UK Dividend Stocks Portfolio: 2022 Year-End Review

Somewhat surprisingly, 2022 was a year of solid progress for my portfolio of UK dividend stocks, although that progress was masked in the short-term by falling share prices.

I'll explain that somewhat paradoxical statement (solid progress and falling share prices?) shortly, but first, here's a quick recap of my goals as a dividend-focused investor:

• Dividend yield: Higher than the FTSE All-Share and ideally above 5%
• Dividend growth: Higher than the All-Share and ideally above 10% (with dividends reinvested)
• Total return: An annualised total return higher than the FTSE All-Share and ideally above 10%

If the portfolio achieves my “ideal” goals, it will grow from its 2011 starting value of £50,000 to about £1 million in 2041, by which time I'll be 70 and perhaps looking to retire. With a 5% dividend yield, it would then produce a £50,000 annual dividend, so a £1 million market value and a £50,000 annual dividend are my very long-term goals.

Please note that this UK Dividend Stocks Portfolio is a virtual portfolio, but my real-world portfolio is effectively identical except for its size.

Table of Contents

• A brief review of 2022: Prices down, fundamentals up
• Changes to my investment process have driven outsized dividend growth in 2022
• Longer-term returns are ahead of the market but behind my “ideal” goals
• The portfolio is much more concentrated than it was two years ago
• Despite its greater focus, the portfolio remains fairly well-diversified
• Looking ahead to 2023 and beyond

A brief review of 2022: Prices down, fundamentals up

2022 was, of course, a year where share prices mostly went down and my portfolio saw a maximum decline during the year of 18%. That may sound like a lot, but it’s the sort of decline you’re likely to see every five years or so, which means that most long-term investors should expect to see several years that are at least as bumpy as 2022.

In the last few months of the year the portfolio staged a near-miraculous (and mostly lucky) recovery, so that across 2022 as a whole it produced a total return of -5%. That’s behind the FTSE All-Share’s virtually flat total return of 0.1%, but it’s a long way ahead of the FTSE 250’s near-20% decline.

Given that the portfolio is about 40% invested in FTSE 100 stocks and 40% in FTSE 250 stocks (with the remainder in small-caps), I’m reasonably happy with its performance over the last year.

In terms of individual holdings, specialist insurer Beazley saw the largest 12-month gain at +46%, driven by optimism around its market-leading cyber insurance capabilities. Investment platform Hargreaves Lansdown saw the biggest decline at -37%, for no credible reason that I can see (although it could be the threat from “free” trading platforms like Robinhood and/or the threat of litigation relating to the Woodford disaster).

As for the other 21 holdings, most saw their share prices decline by double digits, although this was materially offset by reinvesting the portfolio's substantial dividends.

Here's a quick rundown of how some of the best-known holdings performed:

• British American Tobacco: Up 20% (Is BAT’s 6.5% Dividend Yield Sustainable Long-Term?)
• Admiral: Down 32% (Does Admiral Deserve Such a High Dividend Yield?)
• Unilever: Up 6% (Can Unilever’s Dividend Be Trusted After the GSK Disaster?)
• Next: Down 29% (Next: A Quality Dividend Stock Well-Positioned for the Future)

As you can see, share prices went up and down a lot in 2022, which is why it's usually a bad idea to spend too much time worrying about how your investments did in any one year.

What you should be focused on is fundamentals, like dividend growth, and on that basis 2022 was a year of solid progress.

In 2022, the portfolio’s rolling 12-month dividend increased by 42%, from £4,222 to £6,018. This was a significant new record, some 34% higher than the previous record dividend from 2019.

With share prices down and dividends up, the portfolio's yield has recovered strongly and at 5.4% is comfortably ahead of the All-Share's 3.5% yield and my 5% target.

Changes to my investment process have driven outsized dividend growth in 2022

Given the many headwinds we’ve faced over the last three years, a 34% increase in dividends since 2019 is substantial and it has been driven by three fairly recent changes to my dividend investing strategy:

1. Quality companies: After some gentle nudging from a reader in late 2020, who kindly pointed out that my higher quality (and usually higher ROCE) holdings tended to perform better, I developed a Quality Defensive Value framework for analysing stocks and began focusing the portfolio around higher quality companies.
2. Discounted dividend models: In late 2020 and early 2021, I started valuing companies using discounted dividend models. As well as being the theoretically correct approach, building dividend models also had the useful side effect of increasing the depth and quality of my research.
3. Active position sizing: In early 2021, I started actively managing position sizes in order to tilt the portfolio towards its most attractive holdings, i.e. those with the best combination of quality, defensiveness and value.

These improvements to my investment strategy have, in turn, improved the portfolio. For example, relative to 2019, the portfolio’s holdings are of higher quality (with an average ROCE of 17% vs 14%) and they’re more attractively valued (with average dividend yields of 5.5% vs 4.4%).

