How The UK Value Investor Portfolio Performed In 2020

Turning to dividend yield, at year-end it was 2.9% for both the UKVI portfolio and its All-Share benchmark.

Historically the portfolio has had a consistent yield advantage over the All-Share, so hopefully the portfolio’s yield can revert back to its typical 4% range within a year or so.

• Goal for 2021: Drive dividend yield back above the All-Share’s and preferably above 4%

As for long-term dividend growth, this is easy to measure but harder to draw conclusions from.

If we ignore 2020’s abnormally low dividends as an outlier, then the portfolio’s dividend has grown more slowly than the All-Share’s over the last ten years (6% annualised versus 9%).

This slower dividend growth is mostly because the portfolio has moved towards higher quality stocks with slightly lower yields over the last ten years.

In other words, a decade ago the portfolio was mostly invested in lower quality lower growth stocks with yields of more than 5%, whereas just before the pandemic the average yield was 4% from higher quality higher growth companies.

In short, the decrease in yield has acted as a drag on dividend growth.

Going forwards I don’t expect the average yield to continue dropping, so I expect the higher dividend growth rate from the portfolio’s higher quality holdings to show up as higher overall dividend growth over the next few years.

Here’s the related goal:

• Goal for 2021: Grow the portfolio’s dividend faster than the All-Share’s

2020 broke records for the fastest stock market crash in history. The All-Share fell 34% in four weeks from late February to late March, while the UKVI portfolio fell 40% over the same period.

Given that the portfolio is supposed to be defensive, that’s far from ideal. However, again, the degree of underperformance wasn’t huge, but it was disappointing and needs fixing:

• Goal for 2021: Improve the defensiveness of the portfolio so it declines less than the All-Share in down years

The market and the UKVI portfolio have since recovered almost all of that lost ground and the lows of March, April and May turned out, as I suspected, to be excellent buying opportunities.

Although the portfolio’s results haven’t been terrible and it has outperformed the market (slightly) over ten years, it’s disappointing to be some way off the 10% sustainable annualised return I’d hoped for.

Let’s take another look at my goals for 2021 (and beyond):

• Drive total annualised long-term returns back above 10%
• Improve the robustness of the portfolio’s dividend
• Drive dividend yield back above the All-Share’s and preferably above 4%
• Grow the portfolio’s dividend faster than the All-Share’s

I think all of these goals can be achieved with two fairly minor tweaks to my investment strategy.

Essentially, a recent review of all my past and present investments revealed that the best performers tended to be the highest quality, most defensive, best value holdings, while the worst performers tended to be the lowest quality, least defensive, worst value holdings.

My dazzling insight is that the portfolio needs to be tilted towards its highest quality, most defensive and best value holdings, and away from (or out of) its lowest quality, least defensive and worst value holdings.

I’ve spent a lot of time thinking about this in recent weeks and have already detailed how I intend to do this in two blog posts:

• How to categorise stocks as quality, defensive and/or value
• How to build a concentrated portfolio of quality shares

In practical terms, this will have several important effects on the portfolio:

• The number of holdings will reduce from 34 today to around 20 to 25 by the end of the year as the weakest holdings are removed
• The maximum position size will increase from 6% to 8% (if a position exceeds 8% I’ll trim it back) to allow a greater focus on the best holdings
• A new minimum position size of 2% will be introduced so that all holdings pull their weight (and if I’m not confident enough to top up a sub-2% position then I’ll sell it)
• The position size of each holding will approximately reflect the confidence I have in the stock’s ability to exceed my 10% annualised return target. So:
  • High confidence holdings will have overweight positions of around 5% or more
  • Average confidence holdings will have average-weight positions of around 3% to 5%
  • Low confidence holdings will be sold or have underweight positions of around 3% or less

The idea is that this tilt towards the highest quality, most defensive, best value stocks will improve the portfolio’s dividend yield, improve its dividend and capital growth rates and improve its defensiveness.

This process of rebalancing the portfolio towards its best holdings has already begun. At the beginning of January I trimmed an oversized Quality Value holding and used the proceeds to top up an undersized Quality Defensive Value holding.

The Quality Defensive Value holding has a higher yield, a higher growth rate and a more defensive business model, so hopefully this will improve the portfolio’s results in 2021 and beyond.

