Buy a High Yield Portfolio and Hold Forever

In a October 2008 article, Todd Wenning described the High Yield Portfolio approach this way - "Buy 10 to 15 high-yielding large-cap stocks today and hold them -- forever."

Todd Wenning used a ruleset from Stephen Bland writing at the Motley Fool UK back in 2000 to select a basket of high yielding companies. The ruleset is as follows:

• Large-cap stocks,
• With a history of increasing dividends,
• Relatively low debt levels, and
• Sufficient dividend coverage,
• That hail from diverse industries.

These are to held, basically forever, "the only permissible reasons to sell or remove a stock from the HYP portfolio are (1) the dividend is halted or cut, or (2) the company is acquired."

In the research article, Todd Wenning highlighted seven stocks:

	Original dividend yield
Nucor	3.5%
Sysco	3.4%
Eli Lilly	5.5%
Caterpillar	4.1%
UPS	3.5%
Northrop Grumman	3.4%
Reynolds American	7.3%

The blended portfolio came in around 4.5% yield at time of purchase, so an investor who put in $1,500 in each company could realize over $450 in annual income. 

Fast forward to today, we are in a global yield famine. Its actually somewhat painful to look at the yields available circa 2008, but moving along how would an investor have done buying this HYP? I ran some numbers over on Longrundata.com.

	Value of $1,500 is now worth	Annualized Total Return
Nucor	$2,662.28	10.5%
Sysco	2,917.15	12.2
Eli Lilly	3,958.58	18.3
Caterpillar	5,466.24	25.2
UPS	3,939.37	18.2
Northrop Grumman	5,885.32	26.8
Reynolds American	5,202.26	24.1

The net result here is that from the time that Todd Wenning wrote this article on HYP to now, the value of those seven stocks with $1,500 in original (For a total of 10,500) plus dividends reinvested is worth $30,031.20 today. The average annualized return is 17.8%. 

Those are stellar results, but that's not the best part. The High Yield Portfolio concept is about Yield. Otherwise why hold forever? Turning to the current yield in those companies

	Value of $1,500 is now worth	Current Yield	Current Income
Nucor	$2,662.28	2.9%	$77.21
Sysco	2,917.15	3.1	90.43
Eli Lilly	3,958.58	3.2	126.67
Caterpillar	5,466.24	2.6	142.12
UPS	3,939.37	2.6	102.42
Northrop Grumman	5,885.32	2.3	135.36
Reynolds American	5,202.26	4.3	223.70

So with an initial investment in the fictional HYP in October 2008 of $10,500, this group of companies not only delivered capital gains; it now yields $897.92. This equates to a 8.6% yield on original cost, closing in on a holy grail of income investors - a double digit yield on cost. This where a very good return goes to great.

Notice that there was no massive risk taking here, no ground breaking discoveries, no impossible to predict outcomes. Its as dowdy a group of companies as you are likely to find.. The idea of a HYP is sound in principle, and examples like Todd Wenning's show how well it can work in practice. 

The Wine Cellar - Brett Arends on Bunting's Laws

The Wine Cellar series journals investing analysis that I find valuable over the long haul. This entry is more like a nice warm pint of ESB. One hidden gem I came across last year is Brett Arends' account of Bunting's laws - 12 stock investing rules for the next forty years.

One of my favorite aspects of these rules is that the first seven rules are on reasons to avoid investing in companies:

1. Sell stocks of companies that announce huge acquisitions, that overdiversify, or that spend a fortune on a lavish new headquarters.

2. Avoid stocks where management picks fights with analysts (or, by extension, hedge funds). See Overstock.com in 2005; Netflix in 2010.

3. Watch out when executives start selling a lot of stock — regardless of plausible-sounding excuses. Top execs in homebuilders, mortgage underwriters and Wall Street dumped billions before the 2008 crash.

4. “Run a mile” from all stocks in an industry going through a huge investment boom: Massive overcapacity and consequent collapse is inevitable.

5. Steer clear of investing in manufacturing companies. Their industries are usually plagued with extreme cycles of boom and bust, overcapacity and slumps.

6. Pay little attention to economists or market gurus.

7. Mistrust all mathematical trading formulas as well — they invariably fail just when you most need them to work.

A current example of a violation of rule #1. Coach (COH) is a company with a lot to recommend it from an investment standpoint. Its been a leader over many years, trades for a bargain valuation (15 P/E), excellent margins  (20% Net Margin), Return on Equity at 47%, and no debt. What's not to like? This - a new $750 Million Headquarters.

