Winning formula from the O'Higgins chemistry set

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In the long run, shares have given investors far and away the best investment return. Superior performance, however, comes at the price of higher risk and assembling a portfolio that reduces danger while maximising returns is a big challenge.

A year ago we composed two portfolios based on the investment thinking of Michael O'Higgins, an American fund manager who claims in a fascinating book called Beating the Dow to have found a share selection technique that can outperform the market consistently, without increasing volatility or risk. The O'Higgins theory is based on three basic premises about share selection. It is a simple technique for private investors to use and needs little in-depth knowledge of individual stocks. Some fund management groups are adopting the technique for PEP plans.

His first criterion for selection is size, on the grounds that leading companies are considerably less likely to fail completely. Eliminating that possibility reduces risk, especially for small portfolios.

Secondly, Mr O'Higgins looks for high yielding shares. He believes a low share price relative to a stock's dividend payout is the best indication of a share being irrationally out of favour. The other advantage of high yield is that, on a cumulative basis, the income from a share represents a very high proportion of its total return over the years. The difference in total return between two shares with the same capital growth but yields of say 4 per cent and 6 per cent will be massive over a period of more than a few years.

Finally he looks for low priced shares as the companies tend to be the smallest of the Top 100 and can grow faster.

The success of the system over the past two decades has been extremely consistent. Over more than 18 years to 1991, portfolios selected 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, pounds 10,000 invested in the O'Higgins portfolios would have grown to almost pounds 250,000 over the period. The same amount invested in a portfolio matching the performance of the Dow would be worth only pounds 60,000. The method would have worked just as well in the UK. Adapted to the London stockmarket, this involves the following three simple steps:

o Choose the ten highest yielding shares from the FT-SE 100.

o Of these, pick the five with the lowest share price. If you think the lowest share price is a crude measure, choose the five with the lowest market capitalisations (as the tables show, we did both last year and have repeated the dual selection.

o Buy the shares and sit on them for 12 months before repeating the first two steps and rejigging the portfolio.

So how did the system work last year and which shares does it throw up for a 1996 portfolio? Interestingly there was little difference in performance between the portfolios selected for low share prices and for market value. Both broadly matched the performance of the FT-SE 100 index, but including their higher yields they would have slightly outperformed.

The lowest share price portfolio included only one howler, Hanson, which continued to suffer from market scepticism.

MEPC trod water as property remained in the doldrums, but the buoyant fortunes of the financial sector drove the remaining three shares to stunning outperformance. BAT flourished on break-up speculation. Bid speculation lit a fire under L&G, and an upturn in the insurance cycle lifted Sun Alliance.

Legal & General, MEPC and Sun Alliance also turned up in the market value- based portfolio, together with Thames Water, a strong performer, and Redland, which usefully showed why the system is not fail-safe. Redland cut its dividend, proving that sometimes shares offer a high yield for a good reason. Shares slumped almost a fifth.

Looking forward, a recent trawl of the highest yielding Footsie came up with the following: P&O, Hanson, British Gas, British Steel, Allied Domecq, BT, National Grid, Thames Water, North West Water and General Accident. The two portfolios which we will track throughout next year are shown in the tables.

Remember, if you use the O'Higgins technique as a long-term savings plan, put the shares into a personal equity plan. That way the generous yields will compound tax free.

Tom Stevenson

Past and present portfolios

Last year's selections

By share price By market value

Share performance over year (%)

Hanson -13.3 MEPC +3.4

Sun Alliance +29.4 Thames Water +16.1

MEPC +3.4 Redland -15.4

BAT +31.6 Legal & General +55.0

Legal & General +55.0 Sun Alliance +29.4

Average +21.22 Average +17.7

FTSE100 +20.3

This year's portfolio

By share price at end of 1995 By market value

British Steel 162.75p Thames Water pounds 2.3bn

Hanson 192.5p P&O pounds 2.9bn

National Grid 199.5p General Accident pounds 3.1bn

British Gas 254p British Steel pounds 3.3bn

BT 354p North West Water pounds 3.3bn