How to rebuild your share portfolio

Despite last year’s powerful rebound in share prices and the flow of promising economic news for Australian economy in recent weeks, the S&P/ASX200 is still only 68% of its record high of 6,827 reached on November 1, 2007.

In short, investors still have a long way to catch up.

Rather than just waiting for your share portfolio to eventually return to its previous high, you should adopt some serious, straightforward strategies to rebuild your portfolio.

Here are eight strategies to consider:

1. Simply keep investing

One of the smartest ways to rebuild your portfolio is to keep on regularly buying stock – perhaps every month or every couple of months.

In this way, you may be buying while prices are still depressed and you will be placing yourself in a much stronger position to make the most of future capital gains.

Further, by regularly investing, you will have avoided the risk of plunging a huge amount into the market at a single time.

As Ross Bird, head equity strategist for researcher Morningstar, says: “Some of the best strategies are the most simple.”

2. Focus on quality companies paying high dividends

You can easily beat the best interest being paid on at-call deposits – without investing in stocks of questionable quality.

And significantly, the stocks are likely to enjoy solid capital growth when re-rated by the market.

Peter Arnold, financial analyst with interest rate researcher Canstar Cannex, says the highest interest being paid on at-call deposits is typically 6-6.5%.

But there is a basic catch with most of these highest-interest products. Most only pay their top rate for between four to 12 months. (See here).

Arnold says an exception is the National Bank’s online offshoot UBank which is currently offering a rate of 6.51% with the only condition being that investors agree to a regular savings plan.

Investors thinking of placing money in at-call savings accounts should think carefully about their real returns. Despite the intense competition between banks for your deposit dollars, there may be little left after tax and inflation have taken their toll.

3. Understand there are more than just a handful of quality stocks paying high dividends

Investors have a wide choice of top dividend-payers among the blue chips and lesser-known stocks – while investing in strictly quality companies.

Morningstar’s Ross Bird gave SmartCompany a range of under-priced quality stocks that are paying high, sustainable dividends. Their dividends resoundingly beat the best at-call deposit rates – particularly once franking credits are taken into account.

The forecast grossed-up yields (which frank credits) for quality stocks named by Bird include: Leighton Holdings 7.43%, Perpetual 8.57%; Metcash 8.71%, WA News 10.57%, and David Jones 8.71%.

“In terms of the banks,” says Bird, “we currently like CommBank (grossed-up forecast yield, 8.86%), ANZ (grossed-up forecast yield, 7.71%) and Westpac (grossed-up forecast yield, 8.43%). NAB is paying a slight higher dividend (grossed-up forecast yield, 9%) but its track record has been a little up and down, and the market is treating the stock at a slight discount.”

Bird names Telstra among his quality companies paying high, sustainable dividends. Its forecast grossed-up yield is a breathtaking 14.29%.

The inclusion of Telstra on the list may be “a bit debatable”, Bird says. “I would describe it as a quality company and we believe its dividends are sustainable.” Bird points out that Telstra has revised its strategy to compete more aggressively on price.

Fundamental stock researcher Lincoln Indicators has prepared for SmartCompany a sample list of “financially healthy” companies paying high dividends. And crucially, Lincoln Indicators expects these companies to keep on paying their high dividends.

The forecast grossed-up yields for some of Lincoln’s selection are: GUD Holdings 9.24%, Webjet 8.21%, Wotif.com Holdings 6.93%, Iress Market Technology 6.7%, Thorn Technology 6.7%, and Monadelphous Group 8.29%.

Webjet’s dividend per share has grown by a remarkably 91% over the past year while Thorn Technology’s is up 31.94%.

4. Expect dividends to keep rising

Ross Bird expects dividend yields to make up a higher proportion of total share returns in future than over the past 10 years.

“We are expecting further growth in dividends per share,” he says. “It could be in the order to 10-15% in 2010-11. The resource sector is going to have a bumper year. And as soon as the banks wind back on their bad loan provisions, they will have greater capacity to increase their dividends as well.”

In 2009-10, the 150 of the S&P/ASX200 stocks researched by Morningstar’s equity team produced capital gains of 8.8% and income of 4.4%.

5. Avoid the trap of investing in poor quality companies paying exceptionally high dividends

In order words, don’t let dividend size overwhelm your investment decisions.

“If a dividend is too good to be true, it probably is,” says Bird. “If you are looking at a yield of 10-12% [before being grossed-up for franking], be very careful – you should do your homework. If something is yielding around 12% [again before franking], you just smell a rat.”

“The market is suggesting something is wrong; either the dividend is not sustainable or the dividend is highly volatile and extremely sensitive to any changes in economic conditions.”

And Bird adds: “It’s commonsense. Always do you homework on any stock, always make sure the quality is there, the sustainability of cashflows and profits providing the ability to pay dividends year in and year out. Make sure the companies are well managed, make sure they are well positioned in the marketplace.”

A paper on dividend-focussed investing by Chris Robertson, senior portfolio manager with State Street Global Advisors, makes similar points to Bird about the possible dangers with some stocks paying extraordinarily high dividends.

“Investors need to be wary of stocks with apparently very high dividend yields as often the higher yield is the result of extreme price falls as the market reacts to underlying operating issues within the business,” warns Robertson.

6. Use a focus on dividends as a way to take your mind off intense market volatility

Knowing that their quality shares are earning a solid income, investors should be less concerned about day-to-day market movements.

And by concentrating more on dividends, investors take a key step to removing potentially destructive emotion from their investment decisions.

7. Keep reducing your investment costs

One of the most effective ways to cut investment costs is to use extremely low-cost index funds and exchange traded funds, based on a broad market index, as the core of your share portfolio.

And consider investing in direct shares – maybe following the dividend-focussed strategy outlined in this column – as “satellites” to an indexed core. (Of course, some carefully selected actively managed funds might be used as higher-cost “satellites”, even by investors who are determined to reduce their overall investment costs.)

8. Keep reducing your tax costs

This is a straightforward way to increase your real returns.

First, consider investing in an index fund or exchange traded fund with extremely low turnovers (see 7) – therefore reducing capital gains tax as well as transaction costs. Second, adopt a buy-and-hold strategy with your direct share holdings, if appropriate. And third, never overlook the tax rewards of superannuation.

Long-held super holdings can produce tax benefits that are sheer magic in tax terms. Not only is income concessionally taxed but assets sold after the shares are backing the payment of a pension are not subject to CGT.