Saturday, 19 January 2013

Investing for Income via Higher Yielding Shares

I’d like to welcome back John Hulton.  John claims to not be a financial guru, stockbroker or financial journalist, but just an average bloke who has managed to find a way through the minefields of personal finance and develop a system that works for him and, which could be helpful for other people.  He has already retired from full time work which puts him at the end game of what this Site is about – Save Hard, Invest Wisely, Retire Early.  The fact that he did this at 55 means his Save Hard, Invest Wisely element worked for him.  So while John is not a financial expert his approach has given him what many of us are chasing.  I hope you again enjoy his thoughts.

There’s no getting away from the fact that the past 4 or 5 years have been tough for savers and pensioners.  The Bank of England has kept interest rates at a record low 0.5% for the fourth consecutive year.  Annuity rates are equally at an all time low and there appears little reason to think there will be any significant change for the foreseeable future.

According to a recent study by Prudential, people retiring this year will have a typical yearly income of £15,300, around £3,400 less than those who retired in 2008.  In a separate report by Moneyfacts, they found that annuity income fell by 11.5% in 2012, the biggest annual fall since 1998.

Understandably, many savers are looking for alternatives which can provide a better return than the 2% or so on offer from their bank or building society.  Likewise, people approaching retirement are investigating alternatives to the rock-bottom annuity rates currently on offer.

One way to maximise income is to invest in a diverse portfolio of large, well-run companies which will grow their earnings and profits for the decades ahead.  Companies which have weathered the storm over the past 5 years and have also managed to maintain a steady stream of rising dividends are likely to continue doing this in the future.

In my ebook Slow & Steady Steps from Debt to Wealth I set out a step-by-step guide to generating income from the stockmarket.  I have found, through a process of trial and error over several years that a combination of individual higher yield shares together with a portfolio of investment trusts gets the job done for me.

In a post earlier this month I outlined some of the benefits of investment trusts and in this second part, I will cover my higher-yield shares portfolio.

For me, the main advantage of holding individual shares is lower ongoing costs - after the initial purchase, which could be as low as £1.50 plus 0.5% stamp duty, there are no further costs involved in holding the portfolio.  I suppose if you are in the build phase and reinvesting dividends from time to time in more shares, there will be some further minor cost but basically, once you have purchased your 15 or 20 shares that’s it.  With investment trusts there are the same initial costs to purchase PLUS the trusts annual expenses and management fees - usually between 0.5% and 1% (plus any performance fee).

Now you would think that the share portfolio, not having any ongoing costs and expenses, should outperform the investment trusts but my experience over the past 3 years running the two types of portfolio in tandem shows that each year the investment trust portfolio has delivered a slightly better (by 2 or 3%) total return.  I suspect the trust managers ability to take advantage of such complexities as gearing and options may have something to do with performance.  I will keep the two portfolios running in tandem for a few years to see how things progress.

Investment trusts tend to hold back some of their annual income in good years and return it in poorer years thereby smoothing the dividend pay-outs.  For investors who do not require an immediate income, it will be more beneficial to reinvest the higher pay-out ratio from the shares portfolio and thereby turbo charge the rate of growth.  This year, my shares increased dividends by 9% on average but the investment trust portfolio was only 5%.

The third reason I like shares is the appeal of choosing companies in which you might have some direct experience.  For example, I use a Vodafone mobile, I shop at Tesco, I read the FT (Pearson), I also use many everyday household items made by Reckitt Benckiser, Unilever or Glaxo Smith Kline (GSK).  Since acquiring my very first shares in Abbey National when they were demutualised in the late 1980s, I have always held individual shares.

Finally, I suppose personally, I just like the fun and competition of attempting to out-perform the professional managers of my investment trusts - so far, as I say, without much success (but next year!…)

I currently hold a core portfolio of 15 higher yielding shares which have been gradually accumulated over the past few years.  Some investors prefer a much larger portfolio - maybe 30 or 40 shares, however 15 is a manageable number for me to keep tabs on and also, I think beyond 15 or maybe 20 at most, the benefits of diversity start to diminish rapidly.  If you are not careful, it can turn into the equivalent of stamp collecting.  That’s not to say I won’t add one or two shares when an opportunity arises but more likely, I will first scrutinise existing holdings with a view to replacing rather than adding if the prospective new purchase is compelling.  Generally the share purchase is for the long term - maybe 20 to 25 years - and held on a long term buy-and-hold basis.

