Building a safer income portfolio without sacrificing the yield

Last week, I constructed a 40-stock Income Portfolio from a value investing screen. If investors bought all 40 stocks in equal amounts, this portfolio would have a 9.1% forecast yield - a very good income level even in a time of increasing interest rates.

The aim of the portfolio was to be as diversified as possible so that the income would be robust to changes in economic conditions. To do this, I limited the number of picks from each industry group. Also, where it was possible to go for a more diversified option without sacrificing too much yield, I took it.

Despite this aim, astute investors may have noticed that a significant amount of economic correlation remained. The link between many of these companies is exposure to UK house prices. This is not just due to the inclusion of two housebuilders. The UK banking sector is exposed to house prices since a decent proportion of their lending is secured against residential property. Although Headlam (LON:HEAD) is in the Household Goods industry, as a carpet distributor, it sells more carpets when people move house. Likewise, Kingfisher (LON:KGF) is not immune to these home-buying effects.

Some of this correlation is inevitable. At any one time, specific sectors will be out of favour with investors and become oversold. While value investors often want to take a contrarian view, poor economic conditions for a sector can continue for an extended period of time and can cause considerable financial distress. At times like these, companies often cut their dividends. Income investors are usually attracted to dividend payments because they rely on the cash they receive to pay for their living expenses. So they can’t just sit on their hands waiting for their portfolio income to recover.

There are two ways that may help avoid being lumped with a portfolio full of dividend cutters. The first is to look for signals from management that they feel a dividend payout is sustainable. This may come from management saying this explicitly, but not every team is so forthcoming. So this strategy usually relies on looking for indirect evidence. Perhaps the strongest indirect signal is the presence of an ongoing share buyback. The second way is to demand a higher level of industry group diversification.

A more diversified income portfolio

The income investor can avoid being overly concentrated in certain sectors or highly exposed to specific risks by widening their net and accepting a slightly lower dividend yield. Stockopedia’s screening tools allow us to easily build such a portfolio.

In the income screen that I created last week, I used an Advanced Ranking Rule, selecting Rank in Market:

However, the Stockopedia screening tool also allows me to use Rank in Sector and Rank in Industry:

Because I am building a value screen and then adding in income requirements, I want the stocks I pick to still be cheap overall. So for Earnings Yield, I keep the Rank in Market setting.

However, for dividend yield, both TTM and Rolling 1yr, I can use Rank in Industry instead. This opens up the screen to find the stocks that have the highest yield in their Industry Groups, even if they are not in the highest-yielding stocks overall. This industry-specific value approach also has the backing of academic research. David Dremen looked at the data and found that it generated very similar raw performance to a general value strategy. However, this outperformance was remarkably stable and occurred not just over one year but for up to five years in the future.

With this tweak, the screening factors are now:

• Market Cap > £150m.
• TTM Earnings Yield, Rank in Market > 60%
• TTM Dividend Yield, Rank in Industry Group > 60%
• 1-Year Rolling Dividend Yield, Rank in Industry Group > 60%
• Net Gearing, including Pension < 50%

As of writing, this screen generates 65 results. Many of these are the same as the previous screen. However, instead of 20 Industry Groups, there are now 30. This has added potential investments from more diverse industry groups, such as Aerospace & Defense and Textiles & Apparel.

By following the same stock selection strategy as my previous article, I can choose a more diverse 40-stock portfolio:

This more diversified portfolio has sacrificed some income and only yields 7.4% compared to 9.1% for the previous income portfolio. However, this is still a very acceptable overall dividend yield. What I have lost in yield, I have more than gained in robustness.

Buybacks

I have already dispelled the myth of dividend growth investing. Buying expensive, low-yielding stocks isn’t a great strategy, even if that dividend stream is growing rapidly. However, dividends can provide a powerful signal about how a management team views the future of a business. A company already on a high yield that further increases the dividend payout is saying that the market has got its prospects wrong. So looking for high-yielding companies that are raising their dividends may provide an extra margin of safety.

The problem is that a company can raise a dividend, and then market conditions can change considerably in the time between dividend declarations. Looking for forecast dividend growth may also be problematic since brokers often just factor in small increases anyway. So relying on forecasts also exposes investors to the risk that events have changed more rapidly than brokers can update their notes.

However, companies don’t just have the option to allocate spare capital to dividends but can utilise buybacks too. Since these happen much more frequently than dividend payouts, they provide a much more up-to-date look into how management views their current prospects. By looking for companies that have ongoing buybacks, investors are choosing companies that are unlikely to cut their dividends, at least in the short term. The cultural norm within UK markets is that dividends come first, and buybacks occur on top of this. It is highly unlikely that a company would put their dividend payout at risk in order to execute a share buyback.

