The fall in interest rates pushed the Australian stock market higher in June, the sixth consecutive up month. With defensive stocks in keen demand, our model income portfolio has returned almost 20% in 2019.

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

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/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);
• The Aussie 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.

Performance

The income portfolio is up by 19.71% and the growth-oriented portfolio by 15.76% (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 matched the index and the growth-oriented portfolio has underperformed by 3.97%.

Materials lead in June

In a month where all but one sector finished with a positive return, the materials sector was the standout. Surging iron ore and gold prices, the former due to supply disruption and the latter due to falling interest rates, helped the sector post a return of 6.4%. In 2019, the sector is the second best performing with a gain of 26.6%.

Consumer discretionary was the only sector to deliver a negative return  in the month, a loss of 1.5%.  Selling in the retailers, including Wesfarmers, weighed on the sector.

The best performing sector this year, largely due to the performance of Telstra, is communication services with a return of 31.8%. The worst performing sector is consumer staples with a return of 11.4%. The largest sector by market capitalization, financials, which has a weighting in the S&P/ASX 200 of 32%, is up by 17.5%.

All industry sectors are positive for the year. By historical standards, the gap between the best performing  sector and the worst performing is relatively narrow. Returns for the 11 industry sectors in June 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 is not 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 June, the income portfolio returned 3.26% for a relative under-performance of 0.44%. Year to date, it has returned 19.71% and matched the accumulation index.

The return includes both capital and income. On the income side, the return (which takes into account dividends that the portfolio is contractually entitled to) is currently 3.38%, franked at 85.6%.

Helping in June was the strong performance of the “interest rate ” defensives Transurban and APA. Offsetting this was the performance of Link, which fell by another 17% in June.

No changes to the portfolio are contemplated at this point in time. We have decided to keep the position in Link, notwithstanding that there could be some more short term pain.

The income-biased portfolio per $100,000 invested (using prices as at the close of business on 28 June 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 June, the portfolio returned 2.06% for a relative underperformance of 1.64%. Year-to-date, it has returned 15.76% for an underperformance of 3.97%.

Most of the underperformance in 2019 is due to 3 stocks – Link, Reliance and TPG. Each is “out of favour” with the market and it may be a little while before the situation changes. We have decided to keep these stocks in the short term.

The changes made to the portfolio in May (cutting the position in Challenger, taking profit on Aristocrat and replacing with Bluescope, NAB and CSL) have been largely successful, although Aristocrat has continued to move higher and NAB has lagged the other banks.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 28 June  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.