A strong final week helped our portfolios add around 1% in April, as the Australian market broke through 5900 and finished firmly in the black. For the first four months of 2017, both portfolios have returned more than 5%, despite having overweight positions in the worst performing sector, telecommunications.

This is our fourth monthly review. On a relative basis, the income portfolio has underperformed the index this year by 0.87% and the growth portfolio by 0.25%.

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 28 April is up by 5.03% and the growth-oriented portfolio by 5.65% (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 0.87% and the growth-oriented portfolio by 0.25%.

Financials lead, while telco crashes

The market, as measured by the S&P/ASX 200 index, added 1% in April, to be up by 5.9% this calendar year. This has largely been driven by the performance of the financials index, which includes the major banks and Macquarie, and insurers such as AMP and QBE. The biggest index on the ASX, which accounts for 39.2% of the market, it added another 1.9% in April to be up by 8% this year.

Health care continued its strong performance and is the best performing sector this year, with a return of 18.5%, reversing all the losses suffered in the final two quarters of 2016. Largely on the back of increased wholesale electricity prices and steadier bond yields, the utilities sector has also performed strongly.

The resources sectors, energy and materials, experienced negative returns in April as oil, iron ore and non-precious metal prices eased. Year-to-date, both these sectors are lagging the performance of the overall market, up by 2.6% and 1.6% respectively.

The telecommunications sector suffered a loss of 9.9% in the month following TPG’s announcement to build a fourth mobile network, and raise $400m through a dilutive rights issue. Telstra, which dominates the sector, saw its share price slip by 9.4% (down from $4.66 at the end of March to $4.22 at the end of April), while TPG finished at $5.90, a fall of 18%.

Sector returns for the month of April and since 1 January, 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).

The income portfolio is forecast to generate a yield of 4.90% in 2017, franked to 87.3%. The inclusion of Transurban and Sydney Airport, while adding to the defensive qualities of the portfolio, drags down the franking percentage.

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.

Year-to-date, the portfolio has returned 5.03% compared to the accumulation index return of 5.90%. While the portfolio has benefitted from its overweight position in financial stocks, it hasn’t been able to benefit from the health care sector, where it has zero exposure. The performances of Telstra and Brambles, the former due to revenue pressures from the impact of the NBN and the threat of increased competition from TPG, and the latter due to a downgrade in full year earnings, have also weighed on the portfolio.  Also, despite turning in one of the best results in the profit-reporting season, JB Hi-Fi has been impacted by the “Amazon” concerns that are affecting discretionary retailers. To some extent, these negative impacts have been offset by the performances of Transurban, Sydney Airport and AGL.

No changes to the portfolio are contemplated at this point in time, although we are keeping our exposure to Brambles and Telstra under close review.

The income-biased portfolio per $100,000 invested (using prices as at the close of business on 28 April 2017) is as follows:

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 health care 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 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.

Year-to-date, the portfolio has returned 5.65% compared to the accumulation index return of 5.90%. The overweight position in telecommunications, now an adjusted 6.5% compared to a benchmark of 3.5%, has impacted performance. TPG was hit by its dilutive rights issue to fund the acquisition of mobile spectrum (which we weren’t able to participate in, as the model portfolio doesn’t hold any cash and the issue is non-renounceable), while Telstra was also impacted. We are comfortable with the TPG position, but keeping the position in Telstra (which was essentially included to get to a neutral sector exposure) under close review.

Positions in Brambles and JB Hi-Fi are also impacting performance.

On the upside, the overweight position in health care is adding is adding to portfolio returns. CSL is up by 32% since the start of the year and is becoming very expensive.

No changes to the portfolio are contemplated at this point in time, although we are keeping our exposure to Brambles, Telstra and CSL under close review.

Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 28 April 2017) is as follows:

*  Portfolio not able to participate in TPG 1:11.13 non renounceable entitlement offer at $5.25 per share

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.