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A new high yield portfolio for 2011

All your high yield shares should be pulling in the same direction: higher income.

Early on in the life of Monevator, I wrote a series of posts explaining how to pick high yielding shares for long term diversified dividend income, and why you might want to do so.

The series culminated with a example portfolio, which I reviewed for the last time in April 2011.

As promised, I am now going to create a new high yield portfolio (HYP). What’s more, I’m going to do the sensible thing this time, and track the dividend income.

Income is, after all, the entire point of a HYP. And while I’m fairly pleased with how well the capital value of that last HYP withstood the carnage of the credit crunch, I haven’t really got a Scooby as to how the income fared. This time I want to be sure.

Having weighed up various tools to enable me to track both the portfolio and its income – and taking into account the entire Monevator research department seems to have absconded, together with all our interns AND the hapless but dependable jobsworth who might otherwise have been lumbered with tracking the portfolio – I’ve decided to simply buy the shares in real-life to do it.

Yes, I am investing my own hard-earned money to buy and track this HYP here on Monevator.

As a fan of Airfix in my childhood, I can’t really resist having another mini-model portfolio to play with. More importantly, this way is guaranteed to be correct, if rather expensive, unlike the online tools which all have downsides. Also, buying and holding the shares will give us a better idea of how much faff it takes to run even a largely hands-off portfolio, as companies are acquired, go bust, do an Enron, and so on.

I’ll give the exact details, such as prices paid and initial costs next week. For the rest of this post, I’ll tell you what shares I’ve chosen and why.

Important: I’m not recommending you buy these shares, and take no responsibility if you do so. I’m just a private investor, not your personal adviser nor Warren Buffett. Also, if you’re going to hold shares directly, you need to learn about, choose and follow your own shares, not just blindly copy someone else’s picks. There’s no shame in going for an index tracker instead!

Let’s do it like we did last year

There’s no point in repeating what I’ve previously written about selecting shares for a HYP. Please follow the various links in the first paragraph of this article for the specifics (or else see this archive of all my HYP posts).

I think the original strategy stood up fairly well last time, and steered me away from indebted disasters like Yell or from buying too many housebuilders or banks – even if it didn’t avoid banks altogether. (I did note yields on bank shares were high because of fears of a credit crunch, but I said it could go either way and so bought a couple of banks anyway!)

The importance put on diversification and avoiding excessive debt proved itself in the bear market, too.

All that said, my HYP thinking has evolved a little bit since 2007, in that I now think the sustainability of the yield is also worth an extra moment of guesswork thought.

It won’t pay to try to be too much smarter than the market here; let’s be honest, our 20-minute evaluation won’t beat a full-time analyst’s efforts. Our edge, if we have one, comes through buying a basket of higher yielders, not by second guessing the earnings forecasts for every company in the FTSE.

Put simply, I’d now pick a hugely dependable cash generator on a slightly lower yield like Unilever – which only just made my 2007 portfolio – over the average engineering firm or cyclical, unless its yield is stupidly low. (Still no room for ARM then).

The 2011 high yield portfolio

Again, please see my 2007 post for a step-by-step walkthrough of how you can pick your own portfolio of high yield shares using a combination of a screener, further research, and gut feel.

Needless to say, that old portfolio is wildly out of date. Yet I think reading the previous post is arguably more demonstrative than detailing every step today. Truth is, making pronouncements about share A versus share B as commentators and fund managers do gives an illusion of exactitude. By looking at that four year old post, you can see the warts and all, in the harsh light of what happened next.

