Beat the Market With These Stocks

Beat the market with ... dividends? Our friends at the Fool UK have done it. Twice. And now I'm attempting to do the same thing using U.S. stocks.

How they did it
The strategy is called the High-Yield Portfolio, or HYP. Originally created by Fool UK's Stephen Bland in November 2000, the HYP strategy invests in a diversified group of 15 large-cap, dividend-paying stocks with above-market yields, strong dividend coverage, relatively low debt, and a history of increasing dividend payouts.

Sounds reasonable, right? Well, here's where it gets a bit crazy: The holding period is theoretically forever -- unless a stock is bought out or cuts its dividend.

See, the point of the HYP strategy is not necessarily capital gains (although that's certainly a bonus), but to produce increasing amounts of annual dividend income. Daily price fluctuations matter not -- it's the income that matters -- so intentionally ignoring capital movements eliminates emotional trading from the picture entirely.

Bland called this hands-off approach "strategic ignorance," elaborating on the concept in a March 2005 article:

I follow the concept of what I call 'strategic ignorance'. This means that I do not take the slightest notice of any perceived long-term trends that some consider important in share selection. This applies to the macro picture of the economy, the sector and the micro situation of the share itself. Despite the fact that the share is intended to be held for many years, I studiously ignore anything which tries to inform me of its long-term future. My reasons are that nobody knows and that those who think they know, know even less. Attempts to forecast the future are worse than useless because they may well lead you into inferior selection decisions than those made by accepting that you don't know. Strategic ignorance however actually capitalises on the acceptance of not knowing. I believe that long-term shares chosen on the basis of some kind of futurising will tend to do worse than those picked using strategic ignorance, such is the fallibility of long-term forecasting.

The concept takes a bit of getting used to, for sure, but doubters should note the returns of the first two HYP portfolios Bland put together:

Returns are through December 2007 and don't include dividends.

Sure, these performance figures are quite impressive -- especially HYP1, which was started near a market peak and managed to return 68% when the overall market was down 8%. But again, capital growth is a secondary objective of the HYP strategy -- increasing amounts of income in excess of inflation is the primary goal. Again, neither HYP disappointed.

All data through December 2007.

How I'm going to do it (hopefully)
In an effort to replicate Bland's success, I've built my own HYP with U.S.. stocks ("US-HYP") that I'm tracking on Motley Fool CAPS, our 115,000-member investing community.

The HYP is made of 15 U.S.-based stocks hailing from a wide variety of industries to reduce the chance of a sector-based issue adversely affecting dividend growth. Indeed, it's not enough to simply pick a portfolio of the highest-yielding stocks in the market. A HYP stacked with financials, for example, may have done well for a time, but the credit crisis that led to a number of significant dividend cuts in the sector -- including Wachovia (NYSE:WB) and Washington Mutual (NYSE:WM) -- would have destroyed an income-sensitive portfolio like HYP.

With that in mind, my US-HYP features diverse high-yielding names like:

Source: Yahoo! Finance, as of Aug. 27, 2008.

What's perhaps most intriguing about this strategy is that it gives you options as an investor. With a call to your broker or a click of a mouse, you can choose to reinvest the payments back into the portfolio to boost growth – or you can simply take the cash from the dividends to boost income. The choice is up to you.

Not only that, but a number of recent academic studies have shown a positive relationship between higher dividend yields and higher earnings growth. In other words, HYP stocks like these can provide you with the best of both worlds.

So maybe the market outperformance exhibited by the UK HYPs shouldn't come as much of a surprise to us. Unfortunately, it will take some time (five to 10 years) before the US-HYP will be able to show similar merit, but I'm confident that its promise will show itself more quickly than that. I'll provide periodic updates on the US-HYP, and you can track it in real time on CAPS by clicking here.