2020 Mid-year review

Portfolio review Jan - June 2020

Half way through 2020, it's been a hectic year in the markets, so lets see how the portfolio got on. My goals haven't changed:

• Don't lose money
• Increase capital by more than the rate of inflation
• Build a conservative dividend paying portfolio

Through doing the above, I will hopefully also outperform the FTSE All Share Index. I have chosen the FTSE All Share as a benchmark as it most closely matches the pool of companies from which I’m investing. If I start picking stocks from elsewhere, then I might have to change, but it's good enough for now. I'll take a quick look at each of my stated goals to see how things are looking so far this year for the whole portfolio then pull out a couple of points of interest to see which investments were moving the dials.

Don't lose money

The portfolio remains in the green, as do profits, but it hasn't been a comfortable ride in the first half of the year. Excluding new cash invested, you can see below how both the portfolio measured up against my benchmark from January to June.

The portfolio at the half year mark was roughly 6% below where it was in January, compared to a drop of 17% for the benchmark. It might seem strange to hear that I'm quite pleased by losing 6% over the course of 6 months, but I'm trying to build a resilient portfolio, and by comparison to my benchmark I've not done too badly. My investments fell far less than the wider market, but as that elastic has become stretched, the market is bouncing back quicker than my portfolio. I'm quite content with my investments being less volatile that the market as recovering from large falls in value may take longer than expected.

Increase capital by more than the rate of inflation

On a 6 month timescale this clearly didn't happen, the Office For National Statistics latest inflation stats show it as 0.7%, versus a 6% portfolio fall, so we'll have to see if I can claw that back in the second half of the year. We might well end up with some deflation, if so I could sneak through on a technicality... Essentially this goal is to make sure I'm gaining in real terms, accounting for inflation, so a 6 month timescale is too short a measure to be useful

Build a conservative dividend paying portfolio

Over the past few years big blue chip stocks in the FTSE have provided limited capital growth, instead returning excess cash to investors as dividends. This came to an abrupt halt in 2020 as most companies looked to preserve cash to get them through the various lockdowns happening across the planet. My 15 core portfolio holdings were not immune to this, with 4 of them not paying a dividend in the first half of the year. The language used to describe the lack of dividends varied across the businesses concerned, so we'll have to wait and see if the businesses needed this cash, if they can sensibly invest it or it gets paid out in dividends at a later date. 

My preferred measure of the portfolio dividend yield is a rolling 12 month average yield, this has dropped back a bit since the start of the year, from 2.8% to 2.4%, which reflects both a slight reduction in dividend payments, and increased value of the portfolio. My investments are (mostly) in sensibly run, and conservative businesses that I expect to continue to pay out dividends once the current disruption is behind us. Given the axe taken to dividends over this year, I'll consider my dividend receipts a win so far.

Reflections on volatility

I was a little surprised that I was relatively sanguine during the worst of the market collapse. I admit I thought we were going to see the market drop by around 50%, so it faired better than I expected. When it looked like COVID-19 had moved beyond China, I paused my stock buying - in February it looked like the markets were in trouble. This proved to be a good move. I also didn't buy during the March collapse as I was trying to work out which businesses on my shopping list would be hit hard by the virus and/or lockdown measures, and which might be resilient. Not buying in March proved to be incorrect. Although I didn't suffer an immediate loss in Feb, I would have benefited from buying as the markets bottomed in March.  

Porfolio winners and losers

One of my core holdings, Compass, has been hit hard by the lockdowns. It provides catering services and since most events and companies have been either closed or happening virtually, demand for catering took a big hit. Trading updates indicated that around 50% of the business was closed. I'm comfortable staying invested, with the assumption that their scale will be a benefit over the long term. 

The contribution that each of the portfolio has made to the first half results is below:

Compass is the clear outlier dragging down performance significantly. This is partly due to the fall in share price, but also to it being my 4th largest holding at the start of the year. 

Individual performance of investments is below:

The two members of the portfolio I was thinking of selling 6 months ago, I dithered over. As a result Saga and Dignity are still there, albeit very small holdings. I'm in two minds whether to get rid of them, as they are irritants, and I don't regard either as sensible investments. Saga may see a decent bounce if we get good news on the medical front that enables it's cruise ships to set off. One the other hand, they are both very small amounts of cash, so unlikely to have much impact on the overall portfolio whichever way they move.

There are plenty of reasons to be concerned over the state of the markets, with an imminent global recession, US attempts to address the virus seemingly unravelling, a US election, Trumpy's fondness for tariffs, and Brexit. However I suspect all will be ignored if we get good news on vaccines and medical treatments for the virus. Whether that good news is already priced in we will find out in due course...

June 2020 portfolio update

Lock-down restrictions easing off were a bit of a relief, particularly with temperatures increasing. I'm sure once the pubs re-open we'll all be piling in to share our pathogens over a pint. It only took a couple of days of sunny weather to see south coast beaches overwhelmed with people - my fingers are crossed that we don't cause such a spike in infections that schools close in the Autumn.

Markets seemed a bit fragile in June, perhaps with the huge recovery surge in stocks since the March lows investors are looking over their shoulders a little. But there are a few other reasons of course. Trumpy's polling numbers are headed south, giving Biden a lead which will have a few people on Wall Street wondering if their wallets will look a little less plump. Finger pointing from the US and Europe over potential naughtiness involving Boeing and Airbus led to a list of new tariffs being considered on various obviously airline related products such as gin and olives (?). And Whitehouse insiders couldn't quite make up their minds if the US/ China trade deal was still intact. Oh did I forget the massive increase in COVID-19 cases in the US...

