Time to clean out the garbage – are your blue chips worth keeping

Financial journalist
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No portfolio – especially that of an SMSF – can ever be considered a ‘set-and-forget’ proposition. A share portfolio that is not being regularly reviewed is not going to do its job – of creating wealth – properly.

Investors need to keep an eye on the way their stocks are performing. That means reviewing the portfolio fairly regularly. If a stock isn’t doing its job, you’ve got to be prepared to ask whether it is worth its place. You should re-assess your stocks at least twice a year – or quarterly, or even monthly, depending on how hands-on you want to be.

Culling an SMSF share portfolio in accumulation phase should be done to lock in a gain from a good performer, or to expel a loser from the portfolio. But when you decide to sell a stock, sell it in the way that produces the best tax results.

Look after your lots

An SMSF in accumulation phase earns a one-third CGT discount if it holds an asset for more than 365 days: subsequent sale of the asset incurs CGT at 10% unless the asset has been transferred into the fund’s pension account, at which point the tax rate on income and capital gains from the asset becomes zero. It is more tax-efficient for a fund in accumulation phase to sell stocks held for at least a year, to get access to the discounted CGT rate of 10%.

SMSFs in accumulation mode should be just as vigilant on their ‘tax lots’ – parcels of shares that have been bought at different times and at different prices – as a 46.5% taxpayer. The capital gain or loss will be different for each ‘lot,’ and knowing the difference can come in very handy.

A capital loss – for example, losses on the sale of shares – can only be offset against capital gains. If capital losses are greater than capital gains in an income year, the fund must carry them forward, to offset them against future capital gains.

Nobody likes making a loss on a share, but using it to negate tax on a capital gain you have (hopefully) made elsewhere in the fund’s share portfolio goes a long way toward easing the pain. When using a capital loss, make sure that you use it on a stock that the fund has held for less than 12 months, to get the full value of the loss offset.

SMSFs in accumulation mode have to watch the cycles of the market, tending to their portfolio so that it does what it is supposed to do: accumulate wealth.

Yield is never guaranteed

Many SMSF proprietors think that these considerations are not relevant once the fund enters pension phase, because it is then effectively tax-free – it does not pay tax on its investment income or capital gain. This is especially true now the government has clarified the fact that the tax-free nature of the pension account is maintained following the death of the pension recipient, until the pension is commuted and the death benefit paid out.

SMSFs can hold high-capital-growth shares during accumulation phase, and then transfer them into the pension account – in which CGT no longer applies – when they retire.

In theory, an SMSF in pension phase, with a portfolio chosen for its dividend yield attributes, can ignore share price volatility to a large extent, given that its income depends on company profits and dividends, not prices. In the normal course of things on the market, dividends increase as company profits increase, linked by a fairly constant payout ratio. In theory, the dividends grow faster than inflation, providing a hedge against both it and longevity risk.

That’s in theory.

But even the big four Australian banks, long the darlings of yield-seekers, suffered in 2009 as bad debt provisions curtailed their ability to pay dividends. Commonwealth Bank cut its payout by 14%, Westpac reduced its dividend by 18%, and shareholders in ANZ and National Australia Bank saw their dividends slashed by one-quarter. That other yield supremo, Telstra, managed to hold its payout steady (while companies such as QBE Insurance, Woolworths, Origin Energy and BHP managed to increase their dividends during the downturn.)

The franking credit rebates were still delivering SMSFs significantly augmented after-tax yields, but no fund proprietors were blasé about the banks’ dividend regressions.

Have the market’s stars run too far?

It is not surprising that SMSFs have poured into the “magnificent seven,” the high-yielding blue-chip stocks that drive the Australian market. The full franking credit refunds turbo-charge the yields to an SMSF in pension mode to effective yields in the 8 – 9.6% range for the big four banks, Telstra and Wesfarmers (Woolworths is priced to yield 6.1% in FY14 to an SMSF in pension mode.)

But the danger that SMSF owners might not appreciate is that these stocks have become a “crowded trade,” and have arguably been pushed higher than their fundamentals can sustain.

Over the past 12 months, for example, Westpac has delivered a total return of 53.4%; Telstra, 48.3%; Wesfarmers, 47.2%; CBA, 45.5%; Woolworths, 40.9%; NAB, 34.1%; and ANZ, 32.2%. That is heady stuff. But is it sustainable?

This group of stocks (plus BHP Billiton and CSL) drive the Australian market. They are the most liquid, and to overseas investors, they look expensive. Our banks, for example, are priced on consensus estimates at between 12 and 14 times earnings – whereas their global counterparts mostly trade on 9 to 12 times expected earnings.

Likewise, Telstra trades on a big premium to BT; and Wesfarmers and Woolworths are over-valued compared to Wal-Mart and Tesco. Franking credits and higher payout ratios account for some of this premium, but there is arguably considerable froth in the prices. The market may have run ahead of fundamentals, and SMSF owners in accumulation mode should at least consider taking a profit in some ‘tax lots’ of their star stocks, especially if they are looking to boot out an under-performer.

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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