As the ‘euromess’ meanders along and interest rates in Australia fall and are set to fall further, a top of mind question for many DIY super trustees is: how do I select an income-biased portfolio of stocks to help ride out the storm? An effective after tax yield of 7% per annum provides quite a bit of downside protection – particularly over a medium-term horizon.

It is no surprise that the secret to an income-biased portfolio lies in a balanced portfolio of stocks paying franked dividend yields. To recap on the effectiveness of franked dividends in super, a fully franked dividend yield of 6% pa is worth 7.29% in the accumulation phase and 8.57% in the pension phase of your SMSF.

After tax yield in accumulation After tax yield in pension

Sector weighting

So, to the portfolio. I will use a ‘top down’ approach, which starts by looking at a sector allocation and then moving on to the individual stocks. The latest ASX data shows that the stocks that comprise the S&P/ASX 200 are trading at an historic price to earnings ratio (PE) of 12.7, with a weighted average dividend yield of 4.68%. Within the individual sectors, the picture looks as follows:

Although not universally true, a clear take is that the sectors trading on the highest PEs tend to have the lowest weighted average dividend yields, and vice versa. With the two dominant sectors (Financials and Materials) accounting for almost 60% of the index, any sector allocation starts with these. Further, any material re-allocation away from their index weights increases the chance of significant under or over performance of the portfolio compared to the market.

Although I’m creating an income portfolio, I still want the opportunity to participate in a broad-based market recovery. Accordingly, I’m going to apply the following rules:

1. With the big four sectors (Financials, Consumer Staples, Energy and Materials) – the first two arguably more defensive sectors, and the latter two more growth orientated – I’m not going to move more than 33% away from their index weight;
2. Although Property Trusts have a reasonable running yield, there is no tax advantage in superannuation, so I’m going to ignore these;
3. The IT sector is too small and I’m no real fan of the Consumer Discretionary sector or the Industrials sector, so I’m going to keep largely indexweight in these sectors.

Stock allocation

Now to the stocks. I’m after around 15 to 20 (less than 10 is too small, more than 25 is too hard to keep track of). There are industries that, at least in an Australian context, are chronic underperformers, so I’m not interested in stocks from the airline, insurance, building materials or steel industries. I’m going to confine my portfolio to the ASX 100 (that doesn’t mean that there aren’t some fantastic smaller companies), and of course, I am looking for companies that pay franked dividends.

In the Financials, I’m sticking with the majors, avoiding insurances and the minor banks (however, Bendigo is worth considering). I’m not keen on Consumer Discretionary and staying underweight, and despite the selloff in JB Hi-Fi on Friday, marginally lean to David Jones.

Ramsay’s high PE doesn’t put me off, and in both Materials and Energy, it’s hard to go past the industry leaders. The same goes for Telecommunications with Telstra.

While the relative individual stock weightings are largely aligned to their index weighting, I also apply a qualitative overlay about the company’s management and the track record in delivering consistent earnings. There are often good reasons why some stocks always trade on a higher PE than their peers (eg. Commonwealth Bank vs National Australia Bank).

The high-income portfolio

My high income portfolio (per $100,000 invested) is as follows:

The portfolio is trading on a forecast PE of 11.4 (based on the consensus forecasts from FN Arena, prices as at 15 December), and a dividend yield of 5.82%. Within accumulation, this is an expected after-tax yield of 6.87% pa, and 8.08% pa in pension.

Clearly, a critical assumption is the movement away from index weight for the major sectors. If this was 50%, and the portfolio’s weighting in financials was increased, I could increase the yield (and arguably the risk) – however the portfolio may not participate in any sustained market rally.

The portfolio is benchmarked for 15 December 2011 – we will track its performance and report back in upcoming editions of the Switzer Super Report.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.