A choppy end of financial year saw the market close with a tiny gain in June. In 2017, the Australian sharemarket continued to lag offshore markets, recording a total return of 3.2% for the first six months (1.0% before dividends).

Our model share portfolios (income and growth) have produced positive returns this calendar year, although in part due to their weighting in ‘top 20 stocks’, have moderately underperformed. On a relative basis, the income portfolio has underperformed the index this year by 1.70% and the growth portfolio by 0.21%.

This is our sixth 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 30 June is up by 1.46% and the growth-oriented portfolio by 2.95% (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 1.70% and the growth-oriented portfolio by 0.21%.

Real estate and energy down, health care up in June

In the lead up to the end of the financial year, the market traded erratically. Overall, it finished with a tiny loss of six index points, before dividends pushed it back into the black to record a gain of 0.2%. Year-to-date with dividends, the market is up by 3.2%.

While at a headline level the real estate and energy sectors suffered losses while health care was the major winner, this disguised somewhat of a broader trend, which saw profit-taking/switching out of the interest rate defensive sectors (real estate, utilities, some industrial stocks, such as Sydney Airport and Transurban) into sectors that will benefit out of higher interest rates (financials) or respond to improving global growth prospects (materials).

The largest sector by market capitalization, financials, with a weighting of 37.5%, added 1.6% in June and is now marginally positive for the year. The second largest, materials, is also positive with a year-to-date return of 2.1%. Both sectors, however, trail the overall market return.

Health care, with a return of 23.2%, is the best performing sector in 2017. Telecommunications remains the worst performing sector, and following a loss in June of 1.5%, is down by 12.5%.

The top 20 stocks continued to lag the overall market – down by 0.1% in the month and up by just 0.7% in 2017. The midcap 50, an index that represents stocks ranked 51^st to 100 by market capitalization, returned 1.7% and is up by just under 10% this year.

Sector returns for the month of June 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 six 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 1.46% (including dividends) compared to the accumulation index return of 3.16%. 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 only returned 0.7%). 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 JB Hi-Fi, Brambles and Telstra.

No changes to the portfolio are contemplated at this point in time, although we are keeping the exposures to JB Hi-Fi and Brambles under close review.

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

Year-to-date, the portfolio has returned 2.95% compared to the accumulation index return of 3.16%. 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 health care stocks.

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

Mindful of the exposure to the retail sector, both direct and indirect, and the impact that concerns about the disruption being caused by non-traditional participants such as Amazon is 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 to raise $883m.

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 30 June 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 4:11 entitlement issue at $6.75 per shares, trading under stock code LNKR

³ 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.