Ideal solution for investors whilst market is uncertain

AFTER two and a half years of significant losses in the equity markets, many investors are re-examining the benefits of investing for income, with the potential for capital appreciation.

Many quality, well managed companies with prospects have seen punishing falls in their valuations due to the difficult equity market conditions.

Falling valuations presented investors with the opportunity to buy good companies with high yields and the potential for capital appreciation, the ideal mix in the current market uncertainty.

So how has high dividend investing done in the past and what should you look for when investing for income with potential for capital growth? The most famous high dividend strategy is called the Dogs of the Dow.

This method involves investing the same amount of money in the 10 Dow Jones stocks that have the highest dividend yields and holding those stocks for a year. At the end of that year, you sell the Dow components that are not in the top 10 in terms of highest dividend yields and reinvest in the new highest ten yielding stocks.

In the past, the Dogs of the Dow method has worked extremely well, producing a compounded annual return of 17.7% since 1973. Over the same time period, the Dow had a return of only 11.9%! A study by Bath University showed the highest yielding portfolio of stocks produced an annual return of 19% from 1955 to 1988 compared to the index return of 13% during the same period, an average out-performance of 6% per annum.

A high dividend /income strategy for investing in equities beat the market by between 5%-6% per annum over a medium term time horizon. An impressive return on a simple strategy.

However, there are dangers in buying into stocks purely for a high dividend yield without reviewing the reasons why there is a high yield.

Firstly, the biggest threat to a high dividend yield investment is that there is no guarantee that the company will be able to maintain its dividend. Very high gearing levels, poor trading expectations and low cash generating ability all threaten the ability of a company to pay dividends.

Secondly, bombed out stocks which are experiencing negative or poor results often have seen significant price falls, but still do not represent good value investments. On many occasions, they show high dividend yields until they realign their dividend strategy with reality and they are still at risk of further share price falls.

Thirdly, the company may not be able to grow its earnings and increase its dividends. Therefore, it is constantly tagged as ex-growth and will offer very little capital appreciation.

We have specifically designed a 'black box' stock selection system to combat against the dangers when investing in high yield plays. The selection system is designed to identify stocks with above average dividend yields, safe dividends, potential for earnings growth and capital appreciation in the UK, Europe and the US.

Since we created the system, the results have been extraordinary. The high yield October UK portfolio has beaten the UK market by 20% in capital returns, on a yield of over 5%.

In Europe, our October, November and December high yield portfolios have beaten the Eurozone markets by 24%, 18% and 24% respectively in capital returns, on an average yield of 3.5%.

Our December and January high yield US portfolios have beaten the market by 18% and 15% respectively on an average yield of 3.7%.

Why has our system been so successful? We believe that it is a combination of a move to safety during volatile equity market conditions and also a recognition that income is a more valuable component of an investment return when growth is under threat.

So what secret 'black box' system are we using to give us these results? The system searches for companies with specific characteristics and the sequence is actually quite simple.

The companies selected must have:

High dividend yield.

Reasonable size.

Low debt levels.

Not significantly under-performed the market in the previous six months. Expected earnings growth of over 5%.

Price Earnings ratio of below 20 times earnings.

A dividend policy which pays out less than 60% of cash flow in dividends.

The list of companies with which we are left, provides both strong income and a higher potential for capital gain, an ideal combination in the current market conditions. A selection from our current portfolio is shown in the accompanying graphic.

Company Name Last Closing Price % Dividend Indicated Yield Net BOOTS COMPANY PLC Stgp 574.0 4.78 BRITISH AMERICAN TOBACCO PLC Stgp 740.0 4.47 SAINSBURY (J) PLC Stgp 330.3 4.49 SIX CONTINENTS PLC Stgp 648.5 5.35 BNP PARIBAS E 52.3 2.29 TOTALFINAELF SA E149.5 2.53 MERCK & CO. INC. $ 51.9 2.78 PHILIP MORRIS COMPANIES INC $ 50.6 4.58 FYFFES E 1.4 3.71 ARNOTTS E10.8 3.27

Kevin McConnell Head of Equity Research Bloxham Stockbrokers