Income portfolio's first class seal

Rarely does hope trump quality. This was a costly lesson many investors learnt in the heady days of the dot.com boom (anyone remember boo.com? No, thought not). This lesson was reinforced—happily in the opposite direction—by the performance of the model Income portfolio over the past six months.

Established in 2001, our ambition was to craft a low-risk, market-beating portfolio that delivered a reliable dividend stream. Since inception, it’s done just that, generating total returns of 13.0% a year (capital growth plus dividends) and convincingly trouncing the All Ordinaries Accumulation Index (Index) by 6.6% per year.

Over the past six months, our approach­ of selecting under-priced, high quality stocks has been amply vindicated with the Income portfolio widening its performance gap over the index by 0.8% a year and producing a running yield of 6.7% (see Chart 1). That figure would be higher still if franking credits were included. The portfolio rose 0.1% for the period, and remains well clear of the Index, which fell 9.6%.

This admirable result comes amidst increasing concerns about the global economy. But as fear takes hold of the markets, higher quality businesses, such as Metcash (up slightly for the period including dividends), have fared better, underpinning the portfolio’s returns.

Dividends, as one might expect, played a crucial role. The portfolio banked $5,492 in dividends for the period, bringing the annual total to $10,733 (see Chart 2). While this remains below boom year levels, we can and should expect future growth.

The portfolio assumes these dividends are spent on living expenses such as groceries, rather than reinvested. Whilst that mutes capital appreciation, it doesn’t stop it altogether. Since inception in 2001 the portfolio has risen by 60%, or nearly 5% per year, well ahead of the average inflation rate over the period of around 3% a year.

Changes to portfolio composition over the past six months have been minor. We’ve tweaked our holdings to ensure it’s stacked with the highest quality businesses. We’ve purchased stakes at attractive prices in IAG, Australand and Perpetual (see Portfolios pounce on bargain prices from 10 Aug 11).

Stocks for inclusion, however, don’t just have to meet our rigorous criteria to get in. They have to deserve their place to stay there. With Infomedia no longer meeting the ‘quality’ test, we sold our stake (see Portfolios pounce on bargain prices). We’ve also been carefully considering our total exposure to the property sector, which now stands at 22.1%. No stock currently deserves selling, but we’re carefully monitoring this exposure.

Additionally, Servcorp and STW Communications are, perhaps, not quite the right fit for the Income portfolio. Servcorp’s yield has dropped over the past few years as it attempts to bed down its massive expansion program (see Riding the Servcorp escalator from 17 Oct 11 (Long Term Buy - $2.75)). But having just increased its prospective dividend for 2012 to 15 cents per share, and owing to the recent price falls, we’re reluctant to sell.

Similarly, STW Communications is, perhaps, too risky to warrant inclusion. But having recently earned an upgrade in The mad men of STW on 08 Dec 11 (Long Term Buy - $0.85) its value is too compelling to sell right now.

We’ve also boosted our cash reserves thanks to a $2,624 capital return from Sydney Airport (formally MAp Group) and $6,750 windfall from the takeover bid for Foster's; an investment that netted the portfolio a 37% total return. The net result is an increase in our cash holdings to $12,278.

These positive developments were balanced against many stock prices falls. QBE and WHK Group, for example, dropped 24.9% and 10.3%. These price falls however, have—in most cases—prompted upgrades; demonstrating our underlying confidence in the businesses’ intrinsic value. This has helped shift the portfolio’s weighting more towards cheaper stocks; positive recommendations now make up 67% of the portfolio, up from 58% at June 30 (see Chart 3).

This places the Income portfolio in a better position than it has been for years. Our balanced collection of excellent, high quality businesses augurs well for long-term outperformance. Plus, with the kitty replenished, it’s also well placed to pick up a few carefully selected bargains over the coming year.

Look out for a review of the Growth portfolio next week.