Beating the stock market

IN MY book, The Zulu Principle, I recommend additional reading of 10 American books on investment, including Beating the Dow by Michael O'Higgins.

Most experienced fund managers would confirm that beating a main index substantially and consistently over a long period of time is a difficult task. O'Higgins argues that it is easy to beat the Dow, if you use his system.

O'Higgins takes the 10 highest yielding Dow stocks from the 30 in the index and then selects the five with the lowest share prices. At the end of each year, he does the whole exercise again. His statistics show that by following this system over a period of 181 2 years, you would have enjoyed an average annual gain of 19.43 per cent, compared with only 10.43 per cent on the Dow. The five- stock portfolio outperformed the Dow 15 times and lost money only in 1974 and 1990, when the Dow was also down. After adding dividends received, but with no charge for commissions, the cumulative gain before tax was more than 2,800 per cent against only 560 per cent on the Dow.

The underlying rationale of O'Higgins' simple approach is that the 30 companies in the Dow are all of a size and substance that should ensure their future survival, even in extreme circumstances. Union Carbide's Bhopal plant blowing up was, for example, only a very large setback for that company. For a smaller one, it could have been terminal.

The second argument is that stock markets over-react. On good news, greed propels shares to dizzy heights. On bad news, fear drives them downwards to bargain-basement levels. The highest-yielding tend to be companies that are out of favour. They usually have better asset backing and, instead of froth in their share prices, there is often a discount for fear.

You might wonder why O'Higgins goes on to select companies with the lowest prices. He argues that they usually have smaller market capitalisations and therefore tend to register greater percentage gains than larger ones. This particular criterion seems a trifle primitive to me, but I share O'Higgins' enthusiasm for smaller companies. As I say in my book, elephants don't gallop.

During the last 10 years, the O'Higgins system applied to UK shares would have substantially beaten the FTA All-Share Index. Although we still have an FT-30 Share Index, I prefer to use the 30 UK shares with the highest market capitalisations. I have excluded utilities from this select list, as there were none in the Dow.

The 10 leading companies with the highest yields are Shell, BAT, Hanson, ICI, NatWest, BP, HSBC, Barclays, Lloyds and Allied Lyons. Following the O'Higgins' formula of taking the five with the lowest share prices would give the portfolio in the accompanying table.

The portfolio has an average yield of 5.32 per cent, well above the All- Share average of 4.19 per cent and the FT-SE yield of 4.26 per cent. Some people may say that the advance corporation tax changes in the Budget will make high-yielding shares less attractive, but I doubt if the effect will be significant.

Some of the companies obviously have big problems, but that is all part of O'Higgins' thinking. John Neff, a great American contrarian investor, puts it well: 'Get 'em while they're cold.'

It will be interesting to see if the O'Higgins' formula continues to travel well and beats the market during the year ahead.

The author is an active investor who may hold any shares he recommends in this column. Share prices can go down as well as up. Mr Slater has agreed not to deal in a share within six weeks before and after any mention in this column.

----------------------------------------------------------------- An O'Higgins portfolio for the UK ----------------------------------------------------------------- Share Price (p) Dividend yield (%) Hanson 237 6.4 BP 299 4.7 Barclays 415 4.9 NatWest 422 5.5 Shell 569 5.1 Average yield 5.32 -----------------------------------------------------------------