Victorian values suggest fresh routes to wealth

It's difficult to say if the market has finally bottomed out, but this is a great opportunity to invest in high-yielding shares of quality companies, writes Pramit Ghose

In the summer of 1958, an event of great significance took place for those who followed long-standing indicators of stock market value.

For the first time in history, the yield on long-term US and British government bonds exceeded the dividend yield on their respective equity markets.

This moment signalled the confirmation of the "cult of the equity" that had begun in the 1940s, commonly attributed to George Ross Goobey, an actuary and investment manager for the Imperial Tobacco pension fund.

Goobey was one of the first investment managers to invest in equities rather than bonds. His rationale was that, over time, dividend income from a well-chosen basket of shares would grow and exceed the flat yield from government bonds.

Capital appreciation in the underlying shares was simply a bonus that was not part of the rationale, but as more people converted to the income argument and bought shares, share prices went up and yields went down, leading to the crossover of equity and bond yields.

The collapse in global stock markets over the past three years has caused many people to consider whether the "cult of the equity" has ended. I believe a more widespread consideration has become important - the search for income.

Yield is scarce. Bank deposit rates are, at best, 2.5 per cent and likely to fall and Government bonds yield around 4 per cent. Given residential property values, net yields on new apartments are under 3 per cent.

Nineteenth century investment values are returning in this search for income. Guy Monson, chief investment officer of Bank Sarasin, recently highlighted how in the age of Jane Austen, the income of a gentleman was of the most importance.

In the 1813 novel Pride and Prejudice, Mrs Bennet, mother of five single daughters, ranked gentlemen by the size of their annual income.

The Victorians had a similar fascination with income. Anthony Trollope's 1858 novel Dr Thorne bemoaned the failure of the doctor to secure his future income by investing £3,000 or £4,000 in the "Three Per Cents" (government bonds).

Austen and Trollope, and their contemporaries, understood that, in an era of low interest rates and low inflation, recurring and predictable income was far more important than capital wealth.

The scarcity of yields is a major financial headache for non-borrowers. Pensioners with, say €200,000 on deposit - a large capital sum even nowadays - will only get about €5,000 a year in interest.

The financial problems of pension funds are widely attributed to the fall in asset values due to the collapse in stock markets. Much less attention is paid to the liability side of a pension fund's balance sheet where the cost of purchasing pensions has substantially escalated due to low interest rates.

For proof of this, just look at the executive director pension costs table in the annual reports of stock market companies. Prospective pensioners need to be targeting a "fund" of 15 to 20 times their desired annual pension.

Amid all this gloom and doom, a chink of optimism has appeared.

In March 2003, for the first time since that historical event in August 1958 highlighted in my first paragraph, the yield on British equities exceeded that of UK government bonds.

This is an extremely strong signal that stocks have suffered from over-reaction in pessimism.

But, I hear you say, of course he'd say that; after all he works for a stockbroking firm.

What fascinates me particularly at the current moment is that one can put together a basket of high-quality, financially strong, cash-flow generating stocks in Ireland, the UK and Europe yielding close to 5 per cent, with a high probability this income yield will grow at 5-7 per cent each year. The financial logic of this income strategy is very compelling, as the table above indicates.

Thus at the end of five years, the investor's €100,000 would have grown to €126,119 and the expected yield would be €6,920, with no share price gains.

Many studies have shown that a high dividend/income strategy for investing in equities has beaten the broad stock markets by around 5 per cent per annum and with less volatility.

Our own high-yield portfolio has shown an annualised outperformance relative to the FT World Index of over 15 per cent since inception.

My favourite such study, however, comes from Liontrust Asset Management, which attempted to study dividend yield as a stock market timing indicator. Essentially, Liontrust looked for periods when an exceptional number of British stocks yielded 2 per cent or more above UK government bonds.

Three periods over the past 40 years were identified: 1974, 1990-92 and 1998-2000. The returns from investing in the identified high-yield stocks when the signal was given and the stock market had fallen significantly (1974 and 1990) were exceptionally strong (628 per cent and 244 per cent over the following five years respectively).

If one could have had the patience to wait for these occasional periods when an unusually large number of stocks had excessively high yields, and then invested one would have done exceptionally well.

Now is such a time. Unfortunately, as in the mid 1990s when one could have bought good quality Irish commercial property yielding 7-8 per cent, most people will miss this opportunity. As the great British economist, John Maynard Keynes put it: "Human nature desires quick results. There is particular zest in making money quickly."

I am not clever enough to be absolutely sure that stock markets have bottomed out. Perhaps there is another downward lurch or two to come. But I am sure this is another great opportunity to invest in high-yielding shares of quality companies.

Again, Keynes knew how to put it in words: "Finally, it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion.

"If he is successful, that will only confirm the general belief in his rashness; and if, in the short-term, he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

Mr Pramit Ghose is head of investment strategy at Bloxham Stockbrokers