Too many investors think the money is in action, in trading. In fact, most would do well to buy into choice high-yielders and leave well alone, says Stephen Bland
Investing is tough enough in the best of years, but 2008 promises to be tougher than most.
On the one hand, property markets are finally turning down and the US and UK could be destined for recession. On the other hand, emerging markets and commodities are still going strong.
But how long can this last if a weakened America starts to drag on global growth? You'll get different answers from everyone you talk to, largely depending on which particular market they want to talk up.
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But what if you don't want to have to worry about any of this? What if you just want to put away a chunk of your hard-earned money and harvest an income from it without having to change the composition of your portfolio every couple of weeks?
During my lengthy period as a practising accountant, I saw a lot of investors in this situation. The majority chose to get income from one of two common areas. Many of these lump-sum income investors simply stuck the cash into various banks and drew the interest. The advantage of this is simplicity, easy access to funds, and the capital is protected from fluctuation. One obvious downside is that they were at the mercy of prevailing interest rates over the many years they expected to live and draw the income (over the years, interest rates are actually quite volatile). Another problem is inflation. Over time this will erode the value of the capital and the income too. And now the Northern Rock debacle has made many people look again at the security of their bank.
The other popular home for income was some kind of insurance-company income scheme. Unfortunately, all too often these schemes, aimed by cynical insurers at the weakest and most vulnerable investors namely elderly people desperate for income in an era of low interest rates delivered poor results with high risk to the capital and, of course, high charges to the insurers.
So I thought about alternatives to cash and insurance schemes for income investors. As a lifelong investor in equities, using a value approach to trade shares, high yield was one of my criteria, along with low p/e, low price-to-tangible-book ratio, net cash and other features. But high yield is particularly useful. That's because it is both an indicator of value and shows the cash return on the share. The other value indicators merely tell you something about the share, but don't in themselves promise any return.
Some research I did a long time ago into high-yielding UK-equity unit-trusts showed me that their returns, on average, including reinvested income, beat the market over long periods on the same basis. I became convinced that a great alternative to cash, gilts or insurance schemes for income investors would be to hold a portfolio of high-yielding shares and draw the dividends. They would have to be able to live with the risks of capital fluctuations and that of the income as well.
That said, as far as the latter point is concerned, dividends from a portfolio are in fact far more stable than interest rates over long periods and tend to rise gradually rather than merely fluctuating, as happens with interest rates.
So I devised the High-Yield Portfolio (HYP). The idea is to concentrate on buying an income from shares rather than focusing on their capital movements, because over time companies tend to increase their dividends. By picking stocks from a diverse range of sectors, you can minimise the risks of any particular sector being hit by adverse circumstances.
In practice, an income growing over a long period is very likely to lift the share price with it. So it is almost inevitable that an income rising over many years will also lift the capital value of a portfolio. Even so, the point of the HYP approach is to concentrate on income, not capital. Let the latter take care of itself.
How to build a high-yield portfolio
For security, the portfolio must be sector diversified and the shares should all be large caps, drawn almost exclusively from the FTSE 100. A full HYP requires some 15 to 20 shares. The diversification is important to minimise the risks of the strategy. You could construct a high-yield portfolio by just taking the top 15-20 yielding shares in the index, but this would result in a focus on too few sectors. That might produce a higher income, but it would be way too risky for the sort of investors I have in mind.
Note that this isn't a mechanical stockpicking strategy. I like to include a few simple quality checks. So I look for five years of rising dividends plus a forecast rise over the next year. Reasonable debt is another criterion. However, I don't make these tests mandatory and am prepared to stretch some of them in return for an extra high yield, or to include a sector that otherwise might not be caught (so as to improve diversification).
But as far as macro-economics goes, I favour an approach I describe as strategic ignorance'. This means that, quite deliberately, no account is taken of any long-term view of the share, sector or economy in general, whether these be the investor's own views or those of commentators. I think that worrying about all that leads to poor and biased share choices. Instead, it's better if the investor realises that both they and everyone else is, of course, ignorant about all future development over the many years during which an HYP is expected to be held. Far too many small investors uselessly ponder the long term or use others' views of it to make judgements about shares.
Strategic ignorance is liberating for long-term buy-and-hold investing. All you have to do is get that critical sector diversification into your HYP, and then stop worrying about anything else. Over the time you will hold the portfolio, loads of things will happen to the shares in it. These events will often take you by surprise, sometimes pleasantly, sometimes not so. But the point is that you have no way of knowing in advance what they will be so there's no sense in trying to account for them beyond being invested across as wide a range of sectors as possible.
Running the high-yield portfolio
The focus on income is the principal contrast that HYPs have with other share strategies. Nearly all share-investing approaches are aimed at generating capital profits. Yet the fact is that share dividends are extremely stable, far more reliable and predictable than share prices.
Look at it this way. You can check out the forecast dividends on any big-cap share for the coming year and there is a high chance that the actual payout you will receive will be close to the forecast. So if you buy a share and the forecast dividends imply a 5% yield in the year ahead, the odds of your income materialising close to that figure are excellent.
Now compare the chances of achieving that forecast yield return with the chances of any particular capital return on the same big cap. The share price can easily end up within a range of plus or minus 20% or much more in a year. In other words, betting on share prices, whether over a year or eternity, is a much riskier proposition than betting on dividend income.
So how often should you trade? Well, once you've built up your portfolio, never. That may sound extreme, but the fact is that most small investors are poor at trading so avoid it. There is enough mandatory trading anyway from bids, returns of cash, spin offs and so on, so you should let the market trade for you in this way, rather than make any voluntary trades of your own.
