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HYP-othetical: Year 13 review

General discussions about equity high-yield income strategies
Luniversal
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HYP-othetical: Year 13 review

#190889

Postby Luniversal » January 3rd, 2019, 8:17 pm

This is probably the final report on a 'HYP-othetical' conceived in Motley Fool days: a backjobbed pretend portfolio, posted in Feb. 2011. It was to test Stephen Bland's, aka Pyad's, High Yield Portfolio method, in line with tenets laid down in 2000. Could his strategy for drawing a rising income from shares have surmounted the Global Financial Crisis of 2007-09?

To that end the notional date chosen for investment was Friday, January 13, 2006. It gave 'HYP06' a year or two to bed down before the blitz on earnings and frequent need for bailouts stalked big British companies. How bad a dent would that have put in HYP06's income stream, how soon- and how quickly might it have rallied?

Retrofitted portfolios are easy meat for claims of hindsight bias. I tried my best to think myself into the place of an investor in the New Year of 2006, innocent of imminent ructions; but some Motley Fools insinuated bad faith or subsconscious self-aggrandisement, which would only have made sense had I been striving to demonstrate stock selection brilliance, rather than trialling another man's method. Moreover, as with Bland's HYP1, the choice was confined to FTSE 100 stocks, unlikely to produce many baggers or bummers. Anyhow, I have run this trial for twice as long forward as backward, so any bias should be fairly washed out.


PRINCIPLES
HYP06 is, as far as possible, a passive, self-contained affair. No wilful tinkering to improve income or balance, only responses to force majeure. No capital added or removed since the original commitment. Dividends, including special payouts, spent, not ploughed back, but capital returns (e.g Vodafone) held for reinvesting.

Shares would only be dumped if they ceased to pay altogether, with no official indication that they would ever restart. Unfortunately even this concession to wilful activity led me astray. I 'sold' Persimmon, which appeared an early forlorn hope during the crunch but in time turned up trumps through its value-return scheme: see HYP1.

Newcomers would have been acquired for the same amount per unit, £3,712.50 net, as the 20 at launch: in this regard HYP06 is stricter than Bland, who was improvisatory about disposing of takeover proceeds and the like. No extra share would be bought until the total available for reinvestment was 150% of the unit cost: a rule I devised which I now think too limiting (see footnote).

The average trailing yield for the first twenty picks was 3.48% when the All-Share Index (FTAS) yielded 2.9%. I forget why I did not use the Footsie yield as a benchmark, but HYP06 was paying one-fifth more than the FTAS. It seemed adequate for a broadly spread HYP, whose members conformed to Pyad's call for a rising five-year dividend record and sound balance sheet.

At that time I had not yet formulated zonal theories about contenting oneself with a goodish-but-less-perilous target. As it turned out, the starting yield lay in the middle of what I would later christen the Goldilocks or Optimal Zone, where a portfolio's members return between 90% and 150% of the FTAS's yield. Historic yields varied between 2.4% for Tesco and BAe to twice as much for Dixons, but these three alone lay outwith the 'juicy but not too juicy for comfort' bounds.

SELECTION
The assumption was that £75,000, minus 1% purchase costs, went equally into 20 stocks. HYP1 had 15, but most Fools prefer more, and the vital principle of spreading risk through sectoral diversity was upheld with a score of shares from a universe of a hundred. Thirteen of those 20 have survived to the end of 2018:

BAe Systems
British American Tobacco
Centrica
Compass
Glaxo SmithKline
Land Securities
Legal & General
National Grid
Pearson
Royal Dutch Shell B
Tesco
Unilever
Vodafone

Three were taken over:
BOC
Kelda (formerly Yorkshire Water)
Scottish & Newcastle

Four were sold on passing dividends indefinitely:
DSG International (now Dixons Carphone)
GKN (erroneously chosen; it was outside the FTSE 100 in Jan. 2006, but only just)
Persimmon
Rexam

Bought to replace the vanished were:
BHP Billiton (from which South32 was spun off and retained)
Diageo
IMI
Next
Severn Trent
Standard Chartered
International Power, another substitute, was taken over.

INCOME
So far HYP06 has produced £53,614 of income from £75,000 of capital. This includes £647 of interest on monies held for reinvestment, though with today's deposit rates only £20-25 pa would have come in recently.

Last year income would have dropped by 15.4% to £4,935 after an exceptional £5,841 in 2017, due principally to a big special distribution by National Grid. In 2016 income totalled £4,685, in 2015 £4,883. The portfolio's payout fell between calendar years five times out of twelve, indicating the need for a reserve if purchasing power must be kept at least constant over time. (If a HYP is, for example, being used as a top-up of pensions, one might take the fat and lean phlegmatically.)

