VALUE INVESTING
Introducing the HYP Lite

By Stephen Bland (TMFPyad)
December 7, 2001

Following on from some recent discussion on the High Yield board about building up a long term portfolio in stages, where the investor did not have the money to buy all the shares at the outset, I thought it might be worth considering a "lite" version of my particular suggested High Yield Portfolio (HYP) to see if it had any merit. By this I mean a portfolio consisting of far less holdings than the fifteen comprising the original one.

I decided that five shares might be the absolute minimum that anyone would consider putting into HY shares for income purposes so I then went back to my original portfolio in November 2000 and selected the top five yielding shares from it, ensuring that no two were from the same sector so as to spread the risk, a far more crucially important point with only five shares than with fifteen. As luck would have it, the top five yielders were in fact from different sectors and these are the selections with the original forecast yields and price movements since:

                               Forecast         Price
                                  yield        change
                                      %             %
United Utilities (LSE: UU.)         6.9         -10.1
Gallaher (LSE: GLH)                 6.4          +9.9
Scottish & Newcastle (LSE: SCTN)    6.1          +5.1
Royal & Sun All. (LSE: RSA)         5.6         -22.1
Alliance & Leicester (LSE: AL.)     5.6         +22.5



Averages                            6.1          +1.1

The average forecast yield of 6.1% compares well with that on the whole fifteen share portfolio of 4.8%, so a useful improvement on income.

The capital performance of the five share group with a rise of about 1% is, very interestingly, almost exactly the same as the performance of the whole fifteen shares. Another interesting point on the capital side is that the five shares contain one of the best and one of the worst performers respectively from the fifteen, namely Alliance & Leicester and Royal & Sun but that is probably just down to luck.

So an investor in this five share HYP Lite would have had a higher income with a similar capital performance. I suspect though that the similar capital performances of both the Lite and full HYP portfolios are coincidental. One year is not much time in a portfolio that I suggest is held forever. In general I would expect the capital value of a five share version to be more volatile than the fifteen, which means in turn that as time progresses the value of the five could deviate considerably from the whole. Whether in practice it will be better, worse or about the same is impossible to say.

The primary objection to a five share HYP is of course the increased risk. Put it this way, with five shares, if one goes bust you have immediately lost 20% of your original investment. With fifteen and one goes down, you have lost only about 7%. Even if two go you are still down only some 13%. A fifteen share portfolio in the long run should easily produce growth that will take in its stride the total loss of one or two shares.

A similar situation prevails with the most important bit, the income. A dividend cut by a member of a five share HYP will clearly have a greater negative effect on the total income than the same in fifteen. Also, with fifteen, the chances are better that any cuts will be more than made up by increases in the others. Even if this does not happen in the same year as the cut, the recovery time to get back to income growth will likely be shorter with fifteen shares than with five.

Summing up then, I would say that a five share HYP carries excessive risk when compared with the fifteen share version. Minimising risk is a crucial feature of an HYP because the investor is depending on it for income and thus desires the maximum security commensurate with taking the decision to be in equities at all compared with the less riskier alternatives. That doesn't mean that you need a huge number of shares because the risk reduction available by increasing the number of holdings tails off once you get to around the fifteen or so that I suggest. But for those income investors prepared to accept the increased risks, a lite version may hold some attraction. However I don't advise this for any widows and orphans.