High-yield system holds up

One of the advantages of rules-based investing is the elimination of emotional decisions. On updating the High Yield System first published in August 2014, in spite of some mixed performances in what has been a more volatile period for equities, just one of the shares selected has triggered the system’s sell criteria.

To re-cap, having filtered out FTSE All-Share companies outside the top 40 per cent by market cap and shares that paid exceptionally high dividends (the top decile were removed as a precaution), the system selected the 15 shares with positive 12-month price momentum that had the highest dividend yield. Reviewing on 5 November, the shares selected on 24 July had achieved total returns of 2.22 per cent. This is a modest performance, but considering the total returns performance of the FTSE All-Share was -2.75 per cent and the FTSE 350 -2.79 per cent over the same period, encouragingly the early signs are that the High Yield System stacks up.

Conducting the review on 5 November was coincidental and had I run it after exactly three months (on 24 October) then, thanks to the pull-back that the stock market experienced at the end of October, results may have differed. But as the spirit of the system is to follow a semi-passive strategy and stay invested I think a week’s delay is fine – and in fact has saved on dealing charges!

So what of the constituents?

The rules for the portfolio reviews are to sell any share that a) passes its dividend or b) where the yield has fallen below the portfolio average and the share price is now below where it was a year before. On 5 November the average yield of shares in the portfolio was 3.83 per cent. Based on its dividend yield (3.75 per cent) being below this threshold and a negative 12-month price momentum at the review date (-11.1 per cent), DSSmith (SMDS) falls out of the portfolio. This is not to say that it is a bad company. Investors Chronicle still has the shares on a buy and it has actually stayed above water (1.32 per cent total returns) since the screen was first run.

Rather counterintuitively, while the rules have made me sell a company that has not done badly since the screen was first run (DS Smith has outperformed the benchmarks of the FTSE All-Share and the FTSE 350), I am not required to sell the worse performing companies in the original selection. BHP Billiton (BLT) (-20.7 per total returns since 24 July), Anglo American (AAL) (-15.1 per cent) and Amec (AMEC) (-13.42 per cent) all stay in the portfolio by virtue of having dividend yields above the portfolio average. In the case of these shares, it is tempting to push the panic button and sell, but it is in exactly these circumstances that the discipline of rules-based investing can help investors maintain their nerve and avoid selling out too early and crystallising losses.

BHP Billiton, Anglo American and Amec are facing headwinds in the resources sector, but Investors Chronicle still has all three on a buy. There are arguments not to buy these shares right now and indeed none would have made the portfolio had it been run completely afresh on 5 November. However, in addition to some of the highest yields in the portfolio, there are other compelling reasons not to sell the existing holdings.

BHP Billiton’s management is placing a strong onus on capital management that should result in a significant step-up in free cash flow over time. Anglo American has made operating improvements throughout 2014 and is trading at a 35 per cent discount to its sum-of-the-parts valuation. In the case of Amec, exposure to the oilfield services sector has weighed on the share price in the past year, but the group has secured new nuclear contracts and a tie-up with Foster Wheeler will double its revenues outside the heartlands of Europe and the Americas. Of course, as I’m putting my trust in rules, decisions aren’t being made on this basis anyway but it is reassuring.

Two new companies and new rules on diversification

To replace DS Smith I have re-run my screen and the shares with the highest dividend yield that meet my criteria are those of real estate investment trust (Reit) Londonmetric Property (LMP). In fact, the top four of the 15 companies in the 5 November screen are investment trusts, three of which focus on property. Of other companies included, the insurance sector is once again over-represented for the liking of any investor concerned with building a diverse portfolio.

The overconcentration in certain sectors, also evident in the 24 July screen, was noted by readers and is an obvious flaw in the High Yield System. Swapping DS Smith (General Industrials) for Londonmetric Property (Reits) narrows the exposure further. There are now two Reits in the portfolio, but this is still preferable to adding another life insurer, which would have made three in addition to four financial services companies (some of the conditions that have led to the life insurers ticking our selection boxes were covered in our Sector Focus of 19 September: http://bit.ly/15lVkM3). The lack of diversification is enough of a concern for me to introduce new rules to the system. From now on, no more than three companies can belong to the same sector and the broad financial sector (life insurance, banks and financial services) can have a maximum of five companies in total.

To try to avoid the portfolio becoming too concentrated, any new additions cannot increase the total number of companies in any given sector to above two. To enforce these rules, I must sell one of my financial services companies now. Of the four, Investec (INVP) has the lowest dividend yield, so I will cash in for a 9.97 per cent profit. In replacement, the highest yield to be found outside the Reit or life insurance sectors is the HICL Infrastructure Company (HICL), an investment trust. The yield of 4.78 per cent on this Investors Chronicle Top 100 Fund is certainly attractive.

I have to admit that these adjustments so early in the life of the revamped High Yield System do leave me open to allegations of back-tracking but I hope the new rules will be justified in saving ‘running around’ if there are future headwinds in the financial sectors – and that the portfolio will evolve to be more robust as a result.

High-Yield System Performance 24 Jul to 5 Nov 2014 – DS Smith and Investec leave the portfolio

*Sold on account of new diversification rules

High-Yield System screen 5 November 2014 – top two to join the portfolio