The third up month in a row for the ASX ensured that both portfolios are in the black at the end of May. Our income portfolio continued to perform strongly and is up 5.39% since the start of the year.

Year to date, our income portfolio has outperformed the index by 1.76%, while the growth portfolio has underperformed by 2.27%.

The purpose of these portfolios is to demonstrate an approach to portfolio construction. As the rule sets applied are of critical importance, we have also provided a quick recap on these.

We have made some minor changes to the portfolios, effective 31 May.

Portfolio Recap

In January, we made some adjustments to our Australian share ‘Income Portfolio’ and ‘Growth Oriented Portfolio’ (see here and here).

To construct the income portfolio, the processes we applied included:

• we used a ‘top down approach’ looking at the industry sectors;
• so that we are not overly exposed to a market move, we have determined that in the major sectors (financials and materials), our sector biases will not be more than 33% away from index;
• 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 of $3,000;
• we confined our stock universe to the ASX 150;
• we  have avoided stocks from industries where there is a high level of exogenous risk, such as airlines;
• for the income portfolio, we prioritised stocks that pay fully franked dividends and have a strong earnings track record; and
• within a sector, the stocks are broadly weighted to their respective index weight, although there are some biases.

The growth oriented portfolio takes a different approach 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 150 (there are many great growth companies outside the top 150).

Overlaying these processes were our predominant investment themes for 2016, which we expected to be:

• Continued low interest rates (yield sectors will continue to perform);
• The US Fed will be very cautious about further US interest rate rises;
• AUD at around 0.70 US cents, but with risk of breaking down;
• Commodity prices remaining weak;
• A positive lead (or at least not a negative lead)from the US markets; and
• Growth running below trend in Australia.

Performance

The income oriented portfolio to end May is up by 5.39% and the growth oriented portfolio by 1.36% (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 outperformed the index by 1.76% and the growth oriented portfolio has underperformed by 2.27%.

Health Care and Financials lead in May

The S&P/ASX 200 added 3.1% in May and with dividends included, has returned a positive 3.6% since the start of the year. The health care sector roared back into life, as a weaker AUD helped stocks such as CSL, Cochlear and Ramsay reach record highs. Over the month, it added 9.5% to be up 11.4% over the first 5 months.

The largest sector by market weighting, financials, added a respectable 5.2% in May. It is still a major drag on the index this year at negative 3.7%, with concerns about capital and credit provisioning continuing to impact the performance of banking stocks.

After a very strong March and April, the materials sector pulled back in May as the iron ore, copper and gold prices softened a touch. On a year to date basis, it remains the best performing sector with a return of 15.6%.

Property trusts continued to be well bid, adding 2.6% in May for a year to date return of 12.3%. The consumer discretionary and telecommunications sectors also finished with solid gains.

Income Portfolio

The income portfolio is underweight materials stocks and overweight financial stocks. Otherwise, the sector biases are relatively small.

In a bull market, we expect that the income biased portfolio will underperform relative to the standard S&P/ASX200 price index due to the underweight position in the more growth oriented sectors and stock selection being more defensive, and conversely in a bear market, it should moderately outperform.

Strong performances from some of the more defensive stocks such as Medibank, Sydney Airport and Dexus are offsetting the losses on our holdings in the major banks.

The gain on Medibank (from $2.15 to $3.20) is beyond all expectations and we have decided to crystalise this profit. By re-investing $2,442 into BHP shares, we will address the (now) very underweight position in material stocks, lifting our sector weighting to 11.5% compared to an index weight of 13.6%. With healthcare stocks so expensive and low yielding, we have elected to invest the balance of $5,000 into shares of ASX Limited. ASX is a relatively low beta stock, trading on a multiple of just over 20 times FY16 earnings and yielding 4.2% (fully franked).

We don’t propose any other changes at this point in time.

The portfolio is forecast to generate a yield of 5.26% in 2016, franked to 84.2%. The inclusion of Dexus and Sydney Airport, while adding to the defensive qualities of the portfolio, drags down the franking percentage.

By face value, approximately 88% of companies have paid a first half dividend, generating just over 2.2% in income, franked to 92.5%. Despite the greater than expected cut by BHP to its dividend, the portfolio is on track to meet its dividend forecast.

Our income biased portfolio per $100,000 invested (using prices as at the close of business on 31 May 2016) is as follows:

* CYBG Plc demerged from National Australia Bank in Feb 16, on 1:4 basis

** Sale of Medibank at $3.20 on 31/5/16. Proceeds of $7,742 reinvested in $2,242 BHP @ $19.08 per share and $5,000 ASX @ $44.51.

Click here to download the excel file of both portfolios.

Growth Portfolio

The growth portfolio is marginally overweight the sectors that should benefit from increased consumer consumption or a lower AUD; marginally underweight or index-weight the yield sectors (financials, utilities, telecommunications and consumer staples); and underweight the commodity exposed sectors (materials and energy). Despite healthcare being the best performing sector over the last 3 years, we have elected to maintain an overweight position as the demographic factors are so strong.

Although in May the portfolio kept pace with the market, it continues to underperform against the index, mainly due to its bias with top 20 stocks. Year to date, the S&P/ASX 20 index has lost 0.2% compared to the S&P/ASX 200’s gain of 3.6%.

Stock selection is also impacting, both positively and negatively. While Macquarie has returned to form in May (adding almost 22% including dividends in May), Flight Centre has been hit following a profit downgrade and concerns about over-capacity hitting international airline fares. We have decided to lick our wounds on Flight Centre and realise the loss of $830.

We propose to reinvest the net amount of $3,170 into $2,000 of BHP shares (which will lift the weighting in material stocks to 10.9%), and $1,170 into Macquarie. No other changes are proposed at this point in time.

Our growth oriented portfolio per $100,000 invested (using prices as at the close of business on 31 May 2016) is as follows:

* CYBG Plc demerged from National Australia Bank in Feb 16, on 1:4 basis

** Sale of Flight Centre at $31.61 on 31/5/16. Proceeds of $3,170 reinvested in $2,000 BHP @ $19.08 per share and $1,170 Macquarie @ $74.87 per share.

Click here to download the excel file of both portfolios.

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.