VALUE INVESTING
Four Years Of Beating The Market

By Stephen Bland (TMFPyad)
November 19, 2004

My first high yield portfolio (HYP) passed its fourth anniversary on 13 November. Here are the figures.

HYP1 start date 13 November 2000 

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

Un. Util. (LSE: UU.)         5000   620    807    547  4414  -11.7
Gallaher (LSE: GLH)          5000   416   1190    713  8484  +69.7
Scot. & New. (LSE: SCTN)     5000   490   1010    416  4201  -16.0
Royal & Sun (LSE: RSA)       5000   393   1271     74   940  –81.2
All. & Leic. (LSE: AL.)      5000   645    768    872  6697  +33.9
Britannic (LSE: BRT)         5000  1020    485    392  1901  –62.0
Lloyds TSB (LSE: LLOY)       5000   705    702    434  3047  -39.1
Intercon. Hotel (LSE: IHG)   2500   380    658    679  4468  +78.7
Mitchells & But (LSE: MAB)   2500   356    691    291  2010  -19.6
Boots (LSE: BOOT)            5000   575    861    664  5717  +14.3
Land Sec. (LSE: LAND)        5000   771    651   1202  7825  +56.5
Ass. Br. Ports (LSE: ABP)    5000   321   1542    466  7185  +43.7
Hilton (LSE: HG.)            5000   232   2275    276  6279  +25.6
Rio Tinto (LSE: RIO)         5000  1120    442   1529  6758  +35.2
Anglo American (LSE: AAL)    5000   942    526   1274  6701  +34.0
Shell (LSE: SHEL)            5000   572    865    442  3823  -23.5

Totals                      75000                     80450   +7.3
FTSE100                    6274.8                    4793.9  -23.6 

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
           13/11/04 £3,205                   4.3

Because yield is the focus of this strategy, I'll go into this aspect first and it has been a little disappointing so far.

At £3,205, the income for the fourth year is only a tiny fraction up on the third and remains slightly below the year one base figure of £3,451. One of my original aims for the portfolio was to deliver an inflation-beating income over time and this has not occurred to date. However, this is a very long-term strategy and it will only be by comparing, say, ten-year returns at least that I will be able to conclude whether it has worked as an inflation-beating income provider.

There are some encouraging aspects to the income though. The principal feature is that the income has been fairly consistent so far considering that it is drawn from risk investments. The reason for this low volatility of annual income is the sector diversification approach that is so crucial a part of the whole HYP strategy. This is demonstrated strongly by the fact that, despite there having been some substantial fluctuations in individual company dividend payments over the four years, the total income has remained relatively stable. In general, it is very likely that HYP income is actually a lot less volatile than the highly fluctuating interest rates that have characterised deposit accounts over the long term.

The main culprits of the slightly falling income performance over the four years were Royal and Britannic. Both of these cut their dividends drastically over the period, with Britannic suspending them altogether for a time. Several other companies made lesser cuts. Although there have been very attractive dividend rises in the portfolio over the four years, these were not quite enough to counteract the falls, though they went a long way towards it which is the diversification at work.

The highest dividends in year four were from Gallaher at £359, United Utilities at £358 and Alliance & Leicester at £348. The lowest were Royal at £58, Britannic at £75 and Shell at £138.

It seems possible that year four may mark a turning point in the income because most of the bad news on dividend cuts appears to be over. Although forecasting is always chancy, at this early stage year five looks set to show a good increase in the portfolio income. Britannic for example has resumed payments, whilst several other companies that cut in the past should recommence increasing their payouts. No guarantees of course, we'll see in a year.

The capital performance has been outstanding, way over the market, whilst delivering a higher income. As the table shows, the portfolio capital value at £80,450 has gained 7.3% in four years and I estimate the reinvested income value to be about £94,261, a 25.7% gain. These figures are equivalent to annual returns of about 1.8% and 5.9% respectively. Thus tracker funds have been beaten on capital alone but once income is reinvested, which is the way these funds are measured, HYP1 leaves them behind even more because its yield has been much higher.

Another way of looking at it is if £1,000 were invested in the index four years ago, it would now be worth £764 and in HYP1 £1,073, an outperformance of 40% and that is with income withdrawn. The outperformance against trackers on a reinvested basis would be nearer 50%.

The other main comparison I like to use is cash and here too it compares favourably. On capital alone, a deposit account cannot increase whilst the HYP has gained 7.3%. With income reinvested, the 5.9% annual return of the portfolio must have beaten cash over the last four years because interest rates have been less than that. Note too that interest is taxed at the investor's marginal rate of up to 40% whilst dividend income is tax-free to basic-rate payers and costs 25% to higher-rate payers. Thus after-tax comparisons of the HYP with cash are improved quite a bit over the pre-tax.

And has this great outperformance against the market been achieved by taking higher risks? Definitely not. Depending upon how you analyse it, HYP1 has fluctuated similar to or slightly less than the index. It is therefore no more, and probably less, risky than a tracker. Thus on a risk-adjusted basis (where rewards are compared with the risks being run), HYP1 comes out even more ahead of trackers than the raw performance data indicates because it has produced much higher returns for a similar or lower risk. This risk-adjusted way of making comparisons is something few small investors ever consider yet it does matter quite a lot when looking at alternative strategies.

My regular updates over the four years show that at its worst, HYP1 fell to 77% of its start value. This occurred in January 2003. Contrast this with the index which at its worst fell to 56% of its start value, also at that date. So far then this is to be expected of an HYP, that it is more resilient in a bear market. But then HYP1 has now recovered to 107% of its start value whilst the market has recovered to only about 76% of that. And all the time yielding an income of over 4% against the index which yielded only about 2%.

Four years is not enough against the eternity for which this portfolio is designed to draw permanent inferences about capital performance, but it sure has done good so far.

In conclusion, I'd say that it needs to do a little better on income to get up to my original expectations. The income has been fairly stable, considering it is derived from risk sources but I want to see some decent increases in future years so as to at least match and preferably beat inflation which was my aim. Given the reasonable stability of the income, I remain firmly of the opinion that this is an excellent approach for income investors compared with the many alternatives, provided they can accept the risks of equities. And I believe those risks to income to be far less than many might suppose, the data so far supporting my view.

On capital, this has been outstanding against the market. Especially for growth investors reinvesting income, nothing here alters my opinion that that this is a very superior strategy to tracker funds, with not much more than the same very low level of indolence required to manage the investment.

Want to join Stephen and beat the market with a high yield portfolio? Check out his Value Investor newletter. Each month, Stephen provides subscribers with a high yield candidate to help them build a portfolio similar to the one above. To enjoy a free no-obligation trial of Value Investor, and gain access to past editions, click here.