Removing Headlam from my dividend portfolio

When I added Headlam Group to the UK Dividend Stocks Portfolio in 2018, it was (and still is) the UK’s leading distributor of carpets and other floorcoverings. It also had a consistent track record of strong growth following the financial crisis of 2009.

As the market leader, Headlam brought together the largest number of suppliers and customers and, like Rightmove or Amazon, that gave it a network effect, where having the most suppliers and products attracts the most customers, and vice versa.

Unfortunately, Headlam’s performance over the last few years has been disappointing and it recently suspended its dividend for at least two years. Of course, the pandemic can take much of the blame, but I now realise that Headlam has little commitment to its dividend and, on that basis, I no longer consider it a suitable holding for a dividend portfolio. 

Even worse, I purchased Headlam at a fair price rather than an attractive price, and this has also contributed to the investment’s poor performance.

Investing in Headlam was a mistake, as was paying too much for its shares, but in an arena as complex and uncertain as investing, occasional mistakes are inevitable. As investors, the best we can do is (a) understand the root causes of our mistakes and (b) put in place checks and balances to help us avoid repeating them, and that’s what I want to focus on in this review.

Note: You can also download the original version of this review, extracted from the October issue of The UK Dividend Stocks Newsletter:

• Headlam sale review: October 2024 (PDF)

Why did I invest in Headlam in 2018?

I’ve summarised my reasons for investing in Headlam below, but if you’d like to know the full story you should read the original purchase review:

• Headlam purchase review: April 2018 (PDF)

When I added Headlam to the portfolio in 2018, it had an impressive track record of growth, good profitability and a seemingly attractive valuation, based on the metrics I used at the time (shown below).

From a quantitative point of view, Headlam ticked all the boxes, with high single-digit growth, double-digit returns on capital, very little debt, low capex requirements, a near-6% dividend yield and a low share price relative to its average earnings.

Headlam was a dominant market leader with a durable competitive advantage

From a qualitative point of view, the business also looked very attractive. Headlam was several times larger than its nearest competitor and that gave it a dominant position as the UK’s leading floorcovering distributor. That was important because distributors are two-sided marketplaces that bring together buyers and sellers, in this case, buyers and sellers of carpets and other floorcoverings.

Suppliers want to sell to the widest range of customers, so they want to deal with the distributor that has access to the most customers. At the same time, customers typically want to choose from the widest range of products, so they want to deal with the distributor who offers products from the widest range of suppliers.

This creates a positive feedback loop where having the most customers attracts the most suppliers, and vice versa, and this is a classic network effect. This makes it extremely difficult for smaller competitors to overthrow the market leader, as long as the market leader does a half-decent job of running its business well.

And so, at face value, Headlam seemed to be a highly competitive business well-suited to a relatively defensive dividend-focused portfolio, but it wasn’t.

Mistake 1: Investing in a company with a weak commitment to its dividend

When I looked at Headlam in 2018, I saw a company with a consistent track record of progressive dividend growth. However, in 2018, I only looked at a company’s dividend record going back nine years, and in this case that meant looking back to 2009.

The problem with only looking at the 2009-2017 period was that it only captured the expansion phase of a single economic cycle. This is a problem because it’s relatively easy for even low-quality companies to put up year after year of consistent growth when the economy is growing, because a rising tide lifts all boats. But focusing on the expansion phase of the cycle only gives you half of the picture.

To get the full picture, I should have looked at Headlam’s results over 20 years because a 20-year period always includes at least one full economic cycle.

For example, here’s how Headlam’s dividend progressed over 20 years from 1998 to 2017 (as the 2017 results were the latest when I purchased the stock in early 2018).

(If you’ve read some of my recent posts you’ll recognise this table from How I'm hunting for UK dividend hero stocks)

The table shows Headlam’s dividend for each of those 20 years, along with a counter that tracks how many years the dividend was underwater (below its previous high). As long as the dividend is at an all-time high the underwater counter stays green, but if the dividend falls underwater it turns amber and if it’s underwater for more than three years it turns red.

