VALUE INVESTING
Attractive High Yield Shares

By Stephen Bland (TMFPyad)
April 4, 2003

I thought it might be interesting to have a look at what a new high yield portfolio (HYP) might look like if I were setting up another one today. For reasons of utter indolence bordering on catalepsy, I am not going to monitor this as I do the first one. It is just an exercise to investigate which shares I would select for a new list, in light of the large fall in the market since the first portfolio was chosen over two years ago.

I guess the first thing to consider when creating a new list is whether my original selection criteria remain valid or alternatively, should I set different rules now? Two and a third years is of course too short a time in the life of a very long-term portfolio to draw any final conclusions as to its efficacy but it is the only evidence I have upon which to judge the quality of my original ideas.

In capital terms, that portfolio has had a very severe test with the market falling around 40%. But it has come through fairly well in falling only about 17% as my latest review last week showed. It has done better still on an income reinvested comparison. However, it has not so far achieved its primary objective of increasing income by more than inflation, with two shares in particular being almost wholly to blame, namely Britannic (LSE: BRT) and Royal & SunAlliance (LSE: RSA).

Could I have avoided these two by having used different selection criteria and personal prejudices and can I avoid a similar problem with a new portfolio? Don't know and don't know are the answers. It is easy to say with hindsight that I should not have picked these insurance shares. Had the market not collapsed then it is unlikely that they would have got into their present state and, in any case, two or three years is far too soon to know whether over the long term the portfolio income will achieve its inflation-beating objective. These two insurers may well go on to recover both income and capital in the long run.

Broadly then, I am happy with my original criteria so I am going to keep them and retain my prejudices, despite the less than happy experience so far with the above two shares. The main features are large-cap, igher yielding shares with a record of increasing dividends in the last few years. Ideally, modest debt is highly desirable but in many cases this is just not available if the critically important sector spread is to be achieved.

Here is the new list of fifteen, ranked by forecast yield:

                                 Price(p)   Sector          Yield(%)

Lloyds TSB (LSE: LLOY)              335      bank            10.3
Scottish & Newcastle (LSE: SCTN)    345      brewery          8.8
Dixons (LSE: DXNS)                   86      elect. retail    8.1
United Utilities (LSE: UU.)         609      utility          8.0
Hays (LSE: HAS)                      77      outsourcing      7.0
Legal & General (LSE: LGEN)          74      life ins.        6.7
BA Tobacco (LSE: BATS)              575      tobacco          6.7
Bradford & Bingley (LSE: BB.)       294      mort. bank       5.7
Hanson (LSE: HNS)                   317      build. materials 5.4
Land Securities (LSE: LAND)         729      property         5.1
The BOC Group (LSE: BOC)            788      indust. gases    5.0
BAA (LSE: BAA)                      461      airports         4.4
Shell (LSE: SHEL)                   390      oil              4.1
AMVESCAP (LSE: AVZ)                 308      fund manager     3.9
Anglo American (LSE: AAL)           961      mining           3.6

Average                                                       6.2

Note the handsome forecast starting yield compared with, well, anything you like such as cash, gilts, annuities, rents, historical equity yields or whatever. It is very attractive, though you have to look at the relative risks to both income and capital in such a comparison of course. Looking at historical equity yields, the income for year one on my first portfolio was 4.6%, definitely high for the time although the bear market has driven up yields since. Anyone considering becoming an HYP investor now is looking at a very rare and exceptionally desirable situation in my opinion.

Shares common to both the original and the new portfolios are Lloyds TSB, Scottish & Newcastle, United Utilities, Land Securities, Shell and Anglo American. So only six from the original fifteen still qualify. The reasons why the other nine have changed are varied. Primarily, it is because the yield rankings of what I see as the qualifying companies in the market for an eternity HYP have changed a lot. Some original shares no longer qualify at all due to a failure to increase dividends.

The four share bias towards financials remains with two banks, a life insurer and a fund manager. Previously I had two banks and two insurers. The banks consist of a general bank and a mortgage bank as before. The mortgage lender, Bradford, replaces Alliance & Leicester (LSE: AL.) because the yield on Bradford is higher. AMVESCAP I see as a good long-term hold income share at the current low price, which is depressed because of its business. Its share price will tend to follow the market.

The bias towards mining also remains but to a lesser extent. There are two shares from the sector instead of the previous three. I have dropped Rio Tinto (LSE: RIO).

I still have my one tobacco share but now it's British American because Gallaher's (LSE: GLH) yield has dropped considerably as its price has risen.

There are two completely new sectors as represented by Hays, a company involved mainly in providing outsourcing services to other businesses, and Hanson, a building materials supplier. Against that the hotels have gone.

Note that as with my original portfolio, this is just a demonstration of the general high yield portfolio idea as I see it today. It is not a recommended list of shares and is highly coloured by my personal views of the long-term future. Investors should make up their own minds. As I've often said, any long term no-dabble portfolio is built essentially on faith because there is no way of predicting what will happen to the dividends or capital value of any individual company over many years. The real idea is the belief that a portfolio of high yield large caps, collectively, will over time do very well on both income and capital but within this there will inevitably be wild swings of individual share income and capital behaviour. You have to able to live with that.

More: The High Yield Portfolio discussion board

The author owns shares in Lloyds TSB and Royal & SunAlliance