The Power of the High-Yield Portfolio

My timing couldn't have been worse.

On Aug. 14, 2008, I built a mock high-yield portfolio (HYP) based on an investment strategy put forth by our friends at Motley Fool U.K. back in 2000.

The idea of the HYP strategy is to buy 10 to 15 stocks with above-average dividend yields and hold them indefinitely, focusing on income generation and making capital appreciation a secondary objective. One of the benefits of this strategy is that you don't overtrade because daily price fluctuations aren't part of the picture. Instead, you begin to focus on the long-term value of owning strong businesses that produce real returns year after year.

To be included in the portfolio, the stocks must:

  • Be large-caps
  • Have a history of increasing dividends
  • Have relatively low debt levels
  • Have sufficient free cash flow coverage
  • Hail from diverse industries

It's a fine strategy and still is. Problem was, I strayed from the strategy in some cases and my mistakes were quickly exposed.

Five weeks after I started the portfolio, Lehman Brothers filed for bankruptcy protection, and all heck broke loose in the markets. Within months, my HYP was in disarray.

Needing a bailout
At the time, the market conditions seemed at least viable for starting an HYP -- the S&P 500 was 16% off its 2007 highs, so dividend yields were higher, and though there were known concerns about subprime mortgages and the housing market, the full extent of the crisis had yet to be revealed.

The HYP I set up had an initial trailing annual yield of 4.6%, it was well diversified across sectors, and every member had a strong record of dividend payouts. Still, that didn't spare me from the great dividend panic that ensued.

Company

Trailing Dividends
Per Share on Aug. 14, 2008

One year later ...

% Change

Altria (MO)

$1.16

$1.28

10.3%

AT&T (NYSE: T  )

$1.60

$1.64

2.5%

Bank of America (NYSE: BAC  )

$2.56

$0.04

(98.4%)

Carnival (CCL)

$1.60

$0.00

(100%)

Chevron (CVX)

$2.60

$2.60

0%

Consolidated Edison (ED)

$2.34

$2.36

0.9%

DuPont (NYSE: DD  )

$1.64

$1.64

0%

General Electric (NYSE: GE  )

$1.24

$0.40

(67.7%)

Home Depot (NYSE: HD  )

$0.90

$0.90

0%

International Paper (IP)

$1.00

$0.10

(90%)

Kraft (KFT)

$1.08

$1.16

7.4%

Pfizer (PFE)

$1.28

$0.64

(50%)

ProLogis (PLD)

$2.07

$0.60

(71%)

Southern (NYSE: SO  )

$1.68

$1.75

4.2%

Waste Management (NYSE: WM  )

$1.08

$1.16

7.4%

*Data provided by Yahoo! Finance.

Pretty ugly, huh?
It's humbling to admit that six of my original 15 picks had their dividends cut or eliminated. While late 2008 and early 2009 was the worst year for dividends in generations, it's still no excuse.

  • Bank of America's 8% yield should have been a big red flag -- the market seriously doubted the company's ability to maintain that level.
  • International Paper's $6 billion acquisition of Weyerhaeuser's containerboard and recycling assets severely crimped the company's free cash flow, and by extension, its ability to pay dividends.
  • In a similar vein, Carnival had more than enough cash from operations to fund its dividend, but also had massive capital spending for its cruise ships, which limited its ability to maintain its payout when credit tightened.

In hindsight, these mistakes seem obvious, and they were all errors of judgment and not inherent flaws of the HYP strategy. In fact, had I adhered more closely to the tenets of the strategy (particularly the low debt requirement), I would have been much better off.

Now, let's take a look at what went right.

  • My two utility stocks, Southern and Consolidated Edison, held up well during the downturn and modestly boosted their payouts, proving yet again the defensive value of this sector.
  • With more than enough free cash flow to increase their payouts, Altria, Waste Management, and Kraft were exceptions in the dividend-cut era.
  • Home Depot smartly slowed its store growth during the recession, which freed up more cash, improved the balance sheet, and helped maintain the dividend.

The silver lining
As bad as the past 19 months were for my portfolio, the discipline of the HYP strategy prevented much more significant losses. For one, each position was weighted equally, with the same amount of money allocated to each position, so despite the large cuts by a few companies (and subsequent reallocations), the overall portfolio yield decreased to just 3.6%.

Second, by diversifying across industries, I limited my exposure to widespread dividend cuts in the financial sector, which before the crash had made up 30% of the S&P 500 dividends and today account for just 9%. Had I chased more of the high-yielding bank stocks at the time, the dividend cuts in that sector would have likely led to massive losses for this portfolio. By intentionally mixing in lower-yielding stocks from other sectors, the portfolio's overall yield remained well above the S&P 500 average.

Finally, while the HYP strategy discourages tinkering with the portfolio once it's in place, it does allow you to sell stocks that have cut or suspended their dividends. Selling Bank of America and Carnival in late 2008 allowed me to reallocate capital (at a loss, of course) to acquire better dividend-paying stocks at great prices. In the long run, this will benefit the portfolio.