Looking at the bottom half of the table, we can see Headlam’s dividend growing smoothly and progressively from 2009 to 2017, just as I saw in my 2018 analysis. However, the bigger 20-year picture tells a very different story. It tells us that Headlam’s dividend grew steadily during the 2000s property boom and was then cut by more than 50% between 2007 and 2009. The dividend then returned to steady growth, but it took ten years to grow the dividend beyond its 2007 peak.

When I invested in Headlam, I completely missed this bigger picture. Instead, I only saw the steady growth from 2009 to 2017, but that was merely a slow recovery back to levels first seen a full ten years earlier.

This is strong evidence that Headlam had a weak dividend culture. In other words, some companies are happy to be defined as dividend stocks and they have a serious commitment to progressive dividend growth. They attract dividend-focused shareholders who further strengthen the company’s commitment to its dividend. Those companies have a strong dividend culture. 

Other companies, like Headlam, pay a dividend but they don’t have a strong dividend culture. That may be entirely appropriate for those companies, but those companies don’t belong in a portfolio where the goal is to generate a high and rising dividend by owning progressive dividend stocks.

This weak dividend culture reared its head in September when Headlam suspended its dividend to fund a two-year transformation programme. When I asked management about when the dividend might return, their response was little more than a disinterested shrug.

I designed the "dividend underwater" table to stop me from repeating the mistake of only looking back ten years, and the table comes with a related rule of thumb. 

The rule is based on the idea that dividend cuts are sometimes inevitable, as the pandemic proved in spades. However, while I can accept a company cutting its dividend approximately once per decade (such as during a normal recession), I cannot accept it taking forever to be fully reinstated:

• Rule of thumb: Don’t invest if the dividend was underwater for more than three consecutive years in the last 20 years

When I reviewed Headlam in 2018, its dividend had been underwater for nine of the previous 20 years, so this rule would definitely have stopped Headlam from getting it into the portfolio.

Mistake 2: Investing in a cyclical business with thin profit margins

Although I would rather invest in defensive stocks like Unilever or British American Tobacco (and I hold both), I am willing to invest in cyclical businesses, but only if they have buffers that are sufficiently thick to protect their dividends during the next inevitable downturn.

In Headlam’s case, it distributes carpets, lino and other floorcoverings and, unlike Unilever’s soap or BAT’s cigarettes, carpets aren’t a small everyday purchase made with little or no thought. Instead, carpets are a medium to large expense and they’re very durable, lasting much longer than a bar of soap or a pack of cigarettes. This has two consequences.

First, the relatively large cost of the product makes buyers more price-sensitive, and that makes it harder for companies in the supply chain to charge high prices and earn high margins.

Second, the durability of carpets can make demand very cyclical. The reason is that during a downturn, customers can easily save money by keeping their existing (albeit worn out) carpet and putting off the purchase of a new carpet until next year. This can lead to very depressed sales during a downturn, followed by a powerful rebound as the economy recovers.

As a highly cyclical business, I would want Headlam to have three buffers to protect its profits and dividends during downturns:

1. Low debts: When revenues are falling, the last thing you want is to have to keep paying high and fixed interest payments, so highly cyclical companies should have low debts.
2. High returns on capital: During downturns, companies with high returns on capital can continue investing in their core business, because even if their profits are cut in half, they’re still substantial. This widens the gap to weaker peers who are forced to cut back on investment as their already low returns on capital shrink even further.
3. High margins: High cyclicality and thin profit margins can be a recipe made in hell, as a small decline in revenue can quickly turn profits into losses.

In Headlam’s case, it ticked the first two boxes, as it had almost no debt in 2018 and an average net return on capital of 11% (which is above the 7% threshold I used in 2018 and it’s also slightly above the 10% threshold I use today).

However, Headlam’s profit margins are a different story. From 2009 to 2017, its profit margin averaged a wafer-thin 3.9%, which is far below the average profit margin generated by FTSE All-Share companies of about 8%.

Although they aren’t the whole story, those thin margins are one reason why Headlam’s earnings were buffeted so severely by the pandemic, and they’re part of the reason why management has chosen to suspend the dividend to fund a two-year transformation programme (to improve the company’s operational performance).

