In this half-year review I outline my portfolio’s performance, take a brief look under the covers and run through each major buy or sell trade of the last few months.
Table of Contents
A new name and a new all-time high
I’ll get the gritty details out of the way first.
After ten years I’ve decided to change the portfolio’s name from “Model Portfolio” to “Million Pound Portfolio” because (a) it’s more catchy (and yes, more cheesy) and (b) because it sums up the portfolio’s long-term goal.
As a quick reminder, my plan is to grow this virtual portfolio from its 2011 starting value of £50,000 to a million pounds within 30 years (2041). That requires an annualised total return of 10% over those 30 years, and Ideally I’d like about 5% of that to come from dividend yield and 5% from dividend growth (which drives capital gains).
As for performance so far in 2021 (including dividends):
- The Million Pound Portfolio is up 12.7%
- The FTSE All-Share is up 8.9%
Of course I don’t expect to get anywhere near a 13% return every six months, so this is an abnormally good result. Most of that is down to the UK stock market’s ongoing recovery from the lows of last year, which shows up in the All-Share’s abnormally good 9% half-year return.
The strength of the UK stock market’s recovery has driven the portfolio to its first new high in just over a year. Its total value now sits at £112,200 compared to a high of £110,000 in January 2020.
Longer-term returns are ahead of the market but behind my target
Here’s a quick summary of the portfolio’s longer-term results:
- Ten-year annualised total returns are 8.4% for the portfolio, 6.3% for the All-Share
- Five-year annualised total returns are 6.5% for the portfolio, 7.4% for the All-Share
So the portfolio is ahead of the FTSE All-Share over ten years and that’s really my minimum standard. If I can’t beat the All-Share over the longer-term then I should close up shop and find something else to do.
However, it’s behind the 10% annualised return needed to hit my million pound goal. To be on target the portfolio needs to be at £139,000, so it’s 24% behind that. I have no idea whether I can close that gap, but in the last few months I’ve introduced a few changes to my investment strategy which I think should help.
But before I start talking about those changes, here’s a quick review of the portfolio’s dividend track record:
My goal for dividends is that the yield should be better than the FTSE All-Share’s at the very least, and preferably around 5% or more so this is definitely an income and growth portfolio.
As the chart above shows, dividends from the portfolio and the All-Share took a hammering last year, recording declines of 36% and 32% respectively.
Given these lower dividends last year, the yields on the portfolio and the All-Share are 2.9% and 2.6% respectively, which is unusually low.
Although this wasn’t a disastrous performance it was disappointing to suffer a larger dividend decline than the All-Share, so dividend safety is another area I’ve focused on in recent months.
The biggest winners and losers of the year so far
Even though the Million Pound Portfolio follows my Defensive Value Investing strategy, the individual holdings are still going to be volatile. It’s an inescapable part of investing in individual stocks and it’s why you shouldn’t focus on short-term share price movements.
So far this year Senior is up 68%, making it the best performing holding of the year so far with almost all those gains arriving in one day. Senior’s shares were happily sitting at just over £1.02 when out of the blue, investors were told that a private equity firm had offered £1.76 per share to buy the whole company.
Management refused the bid, but the share price still rose to almost £1.60. This pushed Senior’s position in the portfolio up to around 6%, while at the time making the shares less attractively valued (just like a loaf of bread at £2 is less attractively valued than the same loaf at £1).
So following my new rule of active position sizing, I sold down Senior and reduced it to 2% of the portfolio. The proceeds were used to top up an undersized but more attractive holding.
At the other end of the spectrum, Telecom Plus is down 15% so far this year. I still like the company so I used this price decline as an opportunity to buy more shares at a lower price, increasing its position size to 4%.
In summary then, performance so far this year has been better than I’d expected. That is mostly down to luck but some of it may be down to a few improvements I’ve made to my investment process in recent months.
What I’ve changed to improve performance
During its first six or seven years the portfolio was happily ticking along with annualised returns of around 10%.
Then it started to run into problems in early 2018, partly because of Brexit and partly because there was a global economic slowdown. More importantly, too many of the portfolio’s holdings were having fairly serious problems and it became clear that my investment process needed improvement.
