The Joy of Income Portfolios - Part 3 of 5

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If you haven’t read Parts 1 and 2 yet, then scroll back down my Blog Page a tiny bit and you should find them very easily.

Features of an ideal Dividend Stock
There are many aspects and features that make a particular Stock suitable for an Income Portfolio - the following spring to mind as things to consider:

• Fit with Portfolio - I am sure I have mentioned this before in this Blog epic but I see it as an important point to stress. It is vital that any Stock under consideration as a potential candidate for the Portfolio will fit nicely within the overall Portfolio and not result in over-exposure to a particular theme or sector. Any new Stock must add to the diversity to lower Risk of the overall Portfolio rather than to add to the Risk. It is not simply good enough to buy perhaps 12 Stocks which have high dividend yields etc. - they must be considered as a whole and as a complementary and supportive Basket of Stocks. It is the overall Risk of the Portfolio which matters, not that of the Individual Stocks themselves. Think in terms of a ‘Blended Risk’.

• Growth vs. Yield - there is always a trade-off between these 2 factors when it comes to an Income Stock. You can buy a Stock with a very high Yield (perhaps as much as 6% or more) but with such a Stock you are unlikely to see that Dividend Payment grow much over time - in fact, many Big Yielding Dividend Stocks like GlaxoSmithkline GSK for example have not raised their Dividends at all for the last few years - although GSK has had a very good Yield at about 5%. Alternatively, you can buy a Stock which has a lower Initial Yield (perhaps 3% to 3.5% etc.) but which you expect to have much faster growing Dividend Payments - with the result that in a few years after purchase, the effective Dividend Yield you will be receiving on your Initial Outlay will be far higher. I take the view that it is best to have a mix of these kinds of Stocks - for instance, I hold KCOM which has a yield up around 6% but I also have Telecom Plus TEP which pays around 4% but it has a good record of growing its Dividends every year.
  
• Track Record - is something I pay a lot of attention to. One great example of this is Royal Dutch Shell RDSB which has never cut its Dividend Payment since WW2 - this is a remarkable record and woe betide any CEO who gets themselves into a position where they need to cut the RDSB Dividend - such a move would be Career Suicide and they would do all sorts of financial engineering and cost cutting to avoid such an outcome (I haven‘t even mentioned the Press Coverage such an action would get - the CEO would become like a notorious Villain !!). This makes RDSB’s Divvy pretty safe to my mind. Another great one is Vodafone VOD - since it Floated in the mid 1990s or whenever, they have raised the Dividend Payment every year - on a current Yield around 6% that seems highly appealing to me (I don‘t hold VOD in my Income Portfolio but obviously I should !!). Ideally you want to see a Stock have a record of steady Dividend Payments and for them to have continued during tough times like in 2008 etc.
  
• Dividend Cover - This is the Number of Times that the Earnings of a Share will enable its Dividend Payment to be paid out. For example, say a Stock is paying a Dividend of 8p per year and it has Earnings Per Share of 20p, then its Dividend Cover will be 2.5 times (20p divided by 8p) - in other words, the Stock could pay a Dividend 2.5 times bigger if it paid out all of its Earnings and therefore if the Earnings were to drop a bit in a future year, then there would perhaps still be scope to pay out the same Dividend level. So a higher Dividend Cover gives some certainty that a Stock can continue to pay out a given level of Dividend Payment in future. A low Dividend Cover could be signalling that the Dividend might be at Risk of a cut if the Trading of the Company drops off. Obviously if the Stock under consideration also has a nice Cash Pile then that adds to the ‘safety’ of the Dividend.
  
