Concerns about the US Presidential Election helped to drive the Australian sharemarket lower in October. It lost 2.2% in the month, as investors also factored in an increase in US interest rates later this year.

Both our income and growth oriented portfolios performed better than the market in October. The income portfolio has increased its relative outperformance to 3.17% and has returned 7.17% this year, while the underperformance of the growth portfolio has narrowed to 0.86%.

At the end of October, we made a couple of small changes to the income portfolio.

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

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 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 October is up by 7.17% and the growth oriented portfolio by 3.14% (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 3.17% and the growth oriented portfolio has underperformed by 0.86%.

 

Materials sector continues to star

Most sectors finished in the red in October. The sectors that have benefitted most from lower interest rates such as utilities, real estate and telecommunications (which is mainly Telstra) continued to give back some of their gains as investors became more comfortable about an increase in US interest rates and started to think that the Australian interest rate cycle has bottomed. The real estate sector, for example, lost 7.5% in the month, reducing year-to-date gains to just 4.5%.

Some of the better performing growth sectors over the last couple of years, such as healthcare and consumer discretionary, were also hit. The healthcare sector lost 8.3% in October.

On the back of higher iron ore, copper and coal prices, the materials sector continued to make progress. Although only up 1.3% in the month, it remains the best performing sector in 2016 with a return of 34.2%.

The largest sector by weighting of the S&P/ASX 200, the financials sector, also finished marginally higher. The prospect of higher interest rates, together with an improving credit situation, is providing support to the major banks.

Income Portfolio

The income portfolio started the year underweight materials stocks and overweight financial stocks. Otherwise, the sector biases were relatively small.

Strong performances from some of the more defensive stocks such as Medibank and Dexus (now both realised), as well as from the exposure to the materials sector through BHP, have offset the losses on our holdings in the major banks. JB Hi-Fi has also performed strongly, helping the portfolio to outperform the index by more than 3%.

At the end of May, we crystalised the gain on Medibank and re-invested the proceeds into $2,442 BHP and $5,000 ASX Limited. The BHP purchase reduced the underweight position in materials by lifting the sector exposure to around 12.6%.

During September, JB Hi-Fi completed an entitlement issue to fund the purchase of the Good Guys retailing chain. As the model portfolio is fully invested, we assume that the entitlement was sold at on the last trading day.

In anticipation that we are moving into a period of higher interest rates and that property trusts are fully priced, we realised our profit on Dexus at the end of October. The net sum of $8,344 has been reinvested into $5,000 Transurban and $3,344 National Australia Bank.

The portfolio is forecast to generate a yield of 5.26% in 2016, franked to 84.2%. Currently, it has generated an income return of 3.91% franked to 89.6%. Despite the portfolio changes, we expect that when the final dividends on stocks such as ANZ, NAB, Westpac, Sydney Airport and Transurban are declared, the forecast will be met.

Our income biased portfolio per $100,000 invested (using prices as at the close of business on 31 October 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.

*** JB Hi-Fi entitlements on 1:6.6 basis, assumed to be sold on last day of trading (23/9) at $3.02

**** Sales of Dexus at $8.94 on 31/10/16. Proceeds of $8,344 reinvested in $3,344 NAB @ $28.00 per share (cum-dividend), and $5,000 Transurban at $10.39 per share.

Growth Portfolio

The growth portfolio, when set up, was 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 elected to maintain an overweight position as the demographic factors are so strong.

At the end of May, we crystalised the loss on our Flight Centre holding and re-invested the net proceeds of $3,170 into $2,000 BHP shares (which lifted the weighting in material stocks to 12.6%), and $1,170 into Macquarie.

During September, JB Hi-Fi completed an entitlement issue to fund the purchase of the Good Guys retailing chain. As the model portfolio is fully invested and doesn’t hold cash, we assume that the entitlement was sold on the last trading day.

While the portfolio has improved its relative performance compared to the index, it is still down by 0.9%. This is partly due to its bias with top 20 stocks. Also, the stock selection of BT Investment Management, Flight Centre (realised) and Westfield (compared to the traditional A-REITS) has impacted performance.

No 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 October 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.

*** JB Hi-Fi entitlements on 1:6.6 basis, assumed to be sold on last day of trading (23/9) at $3.02

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.