Revenue has compounded at 4.44% pa, an increase in purchasing power averaging around 1.5 percentage points. That is about the same as for UK Equity Income investment trusts in my 'Basket of Eight', which traffick more actively in much the same bunch of blue chip Britstocks. Year 12's income was about 19% higher after inflation than in its first year, if the Retail Price Index rose by the same last month as in Nov.

The assemblage averaged a 4.0% yield on market value, but last year it achieved 3.6% (2017: 3.5%). Higher-yielding equity has been more in demand than in the immediate fallout from the GFC.

Of the 13 survivors, the juiciest payer has been Compass with £5,811 from the initial £3,713 invested; this takes in a £1,030 special dividend. Next comes BATS with £4,650 and no specials. The back marker is Land Securities with £1,160, then Tesco with £1,355. Performances were erratic: the pyadic ideal of a gently rising real dividend was achieved only by BAe, BATS, Compass and (currency vagaries apart) Unilever. Every other share saw ups, downs and complications caused by corporate soft-shoe shuffles.


BALANCE
How diffused is this income now? In 2018 the five biggest payers were BATS (11.4% of total dividends), Compass (10.1%), Legal & General (9.2%), Next (7.8%) and Unilever (7.7%). Hence 46% of the haul came from five out of 19 contributors, if BHP Billiton and South32 are treated as one.

The poorest payers were Standard Chartered (0.8%), Tesco (0.9%), Pearson (2.0%), Land Securities (2.2%) and Vodafone (3.3%, but after two capital handbacks). In all, 9% of the total.

Only BATS and Compass provided, barely, more than twice as much as a mathematically equal 5% of all income, one-twentieth. I do not find such a skew alarming. BATS's dividend growth is decelerating, as has that of Next and Unilever among. Tesco and Standard Chartered are beginning to restore their dividends. The 'market trading' Pyad thought would reorder a portfolio more efficiently than deliberate tweaking seems to work for income as well as capital.

It is noteworthy that the 13 survivors' aggregate market value has been about two-thirds of the portfolio's since inception, as it was at end-2018. No individual valuation has gone to perdition or zoomed heavenward. This implies that in punters' eyes the combined income stream of the 13, while fluctuating among themselves, will not exhibit growing gaps between ever-better and ever-worse payers.

I see nothing in the HYP method that would inevitably conduce to unhealthy reliance on a few positions. Extremes emerged neither within HYP06 and other paper exercises nor in my real-world 'LuniHYPs'. Between disciplined picking (don't chase the yield), rigorous diversification and market trading's invisible hand, Doris needed no sleeping draught.


CAPITAL
By Dec. 28, 2018, HYP06's market value would have risen from £75,000 to £121,984, but it declined by 11.1% last year. Few members escaped: BHP Billiton, Compass, Diageo and Pearson alone showed gains, and three of those were recovering from deep troughs.

Over twelve years HYP06's real value, deflated by the Retail Prices Index, would have put on a modest 11%, and in eight of 13 calendar years. It would have beaten its benchmark, the FTSE 100 index, the same number of times. That said, 2018's slight edge over the index of 1.3 percentage points was below the average of 2.2 points, and followed three years of underperformance. Value investing has been out of style.

Last year's real loss of value, 14.4%, was the second worst after 2008's 21.3% during the GFC storm.

SAFETY MARGIN AND INCOME RESERVE
Holding back part of the income to cover future shortfalls is necessary if losses of purchasing power are intolerable. My way is to set a withdrawal rate below the initial intake, raise it annually by the cost of living and park the rest, if any, in a rainy-day income reserve. Eventually the withdrawal rate may be liftable.

With HYP06 this process supported a yield, net of the transfer to reserve, of 3.55% pa plus inflation in the first seven years. The reserve swelled from one month of current annual withdrawable income at Dec. 2006 to eleven months' worth by Dec. 2012. Investment trusts that major on income like to build such a kitty at the rate of one month's income a year until it holds a year's worth. To have almost reached that target after seven years seemed to merit upward revision of HYP06's withdrawal rate. I reset it at 4.26%+RPI, a one-fifth hike.

Four years later, a string of special payouts from Next and others had boosted the reserve enough to permit another hike in the withdrawable yield: to 4.91%+RPI, a 15% increase. Last year, the second at this level, the income reserve had to be called on for the first time: by only £243 from a reserve balance of £6,787, to fulfil an index-linked payout of £5,203 for 2018, but it is a straw in the wind. The priority must now be protecting the payout. Fifteen months of it was set aside at end-2018, which sounds comfortable... but what of dividends after Brexit, GFC2 (maybe), trade wars and all that?

