The Australian sharemarket made further gains in December, reaching post GFC highs to record an annual gain of 7.1% or 11.8% when dividends are included. Our growth portfolio finished the year with a return of 11.3%.

Our model portfolios, which have a preponderance of major cap (top 20) stocks, enjoyed positive returns during December and marginally outperformed the benchmark S&P/ASX 200 index. Over 2017, the growth portfolio underperformed by 0.54% and for the income portfolio by 3.17%.

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.

This is our final report on performance in 2017. Next week, we will publish our 2018 portfolios, which while based on the 2017 portfolios, will be re-balanced and incorporate some further changes.

Portfolio recap

In January 2017, we made some adjustments to our Australian share ‘Income Portfolio’ and ‘Growth Oriented Portfolio’ (see https://switzersuperreport.com.au/our-high-income-stock-portfolio-for-2017/ and https://switzersuperreport.com.au/our-growth-oriented-stock-portfolio-for-2017/).

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 expected 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 for 2017 is up by 8.63% and the growth-oriented portfolio by 11.26% (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 3.17% and the growth-oriented portfolio by 0.54%.

Sharemarket hits new highs in December

Led by a buoyant Wall Street, the Australian sharemarket finished higher in December, adding 1.6% in price terms and 1.8% when dividends are included. For 2017, the total return (including dividends) was 11.8%.

With the prospects for global growth improving and commodity prices firming, resource sectors starred in December, with both the energy and the materials sectors adding in excess of 6.0%. Over the course of 2017, these sectors were amongst the best on the ASX.

Firming bond yields had an impact on the so called “interest rate defensive” sectors in December, with utilities, real estate and industrials (which includes stocks such as Sydney Airport and Transurban) underperforming. Utilities was the worst performing sector, losing 4.5%.

Weighed down by the threat of a royal commission, the largest sector on the ASX, financials, which makes up 35.6% of the index, underperformed in December adding just 0.4%. In 2017, it lagged the broader market to record a gain of 5.0%, well below the overall market return of 11.8%.

Heath care was the best performing sector in 2017 with a return of 26.4%. On the other side of the ledger, the Telecommunications sector finished with a net loss of 21.3%, notwithstanding a rebound in December.

Sector returns for the month of December and for calendar year 2017 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.

A change to the portfolio (exit of Brambles, replaced by additional ANZ) was made at the end of August.

Over 2017, the income portfolio returned 8.63% (including dividends) compared to the accumulation index return of 11.80%. 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 returned 7.28% in 2017). In what proved to be a market of individual stocks rather than a stock market, the strong performances of Sydney Airport, Transurban and Boral offset to some extent the performances of Telstra and JB Hi-Fi.

On the income side, the portfolio was forecast to generate a yield of 4.90% in 2017, franked to 87.3%. It did marginally better, achieving an income return of $5,128 or 5.13%, franked at 87.3%.

The income-biased portfolio per $100,000 invested (using prices at the close of business on 29 December 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

² Transurban entitlements on 3 for 37 basis to purchase new shares at $11.40 (TCLRA)

Growth portfolio

A critical construction decision with the growth portfolio was 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 (initially) was in telecommunications. 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 US dollars.

Changes to the portfolio were made at the end of May (exit of Westfield, replaced by Link) and at the end of August (exit of Telstra and Brambles, replaced by additional CSL and ANZ).

In 2017, the portfolio returned 11.28% (including dividends) compared to the accumulation index return of 11.80%. Similar to the income portfolio, this is a credible performance given the weighting in top 20 stocks. An overweight position in telecommunications has also materially impacted performance, offset largely by the overweight position in healthcare stocks.

Our growth-oriented portfolio per $100,000 invested (using prices at the close of business on 29 December 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.