Using a wider net to catch candidates for the sieve

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On 27 May this year, I wrote about a method of selecting a high-yield UK portfolio. I used Datastream (a computer database of financial statistics that is constantly being updated) to help conduct the search.

The first requirements were for companies with a market capitalisation of over pounds 200m and a dividend yield of over 6 per cent.

Only 23 companies found their way through these two sieves. I then increased the safety factor by insisting upon dividends being covered by earnings by at least 75 per cent and total company borrowings being not more than 50 per cent. This reduced the candidates to 14 shares. I eliminated one of them because a dividend cut was forecast and another three for a variety of reasons, but mainly because I wanted to reduce the final portfolio to a round number of 10 shares.

The first panel, below, shows the final selections and how they have fared against the market.

As you can see, the average appreciation in the six months to 24 November was 5.3 per cent, which compares with a gain of 7.5 per cent in the FTA All-Share Index during the same period. However, the average dividend yield of my portfolio was 6.66 per cent per annum whereas the market average yielded only 3.92 per cent. Allowing for the extra yield, there was little difference between the two.

The results disappointed me a little and contrast with the very much better performance of the five-share portfolio I constructed based on the O'Higgins system of share selection (the five shares with the lowest share prices selected from the 10 highest yielders of the top 30 UK stocks). That portfolio increased in value by 12.4 per cent against 6.78 per cent for the FTA All-Share Index during the six months ended 30 September 1993.

Although the O'Higgins system identifies its first 10 candidates through their high yield, the essence of the approach is to seek out big companies that are very much out of favour and are overdue for recovery.

During the past few months, recovery stocks may have benefited more than high yielders. We need to run the test for a longer period, so I shall persevere with my safety-first high-yield method to see if the results improve.

Meanwhile, I will construct another larger high-yield portfolio. To do this, I will first widen the net by reducing the market capitalisation criterion from pounds 200m down to pounds 100m and the dividend yield from over 6 per cent to over 5.5 per cent. The other criteria of total borrowings being not more than 50 per cent and earnings cover (based on net adjusted EPS) for the dividend being not less than 75 per cent will remain the same.

High yielders are becoming much harder to find - only 23 shares managed to make it through these much less demanding sieves. Instead of trying to eliminate a few for subjective reasons, I will follow the teachings of Ben Graham and leave them intact as a portfolio. In six months' time we can then compare its performance against the market and against the O'Higgins system.

Anyone thinking of investing pounds 10,000 or more in a high income unit trust should also consider as an alternative investing in my high-yield portfolio of 23 shares (second panel). There is sufficient spread to reduce the risk of a catastrophe and the selective criteria err very much on the side of safety.

If you were investing about pounds 435 in each share, you could certainly negotiate a deal with a commercially minded stockbroker for a commission rate of a maximum of pounds 15 per transaction and possibly a little less. Then there is the market maker's turn and stamp duty so you would not save anything on the 5 per cent to 6 per cent initial charge of most unit trusts; in fact, you might end up paying a tad more. However, you would save the 1.5 per cent annual charge made by almost all unit trusts and that is such a large proportion of any dividend yield obtainable in today's markets.

Although I have suggested a minimum sum of pounds 10,000 you could, of course, invest pounds 9,000 in PEPs, which would be a very tax-efficient way of saving tax on any capital gains as well as income tax on the high annual income.

However, you would first need to make sure that the annual charges for the PEPs were not in any way linked to the number of securities in the portfolio.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. Mr Slater has agreed not to deal in a share within six weeks before and after any mention in this column.

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