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.

*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 it 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 4% versus minus 6% 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%.

Feel free to get started.

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.