Weaker than expected bank half year profit results, a new bank levy, falling iron ore prices, the Amazon scare and concerns about consumer spending impacted the Australian share market in May. Going against the global trend, the local market lost ground, falling by 2.8%. The top 20 stocks were even more impacted, losing 4.8%. While both our model portfolios followed the market down in the month, they are still up by 2% in calendar 2017.
This is our fifth monthly portfolio review. On a relative basis, the income portfolio has underperformed the index this year by 0.88% and the growth portfolio by 0.61%. We have made one change to the composition of the growth portfolio.
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 [1] and here [2]).
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 May is up by 2.10% and the growth oriented portfolio by 2.37% (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 0.88% and the growth oriented portfolio by 0.61%.
Financials get hammered, defensive stocks in vogue
Weaker than expected bank half year results, the new bank levy and a ratings downgrade for the minor banks led to a hammering of the financials sector. The largest sector on the ASX with a weighting of 37%, the sector lost 7.7% in May to be marginally in the red for calendar 2017. From their peak on 1 May, each of the four major banks lost around 10% in value.
Contributing to the negative tone, the major resource companies eased as the iron ore price fell and the major retailers got caught up in the scare about the potential impact of Amazon in Australia. Overall, the top 20 stocks lost 4.8% in the month, and are now up just 0.8% for the year.
Some of the middle cap companies benefitted as fund managers switched out of the top part of the market. The midcap 50 index, which measures stocks ranked 51st to 100th by market capitalisation, rose by 0.9% and has now returned 8.0% in 2017. Defensive stocks such as Sydney Airport and Transurban were also in favour. This is one of the reasons that the industrials index, which includes both Sydney Airport and Transurban, added 4.7% in May.
The healthcare sector also eased in May, as leaders CSL and Cochlear pulled back from recent highs. Year to date, it remains the best performing sector with a return of 16.1%. Telecommunications, the worst performing sector this year with a return of -11.2%, added 3.4% in the month as Telstra rebounded following an ACCC decision not to intervene in the mobile roaming market.
Sector returns for the month of May 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).
The income portfolio is forecast to generate a yield of 4.90% in 2017, franked to 87.3%. 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 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.
Year-to-date, the income portfolio has returned 2.10% compared to the accumulation index return of 2.98%. 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 only returned 0.9%). In what is proving to be a market of individual stocks rather than a stock market, the almost unbelievable performances of Sydney Airport, Transurban and AGL are offsetting the performances of JB Hi-Fi, Brambles and Telstra. Weakness in the major banks, which have been impacted by the new bank levy, hurt in May.
The Amazon scare, as well as a general softness in consumer confidence, has hurt retailers such as JB Hi-Fi and to a lesser extent, Wesfarmers. We have thought long and hard about these positions, but on balance, decided to retain them because we feel that the underlying companies are sound and that the “scare” is largely factored into the price.
No changes to the portfolio are contemplated at this point in time, although we are keeping the exposure to JB Hi-Fi under close review.
The income biased portfolio per $100,000 invested (using prices as at the close of business on 31 May 2017) is as follows:
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 is 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 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.
Year-to-date, the portfolio has returned 2.37% compared to the accumulation index return of 2.98%. Similar to the income portfolio, this is a credible performance given the weighting in top 20 stocks and the underperformance of this part of the market (the top 20 index has only returned 0.9%). 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 Brambles and JB Hi-Fi are compensated by gains on stocks such as Boral and AGL.
Mindful of the overall exposure to the retail sector, both direct and indirect, and the impact that concerns about the disruption being caused by non-traditional participants such as Amazon is having on performance, we have elected to reduce our exposure marginally by exiting our holding in Westfield. This will result in realizing a loss of $384. Replacing Westfield is share registry and superannuation administrator, Link Group (ASX Code LNK).
In the meantime, we will keep positions in Wesfarmers and JB Hi-Fi under close watch
Our growth oriented portfolio per $100,000 invested (using prices as at the close of business on 31 May 2017) is as follows:
* Portfolio not able to participate in TPG 1:11.13 non renounceable entitlement offer at $5.25 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.