The Joy of Income Portfolios - Part 1 of 5

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If you glance over at the ‘Portfolios’ page on my Website, you will see at the top that I start off talking about my own Income Portfolio which I have been running for just a few years. There is a bit of spiel around it trying to explain the logic and principles behind my Income Portfolio but it only recently hit me that this barely even glances the surface of what is actually quite a lengthy subject; and I came to the realisation that my Archive of Information was sadly lacking the kind of detail needed to really do it justice. So this Blog Series is to correct that shortfall.

As you will see from the intro stuff below, this Blog was inspired as an alternative to Annuities and Drawdown upon Retirement but I can see far younger readers finding this useful as a concept for somewhere to stash their ill-gotten gains from Share Trading etc., in a home that is low maintenance, fairly low risk and yet gives a Return which by far exceeds anything that can be gained on Cash or with Bonds or suchlike. 
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The original concept for this Blog arose from a need for Income but I see no reason why an Income Portfolio cannot be used as a Growth type vehicle in years when an Income is not required, and it makes total sense to re-invest the Dividends into the Portfolio - in fact, this is exactly what I am doing at this stage in my life but I sort of have this idea that in a few years time I will start taking the Dividend Income from the Portfolio to help pay for my day-to-day living expenses etc., without the need I currently have to Sell Holdings or whatever to create Income. It would just be a lot easier.

I also think this kind of Approach would be quite suitable for Low Risk, cautious, types who like the idea of Investing directly in Stocks but are nervous about buying Small Stocks etc. and would like something less demanding in terms of Expertise, Time, Interest, Effort etc. Additionally, I think there is a valid case for saying that an ‘adjunct’ Income Portfolio helps to increase overall Diversification across Stockmarket Holdings - I often see that the Stocks in my Income Portfolio perform very differently to the Stocks I hold in my more exciting ‘Trading ISA’.

Introduction
I often mention at the start of Blogs how I seem to trip over (ok, more like wheel over in an ungainly manner) subject ideas on a pretty random basis and quite often these arise from discussions on Tweets or in this case a chat with a mate down the PUB.

I met up with an old School Friend recently and despite him having been an Accountant all his professional life, he has never really invested directly in Shares although he has been in Funds via a Company Pension Scheme. The germ of an idea for this Blog Series came about because he is on the verge of Retiring and had been looking into options to convert a decent sized Pension Pot into a nice Income Stream for his Retirement. 

Anyone who is at this stage in life or has already Retired will most likely recognise the challenge that arises when looking at the ‘usual’ way of converting a Pension Fund into Income - an Annuity. With these particular Products, you in effect surrender the whole Pension Pot (or a part of it if you like) for a Guaranteed Income Stream for the rest of you life. If you have what I think is called a ‘Single Life Annuity’ with no Inflation Link, then the Income Stream you receive will be the highest possible, but if you have other requirements, like a Spouse to cover on the Annuity and/or an Inflation Link or whatever, then the amount you receive in the Income Stream reduces. I am no expert on Annuities (probably because I realised quickly their limitations and have never paid them much attention) so I might have some of this wrong but I think I am pretty much correct here - and anyway, explaining Annuities is not really the point of this Blog !!

It is possible to get something called an ‘Impaired Life Annuity’ or similar nomenclature - this means that if you have an Illness or Disability or something that will most likely shorten your Lifespan, then you can probably get a higher Yearly Payout. As I say, I am no expert on this stuff and you need to seek appropriate Professional Advice.

I don’t know the exact figures but I will give some rough made up numbers to illustrate the drawbacks of Annuities and why my mate was rather perplexed at the options he was facing. In simple terms, if it is just a Single Life Annuity, then for giving the Annuity Provider the Pension Pot, you would probably get around 3% per Year in return - this assumes you retire at say 55 and you are male and fit etc. (there are loads of variations like the age you retire at and what your health is like - if you are suffering a long term illness or disability then you might be expected to live less long so the Payout might be higher). So, as an example, if you had a Pension Pot of £250,000, then you would receive £7,500 per year (3% of £250k) - and remember you have given away the Pension Pot so you have no remaining Capital.

