VALUE INVESTING
Mini High Yield Investing

By Stephen Bland (TMFPyad)
October 21, 2005

A concept I've aired on more than one occasion in the past is the HYPLite. This is a (very) slimmed down version of my normal high yield portfolio (HYP). I would normally construct an HYP to contain around fifteen shares depending upon prevailing market conditions and the availability of suitable selections. The Lite version though is just a five share job.

Sector diversification, so critical for risk reduction in the full HYP, becomes even more so for a Lite. The money is being concentrated into only five shares so these really do need to be from completely different sectors.

There's no magic about the number five, any HYP with a severely reduced number of shares over the usual size could be called a Lite. I choose five because that is the absolute minimum number of shares I see as acceptable for anyone willing to take the higher risks of a much smaller HYP. I don't think it acceptable to have any fewer shares in the portfolio.

One point on this. I don't believe that HYPers at the stage of investing for income should go the Lite route. The risks are not worth it, even with the higher income trade off. I put the idea forward purely for those at the stage of accumulating capital by reinvesting dividends. Most of them will find the risks too high as well so I see this as apposite for only for a small number of people willing to take the chance of higher rewards with the increased risks.

The higher return comes in the form of increased income. By choosing a small number of the very highest yielders in the FTSE100, a yield well above the normal full HYP yield can be obtained. On the capital side though, there is no reason to believe that the Lite will perform any better, or worse, than the full HYP. However it will be more volatile and thus riskier by virtue of that fact alone.

Here are my selections. Yields are derived from consensus forecasts of the dividends payable in the next financial year of each company.

	Share price	Dividend yield
Lloyds (LSE: LLOY)	446p	7.7%
United Utilities (LSE: UU.)	622p	7.0%
DSGI (LSE: DSGI)	142p	5.9%
BT (LSE: BT.A)	212p	5.3%
Compass (LSE: CPG)	187p	5.2%
Average		6.2%

As usual with my HYP strategies, strategic ignorance rules. The less I know the more I know. Thus I have made no attempt to guess the distant future for these sectors or these shares. Imagining that I have the power to do so, or listening to those who think they do, weakens the strategy.

With my HYPs I like to find increasing dividends in the immediate future but am willing to sacrifice this very occasionally for a share displaying a super high yield which appears reasonably safe. This is the case with Lloyds, the highest yielder in the FTSE100, whose dividends have remained static for years. The other four shares all have increasing dividends forecast.

My average yield here of 6.2% is well over that which could be generated by a full HYP. The latter would be more like 5%. This yield premium is the whole point of the HYPLite. That is the only reason to go for it. Trading off the increased risk of holding a small number of shares for a higher income. For someone looking at decades to go before they switch the portfolio to drawing income, that yield differential makes a decent improvement.

For example:

£100 for 20 years at 5.0% becomes £265.

£100 for 20 years at 6.2% becomes £333

Over 30 years it works out at £432 and £608.

Very clearly though, there are far higher risks to both the income and capital with a Lite than a full HYP. If one share went bust, the effect on a fifteen-share portfolio would not be that great. On a five share though, it would be traumatic. Going bust is perhaps not that likely. What will certainly happen though from time to time with any HYP, whatever its size, are dividend cuts by a large number of leading companies which will drop the portfolio income for a period. We have just come through a round of that in recent years.

With a Lite there are not enough shares to achieve the compensating effects in a season of cut dividends. A full HYP won't usually suffer that much because it will contain sufficient shares that don't cut payouts, counteracting to some extent the divi slashers, with the result that total income may be down, but not by a large amount. But the Lite could easily find itself with all shares cutting their payouts substantially in the inevitable bad periods. This is why HYPers looking for income must not follow the Lite route but stick with the full monty.

Long-term savers though might find this approach interesting. It might produce a better total return long term than a full HYP, at the cost of increased risk. Which means that it could also produce a worse return.

Of the shares mentioned here, I hold BT, Lloyds and United Utilities.