Here’s my final chosen portfolio for this year, followed by a few brief notes on what’s in it and why:

Company Size (m) Sector Cover Yield
Aviva £12,440 Life assurance 2.2 6.0%
BAE Systems £11,065 Aerospace 2.2 5.6%
AstraZeneca £42,670 Drugs 2.5 5.6%
Scottish & Southern Energy £12,461 Utilities 1.5 5.5%
GlaxoSmithKline £67,632 Drugs 1.7 5.3%
Vodafone £87,075 Telecoms 1.9 5.2%
Admiral £4,468 Insurance 1.1 4.7%
Centrica £16,181 Gas supplier 1.8 4.7%
Royal Dutch Shell £60,467 Oil 1.8 4.6%
British Land £5,253 Property 1.1 4.3%
Balfour Beatty £2,231 Construction 2.7 4.1%
HSBC £115,135 Banking 2.2 4.0%
Tesco £32,857 Retail 2.3 3.9%
Tate & Lyle £2,831 Food 1.8 3.9%
Unilever £25,561 Household 1.8 3.8%
Aberdeen Asset Management £2,661 Funds 2.0 3.5%
Pearson £9,149 Media 1.9 3.5%
Diageo £30,787 Beverages 1.9 3.4%
Halma £1,383 Engineering 2.2 2.5%
BHP Billiton £51,522 Mining 4.3 2.4%
———
Overall yield
4.3%

Note: The forward yield is rounded to one decimal place.

While I’m not going to run through every company I’ve picked – or indeed the ones that got away or were pushed overboard – a few points are worth noting.

First off, I’ve not included British American Tobacco. I’ve never bought tobacco shares – it’s a mental weakness of mine but I just can’t bear to profit from a habit I loathe, especially given how such companies’ future growth is predicated on selling cigarettes to less well-educated parts of the world.

If you’re made of sterner stuff, then grab the diversity and swap them in for either Glaxo or AstraZeneca. Doubling up on healthcare instead of cigarettes is my idea of share humour, but it’s also a chance to buy an out-of-favour sector that finally looks cheap.

I’ve included two utilities, both of which have a fair bit of debt. As I explained in the original series, utilities always come with debt, which is considered sustainable due to their long-term pricing arrangements.

Vodafone’s debt is horrible, too, but it’s a monster utility-like company. BAE’s pension deficit isn’t great, but it’s debt looks sustainable, provided the US military’s recent coup doesn’t mean the end of defense spending.

Aviva’s high yield is a bit of a mystery. I suspect it’s because it holds a lot of European government bonds. I’m sanguine, given the 6% reward for the risk.

Admiral and British Land both have lower dividend cover than the strategy looks for, but they’re special cases. Admiral has a superb record of paying out nearly all its income as a dividend, but that does make for low cover (and the potential for some lean years in the future). British Land is a REIT, which means it has to pass through most of its income, by law. It’s also got a fair bit of debt, albeit it backed by a great portfolio of commercial property.

The two lowest yielding shares at the end are in for diversification. Halma has one of the very best dividend records on the London market. I first bought it years ago on a near-4% yield, and I don’t deny it looks pricey now, but it’s a super business. As for BHP Billiton, I’m not comfortable setting up a long-term portfolio without a mining company in it, and BLT is as good as it gets today. Again, I can remember a 5%+ yield less than a decade ago on this share.

A purchaser could skip these last two and take the yield up to 4.5%; I’d rather have their proven prowess in the portfolio.

Incidentally, the ability to focus on whatever sector is down in the dumps and thus get higher yields is an advantage of buying your HYP over a period of years, instead of all in one go like this. If you’ve got the cash and you need to buy an income now, it’s better to get the diversification and lose some yield, I say.

I’m happier with the quality of shares in this portfolio than the 2007 version. True, the starting yield is lower, but the quality of companies seems overall higher. Of course, that might just be because we haven’t had the car crashes yet!

This HYP versus cash, trusts, and annuity

Our final yield of 4.3% is much higher than the FTSE All-Share’s yield of roughly 3%. It’s also much higher than cash.

But the HYP yield only just matches the current forward yield on my favourite income investment trust, City of London, which is slightly disappointing. The latter is trading on a 2% premium, but owning it (or better a basket of such income trusts) will be a lot less hassle for most investors. I’ll probably use the trust as a benchmark comparison against this HYP in the years to come.

HYPs were originally conceived as an alternative to an annuity, and the income compares well here, only a little below the £4,583 starting level a 65-year old man might get from the best single life annuity with 3% escalation and a 5-year guarantee. It’s much lower than the £6,491 he’d start with if he skipped the 3% escalation and the guarantee, though. (These quotes come via the Hargreaves Lansdown best buy table).

