Buoyed by a resilient reporting season, the Australian sharemarket withstood the wobbles on Wall Street and was one of the very few global equity markets to finish in the black in February. Adding back dividends, the S&P/ASX 200 posted a return of 0.4% in February to be flat overall for 2018.

Our model portfolios finished marginally weaker. The income portfolio now lags the index by 0.5%, while the growth portfolio has outperformed it by 0.7%.

In our second review for the year, we look at how our income and growth portfolios performed in February. 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 Portfolio’ (see https://switzersuperreport.com.au/our-portfolios-for-2018/).

The construction rules applied were:

• A ‘top down approach’ that looks at the prospects for each of the industry sectors;
• For the income portfolio, we introduced biases that favour lower PE, higher yielding sectors;
• So that we are not overly exposed to a market move, in the major sectors (financials and materials), our sector biases will not be more than 33% away from index. For example, the weighting of the ‘materials’ sector on the S&P/ASX 200 is currently 18.0%, and under this rule, our possible portfolio weighting is in the range from 12.0% to 24.0% (i.e. plus or minus one third or 6.0%);
• 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 size of $3,000;
• Our stock universe is confined to the ASX 100. This has important implications for the growth portfolio, because the stocks with the best medium term growth prospects will often come from outside this group (the so called ‘small’ caps);
• We avoid stocks from industries where there is a high level of exogenous risk, such as airlines;
• For the income portfolio, we prioritise stocks that pay fully franked dividends and have a consistent record of paying dividends; and
• Within a sector, the stocks are broadly weighted to their respective index weights, although there are some biases.

Overlaying these processes are our predominant investment themes for 2018, which we expect to be:

• Synchronised growth in the USA, Europe, China and Japan;
• The US Fed likely to increase US interest rates by 0.75%,
• Interest rates in Australia to remain at historically low levels, with the RBA unlikely to move rates higher until the final quarter of 2018. Some upward movement in bond rates;
• Australian dollar around 0.75 US cents, but with risk of breaking down if the US dollar firms;
• Commodity and energy prices remaining reasonably well supported;
• A positive lead from the US markets;
• 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 28 February is down by 0.58% and the growth-oriented portfolio is up by 0.59% (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 0.49%, while the growth oriented portfolio has outperformed the index by 0.68%.

Healthcare leads in February as the ‘interest rate defensive’ sectors get hit

Healthcare was again the star sector in February, adding 7.0%. This was mainly due to CSL, which, on the back of a strong first half earnings report, saw its shares rise by 11.4% over the month. Cochlear, Primary and Sonic also assisted. Year to date, the health care sector leads with a return of 10.4%.

On the negative side, the so-called “interest rate defensive” sectors were hit as US bond yields (and yields on Australian treasury bonds) rose. The real estate sector lost 1.9%, utilities 1.7% and industrials (which includes heavyweights Transurban and Sydney Airport) 0.4%.

The energy sector was weighed down by Woodside’s $2.5 billion capital raising, while the Telecommunications sector shed 6.0%. This was driven by Telstra’s uninspiring profit report, and a very poor report from Vocus Communications.

The largest sector by market weight, financials, accounting for 35.5% of the S&P/ASX 200, added 0.7% in February and is now on track with the index for the year. The materials sector is marginally in front, with a return in 2018 of 0.9%.

Income portfolio

On a sector basis, the income portfolio is moderately overweight financials and index-weight materials. Exposure is being taken through the major banks (to the former), and the major miners (to the latter).

It is underweight health care, consumer staples and real estate.

It is forecast to generate a yield of 5.13% in 2018, franked to 88.8%. The inclusion of Transurban and Sydney Airport, while adding to the defensive qualities of the portfolio, drags down the franking percentage.

In a bull market, we expect that the income-biased portfolio will underperform relative to the standard S&P/ASX200 price index 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.

In February, the income portfolio returned -0.81%, taking its year to date return to -0.58%. It now lags the index by 0.49%. The portfolio was impacted by the Woodside entitlement issue, together with weakness in Sydney Airport and Transurban.

Half yearly reports from JB Hi-Fi, Wesfarmers, AMP, ASX, CBA, Suncorp, Link, BHP, Fortescue, Rio and Telstra were largely in keeping with expectations, and dividends declared are on track with our forecast.

In regard to the Woodside entitlement (1 for 9 new shares at $27.00 per share), the portfolio won’t be taking these shares up as it doesn’t have a cash balance. For performance purposes, we have assumed that these were sold on the last day of trading (28 February) and a profit realized.

No changes to the portfolio are contemplated at this point in time.

The income-biased portfolio per $100,000 invested (using prices as at the close of business on 28 February 2018) is as follows:

* Closing price 29/12/17

¹ Woodside 1:9 entitlements at $27.00 per share. Assume sold on last day of trading.

Growth portfolio

The growth portfolio is moderately overweight materials, financials and consumer discretionary. It is underweight consumer staples, industrials and real estate. Overall, the sector biases are not strong.

The stock selection is marginally 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. While we expect that the Aussie dollar will remain well supported and trade in a fairly narrow range in the short term, the risk is that a strengthening US dollar causes it to break down.

In February, the growth portfolio returned -0.22% which took its year to date return to 0.59%. It has now outperformed the index by 0.68%.

The performance in February was impacted by the Woodside entitlement issue and a somewhat underwhelming profit report from Ramsay. Offsetting these were the strong performances of CSL and Seek.

In regard to the Woodside entitlement (1 for 9 new shares at $27.00 per share), as stated above, the portfolio won’t be taking these shares up as it doesn’t have a cash balance. For performance purposes, we have assumed that these were sold on the last day of trading (28 February) and a profit realized.

No changes to the portfolio are contemplated at this point in time.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 28 February 2018) is as follows:

* Closing price 29/12/17

¹ Woodside 1:9 entitlements at $27.00 per share. Assume sold on last day of trading.

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 regard to your circumstances.