Here’s a summary of the most important and most recent changes.
Change 1: Focus on higher quality companies
In 2019 I started to focus on companies with high quality earnings, capital employed growth, wide profit margins and perhaps most importantly, high returns on lease-adjusted capital. I also started to focus much more on avoiding turnarounds, recovery stocks and transformations and I wrote an article for Master Investor Magazine about some of these issues to help me clarify my thinking.
I think these changes have really helped in terms of identifying quality companies. More recently I’ve made a few changes that should improve the valuation and portfolio management side of things.
Change 2: Value companies with discounted dividend models
The biggest change of the last six months, by far, is that I now value companies using a discounted dividend model.
This is a big shift because previous I valued companies using backwards looking ratios such as PE10 and PD10 (price to ten-year earnings and dividends respectively). I now think those ratios are a useful starting point, but the real value of a company lies in its future cash returns to shareholders, so that’s what I focus on now.
I find the process of building dividend models extremely useful. It forces you to think seriously about how the company might perform over the next ten or twenty years, and that’s important because that’s a realistic holding period for a long-term investor.
Change 3: Calculate target Buy and Sell Prices
Once I’ve built a realistic and conservative dividend model I use it to generate two target prices: a Buy Price and a Sell Price.
- Buy Price: At this price the stock’s expected rate of return is 10% per year. That’s my target rate of return.
- Sell Price: At this price the stock’s expected rate of return is 7%. That’s the long-term average return of the UK market.
In short, if I don’t think a stock is likely to beat the All-Share over the long-term then I don’t want to own it.
In most cases the Sell Price is around twice the Buy Price, so this gives me a fairly wide price range where I’m happy to hold.
For example, at the moment Senior‘s Buy Price (according to my dividend model) is £0.84 whereas its Sell Price is £1.74. The private equity firm bid £1.76 per share to buy the whole company, so I assume their model is more optimistic than mine, or that owning the whole company will allow them to add value to the company directly.
I like to think of the relationship between the current share price, the Buy Price and the Sell Price in terms of a company’s Margin of Safety.
Change 4: Calculate the Margin of Safety
Ben Graham said that margin of safety is the central concept in investment, and I think that’s exactly right. It doesn’t matter if you’re a value investor, growth investor or momentum trader, if you don’t have a margin of safety at some point you’ll get badly burned.
I calculate a Margin of Safety score to tell me where a company’s share price is relative to both its Buy Price and Sell Price. It works on a sliding scale, but here are the major landmarks:
- If the share price equals the Sell Price then Margin of Safety is zero
- If the share price is halfway between the Buy and Sell Price then Margin of Safety is 50%
- If the share price equals the Buy Price then Margin of Safety is 100%
Margin of Safety tells me how attractively valued a company is and I now use it to drive position size decisions.
Change 5: Actively manage position sizes
Before 2021 I had a hands-off approach to position sizing. The Million Pound Portfolio held around 30 companies, they were added with a default position size of 3-4% and that was that. If the share price went up a lot then the position grew and if the price went down a lot the position became smaller.
This is how indexes like the FTSE 100 work. It’s called passive position sizing and it makes sense for index trackers and inexperienced investors because (a) it reduces transaction fees, (b) it reduces the amount of time and effort required to run the portfolio and (c) it can make sense if the investor doesn’t really know what they’re doing.
But once you’ve been investing with a reasonable degree of success for a few years, I think most investors would be better off by deliberately investing more into their best holdings.
We usually have fairly large portions (5% to 10% of our total assets) in each of five or six generals [generally undervalued stocks], with smaller positions in another ten or fifteen
Warren Buffett, Buffett Partnership Letters
Here’s how I now actively manage position sizes:
I have a separate default position size for defensive companies (4%) and cyclical companies (3%). To arrive at a target position size I adjust those defaults using each holding’s Margin of Safety.
