This article was written by Chris Gilchrist and published in The IRS Report in December 2011

Bets that must pay off

Remaining calm amid the current financial turmoil is a challenge. The stupidities of the europoliticians seem unsurpassable - until the next time they open their mouths. Given the lack of a Plan A, let alone a Plan B, for resolving the euro crisis, it is little wonder that traders and investors increasingly prefer the lesser anxieties associated with holding cash.

For traders who are prepared to duck and dive, selling investments and holding cash is fine. But for those like me with 5-10 year time horizons it is not. The problem, as always, is when to buy. Traders will answer that they don't mind missing the first 10-15% of a rise, but this works only for traders. As an investor, once you are out it will take you longer to convince yourself to go back in and you will probably miss a lot more than that.

So while I sold down many of my holdings over the summer, I never got to more than 30% in cash and that has already diminished as I have been drip-buying stocks and funds I think of as no-brainers on a 5-year view.

Top of my list remains financially strong blue chip companies with dividend yields of over 5%. All the long-term studies of equity performance (Marsh, Dimson et al most notably) have shown that the high-yield strategy consistently outperforms the market. Today it seems more of a no-brainer than ever.

Bank in the 1970s, when you bought high-yielding shares you got a lower yield than you could get on bank deposits. Typically, even if dividends rose by 5-10% a year, it was 4-5 years before equity dividends exceeded deposit interest. But people still bought shares on those lower yields because they knew inflation would erode their capital and they needed a rising income.

Today, you get 3-4% more income from high-yield shares than from deposits. In the UK we have 5% inflation, but let's be generous, trust Mervyn King and assume inflation will be 2% a year from 2013 onwards. That means that after tax you get a negative return of 1-2% on bank deposits, while you get a positive return (just on dividends) of 2-3% from equities. It does not seem at all demanding to assume that these companies will increase dividends at 5% compound over the next 3-4 years; most have generous dividend cover and only a global economic recession could cause a fall in profits sufficient to threaten dividend cuts. That widens the gap to 3-4%.

The gap is smaller between government bonds and equity yields, but it is still sizeable - over 2% on 10-year gilt yields. And that is a fixed 10-year coupon versus a rising dividend stream.

These gaps, and the relative valuations, make so little sense that I often wonder what I am missing. But I don't think I am missing anything. I think the markets are just completely out of whack. The prime reason for that may be that the really big piles of cash are no longer in the hands of long-term investing institutions but are held by emerging nation central banks (China, India, etc) or sovereign wealth funds. To date, these have been risk-averse and heavily bond and currency oriented in their investing strategies. At some point that will change (for a few wealth funds like Norway's and Singapore's it already has). And given their size, these funds will have to adopt exactly the strategies old-fashioned pension funds used to: buy big blue chip stocks and hold them for ever, just like Warren Buffett does.

Whatever the catalyst will be, I feel confident that over my 5-10 year timeframe, these blue chip high-yielders will generate high returns, probably higher than the market averages - but with less risk.

Value investing is the bedrock of my portfolio, but it also has some dangerous-looking outcrops. Here I will focus on just two of them, Japan and oil exploration.

The Nikkei 225 has recently flirted with the 8,000 level, its lowest since early 2009. Yet in relative terms, Japan's economy is doing well, with modest growth in 2011 but a large boost looming as the post-earthquake reconstruction, which is expected to boost GDP by 1.5%-2%, gets going in 2012.

Japan Inc is in good form; companies sport cash and are paying bigger dividends and though the Olympus scandal has again shown up the conservative, consensual nature of too many boards, the quality of management is much improved over the past decade.

Feeble politicians and economic policies have been a big handicap and will probably remain so. With so many older voters, Japan is a deeply conservative society, and this means that many of the changes wanted by economic liberals probably just won't happen. For example, there are millions of old people who live in cities and don't own cars; they like to have local convenience stores they can walk to and don't want them all driven to the wall by supermarkets. So don't expect much liberalisation of rules that restrict competition in retail trading.

Some analysts reckon a large chunk of the Nikkei index trading at book value - a third to a half cheaper than US equities. The big exporters have survived the strong yen and aren't likely to lose their customers to Chinese upstarts. The banks are sounder than those of Europe, the US or China.

Japanese stocks could become cheaper. They have since I topped up my holdings earlier this year, but I am topping up again. If you don't buy things when they look outstandingly cheap, when do you buy?

Funds investing in smaller companies have topped the performance tables over the past three years, though with big variations in returns and volatility. They account for a third of my holdings.

Junior oil exploration stocks can be binary investments: all or nothing. But if you pick those that have gone some way to proving their finds, and the finds keep getting bigger, then the upside is huge, as Tullow proves.

Overall, the fragile balance of global oil supply and demand is maintained by Saudi Arabia as swing producer, with capacity recently raised from under 10m to 12m BOPD, Libya is a minus, Iraq is about to turn into a plus. Most of the recent big finds (Brazil and Africa) won't come onstream for several years. More Middle East turmoil could still cause another price spike. Three or four years out, supply and demand could be in better balance, especially if fracking is adopted in Europe to release potentially massive gas supplies.

Stocks I hold or have on my watchlist: Gulf Keystone, Faroe Petroleum, Falklands Oil & Gas, BG Group, Heritage Oil, Nautical Petroleum.

You can see all of Chris Gilchrist's articles at www.TheIRSReport.com

Chris is the editor of The IRS Report every month

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