Diversified Portfolios - Intelligent Investor Equity Income - 30 September 2016

COMMENTARY

PORTFOLIO COMMENTARY

Commentary PORTFOLIO COMMENTARY What a difference a few months makes. Markets took a hammering right at the end of the 2016 financial year thanks to the Brits’ decision to leave the European Union, but three months of mostly sober reflection have reassured investors that the world is not about to end. The ‘flash crash’ in early October – where sterling fell 6% against the US dollar in a matter of minutes – shows that the UK isn’t out of the woods, but markets are taking the view that any damage is likely to be contained. Meanwhile, the greater threat to global stability – a Trump presidency – appears to be receding.

The All Ordinaries Index gained 5.3% for the three months to 30 September, but our Equity Income Portfolio came in well ahead of that, with a return of 11.4%. Since it opened its doors to investment in July 2015, it has generated an annualised return of 19.6%, compared to 5.9% for the All Ords; and since inception as a model portfolio 15 years ago it has returned 13.7% a year compared to 7.9% a year for the All Ords.

Two of the portfolio’s top four performers for the September quarter came from the mining sector. South32 topped the list with a return of 57% as investors anticipated and were delivered an excellent full-year result. Although the miner reported a headline loss of US$1.6bn, it was mostly due to asset writedowns and operating cash flow actually jumped more than 50% to over US1bn.

South32’s former parent, BHP, also had a strong quarter, returning 21% despite a headline loss for 2016 of US$6.4bn. As with South32, the loss was due to writedowns forced by past mistakes of capital allocation, but the underlying net profit of US$1.2bn was a decent effort given weak commodity prices. New management continues to make strides at recuperating the big miner.

The portfolio’s other top performers were Monash IVF and Ansell, with gains of 38%and 28% respectively. Both companies reported full-year results that suggested past difficulties were behind them.

Monash reported a 12% increase in IVF cycles in Australia, increasing its market share from 23% to 24%, and a 10% increase in cycles in its nascent Malaysian business. Price rises meant that revenue rose 25%, while a slower rate of cost growth meant that net profit increased by 35%.

Ansell, on the other hand, was going backwards, with revenue falling 4% and net profit down 15%. That was, however, at the upper end of the guidance provided in February, which caused the stock to fall 20% and prompted us to buy it. Growth is expected to return this year and the market also cheered plans to sell the company’s condoms division to focus on its other operations (mostly gloves) that sell to businesses rather than consumers.

The only significant faller in the quarter was OzForex (formerly OzForex), which lost 18% as investors fretted over increased competition in international payments –including an agreement between CBA and the UK’s Barclays Bank – and potential disruption from ‘blockchain’ technology. OzForex was another significant faller, losing 18% as investors fretted over increased competition in international payments –including an agreement between CBA and the UK’s Barclays Bank – and potential disruption from blockchain technology. Again, given the risks involved we’re content to sit on our hands.

On 1 September we reduced some of our largest holdings – Trade Me by 2.0 percentage points to 6.6% (at $5.32), and ASX (at $51.51) and Virtus Health (at $7.92) each by 1.0 percentage points, to 6.3% and 4.3% respectively. The funds (and some cash) were used to increase our holdings in Commonwealth Bank by 3.0 percentage points to 5.2% (at $71.60) and Westpac by 1.5 percentage points to 3.8% (at $29.55).

We remain very comfortable with Trade Me, but it’s weighting (at 8.6%) had moved well beyond our 6% recommended maximum.

GROWTH OF $10,000

Income Reinvested

PEFORMANCE SUMMARY TO 30 SEPTEMBER 2016

Source: Praemium, RBA. Returns are before expenses and fees. Returns are shown as annualised if the period is over 1 year. * Since Inception (SI) date is 1 July 2015.

Commonwealth Bank and Westpac offer reasonable value at current prices and are particularly suited to an income-focused portfolio due to their high fully franked dividend yields.

In spite of the excitement around Brexit and Trump, the greatest short-term threat for our portfolios – as for markets generally – is that interest rate expectations start to creep up. That would force investors to raise the ‘opportunity cost’ they put into their valuation models and knock down their valuations accordingly.

The good news is that any increase in rate expectations is likely to be accompanied by improved prospects for growth. Both our portfolios are largely comprised of stocks that add value and enjoy plenty of pricing power, and that should enable them to take their share of any growth that eventuates.

As ever, the sharemarket could see some sharp movements in the short term as investors adjust their expectations for rates and growth. But that’s the penalty for being in an asset class that tends to outperform others over the long term. We see no reason for that to change.

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