Yield portfolio – the final cut

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In my previous articles on my yield portfolio, I outlined my portfolio construction methodology and presented ‘Top Ten’ lists for each sector. The next task is to choose the stocks. Rather than go just by yield, I also give credit for better consensus recommendations (from Thomson Reuters: 1 for a Buy down to 5 for a sell). And I also exclude stocks that worry me – for whatever reason.

Table 1: Sector top tens

Source: Thomson Reuters Datastream & Woodhall Investment Research – as at 25 July

I excluded from Table 1 for my portfolio:

  1. WorleyParsons (WOR) WOR because it is more mining services than Energy.
  2. Mineral Resources (MIN) because it is very much in the mining business and has had some poor recent performance.
  3. Myer (MYR) because of the mergers, takeovers and retail woes.

That means I had no stocks – or weight – in four sectors: energy, materials, staples, and IT. I redistributed the energy and staples allocations proportionately across the other sectors – noting that the sectoral split gave neither space for Materials nor IT.

Weightings

Together with my decision rule for the number of stocks I allocate to each sector, I need to specify how much I invest in each stock. There are three obvious ways of doing this weighting:

  1. Weight in proportion to market capitalisation of each stock
  2. Equal weighting within each sector
  3. Weight with regard to consensus recommendation

I think 1) misses the point for an SMSF. Because most sectors are dominated by one or two stocks, there is little point in going down the list as the size of the allocations falls off so quickly. Of course, by deviating more and more from market cap weights, tracking error (the variability of the fund’s returns compared to those of the benchmark) increases but, to me, there is a good argument that stocks outside the top 20 are more likely to give my portfolio a kick in moderate to good times like now.

Equal weighting makes sense as it is simple and, apart from market cap weights, there is no other standard way of weighting. I prefer to weight stocks in each sector in relation to the consensus recommendations. If a stock gets a ‘1.5’ that is a great recommendation. Such a stock seemingly has more chance of capital gains and yield as a stock with a 2.75 recommendation that scrapes through as a slight outperform.

Final stocks

My actual initial allocation is given in Table 2. But there is more to buying the stocks than dumping your cash into the market – in my opinion. I was in a hurry to get set because there were then only four days to go to the end of the financial year. I thought – and still do think – there was a good chance of a kick in July – and I’ve already made more than 3% capital gains in a few weeks. Tatts Group was particularly kind to me, but four other stocks have made more than 4% since I bought.

Table 2: Initial Allocation

Source: Woodhall Investment Research

The dividend is a forecast and allocation is a dollar value for a nominal $100,000 portfolio. I divided my notional ‘$100,000’ total investment into four portions to take advantage of my estimates of sectoral mispricing, ex-dividend dates and general ‘dollar-cost-averaging’. Because the end of financial year was looming large when I was committed on June 25th, I placed the trades much more quickly than I would otherwise have done. I was set by the close on Friday 27th June.

Of course, the allocations at current prices are no longer the same as market prices have already changed over time. In the beginning, my expected yield was 5.7%, against 4.6% for the ASX 200 index. My ‘grossed-up’ estimate of dividends (with estimated franking credits) was 7.5% against 6.0% for the index.

My capital gains forecast, using sector-averages, was 7.7%. I do not make forecasts at the stock level. I do use broker target forecasts as a rough guide. I think brokers tend to downplay these 12-month price targets so as not to get caught out. They can always inch these valuations up as they go along. My initial target-based capital-gains forecast was +2.7% but that has already been upgraded to +3.9% in less than a month!

The bias

So I am thinking the bias in the ‘target forecasts’ is currently of the order of 4% points. In other words, I am expecting a grossed up yield of 7.5% with a capital gain of about +6.5%, making a total return of around 14%. If I compare that to my index forecast of 6% with a dividend of 4.6% for a grossed-up total return of 12.0%. It may not seem worth all this effort for an extra 2% (14% – 12%) but there is more to it than that:

  1. Will I get the yield component without too many surprises? That is, will my companies deliver on expected dividends better than the rest, or fall short?
  2. Will my flexibility to invest my dividends wherever, over simply re-investing in the companies that generated them, gain an advantage?
  3. Will future rebalancing help my portfolio over the index?

I’ll give you an update after my August holiday in the Motherland. In September, I will focus on how to judge how well you are travelling.

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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