If you wanted Inflation Protection on top, then the Payout is lower - as an example (and it will be approximately right), lets say you get 2% at the start but that will rise over time. So, on a Pot of £250,000, you would start off with £5,000 in the First Year and it would then rise with Inflation (I am being simplistic here - there are variations like RPI and CPI etc. but let’s not get hung up on that sort of stuff - it is not really relevant here).

Obviously to the kind of people who read this Website, chances are you will think these Returns are pretty paltry - especially when you consider that you have surrendered the Pot and therefore retain no Capital. Therefore you might be thinking “why not invest the Money in Shares with decent Dividends and chances are the Returns will be higher AND you retain the Capital?”, which is pretty much the essence of the discussions I had with my mate over a few pints of Marlow Brewery Rebellion.

One way to do this is to put the Pension Pot into ‘Drawdown’ and I would guess all Pension Providers enable this kind of thing. In essence, you pay the Pension Company a certain Fee every year (or it might be a percentage) and they manage your Pot to give you a particular Return each year - this is probably a good option for many people who do not want to invest directly in Stocks themselves for various reasons (like Risk adversity, fear of the unknown, perceived lack of skill, utterly no interest in it, etc.) I am no expert on Drawdown but I guess the Pension Company invests in Funds like Equity Income Funds and suchlike and this is where the Returns come from - but the Costs involved will probably mean that you will get lower Returns this way than if you managed an Income Portfolio of Stocks yourself.

I have meandered around to this point but the nub of it is that if you manage a Portfolio of Income Stocks yourself, I would expect an Annual Return of about 7% a year is very possible (and likely) - and perhaps a little more might be achieved. Depending on taste and Risk Levels desired, I would expect an Income Portfolio to produce 4% to 5% from Dividends and another 2% to 4% in Capital Growth - thus producing a Total Return per year around 7% or perhaps a shade more. 

However, one of the real beauties of this approach is that you also get an Inflation Linked element - in 2 ways. Firstly, and many people do not realise this, Companies have a healthy habit of tending to increase their Dividend Payout in absolute terms over time - so the Dividend Stream in £ note terms should slowly increase over time. Secondly, Shares tend to do well in Inflationary times - partly because the Price of what the Companies sell can be raised to their End Customers and also because in a Share Price sense they tend to be more attractive to Investors than Bonds because Bonds mostly have a fixed Coupon Payment (in effect the ‘Dividend’ from holding a Bond) - so Bond Prices tend to fall.

Purely as an indication of what is possible, at the date of writing this Blog (18th October 2017) my Income Portfolio is up 6% since the start of 2017. I am crossing my fingers that another 1% or 2% will come in by December 31st and this is supported by the fact that I am due more Dividend Payments which will help.

What are Dividends?
I am sure many Readers will find this chunk rather ‘Noddy’ but for completeness and to accommodate the needs of less experienced Readers, I felt it was important to shove it in.

In essence, a Dividend Payout is a ‘reward’ for Shareholders that a Company pays out from the Profits it makes every year and in reality it is this Stream of Income over time that actually defines the ‘Value’ of a Stock. When a Company makes a Profit, it will reinvest some of it into the Business (this is a major factor in where the growth of a Quality Company comes from and this is a very good thing for Shareholders), it will retain some of the Profit on its Balance Sheet for future needs (this could be for acquiring other Businesses, to invest in more efficient Processes/Machinery, to launch New Products, or maybe to give financial strength or suchlike) and the remainder it will pay out to the Shareholders as Dividends.

Most decent Businesses (and certainly the ones we are interested in for the purposes of an Income Portfolio) will make 2 payments each year to Shareholders - an Interim Dividend (this is quite often a smaller amount) and a Final Dividend (this is obviously going to be larger most of the time). However, there are quite a few businesses that pay out Quarterly Dividends - from memory ones like Royal Dutch Shell RDSB, Vodafone VOD and HSBC Bank HSBA do exactly this. Many Readers might like this particular profile of Dividend Payouts.

When a Company puts out an RNS (Regulatory News Service) Announcement regarding its Results, it usually will define what Amount the next Dividend will be and it will give what is know as an ‘Ex-Dividend’ Date - this is nearly always a Thursday and the Share Price of the Company usually drops back on the Day by an amount equivalent to the Dividend Amount. The easiest way to think about what Ex-Div means, is to understand that if you were to buy the Company’s Shares on the Ex-Div Thursday, then you would not be entitled to the Dividend Payment (it ‘Excludes’ the Dividend in other words). You need to own the Shares at the Close of the Day’s Trading on the Wednesday before the Ex-Div Thursday.

