How to use stocks to boost your income during the economic downturn

In last week’s article, I examined the evidence for income investing. I concluded that a pure income strategy might be a sub-optimal way to invest. However, creating an earnings-based value strategy and then choosing to invest in the subset of those stocks that have a high dividend yield will likely generate high performance and deliver an above-average yield. Based on these principles, I can construct a suitable income stock screen. 

The Screen

Here are the criteria:

Market Cap > £150m.

Although I don’t want to be too restrictive at this stage, it makes sense to exclude the smallest companies. There was some evidence that income investing works best in the largest companies.

TTM Earnings Yield, Rank in Market > 60%

In my previous articles on earnings-based value strategies, I described how this appears to be the best valuation metric to use. A value above 60% rank in the market ensures I am capturing only cheaply-rated stocks where the evidence points to long-term outperformance.

TTM Dividend Yield, Rank in Market > 60%

This is an income strategy, after all, so I want to find the highest-yielding stocks. Again the evidence points to the top two quintiles being the sweet spot for income.

1-Year Rolling Dividend Yield, Rank in Market > 60%

I include this extra check to try to ensure that I do not include stocks that have cancelled their dividend or are likely to significantly cut the size of the payout in the near future. This relies on brokers’ forecasts which are not always accurate, particularly during times of economic uncertainty. However, some guidance on this is better than nothing.

There is a risk that this requirement excludes companies that will continue to pay dividends but lack broker forecasts. I conducted a quick analysis by unchecking this criterion in the stock screen like this:

This exercise showed that most of these companies are funds, often income funds. So it makes sense to exclude these since I don’t want to pay fees for someone else to build the type of portfolio I am building myself directly.

Net Gearing, including Pension < 50%

Net Gearing is the ratio of Total Debt to Shareholders’ Equity, which is total assets minus total liabilities. We don’t want excessively geared companies since these are more likely to have to prioritise debt principal or interest payments than dividends in a rising interest rate environment. A 50% net gearing is generally considered the upper limit for conservatively financed companies.

At the time of writing, this screen generates 68 results:

The academic research suggested that income investors may be better off by focusing on larger companies. Hence, unlike my previous value screens, I applied no upper limit on market capitalisation. However, this approach has a downside: it is almost impossible for me to gain an informational or analytical edge over other market participants when considering large multinational companies. Building a portfolio from this screen, therefore, requires a different approach.

A Diversified Portfolio

The way to capture the value premium and high yield on offer is to build a diversified portfolio. In a previous article, I argued that value investors could own risky resource stocks as long as they owned many different companies across different industries and locations. In the same way, the risk of the unknowns in these income stocks can be mitigated via diversification. In this case, I will aim to hold around 40 stocks. This means that I should be able to have a diversified portfolio without compromising the high-yield aim. However, the failure of any individual company will not have a devastating effect on overall portfolio returns.

When looking through the list of the screen results, I see several industry groups, such as housebuilders, are over-represented. Since these companies’ economic outcomes and ability to pay dividends are likely to be highly correlated, limiting exposure to each industry group makes sense. With 20 industry groups represented, and two stocks from each group, this should give the 40-stock portfolio. However, not every industry group has two choices available. I will therefore add additional stocks to get back to the 40-stock portfolio while still looking for diversity in economic exposure. Two industry groups lend themselves to this: Investment Banking & Investment Services and Metals & Mining. The Investment Banking & Investment Services group contains a wide range of financial businesses, from fund managers to spread bet providers. The Metals & Mining group contains companies with exposure to different metals. So, for example, a gold miner can be included as well as a copper miner and retain diversification of economic exposure.

Portfolio Weighting

When building a portfolio, I usually suggest that investors would be better off by overweighting their best picks. Companies that are extremely undervalued and relatively low-risk should be an investor’s largest positions. However, I don’t have sufficient information to make that distinction in this case. All I know is that these stocks are chosen from a collection of stocks that history suggests will outperform the market, are conservatively financed, are not too small and have a high dividend yield. This lack of differentiation means that I will be better off by equal-weighting this portfolio. That is, putting the same amount of money into each stock at the start.

Selecting The Portfolio

Here is the process I follow to build up the portfolio:

1. Download to Excel

Advanced sorting in Excel will make it easier to select the right companies quickly. Stockopedia has the option to easily export the screen results to Excel in the bottom Right-Hand Corner of the screen results.

2. Sort the results first by Rolling 1-Year Dividend yield and then by Industry Group.

This ordering allows me to quickly go down each industry group and select the highest-yielding stocks.

3. Choose the two highest-yielding stocks in each industry group, unless there is a more diversified option available without giving up too much dividend yield.

There is some judgement required in this process. However, I am trying not to overthink it. Investing in value stocks always requires some level of discomfort. And my main risk mitigation tool here is diversification, not a detailed analysis of the company.

The Choices

Investors may want to make their own choices from these screen results, weighing up their need for diversification versus the income on offer. However, here are my picks from each industry group:

Banking Services

Osb (LON:OSB) is a UK buy-to-let mortgage lender, and HSBC Holdings (LON:HSBA) is a large international bank. The yield on both of these is higher than the third choice in this group Natwest (LON:NWG) . Natwest is significantly larger than Osb, however, so some may prefer to sacrifice yield for this greater diversity.

Collective Investments

This group covers a wide range of closed-end funds. The highest yielding is Foresight Solar Fund (LON:FSFL) . There are a couple of other renewables funds on this list, and the market clearly fears a windfall tax on the industry. However, my aim is to remain agnostic on these sorts of judgments. The second highest is Real Estate Credit Investments (LON:RECI) , and this becomes the second income pick from this group.

