The RIT High Yield Portfolio (HYP) – Update and Adding PSON and RDSB

When I reach Financial Independence in less than 3 years I'm going to be presented with a number of options, one of which will be to take Early Retirement.  Should I take that option I've already telegraphed that based on my current research I will start withdrawing from my wealth at the rate of 2.5% of total net worth on retirement day.  Ideally, this strategy will have then given me the option to increase my spending at the rate of inflation annually while ensuring the pot of gold at the end of the rainbow is never extinguished.  Of course I won’t blindly follow this strategy but will instead monitor closely and should that black swan arrive will cut my cloth accordingly.

As the do I take Early Retirement question looms I also want to make sure I have sufficient confidence in my financial situation that I don’t fall into One More Year (OMY) Syndrome but instead make the decision on will I or won’t I for purely non-financial reasons.  One thing that would build financial confidence and hence take some of the do I have enough doubt away was if my dividends and interest being earned across my portfolio exceeded the withdrawal rate from the portfolio allowing some reinvestment even in retirement.  Were I to retire today I estimate that after purchasing a home and moving my employer defined contribution pension into my SIPP my dividend plus interest yield would be 2.53%.  So right on the targeted drawdown amount.  Continuing to build my High Yield Portfolio (HYP) should increase that percentage.


Wealth Warning: 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. 

What is a High Yield Portfolio (HYP)?

In its purest form a High Yield Portfolio (HYP) is simply a strategy designed to develop a stable Income Stream with your Pension Fund or other investments.  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.  If you achieve this then your purchasing power is maintained or increased.

If you achieve the first priority then you can also look to target the second priority which is to maximise the capital growth (what so many fund managers chase) of the portfolio.  This will ideally be an outperformance when compared to the UK market.  Although I think that if one can achieve the first priority there is every chance you will get the necessary amount of the second to meet your Income Stream objectives.

So has my HYP achieved these goals?

Building my HYP is taking a long time.  This is because 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 since beginning my HYP journey, I have been given little opportunity to buy with either new money or through rebalancing.

The purchases to date have been:

• On the 28 November 2011 I purchased AstraZeneca (LSE ticker: AZN), Sainsbury’s (LSE ticker: SBRY) and SSE (LSE ticker: SSE).
• On the 21 December 2012 I added Vodafone (LSE ticker: VOD).  To avoid all the Verizon Wireless disposal fun and games I subsequently sold out on the 21 January 2014 and then repurchased the new VOD on the 30 April 2014.
• On the 11 October 2013 I received 227 shares as part of the Royal Mail Group IPO (LSE ticker: RMG).  I didn’t consider it a HYP purchase at the time (and still don’t) but simply the closest thing to free money I’ve come across in a long time.  The tax payer really was fleeced on that one.  It sits within my HYP as it is the closest match within the different portions of my portfolio.
• On the 03 March 2014 I then added HSBC (LSE ticker: HSBA)

Have the dividends achieved priority one, that is rising faster than inflation?  The answer so far is yes.  In 2012 my HYP provided a dividend yield of 3.76%, the FTSE100 3.72% and inflation 3.09%.  In 2013 my HYP yielded 4.21%, the FTSE100 3.46% and inflation 2.67%.

Having met priority one, has the HYP met priority two, that is capital growth greater than that of the market?  The answer again is yes.  In 2012 the HYP grew by 7.2% compared with the FTSE100 at 5.8%.  In 2013 the HYP achieved growth of 22.3% vs the FTSE100 at 14.4%.

So the strategy after this very short time period appears sound.  Long term the jury is still out.

Buying Pearson and Royal Dutch Shell

In my original HYP post I detailed the Acceptance Criteria for a share to be selected for my HYP.  Let’s today review my current 5 shares (I don’t include RMG as it’s not a pure HYP share) against these Criteria plus the two new share purchases made today.  These are Pearson (LSE ticker: PSON) and Royal Dutch Shell (LSE ticker: RDSB).  It’s worth noting that there were actually 2 shares above these when screening for new candidates.  They were BAE Systems (LSE ticker: BA) and Imperial Tobacco Group (LSE ticker: IMT).  For now I’m ruling them out for ethical reasons.  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.  Royal Dutch Shell is one of the most recognisable brands out there.  They find new oil/gas reserves, extract those reserves, refine the reserves into energy products and then supply those products worldwide.  Pearson is not such a recognisable name but most UK residents will know some of their products including the Financial Times, Penguin and Random House.  They are however transitioning into a global (inc $1.3B now coming from emerging markets) digital services (60% of revenue now comes from this area) learning company.  Both are simple to explain and understand.  All therefore meet my first criteria.

2. Large and in non-cyclical industries.

Both companies are within the FTSE 100 so meet the large criteria.  Whether or not we are in recession people/governments still need fuel and education.  So both meet this criteria.

3. A range of industries

AstraZeneca is from Pharmaceuticals & Biotechnology, Sainsbury’s is a Food & Drug Retailer, SSE which is an Electricity Utility and Vodafone is a Mobile Communications provider (although I consider them as a Communications Utility much like a Water, Gas or Electricity Utility).  Pearson adds Media while Shell brings Oil and Gas Production.  The group 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 3.43% and 150% of the FTSE 100 yield.

Today 3 of my 5 current shares are now over 150%.  PSON and RDSB both meet the 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.

4 of my current 5 have increased dividends at a rate faster than inflation over the medium term.  HSBA sinned badly on this front with a reduction in dividends of 23% but over the last 4 years they are well ahead of inflation with a 44% increase vs inflation at 16%.  Of the newcomers PSON easily meet the criteria.  RDSB are laggards following a few years of a sticky $1.68 dividend.  In the 2 years since the un-sticking they have increased by 7% compared with inflation at 6%.  Shell therefore does give me some concern in this area.

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 of my current HYP shares meet the criteria.  Both PSON and RDSB are on the cusp and make 1.5% if rounded to 1 decimal place.

7. Operating Cash Flow to Dividends

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Companies through ‘creative accounting’ can make their earnings look good, hence make 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.

My current 5 all meet the criteria and so are green.  RDSB also sales through.  PSON last financial year shows that they do not have sufficient cash flow to cover dividends.  The PSON board claim it was caused by restructuring charges, product investment and lower operating profit.  Sales were actually up a couple of percent and so we’ll see with time if this area is corrected.  I’m therefore setting PSON red on this criteria as if it continues over the medium term then dividends certainly won’t be raised and could be cut however given all of their other green’s I’m prepared to take some risk here.

As an aside PSON has also increased their net debt from £918M to £1,379M which is also a little concerning but on the opposite side they seem to have improved their pension liability situation.

Conclusion

I now own 7 of my 15 to 20 HYP shares.  Using my acceptance criteria the previous 5 still look like good HYP share choices.  I’m also genuinely happy with PSON and RDSB.  Of course I’d like more cash flow from PSON and a better dividend record from RDSB but is any company perfect.

What do you think?  Do you own a HYP?  If yes, has it delivered what you thought it would?

Always do your own research.