VALUE INVESTING
Happy 3rd Birthday To The High Yield Portfolio

By Stephen Bland (TMFPyad)
November 21, 2003

On November 13, my first High Yield Portfolio (HYP) had its third birthday. So it's time to review the income for the third year and see how it compares with the previous two. At this point, I would like to thank our reader Gengulphus who monitors my portfolios in far greater detail than I could ever manage.

Regular readers will recall that my primary aim for the HYP strategy is to hold the portfolio for eternity as a minimum, with no changes other than mandatory ones (such as takeovers for example) and to try and achieve a growing dividend income ahead of inflation. The secondary aim is capital growth that at least maintains its real value.

Here are the capital figures as at the third anniversary.

HYP1 start date 13 November 2000 

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

Un. Util. (LSE: UU.) 1       5000   620   807    484  3906  -21.9 
Gallaher (LSE: GLH)          5000   416  1190    609  7247  +44.9
Scot. & New. (LSE: SCTN)     5000   490  1010    359  3626  -27.5
Royal & Sun (LSE: RSA) 2     5000   393  1271     89  1131  –77.4
All. & Leic. (LSE: AL.)      5000   645   768    894  6865  +37.3 
Britannic (LSE: BRT)         5000  1020   485    276  1338  –73.8 
Lloyds TSB (LSE: LLOY)       5000   705   702    408  2864  -42.7 
Intercon. Hotel (LSE: IHG) 3 2500   380   658    532  3500  +40.0
Mitchells & But (LSE: MAB) 3 2500   356   702    231  1621  -35.2
Boots (LSE: BOOT)            5000   575   861    724  6233  +15.0 
Land Sec. (LSE: LAND) 4      5000   771   651    928  6041  +20.8 
Ass. Br. Ports (LSE: ABP)    5000   321  1542    432  6661  +33.2 
Hilton (LSE: HG.) 5          5000   232  2275    207  4709   -5.8 
Rio Tinto (LSE: RIO)         5000  1120   442   1472  6506  +30.1 
Anglo American (LSE: AAL)    5000   942   526   1271  6685  +33.7 
Shell (LSE: SHEL)            5000   572   865    375  3244  -35.1 

Totals                      75000                    72177   -3.8 
FTSE 100                   6274.8                   4371.2  -30.3 

Income                             Yield on capital invested %

Year ended 13/11/01 £3,451                    4.6
           13/11/02 £3,474                    4.6
           13/11/03 £3,197                    4.3

Notes

1 United Utilities cost per share and total holding amended due to rights issue.

2 Royal & Sun cost per share and total holding amended due to rights issue.

3 Intercontinental Hotels and Mitchells & Butlers were acquired as a result of 
  the division of the former Six Continents holding into these two new shares.

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

5 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.

The total income for year three was £3,197, a fall of £277 or a drop of 8% on year two. A disappointing income outcome. It is of course early days, three years against eternity, but that does not change the facts. It demonstrates that dividend income is volatile and that an investor utilising the approach to generate income for living expenses must allow a margin to cover such fluctuation. Note that to maintain the real value of the income against the £3,451 of year one, the income for year three would need to be about £3,625 so we are £428 short of that.

While there were some worthwhile rises amongst the dividends such as AB Ports, Alliance & Leicester, Gallaher and Land Securities, they could not defeat the two principal culprits for the overall fall, Britannic and Royal & Sun. The former cut its dividends entirely while Royal's is a small fraction of previous years.

The capital value of the portfolio excluding dividends has put in a great performance compared with the market, down about 4% against the latter's 30%. And taking that other important benchmark, cash, a fall of 4% is only slightly below the nil return that cash would have shown.

Looking at the capital situation for those reinvesting dividends the total income to date is £10,122. My rough calculation, done by taking this total and assuming it would have performed at half the rate of the portfolio, gives a total valuation including reinvested dividends of some £82,106. This is a gain of about 9.5% on the start capital of £75,000 and, although a little worse than cash, the increase compares very favourably with most equity income unit trusts while trackers are nowhere in sight. My view remains very strongly that an HYP strategy with reinvested income will beat the market by a large margin. Consequently, it's an excellent alternative to trackers or income funds for those savers with sufficiently large lump sums who wish to be in equities. The disappointing income figure for this year does not change my view on this in any way.

There were a surprisingly large number of enforced capital changes during the year. United Utilities and Royal both made rights issues and the former Six Continents split into two new shares – Intercontinental Hotels and Mitchells & Butlers. This sort of thing is bound to happen on occasion, whether the eternity shareholder likes it or not. The number of such events, I make it five over the three years on an original portfolio of fifteen shares, is higher than I would expect. Although the portfolio is strictly no-dabble, decisions have often to be made upon the occurrence of these changes, particularly upon a cash takeover when a new share has to be selected.

In fact, the portfolio's income would have been a lot higher if the special situations where cash is realised by some holdings following reorganisations was treated as income rather than being reinvested as capital. In previous years, we had Land Securities making such a special payment and this year the above rights and splits all produced cash amounts. My rule has been to reinvest such cash in the same share where these special payments would otherwise produce a reduced shareholding. In practice, a strict no-dabble disinterested HYPer would probably just draw the cash. Such treatment would have increased the income substantially both last year and this year, but at the expense of the capital.

What of the future? Well, for year four, one dividend cut has already been announced, Scottish & Newcastle. Also, the split of Six Continents into Intercontinental and Mitchells will likely produce lower dividends from the two new companies compared with the single old one. Against those known falls, Britannic has indicated that dividends may be resumed. Other than that we do not know very much and there is little point in speculating because I do not trade the shares. What happens, happens but I trust in Mammon.

As for the long term future, which is what this particular story is really all about, I remain convinced that HYPs will continue to be a very attractive strategy for investors seeking a capital growth approach, reinvesting income to produce high returns compared with the market and with the fund alternatives. Nothing so far indicates that I may be wrong here. For investors needing to draw the income, then they must accept the volatility inherent in share dividends and plan accordingly.

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The writer owns shares in Lloyds TSB.