The global rally in bond yields for major economies could well be an indication of low growth and tough economic times ahead.

History suggests that low bond yields pre-empt recessions and certainly the yields on ten year bonds in the US, Germany and Japan do not bode well for their equity markets. Here in Australia, equity investors also need to be cautious as the flat yield curve (interest rates from 6 months to 10 years) suggests that Australia will also experience low growth.

If you agree that the outlook for generating high equity returns will be difficult, then you may like to consider a “contrarian” investment approach focused on dividend yield. This portfolio approach suggests an investment in a number of highly recognisable or large household brand companies that exhibit a high yield due to their depressed share prices. The depressed share price may be the result of difficulties created or exposed by the GFC and economic downturn.

For this approach, the investor needs to focus upon the trailing yield of the target companies and compare them with the company’s outlook statements. This is to ensure that the dividend is likely to be maintained. Further, when constructing a portfolio, an investor needs to adjust the dividend yield for attached franking credits to determine a pre-tax or grossed up yield.

As you can see, this type of analysis is quite simple. An investor need not be concerned with interest cover or gearing unless this has already led a company to forecast a decline in dividends.

The approach of focusing on high yield, large capitalisation companies is that adopted in the well documented investment strategy of the “Dogs of the Dow”. This strategy involves an investor acquiring a portfolio of the ten highest yielding companies in the Dow Jones Index. This portfolio is then held for 12 months and reset on its first anniversary. The process then occurs for each subsequent year.

In Australia, a similar strategy to the Dogs of the Dow, colloquially known as the “Underdogs” can be adopted by identifying the top ten highest yielding industrial companies from the ASX 100. Once again, the ten highest yielding stocks are acquired at a point in time in equal proportions.

By selecting stocks from the ASX 100 Index, it allows investors to focus on large and established businesses with a track record of success and have the comfort that:

1. companies will have highly qualified boards who will demand a response from management to recreate value by restructuring, sale of assets or a merger;
2. the maintenance of dividends, even through difficult periods, as the companies should have strong underlying businesses with access to capital and debt;
3. companies with strong and resilient brands which have strategic value and may attract a takeover bid should the business not be turned around by management; and
4. long established companies may have undervalued equity in their balance sheet due to the affects of long term depreciation and the brand names that are not revalued.

Potential investees however should not include resource companies, property or infrastructure trusts. These yields are either volatile or have been created by revaluations and non-cash profits.

At Clime Asset Management, we have adopted this methodology with our Clime High Yield Underdogs Fund (CHYUF). The CHYUF undertakes six portfolio settings per annum. Each portfolio of the ten highest yielding industrials is held for twelve months and reset on each anniversary. By setting the total portfolio six times over the year, the risk of poor market timing is diluted. Investors who undertake this strategy in a fund will benefit from the disciplined approach of the manager versus managing their own portfolio.

The key feature to all three approaches is the equal weighting of stocks. The yield in Australia should be grossed up for franking credits, as they are highly attractive for low tax investors.

A good example of how this investment approach can operate is shown in the chart below. Since the inception of CHYUF in December 2007, the fund has delivered a return 21% better than the market over this period.

 

In February 2009, when CHYUF achieved its best “sub” portfolio return, stocks were acquired in equal proportions and the sub-portfolio generated a 60% return over the year.

More recently on 20 August 2010, Clime acquired the following portfolio (majority at cum dividend) for its fund. We have noted next to each stock a likely reason for the high presented yield:

1. Telstra Corporation Limited (ASX:TLS): $2.98 grossed up yield 13.4%; concerns over the NBN rollout.
2. Tatts Group Limited (ASX:TTS): $2.39 grossed up yield 12.5%; concerns of loss of gaming license in Victoria.
3. Tabcorp Holdings (ASX:TAH): $6.30 grossed up yield 12.5%; concerns over loss of gaming license in Victoria.
4. Primary Healthcare Limited (ASX:PRY): $3.06 grossed up yield 11.7%; concerns over debt and slowing profit growth.
5. West Australian Newspapers Holdings Limited (ASX:WAN): $6.57 grossed up yield 9.8%; concerns over sustainability of published newspapers and against online oppositions.
6. Bendigo and Adelaide Bank Limited (ASX:BEN): $8.74 grossed up yield 9.5%; concerns over second tier bank funding.
7. Goodman Group (ASX:GMG): $1.27 grossed up yield 9.2%; concerns over commodity based food business.
8. National Australia Bank Limited (ASX:NAB): $23.96 grossed up yield 8.8%; concerns over acquisition of AXA (now disappeared).
9. Metcash Limited (ASX:MTS): $4.36 grossed up yield 8.5%; concerns over competitive retail landscape.
10. David Jones Limited (ASX:DJS): $5.03 grossed up yield 8.2%; concerns over former Managing Director litigation.

As can be seen in the above portfolio there is a market concern regarding each stock. The average grossed up yield of this portfolio is approximately 10.4%. At this rate, smart investors looking to protect their capital and minimise the risks associated with investing shares may like to consider this strategy. At this rate, it is highly attractive against other options such as bond yields currently at 4.8% and bank term deposits at 6%.