Of course, a HYP has a big advantage over an annuity in that you don’t lose it just because you’ve done the indecent thing and died. A portfolio of shares can be left to your heirs.

The other key advantage is that both the income and the capital value of our shares will, hopefully, grow ahead of inflation in perpetuity.

The downside of the HYP route – aside from the extra work in buying and monitoring a portfolio – is that either through poor share picking or a market meltdown, your income is hit and you get less than the guaranteed payment of an annuity. I’m decades away from retiring, but if I was I’d probably split a pension pot 50/50 between shares and annuity, to hedge against this risk.

In terms of expectations, I don’t expect fireworks from my mini-portfolio. A HYP shouldn’t beat the wider market, according to the boffins, as that higher starting yield will be paid for by lower capital growth. Over 20 years or so, a FTSE tracker’s income might well have overtaken it, too, due to faster dividend growth. But a HYP is about a higher income now, not some day in the future – a pensioner hasn’t got 20 years to wait!

While it may not beat the market, I’d certainly hope the income will rise ahead of inflation, though, and it’d be nice if the capital value does, too.

We’ll see.

There’ll be more details of the benchmarks I’ll be tracking this HYP against in next week’s post, so if you’ve not done so already please subscribe to make sure you get it.

{ 11 comments… add one }
  • 1 ermine May 6, 2011, 7:48 am

    thanks for this update – much appreciated. It is also rewarding to see that, chasing along the same lines, I have two of these already and near equivalents to three others (similar sectors and yields). And mext month’s ISA candidate is on your list too.

    Since the principles of my HYP were informed by your previous articles and some stuff from TMF then this indicates either your articles are internally consistent or that my prejudices track yours 😉

    I’ve decided to simply buy the shares in real-life to do it.

    Yes, I am investing my own hard-earned money to buy and track this HYP here on Monevator.

    And a hit tip to you here too, sir. Skin in the game always always lends gravitas. I’ll be interested and no doubt envious to see the article, as I slog through wage-slavery to build my HYP. Sorry to hear about the disappearance of those interns at Monevator HQ, you just can’t get the staff these days 😉

  • 2 The Investor May 6, 2011, 8:55 am

    @ermine — Cheers, glad it the spot. In case it wasn’t clear, I should stress I’m not investing a huge proportion into the demo hyp. But enough to make it sensible and useful.

    The skin in the game factor is there, but it’s mainly about realism. Paper portfolios are never as good, and as for specious backtested or hindsight driven ones…

    Good luck with this year’s picks for yours!

  • 3 Moneyman May 6, 2011, 9:55 am

    Great – a lot of good research work there, although some of the yields are below cash bond returns at the moment. It would be good to hear a bit more detail on the reasons for the invidivual picks in a later post.

    You might be doing this already, but my main observation is that you could complement/balance the volatility of the HYP with some fixed-rate high yields from gilts, corporate bonds or PIBS – as I am discussed in a recent post:
    http://www.the-diy-income-investor.com/2011/05/next-investment-for-sipp-uk.html#more

  • 4 Richard Beddard May 6, 2011, 10:38 am

    Good luck Monevator. A very interesting portfolio, which I will follow.

  • 5 The Investor May 6, 2011, 2:49 pm

    @Moneyman — Cheers. Yes, in terms of complete asset allocation an income investor would definitely want some cash and probably at least some short term gilts at present, though I wouldn’t kill myself rushing to buy them.

    This portfolio is meant to suggest an equity component of such a portfolio, rather than the big picture. That said I may trade into gilts at some distant point when equity bearmania gives way to the shunning of fixed income. More on that next week.

    @Richard — Cool, I’ll be interested too! Think it may just prove a decent time to buy dividend income, at least versus the main market.

  • 6 Salis Grano May 7, 2011, 3:55 pm

    I hold eight of these, so a fair measure of agreement and I suppose one could swap a utility or two, e.g. National Grid for SSE. I’m a bit surprised by Admiral , though, as that seems a big leap in expected dividend.

