This article appeared in the August 2011 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.

Use these techniques to allocate funds across the right sectors and stocks.

Photo of Daniel Parasol By Daniel Parasol and Paul Benveniste, Evans & Partners

Like any successful endeavour, investment requires planning and context. Planning involves detailed assessment of an investor's objectives, and context is about the macro-environment and appropriate asset allocation. Equity portfolios or property investments, domestic or international, are the "growth" elements of the allocation.

(Editor's note: Read Toni Case's story in this issue, "Your wealth creation plan" for more on understanding your investment needs before determining asset allocations).

For an equities portfolio to be considered "great" it must perform against established criteria. A well-constructed portfolio must be able to perform across a range of scenarios, and be diversified to provide growth and protection. Diversification requires measured exposures by:

  • Geography (domestic shares versus global shares)
  • Industry sector
  • Currency.

Portfolio fundamentals must be assessed against relevant benchmarks, such as the weighting of particular shares or sectors, and the investor's objectives. Portfolios must be reviewed regularly, because great ones are never set-and-forget.

There is no single answer to constructing a great equities portfolio, because the criteria will be measured against each investor's objectives:

  • Growth
  • Income
  • Volatility (which is often ignored).

If a portfolio can produce an investor's required income, match or outpace inflation, and lets them sleep easily, it comes close to being great.

Although domestic and international share provide the growth element of asset allocation, we recommend investors split funds between the two about equally. Investors may favour Australian shares because of dividend objectives and tax benefits from franking credits. Accordingly, although the franking credits and yields of select Australian shares remain attractive and strong, we continue to invest extra investment dollars offshore.

Challenging environment

At present, the environment for most of the Australian economy looks challenged, but against this backdrop is a universe of opportunity. Market risk premia (the difference between the expected return on a portfolio and the risk-free rate of return) are high, suggesting investors are being adequately compensated for the challenging global macro-environment.

Globally, corporate balance sheets for GFC survivors are strong, and powerful demographic trends are developing from the rise of emerging-market consumers, which will present opportunities for companies with truly mobile capital. We believe the US economic recovery, nascent at best; will gather momentum and prospects for a recovery in home construction will develop in 2012.

For an Australian equities portfolio we seek balance across sectors according to valuation and outlook, namely:

  • Financials
  • Resources and Energy
  • Industrials (domestic and international focused)
  • Utilities and Infrastructure.

Banking outlook uncertain

The outlook for global banks is uncertain, and allied with anaemic domestic loan growth we believe outperformance by Australian banks is unlikely. But Evans & Partners is happy to maintain positions in banking shares, with a preference for NAB and Commonwealth.

(Editor's note: Do not read the ideas below as share recommendations. Do further research of your own or talk to your financial adviser or sharebroker before acting on themes in this article).

As for resources, China will continue to grow. However, the undeniable forces of supply and demand may keep iron ore and coal prices in check more than copper and energy over the next two to three years. This sector's high capital intensity, strong cash flow, production growth and low gearing allows companies greater flexibility to adapt to periods of adverse commodity price fluctuations.

Therefore, we prefer portfolios to include BHP Billiton, Rio Tinto, Oz Minerals and Woodside. We also like exposure to the global growth (commodity) thematic via "volume" rather than "price". QR National is an example of a company that can produce strong revenues irrespective of the price being paid for the underlying commodity. We believe QRN has ability to find more cost efficiencies and drive greater profitability in freight contracts.

Not all bad in retail

There are some positives for Australian industrial companies, consumer staples in particular. Woolworths and Wesfarmers are in highly defendable positions, secondary or tertiary competitors are a long way off, and both companies have efficiency and growth opportunities. They present healthy and growing yields plus capital growth for portfolios, and we are happy to include both.

Portfolios should also include Australian companies with significant exposure to global markets. This builds a buffer, allowing diversification away from the challenging domestic economic environment. The number of high-quality companies that meet these criteria is low, but QBE Insurance, Brambles, CSL, Ramsay Healthcare, Seek, and Coca-Cola Amatil have legitimate claims to be such global businesses. We would have each of them in portfolios, but remember that domestic companies with international business units are not a proxy for international investment.

Utilities and infrastructure companies, like Australian Real Estate Investment Trusts (A-REITS), have undergone a painful recapitalisation period since the GFC. However, unlike A-REITs, some have emerged paying healthy, fully earnings backed yields of 8-10 per cent. Organic growth remains limited but some inorganic opportunities may come along. Evens & Partners prefers Duet and Envestra in these sectors.

QR National provides some infrastructure sector exposure through its rail assets, but Transurban Group (TCL) is included in our model portfolio to give the portfolio a diversified exposure to the sector. TCL also gives portfolios a hedge against inflation, given its revenue rises directly in line with the consumer price index.

Detailed considerations

Once portfolio candidates have been shortlisted and indicative dollar amounts applied to each, we can turn attention to:

1) The number of companies. 15 to 25 is ideal. Share positions of below 2 per cent of the portfolio's value in total are not effective.

2) Exposure to each share. A consistent distribution across large-cap positions (5-6 per cent exposure on average, per company) to small-cap positions (minimum 2 per cent/maximum 3.5 per cent). Portfolios that are heavily biased (such as 50 per cent) to a handful of companies carry undue risk.

3) Diversification across industries. Aim for at least eight industry/sector exposures.

4) Avoiding thematic bias. Be alert to excessive allocation to "financials" or "quasi resources" (resources + mining services) or Australian-dollar-exposed companies.

5) Assess the number of companies in each industry/sector group. The aim is to hold a significant position in the best company in each sector and not waste capital by holding smaller positions in more than three.

Once this exercise is complete, it is important for investors to review the portfolio in its entirety. Do the portfolio fundamentals stack up? Are the portfolio metrics appropriate? Review earnings-per-share, price/earnings multiple, and yield of the total portfolio against the ASX 200 and the stated objectives. If a discrepancy or gap emerges, return to step one.

Any portfolio, and indeed total investments, must be monitored, managed and constantly reassessed by the individual investor. It can only then be considered "great" if it delivers - against objectives and over time.

About the authors

Paul Benveniste joined Evans and Partners in 2010, and has worked in financial services since 1997 (having spent four years in private business previously).

Daniel Parasol has been involved in the finance industry for more than 10 years and joined Evans and Partners in 2009.

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