O'Higgins' bunch of five revisited

A year ago, I told you about a share system outlined in an American book, Beating the Dow by Michael O'Higgins. One of his methods is to take the 10 highest-yielding shares of the 30 Dow Jones Industrial Average stocks and then invest in the five with the lowest share prices.

At the end of each year, he then repeats the whole exercise.

After adding dividends received, but with no charge for commissions, O'Higgins' cumulative gain during an 181 2 -year test period was 2,800 per cent against 560 per cent on the Dow.

The system outperformed the Dow in 15 of the years, lost money only twice when the Dow was also down, and enjoyed an average annual gain of 19.4 per cent against 10.4 per cent on the Dow.

On 25 March 1993, I selected a British portfolio on a similar basis to O'Higgins from our top 30 stocks.

After six months, they had appreciated by 12.4 per cent against a rise of 6.78 per cent in the FT All-Share Index and 5.34 per cent in the FT-SE 100 Index. The table shows how the five shares performed over the full year.

The average gain of 18.8 per cent compares with a gain of 12.5 per cent in the FT All-Share Index and 9.4 per cent in the FT-SE 100 Index.

In addition, the average dividend yield on the O'Higgins share selections would have been 1 per cent better than an investment in either of the two indices.

UNLIKELY TO FAIL

The essence of the O'Higgins system is that the companies selected are of such a size and stature that they are unlikely to fail completely. He also believes that out-of-favour shares with high dividend yields contain very little market froth and shares with a lower price tend to have lower market capitalisations, offering the prospect of greater capital appreciation.

I felt O'Higgins' idea of lowest share prices was a trifle primitive. In America, there is a wide variance between the highest and lowest share prices in the leading stocks, but in the UK there is a greater convergence, especially in the 250p to 500p range.

To my mind, when selecting the final five shares from the 10 with the highest yield, lowest market capitalisation is a far more logical criterion than lowest share price. On 30 September 1993, I therefore decided to run two test portfolios, one based on O'Higgins' original method and the other on lowest market capitalisation.

The O'Higgins portfolio was: BAT, BT, British Gas, Hanson and Prudential. The one based on lowest market capitalisations contained ICI, Lloyds, NatWest, Prudential and Zeneca.

So far, the results of both portfolios are disappointing. During the past six months, the FT All-Share Index has appreciated by 1.6 per cent and the FT-SE 100 Index by 4 per cent.

The O'Higgins shares have depreciated by 5.5 per cent and the shares with the lowest market capitalisations by 2 per cent. The extra income on the average of the two portfolios was about 0.5 per cent during the six months.

PRICES APPROACH

I remain a firm believer in the O'Higgins approach for beating the index. The Financial Times ran a test from 1979-1992 and found that pounds 10,000 with dividends reinvested would have grown into more than pounds 130,000 using the O'Higgins method in the UK, against only pounds 81,540 for an equivalent investment in the FT All-Share Index. However, this test was only on the basis of lowest share prices.

Before I review the O'Higgins system again, I will run a back-test based on both lowest share prices and lowest market capitalisations.

Meanwhile, for anyone considering investments for a new PEP today, the five O'Higgins selections (lowest share prices) for the UK would be BAT, British Gas, BT, Hanson and Prudential. The five selections based on the lowest market capitalisations would be NatWest, Prudential, Lloyds, Zeneca and Bass.

The results for the past six months encourage me to believe that selections based on lowest market capitalisations should fare better than those based on lowest share prices.

The author is an active investor who may hold any shares he recommends in this column. Shares 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.

----------------------------------------------------------------- THE FAMOUS FIVE ----------------------------------------------------------------- Share Price (p) Price (p) Increase 25/3/93 25/3/94 % Hanson 237 275 16.0 BP 299 373 24.7 Barclays 415 537 29.4 NatWest 422 458 8.5 Shell 569 656 15.3 Average gain 18.8 -----------------------------------------------------------------