Six golden rules to maximise equity yields

PORTFOLIO POINT: With a properly structured equities portfolio, investors can maximise yields and minimise risk. Here’s six portfolio rules.

In addition to the mergers and acquisitions column run in Eureka Report each Monday, I also run a yield fund. It is essentially an income portfolio with positions in various equities, and I am able to achieve extra returns by using an options strategy. I will be running through this today in the article below.

The new environment of ultra-low interest rates around the globe is pushing investors away from traditional term deposits and towards equities in their hunt for yield.

Unfortunately, shares represent a much higher level of risk to capital than cash at the bank, notwithstanding the near death experiences many such financial institutions suffered during the global financial crisis. Here, then, are both my rules and current equity income portfolio designed to maximise yield while minimising risk.

The fund that I run offers clients the option of either a simple long position in the equities listed below, or a combination of long holdings and options. The latter approach reduces the prospect of capital gains, but substantially increases the portfolio’s cash yield.

Portfolio Rules

1. All stocks included must be part of the S&P ASX100 Index. Such shares are extremely liquid, well researched and tend to have better than average standards of corporate governance.
2. All stocks must also have ASX-listed options quoted against them (to cater for those clients who choose to write call options against their holdings). This reduces the investment universe from 100 stocks to about 60 (plus or minus five, depending on how many shares the ASX decides to create options).
3. Companies must demonstrate a consistent dividend stream that is both largely franked and likely to rise over time. While some businesses pride themselves on maintaining payouts to investors no matter what (e.g. Telstra), others operate in more cyclical industries where earnings (and, therefore, dividends) can fluctuate substantially (e.g. Tabcorp). In this portfolio, the former is greatly preferred.
4. The preferred number of individual shareholdings is 20-25. That is, I reject about 60% of the stocks in the investment universe. In addition to the stable dividend rule listed above, the rejection criteria includes unsustainable business models, overly expensive share prices and lack of franking credits.
5. Stock weightings are based on relative ASX 100 Index weightings, with the proviso that no individual shareholding is less than 2% of the portfolio (so as to keep holdings material).
6. Because the ‘big four’ banks are such a large part of the Australian fully franked dividend universe, there is no getting away from their large presence in this portfolio. Perhaps, controversially, I allow the banks to constitute as much as 40% of the portfolio – versus their current market weighting of around 26%.

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On current estimates, the 2013 forecast yield for the Equity Income Portfolio is 5.7%, which compares favourably to the ASX 100 Index current average cash yield of 4.6%. Overall portfolio franking levels are expected to come in around 92%, i.e. almost fully franked.

A couple of the more surprising inclusions here include BHP and Tabcorp (TAH). BHP gets a tick, despite its miserly 3% annual yield, for two main reasons:

1. The company has a long-standing commitment never to reduce its dividend – quite an achievement for a resources house; and
2. Because some of my clients choose to write call options against their holdings, BHP’s higher share price volatility means that the cash flows from writing calls more than make up for the stock’s relatively low dividend yield.

As to TAH, until recently it wasn’t included because post the company’s loss of its pokies duopoly in Victoria it was very difficult to assess where its earnings, and therefore dividends, would settle. While not really a growth business at the moment, TAH’s sustainable yield of around 7% fully franked now makes it a worthwhile contributor to this portfolio.

Writing Call Options

For more sophisticated investors who seek income, writing calls against a portfolio of income stocks can generate additional annual returns of 5%-10%, depending on market volatility. My approach is to write calls consistently every two months, taking care to ensure that European options (i.e., those with a fixed exercise date) are employed whenever dividend payments are approaching. Typically I pick strike prices 3%-6% away from current share prices at the date of writing.

Other factors investors need to take into consideration are the 45-day rule for retaining franking credits, plus the transaction costs associated with selling and buying back shares whenever call options are exercised. As mentioned earlier, the use of written calls can add 5%-10% of unfranked cash income on top of dividends received. The downside is that if the shares rise more than the 3%-6% premium suggested for the option strike prices, then investors will give up some, but not all, of their capital gains. Remember, however, that the goal of this portfolio is income, not capital growth.

While there is potential capital downside as well as upside in any portfolio, the total yield return shown above of almost 14% looks attractive in the current low interest rate environment. Clearly, the use of written calls is the ‘X Factor’ in the portfolio, as they have the potential to more than double the annual cash return. Those investors not familiar with options should, of course, seek independent advice.

Tom Elliott, a director of Beulah Capital and MM&E Capital, may have interests in any of the stocks mentioned.

This article is the latest in our series The Yield Chase. To read the articles in this series, click on the story links below.

Six golden rules to maximise equity yields

A new road to yield growth

Money in the non-banks

BYO risk analysis on MYOB’s issue

Hitting the yield switch

Banks’ battle zone will crimp yields

Running out of dividend steam?

Fixing for a high yield fix

Taking a defensive yield tack

Cashing in on term deposits

Shopping for yield in Woolies’ property float

Telstra’s high-speed yield connection

Trustees seek yield safety

Yield spotlight shines on REITs

Hunting in US property