Why This High-Yield Portfolio Is Beating the Market

On Aug. 14, 2008, I created a portfolio of high-yield dividend stocks on Motley Fool CAPS and based it on a slightly modified strategy put forth by our friends at Motley Fool UK in 2000.

The basic selection criteria were that the stocks must be:

• Large-cap companies,

• With a history of increasing dividends,

• Relatively low debt levels, and

• Sufficient dividend coverage,

• That hail from diverse industries.

The trick with any investing strategy is that it can take years to prove its worth. Now that we're past the three-year mark on my original high-yield portfolio, I think we've had enough time to begin to judge its effectiveness.

Out of the abyss
Looking back, my timing couldn't have been worse to start such a portfolio. About a month later, Lehman Brothers collapsed and the market began to slump. Over the next few months, hundreds of companies cut their dividend payouts, including some that had been considered sacrosanct by investors.

Much to my chagrin, a few companies in the original portfolio also cut their payouts, and I began to wonder if the strategy was doomed to failure.

I "sold" a few of the stocks that cut their dividends and replaced them with others; 10 of the original 15 remain in the portfolio.

As you can see, despite a few slip-ups, the results have been quite good:

Open positions

Source: Motley Fool CAPS. Market comparison in percentage points.

Closed positions

Source: Motley Fool CAPS. Market comparison in percentage points.

Without doing much trading, this portfolio (you can track it here) finds itself in the top 20% of all CAPS portfolios. If transaction costs and taxes were considered in CAPS, I'm sure it would be doing even better relative to the more actively traded portfolios in the top quintile.

Moreover, fully two-thirds of the picks are beating the market, and the average pick is beating the market by 15 percentage points. In fact, had you invested $1,000 in each pick, or $18,000 total, the portfolio would currently be worth around $19,200 versus $16,371 for equal amounts invested in the S&P 500.

Granted, a 7% total return isn't much to write home about, but at least it's in positive territory and, in hindsight, was a better alternative than putting your money in the market.

Lest you think this might just be a lucky break, I launched a second high-yield portfolio using the same guidelines in October 2008, and it is doing even better than the original. According to CAPS performance metrics, more than three-quarters of the portfolio's open and closed positions are ahead of the market. Only one of the active picks is currently trailing the market, and even it has posted modest gains.

Lessons learned
These two portfolios have been an interesting experiment and have taught me a few valuable lessons about dividend portfolios.

1. Diversification matters: One of the problems investors face when building a high-yield portfolio is that many high-yielding stocks often come from only a handful of sectors. Yet it's important to resist the temptation to put too many eggs into one basket, even if they offer a higher total yield. In August 2008, for example, many bank stocks had ultrahigh yields, and even though my position in Bank of America turned out to be a flop, other stocks from different sectors supported the overall portfolio. Had I put, say, five bank stocks into the portfolio, the results would have been far worse.

2. Don't chase yield: Don't compromise your quality criteria for high yield. Only buy stocks that have good balance sheets, reasonable growth potential, and plenty of free cash flow to cover the dividend. My worst mistakes in the portfolio came when I chased yield and sacrificed quality. I'd much rather own a portfolio of high-quality stocks yielding 3% than a portfolio of mixed-quality stocks yielding 5%, because there's a greater chance that some of the lower-quality companies in the latter group will cut their payouts.

3. Keep some distance from your portfolio: At times over the past three years, I forgot I even had these CAPS portfolios, and that may have actually helped performance. Many investors -- me included -- check their portfolios too often, and when we see our portfolio values changing, our natural instinct is to do something. More often than not, though, the best course of action is to do nothing.

In my opinion, sticking to these three principles has been what's helped the high-yield portfolio beat the market over the past three years.

Foolish bottom line
Overall, I'm really pleased with how these high-yield portfolios have turned out, especially in a very volatile three-year period for the market, and I expect them to continue to do well as the dividends roll in. Of course, time will tell.

If you're looking to build your own high-yield portfolio, a team of Foolish analysts have put together a report containing 13 high-yield dividend stocks to buy in today's market. If you'd like to receive this free report, simply click here.

At the time thisarticle was published Todd Wenningis the advisor of Motley Fool (UK) Dividend Edge. He owns shares of Intel. The Motley Fool owns shares of Intel, Plum Creek Timber, Waste Management, Altria, and Bank of America, and has bought calls on Intel.Motley Fool newsletter serviceshave recommended buying shares of Intel, Waste Management, Home Depot, AT&T, Southern Co., and Chevron, as well as creating a diagonal call position on Intel and a covered strangle position on Waste Management.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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