How can you choose between competing high yield shares.
I'm doing a rare high yield portfolio (HYP) article this week, prompted by an interesting thread on the HYP board about the relative merits of competitors Tesco (LSE: TSCO) or Sainsbury (LSE: SBRY) as HYP share selections from the retail sector.
What got it going was an article on Tesco by Todd Wenning, which utilises a scorecard method of evaluating dividend shares. Not an approach I personally would use, because it is a little too mechanical.
I prefer to look at selection criteria such as yield, debt, dividend history, market cap and so on and then form an opinion. My style is more seat of the pants rather than the formal allocating of scores to each feature. Comparing competing HYP choices in this way could also mask an underlying factor which on its own might change the investor's judgement, even though the total score is better than a rival choice of share.
It's not a major point though because, and this might seem odd to beginners, the actual choice of shares is not the major part of the decision to become a HYPer. What is more important is belief in the merits of the strategy and its principal selection rules of big caps and diversification etc.
Once you have that belief, it doesn't matter all that much whether you choose Tesco or Sainsbury for example from retailers, or both, provided they meet the selection criteria. The reason that the shares chosen aren't that important is because there is no way to know long term which will prosper in order to deliver that all important income growth, or similarly which might do poorly.
Just about every portfolio over time will have examples of both but the hope is that the good shares outweigh the poorer performers.
Choosing between dividend rivals
I'm not going to reiterate my well-known HYP construction and share selection rules, this article isn't about that, but I wanted to emphasise that my mission was to promote the strategy itself above the actual shares themselves.
Having said that though, it does interest me as to why investors might choose from between two competing shares in a sector like those above where they intend to have only one of them in their portfolio.
My method is simply to decide on the fundamentals. That means quantitative stuff like market cap, yield, gearing, assets, P/E, dividend and interest cover, short term growth rates and other factors may all or partly come into the assessment.
But where I disagree with some HYPers though is that the quality known as "quality" comes into it. I don't believe that this criterion exists or, for those that think it does, its definition is not something upon which investors would agree or therefore upon which they can place any credence.
You can't argue with fundies
This is simply because you can't argue with fundies like yield or cap etc., they're just figures derived from underlying accounting and market data.
But what is "quality"? I could put together a definition if I wanted but it wouldn't have common currency. It couldn't be in the investors' lexicon because it is wholly subjective. Your view of it would likely differ from mine and that yet again from someone else.
Whenever this quality argument arises and I try to convince people that there is no such thing, someone might mention something I wrote in the very early days of my introduction of the HYP strategy to the Fool. I advised not trading off a lower yield share for a higher yielding one of inferior quality.
But I never meant by this the sort of nebulous feature of quality as it used by those who think that exists. I meant inferior quality in the sense of poorer fundamentals, a numerical comparison. In other words, yield alone is not the sole criterion so that if you have two shares with different yields in the same business from which to choose, you should not go automatically for the higher yielder if it had worse numbers that increase risk, such as much higher gearing for example. In such a situation, some yield may well be sacrificed in return for a much lower risk as indicated by the fundies.
The time when you would go for the higher yielder is where there is little to choose between the shares on the other selection criteria which are important to you, gearing or cap perhaps. But that is not going to happen too often. In most cases the other fundamentals, especially those which matter most to HYPers, are sufficiently differentiated between same sector shares to influence selection.
History's quality lesson
The other reason I don't like the idea of quality is the sheer evidence against it from history.
The market is littered with former quality shares gone wrong. This is something that the inexperienced may not realise but the fact is that when you have been around long enough, it is clear that too many shares purchased with quality in mind simply fail.
My favourite example is Rolls Royce because even now its very name is used to indicate quality as a generic term. For all its supposed quality, it went bust around forty years ago and the present company of that name is a different entity. But don't think that is an isolated case, it is not.
The future is far more unknowable than naive investors realise. It is these players who have the greatest belief in "quality" because they lack the experience of having seen it destroyed so many times. It's a psych. thing, comforting for a beginner to feel they are holding a quality share over a lesser one. But it is not within the powers of a typical HYPer to divine where success or failure may lie. That is beginner thinking.
All you know is that a share looks a decent purchase on the current and very near future fundamentals. After that it is 'Strategic Ignorance' and any assumptions about quality will not improve selection. They may actually worsen it if you believe in reversion to the mean so that quality shares might gradually get poorer over time.
So Tesco or Sainsbury? My choice is the latter because it has a higher yield and much lower gearing, therefore lower risk in my view. So it is doubly better than Tesco. Yet some on the discussion board think Tesco is better because of its perceived higher quality, even to the extent of choosing it over the currently higher yielding, lower risk Sainsbury.
The truth is we don't know which will be the better income share to hold forever. Things change a lot in the long run. But I don't believe that ascribing quality to the decision, so much so to the extent that it is allowed to over ride the fundies, improves selection.
I'd rather believe it doesn't exist at all.
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