This month cash was split into two investments, part went into an Investment Trust and part into an interesting software company. I've been looking into a few Investment Trusts that add to the diversification of the portfolio, particularly into businesses listed outside of the UK. This month I bought a few shares in a Trust focused on Asian/ Australasian dividends, the thinking being that most countries in which this Trust is invested seem to be doing a better job of managing their COVID-19 outbreaks, so should get their economies up and running more quickly.

As for the rest of the investment cash - it's often suggested to buy what you know, which is what I decided on with the addition of Elecosoft. I saw a name that looked familiar in an online discussion, and after a quick bit of digging found that they own a software business I used to work for. A positive trading update and decent set of accounts helped convince me to buy a few shares.

Portfolio performance
The portfolio was up 0.6% in June, slightly behind my chosen benchmark the Vanguard FTSE All Share Accumulation which was up 1.6% over the same period.

Best performers this month:
Lancashire Holdings +19%

Fulcrum Utilities +17%

888 Holdings +14%

Worst performers this month:
Saga -26%
Abcam -11%
Craneware -9%

June share purchase 1: HFEL

A few shares of the Henderson Far East Income Investment Trust (HFEL) made their way into the portfolio this month. It is run by Janus Henderson, and as the name suggests it's aim is to provide a growing source of dividends. I bought in at roughly the NAV, although given the volatility in the markets at the moment I think that NAVs should be taken with a decent pinch of salt. It gets 3 stars from Morningstar, which I take as pretty positive given that it's aim is income focused rather than capital growth.

The holdings are spread across Asia and Australasia, with over 30% in China. It has a range of sectors, with the largest being Financials and Telecomms, with Oil and Gas thankfully making up just over 1%, it's most notable holding is the semi-conductor giant Taiwan Semiconductor Manufacturing. It has around 2% gearing, and has reserves from which to payout around 9 months of dividends should it need to. The Trust's dividends have grown at around 3% - 4% over the last few years, and with the Spring sell off the yield is around 6% - 7%.

The Asia Pacific companies from which the Trust likes to invest have tended to hold more cash than their European and US counterparts and have been increasing dividend payments over recent years. A relatively low payout ratio should mean that dividend growth can continue, although that remains to be seen given COVID-19 continues to circulate without us having adequate medical responses.

June share purchase 2: ELCO
Elecosoft (ELCO) was also added to the portfolio in June. They are a software business focused on architecture, construction, and property management. It is a relatively small business, with a Market Cap just under £60m. They listed on the AIM in 2006 and have been making solid progress over the past few years.

Around 40% of revenues are generated in the UK, with most of the remainder being made in Europe and further afield. Recent acquisitions bolt onto a portfolio of architectural and construction systems, provide multiple cross-selling opportunities and should provide a useful comprehensive end to end service offering.

Elecosoft have a potentially sticky customer base as evidenced through their impressive cash conversion. Their recent trading update covering business until the end of April showed a reduction in revenues that was outweighed by increases in profit and crucially in renewed subscriptions for support and software. Recurring revenues such as these are a great way to ensure ongoing income.

The accounts look sound with a net cash position as of April. Revenues, profits and free cash have all been chugging higher over recent years. The dividend is relatively small but has been increased at an annualised rate of over 20%, and they have plentiful free cash covering the dividend.

I'm sticking with my approach of taking smaller positions in businesses I think might be higher risk - in this case, due to the small size of the business, I consider this potentially more volatile. There's a chance this could get hit by any COVID-19 downturns, although the balance sheet looks healthy, there's no need to take unnecessary chances, so only a small number of shares bought at this stage.

Insolvency

If the 2008/9 financial crisis was characterised as a credit-crunch, the 2020 COVID-19 crisis will probably be looked back on as a liquidity-crunch. Businesses were forced to shut down to help enforce social distancing, and as a result, in many cases, forgo any income for a period of time. It happened so quickly there was little time to organise a smooth landing for all parts of the economy, so many bills still had to be paid despite the lack of income. Investors would have seen unscheduled updates from the businesses they hold, stating their liquidity position, giving detailed breakdowns of borrowings, cash in the bank - all to reassure investors that they would survive the shut-down if it only lasted for x number of weeks/months.

I'm certainly better acquainted now with the notes in the accounts giving details on borrowings, restrictions and covenants attached to them, and when those debts need to be repaid. Many investors are cautious with regard to debt, the virus brought home exactly why. The spectre of insolvency became suddenly very real.

Insolvency is one of those words that I thought I understood - but only because I've never had to use it or think about it. There are a few bits of vocab that I have always confused, and as it turned out, researching and unpicking these provided much of the clarification I was after. I enjoy a good rummage on the internet for sources of information - in this case it was the legislation documents themselves. So apologies in advance to anyone legally literate for the rest of this post 😎.

Spoiler alert - it doesn't end well for shareholders.

Bankruptcy ≠ Insolvency

If a person owes money that they cannot repay, then they can be declared bankrupt. The individual or their creditors can apply to a court to become bankrupt and a legal process is then put in place to manage payment of debts, which can include formally agreeing to not repay the debt. The Government's Insolvency Service guide to bankruptcy is available here.

A company typically might have 3 different types of debt, 

• bonds or credit notes which are sold on the debt markets
• a loan/ credit facility which is provided by a lender
• goods/ services on credit from a supplier

If a business cannot repay these debts (in the UK at least) they do not go bankrupt, but will become insolvent. Insolvency is a legal process, and as such there is legislation to follow - the Insolvency Act 1986. 