• Low Risk - as with some of the other Bullets in this list, I have mentioned this kind of thing before in the Blogs I think but it will not hurt to repeat it. In general terms I think it is important to keep Risk Low and to buy Stocks for an Income Portfolio which are boring and stable and likely to continue churning out their Dividend payments come Hell or High Water !! There might be a place for taking on a slightly higher Risk on 1 or 2 Stocks within the Portfolio, perhaps even with a Cyclical Stock if the Dividend Payments in the good times will be sufficient to allow for the fact that in Bad Times the Dividend might not be paid at all - but I would keep such Stocks very much to a minimum. It is probably best to stick to FTSE100 and FTSE250 Stocks and maybe to dive lower down into FTSE Small Caps and perhaps even AIM in extremis, but I would not have more than 1 or 2 Stocks from the lower Indexes and immense care must be taken in selecting them as they are far more likely to give you problems.
  
• Long Term - The ideal Income Stock is something you could envisage holding in perhaps 5 or even 10 years time - stable businesses with predictable demand for their Products and a Track Record of adapting to changing circumstances and clearly demonstrating longevity. This is not an Account where you want to be churning your Holdings and constantly buying and selling - that is for your ‘normal’ Share Trading Account. The focus here should be on Low Risk and Low Activity and keeping Costs down by not overtrading - so the Stocks you select must line up with this philosophy. This kind of thinking is particularly important if you are a younger Person who is using an Income Portfolio as a home to park Money that has been accumulated from higher Risk and more active Stockmarket activities.
  
• Strong Balance Sheets - it is by their nature of being fairly reliable and boring Businesses that many of the Larger Stocks that are suitable for an Income Portfolio often have pretty high levels of Debt. For something that has highly reliable Cashflows like Vodafone VOD this is not too problematic but if you are in doubt then it is best to steer clear of Companies with lots of Debt. As a general Principle, if a Stock has a Pile of Debt that is higher than 3 times its usual Level of Profit for one Year, then it might be a worry and you might want something less indebted. This especially applies for Newer Investors and those who are highly Risk averse - for more Experienced Old-Hands, higher levels of Debt might not cause too much worry (for instance, I would not worry about Debt at VOD at all). In a similar vein, if a Company has a lot of off-Balance Sheet Lease obligations and suchlike, then this is probably best avoided. With recent changes to the Accounting Regulations, it should be easier to establish if a Business has High Lease commitments and certainly if you use a tool like SharePad it is very good at highlighting such Risks.
  
• Problem-free Trading - the bane of all Stock Investors is the dreaded ‘Profit Warning’ which is when a Company puts out a Trading Update (often this is out of the blue and unexpected) which announces to the Market that they have problems and will not meet the Profit Expectations that Analyst Forecasts are based on. Nearly always when this happens the Shares will tank and it is not unusual for even Big FTSE100 Stocks to fall 15% or more on such Bad News. As a general rule I would say it is best to avoid Stocks which have just put out a Profit Warning or succession of Profit Warnings - it tends to be the case that very few Profit Warnings appear on their own and we normally get more Warnings before the Company pulls its socks up and gets a grip on things and starts to recover. I think this is particularly important for Newer Investors to avoid problems, but perhaps for more experienced types, buying after a few Profit Warnings when the Company has had a change of Management at the top and the Chart is showing that Buying Interest is coming back in can work out well. These types of Recovery Situations can be an excellent time to buy in Cheap and get a nice chunky Dividend Yield as well as the potential for a lot of Capital Gain on top as the Share Price moves back up over time. I mentioned this in Part 2 but I will just re-iterate it here - if you hold a Stock in your Income Portfolio and it puts out a Profit Warning, then you need to think very carefully about the situation and how you want to respond to it. Quite often if you hold Big and Reliable Companies with a long history behind them, they will recover with some Organisational Changes and Cost Cutting etc. - if you think this will be the case then you can grit your teeth and ride the Stock down but with a view to Buying more and ‘Averaging Down’ when things are clearly in the Recovery Phase - but immense care must be taken when doing this as the last thing you want to do is put more money into something that is going to go bust. Some people have a rule of simply selling a Stock whenever a Profit Warning is issued and this might be your preferred approach.
  

