Growth portfolio ready to pounce

The Growth portfolio, unlike its Income cousin, has the more audacious goal of chasing market-beating returns by investing in companies with higher growth prospects, with correspondingly higher risks of course. Higher returns are the aim.

So far, the portfolio hasn’t met that goal. While outperforming the All Ordinaries Accumulation Index (Index) by 1.2% a year since inception in 2001, it lags the Income portfolio by 5.5%. That’s the bad news. What of the good?

For reasons we’ll soon explain, the Growth portfolio is poised to claw back some of this underperformance.

The past six months has seen the portfolio chalk up a few significant wins, exit a couple of investments, add a new position and increase its holdings in three existing stocks.

We eagerly pounced on grocery wholesaler Metcash following the market rout in August, buying a 1.9% position at $3.87 per share. Metcash won’t triple overnight but the 6.8% dividend yield and opportunity for organic growth should deliver excellent, low risk returns.

Market panic

We also used the market panic to increase the portfolio’s positions in Computershare, Perpetual and Macquarie. Again, these are high-quality businesses with significant growth potential. We’re pleased to be able to include them at such attractive prices.

To fund these transactions, and owing to a reassessment of each stock, we sold out of Harvey Norman, Infomedia and Catalpa.

Over the past 12 months, we also sharpened the focus of the portfolio by reducing the number of holdings from 30 to 26. That’s still a tad too many stocks, which is why we’ll look to cull a few more positions if we get an opportunity to do so at a satisfactory price.

We’ve also doubled our cash holdings to $11,759 due to $5,415 in dividend payments and Sydney Airports’ (formally MAp Group) $3,222 capital return. The increase in cash reserves is a deliberate strategy; it’s likely that the next few months will produce plenty of opportunities and we want the cash available to take advantage of them.

Combined, these changes have shifted the weighting of the portfolio towards cheaper stocks; positive recommendations (those on which we have a ‘buy’ recommendation of some sort) now represent 71% of the Portfolio, up from 67% six months ago.

Many of the portfolio’s investments have proved successful. Silver Lake Resources and Integra Mining, for example, are respectively up 51% and 22% over the period (see Table 2). The rise in Silver Lake’s price also gave us an opportunity to trim our holding and bank $2,057 in profits (see Silver Lake: Profits and prophecy from 17 Nov 11 (Take Part Profits - $3.59)).

Other more conservative holdings have also performed well. Spark Infrastructure gained 7% over the half and paid a 4.75 cent per security distribution. Investments such as this help underpin the portfolio’s longer term performance and offset riskier holdings like Tap Oil.

Not that there have been mistakes. Elders, for example, hasn’t progressed as we might have hoped. Falling assets values and a delayed turnaround of the key rural service division prompted a downgrade of Elders' hybrids (see Forest fells Elders’ hybrids from 13 Oct 11 (Hold - $37.95)).

Position sizing

This highlights a crucial point about portfolio management (for more see How to build a portfolio from scratch or Profitable lessons for two market-beating portfolios): Position sizing is critical. It’s simply not enough to pick the right stocks; you also need the right amount of money invested in each. By only taking a small 1% position in Elders' hybrids, the capital invested was proportionate to the risks involved and a mistake hasn’t done any serious damage.

In general, most of one's capital should be in the best ideas, which is why we have allocated 4.6% of the growth portfolio to QBE (increased post 31 December to 5.5%) and 5.5% to Macquarie Group.

For similar reasons, we’re currently reviewing our largest position, ARB Corporation. This has been a spectacularly successful investment, generating total returns in excess of 250% and the company continues to impress.

But at 7.3% of the Portfolio’s total value, its weighting is almost too high for a stock that’s edging towards a downgrade. For now, we’re not making any changes but we may well do so in the future.

The returns of the Growth portfolio, whilst beating the index, remain below our expectations. But the changes made over the half are helping move it to a position where it’s poised for an even better performance.

Note: Read the latest Income portfolio update here.