Source: Insolvency service monthly statistics

(Interestingly above the numbers of insolvencies reduce after COVID-19 appears - possibly due to Government support measures, and also to the courts shutting down.)

Insolvency has a specific definition:

A company may be wound up by the court if—

(f)the company is unable to pay its debts

Source: Insolvency Act 1986 122(1)(f)

Even more specifically (and worryingly) the act (section 123(1)(a)) states that if a debt of at least £750 is unpaid 3 weeks after a written demand for it has been received, then the business may be regarded as insolvent. I'm sure many companies have payment terms that exceed this duration, but I'm not sure insolvency proceedings are the best way to get a hurry up on one's invoices, although it's likely to get people's attention...

There is also this juicy snippet in the Act:

A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.

Source: Insolvency Act 1986 123(2)

No wonder then that companies have been rushing to prove adequate liquidity and demonstrate the strength of their balance sheets over the last few months.

Ok so we've established what insolvent means, what next?

If a company cannot pay it's debts it has a number of options open to it:

• Company voluntary arrangement (CVA), whereby the directors attempt to come to an agreement with creditors to accept less of the debt being repaid, but the company continues trading. 
• Administration. This involves appointing an administrator to take control of the company with a view of hopefully rescuing the company, often through a sale of the business. Or if not then through the sale of assets and passing the resulting cash to creditors.
• Liquidation - sell the company's assets to pay off creditors, and close down the business.

Company Voluntary Arrangement (CVA)

The main problem with insolvency is the repayment of debt, so the CVA is a process for companies to ask creditors to reduce this debt, with the trade off being the increased probability that the business survives. For example a proposal may be to ask creditors to accept 80% of the outstanding borrowings, which will be repaid over 4 years, and in return the business will restructure in a certain way. Once the proposal is ready, creditors vote on the proposal and require creditors accounting for 75% of the value of the debt to agree. This has been a favourite tool of struggling UK retailers over the past few years, in particular with regard to property rents.

Administration

If a business goes into Administration an insolvency practitioner is appointed as administrator to take over management of the business from the directors. Their goal is not initially to shut down the business, but to rescue it. This is set out in the Insolvency Act:

Purpose of administration

3(1)The administrator of a company must perform his functions with the objective of—

(a)rescuing the company as a going concern, or

(b)achieving a better result for the company’s creditors as a whole than would be likely if the company were wound up (without first being in administration), or

(c)realising property in order to make a distribution to one or more secured or preferential creditors.

Source: Insolvency Act 1986 Schedule B1

Once an administrator has been appointed, creditors are barred from pursuing attempts to reclaim their loans unless given explicit permission by the courts. This provides the business with the time to work out a solution to it's indebtedness. This proposed solution is then presented to the creditors, who vote on the proposal, and if they can't form a majority the courts decide on an outcome.

Should the administrators find themselves unable to rescue the business, they may decide that they need to enter liquidation. This means that they will sell the companies' assets in order to raise the funds needed to pay creditors.

Liquidation

Liquidation simply means turning assets into cash, i.e. selling them. This is done to pay creditors, and if there is anything left over - to return this to shareholders. The process of liquidation can be started by the business, or can be forced upon it by the courts. Or of course the company administrator can move the business into liquidation if a rescue isn't possible.

What does this all mean for shareholders?

The good news is that shareholders have limited liability for the companies in which they invest - which means they are not liable for any debts incurred by a business. The bad news is that their investment may be lost.

It may not come to a complete wipeout, but shareholders are not first in the queue when it comes to payments from an insolvent business. First come those who have secured lending, then the fees of the administrators, then employee wages and pension contributions, then creditors with unsecured lending, floating charge holders, interest on debts, company share schemes, preferential shares....and then ordinary shareholders...no wonder there is little left to distribute to the average investor...

On that cheerful note, happy investing.

May 2020 portfolio update

The COVID-19 saga moves onto the next chapter. Some welcome moves towards normality with businesses gradually opening. Lock-down fatigue certainly seems to be setting in at Chez Sleepy, I can't see everyone accepting a similar level of restriction if we get further waves of infections.

In other news it's nice to see The Donald getting back to normal and stoking the China trade war embers once again. I expect this will be a central plank (and useful diversion tactic) of the orange buffoon's re-election strategy, so more volatility awaits.

A couple of reassuring updates were announced from companies in the portfolio this month, giving me comfort that whilst we're not out of the corona woods, the businesses in which I'm invested seem to be managing their way through the mess that lock-down has created. The most impacted of my core holdings is Compass, the global catering firm, who have been taking the appropriate steps to shore up the business and this month issued shares to raise funds to avoid taking on more debt. I was tempted, as the offer was open to retail investors, and at a fair discount but ultimately I think it could take them a while to recover the business back to previous levels so decided to pass. We are yet to see what impact the virus has on the daily operations of businesses, including Compass, what has been on display so far is the aftershock of an economy being put into hibernation. All will become clear over the coming weeks and months, particularly in the next round of corporate reporting.

I'm continuing my cautious approach of waiting for business updates to get some understanding of the state of their operations and finances before any investments. Historical data has to be taken with a decent amount of salt at the moment. A positive set of preliminary results from defence firm Qinetiq saw it jump from the watchlist to the portfolio this month.

Portfolio performance
The portfolio was up 3.8% in May, slightly behind my chosen benchmark the Vanguard FTSE All Share Accumulation which was up 3.9% over the same period.

