VALUE INVESTING
High Returns From High Yields

By Stephen Bland (TMFPyad)
April 8, 2005

In my monthly newsletter, Value Investor, the High Yield Portfolio (HYP) is one of the two strategies featured and which so far has been pretty successful. This follows on from the winning strategy of HYPs here on the Motley Fool website where I've been following two portfolios - HYP1, which I picked in 2000, and HYP2, which I  picked in 2003.

I completed recently the first Value Investor HYP and will shortly be commencing the second. The Value Investor HYPs allow trading unlike the two eternity portfolios featured in my column here. In fact, I recently made a trade in the first Value Investor HYP, at a small profit in order to dump a dividend cutter. I'll be replacing it with a higher yielder in next issue of the newsletter, which is out on April 15.

HYP2 passed its second anniversary on April 2. Here are the figures:

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

Lloyds TSB (LSE: LLOY)       5000  338  1479    476  7040  +40.8  506
Scot. & New. (LSE: SCTN)     5000  348  1436    459  6591  +31.8  297
Dixons (LSE: DXNS)           5000   87  5762    154  8873  +77.5  432
Un. Util. (LSE: UU.)         5000  546   915    634  5801  +16.0  409
Hays (LSE: HAS)              5000   78  6435    134  8623  +72.5  193
DX Services (LSE: DXS)          0    0   320    375  1200    -      0
Legal & Gen. (LSE: LGEN)     5000   75  6696    112  7500  +50.0  339
BA Tobacco (LSE: BATS)       5000  580   862    930  8017  +60.3  361
Brad. & Bing. (LSE: BB.)     5000  297  1685    310  5224   +4.5  288
Hanson (LSE: HNS)            5000  320  1563    498  7784  +55.7  271
Land Sec. (LSE: LAND)        5000  736   680   1289  8765  +75.3  256
The BOC Group (LSE: BOC)     5000  795   628   1014  6368  +27.4  251
BAA (LSE: BAA)               5000  465  1075    586  6300  +26.0  218
Shell (LSE: SHEL)            5000  394  1271    475  6037  +20.7  215
AMVESCAP (LSE: AVZ)          5000  311  1609    338  5438   +8.8  121
Anglo American (LSE: AAL)    5000  970   516   1268  6543  +30.9  190

Totals                      75000                  106104  +41.5 4347
FTSE100                    3753.4                  4914.0  +30.9 

Income                         Yield on capital invested %

Year 1           £4,564                   6.1
     2           £4,347                   5.8

Because yield is the focus of this strategy, I'll go into this aspect first and it has been a little disappointing. At £4,347, the income for the second year is down a bit over the year one base figure of £4,564. However this is a very long term strategy so that two years' data is nowhere near sufficient to establish the income trend. It will only be by comparing many years income that I will be able to conclude whether the portfolio has succeeded as an inflation-beating income provider. In general, the income from properly constructed HYPs should be pretty stable so that any reduction in a given year is likely to be very modest, whilst on the other hand over a long period there is a much greater likelihood of growth.

The culprits of the slight fall were Hays, Scottish & Newcastle and AMVESCAP all of which cut their dividend substantially. All the rest increased their payout bar Lloyds TSB which held it. Although there have been some decent rises, these were not quite enough to counteract the falls though they went a long way towards it which is benefit of the diversification at work.

Possibly in return for its dividend cut, Hays demerged a new share in the portfolio, DX Services, so the total value of HYP2 is £1,200 higher as a result of this. DX will be paying dividends in the next portfolio year which ameliorates the effect of the Hays cut as well as boosting capital value.

The highest three dividends were from Lloyds TSB, at £506, Dixons, £432 and United Utilities, £409. The lowest were AMVESCAP, at £121, Anglo-American, £190 and Hays, £193. Oddly, king of the dividend slashers, Hays, is one of the best capital performers in the portfolio, up 72.5%.

The capital performance has been excellent, beating the FTSE 100 whilst delivering a very much higher income all the time. As the table shows, the portfolio value of £106,104 has gained 41.5% in two years against the index up 30.9%.

Put another way, an HYP2 income investor would be 8.1% better off than the FTSE 100 in capital terms whilst having derived an income of around 6% per annum against the market's far lower yield of about 4% on the start capital. Put yet another way, the annual growth of HYP2 excluding income was 18.9% against the FTSE 100's 14.4% whilst delivering a 50% greater income into the bargain.

For growth investors reinvesting income, I estimate the value would be about £116,793, a 55.7% gain equivalent to an annual 24.8%. This figure would have outpaced the FTSE 100 and a tracker fund following this index by even more than the above pure capital growth figures because of the much higher yield reinvested.

It's very early days with the Value Investor HYP but even in the short time I've been following the strategy there, the first portfolio has done the business so far, just as HYP1 and 2 on the Motley Fool have done.

The other main comparison I like to use is cash and without needing to look at deposit interest rates it is obvious that HYP2 performance has dwarfed any possible cash returns.

My overall verdict is that this strategy so far is highly successful and I have no reason to change my views on HYPs, taking account of both this review and the four year anniversary of HYP1 last November. If anything, now that we have a few years results in for two portfolios, my convictions are even stronger than when I launched the idea here back in 2000 with HYP1. The real test as I've always said will be the very long term one and nobody knows how that will turn out either on income or capital. That is a question of faith as with any long-term risk investment. But nothing so far has served to alter my opinions on the HYP strategy for the long run.

The only thing missing that I want to see is inflation beating growth of income and that has yet to appear. Note though that investors have been compensated for the lack of income growth by the outstanding capital performance so far in both portfolios. Due to inevitable equity dividend fluctuations we really need say ten years income figures to form any kind of meaningful opinion on income performance. Recent years have been particularly tough ones for share dividends with a large number of major companies cutting their payouts. I believe that time, now probably past us, to have been an exceptionally poor and untypical period for dividends and not representative of the long term trend.

I continue to maintain that HYPs will prove the most successful strategy of all for the majority of private investors, both income and growth seekers, which I believe will beat other equity investments like trackers, most other funds and also most other individual share approaches too in the long run. Building on this idea, in Value Investor I construct HYPs for readers with one new share a month and take advantage of any suitable trading opportunities which occasionally crop up with the HYP shares too. Sign up for details of how you can get a free 30-day trial.