The portfolio is also significantly weighted towards its highest quality holdings with the lowest valuations. One simplistic way to measure this is by looking at the five largest positions. They have an average ROCE of 23% versus 17% for the portfolio as a whole, and an average dividend yield of 7.4% versus 5.5%.

Unfortunately, last year's exceptional dividend growth will be something of a one-off, as it was driven to a large extent by these one-off changes to my investment process. However, I do think the portfolio now contains higher quality companies at more attractive valuations than two or three years ago, and that should be positive for returns over the longer-term.

Longer-term returns are ahead of the market but behind my “ideal” goals

"Drawing conclusions about an investor’s skill from any single year is about as predictive as reading tea leaves, and that may be doing tea leaves a disservice." - Richard Beddard, How to survive a bad year

Stock market returns over one hour, one day, one week, one month and even one year are essentially random and contain little if any useful information. If you're looking to gauge your progress as an investor, you have to realise that long-term returns are far more informative than short-term returns, so here’s a quick review of the portfolio’s performance over the last five and ten years.

Over five years, the portfolio’s performance is somewhat disappointing, with annualised total returns of 1.4% versus 2.9% for the All-Share.

Historically, the UK stock market has produced annualised total returns of around 7%, so the last five years have not been good for UK stocks. This shouldn't come as a surprise, because Brexit and Covid have both held back companies and valuations over the last five or six years.

Even so, I’m not happy to be lagging the index over five years, but I don’t think it’s a major problem.

It isn't a major problem because five years is still a relatively short period when it comes to stock market investing. Over that sort of time frame, share price gains and losses driven by changing investor sentiment can easily outweigh price changes driven by the fundamental progress (in terms of revenues, earnings and dividends) of the underlying companies.

If you look at the fundamentals, such as dividend growth, my portfolio has comfortably outpaced the All-Share over the last five years.

That's important because, as Ben Graham said long ago, in the short-term the market is a voting machine (where share prices go up and down depending on what is and isn't popular) but in the long-term it's a weighing machine (where share price growth eventually follows the growth of dividends and other fundamentals).

On that basis, I see the portfolio's five-year total return underperformance as a temporary and largely irrelevant annoyance.

Over the more informative ten-year period, the portfolio has roughly doubled in value, with an annualised total return of 7.1% versus 6.3% for the FTSE All-Share.

The portfolio is ahead of the market over ten years, so that's good, but it has failed to achieve my ideal goal of a 10% annualised total return over those years. That's disappointing, but I'm not going to give up on my dream of producing 10% annualised returns over the very long-term just yet. Here's why:

First, the portfolio did manage to achieve annualised returns of more than 10% per year between 2012 and 2018. That was a period where companies and economies were recovering from the global financial crisis, so that was a useful tailwind, but it shows that achieving annualised returns of 10% or more from high quality UK dividend stocks is not the stuff of fantasy.

Second, Covid has been a very significant headwind for most companies and their valuation multiples, and we aren't likely to see another headwind of that magnitude anytime soon (I hope).

Third, thanks to the changes to my investment strategy mentioned earlier, I think the portfolio is now filled with higher quality companies at more attractive valuations than at any time in its history.

I see no reason why these companies, with their current low valuations and high yields, can't produce annualised returns of 10% or more over the next decade and beyond, assuming, of course, that we get something approaching benign economic conditions at some point.

Here's another thing worth mentioning:

When your investments are underperforming and it looks like your dreams of building a million-pound portfolio are going up in smoke, there's a natural temptation to put your money into higher risk investments like tech stocks, gold miners or bitcoin, in the hope that you'll be rewarded with higher returns.

But there's a problem with that logic. If high risk investments automatically guaranteed high returns, they wouldn't be high risk, and history tells us that many investors have lost everything by flying too close to the sun in an attempt to reach impossible goals.

I have no interest in gambling, so I won't try to boost the portfolio's performance by taking outsized bets on high-risk investments. Instead, I will do what I’ve always done, which is to apply my investment process as diligently as I can, while seeking to improve that process as new lessons reveal themselves through successes and failures.

The portfolio is much more concentrated than it was two years ago

My decision to begin actively managing position sizes has had a profound impact on the portfolio's structure. My rules for this are simple:

1. Give defensive holdings a default position size of 4% and cyclical holdings a default of 3%
2. Calculate target sizes by adjusting the defaults up or down based on each holding’s margin of safety (this is effectively the gap between price and fair value, so the lower the price is below fair value, the larger the position should be, and vice versa)
3. Trim or top up holdings when their position size is 2% or more above or below target
4. Avoid overly large or small holdings by keeping all positions between 10% and 2%

For a more detailed explanation of how this works, please read the Calculating and Adjusting Position Sizes section of my article (on my old website), How to Value Shares with the Discounted Dividend Model.

