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VALUE INVESTING
High Yield Selection Rules

By Stephen Bland (TMFPyad)
November 23, 2001

After the report last week on the first year of my High Yield Portfolio (HYP) I felt it might be an appropriate time to revisit the kind of assumptions that in my view should be used in the construction of an HYP. Bear in mind that these are only my views of course. This is an art, not rocket science, so that others could well come up with an alternative set of construction tools. Readers need also to be aware that I am designing for a no-dabble portfolio to be held forever thus relieving the investor of all attention except compulsory events that require action. However, some HYP investors might adopt the style of regular reviews, perhaps based on some rule like dropping a share that fails to increase its dividend for example but I am not approaching the strategy with that approach in mind.

Security of dividend and capital is the prime reason for these rules because investors will be depending on this. We are not talking idle speculative activity here, the HYP is meant to deliver a decent starting yield plus maximum security commensurate with being in equities at all, together with inflation beating income increases and capital growth.

Number one is market capitalisation. I advocate that investors stick with big caps only. Say FTSE350 but preferably FTSE100. Alternatively set an actual limit such as 1bn. The reason for this rule is security. I believe that in general big caps are going to be more secure than smaller ones both in dividend payments and in a lesser likelihood of the company going bust.

Secondly, look for an increasing dividend history for as far back as you can find records. The idea here is to locate shares that are more likely to deliver the required income growth even in years when profits may fall temporarily.

Thirdly, gearing. Try to look for the lowest debt levels though in some cases you could include a very small number of higher than average debt companies possibly. I have United Utilities to add a touch of very high yield but it is substantially geared.

Fourthly, sector diversification. This is critical. My selections represent personal prejudices distilled over many years of watching markets. In fact my fifteen share portfolio is overweight in mining and financials with three of the former and four of the latter. It includes also two hotel groups although as most will know, Hilton includes the Ladbrokes gambling business which I find attractive. Since it is overweight in some sectors it must therefore be underweight in others. With a limit of fifteen shares, which is perfectly adequate however large the amount of money available, you can't have everything particularly if you decide like me to go overweight in some areas.

On underweighting, I advise to readers to avoid some sectors. Construction, engineering shares, shares in rapidly advancing technological industries such as telecoms and computers, airlines spring to mind because of what I see as an increased risk. We are trying to shed risk here, not invite it. Don't try and guess what will be the next big thing, that is not for HYP investors. Instead ask yourself what is likely to be here for as long as you intend to be around but more than that, what is likely to go on generating profits and dividends, year in, year out, whatever happens? Dull and boring is a primary quality of most HYP type shares, indeed of most value shares generally.

Along with the sector diversification rule consider balance. My example HYP at the start had one high yielding utility, United Utilities (LSE: UU.), whilst its lowest yielder was Shell (LSE: SHEL). Even Shell though yielded around the market average at the time. It is more important that you discover shares that are likely to continue increasing dividends, even if some of the start yields are not that high. Never trade off a higher initial yield for a lower quality share, it is just not worth the risk. I could easily have put together a much higher yielding portfolio than the one I put up, but this would have been at the expense of poorer shares which is not the way to go. Rather a lower start yield with greater confidence that the company will be able to deliver increases over decades to come.

Another aspect of balance is the business of the share. For example I have two banks, Lloyds (LSE: LLOY)and Alliance & Leicester (LSE: AL.). But the former is a major international business bank whilst the latter is essentially a wholly UK based retail bank that lends house mortgages. Thus I see them as complementing each other. A similar approach was used with the two insurers, Royal & Sun Alliance (LSE: RSA) and Britannic (LSE: BRT). The former is mainly a general insurer whilst the latter is primarily engaged in life business. What I am saying here is that with fifteen shares, if you have sector duplication in any way, ensure that there is a good reason for it arising from some clear differences in the nature of the ostensibly same sector companies.

Finally, most of these rules are not totally rigid. For example if you have an initial minimum cap limit of say 1.5bn then it is worth looking slightly below that for the right company to meet your portfolio requirements in the situation when you might not otherwise be able to find a sufficient number of shares.

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