Originally emailed to our mailing list on Friday December 14, 2018
The last few months has seen global stock markets more or less crash, resulting in many of our top 50 stocks trading at over 30% lower than they were earlier in the year and in a number of cases at or near 5-year lows. The question is what now and which stocks to buy or sell?
The fall has been across all sectors and global. This has been caused by the perfect storm of Geopolitical worries including escalating trade wars, Trump investigations, Brexit, Saudi Arabia, Italy and Russia. On the top of these concerns, US bond rates were moving higher and there were concerns the US Fed would raise rates too quickly tipping the US into recession, neither of which have happened.
These are the reasons Belvedere Share Managers is accumulating for portfolios.
1. Many companies are trading so far below their fair value and offering over 8 per cent gross dividend yields which is ridiculously high.
2. The first and largest cause for the correction was the fear of the Fed and bond rates. Over the last few weeks, US 10-year rates have pulled back from over 3.25 per cent to 3 per cent and the Fed commentary has been far more accommodating. These changes are significant.
3. This week’s geopolitical news has been absorbed by the US market without dispute. On Monday, the UK Parliament’s decision on Brexit would normally have sent markets down, yet the US and others are up. The same could be said for the arrest of China’s Huawei CFO by Canada at the request of the US
4. In the last few weeks, even though the market has continued to slide, the volumes traded in the US were very low. This technically this indicates that selling has slowed.
5. As many companies are trading way below their fair value, it will not take much for the buyers to re-enter the market resulting a significant and potentially steep bounce.The extent to which the market has dropped, has taken us and most other investment companies by surprise. We began adding to our portfolios when we saw individual company prices fall over 20 per cent, to now being down on those purchases. The companies we liked then, have only become cheaper without any deterioration in their business. No one likes catching a falling knife but these opportunities only present themselves in times of fear and no one knows how long they will be available at those prices.
We are about to embark on a very different era for investing in Australia and across the globe. As we near the close of 2018 our firm paused to reflect on the year and in doing so, it became clear just how much has happened and the profound effect it is likely to have on our economy moving forward. This isn’t to say that we expect things to be worse or better for the next two to three years, just different.
This year we have witnessed an unprecedented series of events unfold both at home and abroad. Trade wars, Brexit, the Royal Commission, Korean nuclear threats and to finish it all off; rioting in the streets of France. With all that has happened, it is no wonder that markets have been a little nervous coming into final months of the year.
Despite the uncertainty, there is one thing we can be absolutely sure of. The world will not end. Consumers will continue to consume products, countries will continue to trade, and we will of course be required to pay our taxes. Unfortunately, the evolution of the local and global economy means that the way we are used to investing isn’t going to produce the same results moving forward. Let me explain:
Active vs Passive debate to take full swing.
Proponents of passive management have enjoyed fortuitous conditions since as early as 2011. Despite a little bump in 2015, most global markets including the ASX have enjoyed very steady consistent growth. The same can be said for the Australian property market. It didn’t really matter what you were invested in or where, it was very likely that it would be worth more in one year than what you had paid for it. This gave weight to the passive management argument, “why pay for active management fees when decent returns could be gained through low cost index investing?”
Unfortunately, this theory is already and will continue to be heavily tested. Property prices in Sydney and Melbourne are already down circa 10% and of the top ten companies on the ASX, which make up 38% of the index, only half recorded a positive 12 months shareholder return. The same can be said in the U.S where the likes of Apple, Amazon, Facebook and JP Morgan which make up a fair proportion of the index have also given back much of the gains earned during the year.
Interestingly, for most of the companies experiencing share price pressure the cause was well telegraphed. Most active managers, many of whom had struggled to outperform the index funds (after fees) during the broad-spectrum bull market had lightened their exposure in anticipation of the recent correction. This is not to say that we expect all active managers to outperform in the coming years, some will perform, some won’t. I do expect however that as the world continues to evolve and markets are disrupted by changing trends that returns for index funds will likely be underwhelming.
