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High yield shares for bears

Created:
25 February 2008
Written by:
David Stevenson

Experience teaches us one thing - in troubled times investors eventually have to dump the risky investments and start putting money into what are perceived as less risky bets. They tend to dump 'growth' shares and small caps, along with emerging markets shares and concept stocks. Instead, the money goes into cash, gilts and large stocks boasting steady cash flow. So make the trend your friend, and use our screen to find solid, large companies with massive cash flow paying healthy dividends.

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One of the simplest ways of stock-picking in this sector is to use Peter Temple's UK version of the classic Dogs of the Dow Strategy. This is a very simple system that starts each year with an exercise that involves ranking the biggest companies by size of dividend yield, and then buying the top five (in terms of yield) companies in the list. That's it!

Sometimes its works, and sometimes it doesn't, so we've been trying to evolve a slightly more sophisticated way of spotting blue chips with solid prospects, using our Large Cap, Low Correlation screen. Here were the original criteria:

• Relatively large cap. That means a minimum of £500m;

• An above average dividend yield - in this case, above 3 per cent if not above 3.5 per cent;

• Solid evidence of decent cashflow. That means the price to cash flow measure must be positive and be below 10

• A low beta. Beta is simply the measure of a share's volatility relative to the market (in this case the FTSE 100). A beta of greater than 1.0 indicates that the share (or fund) is more volatile than the market, and less than 1.0 is less volatile than the market. For example, if the market rises 1 per cent and a share has a beta greater than 2.5, the fund will rise, on average, 2.5 per cent. For a fund with a beta of 0.4, if the market rises one per cent, the fund will rise on average, 0.4 per cent.We're looking for a beta of less than one, as we don't want our shares bouncing up and down every week.

• A low correlation with the stock market. Correlation is simply a way of measuring how two sets of numbers - in this case a share price and a wider index - move together. A correlation coefficient of +1 means that two variables (share price and index) will always move up and down together. A correlation coefficient of -1 means that one variable moves down when another moves up. A correlation coefficient of zero means that the movement of the two variables shows no pattern. We're looking for a correlation as close as possible to 0, but preferably below 0.8.

To date, we've run two versions of this screen with sharply differing results. Our first version has been a tear-away success, handsomely beating the market. The second version, from summer 2007, has been a crushing disappointment, down a nasty 25 per cent. That largely reflects the fact that half the constituents were housebuilders, whose shares have been hammered by worries over slowing house prices and sub-prime lending.

May 2006 portfolio

Name Purchase price (p) Current price (p) % change
FirstGroup 423 601 42.1
Dairy Crest 475 557 17.3
National Express 901 1080 19.9
Davis Service Group 478 516 8.02
Viridian Group 953 1325 39
Average 25.3

July 2007 version

Name Purchase price Current price % change
Bovis Homes 795 556 -30.1
Drax Group  737 528 -28.4
National Express  1115 1080 -3.14
Persimmon 1167 706 -39.6
Average -25.2

Moving forward, we're tinkering with this system to emphasise a number of key characteristics in our chosen companies:

• A progressive dividend policy. We'd like the dividend payout to have risen every year over the last five years. Dividends are an absolutely crucial part of shareholder returns - a recent report by James Montier at SocGen revealed that over any 5 year time horizon, nearly 80 per cent of total real return is dependent on either the dividend yield or the growth in real dividends (this analysis was based on data from 1871 to today). Dividends really do matter over the long term.

• We'd also like to see the dividend payout well covered - that means that EPS is at least twice the dividend payout. In sum, we want hard evidence that the company can afford the dividend.

• We also think that investors need to be wary about timing their purchase of blue chips. We think that you should avoid buying shares where analysts estimate a fall of more than 10 per cent in EPS in the coming year.

Using this set of measures we've now re-run our screen in the current market - but we've made two last small alterations. The first is that we believe you should not pick more than one company from each sector and we've also increased the yield we're looking for to a minimum 4.5 per cent per annum.

The current shares

Let's be very clear about what this screen is going to throw up in terms of shares. They're going to be classic dull-but-worthy, buy-and-hold stocks. We're not going to be buying growth stocks, or high-beta shares that will zip up as soon as the market perks up. The screen isn't designed to look for bargains either. You're buying quality, so expect to have to pay for it.

Price metrics

Name Price (p) Mkt cap (£bn) 3M price change 12M price change Correlation Beta
Hays  104 1.46 -16.27 -34.12 0.43 0.88
Marks & Spencer 411 6.74 -36.38 -40.26 0.4 0.7
Persimmon 726 2.18 -15.09 -47.66 0.29 0.49
William Hill 393 1.36 -32.24 -40.59 0.35 0.53

Financial metrics

Name Consensus broker recommendation Most recent EPS growth % Forecast EPS growth % Fwd PE ratio Fwd dividend yield %
Hays  Weak buy 17.1 17.5 8.76 5.51
Marks & Spencer Hold 27.9 5.9 9.75 5.43
Persimmon Weak buy 14.1 5.2 5.25 7.16
William Hill Weak buy 21 3 8.74 5.92

The four companies highlighted in this screen are all stalwarts of any equity income portfolio. They're all incredibly sound businesses paying out solid dividends that are sustainable. Shares in each of the four companies have fallen in the last six months, especially those of Persimmon. And there's bound to be plenty more grim news in the next few months as the economy slows down.

But this screen is about identifying long term winners, and these four qualify as quality investments. Each of the companies in the list is either number one or two in its market segment, with a premium reputation and well respected management. All are in cyclical markets - recruitment, leisure, retail and housebuilding - that are being downgraded, but the real economy outside the City will prove to be much stronger than analysts forecast.

BUT SHOULD I BUY NOW?

There's an incredibly strong argument for suggesting that you wait for a few months before buying any of these shares, in part so that you can be sure that the worst news is out of the way. But study of investment history also suggests that market timing is a mugs game and these are good buys now, with the bad news already factored into the share price. But for the record, if you were to think about market timing your purchase, we’d set a target buying price of 380p on M&S, 650p on Persimmon, 350p on William Hill and under 100p for Hays. You can set up a watchlist and some price alerts in the IC portfolio tool - just click on the MY PORTFOLIO button and select 'Default watchlist' from the drop-down menu.

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