In a recent article at Financial Freedom is a Journey, I provided a link to an interview that was conducted with Hamish Douglass, Co-Founder, Chairman and Chief Investment Officer of Magellan Financial Group, and Lead Portfolio Manager of Magellan’s Global Equity strategies in Australia.
In that interview, Hamish discussed the art of investing in international equities and shared the following 6 simple guiding principles for investors wanting to gain exposure to international equities.
- Use the Power of Compounding;
- Stick to Quality Businesses;
- Don't be a Fly in a Bottle;
- Consider What You Use as a Starting Point;
- Make a Few Good Decisions; and
- Look at Currency Movements as a One-Off.
These 6 simple guiding principles are not exclusive to investing in international equities. They are simple guiding principles that should be applied…PERIOD.
When Hamish makes reference to ‘Don’t be a Fly in a Bottle’ he is referencing the strategy of ‘over diversification’.
My disclosed and undisclosed investment holdings are spread over multiple accounts (held for different purposes) and are held at two different financial institutions (I have my reasons). This makes it a bit more difficult to manage but I have made a concerted effort not to be a ‘fly in a bottle’.
The last time I closely looked at the overall portfolio composition, however, was February 2018 so with Hamish’s guiding principles fresh in my mind I very recently decided to perform a portfolio analysis.
In February 2018 my findings were that ~75% of our investments were held in 20 high quality companies. The top 10 holdings made up ~53% of the total dollar value of all our equity investments.
- Visa (V)
- 3M (MMM)
- The Bank of Nova Scotia (BNS)
- The Royal Bank of Canada (RY)
- Church & Dwight (CHD)
- Johnson & Johnson (JNJ)
- Chevron (CVX)
- Walmart (WMT)
- Canadian National Railway (CNI)
- The Canadian Imperial Bank of Commerce (CM) and Becton Dickinson (BDX) - tied
The next top 10 made up the next 22% of our overall holdings.
- The Toronto-Dominion Bank (TD)
- Automatic Data Processing (ADP)
- Mastercard (MA)
- Exxon Mobil (XOM)
- AT&T (T)
- Total S.A. (TOT)
- UPS (UPS)
- BCE (BCE)
- Pepsico (PEP)
- J.M. Smucker (SJM)
Following my recent analysis, I see that our top 10 holdings now make up ~42.5% of our overall holdings and that there has been some minor changes from 2018.
- Church & Dwight
- The Bank of Nova Scotia
- The Royal Bank of Canada
- Johnson & Johnson
- The Canadian Imperial Bank of Commerce
The next top 10 make up ~21.2% of our overall holdings.
- The Toronto-Dominion Bank
- Becton Dickinson
- Canadian National Railway
- Automatic Data Processing
- The Bank of Montreal
- United Technologies (UTX)
- Berkshire Hathaway (BRK.B)
- The Brookfield Group of Companies (shares are held in Brookfield Asset Management (BAM), Brookfield Property Partners (BPY), Brookfield Infrastructure Partners (BIP), and Brookfield Renewable Partners (BEP))
- Broadridge (BR)
With the top 20 companies now making up only 63.7% of our overall holdings I took a look at the top 21 – 30 holdings and found that they constitute ~13.7% of the overall holdings.
- Exxon Mobil
- W.W. Grainger (GWW)
- Stanley Black & Decker (SWK)
- Total S.A.
- CME Group (CME)
- United Parcel Service (UPS)
- Apple (AAPL)
- Hershey (HSY)
- Pepsico (PEP)
98.39% of the overall portfolio is held in 30 companies. Certainly a bit more diversified than in February 2018 but I don’t think I am a ‘fly in a bottle’.
I feel comfortable owning all these companies and have acquired additional shares for many of these holdings on weakness. I have also initiated positions in GWW, SWK, CME, and AAPL subsequent to February 2018 when I viewed them as fairly valued/undervalued.
You may notice I have exposure to the Big 5 Schedule A Canadian banks within my top 20 holdings and 3 of the banks are within the top 10 holdings. I was employed in this sector during my entire career and feel I have a reasonably good handle on it; I am very comfortable with this exposure.