  • 7 timarr May 8, 2011, 11:00 am

    I like high-yield strategies and it’s a good post, but there’s one point I profoundly disagree with:

    In terms of expectations, I don’t expect fireworks from my mini-portfolio. A HYP shouldn’t beat the wider market, according to the boffins, as that higher starting yield will be paid for by lower capital growth.

    This is an echo of the rational expectations meme, the idea that excess return can only be achieved by taking on excess risk. There’s now a mountain of evidence showing that this isn’t true: psychological considerations often result in mispricing and, fortunately, high yield is often a signal of that mispricing.

    Not all high yield shares are mispriced, of course, but chosen well these shares can provide income growth and capital growth. Generally you want good dividend cover, because in order to grow earnings in the future – and therefore dividends – companies need to reinvest their earnings. However, you probably need to go one step further if you’re going to create a high yield portfolio that’s likely to stand the test of time.

    The important thing to look at is the split in earnings between actual cash and estimated future earnings. The more hard cash coming into a company the safer the income stream and more likely they are to be able to grow their business in future. Companies with high levels of accounting based future earnings are more likely to suffer profit warnings, dividend cuts and the like, and therefore deserve a low rating and higher yield. Think Enron, Worldcom, RBS, etc, etc …

    Still, using high-yield as an investing technique is a tried and tested value approach. It’s very rare that it becomes so popular that there are no shares worth buying. Rare, but not unknown …

  • 8 The Investor May 9, 2011, 11:46 pm

    @Timarr — Very glad to see a comment from you here! 🙂 Yes, I’ve read/seen research over the years about high yield outperforming, let alone the general behavioural mis-pricing, so I don’t disagree. What Works on Wall Street (O’Shaughnessy?) used to be cited all the time a few years ago… I more recently read some convincing Tweedy, Browne material, too.

    But I basically don’t want to mislead readers into getting the idea that I am putting forward this portfolio as part of a strategy to beat the market. It’s a strategy for getting more income, hopefully, than the market, for a long time (decades). It may or may not beat the market — and as I say theoretically it shouldn’t, even if prior experience / research as cited by yourself, those authors I mentioned, and to an extent even my own experience suggests it can and could again.

  • 9 Ian May 10, 2011, 12:12 am

    The Investor do you ever consider beta in picking stocks for your hyp? Have you thought of aiming for <1 to avoid capital decrease in the event of another crunch or is that not an issue as the best companies for hyp have consistent dividends in bad times anyway?

  • 10 The Investor May 10, 2011, 2:26 am

    @Ian – To be honest, not at all. Good high yield shares tend to be lower beta by their very nature, but it’s not something I filter for.

    Ultimately, for the purposes of this portfolio I don’t really care if the capital value of the HYP fluctuates in the short to medium nearly as much as I care about:

    1) Absolute loss of income (i.e. dividend cuts)
    2) Relative loss of income (i.e. dividend cuts or raises below the level of RPI)
    3) Absolute capital loss (i.e. permanent destruction of capital via companies going bust, which also hits income of course!)

    As private investors in charge of our own portfolios, we don’t have to worry about our investors panicking and selling up when the market goes down, locking in capital losses due to volatility, so the performance of the HYP relative to the market over the short term is an academic matter.

    Which would you prefer – if investing for income: A portfolio that halves when the market falls 25% but that delivers a 5% yield that grows with RPI, or a HYP that falls only 25% when the market halves, but only delivers a starting yield of 2.5%, and thereafter the same growth?

    I’m NOT saying this HYP will do anything like either of those portfolios – I am saying as an income investor, you’d have to plump for the first portfolio provided you’re confident you won’t sell up when the portfolio halves!

    Judiciously forgetting about academic concepts of volatility/risk can be helpful…

  • 11 Mark May 15, 2011, 6:55 pm

    Interesting comparing this with ADVFN’s high yield filter: (“Large Cap Dividend Plays”)
    Drax
    Home Retail
    Rds B
    Rds A
    Vodafone Grp.
    William Hill
    Sainsbury(J)
    Bba Aviation
    Unilever
    Tesco
    Pearson
    Morrison (WM)
    Mondi
    Bhp Billiton
    Nat.Express
    A.B.Food
    Quite a good overlap.

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