Buoyed by a resurgent Wall Street, the Australian share market followed suit to post a gain of 3.9% in January.
Despite being marginally overweight the major banks, our model portfolios delivered solid gains to largely match the performance of the benchmark index. In our first review for the year, we look at how our income and growth portfolios performed in January. 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.
Let’s do a 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/ [1] )
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 18.5%, and under this rule, our possible portfolio weighting is in the range from 12.3% to 24.7% (ie plus or minus one third or 6.2%);
- 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 2019, which we expect 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;
- Interest rates in Australia to remain at historically low levels, with the RBA unlikely to move rates higher;
- AUD around 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; and
- A federal election in May, which will limit any market gains in the first half.
Portfolio performance
The income portfolio to 31 January is up by 3.49% and the growth-oriented portfolio by 3.18% (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 0.38% and the growth-oriented portfolio by 0.69%.
Resources and IT lead the market in January
The resource sectors (energy and materials) were amongst the best performing sectors in January. The energy sector added 11.5% as the oil price stabilized above US$50 per barrel, while the materials sector benefitted from the BHP buyback and at the end of the month, a jump in the iron ore price following the collapse of a dam in Brazil owned by competitor Vale.
The IT sector also recorded a strong gain of 9.3% following gains on Wall Street with NASDAQ stocks.
Despite a positive start to the month, the largest sector by market weight, financials, which makes up 31.4% of the index, lost 0.2% as market nerves came to the forefront ahead of the release of the findings of the Royal Commission into misconduct in the financial services industry.
All other sectors posted gains. Of note were the “interest rate sensitive” sectors of utilities and real estate which both posted gains in excess of 6.0%.
Let’s look at our 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 and that a federal election is due in May, 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 January, the income portfolio returned 3.49% for a relative underperformance of 0.38%. Weighing on the performance was the major banks, with three of the four majors finishing in the red. 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 31 January 2019) is as follows:
Now let’s check on our 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.
On paper, it is overweight consumer discretionary. Part of this exposure is through Aristocrat Leisure (which is servicing the gaming and gambling markets) and through conglomerate Wesfarmers.
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 USD.
In January, the portfolio returned 3.18% for a relative underperformance of 0.69%. Challenger, which issued a downbeat trading update, lost almost 24%, impacting the portfolio’s performance by 0.95%. Offsetting this to some extent were strong performances by Aristocrat, Reliance and TPG.
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 31 January 2019) is as follows:
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.