Best performers this month:
Saga +28%

Abcam +16%
Tritax Big Box +15%

Worst performers this month:
Compass -11%
AB Dynamics -6%
PZ Cussons -6%

May share purchase: QQ.
Defence firm Qiniteq was added to the portfolio in May. They were spun out of a UK Government defence research agency in 2001, and listed on the stock exchange in 2006. There are a supplier of defence services including various technologies, R&D, testing and assurance capabilities, mainly to the UK Govt where they have a long term arrangement with the Ministry of Defence. 

Their other main customers include the US and Australian Governments (the "home countries"), which along with the UK provide their main sources of revenues. Increasing exposure to other international clients and diversifying their customer base is part of the current strategy and appears to be bearing fruit. But this is at the expense of taking on shorter term deliverables, which provides less visibility over earnings than the longer term contracts with the "home countries".

Qinetiq have a sticky customer base, the sensitive nature of the products and services being transacted coupled with the amount of red tape to become a trusted supplier offers a moat of sorts. A recent update indicated that COVID-19 had not disrupted the company unduly. Revenues and profits were up, and the order backlog is growing nicely.

Revenues have been picking up in recent years following a change in strategy a few years ago. Return on capital and net margins have both been in double digits since 2015, and the balance sheet is healthy with a nice net cash position. Dividends are on hold at present whilst COVID-19 is doing the rounds, but there is a progressive policy and it has been covered by free cash flow.

With the above sticky customer base comes a risk of course - with a small number of customers providing revenues, should any of these decide to move to an alternative supplier it could be painful for Qinetiq. Another risk is that should we enter a horrible recession that leads to government defence budgets being reduced, it's likely Qinetiq will also feel the squeeze.

Investing - measuring risk

Investing is often talked about in terms of risk and reward, and as an attempt to balance these two elements. Currently everything feels risky, governments have been putting their economies into hibernation, central banks have turned the money printers up to 11, all to help combat a virus to which we have no medical solutions.

So given the rather frisky nature of the markets of late I decided to look into how investors try to measure risk.

As we’ll see below to a large extent risk is often framed in terms of volatility. To some extent I think this is reasonable. If an investment moved 50% up and down randomly from an average price each day, it would be quite difficult to know when might be a good time to buy or sell. Another investment that only moved 5% would provide some consistency in pricing that might make owning it more palatable.

Perhaps more problematic with using volatility as a measure of risk is that in one direction volatility is surely desirable – a valuation moving rapidly upwards is generally regarded as a good thing. The same degree of volatility going the other way isn’t usually welcome.

I'll look at 3 risk measures:
Beta
Sharpe ratio
Sortino ratio

I’ve set up a googlesheet here to download and play with if you’re so inclined. It shows the measures above, with all the components broken out. It also has a simple scatterplot with regression line, correlation and r², in case these also float your boat.

Beta

Beta is a notion that essentially compares the volatility of an investment against a benchmark (the “market”). The benchmark is given a beta of 1, a beta above 1 indicates that the investment is more volatile than the benchmark, and a beta less than 1 that it is less volatile than the benchmark.

You’ll find it on sites like Yahoo finance – looking at a couple of examples on there, as of mid-May 2020 Diageo has a beta of 0.33 and Lloyds has a beta of 1.1. Booze is less volatile than banking apparently. However, Yahoo don’t state how they have calculated the figure, so a little pinch of salt is required, but it is probably correct to think that a company selling booze will have more stable and consistent returns than a bank which will be tightly aligned to macro-economic conditions.

Beta doesn’t state an absolute degree of volatility but relative to a benchmark. It is a function that for any given input tells us what to expect as an output. In the cases above, if the numbers are to be believed, for every 1% of change in the market, Diageo typically has a change of 0.33%, and Lloyds has a 1.1% change.

Lets take a simple example to understand the principle better, there are plenty of rabbit holes online to disappear into if complexity is what you’re after.

Beta tells us roughly what % change to expect in an asset’s price given a 1% change in the market. Let’s set up a simple pretend business “WidgetX” and see how it performs in good and bad conditions, and how the market also performs:

	Good times	Bad times
WidgetX	30%	-20%
Market	20%	-10%

What we can see here is that the price of an investment in WidgetX tends to be up by around 30% when market conditions are good, but down by 20% when conditions are bad. Whereas the market tends to be up by 20% and down by 10% during these conditions.

If we take the range of scores from WidgetX and the market we get:

WidgetX range = 50

Market range = 30

50/30 = 1.67

So if the market changes by 1%, WidgetX tends to change by 1.67%, which tells us the company is rather sensitive to changes in the underlying market. A bit like Lloyds above which typically moves more than the market, Diageo, on the other hand is insensitive to market conditions, they keep selling booze no matter what’s going on.

To come back to the point above about volatility and direction, this sensitivity will result in a greater movement up and down, so we might expect Lloyds to outperform the market in good years, and to underperform in bad. Diageo, would likely underperform the market in good years and outperform in bad.

Beta is calculated as follows:

Beta = covariance of investment & market / variance of the market

The covariance of both investment & market measures how these two move relative to each other. A positive number indicates that they tend to move in the same direction together. A negative number indicates that they tend to move in opposite directions.

The market variance is simply the amount of variability in the returns from the market from an average - the mean return.

This is all very well, but as discussed more below, not all volatility is created equal.

