Both our income and growth model portfolios posted moderate gains in July, notwithstanding that the Australian share market finished absolutely flat for the month. Year-to-date, the local share market continues to lag offshore markets, recording a total return of 3.15% for the first six months (0.97% before dividends).

The income portfolio has returned 2.17% this year, moderately underperforming the benchmark index by 0.98% in part due to its weighting in ‘top 20 stocks’. The growth portfolio has over the seven months exactly matched the performance of the index, with a return of 3.15%.

This is our seventh monthly portfolio review.

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-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 are our predominant investment themes for 2017, which we expect to be:

• Interest rates remaining at low levels, although some upward movement in bond rates;
• The US Fed likely to increase US interest rates by 0.75%, but probably no move in Australia by the RBA;
• The Australian dollar at around 0.70 to 0.75 US cents, but with risk of breaking down if the US dollar firms;
• Commodity prices remaining reasonably well supported;
• A positive lead from the US markets and President Trump;
• 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 2.17% and the growth-oriented portfolio by 3.15% (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 0.98% and the growth-oriented portfolio has exactly matched the index.

Share market flat in July as financials rally and heath care takes a breather

In somewhat of a first, the sharemarket finished absolutely flat in July. Rangebound, the market traded quietly, well supported around the 5675 level and well offered around the 5800 level. Despite the lack of overall movement, there were some major movements in the sectors.

The largest sector by market capitalisation, financials, with a weighting of 38.0%, added 1.3% in July following APRA’s confirmation on the capital levels that the major banks would need to target, which most analysts believe can now be achieved without the banks needing to conduct dilutive capital raisings. Year-to-date, financials have returned 2.5%, 0.7% below the overall market return.

Material stocks also enjoyed strong support as an improving outlook for world economic growth meant that iron ore and other metal prices remained well bid. The sector added 3.6% to be up by 5.7% since the start of the year.

Going the other way were health care stocks. Following a fabulous first six months, profit takers knocked the sector back by 7.5% to cut the year-to-date return to 14.0% – still the best performing sector. Some of the other high-performing sectors, such as utilities and industrials, also slipped during the month.

Telecommunications remains the worst performing sector this year, and following a further loss of 4.3% in July, is down by 16.3%.

The ‘top 20’ stocks did relatively better in July with a return of 1.1%, but continue to lag the overall market in 2017 with a return of 1.8%. The midcap 50, an index which represents stocks ranked 51^st to 100^th by market capitalisation, is up by 8.1% this year.

Sector returns for the month of July and since the start of the year are set out in the following table.

Income portfolio

The income portfolio is underweight material stocks and marginally overweight financial stocks. Otherwise, the sector biases are relatively small. We have avoided real estate (potential impact of higher interest rates, plus lack of franking on real estate investment trusts), and health care (low dividends and pricing multiples).

In a bull market, we expect that the income-biased portfolio will underperform relative to the S&P/ASX200 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.

It is forecast to generate a yield of 4.90% in 2017, franked to 87.3%. After the first seven months, it has returned as income $2,492 or a yield of 2.49%, franked to 87.7%. With second half dividends typically a little higher than the first half, it should marginally exceed the forecast.

Year-to-date, the income portfolio has returned 2.17% (including dividends) compared to the accumulation index return of 3.15%. This is a credible performance given that the portfolio has no health stocks (the best performing sector), and has a heavy concentration of top 20 stocks (the top 20 index has returned 1.8%). In what is proving to be a market of individual stocks rather than a stock market, the strong performances of Sydney Airport, Transurban and Boral are offsetting the performances of Brambles and Telstra.

No changes to the portfolio are contemplated at this point in time, although we are keeping the exposure to Brambles under close review. With the exception of ANZ, NAB and Westpac, all other constituents will file half year or full year reports in the reporting season over the next few weeks.

The income-biased portfolio per $100,000 invested (using prices as at the close of business on 31 July 2017) is as follows:

Click here for a larger version of the table.

Growth portfolio

A critical construction decision with the growth portfolio has been to take a neutral sector bias in the materials sector. This has led to the inclusion of Rio (along with BHP and Boral).

Overall, the sector biases are relatively small. Despite healthcare underperforming in 2016 and many of the stocks trading on high multiples, we believe that the tailwinds are so strong that our sector position is materially overweight.

The other overweight position is in telecommunications, the only negative performing sector in 2016. The major underweight positions are in real estate and consumer staples.

The stock selection is 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 are not surprised to see the Aussie dollar test 80 US cents due to the strength in commodity prices and less aggressive tightening stance by the US Federal Reserve, this assumption is clearly under pressure at the moment and may need to be re-assessed.

Year-to-date, the portfolio has returned 3.15%, exactly the same as the benchmark accumulation index. Similar to the income portfolio, this is a credible performance given the weighting in top 20 stocks. An overweight position in telecommunications has also impacted performance, offset by the overweight position in healthcare stocks.

In what is proving to be a market of individual stocks rather than a stock market, losses on stocks such as Brambles are compensated by gains on stocks such as Boral.

Mindful of the exposure to the retail sector, both direct and indirect, and the impact that concerns about the disruption being caused by nontraditional participants such as Amazon are having on performance, we reduced our exposure in May by exiting our holding in Westfield. This resulted in a loss of $384. Westfield was replaced in the portfolio by share registry and superannuation administrator, Link Group (ASX Code LNK), which in June announced the acquisition of Capita Asset Services and an entitlement issue.

In the meantime, we continue to keep positions in Wesfarmers and JB Hi-Fi under close watch.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 31 July 2017) is as follows:

¹ Position in Westfield realised on 31 May at $8.48 per share, leaving loss of $384. Balance of $3,616 invested in Link at $7.75 per share.
² Link 4:11 entitlement issue at $6.75 per share. Entitlements sold through institutional tender at $1.10 per entitlement.
³ Portfolio not able to participate in TPG 1:11.13 non renounceable entitlement offer at $5.25 per share

Click here for a larger version of the table.

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.