VALUE INVESTING
The Power Of Income Investing

By Stephen Bland (TMFPyad)
July 30, 2004

This is the latest two-monthly review of my high yield portfolios.

As always, let me stress that the primary aim of this strategy is growth of income not capital, although many people use the concept as a growth vehicle by reinvesting dividends which, in my view, is an excellent idea. Note that these are merely demonstration portfolios to illustrate a high yield approach with no dabbling. They are not a recommended set of shares, nor would I necessarily choose the same portfolios today. The strategy is intended for the very long term, eternity as a minimum, and it follows that short term fluctuations are of little importance.

It is worthwhile emphasising 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.

The portfolios should be considered in total as regards capital and income, as if they were funds but with the distinct advantage of no charges. Investors in HYPs should not pay much attention to individual share movements which can be dramatic.

Here are the latest figures. Cost includes all purchase expenses.

HYP1 start date 13 November 2000 

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

Un. Util. (LSE: UU.) 1       5000   620   807    514  4148  -17.0
Gallaher (LSE: GLH)          5000   416  1190    652  7759  +55.2
Scot. & New. (LSE: SCTN)     5000   490  1010    406  4101  -18.0
Royal & Sun (LSE: RSA) 2     5000   393  1271     77   979  –80.4
All. & Leic. (LSE: AL.)      5000   645   768    833  6397  +27.9
Britannic (LSE: BRT)         5000  1020   485    361  1751  –65.0
Lloyds TSB (LSE: LLOY)       5000   705   702    407  2857  -42.9
Intercon. Hotel (LSE: IHG) 3 2500   380   658    576  3790  +51.6
Mitchells & But(LSE: MAB) 3  2500   356   691    264  1824  -27.0
Boots (LSE: BOOT)            5000   575   861    670  5769  +15.4
Land Sec. (LSE: LAND) 4      5000   771   651   1123  7311  +46.2
Ass. Br. Ports (LSE: ABP)    5000   321  1542    401  6183  +23.7
Hilton (LSE: HG.) 5          5000   232  2275    256  5824  +16.5
Rio Tinto (LSE: RIO)         5000  1120   442   1359  6007  +20.1
Anglo American (LSE: AAL)    5000   942   526   1126  5923  +18.5
Shell (LSE: SHEL)            5000   572   865    390  3374  -32.5
                            -----                    -----
Totals                      75000                    73997   -1.3
FTSE100                    6274.8                   4356.2  -30.6 

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

United Util cost per share and total holding amended following rights issue.

Royal & Sun cost per share and total holding amended following rights issue.

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

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

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.


HYP2 start date 02 April 2003 

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

Lloyds TSB (LSE: LLOY)        5000  338  1479    407  6019  +20.4
Scot. & New. (LSE: SCTN)      5000  348  1436    406  5830  +16.6
Dixons (LSE: DXNS)            5000   87  5762    158  9104  +82.1
Un. Util. (LSE: UU.) 1        5000  546   915    514  4703   -5.9
Hays (LSE: HAS)               5000   78  6435    118  7593  +51.9
Legal & Gen. (LSE: LGEN)      5000   75  6696     96  6428  +28.6
BA Tobacco (LSE: BATS)        5000  580   862    822  7086  +41.7
Brad. & Bing. (LSE: BB.)      5000  297  1685    271  4566   -8.7
Hanson (LSE: HNS)             5000  320  1563    382  5971  +19.4
Land Sec. (LSE: LAND)         5000  736   680   1123  7636  +52.7
The BOC Group (LSE: BOC)      5000  795   628    917  5759  +15.2
BAA (LSE: BAA)                5000  465  1075    555  5966  +19.3
Shell (LSE: SHEL)             5000  394  1271    390  4957   -0.9
AMVESCAP (LSE: AVZ)           5000  311  1609    307  4940   -1.2
Anglo American (LSE: AAL)     5000  970   516   1126  5810  +16.2
                             -----                   -----
Totals                       75000                   92368  +23.2
FTSE100                     3753.4                  4356.2  +16.1 

Income                             Yield on capital invested %

Year ended 02/04/04    £4,564                   6.1

Notes

1 United Util. cost per share and total holding amended following rights issue.

HYP1

The estimated value including reinvested income would be about £86,170, an increase of 14.9% on the original investment in three years eight months. This is about in line with cash.