Sometimes (sadly they are not all that common) a Company will pay a ‘Special’ Dividend in addition to the Regular Dividends that it pays out - this will also have an Ex-Div Date. Shareholders usually receive the actual Dividend Cash around 4 to 8 Weeks after the Ex-Div day - to be honest this tends to vary a lot but it is usually specified in the Company’s RNS where it announced the Dividend.

An important element when looking at Companies with regard to selecting them for an Income Portfolio is to look at what is called the ‘Dividend Cover’ - this is a measure of how many times the Dividend paid out by a Company can be paid out of the Profit a Company makes - if the Dividend Cover is very low (2 or less might be a concern and 1 or below is really rather tight), then it is a worry because there is a danger that the Dividend might get cut in future or even cancelled altogether for a period.

As I mentioned earlier, in absolute terms a decent Company will tend to increase its Dividend Payout year on year. It is probably best if I illustrate this with an Example. Let’s say the Company’s Shares are priced at 100p in the Market and they declare a Dividend of 4p in a particular year - this means the Dividend Yield is 4% (4p divided by 100p expressed as a percentage). Then in the following year, let’s say they declare a Dividend of 4.25p - so it has gone up a little bit in ’Absolute’ terms - now the Dividend Yield on the 100p Price you bought the Shares at is 4.25%. In a similar vein, if the Dividend in the following year goes up to 4.5p, then the Dividend Yield becomes 4.5% and so on.

As ever with Stocks, there is a rather seemingly complex nuance - but once you have been in the game a while it all becomes second nature and you don’t even think about it. Of course the reality is that Share Prices move around all the time, so it could be that in the 3rd Year for the example I mentioned above, that the Share Price has now risen to 120p (although you only paid 100p so you are pretty happy on that score). In this case, you still get the 4.5% Return from the Dividend on your 100p Buy Price, but for new Buyers at 120p, they are getting a Dividend Yield of 3.75% (4.5p divided by 120p expressed as a percentage). And in terms of the Capital you put in, your Holding is now worth 20% more !! (it could of course fall and be worth less - but we will get on to how to mitigate such Risks further on in the Blog Series).

However, it should be possible for the switched on Readers among you to figure out that Shares can still have a pretty decent Dividend Yield even after several years and a decent rise in the Share Price - this is because the Company will tend to increase the Dividend Payout over time as I mentioned earlier - in fact, I am seeing exactly this with many Stocks in the FTSE100 etc. where they have risen nicely over the years but still pay juicy Dividends out which are not dissimilar to the Percentage Yield Level they were paying out many years ago.

Note this is a big difference when compared to Bonds - on a Bond the Coupon Payment (in effect the Dividend if you like) does not rise - but there could be a place for some element of Bond Exposure in an Income Portfolio if that is so desired (although it might act as a drag on the Performance but give a higher level of ‘safety’).

Blog Series Outline
Well that’s it for Part 1. I had expected this to be 4 Parts but with some thought tonight I have decided that it will be better as 5 Parts - with the main critical factor being my ability to write it and I would rather take my time and produce something of a high quality than to rush it for an unnecessarily demanding timeframe.

With how things stand at the moment, I see the Parts panning out as follows with an outline of the subjects I plan to cover:

Part 2

• Features of an Income Portfolio - Ideal number of Stocks, Maximum number of Stocks, My own Portfolio, Cyclical Stocks, Keep Tax minimised, Reinvestment / Drawdown trade-offs.
• Managing an Income Portfolio - Plan your Holdings, DRIP Schemes, A good reason to Sell a Stock, Stoplosses, Rebalancing.
• What happens when the Markets Crash?

Part 3

• Features of an ideal Dividend Stock - Fit with Portfolio, Growth vs. Yield, Track Record, Dividend Cover, Low Risk, Long Term, Strong Balance Sheet.
• Investment Trusts.

Part 4

• Getting Started.
• How to Find Dividend Stocks.

Part 5

• Example Stocks for use in an Income Portfolio.

Needless to say I reserve the right to change the above list in any way I deem necessary. Fortunately most of it is already written in a very good Draft form,

Cheers, WD.