Why didn’t I spot those thin margins in 2018? The simple answer is that I didn’t pay much attention to profit margins until 2019, so Headlam sneaked into the portfolio before my current rule of thumb came into existence: 

• Rule of thumb: Only invest in a company if its ten-year average profit margin is above 5%

As with the dividend underwater rule, this rule would have stopped Headlam from getting into the portfolio and it’s another lesson I’ve already learned and folded into my investment process.

Mistake 3: Paying a fair price for a mediocre business

A mediocre business can be a great investment if purchased at a low price, but in this case, I paid a fair price rather than a low price because my valuation methods in 2018 had some major flaws.

Back then, I valued companies primarily by where they ranked on my stock screen. If a stock ranked highly on the screen then, all else being equal, I assumed that the valuation was attractive.

My stock screen ranks FTSE All-Share companies according to a combination of Quality metrics (Growth Rate, Growth Quality, Net ROC, Debt Ratio) and Value metrics (PE10 and PD10). If a stock scores well across all of those metrics then it ranks highly and was, in 2018, more likely to get into the portfolio.

I won’t go through each of those metrics, but overall, Headlam scored very well, especially on Quality metrics like Growth Rate (7.7%) and Growth Quality (96%). However, there was a problem.

The problem was that those metrics were all based on Headlam’s performance over the period from 2009 to 2017. As I’ve already said, that was a period of economic recovery after the global financial crisis and that recovery enabled Headlam to grow its revenues, earnings and dividends almost every single year. But that steady growth was an illusion.

Headlam’s 7.7% Growth Rate and near-perfect 96% Growth Quality score didn’t reflect its potential for long-term sustainable growth. Instead, they simply reflected the fact that Headlam had gradually returned to normal levels of profits and dividends after the crash of 2008/2009.

In other words, Headlam's performance from 2009-2017 made it look like a much higher-quality business than it really was.

Today, my stock screen’s metrics are still based on ten years of data, but I no longer use a company’s position on my stock screen as a valuation tool. Instead, I use the stock screen as a way to quickly identify potential investments, which I then value using discounted dividend models. And if I'd valued Headlam in 2018 using the dividend models I use today, its price would have looked far less attractive. 

Here are the assumptions I would use to build that model: 

1. Net return on capital remains at a historically average 10%
2. Dividend cover stays at a level that allows the dividend to grow progressively from 2018 onwards
3. The shares are sold in 2027 at Headlam’s historically average PE

Here’s the valuation model those assumptions would have produced (for context, Headlam’s actual earnings in 2017 - the year before the model - were 39p and its dividend was 24.8p).

I think there are two features of the model worth highlighting.

First, in this scenario, Headlam only grows by 2%. That's because it only earns a 10% return on its capital, and most of that is paid out as dividends, leaving relatively little to fund growth. This is further evidence that Headlam's rapid post-2009 growth rate was cyclical rather than secular.

Second, the model's growth is perfectly steady, which is unrealistic for a highly cyclical business like Headlam. However, given that it is impossible to know how the next economic cycle will unfold, I think assuming a steady state of “normalness” is a prudent and sensible approach.

As for Headlam's fair value, if we calculate the present value of all those future cash flows (using a discount rate or fair rate of return of 7%, as that's the UK stock market’s long-term average return) then we get an estimated fair value for Headlam, in 2018, of £4.50.

In reality, I purchased Headlam at £4.40 per share in 2018. At that price, Headlam was trading at a 2% discount to fair value, which is effectively no discount at all. That’s a problem because, like any sensible investor, I only want to invest when the price is materially below fair value.

Today, I like to give myself a comfortable margin of safety by using the following rule of thumb:

• Rule of thumb: Only invest if the discount to fair value is greater than 33%

For Headlam to have a 33% discount in 2018, the share price would have to be below £3.02, but it didn’t get anywhere near that low until the depths of the 2020 Covid-crash.

On that basis, I’m confident that my current approach to valuing dividend stocks would have been another protective layer that would have kept Headlam out of the portfolio.

However, the truth is that in 2018, I didn’t look at 20 years of dividend data, I didn’t look at profit margins and I didn’t value stocks using conservative dividend models. Because of that, Headlam did make it into the portfolio, so the next question is:

What happened while Headlam was in the portfolio from 2018 to 2024?

Headlam’s time in the portfolio can be summarised in two words: Pandemic and Transformation.