Although my portfolio is now largely completed and generating a useful income, I like to maintain a watchlist of shares and, as I research each one, I set a target price at which I would like to purchase.  The more reasonable (lower) the price, the higher the starting dividend yield. Needless to say there have been many opportunities over the past three or four years to pick up quality shares at a bargain basement price - although I must admit it does take a lot of nerve to buy shares when markets all around the world are in freefall!  In the past 12 months I have added Tesco, Carillion and RPC Group.  It’s now a time to sit back, monitor dividend receipts and review annual reports - to quote from legendary investor Warren Buffett, “The stock market is designed to transfer money from the active to the patient.”

Regarding share selection, I usually like to focus on larger, more mature companies as they tend to be more resilient when times are tough.  They must possess good fundamentals, have a history of rising dividends, a record of positive and rising free cash flow and low gearing.

One area that the small private investor does not often focus on is brands.  I will always favour companies with strong brands as I believe they have a significant competitive advantage which will, over time, translate into outperformance and result in increasing shareholder returns.

Strong brands enable their companies to charge premium prices for their goods; not just because customers already know what they're getting but also because humans are instinctively cautious about things that they've never tried before.  We tend to be creatures of habit.

According to a study done by Credit Suisse, companies that focus on brand building by spending at least 2% of sales on marketing outperformed the S&P 500 by more than 4% annually since 1997.  The top 20% of the companies featured in the research outperformed the market by 17% annually over the same period.

Some well known brand names from my portfolio below include: Flora margarine, Johnnie Walker, Sure Deodorant, Cillit Bang, PG Tips, Dettol, Gaviscon, Durex, Guinness and Magnum ice cream.  These names would probably be recognised all around the world.

One other common factor which many of these companies have in common is their increasing focus on faster growing emerging markets.  For example, emerging markets account for over 50% of Unilever’s turnover; Vodafone are looking increasingly to India, Africa and Turkey as key markets to drive future growth; marketing spend for Diageo is over 10% in Latin America, Africa and Asia compared to less than half that in its more mature markets.  The new CEO at Reckitt Benckiser, Rakesh Kapoor, is currently in the process of refocusing the company towards growth markets like Brazil and India and this strategy is likely to have a positive effect on earnings and dividends in the future.
John Hulton’s High Yield Shares Portfolio
Click to enlarge

You can easily see from the above portfolio that I hold a diverse selection with a range of yields.  The yield is, of course, merely a factor of the current share price and in many instances the starting yield when the share was purchased might well have been higher.  Prices will fluctuate, sometimes quite dramatically, but I have learnt to pay little attention after purchase - what I am more focussed on is growth of dividend.  So long as dividends are growing, the share price will always follow.

In 2012 dividends grew at an average of 9.2% - I anticipate things will slow down a little this year and have factored in growth of around 6%.  Using the ‘rule of 72’, you can divide the average rate of growth into 72 to ascertain how quickly the dividends will increase by 100%.  So at the average rate of say 6% they will double every 12 years (72/6 = 12).  Over the planned investment timeframe of 25 years dividends should quadruple. Income on a portfolio of £50,000 today yielding slightly over £2,000, would rise to over £8,000.  If the yield remained at 4%, the capital sum would have increased to £200,000.

I have included a record of how dividends have grown for each company over the past 10 years.  Bearing in mind this period includes some of the toughest trading conditions for over 50 years, I think the dividend growth is remarkable and give me confidence these companies will continue to provide a growing income for many years.

This method generates a tax-free income approximately 50% to 100% higher than that available from cash deposit accounts.  It can be used to maximise income on savings and/or to maximise income within a SIPP ( ) converted to income drawdown as an alternative to taking an annuity.  The first year income from my SIPP (converted to drawdown last July) is slightly less than I was quoted for a level annuity, so in the short term I am a little down on income but by the time of the first review in three years, I calculate the drawdown will be increasingly higher from that point.  Additionally, GAD rates are to be restored from 100% back to 120%.

So there we have it, my portfolio of higher yielding shares which, combined with my investment trusts, should produce a steadily growing income rising ahead of inflation at minimal ongoing cost for the next 25 years. All investments are held either in my SIPP or ISA so there are no tax implications.

I hope some readers will be encouraged to explore some of these concepts and ascertain whether investing for income using higher yielding shares and/or investment trusts might work for them.

As ever, please do your own research and remember…slow & steady steps!

Good luck.

Retirement Investing Today Comment: John is a few years further down the High Yield Portfolio road than me.  It is however interesting to see some commonality emerging between both our portfolios.  I currently hold Astra Zeneca, Sainsbury’s, SSE and Vodafone.  So I match with John on SSE and VOD.  In place of GSK I hold the other big pharma AZN.  I think many may argue that GSK is a lower risk option with AZN heading towards a patent cliff.  In place of TSCO I hold the other big player SBRY. 

1 comment:

  1. Thanks for sharing this as I am also on the road to saving hard, investing wisely (I hope) and retiring early.