
What buy and sell trades were made during the year, and why?
Of course, trimming Next wasn’t the only adjustment I made to the portfolio in 2023 and in total, three holdings were removed during the year:
- Hikma Pharmaceuticals (sold after share price gains made the valuation less attractive):
- Beazley (sold after share price gains and high cyclicality made Beazley a less attractive option):
- Prudential (sold after Prudential restructured itself into a low-yield Asia-focused growth stock):
These were replaced by three new holdings. The details are available in recent issues of the UK Dividend Stocks Newsletter, so here I’ll just say that one of these is a recruitment firm, one is an industrial packaging business and the third sells well-known branded drinks.
All of these are quality companies with long track records of strong profitability and consistent dividends, so they’re a good fit with the rest of the portfolio.
There were also 17 rebalancing trades in 2023, where small positions were topped up and large positions trimmed. That’s too many, to be honest, so in 2024, my plan is to restrict rebalancing trades to one per month, at most.
Based on the events of 2023, what could be done to improve the portfolio?
Over the last couple of years, the number of holdings in the portfolio has shrunk from 34 in early 2020 to 20 in mid-2023. The goal was to (a) focus the portfolio around its most attractive holdings in pursuit of higher returns and (b) reduce the amount of work required to manage the portfolio on a month-by-month basis.
One inevitable consequence is that the portfolio's position sizes have, on average, increased. Back in 2020, positions were limited to 6% of the portfolio and if they exceeded that, they would be trimmed back to the then-default size of 3.3% (giving 30 holdings by default).
As the number of holdings shrank, I increased the maximum position size to 10%, but recent real-world experience has told me that's more than I'm comfortable with.
More specifically, when Direct Line cancelled its dividend in early 2023, it had a position size of about 9% on an “at cost” basis (i.e. based on the price paid for the shares, not their current price). That's a big position for a defensive dividend portfolio and while the impact on the portfolio’s capital and income wasn’t huge, it wasn't insignificant either.
I’m a conservative investor and the UK Dividend Stocks Portfolio is supposed to be a defensive dividend portfolio, so I now feel, with first-hand knowledge, that that level of risk isn't appropriate. To fix that, I have recently updated the portfolio’s position-sizing rules.
I also saw this as an opportunity to simplify the position sizing rules by moving from an active position sizing strategy (where position sizes are adjusted based on each holding's defensiveness and valuation) to the elegant and highly practical simplicity of an equally weighted portfolio. The new rules are as follows:
- Each position should have an equally weighted default size of 4% (which means the portfolio will usually have around 25 holdings)
- Trim any holdings that grow to more than 6% of the portfolio
- Top up or sell any holdings that fall below 2% of the portfolio (if the company's quality and value are intact, top it up, otherwise, sell)
I have also introduced some rules to make sure the portfolio deserves its title as a defensive dividend portfolio:
- At least 80% of the holdings should be in the FTSE 100 or FTSE 250
- No more than 20% of the holdings should operate in highly cyclical sectors (construction and raw materials)
- At least 20% of the holdings should operate in defensive sectors (non-durable consumer goods, utilities and healthcare)
In 2023, I added one defensive sector holding and in January 2024 I added another one. I expect to add one more in February and, at that point, the portfolio will have 25 holdings, five (20%) of which will be operating in defensive sectors, and the portfolio will also meet all of the above rules.
Here’s a chart showing the number and size of the portfolio's current holdings, which I think give a good balance between concentration (to improve returns and to avoid wasting time on sub-2% “Mickey Mouse” positions) and diversification (to reduce risk and to avoid the stress of having a large position blow up unexpectedly).
Looking forward to 2024
So that's what the past looks like, but what about the future?
For some reason, I’m uncharacteristically optimistic about 2024. Perhaps that’s a mistake but after four (or perhaps seven or eight) difficult years, there may at last be some light at the end of this particularly long and unpleasant tunnel.
Inflation is on the way down, wages are going up in real terms and supply chain disruption is almost a thing of the past (although I may have spoken too soon on that one, given recent events). The FTSE 100's earnings are also picking up nicely and although this may be grasping at straws, sentiment towards the UK can hardly go much lower.
I’m also confident that the UK Dividend Stocks Portfolio is filled, for the most part, with a diversified collection of quality companies that are very likely to be trading at a significant discount to their fair market value.
And so, taking all of that into account, I’m looking forward to the rest of 2024, although as a dyed-in-the-wool value investor, there are limits to how optimistic I can be.
Happy New Year
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