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A model portfolio of eight top income stocks

This article appeared in the November 2013 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.

Hold reliable yield performers and a few up-and-comers, to get the best long-term dividend outcome.

Photo of Ken Howard By Ken Howard, RBS Morgans

My current view is that the sharemarket is fairly priced, but then again, what is fair? To me, fair is another way of saying if a client bought a diversified portfolio of top 100 companies, I would expect them to make a reasonable return over the next five to seven years.

Implicit in this is an assumption that the global political, military and economic environment remains stable, but more particularly Australia remains a stable and developed economy.

As a stockbroker I am certainly comfortable to recommend shares and for long-term investors I am happy to recommend buying at a fair price After all, by definition the sharemarket will spend most of its time at a fair price and in time, if a client wanted to sell, it would only be rational to be willing to accept a fair price.

The key to making the most of the current market is to focus on quality. Nine times out of 10 it will be a mistake to trade quality for higher yield. To use a sporting analogy, you want a team of the best performers to take your money forward into whatever the economy brings, to be able to compete for customers, deliver value and generate a return.

There is no point investing your financial hopes on a team of out-of-form poorly performing players. You could certainly consider some of the up-and-coming players and perhaps a couple will make the team in any one year. But the core of the portfolio should be made up of proven performers.

To continue the sporting analogy, I would emphasise, that while picking the individual players is very important, it is equally important to build a team - it will be a team that delivers reliable results. On any day you will not know what next year brings - what the political, economic and technology challenges will be.

By having informed players, you give yourself a very good chance that they will be able to adapt and operate profitably and sustainably within the future environment. But equally, different industries will face varying degrees of challenge and opportunity. In short, you want a diversified portfolio.

I would reinforce the notion that a good portfolio will be resilient. Companies that have spare capacity in good times (call it a lazy balance sheet) will survive and potentially exploit the tough times.

Companies operate in the real world of customers, competitors, suppliers and regulators - not the sharemarket. Successful companies generate returns on invested capital; they generate "free" cash flow that can be used to reinvest and grow, used to build resilience and provide future flexibility, and used to pay dividends. Successful companies have a record of results, producing cash in good and bad economic conditions.

"Free" cash flow is more than just revenue and more than revenue less expenses. It is the cash left over after all expenses and "stay in business/stay competitive" capital expenditure has been met. It is not simply a return of your capital, it is the return on your capital - where your capital is, in effect, the capacity for your investment, the company, to produce returns well into the future.

A model income portfolio

From my experience I would consider the following list of companies to be quality companies that clients can buy and hold, trading at a fair price.

(Editor's note: Do you read the ideas below as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).  

Company Share price 2014(f) div+fc* Forecast yield**
CBA $70.72 5.33 7.53%
Westpac $32.08 2.60 8.10%
Woolworths $33.77 2.01 5.96%
Wesfarmers $41.09 2.86 6.95%
Coca-Cola Amatil $12.27 0.89 7.22%
AGL $15.63 0.90 5.76%
Sonic Health Care $15.50 0.83 5.34%
Telstra $4.91 0.41 8.44%

Average 6.91%
* 2014(f) div+fc = forecast dividend plus franking credits (per share) for the 2014 financial year.
** Yield = the dividend you received/the price you have paid.

Source: RBS Morgans

It would be great to buy the stocks at a cheaper price and perhaps that opportunity will come. But equally, as an initial eight-stock portfolio, you have exposure to various parts of the economy, different regulatory and technology drivers, and varying degrees of exposure to global markets.

 

Depending on a client's objectives, I would certainly include preference shares and other hybrid securities, property trusts and infrastructure funds. I would simply apply the same rules of buying quality at a fair price, or cheaper if possible.

In summary, I believe the current yield on shares is reasonable, certainly when compared to cash at 2.5 per cent. Equally, the risks are real but in some respects they are equivalent to the risk of living in Australia, because if Australia's banks fail, if Australia's major retailers and utility companies fail, you will probably want to pull out your passport and leave.

Some final thoughts

  • If you want performance, ask any athlete and they will tell you it requires effort. A sustainable return that is better than cash can only come from effort. Keep it simple and be mindful of risks. Shares are certainly no substitute for cash, no government has ever guaranteed them, and there is no regulator dedicated to ensuring that the price you pay or receive is fair and reasonable.
  • To sustainably manage a portfolio requires intelligence, experience and temperament.
  • I understand a "low-risk income portfolio" to mean the investor is focused on a sustainable and growing income stream, as opposed to a portfolio with a predictable capital value. I include a growing income stream because most directors and executives of ASX-listed securities consider growth to be an important objective and will retain some earnings each year to fund the sustainability and growth of future distributions and dividends.

About the author

Ken Howard is a stockbroker and financial planner. He has worked with RBS Morgans since 2001 and in the financial services industry since 1996. He has adopted a fundamental approach to investing, looking for value and quality in long-term investments. The strategy is biased towards investments with a long history of paying dividends and distributions. To find out more on the outlook for A-REITs in 2012, contact Ken Howard on 07-3334 4856 or email Ken.

Ken Howard LLB, BEcon, CFA, GAICD is an Authorised Representative of RBS Morgans. RBS Morgans Limited (ABN 49 010 669 726 AFSL 235410) is a Participant of the ASX Group and a Professional Partner of the Financial Planning Association of Australia.

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