As much as the valuation metrics are appealing, spending nearly one billion dollars on a new HQ sounds to me like the opposite of shareholder focus. Rules like Bunting's Laws serve as a critical checklist to get investors to think beyond just the numbers and look at behavioral and other factors.

As Brett Arends' wryly notes "Not all of Bunting’s Laws are about stocks to avoid.":

8. Look for companies where the insiders are buying lots of stock.

9. Look for companies generating a lot of cash — a great sign of sustained outperformance.

10. Look for companies which have monopolies (or near monopolies), and those which manage to take out their main competitors.

11. Remember you are buying businesses, not just stocks. Pay close attention to the quality of the business, and especially the quality of the management.

12. Look for companies which have earned the trust of consumers, and which have very strong brand names.

As to rule #8, insider buying is always a welcome sight. Recently, Kinder Morgan (KMI) was recently targeted by short seller. Last week, two insiders responded vigorously to the 6% drop. CEO Rich Kinder bought 500,000 shares and Director Fayez Sarofim bought 283,000 shares. Its always good to see management aligned with outside shareholders.

Investing relies heavily on analyzing financial metrics, but we have to go inside the numbers to better understand what's going on. In addition, the numbers out of context may not give a full picture and lead us to take undue risk. Think of the great looking metrics companies in the housing industry had leading up to the crash. For this reason its essential to have a combined view of the financial metrics with checklist like Bunting's Laws, the fact that the Laws are weighted with things not to do is a great example of how these rules are most helpful to the investor.

Its true that not all of Bunting's Laws are about stocks to avoid, but the laws on what to avoid are the most valuable because they illustrate traps for the investor to avoid and enumerate reasons to eschew investing in companies with otherwise compelling metrics.

The Wine Cellar - The Remarkable True Story of a $146,194-Per-Year Income Portfolio

Brian Richards reports on the science fiction writer Hayford Peirce's $146,194 per year Income portfolio. It is a concentrated high yield portfolio:

• Three common stocks (Altria, J&J, Philip Morris International)
• Nine master limited partnerships (Alliance Resources, Enbridge Energy, Energy Transfer, Enterprise Products, Inergy, Kinder Morgan, ONEOK Partners, Plains All American, and Suburban Propane)
• One bond
• One annuity

His Altria investment is an incredible story. Hayford began buying shares of the tobacco company back in 1987, when it was quite a bit more than just a tobacco company. Over the years, he kept buying more (in '88, '91, '96, and '97), and eventually accumulated 11,000 shares of Altria (then known by the more familiar Philip Morris name). "Every time there was a panic in the market about Philip Morris, it would go from $70 down to $20 because of a smoking case, I would go out and I'd buy some more." Through spinoffs, his original 11,000 shares of Altria stock turned into an astounding 11,000 shares of Altria, 7,000 shares of Kraft, and 11,000 shares of Philip Morris International.

He still owns Altria and Philip Morris International, but sold Kraft. "At one point my basis for everything, including the Kraft [spinoff], was about $200,000 and it was worth about $1.25 million."

There are a number of takeaways here, first is focusing on dividend over the long run. Patiently building positions over a long time horizon.


Then there is the importance of dividends in long term investing. The story of Hayford Peirce is a concrete example of James Montier's Dividends Still Matter example, which shows that on a one year time scale dividends and dividend growth account for only about 20% of total return to the investor. However over a five year time horizon, dividends and dividend growth account for around 80% of the total return. In my opinion, its foolish to invest for only one year, too many things can happen, and so investing requires a longer term outlook.

Given that then dividends come to the fore in any investment analysis. What we need to look for varies slightly though. Its less about current yield although that clearly matters. A useful metric is Yield on Cost (or effective yields):

30% yields

That Altria investment is spinning off incredible "effective yields" -- measuring today's dividend checks against the original cost basis, rather than the current share price. Hayford's getting a 37% yield on Altria and a 28% yield on Philip Morris International.

That's by design. About half of the $146,194 in investment income will come from Hayford's annuity and the lone bond. The other half will come from a very deliberate investment process in dividend stocks. On a 1995 trip to Tahiti (where he lived for 25 years), Hayford sat down with a legal pad, pen, and his collection of stock tickers:

I was looking over my portfolio. And say there were 12, 14 companies in it, and 8 of them were blue chips like GE and Coke and Johnson & Johnson. … I said, "These suckers are bringing in $14,200 in income this year. Let's see what would happen if we just increased that dividend by 10% every year for 30 years."