I have ranked our holdings on the basis of market value but this is not the metric I most closely follow. Earnings growth, Free Cash Flow, dividend income, dividend growth, dividend payout ratios and share buybacks are of more interest to me.
Despite my heavy emphasis on the dividend aspect of an investment, I am not interested in stretching for yield. Some of our holdings have attractive dividend yields but if you look closely at the top 30 holdings you will find several companies with a sub 2.0% dividend yield (e.g. V, MA, BDX, BAM, CHD, BR).
My preference is to invest in a company with a low dividend yield and a conservative dividend payout ratio rather than in a company with a high dividend yield and minimal/no dividend growth. In addition, I am not interested in investing in a company which is continually issuing new units/shares and in which a component of the dividend or distribution is a return of capital.
Having said this, there are some companies within our top 30 holdings that currently have a dividend yield in excess of 4% (e.g. T, BIP, BPY, BEP, TOT, BCE, CM, BNS, BMO, XOM).
Berkshire Hathaway (BRK.B)
Our 18th largest holding by current market value is BRK.B which pays no dividend. I am willing to forego any dividend from this holding in exchange for this company’s superior ability to generate long-term investment wealth. What also appeals to me about this company is its ability to acquire companies in which I would never be able to invest (e.g. GEICO Auto Insurance, BNSF).
For an even more exhaustive list of companies in which investors cannot invest unless they hold shares in BRK.B, I draw to your attention pages 142 – 146 of the 2017 Annual Report. BRK.B's ownership interest in the publicly traded companies found here also appeals to me.
Yes…I know that owning several hundred Class B shares means my interest in all these wholly owned companies is minuscule but that is fine.
CME Group (CME)
Most readers will be familiar with the companies within our top 30 holdings. CME, however, might be a company with which not everyone is familiar. Investors interested in learning more about CME are encouraged to read Part 1 (Item 1 and 1A) in CME s 10-K.
In early August 2018 I initiated a position in this company following my analysis; I wrote an article at Financial Freedom is a Journey on August 5th but only disclosed the name of the company to subscribers.
I liked what I saw and was of the opinion that investors who rely heavily/exclusively on stock screeners would cast this company aside as a potential investment since this company’s unique dividend policy includes a special dividend which is paid in December or January and is excluded in the calculation of CME’s dividend yield in all stock screeners.
I recognize other companies occasionally pay a special dividend but I have yet to find a company, other than CME, where a special dividend is an annual component of the company’s dividend.
The $1.75 special dividend paid out January 2019 was half of that distributed in January 2018 but this was not because of any deterioration in the business. It just happened to be a level CME’s Board of Directors deemed reasonable given the company’s other needs for cash.
Since the dividend related component of a company’s common stock is what I monitor closely, I track the dividends from our holdings like a hawk (dividend income is our primary source of income with rental income being a distant second – we are not yet at the stage where we can collect a government pension).
Some of our US holdings are held in non-registered accounts meaning that we get a 15% haircut on the dividend income generated from these investments. This would be unacceptable to some investors but this is something I am prepared to live with. There are too few publicly listed companies in Canada that remotely appeal to me, and therefore, I must look to US companies in order to achieve the long-term results I desire.
Another factor that comes into play is that some of our holdings are in tax advantaged accounts. When it comes time to withdraw funds from such accounts, the Canadian tax system calls for a withholding tax on all withdrawals from ‘registered accounts’. For the benefit of investors unfamiliar with the Canadian tax system, I draw your attention to the withholding tax scale related to withdrawals from Registered Retirement Savings Plans (RRSPs).
Time to Cull
As part of this analysis to ensure I have not become a ‘fly in a bottle’ I also want to determine whether there are any holdings which no longer meet my investment standards.
Following my review I have identified the following companies that make up a minuscule component of our overall holdings that really don’t belong:
In the case of CDK, we obtained these shares when this part of ADP’s business was spun off a few years ago. We have never added to our position and this company’s performance and growth potential do not appeal to me. I will liquidate these shares and use the sale proceeds to fund part of this year’s living expenses.