The portfolio capital is down 1.3% but remains substantially ahead of the market, which has fallen 30%. Comparison with trackers on a reinvested income basis would show it to be even more ahead because its yield of over 4% has always been higher than the market.

The familiar pattern of large individual movements continues with the unchanged losers Royal and Britannic, down about 80% and 65%, whilst the top gainers remain Gallaher and Intercontinental Hotels, up 55% and 52% respectively.

HYP2

The estimated value including reinvested income would be about £98,735, an increase of 31.6% on the original investment in about fifteen months. This is way ahead of cash.

The portfolio capital remains ahead of the market in its short life to date, up about 23% against a rise of 16% for the latter. Comparison with trackers on a reinvested income basis would show it to be even more ahead because of its 6% yield, that being very substantially over the market yield.

This portfolio also demonstrates large individual share fluctuations ranging from continuing winner Dixons, up 82%, whilst the largest loser remains Bradford, which is down 8%.

General Comment

Cash is an important target to beat over the long term, as these portfolios are designed for the long term. I would not be too pleased if they beat the market yet failed to beat cash. Equities, to justify investment in them, should deliver a handsome premium over cash over the long term, as compensation for the risks of holding them. Calculating on the reinvested income basis, HYP2 has so far done the business handsomely in this respect whilst HYP1 is about equal to cash.

If you look at the portfolios on an income withdrawn basis, as if a person was having to live on that income, then HYP2 delivered a far higher income of 6.1% in its first year than any deposit account. HYP1 paid out 4.3% last year which at the moment is below the highest deposit accounts. However because interest rates were lower before that and its dividends were a little higher, it was beating cash income for its first couple of years. But that's gross. Once you take tax into account the picture is more attractive because of the very advantageous situation of dividends compared with interest where basic rate payers derive the dividends tax free and higher rate payers are liable for 25%, compared with tax on interest of 20% and 40% respectively.

For those seeking a growth approach in order to accumulate capital long term, I believe this strategy will leave trackers behind. The early evidence, though too soon to draw any long term conclusions, is that it is doing just that. What makes it even more likely is the reinvestment of dividends. Because the HYP yields are so much higher than the market, the portfolios have an automatic advantage over trackers due to the compounding of those higher yields over long periods. The lack of regular charges in HYPs doesn't do any harm either.

Here's an example using HYP1. The original yield was 4.6% but in the third year this dropped to 4.3%. I'll use the lower figure to be conservative. Now the FTSE100 yield at the time this portfolio started was something over 2% but I'll use 2% because a tracker has charges. If £100 is invested for 20 years at 2% compounded the result is £149. But if it invested at 4.3% the result is £232 which is around 56% more. And that's just the effect of the relative yield advantage alone of this HYP over a tracker.

I cannot be certain what will happen to the relative capital values of the HYPs compared with trackers but so far they are winning on that too. If the situation of higher capital gains than trackers continues, then the portfolios for long term growth investors will have the invincible advantage over the market of beating it both on capital and income. Add these two winning factors together and the effect is in my opinion to make this possibly the greatest, and incidentally one of the simplest, long-term strategies around.

Given the lack of investor involvement required, indeed advised, and the similar long term timescales, this makes HYPs eminently suitable alternatives for those considering tracker funds in my opinion.

In my value newsletter I feature a long-term hold high yield selection each month to show readers how to construct an HYP by purchasing suitable shares at regular intervals. You can sign up for a free 30-day trial by clicking here.

Stephen holds shares in Alliance & Leicester, Lloyds, Mitchells & Butlers, Scottish & Newcastle and United Utilities.