VALUE INVESTING
How To Pick A High Yield Portfolio

By Stephen Bland (TMFPyad)
March 4, 2005

My Value Investor newsletter actually features two different share strategies for readers in every issue, thereby delivering a lot more than just the one style indicated by its title. A two for the price of one deal.

The first strategy is that of trading value shares short term and the second is the high yield portfolio (HYP) for long-term investors. Despite the fact that the shares are chosen for income, the HYP strategy is very suitable for both income investors needing to withdraw the dividends and growth investors reinvesting them. Investors can switch between the two without cost, risk or difficulty. This makes the HYP suitable as a long-term savings concept in which dividends are reinvested during the accumulation period and then withdrawn when income is required, just like a pension plan. But a pension plan that is all yours without the onerous limitations and  risks of an insurance company scheme.

This article takes a look at the selection principles behind HYP shares, thus complementing my articles over the last couple of weeks on the selection of value trading shares. First though why do I feature the HYP strategy at all?

Well, because I believe it to be an outstanding market beating performer over time and because not all investors are comfortable with the riskier short-term trading approach of value shares. Many will prefer the low risk style of the HYP, a style which does not require frequent monitoring and involves almost no trading at all. Once you have constructed your portfolio there really is very little to do.

The most critical feature of HYP share selection is sector diversification in order to spread the risks around different industries. Although a higher yield could be obtained by concentrating on certain sectors like utilities for example, the risks to the capital and income would be too high. Diversification is fairly obvious to any portfolio investor but the next bit is my own.

I follow the concept of what I call 'strategic ignorance'. This means that I do not take the slightest notice of any perceived long-term trends that some consider important in share selection. This applies to the macro picture of the economy, the sector and the micro situation of the share itself. Despite the fact that the share is intended to be held for many years, I studiously ignore anything which tries to inform me of its long-term future. My reasons are that nobody knows and that those who think they know, know even less. Attempts to forecast the future are worse than useless because they may well lead you into inferior selection decisions than those made by accepting that you don't know. Strategic ignorance however actually capitalises on the acceptance of not knowing. I believe that long-term shares chosen on the basis of some kind of futurising will tend to do worse than those picked using strategic ignorance, such is the fallibility of long-term forecasting.

Bearing the above things in mind, the selection process is then fairly simple. Rank the FTSE100 or maybe the 350 shares by descending yield then work your way down, picking a share from each sector. Then do a quick check on the share to make sure that at least in the very near future the yield appears sustainable, preferably rising. If so, then go for it. Ideally you want very low borrowings, high cover and so on but almost certainly you will have to give up on a lot of that for the sake of essential sector diversification. This process of using the index ranked by descending yield automatically finds the largest cap highest yielders at that time.

The first few shares will be fairly easy. You'll get banks, utilities, insurers and so on. After a time though you will have exhausted the major sectors and will have to look much harder and accept somewhat lower yielders. Recent choices of mine for the Value Investor HYP for example have included companies like De La Rue (LSE: DLAR), Exel (LSE: EXL) and William Hill (LSE: WMH) which are not in major sectors and have lower yields than my earlier selections like Lloyds TSB (LSE: LLOY) or United Utilities (LSE: UU.). Where I have to accept lower yielders for the sake of diversification, I try to trade off by finding shares that are likely to deliver good dividend growth at an increased rate over the higher yielders already in the portfolio.

One thing to remember is that a high yield share selection is valid only at the time it is made. That doesn't mean that it still won't be a suitable choice months later but it does mean that there no certainty about it. Lloyds for example is still the highest yielding major bank although I selected it for the Value Investor HYP in July 2004. It has performed pretty well, up around 26% including dividends but remains an HYP favourite. In general many HYP shares can remain as such for quite a time but investors cannot assume this, meaning that the selection procedure I outline above should be recommenced whenever there is an appreciable time difference between buying shares.

And that's really it for choosing HYP shares. A simple but highly effective long-term hold strategy, a cousin of value but one with very low costs, requiring minimal maintenance and suitable for both income and growth investors. My experience too is that HYPs carry similar or lower risks to the market whilst outperforming it over time, the best of both worlds.

That's why I chose it for my second strategy in Value Investor. Click here to find out more and take a free 30-day trial.

Stephen owns shares in Lloyds TSB and United Utilities.