Underwhelming outlook statements from companies reporting in August led to a lethargic performance from the Australian sharemarket in August. In price terms, the S&P/ASX 200 lost 0.1% to finish at 5715. With dividends included, it added 0.71% in the month taking the year to date return to 3.88%.

Our model portfolios had mixed results, with the income portfolio adding 0.24% while the growth portfolio slipped by 0.55%. The income portfolio has returned 2.42% this year, moderately underperforming the benchmark index by 1.46% in part due to its weighting in ‘top 20 stocks’. The growth portfolio has returned 2.58%.

This is our eighth monthly portfolio review.

The purpose of these portfolios is to demonstrate an approach to portfolio construction. As the rule sets applied are of critical importance, we provide a quick recap on these.

Portfolio Recap

In January, we made some adjustments to our Australian share ‘Income Portfolio’ and ‘Growth-Oriented Portfolio’ (see here and here).

To construct the income portfolio, the processes we applied included:

• we used a ‘top down approach’ looking at the industry sectors;
• so that we are not overly exposed to a market move, we have determined that in the major sectors (financials and materials), our sector biases will not be more than 33% away from index;
• we require 15 to 20 stocks (less than 10 is insufficient diversification, over 25 it is too hard to monitor), and have set a minimum stock investment of $3,000;
• we confined our stock universe to the ASX 150;
• we have avoided stocks from industries where there is a high level of exogenous risk, such as airlines;
• for the income portfolio, we prioritised stocks that pay fully franked dividends and have a strong earnings track record; and
• within a sector, the stocks are broadly weighted to their respective index weight, although there are some biases.

The growth-oriented portfolio takes a different approach in that it introduces biases that favour the sectors that we judge to have the best medium term growth prospects. Critically, it also confines the stock universe to the ASX 150 (there are many great growth companies outside the top 150).

Overlaying these processes are our predominant investment themes for 2017, which we expect to be:

• Interest rates remaining at low levels, although some upward movement in bond rates;
• The US Fed likely to increase US interest rates by 0.75%, but probably no move in Australia by the RBA;
• The Australian dollar at around 0.70 to 0.75 US cents, but with risk of breaking down if the US dollar firms;
• Commodity prices remaining reasonably well supported;
• A positive lead from the US markets and President Trump;
• A moderate pick-up in growth in Australia back towards trend levels; and
• No material pick up in domestic inflation.

Performance

The income portfolio to 31 August is up by 2.42% and the growth-oriented portfolio by 2.58% (see tables at the end). Compared to the benchmark S&P/ASX 200 Accumulation Index (which adds back income from dividends), the income portfolio has underperformed the index by 1.46% and the growth-oriented portfolio by 1.30%.

Sharemarket flat in August as resources rally

Another flat month in August as the market traded in a tight range between 5675 and 5800. A somewhat underwhelming company reporting season, particularly in regard to outlook statements, saw the S&P/ASX 200 finish with a 0.11% loss to close at 5715. With dividends, the market returned 0.71%, taking year to date returns to 3.88%.

The ‘top 20’ stocks continued to come under pressure, with this component losing 0.8% over the month and now up (with dividends) just 1.0% for the calendar year. Small caps did better, with a return of 2.7% for the month and year to date gains of 4.2%. Midcaps, as measured by the Midcap 50 which tracks stocks ranked 51^st to 100^th by market capitalisation, are up by 8.9%.

In the sectors, the largest sector by market capitalisation, financials, with a weighting of 36.9%, lost 2.2%. This was largely on the back of Commonwealth Bank’s share price fall after AUSTRAC announced proceedings over alleged breaches of anti-money laundering laws, but also disappointing results from insurers QBE, IAG and Suncorp.

Resource sectors performed strongly, with the energy sector up by 5.7% and the materials sector up by 4.4%. This sector, which includes companies such as BHP, Rio and Fortescue, has now added 10.4% this calendar year.

Telecommunications suffered a 7.4% fall in the month to remain the worst performing sector for the year with a loss of 22.4%. Telstra’s decision to cut its dividend by a bigger than expected amount, and the withdrawal of private equity bidders considering an acquisition of Vocus, kept pressure on the sector.

Sector returns for the month of August and since the start of the year are set out in the following table.

Income Portfolio

The income portfolio is underweight material stocks and marginally overweight financial stocks. Otherwise, the sector biases are relatively small. We have avoided real estate (potential impact of higher interest rates, plus lack of franking on real estate investment trusts), and health care (low dividends and pricing multiples).