Investment Trusts
On the ‘Funds’ page of this Website you can find some text explaining the differences between various Fund type Investments like Investment Trusts, Unit Trusts, ETFs, Tracker Funds etc. An Investment Trust is a Company that can be bought and sold just like any other Company that is Listed on the Stockmarket (in other words, there is no difference in the mechanism of buying an Investment Trust like European Assets Trust EAT or buying Shares in a ‘normal’ Company like Tesco PLC TSCO), but with the difference that it is in effect a Company that Invests in other Companies - i.e. it is a sort of Fund.

I do not currently hold any Investment Trusts in my own Income Portfolio but I think it would be perfectly good sense for someone to create an Income Portfolio which held some Investment Trusts. Theoretically it would be possible and quite straightforward to construct an Income Portfolio entirely from Investment Trusts and you could diversify along the Lines of Sector exposure, Geography, Investment Manager expertise, etc. Having said that, if you are aiming for an Income Portfolio with 12 Positions, then perhaps having 1 or 2 as Investment Trusts would make sense and something like the Edinburgh Investment Trust EDIN run by Mark Barnett (he also runs Neil Woodford’s old Unit Trust at InvescoPerpetual) would perhaps make a good ‘Core Holding’ kind of Bedrock thing.

Many Investment Trusts pay Dividend Yields up around 4% or so at the moment and I think adding something like this to an Income Portfolio would perhaps lower Risk and add to the Diversity - although obviously a lot of care needs to be taken in selecting the appropriate Stock (an Investment Trust is just another type of ‘Stock’). Perhaps a good idea is to buy an Investment Trust which invests in Bonds as it would be a completely different Asset Class - I am sure there are a few of these around.

Note John Baron who writes in Investors Chronicle (he is also a Tory MP but don’t let that put you off !!) runs several Portfolios made up from Investment Trusts - if you check out his writings you might get some good ideas from him. His Website is here although sadly much of it is Subscription Only (although the Investment Trusts he uses get listed in Investors Chronicle most weeks):

http://www.johnbaronportfolios.co.uk/index.php

A critical thing to understand on Investment Trusts is their Discount or Premium to the Net Asset Value (NAV) of their Underlying Assets - ideally you want to buy when they are on a sizeable Discount but as always care is needed (and obviously when the Discount is wider the Dividend Yield will be higher as the Share Price will most likely have fallen). See my ‘Funds’ page for more details about this.

Unit Trusts
As mentioned in the ‘Investment Trusts’ bit above, if you look at the ‘Funds’ page on this Website you should get more idea of what the differences between the various types of ‘Funds’ you can buy actually are. When compared to Investment Trusts, I just see Unit Trusts as generally inferior (and in the cases where a direct comparison can be made because there is a Unit Trust and an Investment Trust run along similar lines by the same Fund Manager, it is usually the case that the Investment Trust outperforms), and my limited understanding is that the kind of Dealing Platforms through which you are able to Buy and Sell Unit Trusts tend to have much higher charges than the Platforms which are purely for dealing with Companies (remember, an Investment Trust is a type of Company). I may not be entirely correct on this so I suggest that any Readers looking to buy Unit Trusts investigate this thoroughly.

In some cases an Investor has no option - only a Unit Trust is available. For example, this is the case with Mark Slater’s Growth and Income Funds which are both very good performers (although not necessarily ideal for an Income Portfolio). Having said that, if you want 1 or 2 Unit Trusts you don’t necessarily have to hold them on a ‘Platform’ as such I believe - in fact (although this might be a historic thing) I hold a Tech Unit Trust and a Health Unit Trust outside of any kind of Platform or ‘Wrapper’ - and to Sell chunks of them I just phone up the Fund Management Company. Of course I am liable for CGT and/or Income Tax on these so I need to manage my Sells carefully.

With the above in mind, I would suggest that if you are tempted to buy a Unit Trust for your Income Portfolio, you make sure that you cannot buy a ‘sister’ Fund as an Investment Trust instead - it is probably the more effective way.

