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Aiming for income and inflation beating growth

Our reader wants to generate income and limit downside so he should consider diversifying his portfolio
June 16, 2016, Richard Hunter and James Norrington

Mr Gifford has been investing for 15 years. He is aiming for an income of about 4 per cent, and enough growth to keep ahead of inflation and to increase the value of portfolio. He also has what he describes as "a comfortable and stable company pension," as well as the state pension and £20,000 in cash.

Reader Portfolio
C Gifford 78
Description

Direct shares

Objectives

4% income, growth ahead of inflation

"I would say I have a medium attitude to risk, and would be prepared to risk losing up to 10 per cent in any one year," says Mr Gifford. "I am mainly looking for safe and income focused investments, but also some that may offer growth. I occasionally invest in initial public offerings (IPOs) and higher growth companies such as Ashtead (AHT).

"I want to leave this portfolio to my family.

"My last three trades were selling Ibstock (IBST) and Tritax Big Box REIT (BBOX), and buying Legal & General (LGEN).

"Going forward I am looking at adding investment trusts.

 

Mr Gifford's portfolio

HoldingValue (£)% of portfolio
Aberdeen Asset Management (ADN)2,5440.99
ARM Holdings (ARM)5,2802.06
Aviva (AV.)3,8491.52
BAE Systems (BA.)20,3287.9
Barclays (BARC)10,7584.19
British American Tobacco (BATS)22,2148.65
BT Group (BT.A)18,6217.25
Compass Group (CPG)20,7858.1
Diageo (DGE)20,4467.96
GlaxoSmithKline (GSK)21,6348.43
Legal & General (LGEN)8,4993.31
Marks And Spencer Group (MKS)6,6562.59
National Grid (NG.)20,2827.9
Prudential (PRU)18,7757.31
Royal Dutch Shell (RDSB)11,7514.58
Tate & Lyle (TATE)11,3174.41
Unilever (ULVR)20,4477.97
United Utilities (UU.)12,4984.67
Total256,684

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

I like this portfolio. It has a big weighting in defensives such as Unilever (ULVR), National Grid (NG.) and GlaxoSmithKline (GSK). History and international evidence tell us that these sorts of share out-perform over the long-run on average. And along with momentum stocks, defensives are among the very rare types of share that do better than they should in theory.

One reason for this is because investors under-rate the importance of what Warren Buffett calls moats: barriers to entry such as strong brands or high capital requirements that stop potential rivals from muscling in on their markets. Another reason is that some investors who are bullish on the market generally - which by definition is most of them most of the time - express that optimism not by increasing gearing and buying the general market, but by purchasing high beta stocks and being under-weight in defensives. This causes defensives to be underpriced. As economists at AQR Capital Management have shown, this means it is a good idea to bet against beta. Which is what - for the most part - you are doing.

However, your modest investment objective - to keep ahead of inflation - has put you into the sort of equities that deliver decent long-term growth. This is an example of what economist John Kay calls obliquity: the fact that we often achieve our goals by aiming for something else. You don't achieve good long-run returns by looking for 'growth.'

However, it's possible that in a really bad market downturn you would lose more than 10 per cent. This is partly because you hold a few high-beta stocks such as Aberdeen Asset Management (ADN) and ARM (ARM). It's also because defensives are only relatively defensive - they do fall when the market falls - just not as much as the market.

Also be aware of how defensives tend to outperform. They do this by outperforming in downturns and then, on average, more or less matching the market in normal times. Don't expect much outperformance if the general market rises. And don't be disheartened by this.

 

Richard Hunter, head of research, Wilson King Investment Management, says:

For the most part, you have constructed a well-balanced and diversified portfolio which needs relatively little attention given your investment objectives.

The portfolio is delivering an income of approximately 4.6 per cent, as compared with your requirement of 4 per cent, which by way of example is also the average yield of the FTSE 100. But you hold a few stocks which are failing to keep up with your yield target, such as ARM and Compass Group (CPG).

Given your objectives we would assume you reinvest your dividend income to benefit from the "eighth wonder of the world," as described by Einstein - compound interest.

The constituents of the portfolio are a solid selection of blue chip companies, most of which are in the FTSE 100. Given the variety of markets and businesses in which they operate, you have also managed to achieve diversification not just in terms of business mix, but also in terms of exposure to foreign markets. Prudential (PRU), for example, operates in Asia and the US as well as the UK.

You also have a number of stocks which add a defensive element to the portfolio during difficult investing times - perhaps of particular relevance at the current time

Given your age, a broad selection of income-based equities and a 10 per cent loss tolerance limit are appropriate and prudent. Your other assets have the dual benefit of easing the pressure on your portfolio, at the same time as ensuring you have a rainy-day fund and adequate pension provision. These also allow you to occasionally to heighten your risks by investing in the likes of IPOs and higher growth companies such as Ashtead Group without necessarily upsetting the balance of the portfolio.

