Global share markets fell in August on the back of recession fears and heighted US/China trade tensions. The Australian market followed the US market down, losing 3.1% in price terms and 2.4% after dividends are included. Our portfolios also eased by around 2.75%, but are enjoying strong year to date returns in excess of 15%.

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

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 we performed

The income portfolio is up by 18.76% and the growth-oriented portfolio by 15.79% (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 1.58% and the growth-oriented portfolio by 4.55%.

Health care leads in August, materials dive

Health Care was the standout sector in August. On the back of strong earnings reports from leaders CSL, Resmed and Cochlear, the sector added 3.6% for the month. Year-to-date, it is the third best performing industry sector with a return of 29.1%.

Despite a rally in gold, resource sectors eased as prices for hard commodities and oil fell. The materials sector dived by 7.5% largely on the back of price falls for iron ore leaders BHP, Rio and Fortescue moved sharply lower.

Most sectors finished in the red for the month. The largest sector on the ASX, financials, which makes up  31.5% of the S&P/ASX 200 by market weight, fell by 2.6%. Year-to-date, it has returned an encouraging 16.5%, although this lags the broader market’s overall return of 20.5%.

Information technology remains the standout sector in 2019 with a return of 32%, with the WAAX stocks (Wisetech, Appen, Altium, Afterpay and Xero) leading the way. After a steep early fall, the sector recovered in the last week to end up posting a small gain for August.

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

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, 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 August, the income portfolio returned -2.97% for a relative under-performance of 0.61%. Year-to-date, it has returned 18.76% for a relative underperformance of 1.58%.

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 4.47%, franked at 84.05%.

Sharp falls in the prices of BHP and Rio impacted the portfolio’s performance in August. Most of the companies scheduled to report half year or full year earnings reported in accordance with expectations. JB Hi-Fi was one of the better market reports, while Orora and Woodside disappointed.

No changes to the portfolio are contemplated at this point in time. Woolworths 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 30 August 2019) is as follows:

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.

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 August, the portfolio returned -2.60% for a relative underperformance of 0.24%. Year-to-date, it has returned 15.78% for an underperformance of 4.55%.

Assisting the performance in August were the strong gains made by CSL and JB Hi-Fi, which both reported strongly. Offsetting this was weak earnings reports from Bluescope, Orora and Woodside, and falls by the major iron ore producers BHP and Rio.

Most of the underperformance in 2019 is due to 4 stocks – Link, Reliance, AGL and Challenger. In the case of Link, we continue to monitor closely. No 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 30 August 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.