What's a satisfactory return now? Pt I

Australian stocks have historically delivered a total real return of about 7.5% a year. Add in a few percentage points for inflation and the actual (or 'nominal') return is around 11% per annum. Not so long ago investors seeking returns of this ilk were laughed at. Hadn't they heard of mining services companies, or China, or investment banks, asked their brokers?

The laughed at are now in the majority. Interest rates have fallen to the point where term deposits are lucky to yield 5%, with no prospect of preserving your purchasing power, and risk abounds. The turmoil of the GFC and its tumbling wake haven't been quickly forgotten.

Ridiculed conservative income investors are now trailblazers (don't worry, we were with you all along—Ed). Nowadays, everyone wants security, safety and an acceptable return without much risk, which of course is a problem in itself. With a market up 26% in less than nine months, the question is where. Well, we're about to show you.

Most members of Intelligent Investor Share Advisor have in their portfolio some cash, income securities and higher quality stocks—a mix that forms a solid base for respectable returns. This is the low-risk portion of your portfolio. We're going to explore what's involved in achieving a 9% total return from a basket of income paying stocks, and how the stock mix is crucially important in reaching this goal.

Benjamin Graham put it this way; 'To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.' Against current term deposit rates, returns of 9% before tax should be 'satisfactory'. Moreover, they're within your reach, especially with the benefits of dividend imputation (see Franking credits made simple).

Table 1 contains a selection of stocks that currently sport buy and hold recommendations. The current dividend yield of each is shown, grossed up for franking credits. This number is then subtracted from 9% to reveal how much growth is required to make a total annual return of 9%.

The final column shows our estimate of the percentage likelihood that each stock will achieve the required growth level or higher. Don't be confused by the numerical precision; it just an expression of probability, although the small percentage differences between, say, Sydney Airport and Woolworths are significant.

Our estimate of Sydney Airport's likelihood of achieving the required growth (80%) translates into a 4-in-5 chance. In horse betting terms, we think its chances of not hitting that figure are almost 4-to-1. Woolies' odds of not hitting the growth number are 3-to-1. Sydney Airport is a somewhat safer bet than Woolies to deliver an overall return of 9%.

But with stocks like ALE Property Group and Sydney Airport sporting very high percentage chances of achieving the 9% return target, why even bother with the likes of Computershare and QBE Insurance? These have to grow more quickly due to their lower dividend yields and have a higher chance of falling short. What's the point?

Well, these stocks have a higher chance of providing total returns much greater than 9%.

Consider ALE Property Group: it sports an attractive 6.7% yield, so it only has to grow by 2.3% per year to make a total return of 9%. With an in-built inflation component to its pub leases, that should be a cakewalk.

Two things might prevent it; if inflation averages less than 2.3% or if something goes awry in the mechanics of the business—embezzlement, improper risk controls or inadequate insurance, for example. Both are highly unlikely.

Inflation may fall below 2.3% but may entail Japanese-style deflation. That risk is a 9% or 10% likelihood. The other is even lower, 4% or 5% by our estimation. Taking 10% and 5% for those risk factors, we arrive at the 85% probability of meeting required growth (100% - (10% 5%)).

So ALE is a high yielding stock with inflation protection offering a very high possibility of a satisfactory return. But for those seeking 15%-plus returns, the chances of ALE delivering that are around one-in-30 (a 3% chance). Now compare that to Computershare, with a 65% chance of achieving a total return of 9% or more. What might stop it from achieving the required growth rate?

Market conditions could remain subdued for an extended period, management may not find suitable acquisitions to grow in a stagnant market, and it may not be able to raise prices. Let's call this an 8%-12% chance.

Now let's ascribe a 15%-20% chance of something going seriously awry with one of its acquisitions or an existing business and another 3% - 4% chance of something unexpected (like meaningful fraud or uninsured disaster). Subtracting those from a total of 100% gives a range of 64%-74% (we settled on 65% as a conservative estimate).

Of those 65 percentage points, perhaps 20-25 of them represent an outcome that will deliver a return of 15% or more. Table 2 shows the relativities.

Chat 1 plots the two situations, with the estimated total annual returns on the horizontal axis and likelihood of returns falling into each band on the vertical axis.

See how ALE's chart is more concentrated around the most likely outcome, with negligible chances of a very poor or exceptionally good outcome? Computershare is less likely to hit 9% and more likely to deliver negative returns. But the right-hand side of the chart showing the chance of a very attractive outcome is much fatter.

Eggheads call this the 'distribution of outcomes'. In this example the difference is stark because ALE is a much more predictable beast than Computershare.

After that rather theoretical approach to stock picking, let's consider these very different situations in light of some real numbers; our recommendation performance history. Since June 2001, our average Long Term Buy recommendation, of which Computershare and ALE have both featured, has returned 14.3% per annum. Nice, eh?

Absolutely. But there's a hidden cost to these returns. In Part 2 tomorrow we'll explain what it is, how we're addressing it, and what stocks to look at to secure a satisfactory rather than a superior return.