The D.I.Y model could be more stress and work than it is worth
Access to information via the internet has made it possible for many to undertake research and create their own investment portfolios. Mostly this lead to a concentrated portfolio consisting of the four big banks, Telstra, BHP, RIO and maybe Origin or Santos. The reason being that it is terribly difficult to effectively monitor any more than 10 investments while trying to juggle work, family or enjoy retirement.
For the period leading up to early this year, that strategy could produce a modest return. I remember presenting at a conference in early 2017 when someone in the audience asked, “why would I want to pay an active manager a fee when I can just buy the four banks and Telstra and get a 6% dividend yield?” My answer at the time was that although they are large ‘blue-chip’ companies and seem like a balanced risk, the concentration of the portfolio is significantly adding to that risk by not properly diversifying the investments. Supporting that answer is the fact that as I write this, the capital value of that portfolio would be down circa 23%.
The key to managing risk is proper diversification but this can be difficult. Even in an age where information is at our fingertips and plentiful, we need to consider the quality of that information. Competition for website clicks and digital media subscriptions has forced content producers to choose quantity over quality often behaving like seagulls at the beach, just trying to squawk a little louder than the others in the hope they might end up with a free chip.
Even with company announcements and annual reports, the devil is in the detail. As we have seen with the likes of AMP, Myer and a few other boards that received protest votes from investors at their annual general meetings, no longer can we simply take the word of management as gospel and each report requires careful analysis and interpretation to ensure that the performance of the business is in accordance with what is being reported by the board.
Sitting on cash still not a viable alternative.
Despite the rhetoric from the FED and RBA, interest rate rises are still some way off. With inflation still sitting at around 2.5%, and term deposit rates at 2% doing nothing comes at a cost. Additionally, who wants to lend money to the banks at 2% just so they can lend it back to us at 4%? The other common practice was to just pay off the family home but given the definite turn in the property price cycle, capital growth of the family home is likely to be flat or negative for the foreseeable future and given that interest rates are still only 4% versus the nearly 8% currently on offer from companies trading at near 5-year lows you could argue that the risk of equities is being adequately rewarded. There are many alternatives in between also for those who aren’t particularly comfortable with the risk of direct shares like bonds and hybrids which offer a greater return then term deposits.
In conclusion, if ever there was a time to review the investment strategy this is probably it. With the right advice and the right strategy, there is plenty of opportunity on offer in both property, bonds and shares.
Corrections such as the markets experienced in October are never nice but they are part and parcel of live markets and have to be accepted and taken advantage of. When prices are falling, sentiment turns negative and human nature prevents most from buying. Even for professional investors it is not easy buying when in all likelihood the stock will be down further the next day, but that it is exactly what we do. It is pleasing to write this following a big lift in US Markets following their mid- term elections.
When good companies are down 20 plus per cent on general market sentiment then they are on our buy radar. We know that we will not pick the exact bottom, but we are buying well. A recent example of this is a company called Reliance Worldwide which created a plumbing product that is revolutionising the plumbing industry. In very simplistic terms, it invented, patented and now manufactures a ‘push to connect’ product for pipes (called “Sharkbite”), which enables plumbing without the need for welding. The big advantage – labour hours and costs are reduced dramatically and is applicable to the DIY and professional markets. Reliance has experienced tremendous growth here in Australia and is now rolling out into the US and recently acquired a large plumbing distribution business in Europe at a fair price. I am sure this distribution business will be used to escalate the roll-out of Sharkbite.
Shares pulled back from $6.50 to $5 and we started buying only to watch them briefly hit $4.60. It was only for a very short time and we expect them to continue rise over time to their previous highs. It is a good example of buying well, albeit not at the bottom.
Raphael Geminder took over the reigns from Malcolm Bundey in September this year.
Another example of buying a large quality industrial company after a sizable share price pullback is Pact Group, which is a packaging company with operations here and throughout Asia. Pact’s share price had fallen from $6 to $3.50 after a earnings miss predominantly caused by a rise in the resin costs used in packaging. These costs are ultimately passed on, however there is a timing issue and we believe the market over reacted in the sell down. Importantly, Pact chairman and major shareholder is Raphael Geminder of the Pratt Visy dynasty, who knows a thing or two about the packaging industry.
