Income portfolios revisited: the good, the bad and the ugly

It is coming up to a year since I wrote about income strategies. It is a good time to review their performance. In the first article in the series, I examined the evidence for income investing. I concluded that the historical data suggests a pure income strategy might be a sub-optimal investment method. However, creating an earnings-based value strategy and then investing in the subset of stocks with a high dividend yield will likely generate high performance and deliver an above-average yield over the long term. I suggested that the income investor would be better off screening for value picks and then choosing the highest-yielding of those.

The Income Portfolio

In the second article, I created a screen and an example portfolio. In order to build some diversification into the portfolio (and avoid what would have been a very concentrated bet on the UK housebuilders), I chose a few stocks from each industry sector from the screen results. This gave a 40-stock portfolio.

So, how has it performed? Not that great, if I am being honest:

After a decent start over the first few months, the portfolio never really bounced with the general UK market in April this year. This leaves the income portfolio clinging to a profit while the general market delivered an 8% return. One takeover, Civitas, was not included in the above results, but given that this is a 40-stock portfolio and the premium was relatively modest, this didn’t change the outcome.

However, it is worth noting that this hasn’t been a great period for value investors, with the Top Value Rank Stocks losing 13% over the same period:

So, a comparison with other similar value portfolios may show this income portfolio in a slightly better light. As others have pointed out in the past, the underperformance of a high Value Rank stock portfolio is primarily a function of their weighting to smaller stocks. It may be tempting to think one must only build an income portfolio from the largest stocks, but I believe this would be a mistake. Extended periods where large cap stocks beat small caps are rare, and if the scenario were reversed, we would be saying it was wise to choose smaller stocks. In reality, I believe a mix of different-sized companies makes sense. What larger caps may give is a more internally diversified business. It is worth considering this, but the beauty of being an equity investor is that you don't need to own conglomerates to gain diversification. Investors can simply build diversification in at the portfolio level.

Given that this was an income portfolio that started with a 9.1% forecast dividend yield, you’d also expect the bulk of the returns to come from that yield. In light of this, the biggest disappointment is that the TTM yield of the portfolio is now 5.9%. It’s not terrible, even in current markets, but low compared to the starting point.

Four companies cancelled their dividend altogether:

Notably, three of these four stocks suffer from high political risk. Gulf Keystone Petroleum (LON:GKP) is subject to the vagaries of Iraqi/Kurdistan politics, Ferrexpo (LON:FXPO) operates in a country at war, and Integrated Diagnostics Holdings (LON:IDHC) operates in the Middle East and Africa with operations in Egypt, Jordan, Sudan and Nigeria.

Unsurprisingly, these companies have been among the weakest performers in the portfolio:

On top of this, nine companies appear to have cut their dividends or are forecast to do so:

So overall, dividends have not made up for the poor capital return.

Although I haven’t done detailed calculations of volatility or Sharpe ratios, looking at the graph, I see little evidence that the income portfolio is less volatile than the general market and, therefore, should be favoured for this reason.

The Safer Income Portfolio

I knew the high-yield portfolio was risky when I wrote this article series. So, in a third article, I suggested that income investors would be better off sacrificing some initial yield for a safer income portfolio. Here is the performance of this portfolio over the last year:

Again, this portfolio got off to a good start before tracking the market and finally underperforming over the last month. However, the difference here is smaller, with this portfolio generating around a 5% capital return versus the 8% of the FTSE All Share.

However, this portfolio also contained the same four dividend cutters, and these risky shares appeared amongst the biggest losers:

The most significant loss came from Spirent Communications (LON:SPT) , which has suffered from several profit warnings during the year, including one today. The figure above doesn’t even include today's fall. Spirent doesn’t appear to have cut its dividend, but it started as a share that was quite highly rated. It shows the risk of investing in highly-rated shares when things go wrong.

This portfolio also contained a few shares that reduced their dividend payout:

However, this portfolio contained more strong performers on price:

Interestingly, the two top performers in terms of price were also the best in terms of dividend growth:

In addition to greater industry diversification, my other attempt to add safety to the portfolio was to prefer stocks with active share buybacks. The theory was that a company was unlikely to buy back shares one day and cut their dividends the next. Here are the buyback stocks from the portfolio (excluding Civitas, which was taken over):

This seems to have largely succeeded, with only Investec (LON:INVP) significantly reducing their dividends. So, this may have added an element of stability for investors reliant on the income. However, it doesn’t seem to have made a difference to the yield; with some lower yielders in there, the average TTM yield of these stocks is 5.8%. In terms of capital gains, the buyback stocks have only performed in line with the rest of the portfolio, and hence underperformed the FTSE All Share:

Mea Culpa

So, what have I learned from this exercise?

The first thing is that the riskiest holdings have done the real damage. These stocks clearly had significant political risks when the portfolio was formed. I currently hold Gulf Keystone Petroleum (LON:GKP) and a small amount of Ferrexpo (LON:FXPO) because I believe the market has overreacted to the events here. However, this won’t be any consolation for an income investor who bought much higher and has seen their dividend income cancelled. This is made worse by Gulf Keystone Petroleum (LON:GKP) being an oil producer. More diversified oil producers, such as BP (LON:BP.), have done okay in contrast. It can be tempting to “juice” the income portfolio with high-yielding but risky or under-diversified stocks. With the benefit of hindsight, I would have picked much more stable businesses from these industry sectors.

Secondly, there has been a significant dispersion between the returns of individual stocks in the portfolios, both in terms of dividend growth and capital gains. I don’t think the winners or losers were predictable using simple screening metrics. (Although hindsight bias sometimes makes us think they were.) A 40-stock portfolio sounds well diversified. However, the inclusion, or not, of a few big winners made a big difference to the outcome. So, I think the income investor has a choice. They need to be more diversified than this if their main criteria for selecting stocks is purely dividend yield. Or they need to do a more detailed analysis of the prospects of individual stocks if they want to remain concentrated. There are pros and cons to both approaches. Owning a greater number of stocks may increase costs and the overhead of maintaining a portfolio but may still prove a more straightforward option than doing a more detailed stock analysis on many possible investment candidates.

Finally, with the above tweaks in mind, these results shouldn’t put investors off building their own income portfolio. Even though the performance of these portfolios isn’t amazing, the safer income portfolio may have still outperformed the professionals. For example, here is Schroder Income Growth Fund (LON:SCF) over the last year:

And this is Shires Income (LON:SHRS) :

[Disclosure: Mark owns shares in Gulf Keystone Petroleum (LON:GKP) Ferrexpo (LON:FXPO) Somero Enterprises (LON:SOM) ]