Sharpe ratio

The Sharpe ratio is next on the list and is described as a way to understand an investment’s “risk-adjusted returns”. In other words the amount of return per unit of risk. As with beta above, the notion of risk is based on volatility – in this case the standard deviation of the investment’s returns. (To save a google for those rusty with stats, standard deviation is a measure of the variability of data, which is established by measuring the distance of each data point from the mean of all of the data)

The “return” in the Sharpe ratio is the return of the investment after taking away the return that a “risk-free” alternative would have generated. What is left after the “risk-free rate” is subtracted is called the “excess return”. The "risk-free rate" is often represented by US Treasuries (debt backed by the US Govt). Given that at the time of writing, mid-May 2020, the 2, 5 and 10yr US Treasuries yield less than 1%, they may not be the best “risk free rate”, the 30 yr only has a yield of 1.42%...

After finding our excess return we then divide this by our volatility – the standard deviation of the investment’s returns. This gives us a measure of return for each unit of volatility.

A quick example, imagine our WidgetX business above generates a return of 25% and we have a risk free rate of 5% then the excess return is 25% - 5% = 20%. If the standard deviation of the WidgetX returns was 15, we would then divide the excess return by this, 20/15 = 1.33. So our Sharpe ratio would be 1.33.

What does a Sharpe ratio of 1.33 mean? On it’s own, not a lot, but using it to compare different investments might help – let’s see how the iThing company measures up to WidgetX

	Return	Risk free rate	Standard deviation	Sharpe ratio
WidgetX	25%	5%	15	1.33
iThing	25%	5%	10	2

Both companies generate the same return, but have quite different Sharpe ratios, telling us that for each unit of risk, WidgetX gives us 1.33 return, whereas iThing gives us a return of 2. Since the return on both investments is the same (25%) it is the denominator in our equation that changes, that the risk, or volatility of iThing is less than WidgetX.

The Sharpe ratio is calculated as:

Sharpe ratio = (Investment return – risk free rate) / standard deviation of investment returns

By using the Sharpe ratio we could try to build a portfolio that generated the highest return for the least amount of volatility.

It does, however, have the same fundamental issue as beta, it assumes that all volatility is the same. A 10% change in the price of an investment has the same amount of volatility whether it is up or down – it’s impact on the likelihood of me achieving my financial goals is not the same however. I want to be exposed to the risk of my investments going up. Risk should have a component that accounts for the detrimental impact of something that makes goals more difficult to achieve. Our final ratio does just that.

Sortino ratio

The Sortino ratio is a modification of the Sharpe ratio. It is calculated in a similar way but rather than using the deviation all all price movements to represent risk, it focuses on the element of volatility most of us find uncomfortable – prices falling.                                          

Before digging into the Sortino ratio lets first revisit the statistical notion of standard deviation as it is this that is modified in the shift from Sharpe to Sortino.

From Wikipedia:

“In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values.A low standard deviation indicates that the values tend to be close to the mean (also called the expected value) of the set, while a high standard deviation indicates that the values are spread out over a wider range.”

It is calculated by first establishing the mean of the set of values, and then measuring the distance of each value from the mean. A little more numerical jiggery-pokery gets you to the standard deviation. In most uses this is perfectly reasonable, but as mentioned a few times above, as investors, the direction of the deviation matters. This deviation is regarded as volatility in investing, which is equated, rightly or wrongly with risk. What we really need to do is extract the risky part of the volatility – i.e. an investment losing value.

Downside deviation is what we are looking for. This focusses specifically on downward price movements and uses the volatility of those negative movements – the standard deviation of the losses.

The Sortino ratio calculation is below:

Sortino ratio = (Investment return – risk free rate) / standard deviation of negative investment returns

I’ve highlighted the word “negative” above, as it is the key difference between the Sortino and the Sharpe ratio.

Let’s take our two companies again and apply the Sortino ratio:

	Return	Risk free rate	Standard deviation of negative returns	Sortino ratio
WidgetX	25%	5%	5	4
iThing	25%	5%	10	2

In this case both companies have a return of 25%, from which we subtract the risk free rate of 5%, to leave both with a return of 20%. WidgetX has a lower volatility of downside movements, it’s standard deviation of those movements are 5, whereas iThing has a much more volatile price, with a standard deviation of 10. If we plug these numbers into the denominator of our sortino ratio, we get a score of 4 for WidgetX and 2 for iThing. This indicates that we although we got the same return for both, we had to suffer twice the amount of downside volatility for iThing than WidgetX. As a risk adjusted return, to me this captures much more of the notion of risk, i.e. risk of losing money, than the Sharpe ratio (which includes the risk of making money).

The Sharpe ratio penalises an investment for price appreciation which is included in it’s definition of risk. Whereas the Sortino ratio isolates risk from return by focusing only on downwards price movements – the negative volatility that investors would prefer to avoid. 

So as a risk averse investor I should seek out potential investments with a higher Sortino ratio because it means that the investment has earned more return per unit of risk that it takes on.

The Sortino ratio seems closely aligned to the sensible idea of not losing money, which I discuss here.
To save you scrolling back up, the link to the googlesheet with all the above calculations is here.

April 2020 portfolio update

The novelty of lock-down is starting to wear thin. Child1 turning the garden decking into a rainbow is growing on me though.

Adjusting to working from home, and being dragged into a crisis management team at work made for a busy and rather taxing time over the last few weeks. C'est la vie, everything seems to be calming down a little now.

