Investor/ An insider's guide to the market: Investing in companies that pay a high dividend yield is an investment strategy that has long been adopted by stockmarket investors, particularly private investors. It is probably the most common approach adopted by those investors that follow the "value" approach to picking stocks.

Value investors seek companies that are "cheap" as measured by the conventional yardsticks of value such as price earnings ratios (p/e) and dividend yields. Value investors will generally also seek out companies that have strong asset backing relative to share prices. Therefore, the ideal share for a value investor is one where the net asset value per share is equal to or greater than the share price, where the p/e is at a substantial discount to the market average p/e, and where the dividend yield is well above the market average.

With regard to the last attribute, the value investor will normally only invest in those high-yielding companies where there is a long record of stable and steady profits growth.

The main alternative style to value is "growth" investing. Growth investors seek companies with a recent history of rapid profits growth combined with expectations that the rate of profits growth can remain above the market average for a long period. Such companies typically trade on high p/es and low or even zero dividend yields.

There are many international academic studies comparing growth and value investing but no clear-cut answer has emerged as to which approach has performed best over time. Over the very long run the value approach has the edge, but the historical analysis also shows that over several quite long sub-periods growth has been more profitable.

For example, in the five to 10 years up to the market peak in 2000, growth stocks dramatically outperformed value stocks. Since then the value approach has been winning by a wide margin. In practice most equity market investors adopt elements of both styles in choosing stocks.

Picking a portfolio solely on the basis of an above-average dividend yield has attractions, particularly in terms of its simplicity. Evidence from the UK stockmarket in particular supports the contention that this approach to stock-picking has paid off in the past.

Typically, these strategies focus on the large blue-chip companies and select that subset offering the highest dividend yields. Should investors consider adopting this approach for picking stocks on the Irish equity market?

Based on the performance of the highest yielding Irish stocks over the past year the answer to this question is a resounding "no".

Currently the following 10 stocks offer the highest dividend yields on the Irish equity market: Fyffes, Independent News & Media, Qualceram, Viridian, Bank of Ireland, AIB, Abbey, Greencore, Irish Life & Permanent and Readymix. Dividend yields on these stocks range from 5.1 per cent for Fyffes to 3.0 per cent for Readymix.

The one-year share price performance of these companies should give investors pause for thought before slavishly adopting a high-yield stock picking strategy in the Irish market. No fewer than eight of these 10 companies have underperformed the Iseq index over the past year. In fact, a portfolio that consisted of an equal amount of money in each of these stocks would have underperformed the Iseq by approximately 9 per cent over the past 12 months.

Clearly, a long-term historical analysis of the performance of Irish high-yielding stocks would be needed to come to a definitive conclusion.

However, reasons why a high-yield strategy may not be appropriate in the Irish context are that the number of stocks to choose from is relatively small, and the market capitalisation of each company is small by international standards.

Of the 10 companies listed above, only Bank of Ireland and AIB would be classified as large companies. In general, larger companies have the financial strength to survive economic and corporate ups and downs and, therefore, are more likely to be able to sustain dividend payments over the long term than are smaller companies.

What this analysis highlights is that building an equity portfolio on the basis of one attribute alone is high risk. There is merit to choosing stocks on the basis of a high dividend yield, but this must be combined with a more general analysis of each company's specific prospects.

Investor says...

Reasons why a high-yield strategy may not be appropriate in the Irish context are that the number of stocks to choose from is relatively small, and the market capitalisation of each company is small by international standards. Only Bank of Ireland and AIB are considered large companies.