Introducing our Income First model portfolio

The Income First model portfolio will aim to achieve a gross dividend income greater than the broader market each financial year, with some capital growth over the longer term. Ideally, income will be produced from investing in companies that pay sustainable dividends with consideration over payout ratios.

Further, we are focused on not paying too much for yield. Therefore, the yield will be assessed in combination with the level of valuation support. We also favour companies that can grow earnings that are likely to lead to growing dividends in future years. Cash flow from the company's operations will remain a key focus in understanding the sustainability of a company's dividend yield.

Portfolio allocation

The model will focus on stock picking rather than market timing. Given many of the higher yield stocks are amongst the larger capitalisation companies on the ASX, a portion of the invested portfolio (typically 20-40 per cent) will be allocated amongst high yielding large cap businesses. However, the ASX is littered with smaller cash generating, dividend paying companies that should appeal to the income focused investor. These small-mid caps that provide sustainable income and capital stability will form a portion of the invested portfolio (around 30-70 per cent).

The portfolio will typically hold between 15 and 30 stocks, and performance will be measured based on an initial portfolio of approximately $100,000. Whilst investors should consider that the portfolio outcome and income expectations will be achieved by following all of the recommendations, we accept that some may choose to use the portfolio as a source of idea generation in order to extend and diversify the yield stocks held in their existing portfolios.

Whilst the end objective of income production will remain unchanged, the investing environment will not. Markets are currently providing equity investors with an enviable opportunity to derive income, thus risk adjusted returns for equity investors are compelling. However, circumstances will change, and many of the large cap household names are trading with sentiment similar to a proxy for bonds (i.e. relative sources of income). In order to mitigate this risk, it may be a wise strategy to trade some of the high yields on offer for a focus on earnings growth and dividend growth when considering the need to protect capital through cycles.

In addition, the investible securities for the Income First model will not be limited to equities, with some hybrid securities to be considered. In current market conditions the hybrid allocation is likely to be minimal or non-existent, but both new and secondary hybrid issues will be considered, either as income generation investments, or as portfolio risk mitigation instruments.

Benchmark

The portfolio will set out to produce an income above the broader market, and provide investors with a level of capital appreciation over the long term to protect against inflation. With respect to the income component, the market yield will be calculated as the market capitalisation weighted dividend yield of the ASX, which at the start of the financial year was approximately 5.5 per cent including the full benefits of franking credits (a shade under 4 per cent if we ignore franking). In addition to this, once the portfolio is fully established, we will provide a 12-month forward estimated yield for the portfolio. This should enable investors to manage their investment outcomes and asset allocation with some clarity as to future income expectations.

Given the defensive nature of the portfolio (defensive earnings focus, and potential for hybrid inclusion), it is likely that the portfolio will outperform broad ASX indices in weak markets, but underperform in strong markets, when considering capital returns. Notwithstanding this, the key here is providing investors with a healthy level of sustainable income from equity market investments.

Sustainability

One of the key areas to focus our analyses when looking at income generation will be cash flow, and future capital commitments. Generally speaking, companies that are mature and have lower requirements to fund growth tend to pay out a higher proportion of earnings.

However, a balance needs to be found. Without some level of reinvestment, (i.e. a payout ratio that is considered too high), company earnings and cash flow will decline, leading to lower dividends and less income for the end investor.

In light of this, there again may be a need to pass up dividends that are attractive in the short term in order to invest in sustainable and possibly growing, income generating businesses.

Large cap coverage

Given the obvious relevance of some large cap mature businesses to income investors, the portfolio will hold a portion of its invested weight in large mature businesses, such as banks, telecommunications and insurance companies. This may come as no surprise, and is a good method of positioning the portfolio for near-term yield.

Our approach to these well-covered large caps (likely those in the S&P ASX 100 index) will be to avoid reinventing the wheel, and full financial analysis will not be provided. Rather we will present our reasons for inclusion of a stock, and how it will benefit the portfolio, in light of the widely available research.

To this end, we will look to maximise income from the large cap allocation based upon value and yield metrics. For example, we intend to include only two banks at initiation of the portfolio, with a focus on the yield available, the price-earnings (PE) ratio and the price-to-book (PB) ratio. This focus on taking the best risk adjusted yield from banks, but limiting the exposure, will help keep sector weights and diversification limits in check. We shouldn't confuse this issue though. If the banks were to start reinvesting and simultaneously maintain a compelling yield, we are not averse to holding many more. In the current climate, a larger allocation is unlikely.

Benefits of an income portfolio

Investors so often forget that one of the key ingredients to the creation of an equity portfolio is to set clear objectives and marry the investment decisions directly to those objectives.

Having launched our growth first model portfolio recently, the income first portfolio now allows investors, whose objectives may differ, to benefit from more relevant stock recommendations.

The model will seek to provide a framework to assist investors in producing a healthy income from their investments, retaining exposure to companies with strong earnings outlooks.