Gains wiped out by poor performers

The system selects stocks according to dividend yield from the filtered down FTSE All-Share universe (full rules are in the box below). In the last review, the decision was made to add some new rules and back test the performance as though £150,937 (£150,000 plus initial costs) had been invested on this basis since 24 July 2014, when the portfolio was first published. Broking fees, spreads, income tax and stamp duty have all been taken into account for a more accurate simulation.

Unfortunately, some of the holdings have had a torrid six months, resulting in underperformance of the parent index and the FTSE 350, which is the system's benchmark. After tax and charges, the portfolio would now be worth £147,897.39, which represents a loss of -2.01 per cent from its inception, and of -5.28 per cent since the previous rebalance last September.

The reason for the footballing comparison is the 'Tinker-man' sobriquet bestowed upon Leicester's manager, Claudio Ranieri, towards the end of his spell in charge of Chelsea. The same accusation can be levelled at the management of the high-yield system, but one of the new rules, in particular, can be credited with saving the portfolio from greater losses.

Originally, it was envisaged that holdings would rebalance on an equal-weighted basis at each review. After a few months, this didn't seem sensible - gains from stocks with positive momentum were being recycled into other shares, especially those in the mining and oil services sectors, which were falling like a stone. In the revised methodology, only stocks with positive momentum are rebalanced, with gains spread evenly across these holdings and replacements for positions that are exited (stocks are sold if they combine negative momentum with a dividend yield below the portfolio average; or if the dividend is passed). Dividends are not reinvested right away. Instead, the cash is held until the rebalance and ploughed back into the winners and new additions.

This approach to income and rebalancing has, in part, mitigated the system's tendency to stay in poorly performing investments. On one hand, the rules prevent panic selling, but on the other hand maintaining exposure to the shockingly performing mining sector, on account of the high dividends, has been a serious drag. Positions initially worth £10,000 each in Anglo American (AAL) and BHP Billiton (BLT) are now valued at £3,685 and £3,999, respectively. Anglo American's decision to pass its last dividend means the shares are finally sold at a 63 per cent loss. The portfolio keeps its BLT holding, as although the dividend policy has been adjusted, the last payment was not axed completely.

Knowing when to sell is possibly the hardest part of investing, and many people demonstrate what is known as the 'disposition effect'. This is where actions that engender pride are sought; and those that cause regret are avoided. In a bid to lock in pride, many investors will sell out of profitable positions too early, when they could have run profits for longer. Conversely, seeking to avoid regret, investors hold on to losing positions for too long, hoping to eventually break even. The mechanisms in the High-Yield System seek to take the emotion out of decisions to buy or sell shares, but clearly they have been far from foolproof in hanging on to dogs such as AAL for far too long.

Other holdings under water since September, include Amec Foster Wheeler (AMFW), down a further 40 per cent; Galliford Try (GFRD), down 28 per cent; and Kier (KIE), down 17 per cent. Like BLT, these positions are maintained, as yields are all at least the same as the portfolio average. Going forward, there is a danger that some stocks continue to do badly and the system will, as in the case of AAL, only dispose of them at a massive loss once the dividend has been passed.

Decisions on selling are left up to the system and it must be hoped that the fortunes of companies such as Amec and BHP Billiton can be revived without recourse to passing on the dividend. In the case of Amec, restructuring of debt covenants and the better-than-expected cash flows reported last month, are cause for optimism and Investors Chronicle's companies team has the shares on a buy rating. For BLT, the risks are greater amid an uncertain outlook for commodity prices but, as we reported in February, the company is in better shape than most of its peers.

Turning our attention to non-commodities sectors, the share price of construction company Galliford Try has suffered as the quality of work done on Scottish schools, by the company it acquired, has been scrutinised. This issue does not worry our reporters and Investors Chronicle sees plenty of potential for the shares' longer-term upward price trend to continue. Likewise, Investors Chronicle also has Kier on a buy, with a positive revenue outlook for all its divisions and expectations for smooth integration of recent acquisition, Mouchel.

Along with Anglo American, positions sold in April are Segro (SGRO) and Close Brothers (CBG). Neither of these are bad companies and both are IC buy recommendations. Close Brothers is the victim of wider financial market volatility in the past six months. In the case of Segro, the stock has simply fallen foul of a to-the-letter interpretation of the high-yield system rules. Its yield is below the portfolio average and, despite positive six-month momentum, over one year the shares happened to be marginally down on the date the screen was re-run.

New additions

To replace disposals, the system has bought Sainsbury (SBRY), Greene King (GNK) and Intermediate Capital (ICP). All of these companies match the requirement for positive price momentum. It is something of an anomaly that the high-yield system should sell out of Segro, which had a dividend yield of 3.6 per cent to buy Greene King, which yields 3.5 per cent. Following Mr Ranieri's example (consistent team selection has been the foundation of Leicester's outstanding season), there will be no more tinkering with the rules of the high-yield system. As there has never been an explicit requirement for buys to have a higher yield than stocks they replace, the portfolio accepts the changes foisted upon it by the selection criteria.

Heavy losses over the past six months have been disappointing, but a combination of the portfolio's diverse nature and reinvestment only in stocks with momentum has helped reduce the impact of some of the worst performers. With the problem holding of AAL sold, the current portfolio has a nice balance to it, combining companies with good momentum and stocks with rebound potential. There is always the chance that global macro factors and systematic market risk will bring about more pain, but that enormous caveat notwithstanding, as Investors Chronicle's reviews of most current holdings testify, overall the prognosis is fair ahead of the next review in October. Of course, a lot can change in six months. Just ask Mr Ranieri's more illustrious successor at Chelsea, José Mourinho.

High-yield system holdings 11.04.16

Sources: Thomson Datastream, Bloomberg & Investors Chronicle

High-yield system rules

Stocks are selected from the FTSE All-Share having applied the following screening criteria:

■ Positive 12-month price momentum.

■ Market capitalisation in the top 40 per cent of the universe.

■ Dividend yield not in the top 10 per cent of the universe (this is a quality measure).

■ Dividend cover above 1.5.

■ Remaining shares ranked on dividend yield.

■ Companies sold if they combine negative 12-month price momentum with a dividend yield below the portfolio average; or, if the dividend is passed.

Diversification rules:

■ No new addition can increase the number of companies in one sector above two; and there can be no more than five companies in the broad financial sector (banks, financial services, life insurers).

Rebalancing rules:

■ Portfolio rebalanced every six months.

■ 'Winners only' rebalancing of shares with positive price momentum since the last review.

■ Only rebalance shares where a minimum 5 per cent holding change is required.