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OPINION

The no-brain solution

The no-brain solution
July 19, 2017
The no-brain solution

This week we’re focusing on what we might label ‘the FTSE 100 solution’. First, however, a digression towards equity-income funds – in particular, investment trusts – which can provide a reasonable and rising income stream from a lump of capital while – quite likely – adding to the value of the capital over the medium haul (three to five years).

For online readers, click on the link below for salient details on 18 UK equity income investment trusts. True, lots of open-ended funds can do the same job; but, because capital can be added and withdrawn on demand, these lack some stability and generally come with higher costs than investment trusts. Hence my preference for so-called closed-end funds, where the equity capital is more or less fixed even if its ownership isn’t.

Those big trusts whose shares offer a 4 per cent-plus dividend yield and come at a price below net asset value, with a longer-term performance that’s at least up with the pack and low expenses are likely to be as good a bet as each other. There is little point in trying to pick winners. That would entail a combination of portfolio analysis and guess work that would be as demanding as building a portfolio. A quick reconnoitre indicates that any one of Dunedin Income & Growth (DIG), Murray Income (MUT), Shires Income (SHRS) and Merchants Trust (MRCH) would do a job.

Meanwhile, some components of the FTSE 100 index offer a no-brain solution, even if it involves paying extra in brokers’ commission. On average – and weighted by the market value of its components – the Footsie offers a 3.7 per cent yield on dividends likely to grow by a touch more than UK inflation. That’s an acceptable starting point, although – as we discussed last week – it’s debatable whether it’s a superior solution to buying a plain-vanilla annuity with a lump sum.

As we also discussed, it is possible to top the Footsie’s starting yield while barely raising the risks that growth in dividend income will stall. That’s done simply by bundling into one portfolio equally-weighted holdings of the top 10 FTSE 100 companies by market value. Do that and, on forecast payouts for 2017, the yield starts at almost 4.9 per cent from dividends covered almost 1.5 times by earnings.

A worksheet available online breaks down the Footsie into deciles, showing the components in each group of 10. It also highlights the obvious shortcoming of simply selecting the 10 biggest companies – it concentrates industry-specific risks too much. Three pairs of companies in the 10 are in the same sector. In effect, rather than there being 10 holdings, there are just seven. Express that the other way around – 20 per cent of the capital is invested in each of big oil, big pharma and global mining.

The solution is to eliminate holdings in the duplicated sectors and bring in the next biggest components of the index. Thus BP (BP.), AstraZeneca (AZN) and Rio Tinto (RIO) are axed. It is pointless holding these when the no-brain solution already has Royal Dutch Shell (RDSB), GlaxoSmithKline (GSK) and BHP Billiton (BLT). The next biggest companies to come in are Diageo (DGE), Prudential (PRU) and National Grid (NG.).

Big, unloved, but high yielding
CompanyCodeMkt Cap (£m)Price (£)Div Yield (%)Div coverCash flow cover
Royal Dutch ShellRDSB168,90620.617.30.90.6
HSBCHSBA141,7617.285.61.23.5
UnileverULVR117,80641.782.61.70.6
British American TobaccoBATS96,97752.193.21.70.2
GlaxoSmithKlineGSK78,38916.155.01.41.7
BHP BillitonBLT66,13112.433.52.30.5
Vodafone VOD58,3352.195.80.616.8
Diageo DGE56,76722.612.71.80.7
PrudentialPRU45,81817.802.43.32.7
National Grid plcNG.32,0749.355.21.21.3
Average of 104.31.62.9
Source: S&P Capital IQ

The decision to include National Grid was not completely formulaic. Shares in Carnival (CCL) and RELX (REL) – the former Reed Elsevier – had priority by dint of their market value. However, neither offers much dividend yield, whereas National Grid offers 5.2 per cent and its activities are distinct from the other nine, thus – arguably – it brings the diversification that Carnival or RELX would have.

The result is a 10-stock portfolio that starts with a dividend yield of 4.3 per cent (see table). Granted, that’s half a percentage point less than simply taking the 10 biggest holdings, but it would be foolish to overlook the duplication of stock market sectors. Sure, life being what it is, even these 10 will run into crisis; although from where those extremities will arise – sector specific or stock specific – it’s impossible to say. Nor can I say whether buying 10 big and unloved stocks such as these will be a variation on the ‘Dogs of the Dow’ investment formula.

Of course, I live in hope, and if an investment exercise as simple as this is successful it would solve not just the matter of Steve’s retirement income but a generic need for generating high and rising income from a lump of capital. It would also question the very point of research-driven portfolio selection.