A year on: our high-income portfolio outperforms!

Co-founder of the Switzer Report
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If you have been long banks, health care and Telstra, 2012 has been a great year for equity investors! For example, the health care accumulation index (which includes the income return from dividends) is up almost 50%.

With a bias to the defensive sectors, our high income portfolio has outperformed the market in its first year with a return of 20.2%. With profit and income combined, we turned our original investment of $100,000 into $120,198 over the year, or $122,615 when tax benefits are taken into account.

This is contrary to our expectation – we expected that this portfolio should moderately underperform in a rising market (which it has been), and moderately outperform in a falling market. After all, we constructed it for tax-effective income and are underweight the typical ‘growth’ sectors.

To recap, last December we introduced our ‘income biased’ portfolio of stocks. The portfolio was forecast to generate a dividend yield of 5.82% pa, which given it is 97% franked, translates to a forecasted 7.02% pa after-tax income return in accumulation, and for a fund in the pension phase, 8.24% pa.

How it works

Some of the key construction rules we applied were:

  • a ‘top down approach’ to the sectors, with biases that favoured lower price to earnings ratios (PE) and higher yielding sectors;
  • in the major sectors, our sector biases were no more than 33% away from index;
  • to balance the ‘diversification need’ and ‘monitoring effort’, we sought 15 to 20 stocks; and
  • we confined our stock universe to the ASX100, avoided chronically underperforming industries and looked for companies that paid franked dividends and had a strong record of earnings consistency.

The sector bias rule in the major sectors is critical. If we had just been seeking tax effective income, we may have selected a higher bias (such as 50% or 67%). However, we were concerned about the risk of an underperforming portfolio in a rising market and selected a lower bias of 33%.

Keeping the portfolio within these parameters led us to do some minor rebalancing on 31 August, where we reduced our exposure to the Consumer Staples sector and increased our exposure to Materials. We also marginally reduced our exposure to Health Care by taking profits on Ramsay Health Care, and replacing those shares with Primary Health Care.

The results

Our income biased portfolio (per $100,000 invested) and its performance over the year from 15 December 2011 to 14 December 2012 is as follows:

* Income includes dividends declared and payable. Assume AGL 1:6 rights issue sold for $2.30 per right, and proceeds of $0.25 per share on Brambles Entitlement Offer. Rebalancing on 31 August – RHC sold at $24.90; $500 of WES at $34.52; purchases of $4,855 PRY at $3.77 and $1,000 RIO at $49.24.

Income

The portfolio generated dividend income of $5,735, franked to 98.15%. This was fractionally below our forecast (as the following table shows), due to an unanticipated cut in the David Jones dividend.

Performance and Tracking

So, how has it done on a relative basis?

As income is such a critical component of performance, we track the performance against the S&P/ASX200 Accumulation index rather than the normal price index. Further, as the accumulation index doesn’t take into account the taxation benefits of fully franked stocks to SMSFs, we have included the value of the portfolio ‘grossed up’ for this benefit.

Wrap up

Our income objectives have largely been met, and it is pretty hard to argue with the overall performance of 20.2% for the year. We re-iterate our expectation that this portfolio is likely to lag the market in a strong rally. In 2013, we are going to do some minor re-balancing and re-baseline it to the start of the calendar year. We will publish an upgraded portfolio in the Switzer Super Report in early January.

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. Anyone should consider the appropriateness of the information in regards to their circumstances.

Also in the Switzer Super Report

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