tadamichi
First, an apology. I haven’t written anything for a few weeks, partly because I’ve been busy reviewing company results during results season, but also because Mrs K has been in and out of hospital.
Having other things on my mind seems to have a very detrimental impact on my ability to get my usual long-form posts “out the door”, so I’m going to try writing shorter updates more frequently, which should be easier for me to write and easier for you to read.
And speaking of (relatively) shorter updates, I recently had something of a lightbulb moment in terms of how I diversify my portfolio of dividend stocks.
It’s not like my portfolio isn’t diversified at all, because it is. I’m a rules-based investor, so I already have rules to limit my exposure to individual companies, sectors and countries:
- Company diversity: When a position exceeds 6% of the portfolio, trim it back to 4%
- Sector diversity: Don’t have more than 10% of the portfolio’s holdings in one sector
- Country diversity: On average, the portfolio’s holdings should generate less than 50% of their revenue in the UK
For a long time that was good enough, but over the last few years, my portfolio has struggled to keep up with the FTSE All-Share, at least on a total return basis (in terms of dividend yield and dividend growth, it’s comfortably ahead of the index).
There are various reasons for this lack of performance and few things are straightforward when it comes to investing, but I can now fairly confidently put the blame (at least most of it) on an omission within my diversification policy.
As I mentioned above, my existing diversification rules state that the UK Dividend Stocks Portfolio should have no more than 10% of its holdings in any one FTSE Sector (where “sector” is defined by the official Industry Classification Benchmark system). The portfolio aims for 25 holdings, so in practice, it can have up to two holdings from any one sector (two banks, two retailers and so on).
This is sensible because companies operating in the same sector are usually exposed to similar sector-specific risks. For example, companies in the Retailers sector face similar risks from new online competitors and the ups and downs of consumer sentiment.
However, FTSE Sectors are grouped into FTSE Industries and historically, I paid precisely zero attention to industrial diversity.
I’ll use the financial industry as the example because that’s the one that has caused me (and, I’m sure, many other investors) the most problems.
The financial industry is made up of five sectors:
- Banks
- Finance and Credit Services
- Investment Banking & Brokerage Services
- Life Insurance
- Non-Life Insurance
With 25 holdings, my 10% sector limit means that a maximum of two holdings can come from one sector, so in theory, I could end up holding two banks, two life insurers and so on. The financial industry has five sectors, so that’s a potential maximum of ten holdings from that one industry. Ten holdings would be 40% of a 25-stock portfolio, and that’s a lot of exposure to a single industry.
My portfolio isn’t quite as exposed to financials as that, but it isn’t far off with nine out of 25 holdings (36%) in that industry.
I’m not completely stupid so I have been aware of the portfolio’s heavy weighting towards financials for a long time, but it wasn’t obvious to me what risk factor could materially affect companies as diverse as banks, insurers and investment platforms. Many readers have also pointed out my portfolio’s heavy weighting to financials, but none seemed to have a credible argument to back up their concerns.
But that was then and this is now, and in recent months, it has become clear that there is an overarching risk that runs across the UK financial industry, and that risk is the regulator, otherwise known as the Financial Conduct Authority (FCA).
Rightly or wrongly, ever since the global financial industry almost caused a second great depression in 2008, financial regulation in the UK has become increasingly restrictive in order to protect consumers (while also, a cynic might add, increasing the power of the FCA, whose budget has increased almost 60% in the last ten years).
If anything, the pace and scale of regulatory change is increasing, to the point where even fairly large financial firms are having to hire outside consultants to help them understand their regulatory obligations.
I’ll run through a few of my financial holdings to show you what I mean:
- Close Brothers (OTCPK:CBGPY) (OTCPK:CBGPF) (a leading UK merchant bank) is setting aside £400 million to cover potential compensation payments fuelled by the FCA’s ongoing review of the motor finance industry
- Car and home insurers Admiral (OTCPK:AMIGF) (OTCPK:AMIGY) and Direct Line (OTCPK:DIISF) (OTCPK:DIISY) were both impacted in 2022 by new rules banning different prices for new and renewing policies
- IG (OTCPK:IGGHY) (OTCPK:IGGRF) (a leading online trading platform) was hit a few years ago by new rules aimed at protecting retail traders
- Every company in the UK financial industry is being affected by the FCA’s new Consumer Duty regulation
Given all of this, I am now of the firm opinion that a potential 40% exposure to one industry-specific risk (the FCA in this case) is unacceptable for what is supposed to be a defensive dividend portfolio.