I've had to review my stock market shopping list, given that there were plenty of businesses pulling down the shutters thanks to COVID-19. Even though stock markets were falling I didn't just want to pile in without some consideration as to the impact on each business, and how I felt about investing in them given what is happening.

It has proved difficult to know how to go about judging stock valuations, historical metrics are all very well, but of limited use in the current environment. If a business has no revenue for a while, in a worse case it may not even survive, I think most will, but in what condition? As I point out here, I've decided to only invest in companies that are currently making money. And that I think will be in reasonable shape this time next year. This has had the effect of shuffling a few names on the shopping list. I expect this will all change again as we adapt to our new world.

Some dividends pulled by companies in the portfolio:
AB Dynamics - plenty of cash but prudence required as car makers have taken a beating
Network International - postponed until better clarity on trading
Compass - half the business is shut so needs to preserve cash
Computacenter - permits changes to cash flow from relaxing customer payment terms

The first two are businesses on a sharp growth path so losing the small dividends proposed is of no concern. Compass may take some time to rebuild cash to a point that it can justify a dividend, they effectively have a global duopoly with Sodexo, so I'm confident they'll be a good long term investment. Computacenter's decision is particularly sensible, as helping customers stay solvent is far more useful that getting an invoice paid on time, and the update was quite positive.

Purchases this month included a top up of Sage Group, and adding a small slice of PZ Cussons.

Portfolio performance
The portfolio was up 6.6% in March, ahead of my chosen benchmark the Vanguard FTSE All Share Accumulation which was up 4.4% over the same period.

Best performers this month:
Fulcrum Utilities +64%
AB Dynamics +58%
888 Holdings +16%

Worst performers this month:
Dignity -12%
SAGA -4%
Lancashire Holdings -1%

April share purchase: SGE
A top up of Sage Group was my first April purchase. You'll find Sage in the "Software and Computer Services" sector of the FTSE, but that's where the excitement stops, they provide a range of software to help businesses manage their accounts, people and payments.

They have been moving their business to a subscription model, and were behind the curve in doing so, but seem to be rapidly getting customers across to the new model - at least before the COVID-19 shenanigans. This means that their revenues become increasingly sticky; the cost and disruption of  moving key payment and back office business systems to a different vendor gives Sage a bit of a moat, and the sort of defensive investment that I prefer.

Their revenues and profits have been increasing at around 6%-7%, dividends increasing at a rate just above that. ROCE and margins have both been comfortably into double digits for most of the last 10 years. I'm not convinced historical data is terribly useful at present, but at least they are taking money.

Management are expecting a hit to revenues, and for the second half of the year to look ugly. Businesses can be expected to hold off on contract renewals, and if there are companies succumbing to the lock-down induced economic issues, then there will be some customer churn.

April share purchase: PZC
Second purchase for the month was PZ Cussons, a consumer goods company with brands many will be familiar with - I have some in the bathroom, Carex handwash and Original Source shower gel (love a minty shower 😎). This purchase is a little contrarian as Cussons have been in the doldrums for a while. The share price has reflected the drift in the company's strategy, which has ultimately needed a volte face, and a new CEO. The previous incumbent is also suspected of being naughty - so has had some pension payments cancelled, and the new CEO has spent time at big consumer goods companies, so should know his onions.

An acquisitive strategy has been abandoned in favour of one that focuses on a smaller number of key brands. In addition the business has historically generated a decent chunk of revenue from Nigeria but continued instability in the country has led to this drying up. The demographics in Nigeria are promising, the economics, not so much.

PZ Cussons has all the hallmarks of a plodder, a company with limited growth potential - just handing excess cash back to investors (not a bad thing in my view). But it does have a number of positives, not least of which is that it's business is open, and the tills are ringing. A trading update in April stated that two of it's brands had contrasting fortunes from COVID-19, St. Tropez (fake tan product) has seen sales fall away as people presumably won't be prepping the skin ahead of summer hols, but Carex (handwash) is selling like hot cakes. Announcing that earnings were expected to come in at the lower end of guidance left the markets unperturbed. Simply having earnings and not having to explain how the company is planning to survive the next few months makes for a refreshing read.

Watchlist review

It’s been a wild few weeks in the markets. My response has been less wild, and has mainly been an attempt to review the companies on my shopping list to try to ascertain what the impact of COVID-19 might be on these companies. It’s not just a matter of what might happen over the next few weeks, but whenever we get past this virus, what sort of shape these businesses are going to be in.

Assuming we have another year or so before a vaccine is available to make COVID-19 go away, the intervening period could involve various business disruption, social distancing, further lockdown measures, and public testing protocols. So when I’m considering making a purchase, I now need to think about how the business in which I’m investing is going to make it through this? Part of my review over the past few weeks was to look through my preferred list and ask myself some questions:

• how has the company management responded to the crisis?
• are they still making money today?
• will they still be taking in cash throughout this crisis, even if cash flows are disrupted?
• how will multiple waves of infection affect them?
• how will public testing protocols affect them?

As an example, Greggs, the low key tasty pastry seller, has quietly been making investors very happy over the past few years. It’s been churning out great results, keeping a really simple business, just rolling out more of it. They are currently closed and making zero revenue. They went into the crisis with no debt, as of 9^th April had £47m in cash and were taking up the Government offers of support, so will very likely still be operational once we all emerge from our homes. They are likely to serve up tasty grub to millions of punters once again, and the management team have acted and communicated clearly. But what will be the cost of being closed for the length of time that they are required to do so? What is the impact on their finances, staff, suppliers & partners. How would they manage getting customers into their stores after lockdown - if we all have to wear masks, do they think customers would just pop up the mask to take a bite of their sausage roll? Will they test each customer before letting them into the shop? The impact and cost is unknown, so for me it makes investing in such a company very difficult.