This process of actively managing position sizes has made the portfolio much more focused than it was before. For example, here’s the portfolio in January 2021, with 34 holdings.

As you can see, the largest holding (Next) had a position size of about 5%, ten positions were above 4% and the rest were around 2% to 3%.

There was also a tail of inconsequentially small holdings, with N Brown, Mitie, Petrofac and Hyve each making up less than 1% of the portfolio (all of those holdings have since been sold and you can read the related sell reviews by clicking on those links).

The green bars in the chart indicate defensive stocks, and the chart shows that there was no clear preference for defensive stocks, with defensive holdings having a fairly even spread of position sizes.

If we fast-forward to the end of 2022, the portfolio looks very different.

There are now 23 holdings instead of 34, five holdings have position sizes of more than 6% and there are no inconsequentially small holdings with position sizes below 1% (although one holding, Victrex, comes close).

Just as importantly, the portfolio is now much more heavily weighted towards defensive stocks, with defensives making up the largest five positions and 48% of the portfolio’s value, compared to two of the top five holdings and 35% of the portfolio’s value in January 2021.

The combination of fewer holdings and a greater weighting towards the most attractive holdings means that (a) the portfolio is now a lot less time-consuming to manage and (b) it should produce better long-term returns than it otherwise would have.

There are downsides to a more concentrated portfolio though, with the main one being greater company-specific risk. In other words, if one of those larger holdings goes bust, it will blow a larger hole through the portfolio.

This is why I have a maximum position size of 10%. My thinking here is that my goal is to achieve returns of at least 10% per year on average, so if one holding goes bust, I want the portfolio to be able to recover from that loss within a single year.

Despite its greater focus, the portfolio remains fairly well-diversified

As well as limiting risk by limiting our exposure to individual companies, we can also limit risk by limiting our exposure to individual industries and countries.

• Rule of thumb: Don't allocate more than 10% to any one company (to limit company-specific risk)
• Rule of thumb: Don't allocate more than 50% to any one country (to limit political and economic risk)
• Rule of thumb: Don't allocate more than 25% to any one industry (to limit technological and regulatory risk)

In terms of countries, the portfolio has been slightly overexposed to the UK for years and currently has 55% of its total revenues coming from the UK.

In theory this should be easy to fix by selling down some UK-focused holdings and topping up some internationally-focused holdings. But this is something I’ve struggled to do in practice because the UK is one of the most attractively valued markets in the world. It contains many of the most attractively valued dividend stocks and that’s precisely what I want to invest in.

However, the future remains unknowable, so I don’t want to be over-exposed to the risk of a prolonged economic decline in the UK, especially given that I live and work in the UK as well. So I will do my best, within reason, to get the portfolio’s UK weighting below 50% during 2023.

In terms of industrial diversity, the chart below shows that the portfolio is about 50% invested in finance-related businesses like insurers, lenders and investment managers. As with the UK, finance is where the best value stocks seem to be, so that’s where I’m invested. 

However, I don’t think this level of exposure to financial stocks is excessive. That 50% allocation is spread across four different financial industries and even within each industry, the underlying companies are subject to very different risks.

For example, Beazley and Admiral are Non-life Insurers, but Beazley insures companies against cyber threats and directors against being kidnapped, while Admiral insurers homes and cars.

Having said that, I still think it's sensible to have some sort of limit on industry-specific exposure, hence my 25% threshold.

Looking ahead to 2023 and beyond

Over the last two years I’ve trimmed the portfolio down from 34 holdings to 23 and tilted it significantly towards the most defensive, highest quality and most attractively valued holdings. This particular phase of improvement is now almost complete because my final goal is to get the number of holdings into the 15 to 20 range.

I think that will probably happen in 2023, but I’m not going to force it and I’m not going to sell existing holdings that are still attractively valued just to hit that target.

After that, I don't have any other strategic adjustments in the pipeline. That's because, despite the ups and downs of 2022, I gained no significant new insights during the year. That's because lessons are usually learned when things go wrong (like when you burn your mouth on hot coffee or step on a rake) and from my portfolio's perspective, nothing much went wrong in 2022.

None of the portfolio’s holdings announced any materially negative news in 2022 and, in fact, quite a few companies were surprised by the strength of their ongoing recovery.

Of course, 2023 is likely to be a bumpy year, but that isn’t necessarily a bad thing. Recessions and downturns lead to pessimism, pessimism leads to falling share prices and falling share prices leads to higher dividend yields and higher expected future returns.

As a certain Mr Buffett once said:

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons” - Warren Buffett

If 2023 does turn out to be a difficult year, as seems likely, then I’m comfortable with the quality of my portfolio’s holdings and the strength of their competitive positions and balance sheets.

And if share prices do continue to fall, I will be more than happy to reinvest my dividends and add new money to new and existing holdings at even lower prices and with even higher yields.