A big slide on the final day of the month due to trade tremors saw the share market finish in the red for November. It lost 2.8% for the month, or 2.2% after dividends are taken into account.

The financials sector was one of the better performing sectors in the month, and our portfolios, which are both marginally overweight, outperformed compared to the market in November. Year-to-date, our model income portfolio has underperformed the index by 1.5% while our model growth portfolio has outperformed the index by 0.3%.

In our eleventh review, we look at how our income and growth portfolios performed in November. 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 18.0%, and under this rule, our possible portfolio weighting is in the range from 12.0% to 24.0% (i.e. plus or minus one third or 6.0%);
• 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;
• Australian dollar around 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 30 November is down by 4.26% and the growth-oriented portfolio by 2.41% (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 1.54% and the growth-oriented portfolio has outperformed the index by 0.31%.  Both these numbers don’t take into account the impact of franking credits, or the benefits to a low rate taxpayer of participating in off-market buybacks.

Financials an unlikely winner in November

With the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry drawing to a close, the beleaguered financials sector posted a somewhat surprising gain of 1.4% in an otherwise soft month. Perhaps a case of “sell the rumour, buy the fact”?

The only other sector to finish with a positive outcome was the second smallest sector by market capitalisation, information technology, which added 1.0%. Year-to-date, it is up by 11.7%.

The energy sector fell by 10.3% as the oil price plunged, hitting US$50 per barrel compared to a peak in the last few days in September of just on US$75 per barrel. Year to date, the sector is down by 6.7%. The second largest sector on the ASX, materials, with a weighting of 17.6, also eased and slipped into the red for the year.

Healthcare, which is the best performing sector on the ASX this calendar year with a return of 15.8%, lost 4.0% in November. Profit taking in the sector’s largest stock, CSL, was partly responsible.

One interesting feature of November was the relative “outperformance” of the top 20 stocks by market capitalisation, with a loss of -1.6%. Year to date, this group of stocks shows a small negative return of 1.2%. The weakest performing component is now the mid-caps, down 5.8% in 2018.

Individual sector returns (for the month of November and calendar year 2018) are set out in the table below. Following the demerger of Coles, Wesfarmers has moved from the Consumer Staples sector to Consumer Discretionary.

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 November, the income portfolio lost 0.85% which took its year to date return to -4.26%.  It has underperformed the accumulation index this year by 1.54%.

No changes to the portfolio are contemplated at this point in time, although we won’t seek to hold the newly demerged Coles shares in 2019. While the portfolio won’t be accepting the BHP off-market buyback which closes on 14 December (we can’t readily account for the tax benefit), low rate taxpayers should give serious consideration to this strategy. See https://switzersuperreport.com.au/bhps-buyback-a-no-brainer-for-some-shareholders/

From an income point of view, the portfolio has returned 5.16% franked to 94.4%. With distributions from Transurban and Sydney Airport to come, it will deliver an income return for the year higher than forecast of around 5.42%, franked to 90%.

The income biased portfolio per $100,000 invested (using prices as at the close of business on 30 November) 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

³ Fortescue shares sold on 31 August @ $3.84, loss of $639 realised. Balance re-invested in Transurban Entitlement issue (10 for 57 @ $10.80) and $1,446 Westpac @ $28.54.

⁴ Coles demerged from Wesfarmers on 21/11/18. Until exact proportions available, assume $0 cost base for Coles and original cost base for demerged Wesfarmers.

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 USD. 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 November, the growth portfolio lost 2.11% which took its year to date return to -2.41%. It has outperformed the accumulation index this year by 0.31%.

No changes to the portfolio are contemplated at this point in time, although we won’t seek to hold the newly demerged Coles shares in 2019. While the portfolio won’t be accepting the BHP off-market buyback which closes on 14 December (we can’t readily account for the tax benefit), low rate taxpayers should give serious consideration to this strategy. See https://switzersuperreport.com.au/bhps-buyback-a-no-brainer-for-some-shareholders/

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 30 November 2018) is as follows:

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

² Fortescue shares sold on 31 August @ $3.84, loss of $852 realised. Re-invested in $3,148 Westpac @ $28.54.

³ Coles demerged from Wesfarmers on 21/11/18. Until exact proportions available, assume $0 cost base for Coles and original cost base for demerged Wesfarmers.

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.