I expect many more rebalancing trades to occur in 2021, and in a relatively short time the highest quality, most defensive, best value stocks (those in which I have the most confidence) will dominate the portfolio.

And speaking of trades, here’s a quick review of every company that joined or left the portfolio in 2020.

In line with my growing focus on Quality Defensive Value stocks, four companies left the portfolio in 2020. All of them were either low quality, highly cyclical or unattractively valued, and in some cases all three.

Aggreko is the world leader in portable containerised diesel generators, which are used to power events such as the Olympics or to build temporary or off-grid power stations.

Having invested in 2016, I sold Aggreko in January 2020 for a measly 2.5% annualised return.

This investment’s weak returns are due to the fact that I failed to realise just how cyclical Aggreko really was, and how much it had benefitted from potentially one-off cyclical tailwinds in the years leading up to my purchase.

Those tailwinds eventually turned into headwinds and the company ended up struggling against them for years.

This degree of cyclicality makes it incredibly difficult to form sensible opinions about Aggreko’s future revenues, earnings and dividends, and I now think that such a cyclical company isn’t a suitable holding for the UKVI portfolio.

• Why I sold Aggreko in January

Ted Baker is a relatively well known high street fashion brand and retailer which joined the portfolio in late 2018.

Ted ran into a series of very serious problems which showed that the company was fundamentally weak, so I sold Ted Baker in July. The sale locked in a loss of almost 94%, which was about 4% of the portfolio’s overall value.

Ted’s problems stemmed from a combination of weak returns on capital and excessive growth. This only becomes obvious once returns on capital employed are adjusted to take account of lease liabilities, which is something I didn’t do in 2018.

Ted’s weak returns gave it little cash to reinvest for growth, so it chose to use external funding instead.

The end result was excessive lease costs and too much debt. When demand for high street fashion turned downward in 2018, the company’s lack of competitive strength (the underlying cause of its weak returns) and weak financial foundations led to a host of extremely serious problems.

On a more positive note, Ted provided many lessons on what to look for if you want to avoid weak over-indebted retailers:

• Why Ted Baker has been a disaster and a gift in equal measure
• Ted Baker’s collapse is a lesson in the dangers of too much growth

In September I sold Xaar, a leading high tech digital inkjet printhead business.

Xaar has the potential to be a quality business, but it’s also extremely cyclical. Demand for its revolutionary digital inkjet printheads can explode in an industry where everyone still uses analogue printing, but then collapse once the industry has fully converted to inkjet.

Xaar has also consistently struggled to hang onto market share in newly converted markets once serious competition arrives.

Extreme cyclicality should demand caution so that the business can survive when demand temporarily collapses. But Xaar chose to invest very heavily in ground breaking new technology even as revenues shrank, and it over-committed.

By 2019 Xaar was near bankruptcy and I had learned some very important lessons about why very cyclical businesses shouldn’t be in a defensive value portfolio.

• My worst investment ever
• Selling Xaar: Why heavy R&D and high cyclicality are not a good mix

Most of the sales I made in 2020 could be described as taking out the trash. In contrast, the year ended on a more positive note with the sale of Dunelm in November.

Unlike Aggreko, Ted Baker and Xaar, Dunelm is exactly the sort of company I’d like to keep in the portfolio.

It’s the market leader in UK homewares, it’s highly profitable, has a strong balance sheet and still has a member of the founding family on the board.

Founding family ownership and involvement can be useful as it often helps management stay focused on the long-term future of the business rather than meeting the short-term profit expectations of institutional investors.

We give each [of Berkshire Hathaway’s managers] a simple mission: Just run your business as if (1) you own 100% of it, (2) it is the only asset in the world that you and your family have or will ever have; and (3) you can’t sell or merge it for at least a century.”

Warren Buffett

The investment in Dunelm produced a 15.8% annualised return over four years and I would gladly reinvest in the company if its dividend yield gets back above 4%.

With share prices depressed through most of the year I took the opportunity to add eight companies to the portfolio. All of these companies were high quality and attractively valued according to my Quality Defensive Value criteria.

To give you an idea of what I’m now looking for in an investment, here’s a snapshot of some key metrics for these eight new holdings:

For me the most important metric is ten-year net return on lease-adjusted capital employed (net ROCE), which is usually a good measure of a company’s sustainable competitive strength.