The 'Blazingly Simple,' Must-Have Portfolio

11/22/2010 4:20 pm EST

Focus: STOCKS

Rob Carrick

Columnist, The Globe and Mail

By picking only seven stocks, a retired professor generated stunning 10-year returns, says Rob Carrick, columnist for The Globe and Mail.

Let’s strip your investment choices down to the essentials.

That would be shares of Canadian National Railway (NYSE: CNI), Canadian Pacific Railway (NYSE: CP), Enbridge (NYSE: ENB), Fortis (Toronto: FTS), Royal Bank of Canada (NYSE: RY), Toronto-Dominion Bank (NYSE: TD), and TransCanada (NYSE: TRP).

About 10 years ago, retired political science professor Mike Henderson singled out these companies for the essential roles they play in the Canadian economy. He then invested in each of them for the core of the retirement savings he and his wife would rely on. The cumulative average 10-year total return on these stocks (that’s share-price gains plus dividends) was 305 percent, far better than the 72-per-cent gain for the S&P/TSX composite index.

Though he has a PhD from the London School of Economics, Mr. Henderson is no financial pro. Think of him as an informed amateur whose investing was influenced by his experience lecturing on the interaction of government and large corporations in Canada.

“The idea just came to me, and it was blazingly simple,” he said from his Toronto home. “I basically sat down and thought, what is absolutely essential to our society, and who provides those essentials?”

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Don’t confuse what we’ll call the Essentials Portfolio with companies that are “too big to fail,” an idea that proved faulty after the global financial crisis took down the likes of Lehman Brothers and Merrill Lynch. Mr. Henderson’s focus is on the function of a company, not its size.

The first step in building the portfolio was to set a rule that all stocks had to pay a dividend. As a retiree, dividend income is essential to Mr. Henderson.

Next came the search for the right companies. The first group of essential companies, Enbridge, TransCanada, and Fortis, operate pipelines that carry oil and/or natural gas. (Fortis actually made the portfolio through its 2007 acquisition of natural gas utility Terasen). The reasoning here is that a guaranteed source of oil and gas is necessary for the country’s industrial and transportation needs, not to mention home heating. “If someone declares that winter is cancelled, I’m going to sell TransCanada and Enbridge,” Mr. Henderson joked.

The essential nature of railways was shown a year ago when locomotive engineers at CN went on strike, he added. The company and its workers resumed bargaining only after the federal government, worried about damage to a fragile economic recovery from the recession, started talking about back-to-work legislation.

Banking is the other essential sector in Mr. Henderson’s analysis, and one that raises safety concerns about the whole strategy.

Canada’s banks were lauded ad nauseam during the financial crisis for not getting caught up in the same problems as many of their global counterparts, but the fact remains that the S&P/TSX capped financials index lost more than half its value between late 2007 and early 2009.

There was genuine concern back then that a Canadian bank could fail, but Mr. Henderson said he draws comfort from the oversight of the banking sector provided by the federal Office of the Superintendent of Financial Institutions. To add a level of safety, he has chosen the two largest and arguably most stable banks, Royal Bank of Canada and Toronto-Dominion Bank.

Investing for the long haul is key

The non-bank stocks in the Essentials Portfolio held up well compared with the index during the financial crisis, CP excepted. But Mr. Henderson is much more focused on 10-year results than he is on any one particular year.

“Any data that is for less than ten years is deceptive,” he said. “It will not encompass market reaction to a full short-term business cycle, which normally takes six to eight years.”

For that reason, he feels the right approach for the Essentials Portfolio is to buy and be prepared to hold through a full market cycle, while ignoring daily ups and downs.

As for setting up the portfolio, he suggests a dollar-cost-averaging approach of periodic purchases rather than committing all your money at once. You’ll pay more in brokerage commissions this way, but there’s an offsetting benefit in that your risk of buying at peak prices is reduced. If prices fall, you’ll also have opportunities to capitalize.

Using the long-term view preferred by Mr. Henderson, the Essentials Portfolio did extremely well over the past decade. According to his data, all essentials stocks outperformed the S&P/TSX composite index and the best stocks in the group did vastly better.

Mr. Henderson doesn’t make a big deal of it, but the Essentials Portfolio stocks offer an additional attraction beyond good long-term performance. Each not only pays a dividend, but also has a record of increasing the quarterly payout periodically. Rising dividends are a sign of a well-run company, and they increase your income flow in a way that bonds never can.

The Essentials Portfolio has been the core of Mr. Henderson’s retirement fund for years, but it’s not all he owns. He’s had some success with income trusts and continues to hold some of those. Also, he has what he calls a “gambling account” where pursues his belief that the energy sector has great potential.

No role for fixed income

Where are the bonds? There aren’t any. Mr. Henderson believes the yields are too low to sustain a retirement fund, and they don’t offer any inflation protection.

The Essential Portfolio stocks are a pretty good inflation hedge, though. Companies like Enbridge are, to varying degrees, government regulated, Mr. Henderson argues. If inflation rises, these companies will be allowed to raise their prices because the government recognizes the need for them to remain profitable and continue their vital role in the economy.

An obvious issue with the Essentials Portfolio is an extreme lack of diversification. Its seven stocks cover only three of the 10 TSX sectors and there’s also the absence of bonds.

But there’s also the security that comes from investing in companies providing essential services. As Mr. Henderson argues, it’s hard to see demand for oil, natural gas, rail transport, and banking disappearing.

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