It’s been another disappointing six months for Investors Chronicle’s high-yield system which despite generating £4,883 in dividends since April 2016 (just below the new £5,000 threshold before dividend taxation needs to be applied) is down by another 3 per cent overall. Casting an eye over the worst performing stocks in the portfolio, it seems the way the system works as effectively a value investing strategy is behind much of the weakness.
Value stocks achieve capital gains for investors when the price re-rates because the market has previously discounted the underlying assets and/or earning potential of a business. The most commonly used indicator of value is the price to book (PB) ratio, which gives the share price as a multiple of the book value of assets (land, plant, inventory, receivables, cash etc). One of the main rationales for value investing is that often companies have temporarily fallen out of favour and are trading on a low price to book, even though they have now improved their situation. This assumes that those undervalued assets are productive; and some stocks are value traps because companies are not currently capable - thanks to the macro economy, regulatory restrictions or poor management - of generating additional utility. This has been the case for many value stocks over the last few years, as globally weak GDP has meant there hasn’t been demand in the economy for unloved stocks to make full use of their capacity.
The high-yield system has filters (see below for the full rules) but, after these have been applied, FTSE All-Share companies are selected on their dividend yield. If companies that pay a dividend have a lower share price then the yield will be higher which, like a low PB, can indicate value. Given the strange circumstances of quantitative easing and rock bottom bond yields, traditionally safe income stocks are expensive and trading on a low dividend yield, effectively pricing out the high-yield System. The result is that the portfolio has more value stocks – companies which are facing difficulties or are out of favour but have a nominally generous dividend – and in the absence of the economic growth the value factor typically needs to make good, this has meant a general underperformance across the board.