The Fundamentalist: Investing for income

25th Sep 2009 02:29

As its name suggests, Dunedin Income Growth Income Trust is an investment trust which invests in income stocks. It released interim results on Thursday which showed the value of the trust's investments had grown, but not as fast as the market.Net asset value (NAV) per share in the six months to the end of July rose by 13.2%, versus a gain of 16.1% by the FTSE All-Share index. This suggests that investing in income (dividend paying) stocks in the recent the recent bull run has not been an optimal strategy.If investing for income has been your policy over the last six months, don't feel too disheartened. In general, recovery stocks have been the flavour of the season as they have celebrated their return from their near death experiences. Investing in high yielding stocks should be a long term buy and hold (LTBH) strategy and over the long run there is a lot of evidence to suggest it is a more profitable course to follow than chasing after the next 'ten bagger' (a stock which shows a tenfold increase in share price).Digital Look High Yield ScreenerA look at Digital Look's default High Yield screener over a six-year period shows that the High Yield portfolio was doing better than the market throughout the period from September 2003 until about the mid-point of 2008. Indeed, at the end of 2007 it was showing a clean pair of heels to the FTSE 100 but suffered badly in 2008 (see chart).The strategy's sub-par performance during the panic stricken days of 2008 is initially surprising. The general perception is that a high yield portfolio should prove more resilient during a downturn than a portfolio consisting of growth stocks. However, I can think of two possible reasons for the poor showing of the High Yield portfolio in 2008.1) The performance of the portfolio assumes dividends are reinvested into the shares from which the dividend income was received. In general, this is a very good thing - I'll talk about dividend reinvestment in a future article - but in 2008 you would have been ploughing back your money into assets that were declining in value, which has a negative effect on performance. Over the longer term, of course, it should work out well as the dividend income is being invested in shares that have become cheaper.2) The 2008 bear market was characterised by a freezing up of the credit markets, which prompted many companies, even financially healthy ones, to reduce their gearing (the relationship between a company's debt and equity shareholders' funds - our American cousins would call it 'leverage'). They conserved cash in many ways, such as cutting back on capital expenditure, and many chose to do so by cutting or abandoning dividend payments. Reduced dividend payments is self-evidently not a good development for a High Yield portfolio.The good news is that the strategy seems to be gaining ground again in 2009 on the Footsie; those reinvested dividends are beginning to (for want of a better phrase) pay dividends.Admittedly this has not been the experience of the Dunedin Income Growth Invest Trust but the company might have just been a bit unfortunate in its stock selection this year; the company has also hit by lower returns on its cash balance in the current low interest rate environment.Tweaking the High Yield ScreenerThe criteria for the Digital Look High Yield Screener are few and fairly basic:1) Companies with a market value of £500m or more2) Companies with a dividend yield of 3% or more3) Companies with a dividend cover of 2 or more(Dividend cover is calculated by dividing earnings per share by dividend per share)In a future article I will look at possible tweaks to the strategy, such as putting an upper limit on the dividend yield parameter to screen out those companies which, in the market's view at least, are unlikely to maintain their dividend payments.Running the above screen generates 59 stocks that meet the criteria; this is far too many for the average private investor's portfolio so we need to find some sensible way of reducing it to a more manageable number. Having a broad portfolio is no bad thing for the risk averse investor so I would be aiming for about a dozen or so stocks. Hopefully, with a few well thought out tweaks to the High Yield screener we can whittle down the number of stocks to la crème de la crème.