The well publicised practices of the banks and the wobbles in the residential property markets exacerbating the negative sentiment saw the prices of banks fall to a point where the grossed-up dividend yields were approaching circa 9 per cent. Updates from a number of the banks reaffirmed their dividends, and more importantly to us that their excess capital was better than what the market was anticipating. The only real risk to their business models is a very serious fall in the property prices across Australia. On balance, we don’t see a property crash ( over 30% )and they remain some of the strongest banks in the world operating in an oligopoly and offering an oversized yield.
In all likelihood the recent volatility will continue, and regardless of the short-term outcome, markets will always experience corrections. They are part and parcel of investing and are a reminder to stick with defined strategies.
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Rarely do you hear a fund manager talk about the ones they got wrong, however even the world’s best investors, including the great Warren Buffet, admit that a 60% success rate is about the industry standard. Regardless, when you are managing money on behalf of clients, it still makes you a little sick in the stomach when an investment underperforms to your expectations or externalities kick your carefully formulated assumptions to the kerb. Such was the case for me with Village Roadshow Limited.
In 2016 I bought Village after the share price fell from over $7 to just over $5 caused by the cyclical underperformance of the theme parks, accompanied with sector disruption in their film distribution business brought on by illegal downloading and low-cost media streaming. Conversely, their cinemas were producing record results despite vigorous competition from Hoyts who were doing their best to increase their market share in the sector. All things considered, the Company looked fundamentally very cheap. Trading at 5 times EV/EBITDA and paying a 5% dividend.
I saw a contrarian play.
I liked that the board (the Kirby Family) owned almost 50 per cent of the Company thereby having significant skin in the game and I expected the theme parks to benefit from a forecast fall in the Australian dollar, and the Commonwealth Games hosted in the Gold Coast in 2018.
Sadly, I was wrong.
Notwithstanding that there were some causes out of the management’s control (the Dreamworld Tragedy and questionable management of the Commonwealth Games by the Queensland Government), the reality was that the downgrades kept coming, the dividends ceased and the share price fell to $2. The bad news story reached a climax this week when the Company was forced to raise capital at $1.65 per share, a 77% discount to the January 2016 price when this story began.
Discussing the Village Roadshow Capital Raising with Ingrid Willinge on Sky News Business.
As a fund manager, you have to understand that scenarios just like this one have happened before, and will happen again but rather than dwell or make excuses I choose to reflect, analyse and dissect the investment and identify where the mistakes were made, so that I could leverage these experiences to make better decisions in the future. This particular reflection provided two key reminders:
1. The best laid plans need the right people to execute
Irrespective of the economic environment, even the best corporate strategies need the people behind them to execute them effectively. A management team that is focused, transparent, reliable and diligent will in most circumstances, outperform their peers in both good times and bad. When we invest in a company, we are essentially employing the management to look after our money, to make decisions every day that will enhance the value of the business.
Examples of businesses with quality management are Boral, Bluescope Steel, and AMA Group. In all cases the management are passionate about what they do, understand their respective businesses inside and out and this is portrayed every time they address their shareholders. Needless to say, I own shares in all of these companies.
2. Take the time to experience the business from the customer’s perspective
Such a simple rule but one that is often overlooked.
Fund managers can sometimes get too involved with the accounting, measuring performance on the financials alone and neglect to consider that it might just be good luck or a booming sector that gives the appearance of a high performing business. Perhaps it has simply not yet met a worthy competitor. As we embark on an age of disruption, customer experience is often the catalyst that will see an incumbent’s long-standing customer base, slowly venture over to the up-and-coming, especially in our world of social media and interconnectivity (where good news travels fast but bad news travels faster and further). It often isn’t long before the rest of the customer base is aware of the better option and decides to make the move also.
