Building A Safer Income Portfolio Without Sacrificing The Yield

26th Oct '22 by Mark Simpson

16 comments 5287 reads

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…

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timarr

26th Oct '22

Note that Jupiter Fund Management (LON:JUP) have announced and commenced a buyback program, so I assume they'd be preferred to Abrdn (LON:ABDN) on the grounds that they have a marginally higher dividend. Dividend cover for both looks dubious next year, mind.

Mark Simpson

Thanks timarr,

Good spot, and backs up the idea that Jupiter Fund Management (LON:JUP) must think that level of payout is sustainable. In general, I think any of these are a good contrarian bet as part of a diversified value portfolio.

Jamboreebop

These have been a great series of articles, I've learnt a lot from them.

On the subject of a company buying back shares; in the case of Somero Enterprises (LON:SOM) (I hold) it's worth noting that management have stated that they buy back shares primarily as a mechanism to satisfy staff stock options. So their recent purchase doesn't necessarily say anything about how they see the company's prospects or about the safety of the dividend.

mortimer

thanks mark i feel like i have had a pep talk. by the way LG. is underated it was the first share i bought 15 years a go for income and still have what an earner its been.

Silver Moon

Usually the company, in its RNS, states what it will be doing with the bought-back shares. If it doesn't say they will be cancelled, only held in Treasury then I don't want to know. I really like Mark's article of today. I might have pre-empted it by selling half my Glencore (LON:GLEN) and buying Gulf Keystone Petroleum (LON:GKP) using the cash returned from a mining sector to an oil sector, now with a foot in each camp.

Silver

lightningtiger

Thank you Mark for your articles on dividends. I try to get over 10% with help from Stockopedia & dividenddata.co.uk where you can get a free book, (just pay for postage.)

There is safety in numbers. Over the last 3 months there has been 45 dividend payments paying an average of just over £150 each. The portfolio is currently producing 12.9%, which currently beats inflation, so I am reasonably happy with that. there is still room for improvements.

Special dividends also make a big difference to the yield too. eg GKP.

I am surprised that Rio Tinto (RIO) does not get much of a mention. Worth checking out.

Worth mentioning SHELL div 3.66% & BP 4.13%.

DavidMcCabe

Another great article - quite thought provoking!

David

Geoff Sparks

Exceptionally helpful

27th Oct '22

Good spot, and backs up the idea that Jupiter Fund Management (LON:JUP) must think that level of payout is sustainable

Well no. This is what the management had to say:

With effect from the year commencing 1 January 2023, our ordinary dividend policy will be reset to 50% of pre-performance fe earnings and will no longer be subject to a minimum of the prior year amount. In line with the current approach, the Board's capital allocation policy is to make additional returns to shareholders on a periodic basis, based on the capital needs of the business for growth and a healthy regulatory surplus.

Which looks like a dividend cut by any other name.

Abrdn (LON:ABDN) on the other hand have committed to holding the dividend at current levels until cover is restored to 1.5 times. Whether or not that's realistic depends on whether the management can actually stem the losses. Personally I've opted for M&G (LON:MNG) in this space.

Good article, though. I'd observe that many of the companies selected wouldn't traditionally be considered value stocks, which shows how far the UK markets have fallen. Stocks here do look extraordinarily cheap.

AcornInvestor

Thanks Mark, a very interesting article, thank you. You disclose that you only hold two of these stocks. Is that because you are not an income-focused investor?

sady

Thank you for your article.

28th Oct '22

Yes, and I try to concentrate on smaller caps or special situations where I think I can get an informational or analytical edge versus the market, not just a behavioural one.

1MCF

29th Oct '22

This is excellent, thank you Mark.

Steve Wilden

7th Nov '22

Really helpful article Mark. Much appreciated!

Royeggy

3rd Dec '22

Really helpful article and looks like an ideal way to create my retirement portfolio in a couple of years . Would this work equally well with US and European Stocks or would a mix of 2 or 3 exchanges even be better ? Obviously exchange rates and specific SIPP charges would have to be taken into consideration with this.

I don't see why these principles wouldn't transfer between exchanges, and the more geographic diversification, the better. One thing against it is broker FX charges, which can often be extortionate. I don't think this should necessarily put investors off completely, but personally, I'd favour slower re-balancing to offset the increased costs.

Building a safer income portfolio without sacrificing the yield

A more diversified income portfolio

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Mark Simpson

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