The basic idea is that as Margin of Safety gets larger so does the target position size, and vice versa. I use a simple formula to make the adjustments, for example:
| Margin of Safety | Target Position Size |
|---|---|
| 150% | 200% of default |
| 100% | 150% of default |
| 50% | Default |
| 0% | 50% of default |
| -50% | 0% |
If you want to try this out I’ve added this formula to my investment spreadsheet.
I’ve only been actively managing position sizes for a few months, but so far I like it. The portfolio is now much more weighted towards the best companies at the most attractive valuations.
The most noticeable difference is that the top four or five holdings (about 25% of the portfolio) are all Quality Defensive companies and they have an average dividend yield of around 6%. These large dividends have started to flow into the portfolio and that makes me happy.
What I’ve sold so far this year
This review has gone on long enough, so finish off by taking a look at all the major trades I’ve made this year.
Somewhat unusually, I haven’t added any new holdings to the portfolio this year. All I’ve done is remove quite a few holdings as part of my plan to build a more concentrated portfolio (and they had very small target position sizes too).
Most (but not all) of these investments worked out badly, so hopefully what comes next will provide you with some useful lessons on what to avoid.
January: Sold Hyve because it’s too acquisitive for my liking
I bought Hyve Group in 2015 when it was called ITE (International Trade Exhibitions). It was a Russia-focused trade exhibitions business and its operations and share price had been hit by the Russo-Ukraine War, so it was trading on attractive-looking valuation ratios.
Buying ITE was a mistake (and a learning experience) and it produced a total return of about minus 50%.
Hyve struggled because in the past it had repeatedly followed a strategy of growth using debt to acquire other companies.
In 2015 my company review were far shallower than they are now, and although I did spot Hyve’s acquisitive history it didn’t put me off investing.
Today I know better, having seen debt-fuelled acquisition sprees blow up on more than one occasion.
For the complete lowdown on why I bought and sold Hyve, here are the full reviews taken from my monthly newsletter:
February: Sold N Brown because it doesn’t meet my Quality criteria
When N Brown joined the portfolio in late 2014 it was a successful mail order catalogue business doing what, at first glance, seemed to be a decent job of transitioning to the online world.
In reality it was a long way behind where it needed to be, and had seriously underinvested in the hard and soft infrastructure needed to compete in a mobile-first world.
Today N Brown’s transition to a pure-play online retailer is almost complete, but it has lost the major competitive advantage it held as a dominant mail order catalogue business (the advantage has been lost because almost nobody uses mail order catalogues anymore).
As a pure-play online retailer N Brown doesn’t have the sort of proven track record of success that I’m looking for, so I decided to sell (although I do like its market-leading Simply Be brand and think that may have a good long-term future, but it’s only a small part of the overall business).
This was another mistake (or learning experience), with a total return of around minus 60%.
That sounds bad, but with a position size of 4% or so a 60% loss only translates into a 2.4% loss at the portfolio level. That isn’t the end of the world, which is why small position sizes make sense when you’re less experienced (as I was in 2014).
March: Sold Mitie because it operates in a super-competitive high risk industry
Mitie was one of the first “defensive value” investments I made, way back in 2011.
Before that I’d spent several years investing in micro-cap deep value stocks, but that didn’t suit my personality. What I really like is a decent dividend yield and reliable dividend growth, and as the UK’s leading facilities management company that’s what Mitie seemed to offer.
In 2011 Mitie had a long history of impressive growth, growing by 18% per year in the decade to 2011 and raising revenues, earnings and dividends almost every year.
However, rather than being a steady and dependable dividend growth stock, Mitie was in fact more like a race car being driven too fast on worn out tyres. To the more experienced eye (which I didn’t have at the time) a serious crash was virtually inevitable.
The main problem was Mitie’s history as a company built from over one hundred small acquisitions, a strategy which often produces large companies with no coherent structure.
In the computer programming world this is known as a big ball of mud, or a hairball/spaghetti system. There are lots of different components, many of which don’t play nicely with each other, and the end result is a system which can grow very quickly until it collapses under its own inefficiencies and complexities.
That’s bad enough, but Mitie also operates in the super-competitive outsourcing industry, where suicide bidding on very large contracts is an occupational hazard. Problems at Capita, Carillion and Interserve provide good examples of just how hard it is to run a conservative and sustainable business in this sector.