Rightmove is (was?) another business on my shortlist. An incredible investment with operating numbers off the charts and a genuine moat. On 18^th March they stated they would defer part of their subscription for up to 6 months for some estate agents, had a strong balance sheet, but were not buying back shares (revealing the flawed logic in shared buybacks – if now wasn’t a good time when would be?). 2 days later another announcement stated that they would reduce their subscription fees by 75% for 4 months, which superseded the deferment offer. 7 days later another statement cancels the dividend. A company that has looked so astute, suddenly looks indecisive, dithering and panicked. The extent to which they make it through this in a position of strength is largely dependent on the survival of the estate agents and their subscriptions – so why ask them to pay anything if the Rightmove balance sheet is so strong. A strange series of statements that do little to endorse the management of the business, just when you need clear heads.

Admiral insurance as a 3rd example – the share price has hardly moved over the past few weeks. Amazingly resilient share price – doesn't seem to give a monkey's about COVID-19.

There are no answers to any of this, markets may get cut in half, or may surge to new highs. It’s difficult to work out if share price falls constitute bargains or not. After all if businesses are making less money, and the share price has dropped by an equivalent amount, the value of the business has arguably stayed the same.

Using Price to Earnings (P/E) values as a short hand for valuation:

Price = 150

Earnings = 10

P/E = 15

With a 20% reduction to price

Price = 120

With a 20% reduction to earnings

Earnings = 8

PE = 15

In other words the valuation is unchanged.

To flip the P/E into the earnings yield (E/P - earnings divided by price) we can show the same as the above:

Price = 150

Earnings = 10

Yield (E/P) = 6.7%

With a 20% reduction:

Price = 120

Earnings = 8

Yield (E/P) = 6.7%

Valuations are unchanged.

The problem is most companies don't know what impact the measures to inhibit the spread of the virus will have on them.

What adds to the madness is not knowing what is supposed to be baked into the share price. If it is supposed to be all future discounted cash flows, losing a quarter or two of earnings shouldn’t make much difference, so why the large moves in share prices?

Taking a simple approach to the Rightmove example above, the reduction in fees will apparently lead to a £65m - £75m cut in revenue for 2019. They made £289m in revenue in the prior year, taking the midpoint of the revenue impact as £70m, leaves us with around a 24% drop in revenue. The share price dropped over 40% from mid February to the low on the 23^rd March, the cancelled 4.4p dividend would only have accounted for a small % of the loss (the share price dropped to around 400p – equating to cancelling a 1% payout). It looks as if the market is pricing in bad news for Rightmove, is it a margin of safety? As noted above the condition in which the business comes through this is predominantly about their customers, it’s not something that Rightmove control. This makes it very hard to invest into.

Banging a few numbers into spreadsheets to get some back of the envelope calculations has helped, but it has also been useful to revisit these companies and try to think through not only will they survive, but in what shape. It’s certainly led to some movement on the shopping list, with a few companies being removed completely. Strange times.

March 2020 portfolio update

Only one thing in the news - COVID-19.

It's not the only problem affecting the markets of course. Oil prices have been smashed by demand dropping off a cliff since nobody is going anywhere, and the Saudi's opening their taps. And until they have achieved whatever they have in mind, any business dependent upon oil is going to suffer.

The collapse in price of a key global commodity, such as oil, and the suspension of the vast majority of consumer spending in a number of economies on the planet is certainly making everyone sit up and take notice. With this happening against the backdrop of expensive markets, it's unsurprising we have seen significant reductions in share prices.

It's going to be interesting to see how far revenues, profits and cashflow have fallen once we start getting earnings reports issued, and whether any businesses are actually priced as bargains. I have a list of companies I'd like to buy into, but I'd like to see a bit of economic data first. Even though some of them are historically very good companies, there is a genuine whiff of existential angst in the air. I'm quite comfortable missing the bottom chunk of the recovery if need be, and I'm equally not fussed about getting in too early. Most quality businesses should recover over the next year or two.

As an investor keen on dividends, it is disappointing to hear of dividend cuts but these are unusual times. The investor community has insisted on spare cash being returned to us via dividends or share buy backs, so we should be not be surprised that an acute cash flow crunch leaves firms a little exposed. Three of my portfolio have so far reported cuts to their dividends, I'm relatively sanguine as this should help reduce the probability of needing to borrow to survive the next few months.:

Somero Enterprises - postponed dividend to 2021 (it's ok guys, you can cut it - we understand 😎)
Nichols - cut dividend as revenues are likely to materially impacted by COVID-19
Fulcrum Utilities - dividend had been postponed whilst asset sale completed, now formally cancelled

Nothing bought or sold during March, waiting for things to stabilise a tad, so keeping the powder dry just a little longer.

Portfolio performance
The portfolio was down -8.9% in March, losing less than my chosen benchmark the Vanguard FTSE All Share Accumulation which was down -15% over the same period.

Best performers this month:
888 Holdings +9%
Reckitt Benckiser +7%
Craneware +1%

Worst performers this month:
Dignity -52%
SAGA -47%
AB Dynamics -33%

Portfolio COVID-19 update

Given the destruction wreaked upon the markets of late, it seemed like a reasonable time to reflect on the status of my investments.

