An O'Higgins portfolio for contrarians

Investment theories have an annoying habit of working just long enough to convince everyone they have found a sure way to stock market riches, only to stop performing promptly. The O'Higgins Theory, a system of picking supposedly top-performing high yield shares, is a depressing case in point.

Devised by an American fund-manager called Michael O'Higgins, the theory is simplicity itself. Investors, it says, should buy high-yielding shares because their low share prices relative to the income stream they generate is often an indication that the market has unfairly downgraded them.

The other advantage of high-yielders stems from the fact that dividend income has over time represented a large part of the cumulative total return from equities. A high yield should, in theory, give investments an immediate headstart.

To narrow the field of potential investments, Mr O'Higgins uses a couple of selection screens. He chooses shares only from the largest blue chips because he believes large shares are less likely to fail totally.

From the highest yielding blue chips he selects those with the lowest share prices. He picks those on the basis that they are more likely to be relatively smaller companies and better able to grow meaningfully.

The success of the system during the 1970s and 1980s was remarkable given how clumsy it appears at first sight. In the 18 years to 1991, for example, portfolios chosen on the O'Higgins criteria would have generated a compound annual return (with dividends reinvested) of 19.4 per cent compared with 10.4 per cent for the Dow Jones index. To put that in perspective, $10,000 invested in the O'Higgins portfolios would have grown to almost $250,000 while investing in a Dow tracker fund would have turned the same amount into just $60,000.

Sadly, the 1990s have not produced such rich pickings. In 1995, a portfolio of five British shares chosen with an adapted version of the theory increased by 21 per cent on average, a fraction better than the market's 20 per cent rise that year. Last year, as the table shows however, the system was a disaster, registering an average fall of over 7 per cent against the market's rise of 10 per cent plus.

There are several possible reasons for this underperformance but the most important would appear to be the preponderance of utilities thrown up by the system. In the run-up to a probable Labour election victory worries about proposed windfall taxes have been to the fore. With many companies paying special dividends or staging share buy-backs there has also been less demand for income from institutions, which has helped keep high-yielders in the dog-house.

Things change, however, and when a share (or a system) is friendless it is usually a good time to take the contrary view. For those who fancy that time has come we have drawn up another O'Higgins portfolio.

British Gas has had a dreadful 1996 but could perform better after demerger. Imperial Tobacco remains a persistent bid target in the City rumour mill. Two shares which could do well this year, Allied Domecq and P&O, were knocked out of the high-yielding shortlist of 10 because of their relatively high share prices. If you believe in the system, however, you have to trust it implicitly. Better luck this time.

The O'Higgins theory - O'Dear

Last year's selection

Price end 95 Price now % change

Hanson* 120p 81.5p -32%

British Steel 162.75p 160.5p -1%

National Grid 199.5p 195.5p -2%

British Gas 254p 224.5p -13%

BT 354p 394.5p +11%

This year's selection

Price on 27/12/95

British Gas 226p

British Steel 162p

National Grid 190p

Imperial Tobacco 381.5p

Scottish Power 343.5p