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.
About the Author
Steven Everett is a Portfolio Manager for Belvedere Share Managers. Specialising in emerging sectors particularly technology, Steven is also a guest presenter on Sky News Business.
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.