An example of this phenomenon is AfterPay. The buy now, pay later app has a simple, easy and efficient customer experience that for many is a perfect alternative to high interest credit cards with complex terms and conditions and onerous application processes. AfterPay has return over 200% this year and is one of the best performing stocks on the ASX despite trading at a multiple of over 10 times that of the banks it is pinching its customers from.
The same principle can be applied when deciding whether to pay a premium for a company that has the appearance of a high margin, recurring customer base. Although this might currently be the case, if the customer experience is poor you can bet your last dollar that other companies will try and coax away that customer base and if they are disgruntled, it won’t take a lot of effort. Before you know it, the incumbent is trying to win back their customers in the only way they can… with a lower price. It’s not always easy to experience the offering from every company in your portfolio, but it is worth the effort.
So, reflecting on the case of the ‘Village Roadshow Mistake’ it’s always painful to admit when you are wrong, but the reality is that as humans we are all bound to make mistakes. What defines us is not the mistakes we make but how we learn from them and apply that learning to what we do going forward. In this case, I have been reminded the utter importance of these two rules and even the most attractive fundamental valuation means nothing without quality management and exceptional customer experience.
At Belvedere, we manage portfolios which for the most part are relatively conservative, and invested across a range of companies that have a favourable outlook. From time to time specific trends occur in the market which can present opportunities for shorter term gains, albeit with risk. What has been increasing is the number of attempted takeovers leading to significant gain for current investors.
In most cases, the share price will start to move up on higher volumes of trading before the actual bid. There can be a rumour, as happened with Healthscope Hospitals; that smoke lead to fire and an offer being made the following week. It doesn’t always happen so, investors need to be comfortable holding the shares in what could be a problematic company. That is the risk/reward game.
Healthscope (HSO) – Daily Trading Chart
Very few people have commented upon this increase in takeover offers, most likely as it has not been concentrated in the one sector. The common thread is that the takeover offers are coming for companies that have been completely out of favour and trading at or near multi-year lows.
Consider the takeover offer for Santos, who’s share price had fallen from $12 to under $3 before the offer. That offer for almost $7 has since been knocked back as insufficient!
Healthscope Hospitals suffered a series of profit downgrades and like Santos was carrying high debt levels. The general market had virtually given up on the current management and the stock, when two consortia recognising the value in the hard assets made premium bids.
A cleverly named company, Here There and Everywhere (HT1) has an outdoor advertising and radio division which through a number of management mis-steps saw their share price smashed, only to lead to two competing companies making bids for their outdoor advertising division. This has caused a 30 per cent jump in the HT1 share price.
And most recently the owner of Sukin, BWX fell from $8 to $4.50 at which point management made a Management Buy-Out bid at $6.60. It is a solid company on an international growth path which was punished for a slight miss on a recent profit announcement.
The examples differ across industries, however each of the targets were very out of favour with the market which meant that they were so undervalued that they became targets. At Belvedere, we expect this to continue. There has never been more funding for Private Equity firms and we are now seeing international firms compete with local Private Equity firms. Finance is still very available (and cheap) for such transactions enabling Private Equity to leverage the takeover with a five-year timetable to fix whatever was the issue that had created the low share price.
We have been fortunate enough to have picked some of these opportunities, and are now very focused on identifying the next targets. Identifying take-over targets is a riskier strategy and requires significant in-depth analysis, as the reason the share prices are down are generally due to high debt levels, management failures, and or industry headwinds. However, when we allocate a small proportion of a balanced, diversified investment portfolio to potential takeover targets, the upside (if captured) can produce an outperforming portfolio.
The Banking Royal Commission shining a spotlight on financial advisers is no surprise to many. It is long overdue. My wife will attest that I have been on my high horse about this for decades. Worse still, previous enquiries failed to address the core conflict of interest. The issues are systemic.
The reason I say this I was part of it, until I couldn’t stand it any longer.