Given your other assets we hope you review your tax position regularly, particularly with regard to income, capital gains and inheritance tax.

 

James Norrington, specialist writer at Investors Chronicle, says:

It is good you have a comfortable and reliable source of income in the form of your pension, and you are sensible to keep £20,000 cash for a rainy day or any unexpected liquidity needs. You don't mention property but, presuming you have a mortgage-free home and your regular outgoings and needs are covered, the basics are well taken care of.

The risk profile of your portfolio is higher than your stated tolerance of a 10 per cent maximum loss a year. In a bad year even defensive shares can suffer worse peak-to-trough drawdowns than this, as they did in 2000-2003 and 2008-2009. This is an important consideration because if capital preservation is now your primary concern, the portfolio should not be so overweight in UK shares. In studies, more diverse asset allocation has consistently been shown to reduce overall risk and could help you pursue your objective of income and moderate capital growth, with less chance of a large loss than if your portfolio remains heavily concentrated in UK equities.

The first thing you need to do is prioritise your objectives and be very clear on what you are trying to achieve. You mention income and capital preservation, but which is most important? Portfolio management is about achieving the highest return for the level of risk that is acceptable to you, so perhaps the best starting point is the 10 per cent drawdown tolerance. In the past achieving a target 5 per cent annualised return - 4 per cent income plus 1.3 per cent capital gain to keep pace with Retail Prices Index (RPI) inflation - was not hugely ambitious.

But in a low-interest world, investors are having to take higher risks to achieve what would once have been modest objectives. Annualised returns of over 5 per cent may require you to continue to take risk that heightens the probability of more than a 10 per cent drawdown, so you need to assess whether you are still comfortable with this.

If you still want to occasionally speculate on a potential growth story or initial public offering ( IPO), then set aside a portion of capital that you don't mind risking as your 'fun money.' Some Alternative Investment Market (Aim) stocks can have inheritance tax benefits (IHT), so think of it as playing with the taxman's slice of your family's inheritance. What's more, if you lose money, you can offset it against any capital gains tax (CGT) liabilities you incur.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You say you occasionally venture into IPOs. Please make it very occasional. We know that IPOs on average underperform in the months after flotation. This is partly for the same sort of reasons that defensives outperform - because investors pay too much for growth stories. And it's partly because the owners of the businesses - who know them better than you do - use their superior knowledge to sell at the best time.

You also say you're looking at investment trusts. While I like these in principle, ask what it is you want to achieve with them. Several good UK equity trusts already do what you're doing - invest in big dividend-paying defensives - so would add little to your portfolio.

A possibility here is to consider overseas stocks. Except to the extent that you have a few multinationals, and UK stocks tend to rise and fall with the global market, you don't have much exposure to these. You might want to consider doing this as a way of protecting yourself from a domestic downturn and fall in sterling.

 

Richard Hunter says:

With a broad list such as this, manageable though it is, a foray into investment trusts is also a sensible way of building the portfolio further. These can give access to sectors and countries in which you may currently be light, whilst also benefiting from the diversity of the underlying portfolio and in theory lessening the risk load factor at the same time.

There are a few individual stocks which have above average weightings within your portfolio, such as British American Tobacco (BATS) which accounts for 8.7 per cent and GlaxoSmithKline which accounts for 8.4 per cent. The recent addition of Legal & General, meanwhile, takes exposure to financials up to 17 per cent, which is something to think about given both the the volatility and generally lower income yield within this sector of late.

If you add in your holdings in Diageo (DGE), Tate & Lyle (TATE) and GlaxoSmithKline, exposure to consumer exposed companies is also high at around 30 per cent, so you may wish to reduce this somewhat either by taking profits or disposing of a lesser yielding stock.

 

James Norrington says:

The best way to achieve a higher rate of return for lower risk is through more diverse holdings, but as someone who has been actively managing their portfolio for 15 years, you may be broadly happy with your investing style and not want to make wholesale changes. In a review of individual holdings, however, it is worth considering whether they match your predilection for income and defensive characteristics.

You need to consider the following:

■ Do the dividend yields meet your income objective?

■ Are the dividends well covered by earnings? And,

■ What sort of earnings multiples are the stocks trading on, and how does this compare with the past and their sector peers?

If you decide to free up capital to diversify your portfolio more broadly, then prune wherever you think the investment case is weakest. It is also worth considering whether selling out of holdings where you have a smaller stake would make your portfolio more manageable. Any freed up capital can either be held as cash or reinvested in a more diverse mix of assets.

You mention looking at investment trusts for future holdings, which is an opportunity to diversify risk with exposure to international shares and other asset classes. Keep in mind that investment trusts can move from premiums to discounts and vice versa, which can add volatility to the portfolio.

You might also consider exchange traded funds (ETFs) as cost effective vehicles to add exposure to overseas stock markets, and different investments such as bonds, property, gold, commodities and private equity. Investors Chronicle's Top 50 ETFs list is a good place to start, to understand some of the options which are available.