With the ASX and Wall Street hitting record highs, our portfolios continued to surge in July. Record low interest rates have fuelled the demand for defensive stocks, allowing our income portfolio to return more than 22% this year.

In the seventh review for 2019, we look at how our model income and growth portfolios performed in July.

The purpose of these portfolios is to demonstrate an approach to equity portfolio construction. As the rule sets applied are of critical importance, we provide a quick recap on these. Also, it is important to note that these portfolios are designed as “long only”. They don’t allocate to “cash” and don’t represent a view about the outright direction of the market.

Portfolio recap

In January, we made some adjustments to our Australian share ‘Income Portfolio’ and ‘Growth Portfolio’ (see https://switzersuperreport.com.au/here-are-our-portfolios-for-2019/ )

The construction rules for the portfolios are:

• we use a ‘top down approach’ looking at the prospects for each of the industry sectors;
• for the income portfolio, we introduce 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 18.9%, and under this rule, our possible portfolio weighting is in the range from 12.6% to 25.2% (i.e. plus or minus one third or 6.3%);
• 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 were our predominant investment themes for 2019, which we expected to be:

• Economic growth to slow in the USA, Europe, China and Japan, but not into recession territory;
• The US Fed moving to a more neutral stance on US interest rates. If not pausing, only one or two more hikes in 2019 (but no expectation of rate decreases);
• Interest rates in Australia to remain at historically low levels, with the RBA unlikely to move rates higher (but again, no expectation of rate decreases);
• Aussie dollar around  0.75 US cents, but with risk of breaking down if the US dollar firms;
• Oil price remaining well supported around US$50 per barrel. Base metal and iron ore prices to soften;
• A positive lead from the US markets;
• Growth in Australia  to ease to around 2.5%, with no real pick-up in domestic inflation;
• Housing prices in Australia to ease moderately, but not collapse.

How did our portfolios perform?

The income portfolio is up by 22.39% and the growth oriented portfolio by 18.87% (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 0.84% and the growth oriented portfolio by 4.38%.
 

Green everywhere as all sectors positive

All industry sectors finished in the “green” for the month of July. They are also all positive for 2019, with a surprisingly small difference by historical standards between the best performing sector, communication services at 35.6%, and the worst performing sector, utilities, at 15.9%.

After communication services (which is largely down to Telstra), the next best performing sector is IT at 31.7%. This is mainly due to the performance of the WAAAX stocks (WiseTech, Afterpay, Altium, Appen and Xero), offset by the performance of Link. Materials, driven by the surge in iron ore and gold prices, is third at 27.9%.

The largest sector by market capitalisation, financials, with a weighting of 31.6% of the S&P/ASX 200, has lagged the broader market and returned 19.5%. Utilities and energy make up the bottom two sectors, a function of an oil price that hasn’t made much headway and concerns about the electricity market.

Consumer staples was the best performing sector in July surging by 9.8%. This was driven by renewed interest in “defensive” stocks such as Woolworths and Coles, and a boost in support for A2 Milk. Healthcare was second at 5.9%. One interesting feature in July was the relative outperformance of small cap stock, and relative underperformance of the top 20 stocks.

Returns for the 11 industry sectors in July and calendar 2019, plus their respecting weighting as part of the ASX 200, are shown in the table below.
 

Income portfolio

On a sector basis, the income portfolio is moderately overweight financials and utilities, and underweight materials and health care (where there are no medium or high yielding stocks in the ASX 100). Otherwise, the sector biases are reasonably minor.

On paper, it is roughly index weight in industrials. However, this exposure is being taken through toll road operator Transurban which is not your typical industrial stock.

In the expectation that interest rates in Australia are staying at record low levels, it has a defensive orientation and a bias to yield style stocks. In a bull market, we expect that the income portfolio will underperform relative to the broader market 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 yield 5.78%, franked to 82.3%. The forecast yield is higher than would normally be expected due to the payment by BHP of a special dividend of $1.42 per share. When this is excluded, the yield drops back to 5.49%.

In July, the income portfolio returned 2.24% for a relative under-performance of 0.70%. Year to date, it has returned 22.39% for a relative underperformance of 0.84%.

The return includes both capital and income. On the income side, the return (which takes into account dividends that the portfolio is contractually entitled to) is currently 3.38%, franked at 85.6%.

Helping in July was the performance of the consumer staples and consumer discretionary sectors, resulting in strong gains for Woolworth, Wesfarmers and JB Hi-Fi, and ongoing interest in “interest rate  defensives” such as Transurban. Offsetting this was a mixed performance by the major banks, weakness with Woodside  and a pullback with the major material companies.

No changes to the portfolio are contemplated at this point in time. If it wasn’t a ‘long-only’ portfolio, we would probably take some profits and weight towards cash. We are watching the position in Link closely and will review following their half year report (due 29 August). Woolworths is expensive and if there was a ready substitute at a reasonable price, we would probably swap it out.

The income-biased portfolio per $100,000 invested (using prices as at the close of business on 31 July  2019) is as follows:

¹Does not include the tax benefit of accepting the Woolworths off-market share buyback

Growth portfolio

The growth portfolio is moderately overweight financials and energy, and underweight materials, consumer staples 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.

In July, the portfolio returned 2.69% for a relative underperformance of 0.35%. Year to date, it has returned 18.87 for an underperformance of 4.38%.

Assisting the performance in July was the strong gains made by CSL, Wesfarmers, JB Hi-Fi and TPG. Offsetting this was a mixed performance by the major banks, Woodside following the release of a weak  production report and a pullback with the large iron producers Rio and BHP.

The changes made to the portfolio in May (cutting the position in Challenger, taking profit on Aristocrat and replacing with Bluescope, NAB and CSL) have been largely successful.

Most of the underperformance in 2019 is due to 3 stocks – Link, Reliance and Challenger. In the case of Link, we are watching closely and will review following their half year report (due 29 August). No changes to the portfolio are proposed at this point in time, although if the portfolio could hold cash, we would do some limited profit taking and build up the cash reserves.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 31 July 2019) is as follows:

¹ Aristocrat ($4,000) purchased 1/1/19 @ $21.84, sold 31/5/19 @ $29.12 for profit of $1,333
² Challenger ($4,000) purchased 1/1/19 @ $9.49, sold 31/5/19 @ $8.07 for loss of $599
³ Following sale of Aristocrat and Challenger, proceeds re-invested on 31/5/19 into $3,734 NAB @ $26.49, $2,000 CSL @ $205.49 and $3,000 Bluescope @ $10.54.

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.