High-yield systems

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Last week I argued that the theory of the stock market being efficient was absolute nonsense. For example, by only using one simple investment measure and buying shares that have a high dividend yield, you should be able to beat the market consistently. How can the market be efficient and perfect if this is so?

High-yielding shares tend to outperform both general and growth shares, as is readily evidenced by unit trust statistics from Micropal.

During the 20 years from 1973 to 1993, pounds 1,000 invested in the average UK growth unit trust with dividends reinvested would be worth pounds 12,800; in the UK general sector it would have grown to pounds 14,989 and in equity income to pounds 16,856. The best growth fund would be worth pounds 23,435, the best general fund pounds 24,927 and the best income fund pounds 28,232.

Further evidence is provided by Michael O'Higgins in Beating the Dow. He clearly demonstrates that, on a total return basis, high yielding stocks beat the Dow Jones Industrial Average. One of O'Higgins' systems simply selects the 10 highest-yielding Dow stocks. At the end of each year he repeats the whole exercise again, selling those companies that no longer measure up and replacing them with new high-yielders.

O'Higgins' statistics show that by following this system over a period of 18 1/2 years from 1973 to 1991, an investor would have enjoyed an average annual gain of 16.61 per cent, compared with only 10.43 per cent on the Dow. The 10- stock portfolio outperformed the Dow 13 times out of 19. After adding dividends received, but with no charge for commissions, the cumulative gain before tax was more than 1,750 per cent against only 560 per cent on the Dow.

Further evidence was provided by Capel-Cure Myers in March 1991 in an excellent paper in which they examined the extensive earlier work of Levis. About 4,000 UK companies were analysed between January 1955 and December 1988. The results demonstrated that a large differential return existed between UK portfolios comprising low-yielding shares and those that contained some of the highest-yielding shares.

Levis also proved that, during the period, portfolios with an average yield 25 per cent above the market average, as a general rule, substantially outperformed the FT All-Share Index.

I believe that high-yielding shares outperform the market on a total return basis because they are usually companies that are out of favour. The stock market over-reacts to good and bad news and often drives up the prices of growth shares to dizzy heights and leaves less popular (and apparently more risky) stocks to languish at bargain levels.

In essence, therefore, buying high-yielding shares contains a strong element of contrary thinking. John Neff, the very successful American money manager, sums this up best with his comment, 'Get 'em while they're cold'.

Another reason high-yielding shares do well is advanced by O'Higgins. He points out that, historically, dividends have accounted for 40 to 50 per cent of the total return on the Dow, so the continuity of dividends is of more than passing importance to Dow stockholders. Companies do not cut their dividends lightly, so they are less likely to fluctuate than earnings.

I offer yet another possible reason for high-yielders being relatively strong performers. When analysts examine a share and assess its likely future value, say a year hence, I wonder how many of them factor into the equation the extra income that is likely to be received in hard cash and could be reinvested. In some cases, it is a significant factor, which is only too easy to overlook.

In the present climate of falling interest rates, high-yielding shares are performing exceptionally well as investors become more yield- conscious. However, this can easily change as there is a definite cyclical element about buying high- yielding shares.

I should also point out that it is a dangerous game to buy shares willy-nilly just because they appear to have a high yield. To be selective, investors following a high-yield system should avoid companies with dividends that are very poorly covered or are likely to be cut. Also investors should be wary about high-yielding companies that have very substantial borrowings.

In conclusion, I hope I have proved to you that high-yielding shares do on average outperform the market. This, in turn, demonstrates that by using just one primitive investment measure, the efficient market theory can be faulted. Investors should rejoice, as nowadays they are spoilt for choice and have many far more selective investment measures at their disposal.