VALUE INVESTING
The High Yield Portfolio Is Two

By Stephen Bland (TMFPyad)
November 15, 2002

My High Yield Portfolio (HYP) has just passed its second birthday and thus provides the first opportunity to compare the income year on year.

For any new readers I stress that the primary aim of the portfolio is growth of income not capital, although some people do use the concept as a growth vehicle by reinvesting dividends, which in my view is an excellent idea.

The original idea of the HYP was for income investors, to be held forever with no dabbling and to deliver a decent initial yield far higher than the FTSE100 index.  Currently the yield is well in excess of cash deposit rates as well. Crucially, though, the portfolio aims for inflation beating income growth over the long term for investors prepared to take the risks of equities. I believe that capital growth will go hand in hand with income growth, but as I say that is a secondary motive for this particular portfolio.

Here are the latest figures. The start date was 13 November 2000 and the cost includes all purchase expenses.

                                £ orig.  no.  price   val   move forec
                           invest price shs.    now   now    %   yield

Un. Util(LSE: UU.)           5000  690   718    603  4330  -13.4  8.0
Gallaher (LSE: GLH)          5000  416  1190    640  7616  +52.3  4.6
Scot. & New. (LSE: SCTN)     5000  490  1010    479  4838   -3.2  6.5
Royal & Sun (LSE: RSA)       5000  498   994    116  1153  –76.9 10.3
All. & Leic. (LSE: AL.)      5000  645   768    853  6551  +31.0  5.1
Britannic LSE: BRT)          5000 1020   485    270  1310  –73.8 11.6
Lloyds TSB (LSE: LLOY)       5000  705   702    530  3721  -25.6  7.0
Six Continents (LSE: SXC)    5000  723   685    508  3480  -30.4  7.2
Boots (LSE: BOOT)            5000  575   861    588  5063   +1.3  5.0
Land Sec. (LSE: LAND) Note 1 5000  771   651    736  4791   -4.2  5.0
Ass. Br. Ports (LSE ABP)     5000  321  1542    412  6353  +27.1  3.7
Hilton (LSE: HG.) Note 2     5000  232  2275    160  3640  -27.2  5.8
Rio Tinto (LSE: RIO)         5000 1120   442   1215  5370   +7.4  3.3
Anglo American (LSE: AAL)    5000  942   526    858  4513   -9.7  4.2
Shell (LSE: SHEL)            5000  572   865    399  3451  -31.0  3.9
Totals                      75000                   66180  -11.8  6.1
FTSE100                    6274.8                  4029.4  -35.8 

Note 1 - Hilton replaced Blue Circle which was taken over for cash at a profit over the £5,000 cost, the whole of the proceeds being reinvested. This is why the total original cost of Hilton derived from the above table is more than £5,000. The start investment of £5,000 has though been retained here so as to maintain the original cost of the portfolio at its true figure of £75,000, which has to be done in order to facilitate accurate measurement of capital value fluctuations.

Note 2 - Land Securities reorganised in September 2002 resulting in a cash payment which was used to purchase additional shares in the company.

The income in the first year to November 2001 was £3,451 making a yield on the £75,000 invested of 4.6%. The income in the second year to November 2002 was £3,474 making a yield of 4.6% on that original capital.

Note the highly attractive tax situation of dividend income compared with other types such as interest, rents or pension annuities. Dividends are tax free to a basic rate or lower taxpayer and liable to tax at only 25% on a higher rate payer.

I think the most important point to state is that in this second year the total dividend income was £3,474, an increase of only about 0.7% on the first year figure of £3,451 and representing a yield on the opening investment of £75,000 of 4.6%. With inflation of around 2-3% this means that the portfolio has failed to produce the desired inflation beating increase in its income. Early days of course in a portfolio designed to be held forever but disappointing nevertheless. The main reason for the low increase has been Royal & Sun with its serious dividend cut.

Considering the fall in the FTSE100 index of 35.8% over the two years, the capital of the HYP has held up quite well in falling by 11.8%. A diversified portfolio cannot totally escape the background market conditions but I think it proves the defensive nature of this idea admirably. In addition to this outperformance, an HYP investor would have received a much higher income than the index. At the time of inception the yield on the FTSE100 was only about 2% whereas the HYP yield was around 4.6%.

A truer comparison for the HYP than the FTSE100 would be with a tracker fund, being the only practical alternative for someone considering whether to invest in the general market or the HYP. I don't have the figures but the comparison would show the HYP to do even better against such a fund than the market and better still on an income reinvested basis.

Notice that the forecast start yield for an investor buying this portfolio now is 6.1%. However this includes the very high yields on Britannic and Royal which may be in some doubt, though Royal has already delivered a large cut in the year just ended. Also, Six Continents has announced a reorganisation for next year which will result in two new shares in place of the existing one, but the total dividends will initially be some 38% less than the present figure in a full year, though there will be a sizeable cash element as well which could be taken as special dividend income if desired.

My rule with reorganisations in the HYP is to reinvest any cash arising in the new shares but not every investor would necessarily wish to do so, preferring perhaps to boost their income in some cases. We had one such reorganisation in the year, Land Securities, and the cash element was reinvested. If a company paid a special dividend though, without reorganising, I would take this as income.

There continue to be massive individual swings in constituent share values ranging from very large falls of about 77% by Royal and 74% by Britannic to rises of 52% by Gallaher and 31% by Alliance & Leicester. Such variations are typical of a sector diversified portfolio and in fact illustrate why such diversification is critical for security reasons. Expect such large differences in individual values to continue for all time, though not the same ones. In total there are five rises and ten falls. I suggest that investors consider only the total value of the holdings rather than worry about individual fluctuations, exactly as if it were a managed fund, the difference being that you pay no charges.

Incidentally, whilst talking fund comparisons it is interesting to note that the HYP has not only left behind poorly performing trackers, which doesn't surprise me, but outperformed most other funds as well over its two year life. Whether that will continue over the very long period for which the HYP is designed cannot be known and it is far too early to draw any conclusions.

My suggested approach to the whole strategy, which I intended for the hands-off investor, is simply to forget about it once invested, don't follow the shares, don't listen to any comment, just enjoy the income. Perhaps take a peek at it once every decade or so if you feel you have to get involved in some way.

Finally, I would like to thank our reader Gengulphus on the HYP board who has taken a great interest in this idea, providing a lot of supporting information on performance and in far greater detail than that into which my genetic indolence would ever permit me to venture.

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