This article appeared in the October 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
A guide to growth stocks and how best to a build a portfolio of them.
By John Reynolds, Bell Potter Securities
ASX Investor Update asked John Reynolds, a leading retail stockbroker with Bell Potter Securities, about investing in growth stocks and his preferred portfolio. Here is his response:
ASX Investor Update: John, what is a growth stock?
John Reynolds: There is no clear-cut definition. Some investors think share investing is a choice between income and growth. That is, they buy income stocks that pay higher dividends or those with potential for bigger capital growth through share price gains. Many of the best share investments over the years have had a mix of good dividends and capital growth in the total shareholder return.
Growth companies typically reinvest more of their profits and thus pay lower dividends or none at all. Or they are more sensitive to the state of the economy. David Jones is an example of a cyclical growth stock; its profits are highly leveraged to the health of the economy and retail spending. Woolworths, in contrast, is far less cyclical because people still buy food in strong or weak economies. You often find growth companies in sectors such as construction, financial services, retail, media, transport and other industries where profits tend to go up and down depending on the state of the economy.
Small and mid-size companies usually have characteristics of growth stocks. They pay lower dividends because they retain more profit to reinvest in the business and accelerate growth. When successful, they can compound profit growth and provide higher shareholder returns.
ASX Investor Update: Is it a good idea to have some growth stocks in your portfolio?
John Reynolds: Yes. Even if your main purpose for share investing is to achieve income from dividends, it pays to have some exposure to shares with higher capital growth prospects. As people live longer and need their money to last longer, share portfolios arguably need more exposure to growth to ensure returns stay well ahead of the rate of inflation, and to have a comfortable retirement. Look for high-quality companies that offer some yield as well.
ASX Investor Update: What are some key main strategies for investing in growth stocks?
John Reynolds: It depends on your risk tolerance and timeframe. An investor who builds a portfolio of growth stocks needs to accept above-average capital risk and volatility of returns in the short term, to take advantage of opportunities for superior portfolio outperformance in the medium to long term. Their investment horizon should be at least five years and they should be prepared to hold companies that pay low or no dividends, in favour of those with stronger prospects for share price gains. They are more likely to hold larger companies with well-established market positions, such as CSL, which has been a very profitable investment for those who have held the shares over many years.
A more aggressive growth investor will seek higher long-term gains by including in their portfolios small-caps, cyclicals (such as building materials companies) and stocks that have a history of volatile performance. For these investors, the security of capital is secondary to the potential for wealth creation. They too need a long-term focus and preparedness to invest more actively and take profits on shares when opportunities arise. Highly cyclical stocks are not long-term, set-and-forget investments. They must be monitored closely, given their potential for sharp rises and falls.
ASX Investor Update: Why do growth stocks often rise when the economy is sluggish?
John Reynolds: Cyclical growth stocks tend to anticipate the economy growing faster in 12 to 18 months. Investors who buy these today are betting that further interest rate cuts will spark faster profit growth for companies that are highly sensitive to the economy. You cannot wait until the economy is booming to buy growth stocks, because their share prices will have already rallied. Often the best time to buy cyclical stocks is at, or near, the bottom of the interest rate cycle, when a few final rate cuts are likely to stimulate the economy, before rates start rising again. Of course, the same advice applies to selling growth stocks; you cannot wait until the economy is weakening to sell because the market will have already anticipated lower profit growth.
ASX Investor Update: Is it time to buy more growth stocks?
John Reynolds: Over the past year, many clients have been risk-averse, given events in Europe and the United States. As interest rates in Australia have fallen (as have rates on bank term deposits), investors have sought the perceived safety of high-yield shares such as in infrastructure, the banks and Telstra. This has been a good place to park funds because of high fully franked yields. Some income shares have also had good capital growth.
But the tide is starting to turn. With interest rates in Australia likely to fall further, it is time to look at growth companies as the market starts to factor in higher future earnings growth. Be realistic about potential growth in earnings. It may take time for much stronger profit growth for companies in struggling industries, such as retail, media and construction. In addition to rate cuts, a lower Australian dollar would be the most positive macro-economic value driver for many cyclical stocks.
ASX Investor Update: What does your preferred growth portfolio look like?
John Reynolds: I have assumed an investor wants to build a $200,000 portfolio of growth stocks, is willing to hold them for at least five years, and able to accept a slightly higher level of risk compared to investing in more defensive income stocks. That said, the portfolio below is designed for conservative growth investors, rather than those seeking aggressive growth exposure.
(Editor's note: Do not read the sample growth portfolio below as a recommendation to buy these stocks. Do further research of our own or talk to your adviser before acting on themes in this article.)
I recommend spreading $200,000 equally across 10 shares and choosing companies across different sectors to further improve diversification.
The 10 are: Crown, Woodside Petroleum, CSL, AMP, Lend Lease Group, Brambles, Seek, Qube Logistics Holdings, Computershare and BHP Billiton.
The table below shows Bell Potter's dividend forecast for each. The portfolio has a forecast 2012-13 dividend yield of about 4 per cent. Investors can receive a similar return (after accounting for franking credits) from this growth portfolio as they would from investing in a bank term deposit, and have exposure to capital growth through potential share price gains. Of course, the growth portfolio has more risk than investing in cash, but a mix of higher-quality blue-chip companies are across several sectors improves diversification.
A sample growth portfolio
|Code||Company||Recent price (cents)||Quantity||Value||Forecast yield %||Forecast dividend||Franking %|
|LLC||Lend Lease Group||781||2600||$20,306.00||5.2%||$1,055.91||50|
|QUB||Qube Logistics Hldg||145||13700||$19,865.00||3.3||$655.55||100|
|Forecast FY13 yield:||3.94%|
Source: Bell Potter Securities
About the author
John Reynolds is a client adviser with Bell Potter Securities, and has advised on wealth-management strategies for almost 20 years. He owns some shares mentioned in this article. Contact John or visit Bell Potter for more information on the firm's services.
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