In a bull market, we expect that the income biased portfolio will underperform relative to the S&P/ASX200  due to the underweight position in the more growth-oriented sectors and the stock selection being more defensive, and conversely in a bear market, it should moderately outperform.

It is forecast to generate a yield of 4.90% in 2017, franked to 87.3%. After the first eight months, it has returned as income $3,548 or a yield of 3.55%, franked to 90.65%. With further dividends to come in September, and three major banks in December, it should now marginally exceed the forecast.

Year to date, the income portfolio has returned 2.42% (including dividends) compared to the accumulation index return of 3.88%. This is a credible performance given that the portfolio has no health stocks (the best performing sector), and has a heavy concentration of top 20 stocks (the top 20 index has returned 1.0%). In what is proving to be a market of individual stocks rather than a stock market, the strong performances of Sydney Airport, Transurban and Boral are offsetting the performances of Brambles and Telstra.

Brambles reported its full year result, and while within its revised guidance, the outlook statement suggested that underling profit growth would be subdued. We have been keeping this position under close review for some months and have now decided to crystalize the loss of $997 and exit the holding as at 31 August.  The balance of $3,003 has been re-invested into ANZ shares at $29.40 per share, increasing the overweight allocation to financials.

The income biased portfolio per $100,000 invested (using prices as at the close of business on 31 August 2017) is as follows:

¹ Position in Brambles (FV $4,000) realised on 31 August at $9.31 per share, loss of $997. Balance of $3,003 re-invested in ANZ at $29.40 per shares

Growth Portfolio

A critical construction decision with the growth portfolio has been to take a neutral sector bias in the materials sector. This has led to the inclusion of Rio (along with BHP and Boral).

Overall, the sector biases are relatively small. Despite healthcare underperforming in 2016 and many of the stocks trading on high multiples, we believe that the tailwinds are so strong that our sector position is materially overweight.

The other overweight position was in telecommunications, the only negative performing sector in 2016. The major underweight positions are in real estate and consumer staples.

The stock selection is biased to companies that will benefit from a falling Australian dollar – either because they earn a major share of their revenue offshore, and/or report their earnings in USD. While we are not surprised to see the Aussie dollar test 80 US cents due to the strength in commodity prices and less aggressive tightening stance by the US Federal Reserve, this assumption is clearly under pressure at the moment and may need to be re-assessed.

Year to date, the portfolio has returned 2.58% (including dividends) compared to the accumulation index return of 3.88%. Similar to the income portfolio, this is a credible performance given the weighting in top 20 stocks. An overweight position in telecommunications has also impacted performance, offset by the overweight position in healthcare stocks.

In what is proving to be a market of individual stocks rather than a stock market, losses on stocks such as Brambles are compensated by gains on stocks such as Boral.

Mindful of the exposure to the retail sector, both direct and indirect, and the impact that concerns about the disruption being caused by nontraditional participants such as Amazon is having on performance, we reduced our exposure in May by exiting our holding in Westfield. This resulted in a loss of $384. Westfield was replaced in the portfolio by share registry and superannuation administrator, Link Group (ASX Code LNK), which in June announced the acquisition of Capita Asset Services and an entitlement issue.

With both Telstra and Brambles reporting full year results (largely within guidance) but alluding to subdued outlooks for profit growth, we decided to realise our losses on these positions ($997 for Brambles and $1,122 for Telstra) and exit both stocks as at 31 August. The balance has been re-invested into $4,000 ANZ shares at $29.40 per share and $1,881 CSL shares at $128.52 per share, increasing the overweight allocation to health care and moving to very marginally overweight financials.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 31 August 2017) is as follows:

¹  Position in Westfield realised on 31 May at $8.48 per share, leaving loss of $384. Balance of $3,616 invested in Link at $7.75 per share.

² Link 4:11 entitlement issue at $6.75 per share. Entitlements sold through institutional tender at $1.10 per entitlement.

³ Portfolio not able to participate in TPG 1:11.13 non renounceable entitlement offer at $5.25 per share

⁴ Position in Brambles (FV $4,000) realised on 31 August at $9.31 per share, loss of $997. Position in Telstra (FV $4,000) realised on 31 August at $3.67 per share, loss of $1,122. Balance of $4,000 invested in ANZ at $29.40 per share, $1,881 in CSL at $128.52 per share.

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.