I started my career 30 years ago in banking and bank-owned financial service companies, culminating in being appointed, at different times the Managing Director of two large household name firms. At these firms I was responsible for 250 financial advisers and 500 support staff including Margin Lending and Compliance. These firms’ business models were typical in that they serviced retail and sophisticated clients. Despite the trappings of corporate life, I struggled with the culture and so moved on 18 years ago. I have been a principal of an independent financial services business ever since, operating with complete transparency with all clients. To do otherwise would compromise my values, which I am quite simply not prepared to do.
Author – David Manchee
The industry has evolved under the guise of “’compliance’ into a vertical integration of institutionally owned advisers selling institutionally owned administration platforms, administering institutionally owned fund managers. Of course, each charge their own fees, but that’s all in the fine print.
What could possibly go wrong? It turns out a great deal.
Advisers do not require any relevant education or experience. They simply act under a bank owned licence, and although the licence is bank owned it is not guaranteed by the bank. We’ve all heard and seen the advertisements with the laundry list of T&Cs. Further, the vast majority of advisers have nothing invested in shares or the funds they “advise” clients invest in.
The licensee (i.e the bank adviser) does not have to have Professional Indemnity Insurance. Yet I do as an independent.
The banks lobbied to the Federal Government that each licensee should have an approved list of investments so as to protect the end customers, recorded on an administrative platform. These are owned by the same bank. Of course, the administrative platform charges annual and transaction fees on top of the investment fees.
The approved lists issued to the licenced adviser and the associated administrative platform are of course dominated by funds that are in turn owned by the same bank, creating another revenue stream for the bank.
Why do I believe the issues are systemic? Apart from the arguments above, there are these additional frictions:
Advisers charge a fee ranging from $2000-$10,000 for their initial recommendation (called a statement of advice by ASIC). This fee is for what any other profession would call a quote for future services. It is a disgrace.
They then charge ongoing fees, annual review fees despite no investment changes, nor the adviser doing any investment transactions or administration.
The Rogue Adviser
Having managed large teams of advisers across Australia, the reality is that however good your compliance is, there will be a few advisers in the mix who operate outside the law, a number who skate on very thin ice and a reasonable percentage who are negligent and without empathy. Not to accept this reality is denying the sun will come up. Twenty years ago, we had the IT systems to track daily an individual adviser’s business and could investigate irregularities. It is then up to the firm the action taken to eradicate these people and send a strong message that such behaviour is not acceptable. In my case, I sacked a number of advisers, who turned up elsewhere; years later some were jailed for subsequent behaviour. At the time, I was chastised for losing a good producer!
AMP boss resigns following revelations of poor conduct
The banks’ administrative platforms were built to administer unlisted funds, many of which the bank owned. The platform provider also acts as a gatekeeper deciding which investment products can be administered on the platform and at what cost.
Fund management is a very expensive business to set up and scale is critical. For instance, each fund also pays trustee companies and custodians, which of course another division of the banks can supply. With the knowledge that a new fund will be approved and included on the platforms, it de-risks the launch if it is owned by the bank. This results in poor performing bank funds being left on the approved list for years precluding better performing or cheaper alternatives.
Despite the David Murray led enquiry some years ago heading towards the same conclusion, the bank lobbyists convinced the Government not to disband the vertical integration model, but instead to increase regulation and further ingrain the ‘approved product lists’. Of course, this has led to an even greater market share for the banks. A win-win for the banks. Too bad for the investors.
The banks and AMP’s business strategy is vertical integration with ingrained and hidden fees. Either their Boards have to admit they did not know their business model or they are complicit.
On the weekend, I noted a suggestion by Alan Kohler that all fees should be invoiced to the client, rather than hidden and automatically deducted. His rational was that this way each client would know exactly what they are paying at the start and every month thereafter. (i.e. transparent invoices would destroy hidden fees.)
This is the basis of the investment management firms I started independently 18 years ago and still practice today. It is fair, and it is the right thing to do. Belvedere Share Managers will never be big, but I can walk down any street and keep my head high. I welcome a conversation with anyone about their investments, and hey the good news is I don’t charge any fees to have a chat!