Construction & Engineering

This group only has two companies that meet my criteria: structural steel manufacturer, Severfield (LON:SFR) , and construction business, Galliford Try Holdings (LON:GFRD) . These are, therefore, my picks from this sector by default.

Construction Materials

The highest-yielding is Marshalls (LON:MSLH) , which supplies natural stone and concrete products. Forterra (LON:FORT) and Ibstock (LON:IBST) are both brick makers, so I choose the highest yielding of the two: Forterra.

Containers & Packaging

Just one choice here, packaging manufacturer DS Smith (LON:SMDS) .

Food & Drug Retailing

J Sainsbury (LON:SBRY) is my only choice from this industry group.

Food & Tobacco

Palm oil producer M P Evans (LON:MPE) is the only choice here. I looked at this company in one of my previous articles. I was too worried about mean reversion in palm oil pricing to add this to my value watchlist. However, a recent 25% increase in the dividend means that the high income on offer, plus diversification, will appeal to income investors.

Healthcare Providers & Services

Integrated Diagnostics Holdings (LON:IDHC) is another company I looked at in a previous article. In this case, I was concerned that events in Egypt may mean that the company struggles to remit profits back to the parent company to pay dividends. More cautious investors may want to exclude this or at least wait until the situation looks a little clearer. The company only pays a final dividend, so the next ex-dividend will be June 2023. Given that the main risk management tool I am using here is diversification, and this is the only option from this industry group, I will keep it in.

Homebuilding & Construction Supplies

Unsurprisingly, this is one of the industry groups with the most options to choose from. The market is assuming that the property market will be very weak going forwards. However, these companies have not yet reported significant weakness in trading. This means some exceptional yields are on offer. It can be risky to bet against the market in this way, but a high-yield portfolio is, by nature, a contrarian bet.

I really could choose almost any company from this sector. I pick Persimmon (LON:PSN) due to being the highest forecast yield. Vistry (LON:VTY) has announced a merger with £CWD, so it's not clear if this will change the dividend payout when the dust settles on this deal. Therefore, I instead pick the third highest yielder Taylor Wimpey (LON:TW.)

Household Goods

Carpet manufacturer Headlam (LON:HEAD) is my only choice in this industry group.

Insurance

Direct Line Insurance (LON:DLG) and Sabre Insurance (LON:SBRE) are my only choices from this industry group. Sabre is a motor insurer, whereas direct line also does home insurance and owns Green Flag. This adds some level of diversification.

Investment Banking & Investment Services

The highest-yielding companies in this industry group are fund managers, and I choose the top two yielding ones: Jupiter Fund Management (LON:JUP) and £POLR. In addition, I add Investec (LON:INVP) since their investment banking and wealth management are sufficiently different to the fund managers. I also added inter-broker dealer, TP Icap (LON:TCAP), listed trend-following hedgefund Man (LON:EMG) and Spreadbet provider IG group (LON:IGG) . All of these provide different economic exposure despite being in the same industry group.

Machinery, Equipment & Components

Concrete laser screed manufacturer Somero Enterprises (LON:SOM) is my only choice in this group.

Media & Publishing

Newspaper publisher Reach (LON:RCH) , and TV producer ITV (LON:ITV) are the only choices from this sector.

Metals & Mining

This is another industry group where I have chosen multiple companies. This is because they produce different commodities:

Ferrexpo (LON:FXPO) - Iron Ore - The Ukraine exposure may worry some, but as part of a diversified portfolio, it makes sense to go for the highest-yielding stock.

Kenmare Resources (LON:KMR) - Heavy Mineral Sands - I looked in more detail at this company here.

Rio Tinto (LON:RIO) - Iron Ore, Aluminium, Copper - as a £77bn company, this has significant diversity of operations in itself.

Pan African Resources (LON:PAF) - Gold - I looked in more detail at this company here.

Oil & Gas

Gulf Keystone Petroleum (LON:GKP) and Seplat Energy (LON:SEPL) are the only choices from this industry group. I looked in more detail at Gulf Keystone here.

Residential & Commercial REITs

The two highest-yielding REIT stocks are both in the social housing sector. I only choose one of these, Civitas Social Housing (LON:CSH) , which is the largest and highest yielding. I also pick Target Healthcare Reit (LON:THRL) and Urban Logistics Reit (LON:SHED) since these add property exposure to the healthcare sector and distribution businesses, respectively.

Software & IT Services

Moneysupermarket.Com (LON:MONY) and FDM (Holdings) (LON:FDM) are my only choices from this industry group.

Specialty Retailers

B&Q and Screwfix owner, Kingfisher (LON:KGF) , is my only option here.

Transport Infrastructure

Brazilian shipping company Ocean Wilsons Holdings (LON:OCN) is my only option here. When I looked at the company after its appearance on 52-week low screen, I concluded that it would be hard for me to gain an analytical advantage, given the complexity of the business. However, in this more diversified portfolio, this doesn’t matter.

The Income Portfolio

Here is the full list:

This equal-weight value portfolio of 40 stocks is currently forecast to yield 9.1%. This is a particularly good income compared to other alternatives, even in the current rising interest rate environment.

Next week, I will look at a possible enhancement to this income strategy which may appeal to more cautious income investors.

[Disclosure: Mark owns shares in £SOM  and Ferrexpo (LON:FXPO) ]