I was having a look at my high conviction large cap recommended portfolio to see whether it needed some adjustment. While it’s got some riskier stocks, it’s actually quite conservative and full of high yield industrials already.

While Seven Group (SVW), Santos (STO), BHP Billiton (BHP) and Fortescue (FMG) have underperformed, the rest of it has been respectable. As I have grown older, I have realised the key to a successful model portfolio management is actually resisting the temptation to sell winners. The real trick is to cut losers.

I wrote a few months ago that Santos (STO) didn’t have yield support and had capex risk. I wrote that I would give it the benefit of the doubt in the portfolio and stick with it. That was a mistake, as a couple of weeks ago they came out with a capex blowout that took the stock down another leg. It was a bad call of mine not to cut it on the first hiccup.

So today I am going to belatedly fall on my sword and remove STO from my high conviction portfolio. We still have a buy rating and $18.42 price target on STO, but inside my model portfolio I don’t need two LNG stocks. I am going to play LNG through Woodside (WPL) where at least they appear to be through the capex blowout stage and are supported by a sustainable dividend yield. I also get US gas exposure via BHP Billiton.

I am going to replace STO with Wesfarmers (WES). WES is a stock I haven’t written about for a long time but it fits all the criteria I believe will drive outperformance in the year ahead. It’s a big cap, is high quality, has diverse earnings streams, a strong balance sheet, excellent management and a high sustainable fully franked dividend stream. It also has clear leverage through Bunnings, Coles, Target and K-Mart to the improving East Coast economy, while Blackwoods gives you mining service leverage (industrial & safety). They are also involved in chemicals, energy, coking coal (where prices have bottomed), fertilisers and LPG, and I also like the insurance broking business. The Board is strong and Richard Goyder has proven himself a very capable and consistent CEO.

On full-year 2013 consensus estimates, the stock is cheap for its quality, remembering the defensive supermarket earnings are the largest profit driver. The full year 2013 (FY13) price to earnings ratio (P/E) drops to 14-times, EV/EBITDA to 7-times, and price to book to 1.33-times. Return on equity (ROE) edges up to 10%, while earnings per share (EPS) growth is forecast to be 12% and dividends per share (DPS) growth 12.7% to a fully franked yield of 5.90% based off an 88% payout ratio. Group sales rise to over $60 billion in FY13.

Globally, big consumer stocks are being re-rated daily, led by Wal-Mart, yet WES offers triple the dividend yield of major global consumer stocks, higher growth, and a lower P/E. I think WES is every chance of getting support from global investors as it looks cheap versus its peers. I am really adding WES as my play on Australian consumer confidence bottoming. Interestingly, I did notice on the radio driving in this morning an advertisement for Coles car insurance issued by Wesfarmers General Insurance. Who knew supermarkets and insurance had synergies!

WES, from a technical perspective, should head back to the top end of the three-year trading band at $34.00. That should occur as FY12 earnings and dividends are confirmed in August. WES is a solid 3.6% of the ASX200 and I don’t know many investors who are overweight.

So my new high conviction large cap portfolio has a lot of stocks starting with “W” in it:

ANZ, AMP, BHP, CWN, FMG, NAB, SUN, SVW, TLS, WBC, WES and WPL.

Seven Group Holdings (SVW) – Buy

The share price of Seven Group has continued to deteriorate along with CAT in the US and the deteriorating value in the media investments, particularly Seven West Media (SWM), which has announced a $440 million capital raising to pay down debt. Seven West has indicated an intention to take up its entitlement in the raising, suggesting a funding requirement of about $146 million on the part of SVW.

With headline net debt at SVW likely to exceed $2.3 billion at year end or about 3.5-times FY13 estimated reported earnings before interest, tax, depreciation and amortisation (EBITDA) – 3.7-times adjusted for SWM – the market has been concerned with SVW’s debt balance, though we believe these concerns are overstated.

The industrial elements of SVW are now trading at 5.1-times FY13 estimated EBITDA, undemanding when compared to the peer group. Gearing of the core Industrial businesses is substantially lower than headline numbers would suggest (FY13 estimated Net Debt/EBITDA of 2.35-times).

• Recommendation: Buy (unchanged)
• Target  price (12 months): $10.90 (previously $11.30)
• Capital growth: 62.7%
• Dividend yield: 5.4%
• Total expected return: 68.1%

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