September 2007

THE SCENE: A beautiful couple – they might be models fresh from a home shopping catalogue photoshoot – relax in their sixth-floor two-bedroom, two-bathroom, new build apartment.

He is in the kitchen area, mixing up mojitos on the island unit. She is on the balcony, gazing across the city landscape (an out-of-focus backdrop of railway tracks, supermarket car parks and the back of the block next door). And unseen in these shiny advertisements is the Buy-To-Let (BTL) investor in the suburbs, tearing her hair out as she tries to make the maths work.

Welcome to the bursting edge of Britain’s housing bubble. Get out while you can.

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‘My dear Mr Clennam,’ returned Ferdinand, laughing, ‘have you really such a verdant hope? The next man who has as large a capacity and as genuine a taste for swindling, will succeed as well. Pardon me, but I think you really have no idea how the human bees will swarm to the beating of any old tin kettle; in that fact lies the complete manual of governing them. When they can be got to believe that the kettle is made of the precious metals, in that fact lies the whole power of men like our late lamented.
Ferdinand Barnacle (Little Dorrit, by Charles Dickens)

Last night Alastair Darling, the UK Chancellor, guaranteed 100% of savings in Northern Rock – and indeed the Financial Services Authority has since gone further, stating this guarantee extends to other troubled financial institutions that might emerge in coming days.

Given the scenes we’ve witnessed since Thursday’s news that Northern Rock required a lifeline from the Bank of England, many will think it’s a good move. And sure, the decision will probably quieten the recent financial upheavals. It will certainly get the government off the hook for now (and to be clear, I don’t believe the government was responsible for the problems in the first place).

But it is without precedent in the UK, and has potentially serious consequences that sound academic but which in extreme cases have previously led to unpleasant upheavals of the blood and barricades variety. What’s worse, the guarantee has for now come without any balancing regulation to ensure the banks do not abuse the facility for their own ends.

At the very least then, a move designed to bring short term confidence to the UK banking system will prove embarrassing for years to come, with consequences for all of us in Britain who save, borrow and spend. Everyone, in other words.

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As I write, people are queuing outside a major British lender, Northern Rock, to take all their money out. Only in Britain would a run on a bank see customers forming an orderly line from the back.

Reading comments in the press, it’s clearly something that many people never expected to see in their lifetimes. Certainly, frightened customers demanding their money from a bank they fear is going bust is a scene you’d more expect to see in black-and-white images from the 1930s rather than on the Six O’Clock News on a flatscreen TV. But that never meant it couldn’t happen.

Indeed, the belief that instability and crisis is something that only ever occurred in some unreal yesterday is exactly why financial markets turn in cycles (if you wait long enough) and crises repeat themselves (if you read back enough).

Is it blind panic to take your money out of Northern Rock? Not necessarily. Perhaps many Northern Rock savers are panicking, but taking your money out is also a perfectly rational choice.

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We’ve already considered the attractions of dividends and what makes a good individual high yield share. Part 3 now looks at how many different shares you need to get a squad of high yield shares fit for the long-term.

(For those who like spoilers: Part 4 will offer an illustrative portfolio assembled using real share data, Part 5 will look at buying your HYP with a lump sum versus regular savings, Part 6 at managing your HYP over the long-term, and finally (if all goes to plan!) Part 7 will touch on high yield investing in the US and other non-UK markets, and also look at some potential pitfalls to the high yield approach. Don’t miss out: subscribe for free via RSS).

So, how many and what kind of shares do you need to buy to graduate from making a few ‘punts on the market’ into owning a well-diversified portfolio of high yield shares?

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What’s the best use of a newly-arrived immigrant?

1. Whipping boy for nasty political opportunism?
2. Cheap painter and decorator?
3. Inspirational figure who can help you earn more, invest more and generally try harder to be who you want to be?

While I’ve nothing against tarting up your house, I vote for option three. Leaving aside the difficult political questions, I find it inspiring that someone will leave their home, family, friends and even their language behind in pursuit of a better life.

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A friend (let’s call him Peter, which is nicer than his real name) has bagged a pay rise from the BBC. Well done Peter.

(Incidentally, Peter’s job is to shepherd the flocks of so-called ‘runners’ you find clogging up TV and film sets. If you’re ever at such a media palaver, you can easily spot the runners: they’re the ones standing still. ‘Loiterers’, ‘texters’, or ’sullen coffee guzzlers’ would be more appropriate. That said, they’re young and paid bugger all, so we’ll let them off. Our warmongering ‘Defence Ministers’ are harder to forgive).

Peter is now thinking about buying a flat, afraid he’ll be the last person renting come the university reunion, and hankering for seagrass flooring. He’s also got an inheritance of around £40,000 to blow (my estimate – we are British, after all, and I reached my understanding of his financial position via a steady exchange of ‘ums’, ‘around’s, and frothy pints of Kronenburg).

Should Peter buy a flat, or continue renting?

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Part One of this series introduced how dividend payments from shares can produce a growing income stream with minimal effort on your part, and certainly no need to frenetically ‘play the markets’ like a demented monkey bashing the bongo drums. (Remember, study after study has proven most share traders fail to beat buy-and-forget tracker funds over the long-term).

Now we’ll consider in detail what makes a particular share an attractive candidate for a portfolio of high yield shares (known as a High Yield Portfolio or HYP). Part Three will outline how to assemble 15-20 such shares that complement each other by drawing their earnings from different industries, and thus avoid you having all your eggs in one basket. Part Four will demonstrate with real examples from the London stock market the construction of such a portfolio.

While we’re consider high yield shares in isolation below, keep in mind that holding only one high yield share (or several in the same sector, such as banking) is far too risky for our purposes: we’ll look at how to reduce the risks of picking a duff share below, but the greater protection comes from the portfolio approach explained in Part Three.

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“Buy! Buy! Buy!” shout the city folk in blue braces from one side of the trading pit. “Sell! Sell! Sell!” retort those with red neckties.

Whatever happened to “Wait! Wait! Wait!” wonders your writer?

These days sharetrading is conducted via computer – the trading is often done automatically according to decisions made by the computers themselves – and the drama of the buyers and the sellers at loggerheads is consigned like steam engines and home brewing to our rosy-tinted memories of yesteryear. Institutions and individuals alike now haggle over shares in front of screens that blink red and blue, with more arrows, buttons and switches than a computer game.

When trading platforms look like fruit machines, it’s no wonder investors behave like short-term gamblers. But there’s a way of profiting from holding shares that requires no selling at all, by receiving the (generally) twice-a-year dividend.

The dividend is the money a company pays every shareholder out of its retained profits, as a reward for holding its shares. It’s too often forgotten that as a shareholder in a company, you’re a part-owner in its business. The dividend you receive is your share of the annual earnings.

Annually, the amount paid out by companies in the London stock market as dividends is about 2-3% of the entire market capitalisation. Some shares pay more: several UK banks, for instance, are currently paying the equivalent of over 6% of their market capitalisation in annual dividends. Others, typically high tech or loss-making companies, don’t pay any dividend.

The amount paid out as a percentage of your shareholding (such as the 6% just cited) is called the yield of the share. There’s more detail elsewhere on Monevator.com regarding calculating the dividend yield; for now it’s enough to know that shares paying relatively high dividends are known as high yield shares.

Do the small percentage returns from dividends sound dull to you? Sure, you won’t hear much about dividends from excited market pundits on CNBC and Bloomberg, who prefer to scream that the price of Wibbly Wobbly PLC has fallen by 0.2% in early morning trading.

What if I was to tell you that over the long-term, the bulk of profits made from investing in the stock market have historically come from receiving and reinvesting dividends?

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