This morning Bill Shorten revealed his latest attack on the retirement savings of Australia’s self funded pensioners, proposing an amendment to the dividends and input tax credit rules. The change would see the tax refund normally returned to superannuation funds slipped unscrupulously into the coffers of a Labor government if elected.
Banks and corporations raise money by issuing Income Securities (technically floating rate preference shares, convertibles or notes), which then trade on the ASX. Such securities offer a quarterly return above the 90 day bank bill rate through distributions that have been already taxed at the company tax rate (typically 30%).
For example – a hypothetical fully franked distribution of $100 would carry with it a credit of $42.86 for tax paid. Super funds in pension mode paying no tax, and funds in accumulation phase paying 15% would receive a cash refund for this credit in excess of their respective tax rate.
The better than bank interest return from these securities coupled with the liquidity of ASX listing, low volatility and low risk has made them popular with self-managed superannuation funds.
Labors policy to cancel the tax credit would mean that from July 2019, super funds will receive a lower return from the same security, entirely changing the risk/return metric and investment thesis.
In our opinion, the listed securities price will need to be discounted for the lower yield in 2019. Upon the announcement, we have sold all the listed securities/hybrids we had exposure to, as we believe the market will start to price this risk well beforehand.
The fact that we were able to move quickly and fluidly is just another example of the benefits our clients receive from professional management under the individually managed account structure.
Codan Limited today announced that they expect to outperform their FY18 profit guidance of $20-$25m. It was reported in the announcement that the Company will likely achieve a first half profit of around $15 million and that historically their second half profit exceeds that of the first.
I have been following Codan for some time and started buying in the past few weeks. Here are the reasons why Codan appealed to me as an invest-able Company:
1. The valuation is appealing
At the current price Codan trades at around 5 times EV/EBITDA and a price/earnings of circa 9 times. Acknowledging that the Company has experienced lumpy earnings over the years, these metrics are based on what management refer to as their “base-level” business and seems quite conservative.
2. Codan have been in business for over 50 years
The business was founded by three university buddies in 1959 and one of the founders is still the Company’s largest shareholder. This says to me that management and the board are experienced and prepared for changes in business cycles, as they have likely seen many over the years. Additionally, governments often look for long-standing ownership and management when awarding contracts because stability is an important factor given that government approval process can be lengthy, and trying to shift suppliers quickly if one were to fail to perform is difficult. Not surprisingly, Codan has standing contracts with the United States government, supplying military communication equipment.
3. Diversified portfolio of products
Last year’s record result was primarily attributed to their Minelab metal detectors and the overwhelming demand received from their expansion into the African market. Before making the decision to invest, I thought I would drop into the local gold prospecting equipment retailer and see what I could find out. The veteran shopkeeper had nothing but good things to say about the Minelab products, including their innovation, durability and after sales support. In his opinion they are the best currently on the market.
Other products include radio communication and defence electronics, but what I find more exciting is Minetec, a real-time underground scheduling and monitoring system that improves safety and productivity.
Recently there was speculation that the Company had landed a large mining player as a new Minetec customer, but the Company responded by saying that there were in negotiations but no agreement had been formed as yet.
4. Strong balance sheet
After a bumper result in FY17, the board decided to payout the excess cash generated to shareholders via a special dividend. Total dividends paid for the year were 13 cents per share. Given that the Company has no debt, another stellar result will likely result in the same outcome. Moelis seem to have the same opinion in their research report, forecasting a full year FY18 dividend of 10 cents per share or 4.6% based on yesterday’s closing price. Oh, and did I mention the Company has no debt.
I don’t think there is a lot of downside here, and that the only reason the share price isn’t higher is that this is a lesser known Company in what most would consider a boring industry.
It seems I am not the only one with this opinion, Cannacord Genuity recently produced a research report forecasting a full year 2018 net profit after tax of $31 million and I tend to agree, maybe even slightly higher. Like Moelis, Cannacord’s price target is $2.60.
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