Currently there is about $600b in self-managed super funds (SMSFs) which represents about one-third of total superannuation assets. While SMSFs offer both flexibility and a lower cost alternative than managed funds, the trade-off is the added responsibility of proper portfolio construction. As a result, I am often asked by SMSF trustees at conferences and public forums about the weightings of individual asset classes and the stock selection criteria within those asset classes. Given the aim of a super is to provide either capital growth in the accumulation phase, or retirement income in a drawdown phase, the composition of assets within a SMSF can provide headaches for many trustees.
My advice on asset weightings has always been diversification but that will also depend on individual time horizons and financial circumstances. As a general rule, I believe a good mix of equities and property is usually consistent with the requirements of both long term capital growth and regular annuity-style income streams. As regular readers would note, I have recently begun to introduce the occasional residential property update which I intend to continue in future publications. In today's note however, I want to focus on stock selection within the equity component of a SMSF portfolio.
In a financial world obsessed with short termism and instant gratification, it seems the time frame for equity returns has narrowed. In the current climate, the publication of managed funds returns has been progressively compressed from yearly, to quarterly, and now monthly performance tables. In addition, the speed of news flow within an increasingly inter-related financial world, and the rise of high frequency trading, have significantly increased equity volatility. As such, trustees overseeing a SMSF equity portfolio are being forced into regular monitoring of equity positions due to higher volatility levels.
To be sure, responsible portfolio management requires careful monitoring. But I am often asked if there is an opportunity for "long-only" investing or "set and forget" portfolios within a SMSF structure. The answer is yes and no. Yes, I believe you can still invest in a combination of growth and income stocks over the medium term. But no, I certainly don't advocate buying a portfolio of stocks and putting them in the bottom drawer for the next 20 years. The reason is that disruptive technology has the ability to quickly undermine what appears to be an enduring equity theme.
While the concept of "long-only" equity investing has subsequently lost favour with many managed funds in recent years, it dominated US investment strategy in the 1960s and the early 1970s with the rise of the Nifty 50. As the name implied, the Nifty 50 was a portfolio of 50 blue chip, "buy and hold" growth stocks. The common characteristics included: household names with dominant industry positioning and strong and stable earnings growth. The stock composition included : Proctor and Gamble, Coca Cola, General Motors, Merck, Pfizer, GE and Walmart which still remain industry leaders today.
At the time, the Nifty 50 formed an integral part of any investment selection criteria, and became a benchmark for equity performance over the course of nearly 2 decades. With the index's popularity however, the PE multiples of the individual stocks soared with many trading on 40 to 50x earnings. In one way, the Nifty 50 was an index within an index. Considering the high index weights and big market capitalisations, a market weighting in the Nifty 50 was required, or risk underperforming the broader index. After a long period of strong performance, the recession and high inflation of the savage 1970s bear market decimated the high PEs of the Nifty 50. Subsequently, many of the stocks suffered 40-50% falls.
Despite the long passage of time, I think the Nifty 50 still provides some very valuable lessons for SMSF trustees and equity investors. Firstly, it is most definitely a cautionary tale on the pitfalls of a portfolio comprised almost exclusively of high PE growth stocks. Secondly, it's also a reminder of the dynamic nature of financial markets given ex-Nifty 50 stocks and household names such as Eastman Kodak, Polaroid and Xerox have all become yesterday's heroes due to the power of disruptive technologies.
Lastly, I believe that the investment criteria for inclusion within the Nifty 50 provides a perfect example of the stock selection process for a "buy and hold" SMSF equity portfolio. The stocks should have: dominant industry positioning, high barriers to entry, double digit return on equity, strong balance sheets, strong free cash generation, and strong sustainable earnings. In the current climate I would recommend tilting towards fully-franked dividend yield growth over pure eps growth. In essence this is virtually the same stock selection criteria used by Warren Buffett the world's most successful and recognised "buy and hold" investor.
In line with the Nifty 50, my strong recommendation would be to only include blue chip, big cap and high index weight stocks. The idea is to create a small equity portfolio of 10 to 15 stocks with roughly a 50-60% weighting in the ASX 100. The aim would be to try and minimise the tracking error of the portfolio by attempting to partly replicate the performance of the ASX 100 benchmark index. In short, such a portfolio structure would enable a SMSF trustee the benefit of near index performance, with a balance of sustainable earnings growth and dividend yield without the fees associated with a managed fund.
A “Nifty 15” would be more appropriate in Australian equities. Interestingly, in the post GFC low interest rate/low growth environment a style of “Nifty 15” has emerged in Australia, where dominant industrial franchises with all the attributes of the US Nifty 50 have led the broader ASX200.
That “Nifty 15” list would include (all are ASX100 members):
- Amcor (AMC)
- Brambles (BXB)
- Commonwealth Bank (CBA)
- CSL (CSL)
- Goodman Group (GMG)
- Macquarie Group (MQG)
- Ramsay Healthcare (RHC)
- REA Group (REA)
- Telstra (TLS)
- Transurban Group (TCL)
- Sydney Airport (SYD)
- Wesfarmers (WES)
- Westfield (WFD)
- Westpac (WBC)
Consistent with my current strategy view, I believe the majority of the stocks included in a local version of the Nifty 15 should are leveraged to my sustainable yield and a strong US dollar themes. They all have dominant industry positions and in turn high sustainable ROE’s.
How I would weight those stocks inside a domestic high conviction equity portfolio is a note for another day.
My point today is we could well be in for an extended period of outperformance by industrial stocks with the same fundamental attributes as drove the “Nifty 50” in the USA.
While many commentators, analysts and institutional investors have described most of the names in the list above as “expensive”, for the last 3 years, they continue to deliver above market total returns. The true question is “expensive versus what??”. Cash isn’t the answer. Their peers isn’t the answer.
The lesson of the last few years remains to let winners run and be a ruthless cutter of losers. Winners keep on winning, losers keep on losing. As Warren Buffet says, very few companies can truly be turned around and you are better off paying a higher multiple for a great and enduring company. That remains sage advice in a low growth environment with heightened volatility.
© 2015 Bell Potter Securities Limited. This information is of a general nature only and has not been prepared to take into account any particular investor’s objectives, financial situation or needs. Investors should seek professional advice from a financial adviser before making any investment decision. Bell Potter does not take any responsibility if there are inaccuracies, errors or omissions in this information.