High-yield stocks can form basis of profitable portfolio

Investing SSIAs: The infamous value-investor, Ben Graham, once said that "an investor can approach investing in the the stock market by way of prediction or by way of protection". The simple truth behind that maxim is as powerful today as it was when he first wrote it back in 1949.

His point was that the average investor can assemble a portfolio of stocks that gives him/her every chance of getting the returns on offer from the markets without ever having to make a prediction. It was far better, Graham believed, for the average investor to "protect" him/herself by ensuring a decent "margin of safety" at the time of purchase.

Some hard facts should help make the point. Had an investor picked the 15 highest-yielding shares from the 75 largest companies in the UK market at the end of October 1994, held that portfolio for one year and then repeated the exercise each year up to the end of October 2005 - an 11-year period inclusive - he/she would have generated a total return, which included dividend income, of 12.0 per cent per annum compound. This compared to a return of 8.5 per cent per annum from the UK market itself, and 5.6 per cent per annum from UK interest rates over that same time horizon. A £10,000 (€14,484) investment in this high-yielding approach in late October 1994 would have grown to £34,700 by end-October 2005 (before costs) compared to £24,500 from the market index and £18,200 if left on deposit with the banks.

The average dividend yield on offer in the portfolios over this 11-year period was 5.9 per cent and the average price-to-earnings ratio that an investor had to pay was 11.4. Over the same period, the overall market offered a lower dividend yield of 3.7 per cent and was trading on a higher price-to-earnings ratio of 16.6. It appears then that, with the bigger companies at least, if an investor is always loading his/her portfolio with more value, the subsequent returns are going to be higher.

Not convinced? Well the evidence to back up this claim mounts! The bar chart (left) highlights the returns from each subsequent portfolio of 15 stocks out of the top 75, ie the top 15 stocks ranked in terms of dividend yield, then the next 15 (16-30), etc. What is patently clear is that the higher the aggregate dividend yield in the portfolio, the higher the subsequent returns; and the lower the yield, the lower the subsequent returns.

The table (left) lists the 15 highest-yielding stocks (at June 24th) from the top 75 in the UK market. The average dividend yield on offer is an attractive 5.3 per cent and compares favourably to current UK interest rates of 4.5 per cent. In addition, dividend growth in aggregate should equal the historical industry average rate of 5-6 per cent per annum which, all other things being equal, can be expected to underpin similar growth in their share prices over time and total returns of near 10 per cent per annum over the medium term. A swing back into favour by even a couple of the shares in this basket would boost those returns somewhat further.

By following this type of approach, it is the strategy that counts, not the individual stocks that an investor holds. By diversifying among a portfolio of substantially-sized, blue-chip UK companies an investor can substantially reduce stock-specific risk and gain exposure to several quality recovery situations. In the current listing in the table, it matters little what the "consensus" view is on Vodafone, Royal Bank of Scotland or United Utilities.

In aggregate, the value on offer is clear and if the past is any guide - and I am convinced it is - this approach has every chance of delivering the market returns, and quite likely more besides, in the years ahead. Stock market investing can be as complex as you make it or as simple as you want to keep it.

This series of articles is being written by Rory Gillen, who manages the Select GV Equity Fund in Merrion Capital and is the course director for the stock market training company Invest Like the Best (www.investlikethebest.com). A copy of all six articles can be obtained by emailing to r.gillen@iltb.ie