On the back of a post-election bounce and growing expectations of an interest rate cut, the Australian share market recorded a gain of 1.71% in May. This stood out from other global markets, with the lead US market falling by 6.35% (S&P 500). Our model portfolios tracked the market higher, recording gains for the fifth consecutive month.
We have made some changes to our growth portfolio, which are outlined below.
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.
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 18.5%, and under this rule, our possible portfolio weighting is in the range from 12.3% to 24.7% (i.e. plus or minus one third or 6.2%);
- 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;
- Interest rates in Australia to remain at historically low levels, with the RBA unlikely to move rates higher;
- AUD 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; and
- A federal election which may limit any market gains in the first half.
The income portfolio to 31 May is up by 15.93% and the growth-oriented portfolio by 13.42% (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 0.47% and the growth-oriented portfolio has underperformed by 2.04%.
Top 10 stocks lead in May
The biggest companies set the tone in May and this was reflected in the sector performances, with financials, materials, healthcare and communication services posting gains of over 2.5%. The major banks rallied following the election of the Morrison government, BHP and RIO continued to benefit from supply disruptions to iron ore, and Telstra remained well bid following confirmation of earnings guidance. CSL rose strongly to help lift the health care sector.
On the other side of the ledger, the high-flying information technology sector followed the lead of Wall Street and pulled back by 4.0%. It remains the best performing sector in calendar 2019 with a return of 24.1%.
Consumer staples also came under pressure as Woolworths completed its off-market share buyback and the market re-assessed the competitive forces at work in the supermarket sector. The energy sector eased as oil prices softened, while the real estate sector responded to the prospect of lower interest rates and added 2.8%.
All industry sectors are positive for the year. By historical standards, the gap between the best performing sector (information technology) and the worst performing sector (consumer staples) is relatively narrow. Returns for the 11 industry sectors in May and calendar 2019, plus their respecting weighting as part of the ASX 200, are shown in the table below.
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 May, the income portfolio returned 1.80% for a relative out-performance of 0.09%. Year to date, it has returned 15.93% for an outperformance of 0.47%.
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 2.98%, franked at 95.7%. Transurban, APA and Dexus are yet to declare their first half dividends.
Helping in May was the strong performance of the major banks, and “interest rate sensitive” defensives Transurban, APA and Dexus. Offsetting this was the performance of Link, which fell by 23% on 31 May following an earnings downgrade.
No changes to the portfolio are contemplated at this point in time, although we note that Transurban, JB Hi-Fi and Dexus are looking fully priced. We have decided to keep the position in Link, notwithstanding that there could be some more short-term market pain.
The portfolio was not able to participate in the Woolworths off-market share buyback, which would have been very attractive to zero rate and low rate taxpayers.
The income-biased portfolio per $100,000 invested (using prices as at the close of business on 31 May 2019) is as follows:
¹Does not include the tax benefit of accepting the Woolworths off-market share buyback
The growth portfolio is moderately overweight financials and energy, and underweight materials, consumer staples and real estate. Overall, the sector biases are not strong.
On paper, it is overweight consumer discretionary. Part of this exposure is through Aristocrat Leisure (which is servicing the gaming and gambling markets) and through conglomerate Wesfarmers.
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 May, the portfolio returned 0.58% for a relative underperformance of 1.13%. Year-to-date, it has returned 13.42% for an underperformance of 2.04%.
Gains by the banks, Seek and Aristocrat were offset by falls with Reliance, Link and TPG. The latter came following the rejection of the merger with Vodafone by the ACCC, while Link and Reliance issued profit downgrades and their prices slumped by around a quarter.
We have decided to make two changes to the portfolio. We propose to take the profit on Aristocrat Leisure (which is up 33% this year) and realise the loss on Challenger (where we can’t readily see a catalyst for re-rating in the short term). The net funds will be re-invested in NAB and CSL, and a new small position in Bluescope. We are going to maintain the holdings in Link and Reliance, which we believe provide scope for earnings growth in the medium term.
Our growth-oriented portfolio per $100,000 invested (using prices as at the close of business on 31 May 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.