This doesn’t only apply to the financial industry. There are industry-wide risks in other industries including consumer staples (eg cheap but high-quality own-brand alternatives), utilities (eg the threat of nationalisation), consumer discretionary (eg weak consumer sentiment), basic materials (eg the capital investment cycle) and so on.
Given these industry-wide risks, I think it’s sensible to put a limit on how much you’re willing to invest in one industry, so I’m going to start using the following rule:
- Industrial diversity: No more than 20% of the portfolio’s holdings can operate in one industry
I don’t like to make big changes all at once, so my plan is to gradually reduce the portfolio’s exposure to financials as and when their share prices approach my fair value estimates. Don’t be surprised if this takes at least a year.
The good news is that my portfolio isn’t over-exposed to any other industry, as the second-largest industry is the industrials industry, at 20% of the portfolio.
With this new rule in place, I thought it might make sense to remove the old 10% sector limit, but I didn’t think that for very long.
If I only diversified by industry then the portfolio could have all of its 20% per-industry allowance allocated to one sector. That could mean 20% invested in banks or car insurers or clothing retailers. For me, that would be too much exposure to a single sector-specific risk, so I think it’s better to diversify across both industries and sectors.
And speaking of sectors, here are the portfolio’s current sector weightings:
If you’re eagle-eyed, you’ll have spotted that I have 12% in the investment banking & brokerage services sector, which breaks my 10% sector limit rule. That’s because I have three holdings from that sector, which was okay when the portfolio had 30 holdings a few years ago but is too much now that I’ve reduced the number of holdings to 25. This was a schoolboy error and it will be rectified when I reduce the financials weighting to 20% or less.
Also, I’m actually looking forward to reducing the weighting to financials as it will force the portfolio to invest in a wider cross-section of the global economy, including industries where it’s currently underweight, such as technology and health care.
In addition to the new industry diversity rule, I’ve also introduced some rules to further tilt the portfolio towards larger and more defensive companies:
- High defensiveness: At least 20% of the portfolio’s holdings should operate in defensive industries
- Low cyclicality: No more than 20% of the portfolio’s holdings should operate in highly-cyclical industries
- Large size: At least 80% of the portfolio’s holdings should be in the FTSE 350
And what, pray tell, are these defensive and highly-cyclical industries? I thought you might ask, so I’ve included a handy cheat sheet below.
Defensive Industries & Sectors
- Consumer Staples
- Beverages
- Food Producers
- Personal Care, Drug and Grocery Stores
- Tobacco
- Health Care
- Health Care Providers
- Medical Equipment and Services
- Pharmaceuticals and Biotechnology
- Telecommunications
- Telecommunications Equipment
- Telecommunications Service Providers
- Utilities
- Electricity
- Gas, Water and Multi-Utilities
- Waste and Disposal Services
Cyclical Industries & Sectors
- Consumer Discretionary
- Automobiles and Parts
- Consumer Services
- Household Goods and Home Construction
- Leisure Goods
- Media
- Personal Goods
- Retailers
- Travel and Leisure
- Financials
- Banks
- Finance and Credit Services
- Investment Banking and Brokerage Services
- Life Insurance
- Non-Life Insurance
- Industrials
- Aerospace and Defense
- Construction and Materials
- Electronic and Electrical Equipment
- General Industrials
- Industrial Engineering
- Industrial Support Services
- Industrial Transportation
- Technology
- Software and Computer Services
- Technology Hardware and Equipment
Highly Cyclical Industries & Sectors
- Basic Materials
- Chemicals
- Industrial Materials
- Industrial Metals and Mining
- Precious Metals and Mining
- Energy
- Alternative Energy
- Oil, Gas and Coal
- Real Estate
- Real Estate Investment and Services
PS: Yes, I realise the above list isn’t perfect and that cyclicality and defensiveness depend to varying degrees on the industry, the sector and even the individual company, but I think the list is more than good enough to be helpful when choosing how to diversify a portfolio.
PPS: The above list is based on the Industry Classification Benchmark, but there are other systems, such as the Global Industry Classification Standard (popular in the US) which, annoyingly, has Sector as the top-level grouping with multiple Industries per Sector (ie the complete opposite to the ICB system). Exactly which system you use will depend on where you get your data, but the most important thing is to be consistent.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
