Top FTSE tips

Whatever the proponents of the efficient-market hypothesis may say, the fact is that market returns aren't entirely random. There are, as Tony Jackson points out in The Sunday Telegraph, "some simple rules for making money".

To see what those are, there is no better place to turn than the ABN Amro Global Investment Returns Yearbook 2005. Authored by three professors from the London Business School, this contains 105 years worth of data from 17 countries.

The findings? "Countries showing very rapid rates of economic growth tend to have the poorest performing stockmarkets," says Jeremy Warner in The Independent. "It is to mature, plodding, slow growth countries that you must turn for the best and most consistent long-term rates of return. The same is true of individual stocks."

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As one of the report's authors, Professor Marsh, puts it, in most time periods, "investors would have done better to shun growth and go for boredom". That means shares in dull, slow-growing companies with high dividend yields: thanks to reinvested dividends and the magical effects of compounding returns, there is a strong correlation between the level of real dividend growth in stocks and their long-run total return, or so says the report.

Buying low-growth, high-yielding shares makes complete sense to me. First, because high-growth shares tend to be more volatile and that can hurt long-term returns: a stock only has to return 6% a year for three years to outperform one that rises 30% for two years but falls 30% in the third. But second, because buying high yield is shorthand for pursuing a contrarian approach: if the absolute dividend is relatively constant, it follows that when it is higher than usual in percentage terms, the shares have fallen out of favour for some reason.

No wonder, then, that the strategy tends to work. In the UK, writes Graham Searjeant in The Times, "an index of high-yield stocks has delivered a return averaging 11.2% a year compared with the 9.6% market average".

James O'Shaughnessy, in his 1998 book What Works On Wall Street, found that the effect of the high-yield strategy is especially marked for the large blue-chip stocks. Between 1952 and 1996, he found the "highest yielding (large) stocks doing almost twice as well as their universe with virtually the same risk". Since then the effect has continued unabated. That's important, because most simple market-beating strategies fail once people know about them. In quantum mechanics, they call this effect Heisenberg's Uncertainty Principle and it states that you can't measure something without changing it.

For example, over 50 years, says Tony Jackson in The Sunday Telegraph, the small companies index has beaten the broad market by a factor of three. But 18 years ago, the index started to be published and the outperformance became common knowledge. Since then, small caps have performed more in line: "the mistake - the undervaluation of small companies - was corrected as soon as it was understood."

However, adopting this strategy is not quite as simple as you might think. One problem is that as soon as your high-yielding stock goes up, all other things being equal, the yield falls. A year ago, Shell (RDSB) had a dividend yield of 5%, but its 35% rise since then means the yield's now just 3.6%, which doesn't put it in the top 25 FTSE 100 high yielders any more; high-yielding holdings don't have to go up much before they're no longer high yielding, and many of them are vulnerable to dividend cuts. These two factors mean that a high-dividend approach can end up being high risk and high turnover, both things that, as investors, we want to avoid.

How do we do it? The secret is to try and find high-yielding blue chips that also offer substantial upside from an earnings-valuation point of view. Earnings that aren't growing over time can't support future dividend growth.

For example, United Utilities (UU) and Lloyds TSB (LLOY) both leap off any list of high yielders, offering as they do a tempting 6.8% yield. However, both have seen their earnings outlooks deteriorate over the last five years and dividend cover is low, suggesting future dividend growth will be constrained. United Utilities' recent rally has also put it on a record high p/e of more than 13 times.

Other high-yield stocks that offer high dividends but with record high p/es are British American Tobacco (BATS), Scottish and Newcastle Brewery (SCTN) and Severn Trent Water (SVT). BAT's shares have risen 70% in the last two years, but earnings have been flat for a decade. The other two stocks have seen earnings trend down over the last five years.

Below, I have chosen seven companies - all from the FTSE 100 - where this is not the case. Instead, they have all shown over the last five years that they can grow earnings and hence sustain dividend growth. They are also high yielding and trading below where their profit outlook suggests they should be.

In other words, they are cheap blue-chips - good-quality stocks generating impressive income that are out of favour for no good reason. I'd expect them all to rise substantially this year.

Legal & General

The yield on Legal & General (LGEN) shares is a very reasonable 4.2%, but their real prospects are revealed by the p/e, which is currently about half its long-run average. With bond yields currently so low (justifying higher share prices in general), the p/e should, if anything, be higher than average. But even a return to the norm would necessitate the share price doubling. Add to that a steady underlying double-digit, long-term earnings-growth trend, and I believe there is a strong chance of a potentially spectacular share-price move over the next year or so.

Dixons

Dixons (DSGI) is an out-of-favour retailer, but again there's a solid, if unspectacular, earnings growth trend and a sub-normal p/e backing its 4.5% dividend yield. If valuations revert to norm, the stock should yield nearer 3% and the p/e should be nearer to 19 times than its current 13 times. The potential upside is 40%-50%.

Boots

Update: Boots was taken private in mid-2007

Alliance & Leicester

Alliance and Leicester (AL) shares offer a yield of 4.8% - even more than gilts. This seems mean, given their long-run earnings-growth trend of more than 8% a year.The shares seem unable to break through 9,500p a share, but once they have, there's no reason why the share price shouldn't follow earnings up to the 1,300 level. Even then it would be a cheap stock on just 14 times and yielding 3.5%.

BOC

Update: BOC was bought by Linde (LIN) in 2006.

Rentokil

Ten years ago, Rentokil's (RTO) dividend yield was half what it is now (4%), while gilt yields were double today's level. Now the two are almost the same. Rentokil also trades on a p/e of about half its long-run average 14 times). As is the case with our other candidates, with gilt yields being so low, p/e should theoretically be higher than average, not lower.

Shell

Finally, even though the dividend yield is not that high at 3.6%, I must add Shell (RDSB) to the list because of the surge in value being driven by the rise in the oil price over the last 12 months, which has taken its earnings yield up to 15%. This, together with ever lower gilt yields, makes Shell a high dividend-yield stock with enormous possible upside. Shell's yield always used to be half that of gilts, which would imply a share price some 25% higher. But Shell can also afford a much higher dividend: based on its profits alone, it could double and not look expensive.