How the 2005 portfolios performed

Unsurprisingly, the portfolio didn't do too well, just up 7.7 per cent in three years (although it was still in the black despite suffering a fair smattering of casualties). The highest yielder of them all, Ultraframe at 20.8 per cent, disappeared after a knock-down takeover approach, and only after cancelling its payment altogether. In total, five of the portfolio fell to takeovers, with three of those – department stores group James Beattie and logistics operators TDG and Christian Salvesen – all securing a healthy premium. Only five of the companies cut their dividend altogether, suggesting that companies that pay a dividend are determined to keep doing so even if times get tough.

Portfolio 2: Consistent high yielders

The second portfolio, consistent high yielders, looked for companies with the highest six-year average dividend yield. These companies offered a degree of consistency that the raw high yielders did not. And this portfolio has not done too badly, up an average of 35 per cent over the three-year period measured.

Again, several of the companies in the portfolio were subject to acquisition – six in total, including Christian Salvesen, Ultraframe and James Beattie again, and also House of Fraser, which itself acquired James Beattie. Companies that historically pay steady dividends at an attractive yield make attractive bid targets, with buyers presumably attracted by the cash-generative qualities that back the payment.

Portfolio 3: High yielders with solid dividend cover

With portfolio three, I started to apply some safety measures, in particular the level of dividend cover that companies had in place. Surprisingly, this portfolio, high yielders with solid cover, didn't perform nearly as well as might have been expected. It returned an average of 5.3 per cent over the three-year period – the worst of the four portfolios. That suggests that dividend cover doesn't work especially well in isolation as a screening measure for income portfolios.

How could this be? The measure – which divides earnings per share by dividend per share – should indicate the affordability of the dividend. The higher the cover, the safer the dividend and the higher the potential for dividend increases. The failure of the measure highlights the weakness of earnings per share as an indicator of a company's financial health – it doesn't reflect the cash earnings of a business, or indeed its future prospects.

Two-thirds of the portfolio produced negative returns over the period and, again, it was only corporate activity that meant the portfolio didn't perform even worse – Nord Anglia Education and Atrium Underwriting were both acquired, returning 188 per cent and 98 per cent, respectively, over the period. But five companies cut their dividend altogether, while several – including retailers JJB Sports, Kesa Electricals and DSG International – are suffering and are likely to see their temporarily attractive dividend yields come under pressure.

Portfolio 4: Dividend growers

The final portfolio was dividend growers – companies that had consistently increased their dividends over an extended period. There were one or two horror stories – most notably Dyson Group, which slumped 75 per cent, and property fund specialist Capital & Regional, which slumped 50 per cent on debt troubles. In the main, though, this portfolio did extremely well, particularly in terms of capital returns, up an average of 41.9 per cent over the period. Only six of the companies in the portfolio produced negative returns over the three-year period, and not one of them stopped dividend payments altogether.

This was always likely to be the portfolio that really produced the goods. Companies that had consistently grown their dividends were more likely to have consistently grown their earnings, too. And that indicated that they were probably well-run businesses, with a focus on long-term growth (I took the companies with the highest 10-year aggregate dividend growth rather than those with the highest over a shorter period).

Interestingly, the level of dividends these companies paid at the time was relatively low compared with the other portfolios – at just 2.5 per cent, the average dividend yield was almost half that offered by the next lowest group average of 5 per cent (the relatively unsuccessful dividend cover portfolio).

The 2005 Dividend portfolios (21 May 2005 to 21 May 2008)