Tracker Funds
I see these things as very similar to Unit Trusts but in this case they do not have an ‘Active’ Manager as such but they are in effect copies of an Index (for example, like the FTSE100 or S&P500 etc.) and are created to ‘mirror’ the actual Index with regards to the Stocks included and their individual Weightings within that Index. I have a fairly limited understanding (in simple terms this is because I have little interest in them !!) but I think they need to be Bought and Sold like a Unit Trust and require the same sort of Platforms/Wrappers to use them.

I am unsure about these with regards to suitability for an Income Portfolio. My gut reaction and personal bias is that I wouldn’t have one myself, but maybe within a collection of 12 to 18 Assets, the odd Tracker wouldn’t hurt. The obvious benefit of these things is that they are very low cost but the disadvantage is that they do what it says on the Tin - in other words, it is marvellous when they Track a Bull Market to ever new Heights, but extremely unpleasant when they Track a Bear Market downwards with immense velocity !!

Perhaps is you are a particularly adept ‘Trader’ and ‘Timer’ of Markets, then you could Sell your Tracker Fund before the drop but of course this sort of defeats the ‘do as little as possible’ aspect of a Low Effort Income Portfolio and if you are out of the Market you will not be benefiting from any Dividend Payments - this could be really problematic if you rely on the Income to eat and drink Beer (or Wine, Gin, Fevertree, etc. for you posh types). And of course if you try to time the Markets and get it wrong (it is almost guaranteed that you will) then you will be missing out there as well.

My thinking is that if you use Trackers (or anything which ‘Tracks’ a Market) then you are sort of ensuring that you will suffer the Bad Times quite hard. I take the view that with careful Stock Selection and a focus on Diversity and Defensives, it is possible to create a Low Risk and Low Effort Portfolio which will perhaps perform slightly better than ‘The Market’ in Bear periods - this makes sense because it is likely that Cyclicals get really beat up and the type of boring stuff in an Income Portfolio will fare better. However, sadly I think it is impossible to create an Equity-based Income Portfolio which is totally immune from Bear Markets - you will take some sort of hit but as I mentioned in an earlier Part, if you have a Diverse collection of Decent Stocks then they should recover in time.

Exchange Traded Funds (ETFs)
If you look on my ‘Funds’ page I have written a bit about these and in particular it is important to understand the difference between ‘Physical’ and ‘Synthetic’ replication which I have explained there.

As I see it ETFs are just in effect another form of ‘Tracker Fund’ and the comments I made in the Section just above on Trackers largely applies to these. I am not totally averse to the use of maybe 1 or 2 ETFs within an Income Portfolio but I think care must be taken to ensure you are not taking on a ‘Market Risk’ that perhaps is avoidable by diversifying across Stocks with some sort of defensive nature. The big advantage of ETFs over Trackers is that they can be Bought and Sold via a ‘normal’ Share Dealing Platform and are treated in effect like Companies (similar to Investment Trusts if you like). ETFs also tend to be very Low Cost which is always a good thing.

A recent trend is the proliferation of ‘Smart Beta’ ETFs - these are special and complex ETFs that instead of merely Tracking an Index or whatever, they try to give the Performance of particular Sub-Divisions of the Market. For example, a Smart ETF might in effect track all the Stocks in the FTSE350 which have a Dividend Yield over 3.5%, or perhaps one might track the Return of Stocks which would qualify as being something Warren Buffett might invest in - you get the idea (hopefully).

I am really unsure about these ‘Smart’ ETFs (it often seems to be the case that such complex and artificial ‘Products’ turn out to be very ‘Dumb’ for Investors) and my gut instinct would be to leave well alone. As with any of these things, if you are tempted then I suggest doing really thorough research and before rushing into buying one for your Income Portfolio, think carefully about the Alternatives and whether or not the potential Smart ETF actually brings anything to the Diversification Party which should make up your Portfolio. Rather than these kind of things, I would probably stick to Investment Trusts myself.

That’s it for Part 3, now I need to crack on with writing Part 4 !!

Cheers, WD.