The RIT High Yield Portfolio (HYP) – Adding VOD plus the New Contenders

The full detail on what a High Yield Portfolio (HYP) is, why I decided to build one and full detail on my initial selection can be found in my original post on the topic.  This post builds on that original HYP post and so is important reading for any newcomers to Retirement Investing Today.

Wealth Warning: As I said in the original post I don’t know if long term this HYP strategy will work.  There is every chance that a simple diversified portfolio of lowest expense index trackers that are invested tax effectively will in the long term outperform this strategy.  Only time will tell.

In November 2011 I added my first 3 HYP companies.  These were AstraZeneca (LSE ticker: AZN), Sainsbury’s (LSE ticker: SBRY) and SSE (LSE ticker: SSE).  I’m writing this post as late last week I added my 4th company, Vodafone (LSE ticker: VOD), for which I had to pay £1.552 per share.  This purchase was funded by moving 0.8% of my Low Charge Investment Portfolio assets from cash.  It takes the HYP portion of my Portfolio to 3.2% of total assets.

It’s been over a year between purchases.  The HYP is counted as part of the UK Equities allocation within my non-emotional mechanical investment strategy.  With the majority of that currently being FTSE All Share Trackers, which have risen nicely over that period, I have been given no opportunity to buy with either new money or rebalancing.

Reviewing the High Yield Portfolio

In my original post I stated that “The first priority is to amass 15-20 shares (minimise company risk), from different industries (minimise sector risk), from the FTSE 100 (minimise stability risk) that you believe will spin off dividends that rise at or above the rate of inflation.”  The purchase of Vodafone means I am still a long way from a mature HYP with a need to purchase shares in a further 11 to 16 companies.  All 4 companies to date are from different industries and are from the FTSE100.  Year on year all have increased their dividends at or above the rate of inflation – SBRY by 6.6%, AZN by 9.1% (once converted from $’s to £’s), SSE by 6.8% and VOD by 7.0%.

With the first priority met my second priority was “to maximise the capital growth ... of the portfolio” which will “ideally be an outperformance when compared to the UK market.”  To account for purchases at different times, which I need to do if I am to benchmark myself against the FTSE100, I unitise my HYP.  Since purchase my HYP units have risen by 12.3% and calendar year to date they are up 8.1%.  This compares favourably against the FTSE100 which with a Price of 5,951 at the time of writing is up 12.0% and 6.8% respectively. 

All have provided a dividend yield above that of the FTSE100’s current 3.69%.

Buying Vodafone plus the New Contenders

In my original post I detailed the Acceptance Criteria for a share to be selected for my HYP and mused that the next share purchase could be Vodafone.  Let’s review my current 4 shares against these Criteria plus add 3 new possible next purchase shares into the mix.  These are BAE Systems (LSE ticker: BA), Royal Dutch Shell (LSE ticker: RDSB) and Imperial Tobacco Group (LSE ticker: IMT).  The reason I am reviewing 3 shares is that I need to make a serious ethical decision on two of the companies before my next share purchase.  BAE Systems make weapons and IMT make cigarettes both of which I believe can easily be argued kill people before their time.

1.    Is the business model simple to understand?

The first criteria is qualitative.  I want to understand how the business I’m buying makes its revenues in less than 10 seconds.  Vodafone provides mobile voice, messaging, data and fixed broadband and has over 40 million customers.  BAE Systems makes products and delivers services covering defence and national security.  Royal Dutch Shell finds new oil/gas reserves, extracts those reserves, refines the reserves into energy products and then supplies those products worldwide.  With Imperial Tobacco it’s all in the name with the focus being manufacture of tobacco products.   All are simple to explain and understand.  All therefore meet my first criteria.

2.    Large and in non-cyclical industries.

All of the companies are within the FTSE 100 so meet the large criteria.  Whether or not we are in recession people/governments still communicate using various non face to face means (Vodafone), want to kill (maybe a little harsh) each other (BAE Systems), need energy (Shell) and smoke (Imperial Tobacco).  So all meet this criteria.

