Diversity pays off for growth portfolio

Eureka readers will recall that I structured the growth portfolio in April 2012 with $120,000 to invest across 10 equally-weighted stocks.

The portfolio value fell with the sharp market declines in May 2012, and since that time it has steadily risen. As at June 30, 2012 the portfolio value was $111,000, and this has lifted to $145,000 as at the end of the third quarter of the 2012-13 financial year.

Our target rate of return is 10% per annum. The portfolio will reinvest all income each six months back into the portfolio, and this will aid our target to double the portfolio value over seven years. The combination of solid stock selection, minimal rotation or trading, with the reinvestment of dividends should allow us to achieve our targeted return.

From the commencement of the portfolio and the start of this financial year we have achieved our target return, and so we are well on our way. So why target a 10% return?

First, it is a reasonable margin above the risk-free rate of return of 3.6% for an Australian long-term bond. Further, and think about this carefully – would you be happy or unhappy to double your capital over 10 years? This can be done through the power of compounding, and a 10% return per annum compounded will achieve an approximate 100% return over seven years.

Key investment decisions – Good and Bad

My intention is not to trade aggressively and to hold our portfolio positions so long as the companies that are held are not excessively priced against my assessment of intrinsic value. Also, I will continue to monitor dramatic changes in the outlook for companies, their industries and our economy.

Over the last nine months we have made the following key portfolio changes:

1. Sold OrotonGroup (ASX:ORL) and judiciously bought Flight Centre Limited (ASX:FLT) in December; and
2. Sold Blackmores (ASX:BKL) and lifted cash towards 10% last month.

In particular, the decision to raise cash was because I could not find a new investment opportunity at a reasonable discount to our valuation. So better to hold cash and wait.

One mistake that I made was not to withdraw Rio Tinto (ASX:RIO) from the portfolio at prices above $70. At this price it had lifted above my 2014 value, but I chose to wait to review the final 2012 result. Frankly the result was disappointing and the opportunity was missed. However, in the low $50 range it is moving well into value.

Another company that became rather overpriced in late 2012 was Iress (ASX:IRE). At prices above $8.50 it went above my 2014 valuation. It remains a high-quality company that became very expensive. Its outlook remains good and its balance sheet is strong. By resisting a temptation to trade a short-term gain was missed, but at current prices I am happy to hold.

The good news is that the portfolio has lifted despite these stock gyrations, and that is the benefit of diversity. My preference is for there to be 12 stocks, and hopefully in coming weeks with a weakening market I will be able to find another stock to buy.

Outlook for Portfolio positions

In scanning across the portfolio I thought that it might be appropriate to outline my current thoughts on individual stocks and revert where appropriate to the MyClime valuations.

1. BHP Billiton (ASX:BHP) actually represents the biggest discount to the 2013 valuation of around $39. The stock price has retreated quickly in the last month as market commentators speculate on a declining outlook for the iron ore price. I am not so sure, due to the following outlook tables for urbanisation and car production in China. Further, the recent lift in gas prices in the US has been totally ignored by the market. So I actually perceive that BHP is one of the better buys in the market at present;

2. The two bank positions of Commonwealth Bank and Westpac still offer a reasonable yield and a slight discount to market forward value some 12 months out. I am actually a solid holder as I suspect that all of the Australian banks may well lift dividends above expectations in 2013-14. I also perceive that interest margins are well under control and their wealth management operations will grow nicely;

3. I commented earlier on Iress, but I am remain solid in my conviction to McMillan Shakespeare (ASX:MMS). It continues to grow earnings at 20% per annum and does so through its inherent ability to self-fund its own growth. Any weakness to below $14 would represent an attractive buying opportunity;

4. Woolworths (ASX:WOW) remains a solid hold at current prices. The stock, based on consensus earnings, has its intrinsic value lifting towards $37 in the next 12 months. Should it move above this level too quickly then I would reconsider my position;

5. Brickworks (ASX:BKW) has moved solidly above $13 in recent weeks and defied a generally weak market. The improving outlook for building starts and the chatter about the push for a group restructure have clearly excited the market. The shares have moved to intrinsic value, but clearly this value is understated by the effect of the BKW and Washington H. Soul Pattinson & Co. (ASX:SOL) cross-shareholding; and

6. Of the remaining stocks – The Reject Shop (ASX:TRS), Flight Centre (ASX:FLT) and Mineral Resources (ASX:MIN) – the latter is the best value. MIN continues to attract with a long-term “take or pay” crushing contract from Fortescue Metals Group (ASX:FMG). The current spot price for iron ore is well above the MIN cost base, and so I suspect there will be marginal upgrades to 2013 earnings forecasts shortly. Certainly MIN looks attractive at prices below $10. As for TRS and FLT, they are fully priced with no margin of safety at present. However, the quality of their businesses means I am happy to hold them.

In conclusion, I remain confident of achieving a rolling 10% per annum return from this portfolio. Greater returns are certainly hampered by the strength of the Australian dollar, which is choking our economy and therefore our equity market. However, equity investment should be a long-term undertaking and patience in the current environment will be an important attribute to ensure long-term investment success.

John Abernethy is the Chief Investment Officer of Clime Investment Management. 

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