Down, but not out
The true power of the high-yield portfolio strategy is its ability to save you from your own mistakes. As long as you don't stray from its core principles (as I did in some cases) of selecting only industry-diversified large-cap stocks with a history of increasing dividends, relatively low debt levels, and sufficient free cash flow coverage, you not only stand a better chance of generating above-average dividend income but avoiding some huge losses, as well.

A year and a half later, the sun has broken through the clouds a bit, and a remarkable thing is happening -- the companies in the current HYP are beginning to raise their dividends again and the overall yield is ticking higher. Even the capital returns haven't been all that bad -- the average return of each investment is ahead of the S&P: minus 8.6% versus minus 9.5% for the index. Given that this all happened during the worst dividend environment in generations, the HYP has held up remarkably well compared with other dividend-based strategies.

If you're interested in building your own HYP or just finding some great dividend stocks, take a free trial to Motley Fool Income Investor. Since the service began in 2003, 75% of its picks are beating the market, and current recommendations post an average yield of 4.2%.

To get started, click here.

Fool analyst Todd Wenning tracks the HYP on Motley Fool CAPS under the name TMFHighYield. He owns shares of Home Depot. The Home Depot, Pfizer, and Waste Management are Motley Fool Inside Value selections. Southern and Waste Management are Income Investor picks. The Fool has a mellow disclosure policy.


Read/Post Comments (10) | Recommend This Article (67)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 12, 2010, at 3:44 PM, BillNyeman33 wrote:

    Dividend Aristocrats are companies in the S&P 500 that have increased dividend payouts to shareholders every year for the last 25 years:

    http://www.TopYields.nl/Top-dividend-yields-of-Dividend-Aris...

  • Report this Comment On March 12, 2010, at 6:42 PM, falcon2382 wrote:

    why not just invest in a single dividend etf such as SDY which deals with the issues you confront by simply rebalancing for you each year those companies that couldn't hack it? Then you can add to the list of positives of this strategy the fact that you have now limited your transaction/commission fees dramatically.... this is especially true if you are only contributing $500 here and a thousand there. just a thought. (oh plus its diversified across 50 companies instead of just 15)

  • Report this Comment On March 12, 2010, at 6:43 PM, falcon2382 wrote:

    why not just invest in a single dividend etf such as SDY which deals with the issues you confront by simply rebalancing for you each year those companies that couldn't hack it? Then you can add to the list of positives of this strategy the fact that you have now limited your transaction/commission fees dramatically.... this is especially true if you are only contributing $500 here and a thousand there. just a thought. (oh plus its diversified across 50 companies instead of just 15)

  • Report this Comment On March 13, 2010, at 6:03 AM, marc5477 wrote:

    Over diversification is a failing strategy. This last crash proved it. You are much better off picking 2-3 good stocks in each major sector than 5-6 because there simply arent that many good companies out there. All you are doing is diluting your investment. Is it safer? As we saw in March of '09 it is not. Is it safer for the person who doesnt know what he is doing? Nope, he shouldnt be in the market to begin with or he should use funds like you suggest.

    For anyone who knows how to read financial statements and has a good sense of logic and numbers, a self managed portfolio will be 100x more beneficial than a fund. I am living proof. I had a 1080% gain in 2009. No more working for idiots for me.

  • Report this Comment On March 13, 2010, at 12:40 PM, JustMee01 wrote:

    An interesting thought experiment might be worth examining?

    One natural extension of any dividend strategy is dollar cost averaging into your own holdings, compounding returns over time.

    If you roll your dividends in the portfolio back into the distressed group (as measured by crashed yield, or PE), and continue that process over time, I wonder how that will perform over time? Kind of a Dogs of the Dow approach without the mechanical selling and rotation...

  • Report this Comment On March 13, 2010, at 7:32 PM, griyguy wrote:

    Hot 10 Stocks for 2011 for the Recovery from America's Leading Advisors marks the eleventh edition of NewsletterAdvisors.com's complimentary signature publica-tion.

    http://hot-penny-stocks.blogspot.com/2010/03/hot-stocks-for-...

  • Report this Comment On March 13, 2010, at 7:32 PM, griyguy wrote:

    ?

  • Report this Comment On March 14, 2010, at 10:18 PM, valari25 wrote:

    "why not just invest in a single dividend etf such as SDY"

    Because they hold companies like GE, who announced a dividend cut months in advance, because they haven't actually yet cut the dividend. So the price is tanking and the ETF rides it all the way down, finally selling when the reduced dividend is formally declared.

    My crackberry will wake me up if a dividend cut is announced on any company I own, which saved me a pantload on ACAS. I make the call when it occurs, I don't have wait for the rebalancing period.

  • Report this Comment On March 16, 2010, at 1:55 PM, mikecart1 wrote:

    I believe in investing in 1 dividend and that is MO. Recession ain't got bleep on MO!

  • Report this Comment On March 17, 2010, at 12:34 PM, colonel10314 wrote:

    Diversification is the key to success. I own the entire S&P 500 Index through an index fund and over the last 25 years have made out quite well. Anyone who says they can beat the market over 25 years is truly a fool and not a motley one.

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