Ignore stocks outside the Big Four + one at your peril

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The yield theme continues around the share market and, with term deposit and call rates potentially under further downward pressure, SMSF investors can’t ignore the attractions of the yield favourites: the banks and Telstra.

But there are several reasons for investors to look beyond a narrow list of stocks – perhaps even to BHP.

The first reason is the concentration of risk, especially with the banks, in such a portfolio. While the potential risks (either individually or collectively) for the banks may be low, the bears are still apt to re-appear, citing the risk of house prices being over-priced and subject to a fall. There have been renewed murmurs from a few overseas hedge funds along these lines.

This scenario is probably very unlikely – but, if the only shares in your portfolio are banks (and you also have some bank hybrids for more yield), such a concentration could produce the occasional sleepless night.

Rising earnings

There is another factor to consider. Sustainable, long-term rising dividend payouts depend on companies maintaining earnings growth. This aspect is particularly important for SMSFs still in the accumulation phase, but also can’t be ignored by funds paying out pensions.

Rising earnings should ensure growth in the share price, as well as enable companies to keep increasing dividends. If interest rates are going to remain low for some time, any portfolio will require capital growth to produce even modest returns – say 5.5% to 6% or 3% to 3.5% above inflation.

The banks have had a sterling record of growth in earnings and dividends per share over recent years and are tipped by many brokers to lift distributions this year. But they may have some slight headwinds, with potential pressure on margins from things like demands by regulators or limited growth in the loan market.

Similarly, Telstra, though generally well placed in the national broadband network expansion, still has a relatively narrow margin of earnings above its current dividend rate and any forecast slight rise in dividends in the next two years.

Investors relying on yield from shares need to realise that, in the longer term, such shares can react to moves in interest rates just like bonds and fixed interest securities – and initially the market adjusts yields by lowering market prices. In addition, with current market Price Earnings ratios no more than fair value, an easing in confidence could also affect PE ratios and thus share prices.

Trading on emotions

There’s another, behavioural, reason for self-directed investors to watch what shares they hold: most investors have a much greater fear of losses than a love of profits. Allowing this to rule a portfolio will expose investors to what may be a too cautious approach to their longer-term portfolio. This suggests a need for more diversification in share portfolios and a little more emphasis on growth stocks. If, as seems likely, the US market is still in a bullish mood, growth stocks are likely to out-perform over value stocks.

Whether this means investors should start re-looking at resources stocks is another matter. U.S. S&P 500 stocks may be a better ploy than Rio Tinto or BHP, which the market seems to think may be another year away from earnings growth.

Still those investors without any resource stocks – and confident in China not imploding – might consider BHP, which is even looking a little like a value rather than a growth stock. Its current gross yield is 5%, which is tipped to rise (above other growth stocks) and it is on a PE of around 10 times projected earnings in the next couple of years – well below current and prospective ratios for Telstra and some of the banks. Its addition could be a baby step in the direction of a more diversified portfolio.

Important: 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. Consider the appropriateness of the information in regards to your circumstances.

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