VALUE INVESTING
You Can't Beat A Good Yield

By Stephen Bland (TMFPyad)
July 16, 2004

A couple of days ago, Maynard wrote an article entitled 'Proof That High Yield Works'. I've known this for decades and there are several books on the subject but if the article helped convince those, perhaps newcomers to investing, who have not heard of this idea before then so much the better. To avoid any misunderstanding, by the term "work" in this context we mean that the strategy beats the market in general on total return. In practice, for the private investor this means beating tracker funds.

To get one criticism out of the way, many attack a strategy that appears repeatedly to work on the grounds that if it was so good, everyone would do it and thus it would become arbitraged out. Well yes, if everyone did it that would happen. But the point is that everyone doesn't do it. I would guess that only a small minority of investors follow a long term high yield strategy, either by setting up the kind of High Yield Portfolios I have demonstrated here on TMF and in my Value Investor newsletter, or for funds players by investing in selected equity income funds rather than trackers. Few investors in practice can be bothered to follow very long-term share strategies, they are not sexy because they don't carry the chance of short term big profits. The latter is what attracts a lot of small investors to shares in the first place, but most of them end up losing.

Why does high yield equity investing work long term?

Two main reasons in my opinion. The first is that by delivering a yield substantially above the index, then, in the theoretical "other things being equal" world, the total return must be better on high yield shares than on the market.

Secondly, high yield is a value indicator. Often but not always, shares on higher yields are not in terminal decline or about to slash their dividends as some might suppose, but only temporarily depressed by some short-term corporate or general economic news for example. Anyone buying for the long term may in consequence be buying many such shares at an advantageously low price compared with their long-term trend.

Taking the first point, in practice other things are never equal of course, because the underlying capital performance of an high yield portfolio will not be the same as the market. The total return will be better on high yield shares if the underlying capital performance is the same as or a bit worse than it. But if the capital performance of high yield shares is sufficiently poor relative to the market, there can come a point where this cancels enough of the higher yield to give a lower total return. I don't see though that there is any fundamental reason why the capital performance of an high yield portfolio over long term should be any worse than the market. Remember, all it has to do to win is to be the same or even just a bit worse, the dividends will then deliver the outperforming part.

Looking at the second point, there is something in the frequently heard comment that high yield shares must be in some sort of difficulty. But only a little something. In practice some high yield shares will indeed cut their dividends and experience severe capital falls too, but in my experience this will be only a minority. By investing in a sector diversified portfolio of high yield shares the investor minimises this risk though it cannot be eliminated.

Don't forget also that the same though would go for any diversified portfolio of shares in general or an index. These are bound to contain some poor performers, both in capital and dividend terms. Just look at the history of the constituents of any index over long or short periods. If you are not experienced with this, you may be very surprised at the large spread between the movements of the best and worst performing shares.

The question therefore is not whether an high yield portfolio contains a number of poor performers, it will, but whether, relative to the whole portfolio, an high yield portfolio has a greater proportion than a general or index portfolio. Nothing I have observed over decades, or research by others I have read, suggests to me that high yield portfolios have proportionally more duff shares than general or index portfolios.

In fact, the reverse is true in my opinion. Because of the value characteristic of high yield, such portfolios may well contain fewer poor capital performers than a general or index portfolio. Consequently, the long term capital performance alone of an high yield portfolio, even if the income is withdrawn, will likely beat the market. If that holds true then, once you add in dividends to calculate a total return, you will find very strong outperformance against the market being the sum of both a higher capital and a higher income showing.

But as I said this HY strategy is for the ultra patient long-term investor. It is not a get rich quick idea, it is a get rich slowly idea. Well, compared to the market anyway.

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