Ready to switch CBA for ANZ

The growth portfolio was constructed in April 2012 with the long-term aim of achieving a 10% per annum return.

This target was set because the portfolio, under my direction, retains the right to not be fully invested at all times. If value in quality companies is difficult to find, then it can divert funds to cash. The 10% per annum return target, if achieved and allowed to compound, will generate about a 100% return for investors over seven years. That is both a reasonable and sensible long-term rate of return, given the high-risk nature of equities.

Over the first six months of this financial year the growth portfolio achieved a return of more than 10% (or annualised 20%). The compounded return since inception, some 20 months ago, is in excess of 30%.

So at this review point the portfolio has clearly exceeded its targeted return, and we are well on our way to double our capital over seven years.

While the Australian equity market has generally been on an upward trend since April 2012, it has been a volatile ride. The first three months of the portfolio’s life was a period that encompassed a sharp market correction. There was a correction in May to June last year, followed by another correction in November/December just passed.

This leads to the conclusion that many market commentators and retail investors put too much emphasis on short-term returns.

In the short term, timing is everything. Over a longer period, it is the power of the compounding returns (capital and income) from quality companies that generates far superior returns.

A sober outlook

In my view, 2014 is shaping up as a difficult year for the Australian equity market.

The downturn in the resource capital investment cycle is well documented and the delayed effects of an excessively valued currency are filtering through the economy.

It has been 22 years since Australia had a recession and this has resulted in an economy that is somewhat bloated with excesses across both the public and private sector. Slowing productivity growth is one notable feature. Another is the resounding lack of growth opportunities presented in the Australian equity market.

On a recent trip to Europe I looked back to an equity market that is dominated by four banks, two major resource companies and a big telecommunications company. There is so little on offer in Australia that presents an investor with leverage to the great growth engine of the world in the next decade – the massive and emerging consumer class of China.

The following chart (Figure 1) shows that this great cycle has commenced, as imports into China for domestic use have already begun to rocket in the last four years. Unfortunately, the Australian sharemarket presents investors with precious little exposure to this, and we merely present as a market that is fixated on franked yield. Never before has the need for Australian investors to seek out offshore companies been so acute.

Click to enlarge

The saving grace for our market may well be a sharply weakening currency and an influx of tourists. However, that will lead to inflation and a compression of equity values unless there is earnings growth.

Stock comments and portfolio switches

The above commentary and a review of intrinsic valuations has led me to the following recommendations for the growth portfolio.

• BHP Billiton Limited (ASX:BHP) presents as a solid hold at present. It still presents as value and this will be enhanced by a weakening Australian dollar. It does represent as one of the best opportunities for an Australian investor to be exposed to both growing Chinese incomes and consumption.
• Commonwealth Bank of Australia (ASX:CBA) presents as very fully priced. There is no doubt that 2014 will see both earnings and dividend growth. However, at this point Australia and New Zealand Banking Group (ASX:ANZ) presents better value with some semblance of growth emerging from its Asian roll out. Therefore, the portfolio will be selling CBA (above $76) and buying ANZ (below $31) in the coming week. Readers should recall my view, outlined in The ‘big four’ are overvalued in early November, that banks in general are fully priced at present.
• Westpac Banking Corporation (ASX:WBC) has predictably drifted back from the heady heights of about $35 last year. Today, it is fair value with a reasonable yield. WBC, like its peers, has focussed asset growth on residential lending and this preoccupation does concern me. I will monitor developments in coming months to determine if risk levels are actually rising in the banking sector as unemployment lifts. I am holding WBC at current prices.
• Woolworths Limited (ASX:WOW) continues to offer our portfolio leverage to the solid growth in the Australian population. The solid growth in immigration levels and the maintenance of high birth rates suggest a reasonable outlook for WOW and it is a strong hold.
• The Reject Shop Limited (ASX:TRS) has a similar profile but does find itself in a slightly more competitive landscape. There is limited margin of safety in the current price and it is subject to an excellent half-year result. I am inclined to suggest that a price above $18 could provide an exit opportunity. Hold for now but monitor carefully.
• Brickworks Limited (ASX:BKW) has certainly been pumped up by the corporate restructuring proposals of Perpetual Investment Management. However, I suspect that the BKW is really benefitting from a sustainable recovery in the housing commencements cycle. The stock may well be subject to upgrades in coming months and this is unique in a docile market. Nevertheless I am holding but would question holding above $15.
• McMillan Shakespeare Limited (ASX:MMS) was covered by me in late 2013 (McMillan Shakespeare well on recovery road). During then, I suggested that it was a strong buy at $11. It has now rallied to about $12 and it is a strong hold.
• Mineral Resources Limited (ASX:MIN) has had a controversial few weeks as it scrambled to alert the market to the consequences of losing a significant crushing contract with Fortescue Metals Group (ASX:FMG). Its latest announcement suggested that the contract will not impact the previous 2014 profit guidance. Thus, it is very likely that MIN will announce an extremely strong first-half result in about three weeks’ time. There is value in MIN but it has certainly been depreciated by recent events. Hold for now but $12 would look a bit expensive to my eye.
• SMS Management & Technology Limited (ASX:SMX) has come into our portfolio as its price retreated over the last six months. Towards the end of 2014 I have no doubt that SMX will be emerging from the downturn that currently presents across the IT sector. In particular, SMX has some strategic operational and service skills that could well see it become a takeover target for international IT service companies that are seeking an entry point into Asia. It is a certainly a hold in our portfolio.

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

* This article is part of the “It's Time” series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.

Clime Growth Portfolio Statistics

Return since June 30, 2013: 12.42%

Returns since Inception (April 19, 2012): 32.22%

Average Yield: 6.12%

Start Value: $141,128.64

Current Value: $158,663.19

Dividends accrued since June 30, 2013: $3,622.96