Testing the O'Higgins theory

The Investment Column
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The 33 per cent cut in Redland's final dividend earlier this week focused attention on the dangers of investing in high yield stocks. The decision to cut the payout, which took the shares 7 per cent lower, showed that sometimes there is a good reason for an income looking too good to be true.

One US investor, Michael O'Higgins, has made a career out of investing in high yield stocks. He believes that in the long run, because income is such a large part of the return from equities, high yielders tend to outperform the market as a whole. He has tested the theory in the US and found a steady record of outperformance. After a similar exercise by Jim Slater on UK stocks, Johnson Fry, the fund manager, has launched a savings plan using the O'Higgins technique.

The system has attractions for many private investors because, as a purely technical exercise, it avoids having to know and understand individual businesses in depth. Once a year Mr O'Higgins selects a portfolio of five shares from the biggest shares available on the stock market. He does this by taking the ten highest yielding shares and then selecting the five of these with the lowest share price.

The shares are then held, come hell or high water, for a year. Then the process is repeated and a new portfolio is bought.

The logic behind the system is that big shares tend to be safer, thus avoiding the disaster of one share in the portfolio going bust and dragging down the average performance.

High yielders, Mr O'Higgins argues, tend to be out of favour stocks which stand a good chance of bouncing back into fashion. Within the big company universe, smaller companies (often those with lower share prices, especially in the US) stand a better chance of growing relatively fast.

That is the theory. How has it worked in practice so far this year?

To test the system we have generated two portfolios using the FTSE100 index as a core universe and share prices and yields at the end of last year.

The first portfolio follows Mr O'Higgins to the letter. For the second list we have substituted low market capitalisation for low share price on the principle that, in the UK, share prices have a looser relationship with market value than in the US, where scrip share issues to reduce a share price are less usual.

As the tables show, both portfolios, which share three constituents, have outperformed the Footsie index as a whole over the first quarter of the year, although not by a massive amount. It is no surprise that Redland is the worst performing share of either group.