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How to build a portfolio

I am going through the motions of building a new portfolio framework for my own SMSF. I plan to enact it in September of this year. I’ll explain why I chose that date later. I started work on this project in January and it will take me that long (until September) to trial what I have come up with. Please feel free to join me on my journey. I will update those who want to read my ‘blog’ each fortnight in this regular column that I write for the Switzer Super Report.

At this point, I think I will need 10 steps to walk you through my thought process.

Step 1: Watch reporting season before you start – read the signs
Step 2: Define objectives – yield, growth, value etc and sector weights
Step 3: Stock exclusions – which to avoid?
Step 4: Stock picking – who to follow (and who to avoid)?
Step 5: Performance expectations – re index hugging, yield versus gain etc
Step 6: Going ex-div – fallacies about gaming ex-div dates
Step 7: Reinvestments, DRPs etc – what should you do with those dividends and new cash?
Step 8: Rebalancing (or rotation) – when and how?
Step 9: Boom and doom – sit and wait or anticipate?
Step 10: Exit plan – how should you approach the end of the road?

So, in 20 weeks (10 steps x 2 weeks) time, you should have a reasonable idea about what I think is important. Hopefully not everyone will agree with me – it takes two sides to make a market! I have been building portfolios for years with a sizeable amount of funds following my process. But this is a breed of portfolio for me that I have not offered before. And I am going to invest most, or all, of my SMSF funds in it.

The reasoning

So why did I want to invent a new portfolio structure? The one I have dates back to 2007 when I started my SMSF with the $450,000-in-the-pot rule. I was then seven years younger, fitter and with a life expectancy just about seven years longer than I have now. Importantly, I was able to tip in a lot more into my SMSF under the rules and my portfolio made some money along the way.

The year I was about to turn 60 (2009), I spent part of my January holidays planning my possible futures and realised I could afford to retire that year – so I did. I conducted my 65-year-old review in January of this year and I realised my objectives and expectations have evolved – actually quite a lot. So I need a new portfolio structure. In essence, I no longer need as much growth and a little more yield might help. Indeed, I worked out I might be able to live only off the yield and preserve my capital so that it no longer matters how long I live and, if necessary, I can use the capital for some aged care facility.

Reporting season

So let’s get back to Step 1! The vast majority of companies report their annual or interim accounts in February and August. Three big banks (ANZ, NAB and Westpac) are three months out of sync. Even the three out-of-step banks put out limited data in February and August. So gamblers go in hard before reporting and some win and some lose. I think retirement funds can afford to lose a possible two or three per cent upswing on any good news in the season but avoid those bad surprises. So that’s why I will set my new portfolio in September (March is too soon as I am not yet ready).

But precisely because of the possible savagery of February (which didn’t actually happen), I built a skeleton of my new (Yield) portfolio on Feb 1 so I can watch and learn! I used to offer High Conviction and High Octane portfolios at CBA. I have changed the definitions but the sense is the same. One should be able to sleep at night with a High Conviction portfolio (maybe even go on a long holiday!). Any new money might go on the existing stocks. If one can sleep at night with a High Octane portfolio, one must be ‘mellow’. But some people might benefit from having ‘some’ money in such a portfolio – but probably not in an SMSF – unless there is no other way out.

So how did my three portfolios go for the first three weeks in Feb? Take a look at Table 1. The High Octane portfolio could have gone either way (two stocks – Buru Energy and Karoon Gas – have already ‘tanked’ but there are a few big winners so far to set against those losses). The other two portfolios are sort of jogging along nicely but it is early days and yield hasn’t really started to come in yet. Amcor and Fox were the only two to go backwards in the High Conviction portfolio. Worley Parsons and Goodman Fielder did the damage in the High Yield portfolio.

Table 1: Returns on Feb 1 portfolios

Source: Woodhall Investment Research and Thomson-Reuters – Period 1 Feb to 21 Feb 2014

But the main point here is what did we learn from reporting season? Overall, the season has been quite strong but a few companies chose not to pay dividends this time around. Except for Origin, I have found the Energy sector to be a bit disappointing.

I had positive prior beliefs but now I feel particularly good about my investments in BHP and RIO – but no Material stocks made it into my prototype yield portfolio. I was backing them to the hilt and now I feel justified.

CBA did what I expected. But there has been a big increase in cash holdings by those companies that have so far reported. While that means these companies’ balance sheets are stronger, it also means that some companies just don’t know how to invest their surplus cash. That does not bode well for growth in the near term. So I need to turn more to yield – but I know analysts can get things wrong so I won’t just migrate completely from growth yet.

The outcome

So, to put it simply, I strengthened my resolve to move out of smaller companies this February. With the talk of BHP and Rio possibly doing buy-backs or special dividends, I am looking to evolve my yield portfolio into a hybrid ‘yield-conviction’ portfolio going forward. On 1 February, I estimated that the yield portfolio would produce an income stream of 7.7% including franking credits. And I think there is some growth potential on top of that! Of course, there are some stocks in this yield portfolio with which I am not too familiar. The next six months will give me enough time to get to know these stocks and expand my field of interests. Next fortnight, I will write about what underpins these three portfolios and how I derived the sector weights.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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