Fool's Eye View

[ June 26, 2000 ]

Should You Yield?

By Stuart Watson (TMFTiger)

Potters Bar, Herts -- If you have been following the stock market in the last year or so you cannot have failed to notice the much-publicised divergence in the valuation of old and new industries. In addition the stock market boom of the last decade, combined with falls in annuity and saving rates, has created large numbers of people who are capital-rich but face the prospect of becoming income-poor in retirement. Perhaps the two can solve their problems by coming together?

The problem with savings and annuities

High interest savings accounts are not good long-term investments. They offer no prospect of capital appreciation. Unless your after tax return is better than inflation you are effectively losing money each year. Annuities offer an alternative but in return for a higher and potentially increasing rate of income you have to give up all your capital.

Perhaps a better alternative is a portfolio of high-yielding stocks? Many solid companies offer dividends yielding over 5% at the moment. Not only can you preserve your capital but there is the prospect of steadily increasing dividend payments as well. Of course, there is a catch. Unlike savings and annuities both your capital and income is at risk and could go down, rather than go up. To combat this you can spread your risk over a number of different investments. A certain element of risk will always remain. But if want to achieve returns higher than a standard no-risk investment like a savings account then you have to accept and understand this.

Earlier this year there was a report published by the Retirement Income Working Party, looking into ways to provide a better alternative than annuities for pension money. Michael Portillo, who is not someone who leaps to mind as a Foolish investor, referred to this report last week when he proposed scrapping the compulsory purchase of annuities. The report suggested the purchase of a 'minimum' annuity to cover a basic level of income. After that we would be free to apply the remaining funds in whichever way we saw fit. Such an approach may be appropriate in this instance as well. After securing a core level of income a yield-based investment strategy could be the icing on the cake.

OK, so which companies?

Now for the tricky bit. It is very simple to gather a collection of companies paying high dividends. But any random selection is likely to contain investment dogs by the kennel-full. Any company yielding more than 10% should probably be ruled out immediately. These are much more likely to be flea-ridden mongrels than a standard mutt. Remember that quoted dividend yields are based on historical information whereas the market is looking forward. A yield of over 10% normally indicates that a drastic cut is expected at the next set of results or that dividends could be discontinued altogether. There are exceptions but you could probably count them on one hand.

A decent range for consideration could perhaps be between 5% and 8%. This is equivalent to an income before tax of 6.25% to 10%. That compares pretty well with index-linked annuity rates available at the moment. The sort of companies we are looking for need to be solid with little chance of their dividends being cut. They are likely to have little debt or even surplus cash. Ideally they should also have reasonable growth prospects over the long-term as well.

After a scan of the Financial Times at the weekend I came up with the following list that would all be worthy of further investigation, and indicate the sort of companies that look the most appropriate. All of them are of a substantial size. The smallest in terms of market capitalisation is £1b.

Company                      Current Yield
Tomkins (LSE: TOM)                    7.6%
Royal & Sun Alliance (LSE: RSA)       6.3%
Pilkington (LSE: PILK)                5.4%
Tate & Lyle (LSE: TATE)               7.2%
Scottish & Newcastle (LSE: SCTN)      5.0%
Rexam (LSE: REX)                      5.8%
Average                                6.3%

This is a strategy that has many overlaps with some of our mechanical strategies such as Beating the Footsie, in that it throws up many of the same companies. The key difference is that this is more of a buy and hold approach whereas mechanical portfolios are often rebuilt every year. But this sort of strategy is only going to suit a limited number of people. Some reasonably detailed knowledge of company analysis is required in order to come up and monitor a list of suitable companies.

It could also suit women more than men. The former receive lower annuity rates so there is more incentive for them to look for an alternative. Like all such strategies if it was widely adopted, it probably wouldn't work as the companies in question only make up a small part of the market and widespread buying would drive up their prices and reduce their yields. Nevertheless it looks like a valid alternative for those looking for a little bit extra income from their pile of capital.

Related Links

• Retirement Investing discussion board
• Fool's Guide to Retirement
• Fool's Guide to Dividends
• Working Party Report