HYPers should also avoid monitoring their portfolios or reading financial news frequently. Investors who measure their performance regularly are often the same people who panic trade because they are affected by every little bit of news most of which is ephemeral and of no real long-term consequence. Selling too soon is a common failing of the small investor. If you simply can't resist flicking through the business sections, then develop a thick enough fiscal skin to soar well above them.
A major criticism of many investors and the reason why so many do poorly is that they succumb to Recent Events Syndrome'. This means that in evaluating shares, they place too much weight on recent events and too little on long-term trends, because the former appear in their minds to be far more important than they really are. The HYP approach is the antidote.
What are the risks?
Clearly, the HYP approach is not without risk, like any investment. You have to be prepared for the sometimes steep falls that can occur and, if you absolutely cannot live with that, then you should avoid it. But, as I say, it is all about income; capital is very much secondary.
There is, of course, also some risk to the income. Experience so far shows that on occasion there is widespread dividend cutting by big-cap shares. One such period occurred in the early years of this decade. When that happens the portfolio income is likely to suffer. But this is when the diversification comes into its own, because it's likely that not every share will cut dividends. Some will be static, some will even rise, while others fall.
Overall there may well be a fall in portfolio income comparing any one year with the previous one at such times, but it will probably be nowhere near as bad as if one's portfolio focused on just a few sectors. Accepting these risks, the HYP income investor is likely long term to see great advantages: a growing income, more than likely growing capital too, total liquidity at any time, no management charges, and no interference from governments or insurers. No guarantees, of course we're talking about shares here, after all.
The capital accumulation version
As I have consistently stressed in this cover story, the HYP is principally an income vehicle. But it can easily be adapted for growing your capital simply by reinvesting your dividends.
You can start at any age and the whole scheme immediately becomes immensely versatile. Keep investing regularly, building up the portfolio, and when you reach enough shares and the available yields start becoming too low, increase the existing holdings. You can do this for as long as desired. Then when you need the income, you simply switch from reinvesting dividends to withdrawing them.
This is a sort of do-it-yourself pension plan, but with the huge advantages of complete liquidity at all times you won't have to wait until you're 55 to get access to your money and no costs or onerous regulations from insurers or governments forcing you to tie up your cash or buy annuities. Moreover, you can run it within an Individual Savings Account (Isa) up to the annual limits for even greater benefits. For a sample of the type of stocks I'd be considering for an HYP now, see below.
A High-Yield Portfolio
A sample 16-share portfolio based on information available at 15 January 2008.
Share, Business, Price, Forecast yield %
Lloyds TSB (LLOY), Bank, 427p, 8.3
Persimmon (PSN), Housebuilder, 749p, 7.0
Rentokil (RTO), Business services, 109p, 6.7
BT Group (BT.A), Phones, 276p, 5.6
Marks & Spencer (MKS), Retail, 399p, 5.5
William Hill (WMH), Gambling, 410p, 5.5
Aviva (AV.), Insurance, 644p, 5.1
Pearson (PSON), Publishing, 665p, 4.7
Rexam (REX), Packaging, 409p, 4.6
Land Securities (LAND), Property, 1,517p, 4.2
Compass (CPG), Business catering, 302p, 3.9
National Grid (NG.), Power distribution, 850p, 3.8
GlaxoSmithKline (GSK), Pharmaceutical, 1,343p, 3.8
Carnival (CCL), Cruise ships, 1,975p, 3.7
BP (BP.), Oil, 586p, 3.5
Diageo (DGE), Beverages, 1,026p, 3.3
Average forecast yield: 5.0%
All these shares, except William Hill, were selected from the FTSE 100 and are high yield, defined as yielding above the index at the selection date. The idea is that equal amounts are invested in each share strategic ignorance' rules in selection then the investor relaxes and does nothing for the rest of his life, enjoying the income and dealing only with mandatory corporate activity when necessary.
Three frequently asked questions
If it's so good why doesn't everyone do it?
The reason is simply that most investors have no interest in very long-term buy-and-hold. That applies equally to professionals and the small guy. The HYP and its do-nothing approach is boring. Boring is good, but too many people think that the money is in action, in trading. For a tiny minority, it is but very few have those skills. Sadly, too many think they do have them and lose a lot of money finding out that they don't.
For the vast majority, the great returns will come from the tortoise approach of long-term buy-and-hold, accumulating modest average annual gains, which build up over time. But add diversified, big-cap, high-yield shares to that idea and you have the cherry on the icing on the cake. Without the diversified HY element, it would be like Hamlet without Yorrick.
But I can get a better yield in the bank
That may be the case at times, but you can't get a growing return in the bank. In fact, when interest rates fall as they often do then so will your income. Nor can you obtain a growing capital value. Over time, I am very confident that an HYP will deliver a return far in excess of keeping money in a bank savings account.
What sort of returns can I expect?
The longest demonstration portfolio I have been running is the 15-share, total £75,000, HYP1, which I launched on the Motley Fool in November 2000. It's a good example because it has been through both bear and bull markets. Recently, in its seventh anniversary review, it was worth £140,417, a gain over that time of 87.2% against a 1.4% increase in the FTSE 100. That assumes income withdrawn. So the average annual gain of this portfolio was 9.4%, and on top of that, the investor received an inflation-beating rising income.
That income in year one was £3,451 and by year seven it had risen to £4,452. I estimated that an HYPer reinvesting those dividends would result in a portfolio worth £176,972, a total return of 136.0% for an average annual gain of 13.0%.
So with this portfolio we have the annual capital return to an income withdrawing investor of 9.4%, or to a saver reinvesting dividends, 13.0%. But in answer to the original question, it is always better to err on the conservative side. So let's assume long term around 8% annual capital growth to an income investor, plus that growing dividend stream, and 12% per year total return to a saver reinvesting. No guarantees, of course.
Stephen Bland writes The Dividend Letter, based on his successful High Yield Portfolio' investment strategy.
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