Taking stock from a market upturn

With portfolio returns of more than 20% in six months, it’s time to make some changes.

PORTFOLIO POINT: Positioning the growth and income portfolios for the best returns in 2013 requires some holding adjustments at the end of the year, with a focus on Flight Centre and NAB.

A solid run in the sharemarket, with the likelihood of more to come, does give me cause to take breath, review my portfolios, and determine if changes need to be made.

Absolute returns 30/6/12 to 20/12/12
Growth Portfolio: 20.30%
Income Portfolio: 22.33%

At the outset, let me reiterate that the two portfolios that I designed in April are long-term portfolios and the intention of them is to allow the effects of compounding of returns to flow through the portfolios. The compounding of returns is one of the simplest and least understood investment phenomenas in the investment market. It is compounding that makes good investments become great ones.

It is arguably the fundamental reason as to why Warren Buffett has achieved the enormous returns in Berkshire Hathaway over 60 years. In Berkshire, Buffett has retained all of its investment cash flows after costs of running the business. Berkshire does not declare dividends to its owners but meticulously hoards investment flows to reinvest in selected companies when opportunity presents itself. That opportunity is invariably when excellent companies are offered in the market at a discount to the forward estimate of value.

My portfolio process does not have the benefit of market timing and so my intention is to rotate my positions selectively at six-monthly intervals unless there is a dramatic event in the meantime. There is no cash allocation in my growth portfolio as investors can allocate their own cash to the income portfolio if they wish. The allocation between income and growth portfolios is therefore left to the individual, but both portfolios are fully invested at all times.

To achieve the benefits of compounding I intend to reinvest the cash income (dividends and interest) equally back into the portfolio as at 31 December and 30 June each year. There is no magic to this, rather it is a convenient time to reinvest.

Proposed Growth Portfolio Changes

What is apparent from my review of this portfolio is that three companies need to be considered for a portfolio review based on current share prices. These are Blackmores Limited (ASX: BKL), OrotonGroup Limited (ASX: ORL) and Rio Tinto Limited (ASX: RIO). These three companies currently have market prices above my estimate of value in mid to late 2013.

Of the three companies the most difficult to assess is ORL as it has a major restructure ahead to replace the loss of its Ralph Lauren licence. Thus, the current price is very full and the assessment of potential value is difficult as I look at 2014 market forecasts. When I look at BKL and RIO and consider current market forecasts I can see that their value will continue to grow in 2014. Further, because I suspect that we will be seeing a lower A$ in that year my confidence levels are enhanced.

So I have decided to exit ORL effective 31 December and replace it with Flight Centre Limited (ASX: FLT). This is in no way a reflection of ORL or its management but rather a reality check. Time will tell whether ORL can redeploy its capital and replace its lost business. It may well choose to return cash with a massive dividend.  However, it is too uncertain at this point for my focussed portfolio.

Flight Centre has the following estimate of value as of 30 June 2013.

Clime Growth Portfolio

Return since June 30, 2012: 20.30%

Returns since Inception (April 19, 2012): 18.39%

Average Yield: 7.78%

Start Value: $111,580.24

Current Value: $142,865.40

Clime Growth Portfolio - Prices as at close on 19th December 2012

FY13 (f)
GU Yield
BHP BillitonBHP$31.45$37.064.51%$42.6315.03%18.00%
Commonwealth BankCBA$53.10$61.338.08%$64.835.71%21.75%
The Reject ShopTRS$9.15$15.163.96%$15.522.37%51.04%
McMillan ShakespeareMMS$11.82$13.875.25%$14.232.60%21.86%
Mineral ResourcesMIN$8.95$9.567.17%$12.6332.11%8.82%
Rio TintoRIO$56.50$65.713.70%$64.58-1.72%15.30%
Oroton GroupORL$7.30$7.0010.41%$6.24-10.86%1.16%

Clime Income Portfolio

I mentioned last week that the effects of an unrelenting quantitative easing program and belated interest rate adjustments by the RBA will put pressure on income securities. The pressure is two-fold. First there is the revaluation effect on income securities (debt and equity). Second, there is the pressure on investors to reassess income assets. In doing so they have to reconsider the merits of low-yielding floating debt compared to higher-yielding equity. The starkest comparison is between bank debt securities (listed or otherwise) and bank listed equity securities.  Remember as the RBA cuts rates in 2013 then this will flow directly through floating-rate securities. The value of the lowest-yielding securities (best quality) will be affected, and more so if they are trading above their issue price ($100).  Investors need to understand that the reset terms of these securities (ANZHA) do contemplate redemption at the issue price. If they are redeemed at issue then a holder’s return from now drops to below 5% pa.

While I am conscious of the volatility in equities compared to income securities I believe that a logical switch presents itself. That is, I propose to sell ANZHA and replace these with National Australia Bank ordinary shares as 31/12/12.

The market consensus forecast yield for NAB in 2013 is over 10% (including franking). So I propose to own more bank shares in my income portfolio and lend less to the banks directly. This will result in a lift in the yield across the portfolio but with more volatility.

Clime Income Portfolio

Return since June 30, 2012: 22.33%

Returns since Inception (April 24, 2012): 13.76%

Average Yield: 6.31%

Start Value: $118,757.19
Current Value: $136,499.46

Clime Income Portfolio - Prices as at close on 19th December 2012

Hybrids/Pseudo Debt Securities
Company Market Price Margin over BBSWRunning YieldFrankingTR (%)
High Yielding Equities
Company Market Price FY13 DividendGUDYFrankingTR (%)

John Abernethy is the chief investment officer at Clime Investment Management.

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