Try to imagine this matrix in chart form. Along the horizontal axis, going from left to right, we place sectors with declining degrees of cyclicality, from hugely cyclical ones, such as housebuilders and engineers, to the non-cyclicals, such as utilities and food producers, far out on the right. Along the vertical axis, from bottom to top, we position sectors according to whether their constituent companies sell small-ticket or big-ticket items. At the bottom would be sectors such as retailers and beverages, which get by with many thousands of small transactions. At the top would be the likes of aerospace and oil exploration, where transactions are fewer and bigger. This separation also attempts to show where a sector stands in the economic cycle. Small-ticket players are more likely to be consumer-facing and early cycle. Big-ticket players veer towards selling capital goods to business customers and will be late cycle.
True, it's a messy exercise - trying to squeeze three or four factors into two-dimensional space. But it focuses the mind on which stock market sectors may be in or out of fashion. In the past six months the bottom left-hand quadrant has been the in place, as shares in housebuilders or general retailers testify. Bearbull - cautious as ever - has favoured the bottom right-hand quadrant. This area is populated by non-cyclical small-ticket sectors, such as food retailers or tobacco stocks, about as defensive as it is possible to get.
However, the pertinent question is: in which quadrant do you want to be now? To put it another way: are you gutsy enough to be in the top left of the matrix. This is the part occupied by cyclical sectors where component companies sell big-ticket items. So it should be the place of choice for those who truly believe that global economic recovery will be untroubled and is imminent. Clearly, some brave souls are already there because top-left-quadrant sectors, such as technology hardware and oil services, are among the best-performing sectors so far this year. By the same logic, defensive sectors have been dumped. That's an exaggeration, but some safe sectors, such as utilities, pharmaceuticals and tobacco, are among 2009's worst performers.
Then again, the performance of other sectors makes the message fuzzy. For example, if investors have discounted the first phase of economic recovery, then why are general retailers still so strong? If they are now focusing on the second phase, when capital goods suppliers come into their own, then why is the real-estate sector still so weak? Besides, stock market sectors are often a hotch potch, so lots of company-specific factors can affect their performance.
However, my imperative is to find new holdings for the Bearbull Income Portfolio. If that means venturing into the top-left quadrant of the matrix, then so be it. The test should not be whether a company is highly cyclical but whether the dividend yield on its shares meets my threshold - currently about 5 per cent - and the payout looks fairly well assured. Possible penalties or rewards for investing in a dangerous part of the equity market are subsidiary factors.
Certainly, high-yield shares in the likes of Bodycote, Meggitt and Umeco, which have all crossed my radar screen, are top-left stuff. True, Investors Chronicle has a sell recommendation on Bodycote's shares (see last week’s magazine). But I was encouraged that the firm's bosses have maintained the half-year payout for 2009 and that they see a small uptick in demand from automotive and general industrial customers. That, incidentally, is consistent with the message from instruments maker Renishaw, which is similarly exposed to the automotive industry.
Meanwhile, the 8.5 per cent yield on shares in Umeco indicates the dividend may well be cut. Granted, Umeco's exposure to aerospace, via both its composites and supply-chain operations, and to automotive, via composites, is hardly ideal. But the group started 2009-10 with an order book of £219m, which was marginally ahead of the situation a year earlier and covers roughly half expected revenues for the year. In addition, its bosses have pledged to reduce debt during the year, which should not be too hard if sterling maintains its recent strength against the dollar as most debt is in dollars. Combine these two factors, and a maintained dividend for the year does not look so outlandish after all.
So what I've done is to buy 9,500 shares in Umeco at 207p each and combined those with topping up the income portfolio's existing holdings in GlaxoSmithKline and Chesnara. At £11.56, Glaxo's shares yield 5.2 per cent on a payout that's as safe as houses and, at 155p, Chesnara's yield 10.3 per cent. I have bought an additional 850 shares in Glaxo and 3,200 in Chesnara, giving me a weighted yield on these transactions of 7.8 per cent. That should be enough to compensate for much of Umeco's risk. Besides, the historic covariance between these three shares is beautifully low, meaning that they should work together well in a portfolio. That is important because a portfolio must cope with unknown hazards, pitfall and uncertainties. It's as they say in the film, The Matrix: "Welcome to the real world".