3.    A range of industries

I already own AstraZeneca which is from Pharmaceuticals & Biotechnology, Sainsbury’s which is a Food & Drug Retailer and SSE which is classified as an Electricity Utility.  Vodafone is classified as Mobile Communications although I wonder if in the modern day they are simply a big Communications Utility much like a Water, Gas or Electricity Utility.  BAE would add Aerospace and Defence, Shell would add Oil and Gas Production and Imperial Tobacco would add Tobacco.  The group would then continue to meet this criteria.

4.    Dividends payouts that are above that of the FTSE 100.

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I am looking for shares with dividend yields somewhere between the current FTSE 100 yield of 3.69% and 150% of the FTSE 100 yield.

Today 3 of my 4 current shares are now over 150%.  My existing 3 were all green when purchased.  VOD was slightly over 150%, at 166%, when purchased.  The 3 New Contenders all meet my Acceptance Criteria.

5.    An unbroken history of continually increasing dividends plus dividends increasing at a rate equal or greater than inflation.

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My acceptance criteria under this metric are that the dividends over the medium term must increase at a rate equal to or greater than inflation.   Ideally, for at least the last 5 years dividends this will be year over year increases. 

All have increased dividends at a rate faster than inflation over the medium term.  Shell, however, have not increased their dividends in the last two full years which is a potential concern.  Year to date they have however declared 3 quarters worth of dividends which if the trend continues into the fourth quarter would see dividends increased year on year by 2.6%, when measured in dollars, which is a little better than UK inflation.  I’m therefore going to set Shell to Amber and watch what unfolds closely.

6.    Dividend Cover.

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My acceptance criteria requires a ratio of greater than 1.5 for all HYP type shares except utilities where I think that greater than 1.25 is ok.  I accept a lower Dividend Cover for good utility companies as their earnings should be some of the most consistent with little to no cyclicality.  I also don’t like too high a Dividend Cover as I think this encourages CEO’s with delusions of grandeur to run off and make over priced acquisitions, or worse, use the profits not paid as a dividend to buy back the companies own shares thereby maximising their bonuses.  All meet this criteria and so are green.

7.    Operating Cash Flow to Dividends.

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Companies through ‘creative accounting’ can make their earnings look good, hence Dividend Cover look good.  Therefore while I look at Dividend Cover, I also set a criteria on Operating Cash Flows compared to Dividends.  The criteria is greater than 2. 

Sainsbury’s, SSE, Vodafone and Royal Dutch Shell all meet the criteria and so are green.  Astra Zeneca and Imperial Tobacco while meeting the criteria have seen falling operating cash flows per share for the last two years.  They will need watching carefully and so I have set them to amber.  BAE has seen operating cash flows to dividends fall by more than two thirds in the last 2 years and to make matters worse these cash flows don’t cover the dividend.  I’m therefore setting BAE to red on this one.     

Conclusion

I now own 4 of my 15 to 20 HYP shares.  Using my acceptance criteria the original 3 still look like good HYP share choices.  I’m also happy to have picked up Vodafone at £1.552 per share.  The only concern is that VOD’s Dividend Yield is more than 150% above that of the FTSE100.  What does the market know that I don’t?

Finally, ignoring ethics who would I choose out of RDSB, IMT or BA today?  I’d exclude BA on cash flow concerns.  Of the other two IMT’s cash flows per share seem to be falling and RDSB is possibly struggling to increase dividends fast enough.  Before deciding I’d probably have a closer look at the other big tobacco company, British American Tobacco (LSE ticker: BATS), where I know their operating cash flow per share is increasing.

What do you think?  Do you own a HYP?  If yes, has it delivered what you thought it would?  Do you have better metrics than the ones I use above?  Do you agree with my metrics?  I’d value any comments or thoughts.

Always do your own research.