The pandemic part is obvious and easy to explain. When the pandemic struck in 2020, Headlam’s business was, quite understandably, knocked for six. Its operations and those of its customers were forced to close, on and off, for the thick end of two years. This led to a large loss in 2020 and a brief dividend suspension, followed by only a partial reinstatement. 

There was a strong recovery in 2021/2022 after the stamp duty holiday caused a property market frenzy, with all those housemovers wanting to put in new carpets. But that was unsustainable, so the floorcovering market crashed in 2023 as the cost-of-living crisis began to bite and as the UK sunk into a long post-pandemic downturn.

Data source: SharePad

The second key word of the last six years was Transformation and that story is, I think, more interesting.

The need for a major transformation can be traced back to Headlam's origins. The company was mostly built using the roll-up strategy, where it rolled up several dozen competitors through a long series of acquisitions in the 1990s and early 2000s.

Roll-ups are an excellent way to quickly gain market-leading scale, and that’s exactly what Headlam did. However, rollups are often poorly structured businesses built from dozens of companies that have different cultures, practices, IT systems and so on, and that was very much the case at Headlam in 2018.

There are two common ways to deal with this: (1) Run the overall group as a confederation of largely independent businesses that share some back-office systems, customers and best practices, or (2) transform the overall group into a seamless whole by fully integrating the acquired businesses, with standardised processes, systems, databases, brands and so on.

Headlam chose option two, and its transformation into a fully integrated business began somewhere around 2016 and was still in the early stages when I invested in 2018. The company bravely (or stupidly) chose to step up the pace of this transformation in 2021, right in the middle of the pandemic.

I supported this move as I prefer rollups to be fully integrated, and there were some impressive early wins, including the successful optimisation of the company’s previously hodgepodge transport network and the construction of a new and more efficient distribution centre in Ipswich. There was also the promise of rapid growth, by expanding and upgrading the company’s trade counters and by entering the large customer market, including national housebuilders and homeware retailers.

This transformation programme was progressing largely to plan, but when the economy slowed in 2023, management decided to cut the dividend almost in half to continue funding the transformation. That was bad enough, but since then, things have gone from bad to worse.

In 2024, the floorcovering market has remained weak, but Headlam has also remained committed to its transformation programme. During the first half of the year, the business recorded a loss, so management decided to completely suspend the dividend to retain even more cash to fund the transformation. I can understand the logic, but this is still a hard pill for a dividend investor to swallow.

Even worse, the dividend is expected to remain suspended for at least two years, with no clear guidance on when (or at what level it) will be reinstated (currently, 2026 has been pencilled in, very lightly, as the date to watch, but I won't be holding my breath).

Why am I selling Headlam now?

When Headlam cut its dividend in 2008 and 2009, it took a full ten years to fully reinstate it back to 2007 levels. There is, I think, every chance that if the dividend is reinstated in 2026, it could then take the company another ten years to raise its dividend back to where it was when I first invested in 2018. Of course, the future is always uncertain, but that is one future I do not relish.

To be fair, although Headlam isn’t a progressive dividend stock, it has never claimed to be one. It doesn’t have a progressive dividend policy and, with hindsight, it was never a suitable holding for a dividend portfolio, especially one focused on owning progressive dividend stocks.

Headlam has managed to stay in the portfolio over the last six years because the share price was low and it continued to pay regular if non-progressive dividends, but with the dividend gone and no clear line of sight to its return, I see Headlam as little more than an out-of-place legacy holding.

On that basis, I recently sold Headlam at £1.37 per share and it produced the following results over a six-year holding period:

• Dividend income of 14%
• Capital loss of -50%
• Total return of -35%
• Annualised total return of -16.1%

A 35% net loss sounds like a lot, but thanks to a sensible degree of diversification (across 25 or so holdings), that equates to a 2.8% hit to the portfolio's overall value, which isn't enough to keep me up at night. It's this diversification that allows investors to remain "alert but detached", as Ben Graham put it, so we can accept these occasional mistakes and learn from them, rather than being financially and emotionally crushed by them. 

As for the proceeds of this sale, I have already reinvested them into another of the portfolio's holdings and, perhaps unsurprisingly, I chose a company that hasn’t cut its dividend for more than 20 years.