Here are the companies from this week’s screen that have conducted buybacks in the last month:

This is only 18 companies, so it is too few to create a diversified portfolio alone. However, when I have a choice of high-yielding companies from an industry group, I can select the one with a buyback in place.

This means that I prefer Galliford Try Holdings (LON:GFRD) over Severfield (LON:SFR) , Ibstock (LON:IBST) over Marshalls (LON:MSLH) , Barratt Developments (LON:BDEV) over Persimmon (LON:PSN) , Abrdn (LON:ABDN) over Jupiter Fund Management (LON:JUP) and Robert Walters (LON:RWA) over Pagegroup (LON:PAGE) .

This portfolio is forecast to yield 7.2%, and 17 of the constituents have bought back shares within the last month. This is a very reasonable income from a (hopefully) well-protected portfolio.

Re-balancing an Income Portfolio

One of the readers of last week’s article, 1MCF, asked what is the best way to manage an income portfolio. Should investors sell stocks when they reach the market-average dividend yield? Or if a company cuts its dividend?

Some income strategies suggest that you never sell the stocks in an income portfolio - investors should simply re-invest the dividends. I don’t subscribe to this philosophy. Any “never sell” portfolio that re-invests into the same highest-yielding stocks becomes massively unbalanced over time. Such an income portfolio would have become heavily invested in banking stocks in 2007. When Lloyds Banking (LON:LLOY) failed to pay its usual final dividend in May 2009, investors had already lost over 80% of their capital. It took a further six years before dividend payments returned, and the share price today remains around the same level as in mid-2009. I think it is clear that this is sub-optimal!

Since my portfolio screen is really a value screen with a high dividend yield overlaid, it is worth understanding why value stocks tend to outperform and over what period. This should act as a guide to a better strategy than never selling. As often is the case, a chart speaks a thousand words. Here is one from a study by Chris Meredith, Patrick O’Shaughnessy, and the pseudonymous Jesse Livermore called Factors from Scratch:

This chart shows the average Earnings Per Share (EPS) and Price-Earnings Multiple progression of a Value portfolio formed from quantitative data from the point of formation. It demonstrates that value stock portfolios outperform because they tend to see multiple expansion. This occurs even as the EPS declines, as the market anticipates the eventual stabilisation and recovery in business performance. This multiple expansion is most rapid in the first year but continues for around four years and is typically joined by growing EPS.

This means that the income-seeking value investor can choose to be relatively slow to re-balance their portfolio. Holding periods of up to 4 years should see continued outperformance (on average, over a diversified portfolio.) This is certainly not a “forever” portfolio. However, it is one that favours slow, deliberate review over frenetic trading. Significant changes to the portfolio in the first year are likely to be suboptimal due to the costs involved. But I don’t think it matters whether an investor chooses to hold for some years to minimise costs, or seek a higher proportion of returns via dividends by rebalancing to higher-yielding value stocks every year.

I also don’t think value investors should sell a stock simply because it drops below a certain dividend yield. Selling stocks that are no longer cheap certainly makes sense. For example, if a stock no longer meets the TTM Earnings Yield, Rank in Market > 60% criteria. Given that dividends are paid out of earnings in the long run, cheapness and high dividend yield should be somewhat correlated. The point is that, in a value strategy, income alone provides a relatively weak signal for generating outperformance.

In an ideal world, any rebalancing will have occurred due to a positive re-rating of the stock but may also be due to bad news. Immediately selling a stock that has bad news or cuts its dividend is likely to be a suboptimal strategy. Investors are often just joining the clamber for the exit and rarely achieve a good price. Michael Mauboussin looked at how the market tends to react to bad news in a study called Managing the Man Overboard Moment. He found that cheap stocks with poor momentum tended to recover all of the initial drop on bad news within 90 days. It is still worth cutting stocks that no longer meet an investor’s criteria for cheapness or income but doing so at a pre-set periodic review point is likely to prove better than reacting immediately.

Finally, investors may want to set an upper portfolio limit to avoid too much of their wealth and income being concentrated in one stock. In this case, top-slicing and re-investing into a stock in an uncorrelated industry group makes sense. I explain more about the importance of upper portfolio limits in my book.

Over the last few weeks, I have shown investors how to use the Stockopedia tools to build a value portfolio that also generates a high and stable income. I used diversification to overcome the need to research every stock in detail. However, this strategy may not suit every investor. So next week, I will analyse one of the smaller income stocks from this screen in more depth.

[Disclosure: Mark owns shares in Somero Enterprises (LON:SOM) and Ferrexpo (LON:FXPO) ]