I wish I could say something positive about MFC, Canada’s largest life insurance company from a market cap perspective, but I can’t. The company cut its dividend in half from $0.26/share to $0.13/share in FY2009. Here we are, several years later, and the quarterly dividend has still not been restored to its pre-Financial Crisis level. One look at MFC's stock chart and we see that the share price has also let investors down. I will use these sale proceeds to fund part of this year’s living expenses.
The only saving grace with this investment is that I invested very little immediately after the stock price was decimated in late February 2012; I have not made further investments other than the reinvestment of dividends. I most certainly could have done much better by investing in a good company.
Just prior to the Financial Crisis, before I started to properly analyze companies, I listened to a highly respected global financial services firm that provides a wide array of investment research and investment management services. Its research and recommendations are considered extremely influential in the asset management industry, and a positive or negative recommendation from its analysts can drive billions of dollars into or away from any given fund.
This company’s recommendation? Wachovia! Perform a web search if you are unfamiliar with Wachovia. Put it this way….it no longer exists. The Wachovia brand was absorbed by WFC after a government-forced sale to avoid Wachovia's failure.
My original Wachovia shares became WFC shares and my investment is currently valued at ~35% of my original investment. Once again I should have exited my position ages ago but the value of those shares is so small I never bothered to do anything with them to date.
Proceeds From Proposed Cull
The proceeds from the upcoming sale of CDK, MFC, and WFC shares will not be reinvested. Those proceeds will be withdrawn from the RRSPs to service our living expenses. This will allow me to reinstate the automatic dividend reinvestment for high quality companies which I recently discontinued because I had intended to withdraw the dividends generated from those holdings to fund our living expenses.
The proceeds from the sale of the SNCAF shares will be reinvested in a high quality company (e.g. V, MA, CNI) when we get our next broad market pullback.
I am of the opinion that another broad market pullback is imminent and am reluctant to immediately reinvest the proceeds from the sale of SNCAF shares. In fact, I have recently published articles at Financial Freedom is a Journey in which I have indicated that I have written short-term out-of-the money covered calls (BDX, NKE, MA, and ADP) where I think valuation levels are somewhat stretched.
In some cases, I have been of the opinion that the shares of certain companies were undervalued or fairly valued and have acquired shares. Articles to this effect are:
- BRK.B and SWK articles in January;
- AAPL article in January;
- CHD and BR articles following their respective share price retracement in February.
I think a good exercise that should be performed at least annually is to look at all our individual holdings to ensure we do not become a ‘fly in a bottle’.
It might seem appealing to ‘diversify’ over a great number of companies but this level of diversification can become extreme. When this happens it becomes difficult to truly understand each company in which an investment has been made.
A more prudent strategy is to focus on investing in a more manageable number of high quality companies in the 5 main economic sectors and to do your best to truly understand these businesses:
- Manufacturing & Industry;
- Resources & Commodities
- Finance; and
When I undertook my recent analysis, I looked at:
- Each individual holding from a market cap perspective and the exposure relative to the overall value of the entire portfolio and ranked each holding by total market value from largest to smallest;
- The earnings growth, dividend yield, dividend growth, dividend payout ratio, free cash flow, and share buyback track record of each company;
- Whether the underlying reason for my initial purchase made sense and reassessed whether each holding was a worthy long-term investment.
In my case, I came to the conclusion that 4 companies are not worth holding and I will be exiting these positions very soon.
Depending on the number of holdings and the number of accounts over which your investments are distributed this can be a time-consuming exercise. Nevertheless, I highly recommend you take the time to perform this analysis at least annually to ensure you do not become a ‘fly in a bottle’.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Disclosure: I am/we are long V, MMM, BNS, RY, CHD, JNJ, CVX, WMT, CNI, CM, BDX, TD, ADP, XOM, MA, T, TOT, UPS, BCE, PEP, SJM, UTX, BRK.B, BAM, BPY, BIP, BEP, BR, GWW, SWK, CME, UPS, AAPL, HSY, PEP, CDK, MFC, WFC, SNCAF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.