To date the safety margin transfer to reserve has averaged 12% of 'raw' revenue. It is interesting that all sorts of portfolio to which I have applied derisking, not all oriented to income growth, have needed safety margin appropriations in a 10-15% range over time-- to keep spendable purchasing power at least stable and, occasionally, safely increased. I do not know if this is a universal rule. Possibly if inflation were endemically higher, and dividends found it harder to march in line, the 10-15% rule of thumb would fail.


OUTLOOK
I stress-test HYP06 with my gloomy hat on. Suppose inflation creeps over its 30-year norm of ~3%, up to 4% until the portfolio's twentieth anniversary. Then imagine that the bedrock of HYPs-- large, mature, potentially disruptable companies on highish yields-- struggle to keep distributions rising and manage only 4.5% more per share pa. That would leave ten months in the income reserve at Dec. 2025. Not quite enough for comfort.

It gets worse if one anticipates a year of sharp overall cutting, like 2008, coming soon. (There have already been two such since 2006.) Say that divis dropped by one-tenth in 2019 or 2020. If inflation were 4% and income recovered as soon as previously, rising by 4.5% pa after the annus horribilis, so small if prolonged a real improvement after bad cuts would not suffice: the reserve would be almost empty by 2025. The wisdom of 2016's second uplift in the withdrawal rate would have come to look questionable. However no allowance is made for one-off payouts such as lapsed-rights entitlements, which often accompany economic revival after a heavy fall.

The more one ponders such upsets, with all due respect for Strategic Ignorance, the more this lazy old so-and-so feels like bunging it all in investment trusts and letting their bods do the worrying.

Yes, HYP06 has supplied more spendable income than the Basket of Eight, and with a fair chance on precedent of widening the gap. Neither has it demanded an unconscionable amount of fuss: the last recycling purchase was Standard Chartered in March 2014. But if a decade of relative calm in corporate activity and of gently rising markets is closing, I might settle for Dorisian delegation and drowsiness.

PS: Scrapping my rule about having 150% of a unit purchase cost in the unallocated capital account beforehand, I could afford a 21st constituent. That might lift income by ~£180 pa, should a canny 5% yielder be available. My impression, though, is that Footsie candidates showing steady income growth, in sectors not yet filled, have become fewer since 2016.

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Re: HYP-othetical: Year 13 review

#190901

Postby TUK020 » January 3rd, 2019, 9:48 pm

Very educational. Thank you for sharing the wisdom gleaned from such an exercise.

pendas
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Re: HYP-othetical: Year 13 review

#191090

Postby pendas » January 4th, 2019, 5:47 pm

Thanks for continuing to report on this Luniversal, I'm sure it's much appreciated by many.

"PS: Scrapping my rule about having 150% of a unit purchase cost in the unallocated capital account beforehand, I could afford a 21st constituent. That might lift income by ~£180 pa, should a canny 5% yielder be available. My impression, though, is that Footsie candidates showing steady income growth, in sectors not yet filled, have become fewer since 2016."


An alternative in real life of course is to add spare cash to one of the existing holdings using one of the cheap dealing methods offered by some brokers when say £500 is accumulated. I realise it may complicate your reporting with the demo portfolio though.

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Re: HYP-othetical: Year 13 review

#191130

Postby 88V8 » January 4th, 2019, 8:23 pm

Luniversal wrote:The more one ponders such upsets, with all due respect for Strategic Ignorance, the more this lazy old so-and-so feels like bunging it all in investment trusts and letting their bods do the worrying.

Yes, HYP06 has supplied more spendable income than the Basket of Eight, and with a fair chance on precedent of widening the gap. Neither has it demanded an unconscionable amount of fuss: the last recycling purchase was Standard Chartered in March 2014. But if a decade of relative calm in corporate activity and of gently rising markets is closing, I might settle for Dorisian delegation and drowsiness.


Thankyou for posting this once more. Only over years is the QED of the pudding proven, or not.

Considering how much time I spend on my not very well managed HYP, it has to be said that far from being Dorisian, the selection and management process can be a veritable time sponge.
I come more and more to regard it as a hobby. A potentially beneficial hobby if well executed and with a suitable dollop of luck, and engaging for them as enjoys spreadsheets. My wife enjoys growing vegetables, with me it's old cars, it takes all sorts.

I persist HYP-wise, but time is not infinite, and I fear the Funds will get me eventually.

V8


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