Despite Westpac’s woes, the Australian share market followed the lead of Wall Street and tested record highs in November. Healthcare continued to be the sector setting the pace. Our model portfolios, which hold the majority of their exposure to the financial sector through the major banks, were hit by the Westpac scandal but still managed to post solid gains for the month.

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

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);
• 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 22.04% and the growth oriented portfolio by 24.15% (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 4.09% and the growth oriented portfolio by 1.98%.

Health care leads, financials lag badly

Health care was again the sector setting the pace in November with a return of 8.9%. Year to date, it is the best performing sector in the market with an astonishing return of 47.4%. Led by CSL, Resmed and Cochlear, it is now the third biggest sector in the S&P/ASX 200 with a weighting of 10.5%.

Information technology was the best performing sector in the month with a return 11.0%. Consumer staples and communication services also enjoyed healthy returns. An increase in iron ore prices offset weakness in the gold price to support the materials sector, which rose by 4.7%.

At the other end, the biggest sector on the ASX, financials, which comprises 29.7% of the S&P/ASX 200 by weighting, lost 2.1%. This followed Westpac’s woes with an anti-money laundering scandal, and flow on impacts to ANZ and NAB. Year to date, the sector lags badly with a return of 15.4%, 10.7% below the overall market. The utilities sector also lost ground.

All sectors are positive for the year, although the gap between the best (healthcare and IT) and the worst (financials and utilities) widening considerably over the last couple of months.

Returns for the 11 industry sectors in November 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.

In November, the income portfolio returned 1.68%, underperforming the market by 1.6%. Year-to-date, it has returned 22.04% for a relative underperformance of 4.09%. A key reason for the underperformance has been the absence of any healthcare stocks (the best performing sector on the ASX), plus in November, the mark-down in banking stocks following Westpac’s anti-money laundering scandal.

The return includes both capital and income. On the income side, the return is currently 5.75%, franked to 87.8%. When final distributions from Transurban, Dexus and APA are received, the income return for the year on the original $100,000 will be 6.15%, franked at 82%. This will comfortably exceed our original forecast of 5.78%.

No changes to the portfolio are contemplated in the short term, but we will be reviewing and re-balancing the portfolio at the end of December.

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 November, the portfolio returned 2.31% for a relative underperformance of 0.97%. Year-to-date, it has returned 24.15% for an underperformance of 1.98%.

The underperformance in November was primarily due to an overweight position in the major banks (Westpac, NAB and ANZ). Reliance slipped, while Link also struggled. This was offset to some extent by the ongoing performance of CSL.

No changes to the portfolio are contemplated in the short term but we will be reviewing and re-balancing the portfolio at the end of December.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 29 November 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.