My goals are pretty simple and can be distilled into 2 key points:

• Don’t lose money
• Build a portfolio of dividend paying investments

There is more finesse to these goals detailed here but it boils down to these two things. Since I’m looking to these investments to supplement my pension in a few years, I’m principally looking for income over capital growth.

Many businesses are experiencing disruption to both supply and demand, hardly a recipe for fat cashflows and pristine balance sheets. I’ve been through each of the investments that make up the core of my portfolio and the updates provided by each company over recent weeks, and tried to guess what the likely short-term and long-term impacts are likely to be.

Company	Business activity	COVID-19 update	Likely short-term impact	Likely long-term impact
Abcam	Provider of biological ingredients, kits and information to life sciences	9th March Chinese impact to operations quantified. Further impact outside of China unknown.	Reduced turnover and potential supply chain disruption. Possible increase in demand for products if relevant for COVID-19 research.	Little impact. Potential for increased funding for life sciences as a reaction to global pandemic which might benefit Abcam.
AG Barr	Soft drinks	23rd March Delayed annual results. Contained update on COVID-19.	Not material so far. No immediate interruption to production, hit to demand, balance sheet ok.	Little impact.
Compass	Contract catering	17th March Severe impact from March onwards.	Severe impact. Possible breach of debt covenants if impact continues.	Assuming customers remain trading, long-term impact should be positive. Compass should have scale to take market share from smaller businesses or to acquire these at lower prices.
Computacenter	Tech services	12th March	Increased demand for remote working. Potential for decreased technology infrastructure.	Likely to see increased spending in ecommerce and ensuring resilient remote working.
Foresight Solar	Solar energy provider	9th March FSFL Statement: No impact	Minimal impact.	Minimal impact.
Glaxosmithkline	Pharmaceuticals and consumer health products	5th February GSK Statement: Impact unknown	Reduced turnover and potential supply chain disruption. Potential increase in demand for any respiratory medicines.	Potential for increased funding for research and respiratory medicines.
National Grid	Energy infrastructure	None	Minimal impact.	Minimal impact.
Nextenergy Solar	Solar energy provider	20th March No significant impact. Cancellation of scrip dividend.	Minimal impact.	Minimal impact.
Nichols	Soft drinks	None	Reduced turnover and potential supply chain disruption	Little impact.
Reckitt Benckiser	Consumer goods	27th February Some disruption to Chinese supply chain	RB’s portfolio contains a number of household cleaning products which should benefit. Potential supply chain disruption.	Little impact.
Telecom Plus	Utilities and telecoms reseller	None	Little impact.	Little impact.
Tritax Big Box	Distribution centre property REIT	17th March Vague risk around global recession.	BBOX customers include retailers that could become distressed, e.g. M&S. These could look for rent reviews, or even potentially fail.	Potential for increased demand for online sales during COVID-19 outbreak. If ecommerce gets even more ingrained into consumer habits it could benefit BBOX.
Unilever	Consumer goods	30th January Statement: impact unknown	Little impact.	Little impact.

The true extent of the disruption is unknown, and fortunately for most of my investments is it unlikely to be crippling. The one exception is Compass. Compass is a catering company, providing catering services to business, governments, events, and have the market essentially split with Sodexho.

By my calculations if the current levels of disruption continue for too long, they may breach their debt covenants. Exactly what this means is unclear, if the loan defines covenant breaches as ‘potential’ or ‘actual’ events of default. The lenders may either have the right to demand immediate loan repayment – which with a cashflow crunch may not be ideal. Watch this space (from behind the sofa)

Compass update and back of the envelope calculations below:

"Compass' organic revenue growth for the five months ending 29 February 2020 was 6% as measures to contain the virus in our Asia Pacific region did not materially impact our business. Our operating margin during that five month period increased by around 10bps with the benefits from the restructuring programme in Europe coming through strongly. 

However, the acceleration of containment measures adopted by governments and clients in Continental Europe and North America have affected our expectations for the Half Year. The vast majority of our Sports & Leisure and Education business in these regions has been closed, and our Business & Industry volumes are being severely impacted.  Our current expectations are that Half Year 2020 organic revenue growth should be between 0-2%.  We are implementing significant mitigation plans to manage our costs, and at this stage expect the drop-through impact of the lost revenue to be between 25%-30% across the business.  As a result, our operating profit for Half Year 2020 will be £125 million - £225 million² lower than expected.

We are working to protect our cash flow and are pro-actively managing our capital expenditure and working capital.  We have significant headroom against a 4x net debt/ EBITDA covenant in our US Private Placement Agreements and we have substantial liquidity with a £2 billion committed Revolving Credit Facility³ maturing in 2024.  Stable outlooks have recently been reconfirmed on our A/A3 credit ratings."

Revenue for 2019 was £25.2 billion, the update indicates a 25% - 30% loss of revenue but it is not clear over what time period. Assuming the whole year that would put the 2020 revenue around £17.6 billion, similar to 2015 revenues, roughly where the share price is at the moment.

Based on the update, most of the impact has occurred in March, as for 5 months ending in Feb, revenue was up. For 1 month losses were material enough to result in projection of operating profit being £125m - £225m lower than expectations. EBIT consensus projections on the Compass website for 2020 are £1950bn, which breaks down roughly as a £163m per month. That's not going to leave a lot of spare change if the bad end of the losses plays out.

Net debt was last reported as £3.3bn, the update states that they need to keep net debt/EBITDA to 4x, which implies EBITDA needs to be greater than £800m to keep out of trouble with the bank. 2019 EBITDA was £2.5bn