VALUE INVESTING
Is Big Beautiful?

By Stephen Bland (TMFPyad)
September 2, 2005

My title this week refers specifically to the shares selected for high yield portfolios (HYP) I feature in Value Investor, and as I started on the public Motley Fool with my first eternity portfolio back in November 2000. For these portfolios, I have always concentrated on the largest possible capitalisation shares that met my requirements because as far as I am concerned, big is definitely beautiful for HYP selections.

The question has been raised more than once as to whether a small cap HYP might not be a better performer long term than one comprised of the sort of market leaders that I advocate. Clearly you can't know the future for sure but I believe that big caps are more likely to maintain dividends than small caps and more likely in general to actually be around in the long run. Simply put, given that an HYP might consist typically of around 15-20 shares, then a portfolio comprising big caps is probably less risky than one of small caps, both on income and capital.

I've always promoted the HYP strategy as being low risk by equity standards, entirely suitable for widows and orphans as well as those with living spouses and parents. By going small cap, my view is that this low risk would be prejudiced yet I doubt that there would be any trade off in the form of increased capital and income performance. And if there is no such trade off, or only an inadequate one, then there can be no justification for the small cap route into HYPs.

Many investors believe that in general small caps do deliver better performance over time. The usual explanation given is that because they start from a small base such shares can grow far more rapidly than the biggest caps in the market. As a vague generalisation, it may well be true that company with a cap of £50m has in theory the potential to grow much faster than one of £5bn. But such comments apply only across a large number of small caps. In practice only a very limited number of them will do the business on income and capital over time.

Picking a small group for an HYP, though they will have been filtered by the investor to locate those with the decent yields and safety features etc., is unlikely to deliver a higher start yield or a more rapidly growing one than a big cap HYP. Thus the trade off sought by the investor going for small caps can arise only in the expected capital outperformance over time. But how likely is it that a sufficient number of the small caps which are going to deliver this outperformance, chosen from the large number out there, have found their way into your HYP?

HYP big cap classics Lloyds TSB (LSE: LLOY) and United Utilities (LSE: UU.) are the top two yields in the FTSE100, forecast to deliver around 7.5% and 6.9%. These are both in my Value Investor HYPs. With shares like that I don't see much need to build an HYP from smaller caps with more risk and with a very uncertain trade off in greater performance.

And it's not just the above top two large cap yielders. The average forecast yield of the top ten shares in the FTSE100 is 5.7%. Pretty good in my view compared with cash or the market average yield of about 3%.

James O'Shaugnessy in his book What Works On Wall Street found that in over 40 years worth of testing a number of mechanical ratio strategies, high yield was an outstanding indicator of great performance. But in particular this was the case with what he calls market leaders, far more than selecting high yielders from all shares. In his findings, high yield as a works much better with the largest caps than with other shares.

Apart from such evidence, my gut tells me that big caps are better than small caps for the HYP approach so I don't advocate a small cap portfolio. I don't believe a small cap HYP will necessarily do better than a large one, plus it offers more risk.

In any event, the principal reasoning behind the HYP idea is not to seek out capital growth as a deliberate policy, strategic ignorance should rule there. Instead investors should aim to buy as secure and rising an income as possible and let the capital take care of itself over time with the minimum of risk. And the least risky source of such income is the very large caps. And that is exactly what I do in the Value Investor HYPs. A policy which has produced very good returns averaging 16.4% so far from a low risk approach. You can sign up here for a free 30-day trial to find out more.

Stephen owns shares in Lloyds TSB and United Utilities. The Value Investor HYP return of 16.4% is measured as at 17 Aug 2005 and the average gain to date for all shares picked in the newsletter is 10%.