Motley Fool: Beat the Footsie and retire happy

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The Motley Fool started as an irreverent investment newsletter and has grown to become one of the most popular personal finance and investment websites. Anyone who follows its philosophy is called a `Foolish investor'.

People invest for all sorts of reasons and in all manner of styles, but one style of investing is common in just about all of the world's big stock markets: investing for retirement income.

At different stages of our lives, we are all going to have different requirements and will often pursue different investment strategies at different times. When we are younger, we are likely to be investing for long-term growth rather than for a regular income, for example, and can afford to take on a little more short-term risk with our money. After all, we won't be planning to spend it for some time yet. But when that retirement date starts drawing nearer, it is usually time to start thinking about safer investments and working out a method for drawing regular income from those investments.

That method frequently consists of investing in companies that pay out a large proportion of their earnings in the form of dividends. The only companies that can really do this reliably are those that do not need to retain large amounts of their earnings in order to fund future growth, and so we find that they are the larger, more mature and more stable companies in the market. They are known as the "blue-chip stocks".

An interesting thing about these blue chips is that year in, year out, they have a tendency to keep their dividends constant, using the profits from better years to cover the dividends paid out in less good years. There is a very good reason for this: the managers of these companies know full well that a significant number of their shareholders are holding them precisely because they want their regular dividends, and if those dividends were cut some years and raised other years, the resulting unpredictability would drive away such investors in their thousands.

So despite the varying fortunes in blue-chip companies, and despite variations in their share prices, they really do like to keep their dividends constant. The knowledge of this led a particularly astute American investor, Michael O'Higgins, to wonder whether examining the dividends paid by such companies might lead to a strategy for finding companies whose share prices are temporarily depressed, through being out of favour with investors, and which might have a better than average chance of enjoying a share price rise in the not too distant future.

The result was Mr O'Higgins' ground breaking book, Beating the Dow, published in 1992. What Mr O'Higgins did was examine all the companies that make up the Dow Jones Industrials Average. There are only 30 of them, and they are hand-picked to represent a fair cross-section of American business. Mr O'Higgins calculated the dividend yield for each company in the index, and ranked them all accordingly. And what is the dividend yield? It's quite a simple ratio, and to obtain it all you need to do is divide the latest dividend paid by the company by its current share price, to give a percentage. Say, for example, a company has a share price of pounds 1, and its last full-year dividend was 6p per share, then we just divide the 6p by the share price of pounds 1, to get a result of 6 per cent. That's all there is to it.

Mr O'Higgins' theory was that, as these companies all consistently followed pretty much the same dividend strategy, in the long term they would all tend towards having similar dividend yields. After all, there are many investors out there pursuing all of these companies for exactly the same reason - to get hold of those dividends. In such circumstances, all of the 30 Dow Jones companies should tend to be priced accordingly.

So, by concentrating on those companies whose share price is low relative to their dividends, that is those with the highest dividend yields, Mr O'Higgins thought that he might identify those that are currently temporarily undervalued by the market. If the dividend is constant, it must be the share price that is the anomaly.

After a great deal of back-testing using historical records, that is exactly the result that Mr O'Higgins found. And by varying his approach to which companies he chose - the five with the highest yields, or the cheapest five of the 10 highest yielders, for example - he found that he could significantly and reliably outperform the Dow Jones itself over the long term.

When the Motley Fool first took shape in the US, this "beating the Dow" approach was seized upon and re-examined as a great way to run a real portfolio. In fact, by testing a number of variations, the strategy was actually improved upon and higher returns than Mr O'Higgins managed have been achieved. Details of this strategy and its returns can be found on the Fool's American website (www.fool.com).

So is this strategy an American phenomenon, or can it be suitably adapted to other countries? Well, that was foremost in the minds of the founders of the Motley Fool UK at its outset, and the strategy has been successfully modified to use the FT-SE 30 index instead of the Dow Jones. The FT-SE 30 is a rather old index, and one that is not followed by many people these days. But it is an index of hand-picked companies, and it does concentrate on the equivalent of those mature blue chips that are to be found on the Dow. Backtesting showed similar results to those obtained using the Dow, and so the "beat the Footsie" strategy was born, or BTF as it is often known. In an even simpler form than its Dow Jones counterpart, the BTF simply buys the five companies in the FT-SE 30 that have the highest dividend yields, in equal pound amounts, and repeats the process every year. Since inception, even though it had a bit of a rocky start, the BTF has soundly beaten the main UK stock market indices, and the results can be found on the Fool's UK site (www.fool.co.uk).

There are other strategies like this, known as "mechanical" strategies, which successfully take all the emotion out of investing. Emotion is a bad thing for Foolish investors, who must keep their shares for the long term. If you are interested, something like this could be a great way to start your own investments, Fools.

Motley Fool, www.fool.co.uk

FOOLISH TRIVIA

The first five correct answers out of the hat win a super de luxe, black Fool baseball cap.

Which cable company announced plans last week to launch a new high-speed internet service?

Answers by e-mail to: UKColumn@ fool.com or post to: Motley Fool, 79 Baker Street, London W1M 1AJ.

n Last week's answer: Barclays Bank

ASK THE FOOL

Can I hold US shares in my self-select maxi ISA ?

BW, London

The Fool responds: Yes you can. The predecessor of the ISA, the late, lamented PEP, only allowed you to hold European shares in self-select schemes. Although many of the changes from PEPs to ISAs were for the worse, one of the improvements was the decision to allow investors to hold shares listed on any recognised exchange. So, yes, you can buy US shares, or shares in many of the world's leading companies in other parts of the world. It is also good that you choose to do this in a maxi ISA. This allows you to invest up to pounds 7,000 this year. If you had chosen a mini ISA, you could only put pounds 3,000 in this year - a trap many are believed to have fallen into.

n If we publish your question, you'll win a Fool baseball cap. E-mail UKColumn@fool.com or post to Motley Fool, 79 Baker Street, London W1M 1AJ.

MY SMARTEST INVESTMENT

After completing A-levels I took a gap year and travelled around the world before starting my university course. Working my way through Asia I was so impressed by the dynamism and vigour of the Asian economies that I thought it just had to be place with a future. When the Asian markets crashed last year I took the opportunity to buy some shares in HSBC at the price then of pounds 12. Now they are twice the price, should I sell and lock in my profit?

FH, Oxfordshire

The Fool responds: Well done on your investment, and timing. It does not always work out as well, but when it happens make the most of it. Next time might be different. HSBC has done very well in the past 10 months. It is not often that a company as large as this doubles in such a short time. It is now worth pounds 62bn and is one of the biggest banks in the world. Of course it has had a stock split recently, so for every one share you had then you now have three. The results last week justified their rise. Attributable profit for the first six months of the year rose 12 per cent, much better than expected. As you know, the Foolish strategy is to buy and hold. You've got a good start with this one and you should stick with it.

Send us your smartest or dumbest investment story. If we publish it, you'll get a free copy of our investment guide. E-mail to UKColumn @fool.com or post to Motley Fool, 79 Baker Street, London W1M 1AJ.