HYP #2 - How to select sectors in a High Yield Portfolio

Part 3 of our HYP Series (read Introduction here and Article #1 here).  Last week in the series I outlined briefly the selection method for choosing HYP shares and this week I’ll look closer at some of the nuances that influence those choices. A number of my rules governing selection will in practice often need to be bent to a certain extent in order to satisfy the one rule that is never compromised, diversification and its soul mate, equal investment per sector. This trumps everything else.

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 I’ve said that a minimum of fifteen sectors is required to construct a sufficiently diversified portfolio. I usually have a few more but the maximum is at the discretion of individual HYPers, I don’t set any limit on this factor. The more sectors you have, the less the risk but the effect of this reduces a lot once you have more than my minimum of fifteen. Each additional sector thereafter does not ameliorate risk to anything like the same extent as the earlier choices.

Which Sectors?

The question then arises as to which sectors should be included, or indeed excluded. Are there any fundamental sectors that should always be present in every HYP? Or does it depend merely on the chance presence of the shares thrown up at the time, by my method of choosing from the FTSE100 ranked by descending yield I described earlier?

My view is that there are certain sectors which are more important than others to the general economy of the world and I like to include these in every HYP I build. But do be aware that just because a company is in an essential type of industry, this is no guarantee that for this reason it will do better long term than other shares in less basic sectors. That is not why I have common sectors.

The reason I include certain sectors in all portfolios is more to do with modelling the world economy in a very crude way. Recall my concept of Strategic Ignorance which says I know nothing about the long term future, but, I will use that attitude to my advantage in the way I design portfolios. 

It’s a popular fallacy of naïve small investors, something I’ve heard repeatedly over the years, to think that if a business is supplying essentials, then it must for that reason be a sure thing. The reason this is wrong is competition. A company may well be selling vital products without which we cannot live, but so will rival businesses too. So holding such a share is no guarantee of long term outperformance. Remember that outperformance in the HYP world means delivering a superior long term income stream, capital performance is not an aim of the strategy.

Some of those basic sectors I like to see present in all my HYPs include mining and oil; banks – despite the catastrophes of the last few years; property; pharma; alcoholic beverages; utilities. The booze sector might not be as literally fundamental to our existence as, say, mining but nevertheless I find that in practice and for thousands of years it has been effectively so. 

Your view may differ somewhat on what constitutes essential HYP sectors, but the general idea is to compel the avoidance of a portfolio based on too many relatively frivolous businesses which are little more than flavours of the time, lacking potential longevity. There can never be any guarantees of course but I am pretty sure that mining for example is not going to disappear any time soon, and am far less convinced that this applies to some techy business or a specialised retailer. And to repeat, this is not because I think miners may produce better dividend returns than less fundamental businesses over a few years, but because I think they stand a higher chance of simply lasting, over the eternity for which HYPs are intended. 

This doesn’t mean that a whole HYP should be composed solely of what could be described as ultra-basic industries. There probably aren’t sufficient suitable shares in such sectors anyway to fill a portfolio. So some less vital industries will have to come in, depending on how many sectors the HYPer requires.

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More than one share in a sector?

Sometimes you may find that there are two shares in a sector that you can’t slip a hair between to determine which one to choose, so closely do both satisfy your selection criteria. A good example at present could be the two big oils, BP and Shell.

They have roughly similar yields and both have low gearing. Okay BP has the patchier dividend record having temporarily suspended and then cut payouts following the Gulf of Mexico spill, for which the final enormous bill has yet to be established. But even so, depending upon your personal HYP selection filters, you might not see much difference between these two as an example. How then to choose between them?

Buy both.

What you do is take your unit investment per sector, divide it in two and purchase an equal share in each company. That way you have not compromised your oil sector by over or under weighting it. It will have the same amount invested in it as your other sectors.

Having both BP and Shell in your HYP doesn’t hurt any, if anything it reduces your risk a little and there is no compromise on immediate yield because they are both offering the same return. As always with HYP construction forget the long term, Strategic Ignorance kicks in here so you deliberately disregard any opinions of your own or others on which of these two may offer the better income stream to eternity.

By the way, the unit investment per sector for a lump sum HYP is the cash available divided by the number of sectors. For a portfolio built up over a longer period of time, the amount to invest in each new sector would be the then average value per existing sector.

Next week I’ll consider some further selection factors such as whether foreign shares may be appropriate for an HYP and if non-equity investments such as preference shares or bonds have a place in the strategy.

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