October will go down as “CSL month” because a 9.6% rise in CSL’s share price made it Australia’s second biggest stock by market capitalisation and worked to temper overall losses for the share market to just 0.4%. The growth portfolio was a huge beneficiary, adding 1% in the month, while our income portfolio, which doesn’t hold CSL, slipped by 0.7%.

In the tenth review for 2019, we look at how our model income and growth portfolios performed in October.

The purpose of these portfolios is to demonstrate an approach to equity portfolio construction. As the rule sets applied are of critical importance, we provide a quick recap on these. Also, it is important to note that these portfolios are designed as “long only”. They don’t allocate to “cash” and don’t represent a view about the outright direction of the market.

Portfolio recap

In January, we made some adjustments to our Australian share ‘Income Portfolio’ and ‘Growth Portfolio’ (see https://switzersuperreport.com.au/here-are-our-portfolios-for-2019/ )

The construction rules for the portfolios are:

• we use a ‘top down approach’ looking at the prospects for each of the industry sectors;
• for the income portfolio, we introduce 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 18.9%, and under this rule, our possible portfolio weighting is in the range from 12.6% to 25.2% (i.e. plus or minus one third or 6.3%);
• 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 were our predominant investment themes for 2019, which we expected to be:

• Economic growth to slow in the USA, Europe, China and Japan, but not into recession territory;
• The US Fed moving to a more neutral stance on US interest rates. If not pausing, only one or two more hikes in 2019 (but no expectation of rate decreases);
• Interest rates in Australia to remain at historically low levels, with the RBA unlikely to move rates higher (but again, no expectation of rate decreases);
• Australian dollar around  0.75 US cents but with risk of breaking down if the US dollar firms;
• Oil price remaining well supported around US$50 per barrel. Base metal and iron ore prices to soften;
• A positive lead from the US markets;
• Growth in Australia  to ease to around 2.5%, with no real pick-up in domestic inflation;
• Housing prices in Australia to ease moderately, but not collapse.

How did our portfolios perform?

The income portfolio is up by 20.03% and the growth-oriented portfolio by 21.34% (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 2.09% and the growth-oriented portfolio by 0.78%.

Health care leads in October

On the back of a 9.6% gain by CSL and 7.2% by Resmed, the health care sector surged by 7.6% in October. In 2019, it is the best performing sector with an astonishing return of 35.4%.

The industrials sector, led by leaders such as Brambles, Transurban and Sydney Airport, also performed strongly with a return of 3%. These sectors acted as an offset to losses by the major sectors. The biggest sector, financials, which comprises 31.6% of the S&P/ASX 200 index by weighting, lost 2.8%. It was dragged down by weakness in the major banks, particularly ANZ. The second largest sector, materials, which comes in with a weighting of 17.1%, lost 1.9% as iron ore prices and other commodity prices softened.

The information technology sector was the biggest loser in October with a loss of 3.9% as the WAAAX stocks (WiseTech, Altium, Appen, Afterpay and Xero) came under some selling pressure.

All sectors are positive for the year. Interestingly, the performance of the sectors is fairly even, with the gap between the best performing sector (health care at 34.5%) and the worst performing sector (utilities at 16.0%) relatively narrow by historical standards.

Returns for the 11 industry sectors in October and calendar 2019, plus their respecting weighting as part of the ASX 200, are shown in the table below.

Income portfolio

On a sector basis, the income portfolio is moderately overweight financials and utilities, and underweight materials and health care (where there are no medium or high yielding stocks in the ASX 100). Otherwise, the sector biases are reasonably minor.

On paper, it is roughly index weight in industrials. However, this exposure is being taken through toll road operator Transurban, which isn’t your typical industrial stock.

In the expectation that interest rates in Australia are staying at record low levels, it has a defensive orientation and a bias to yield style stocks. In a bull market, we expect that the income portfolio will underperform relative to the broader market 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.

The portfolio is forecast to yield 5.78%, franked to 82.3%. The forecast yield is higher than would normally be expected due to the payment by BHP of a special dividend of $1.42 per share. When this is excluded, the yield drops back to 5.49%.

In October, the income portfolio returned -0.73%, under[performing the market by 0.38%. Year to date, it has returned 20.03% for a relative underperformance of 2.09%. A key reason for the underperformance has been the absence of any healthcare stocks (the best performing sector on the ASX).

The return includes both capital and income. On the income side, the return (which includes dividends that the portfolio is contractually entitled to) is currently 4.94%, franked to 88.4%. When final dividends from the three major banks, Macquarie, Transurban, Dexus and APA are received, the income return for the year will exceed 6%.

No changes to the portfolio are contemplated at this point in time. Woolworths, JB Hi-F, Transurban and Wesfarmers are very expensive (the portfolio is a ‘long-only’ portfolio – if not, we would probably take some profits and move to cash), and we continue to monitor the position in Link closely.

The income-biased portfolio per $100,000 invested (using prices as at the close of business on 31 October 2019) is as follows:

¹Does not include the tax benefit of accepting the Woolworths off-market share buyback

Growth portfolio

The growth portfolio is moderately overweight financials and energy, and underweight materials, consumer staples 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.

In October, the portfolio returned 1% for a relative outperformance of 1.35%. Year-to-date, it has returned 21.34% for an underperformance of 0.76%.

A 9.6% spike in the price of CSL, together with strong gains by Ramsay and Bluescope, drove the outperformance in October. This more than offset the weakness in the banks and major resource stocks.

We continue to monitor Link closely. JB Hi-Fi’s performance has been extraordinary and we will give some consideration to taking profits on this stock. That aside, no other changes to the portfolio are proposed at this point in time.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 31 October 2019) is as follows:

¹ Aristocrat ($4,000) purchased 1/1/19 @ $21.84, sold 31/5/19 @ $29.12 for profit of $1,333
² Challenger ($4,000) purchased 1/1/19 @ $9.49, sold 31/5/19 @ $8.07 for loss of $599
³ Following sale of Aristocrat and Challenger, proceeds re-invested on 31/5/19 into $3,734 NAB @ $26.49, $2,000 CSL @ $205.49 and $3,000 Bluescope @ $10.54.

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.