The Australian share market added 1.4% in July as it pushed towards 10-year highs. Most sectors made a positive contribution, with the two laggards this calendar year, financials and telecommunications, amongst the better performers in July.

Our model portfolios recorded gains of around 2% in July. Year-to-date, our model income portfolio, which is overweight financials and telecommunications, has underperformed the index by 3.5%, while our model growth portfolio has outperformed the index by 0.7%.

In our seventh review for the year, we look at how our income and growth portfolios performed in July. 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.

Portfolio recap

In January, we made some adjustments to our Australian share ‘Income Portfolio’ and ‘Growth Portfolio’ (see https://switzersuperreport.com.au/our-portfolios-for-2018/).

The construction rules applied were:

• A ‘top down approach’ that looks at the prospects for each of the industry sectors;
• For the income portfolio, we introduced 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%, and under this rule, our possible portfolio weighting is in the range from 12% to 24% (i.e. plus or minus one third or 6%);
• 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 2018, which we expect to be:

• Synchronised growth in the USA, Europe, China and Japan;
• The US Fed likely to increase US interest rates by 0.75%,
• Interest rates in Australia to remain at historically low levels, with the RBA unlikely to move rates higher until the final quarter of 2018. Some upward movement in bond rates;
• Aussie dollar around 0.75 US cents, but with risk of breaking down if the US dollar firms;
• Commodity and energy prices remaining reasonably well supported;
• A positive lead from the US markets;
• A moderate pick-up in growth in Australia, back towards trend levels; and
• No material pick up in domestic inflation.

Performance

The income portfolio to 31 July is up by 2.19% and the growth-oriented portfolio is up by 6.42% (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 3.54% and the growth-oriented portfolio has outperformed the index by 0.69%.

Telco and financials enjoy support in July

After a horrid two and a half years, the telecommunications sector enjoyed a surge of support to return 7.9% in July (see Table below). Telstra rallied from $2.62 to $2.84, with the market reacting positively to a late month organisational shake-up. The largest sector on the ASX, financials, with a market weighting of 33.4%, posted a gain of 2.1% as Royal Commission “pressures” eased. Year-to-date, it is still very marginally in the “red” with a return of -0.1%.

The health care sector leads the market over the first seven months. The performance of stocks such as CSL, Resmed and Cochlear has driven the sector’s return to 27.1%. Energy, consumer staples and information technology have also performed strongly, the former on the back of a higher oil price.

Apart from telecommunications and financials, laggards this year are the so-called “interest rate defensive” sectors of utilities and real estate.

Income portfolio

On a sector basis, the income portfolio is moderately overweight financials and index-weight materials. Exposure is being taken through the major banks (to the former), and the major miners (to the latter).

It is underweight health care, consumer staples and real estate.

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 the stock selection being more defensive, and conversely in a bear market, it should moderately outperform.

The portfolio is forecast to generate a yield of 5.13% in 2018, franked to 88.8%. The inclusion of Transurban and Sydney Airport, while adding to the defensive qualities of the portfolio, drags down the franking percentage.

In July, the income portfolio returned 1.80%, which took its year to date return to 2.19%, 3.54% below the accumulation index return. It benefitted in July from a marginal outperformance of the major banks, a boost in Telstra and support for Link.

Despite the underperformance of the portfolio relative to the benchmark, no changes to the portfolio are contemplated ahead of the August company earnings season.

From an income point of view, the portfolio has returned 2.67% franked to 89.9% this year. This is tracking to plan and we remain confident that the full year forecast of 5.13% will be met.

The income-biased portfolio per $100,000 invested (using prices as at the close of business on 31 July 2018) is as follows:

* Closing price 29/12/17

¹ Woodside 1:9 entitlements at $27.00 per share. Assume sold on last day of trading.
² AMP shares sold on 30 April @ $4.04, loss of $886 realised. Balance of $3,114 invested in ANZ @ $26.84

Growth portfolio

The growth portfolio is moderately overweight materials, financials and consumer discretionary. It is underweight consumer staples, industrials 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. While we expect that the Aussie dollar will remain well supported, and trade in a fairly narrow range in the short term, the risk is that a strengthening US dollar causes it to break down.

In July, the growth portfolio returned 2.08%, which took its year-to-date return to 6.42%. It has outperformed the accumulation index by 0.69%.

Strong performances by CSL, Aristocrat Leisure and Macquarie are being offset by weakness in JB Hi-Fi, TPG, Challenger and Ramsay.

No changes to the portfolio are contemplated ahead of the August company reporting season, although we are watching very carefully CSL and Ramsay (CSL in relation to taking profits and pruning, Ramsay whether to exit).

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 31 July 2018) is as follows:

* Closing price 29/12/17
¹ Woodside 1:9 entitlements at $27.00 per share. Assume sold on last day of trading.

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.