This investment was another mistake with a total return of about minus 30%, but at least Mitie taught me a lot about the importance of detailed research and how consistent and profitable growth, in and of itself, means nothing.
April: Sold Standard Life Aberdeen because I don’t think it has any durable competitive advantages
Standard Life Aberdeen originally joined the portfolio in 2016 as Aberdeen Asset Management, which was then the second largest active fund manager in the UK. The investment in Aberdeen worked out well, with the 2017 merger of Aberdeen and Standard Life leading to annualised return of 17% at the merger date.
Unfortunately I decided to hold on to the merged company’s shares.
My opinion at the time was that Standard Life was a leading asset manager and the combined group promised additional economies of scale and a more diverse and robust business.
Four years later and as a more experienced investor, I now think both companies lacked durable competitive advantages and I think that’s true of the combined business too. This matters because I only want to invest in a company if I think I can see and understand its competitive advantages, because without those I cannot have any faith in its long-term future.
Standard Life Aberdeen (or Abrdn plc as it has now inexplicably been renamed) doesn’t have obvious competitive advantages that give it an ability to earn consistently high returns, so it isn’t a suitable holding for the Million Pound Portfolio.
I would call this a mild mistake and another good learning opportunity, and in the end the total return was about 20% over five years, or 4% annualised.
May: Sold Petrofac because it operates at the crossroads of two extremely cyclical sectors
Petrofac is an oil and gas construction and engineering business, and when joined the portfolio in early 2014 it had a track record most companies can only dream of.
It had grown by 35% per year over the previous ten years, increased revenues, earnings and dividends almost every year and its average return on capital (ROCE) was a very impressive 30%.
What I didn’t appreciate at the time was the extent to which those results had been driven by a huge boom in oil and gas prices and oil and gas construction projects from the early 2000’s until 2014/2015.
When supply finally caught up with demand, prices fell and the oil and gas projects that Petrofac depends on dried up. Petrofac has struggled ever since and several major self-inflicted wounds have made its recovery much more difficult.
Looking longer-term, Petrofac’s core market is likely to be in decline as the world transitions away from fossil fuels.
So this was another mistake and another opportunity to learn about the difficulties that come with investing in highly cyclical industries. The total return was about minus 75%.
June: Sold XP Power because the price is close to my target Sell Price
After months of seemingly doing nothing except selling badly performing investments, it was nice to finally close out a position which has produced very solid returns over the last few years.
XP Power has been one of the portfolio’s best investments to date, returning 130% over four years. The annualised return was even better, at almost 50% per year. That was mostly because I sold about half the original investment after a near 100% gain in the first nine months.
When XP Power joined the portfolio in early 2017 it was one of the world’s leading designers, manufacturers and distributors of AC-DC, DC-DC and other power converters. It started out as a distributor and over many years expanded into design and manufacturing as part of a long-running and highly consistent strategy.
Today XP is a global leader with the largest technical salesforce and the broadest and most up to date range of converters in the industry. The only problem is that its share price has almost tripled and is now close to my target Sell Price (which is effectively my estimate of fair value).
In practice that means its dividend yield was a healthy 3.7% at the time of purchase and today its below 2% (although of course there’s much more to valuing a company than simply looking at its dividend yield).
I still think XP is a high quality business, but I’m in the process of reducing the number of holdings in the portfolio from 35 at the end of last year to 25 by the end of 2021. Something has to give and this time it was a quality company at a not obviously attractive price.
Just for the record, here’s are XP’s various prices:
- Price today: £52.00
- Target Buy Price: £22.39
- Target Sell Price: £51.07
Summary: A good start to the year, let’s hope it continues
Overall, 2021 has been a good year so far for the UK stock market and that has helped my portfolio.
Crystallising multiple losses is never easy, but having sold off all the dross I am much more happy with the remaining holdings and their relative position sizes. I’m looking forward to the rest of the year and hopefully the pandemic won’t throw any more spanners into the works.
Feel free to share your own portfolio’s ups and downs in the comments below.
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