HYP #3 - Why you should avoid foreign shares and bonds in the hunt for yield

This is part 3 in the Stockopedia High Yield Portfolio series by Stephen Bland (HYP).  

Last week I looked at the desirability of prioritising certain sectors over others in an HYP and also, when it may be a good idea to include more than one share from the same sector, dividing your sector unit investment equally between those selections. This was all under the general heading of rule-bending because most of my construction rules can, indeed must, be broken at times because too rigid adherence would not allow enough shares to be located for a suitable portfolio to be built at all. But all the rules with their permitted flexibility are subservient to the one inviolable law that is never be broken, diversification accompanied by equal investment in each sector.

This week I’ll take a look at the extent to which in my opinion some other investments may be included in an HYP, starting with foreign shares. Whilst I have never thus far included any foreign shares in any HYP I’ve constructed, I have been asked many times over the years whether this may apposite.

The reasons I’ve avoided shares listed abroad have nothing to do with xenophobia and more to do with practicalities. There are several objections as follows, in no particular order. I’m assuming here that the investor is based in sterling.

1. Avoid Currency Risk

First is currency risk. Clearly the capital value of a share held in a foreign currency will suffer exchange rate fluctuations in addition to the share price movements on its own stock exchange. That may be positive, negative or broadly neutral over time but whichever, it adds volatility, ie. more risk, to the sterling value.

Now before anyone points this out, it is true that I’ve always maintained that capital is virtually irrelevant or very much secondary at best in the HYP strategy so why am I concerned with the inevitable currency fluctuations of a foreign share? My response is that I intend HYPs to be a very low risk income investment, given the unavoidable risks that investors must accept for being in equities at all. More or less a Widows and Orphans equity approach. So I see little reason to add further risks to those already present, even to the capital.

Note that I don’t see the currency risks to the all-important dividends as part of my objections to foreign shares. That’s because quite a number of UK listed shares which are suitable for an HYP already pay US dollar dividends and at least one pays in euros. These payments are then converted to sterling at the prevailing rates by the paying companies so we have to accept dividend currency risk even with UK shares in several cases. A few more would not make much difference.

2. Avoid complexity

My second reason is complications. One of the principles of HYP construction is KIS, Keep It Simple. It is much easier these days to buy foreign shares in major markets like the US but there can be additional paperwork and worse, dividends, which is what my strategy is all about, may be reduced by withholding taxes.

3. Emotional discipline

My third reason is not quantifiable but I could describe it as a sort of gut feel. My very long experience in the market has given me a knowledge of a lot of shares but they are nearly all UK based businesses. That doesn’t mean I ignore the necessary background research into the numbers when considering a new selection, there is no emotion involved, but it means I will already have some information in my head about it. That is not going to be the case with most foreign stocks to which I would be coming fresh. I would lack a certain historical perspective on those though if I wished I could get up to speed. 

4. UK equities are already international

Finally on the objections, we are fortunate in the UK in that our stock market contains so many international businesses amongst the sort of big caps that may present as potential HYP candidates. Oils like BP or Shell, mining like BHP Billiton or Rio Tinto, banking like HSBC, even contract catering like Compass, are just a few examples of companies whose business ranges round the world, often with their UK operations only a small element of the total. There are many others. If the shares in our own stock market were wholly UK based I would definitely look overseas but as things are, there is no compulsion to do so in my view. 

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 [Editor’s examples: the FTSE 100 can be ranked at Stockopedia by yield on the Index Report page, or you can screen for income stocks in the FTSE 100 here ]

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 Having said all that, I’m not really against foreign shares on principle, it’s just that I haven’t yet felt the need to incorporate them. But I don’t rule them out. It’s not one of my HYP construction criteria.

So if I might be willing to accept foreign shares, what are the positives for doing so? The key attraction I see is that there are many sectors which just don’t exist in the UK market compared with abroad and the US in particular.

We don’t have for example an international chain of hamburger joints, a major vehicle or aircraft manufacturer, a major tech product maker and so on. I don’t know because I haven’t researched them whether any US companies in such sectors would make good HYP choices, I’m just making the point about their existence there and their non-existence here. So diversification could potentially be widened by looking overseas.

As I say I haven’t so far felt the urge to go foreign, having been sated in the past by the UK choices but I accept that my objections could well be traded-off against the desirability of some overseas stocks in future so I am not suggesting that HYPers should always avoid these. But I certainly advocate that it is limited to leading economies with good regulation. I can’t see emerging markets or the like being a fruitful source of HYP shares.

5. Owning beats lending - stick to shares

The other type of HYP investment I’m considering this week is the non-equity kind of stock market holding like bonds or preference shares. I don’t see those as part of an HYP. I designed the strategy to be equity based due to the fundamental definition of an equity which is an investment, a form of ownership, having no limit to its return.

Dividends can grow indefinitely but in contrast prefs and bonds normally have fixed percentage interest returns. But against that equity dividends are far more risky, can easily be suspended or cut, whilst the interest on prefs and bonds is hugely more dependable. In fact UK government bonds, gilts, are the least risky investment of all, effectively considered to be the nearest thing to the theoretical risk free rate.

But I designed the HYP to carry a certain amount of risk in return for the likelihood, though not the certainty, of a long term growing income at least matching inflation, and for those that are concerned about it, similar capital growth too. That can’t be done with most prefs and bonds.

I should point out here that this aim can be achieved with index linked gilts, in fact it is as guaranteed as it gets that their income and capital will grow with inflation. So why bother trying to achieve this with risky equities then? Part of the answer is that the initial yields available on ILGs are tiny, a fraction of the current start yield on an HYP. Not much good for those who need income now or soon. The other part is that equity dividends, and the capital too if that concerns you, have the potential to beat inflation long term. That cannot happen with ILGs.

So for these reasons I have ruled out non-equity investments from the HYPs I build. 

Next week I’ll give my views on the various options for an HYP holding vehicle including direct ownership, ISAs and SIPPs. Also, whether one’s age should influence the degree to which equity investment for income may be desirable. Don’t expect me to agree with the conventional advice from the investment industry on these matters.

By the way, I’ve just published the results of the thirteenth year of my original public HYP that I put up on the Motley Fool back in the year 2000. The income this year was £5,828 against £3,451 in the first year and the total income to date is £50,940. The capital value is £144,000 from a start figure of £75,000 without reinvesting that income. And that’s all for doing no voluntary trading, in fact doing precisely nothing except dealing with any occasional mandatory corporate action such as bids or rights etc. that require attention. 

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