Upon returning to the States, he transferred his legal pad scribblings to a series of spreadsheets, and the long-term vision for these 12-14 dividend stocks took hold. His stated goal was to increase his annual investment income from $14,200 in 1995 to $250,000 in 2025. "Up until a year and a half ago, I was ahead."

Then the financial crisis hit, former widow-and-orphan stocks like GE and Bank of America (both owned by Hayford in '08) slashed their dividends, and even the best-laid of plans went to mush. Hayford tilted his dividend portfolio toward high-yielding MLPs.

Yield on Cost is a misunderstood metric, as an input to current decision making its mostly useless.

For example, would I rather own Chevron or Exxon? Chevron (3.3%) pays a higher dividend yield today than Exxon (2.9%).  But let's say I bought Exxon back in 2005 and since then their dividend has doubled. So my effective yield on Exxon is more like 5.8%, so wouldn't I rather own Exxon at 5.8% than Chevron? No because the 5.8% is only on cost and if I sold all my Exxon and put it all into Chevron then I would increase my current yield by more than 13% (the difference between 2.9 and 3.3). That current income is predicated on current yield not yield on cost.

So if current yield is all that matters then why focus on Yield on Cost at all? Yield on Cost is useless as a comparison metric but in my view its very helpful for planning and goals because it clarifies what you are shooting for. In other words, my goal as a dividend investor is to generate as many double digit percentage yield on cost as possible. Getting to 30% can take awhile, but 10% Yield on Cost is doable for a number of different companies. A 4% current yielder that  raises its dividend 10% year will be over the 10% Yield on Cost hurdle in ten years.

So focusing on identifying candidates for double digit Yield on Cost percentages means that you are looking for companies that will be there for the long haul. You have to look at different factors. Quality matter, sustainability matters. Flavor of the month companies need not apply. The companies need to be able to withstand two business cycles, recessions and other events that a decade can throw at it. Its a totally different game and totally different metrics than trying to handicap what iPhone 5's impact will be, Twitter's IPO or almost any headline that dominates business news. But for long term return generation, the fact that dividend corner of the market is underfollowed is a great opportunity.

The question to ask to generate high yield on cost is not so much what the company is going to do this year or next, but rather can the 3-4% yielder triple its dividend over the decade? This mindset is about as far from a short term mentality as you can imagine. 

The Wine Cellar - James Montier: Dividends Still Matter

One of the main things I am using the blog for is an ongoing notebook of my favorite insights on investing.  The Wine Cellar is the ideas, papers and analysis that are most useful and informs my perspective over the long haul.

So the first one to be added to the Wine Cellar of ideas is from James Montier's August 2010 paper "A Man from a Different Time"

Dividends still matter
To those who charge around in markets trying to guess
the next quarter’s make-believe earnings number, the
concept of dividends seems wholly irrelevant. However,
to those with an attention span measured in longer than
milliseconds – who are few and far between, to judge
from today’s markets – dividends are a vital element
of return. Exhibit 2 illustrates this point graphically.
Looking at the U.S. market since 1871, on a 1-year time
horizon, nearly 80% of the return has been generated by
fl uctuations in valuation. However, as the time horizon
is extended, “fundamentals” play an increasing role in
return generation. For example, at a 5-year time horizon,
dividend yield and dividend growth account for almost
80% of the return.

Having a long term orientation is fundamental for individual investors. I think the ability to have a longer time horizon is our single biggest advantage over the pros, we can be patient and wait out 3 years, 5 years for things to play out. Pros have a bad quarter and then they are updating their resume LinkedIn. They cannot wait it out.

But the time horizon advantage is amplified if we focus on approaches that unfold (albeit slowly) over time. This insight highlighted for me the importance not just of dividends, but dividend growth as the overriding factor in long term returns. If you are measuring your investing lifecycle in years and decades, not mouse clicks, milliseconds, and Cramerisms, then dividend growth is like having the wind at your back.

Dividend growth investing moves the focus from not just preferring higher yielding companies over those with low or no dividends, but more in the direction of companies that can grow their dividend by meaningful percentages year after year. Time is the friend of the dividend growth investor.