While both portfolios finished higher in 2014, the income-oriented portfolio outperformed the market. It returned 8.13% for the year, compared to an index return (including dividends) of 5.61%.

Over two years, the income-oriented portfolio has outperformed the market by 3.29% per annum and the growth-oriented portfolio has outperformed by 2.14% per annum.

Although the total share market return was lower in 2014 (5.61% for the S&P/ASX 200 compared with 20.20% in 2013), yield based sectors again led the market higher and portfolios with a bias to these sectors performed strongly. For example, the largest sector of financials, which includes the major banks, returned 9.8% in 2014 following a 28.1% gain in 2013.

Portfolio recap

In January last year, we made some adjustments to our Australian share ‘Income portfolio’ and ‘Growth-oriented portfolio’ (see here and here).

The purpose of these portfolios is to demonstrate an approach to portfolio construction. As the rule sets are of critical importance, we always commence a review by briefly recapping the key portfolio construction processes applied.

The income portfolio is forecast to generate a yield of 5.01%, franked to 90.4%. The construction rules applied include:

• Using a ‘top down approach’ and introducing biases that favour lower PE, higher yielding industry sectors;
• To minimise the market tracking risk, adopting a rule that says that our sector biases in the major sectors (financials, materials and consumer staples) will not be more than 33% away from index;
• Identifying 15 to 20 stocks (less than 10 is insufficient diversification, over 25 it is too hard to monitor), with a stock universe confined to the ASX 100; Within a sector, weighting the stocks broadly to their respective index weights, although there are some biases; and
• Of course, we look for companies that pay franked dividends and have a consistent earnings record.

The growth-oriented portfolio takes a very different approach to the sectors 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 100 (there are many great growth companies outside the top 100).

Performance

The income-oriented portfolio finished up 8.13% for the year and the growth-oriented portfolio by 3.39% (see tables at the end). Compared to the benchmark S&P/ASX 200 Accumulation Index (which adds back income from dividends), the income portfolio outperformed the index in 2014 by 2.52% and the growth-oriented portfolio underperformed that index by 2.22%.

On a two-year basis, both portfolios have outperformed the S&P/ASX 200 accumulation index. The income portfolio by 3.29% pa and the growth-oriented portfolio by 2.16% pa.

Yield sectors shine

Continuing a major investment theme of the last couple of years, the yield sectors in the main shined during 2014. Property trusts added 27.04%, Utilities 16.09% and the dominant financial sector, which includes the four major banks and makes up a massive 40.3% of the index, returned 9.84%. Telecommunications, which is predominantly Telstra, added 20.82%. The exception was consumer staples, which fell 4.58%, dragged down by falls in the prices of Woolworths and Coca Cola Amatil.

The other star sector in 2014 was healthcare, which produced a total return of 24.38%.

The laggards include the commodity exposed sectors (materials at -11.63% and energy at -11.97%), and consumer discretionary at -0.94%. With no discernible pick-up in consumer or business confidence, and generally subdued retail sales, stock prices for many of the companies in this sector suffered in 2014.

The table below shows the sector weights (as a proportion of the S&P/ASX 200 at 31 Dec 14), and performances (total return) for 2014.

Income portfolio

The income portfolio is overweight financials, consumer staples, utilities and telecommunications; underweight materials and consumer discretionary; and broadly index-weight the other sectors. It also includes an allocation to property trusts (formally called the A-REIT sector), and somewhat more exposure to the “cyclicals” through the selection of stocks from the Industrial sector.

The portfolio outperformed the index by 2.52% in 2014. While sector selection played a key role with overweight positions in financials and telecommunications, stock selection also assisted. The inclusion of stocks such as Leighton, Orora and Dexus compensated for the poor performance of stocks such as AGL, Primary and more recently, BHP. A slight bias to stocks that will benefit from a weaker Aussie dollar, such as Brambles, also assisted.

The income portfolio generated a yield in 2014 of 5.05% franked to 84.54%, slightly higher than forecast at the time of selection of 5.01%.

Our income-biased portfolio per $100,000 invested (using prices as at the close of business on 31 December) is as follows:

Income includes dividends declared and payable.

*Wesfarmers includes $0.75 return of capital, $0.25 special dividend and 1:0.9827 share consolidation. **AGL rights following 1:5 renounceable issue at $11.00, assumed sold on last day of rights trading at $2.62. ***Assumes 37.5% Leighton shares sold in partial offer at $22.50, repurchased on 30/4 at $19.08.

Growth portfolio

Similar to our approach to the income portfolio, we applied a ‘top down’ approach to the industry sectors and introduced biases that favour the sectors that we feel have the best medium-term growth prospects. The growth-oriented portfolio is overweight healthcare, consumer discretionary and industrials; underweight financials and property trusts; and largely index weight the other sectors including materials.

Critically, we biased the stock selection to companies that should benefit from a falling Australian dollar – either because they earn a major share of their revenue offshore, or report their earnings in US dollars – such as CSL, Amcor, Brambles and Computershare. Other biases include Woolworths over Wesfarmers (which suffered over the last couple of months), CBA and Westpac over ANZ and to a lesser extent NAB; and the selection of Crown and JB Hi-Fi.

At the end of May, we made some changes to the portfolio. We reduced our exposure to the materials sector by selling our holding in Rio for a loss of $391, exited our holding in Primary Health Care for a loss of $291 and replaced this with Resmed, and increased our exposure to the consumer discretionary sector through additional holdings in Crown and JB Hi-Fi.

Although producing a small positive return of 3.39%, the portfolio underperformed the index by 2.22% in 2014. Our biases away from the yield sectors (for example, no property trusts and under-weight position in financials) hurt, and the performance of our stock selections in the consumer discretionary sector (Crown and JB Hi Fi) has been very disappointing.

The stock selections that favoured a lower Aussie dollar – CSL, Brambles, Resmed, Amcor and Computershare – have performed strongly, and the relative underperformance of the portfolio has narrowed over the last few months.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 31 December 2014) is as follows:

Income includes dividends declared and payable.

*Prices of Crown (new), JB Hi-Fi (new) and Resmed (new) as at 30 May. ** Wesfarmers includes $0.75 return of capital, $0.25 special dividend and 1:0.9827 share consolidation. *** AGL rights following 1:5 renounceable issue at $11.00, assumed sold on last day of rights trading at $2.62.

2015 updates

Next Monday, we will publish our updated income portfolio for 2015, and the following Monday, January 19, our updated growth-oriented portfolio.

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.