A transcript of Wednesday's interview with funds manager Geoff Wilson

Michael Pascoe: Geoff Wilson, you’ve got a new book out, Masters of the Market, Secrets of Australia’s Leading Investors, but you’re also chairman and investment manager of one of the market’s biggest investment dogs. Is that an embarrassment?
Geoff Wilson: No, I mean I suppose you’re referring to the Wilson Investment Fund, which floated two years ago at $1 and now is trading at the low 90s. What we’ve actually delivered for investors over that period of time is '¦ currently they’ve got a yield of a little over 4% fully franked and the net asset backing has gone up to, I think last month’s one was, around $1.10.

Unfortunately for listed investment companies, marginal investors '” who play the market '”tend to be sellers of listed investment companies when the market is strong and buyers when the market is weak. The logic goes that when a market is running they’ll say, 'Look, I’ll buy Aristocrat at $2 and it goes to $10’. They want that direct exposure, and they actually probably want a fairly concentrated portfolio. But then when things go bad '” say they bought One.Tel at $13 and now it’s worth nothing '” they say, 'Well actually, maybe I actually do need a more diversified portfolio’. So we’re just going through the normal '¦ the early teething.

Same when we floated WAM Capital. We floated WAM Capital about six years ago and it traded down to a 20–25% discount to net tangible assets (NTA). After all the shareholders who didn’t know why they were there left, Wham actually gained a lot more shareholders and ended up going up to a high of a 15–20% premium to NTA. Now both those extremes are crazy. I mean in theory the assets are the assets and the companies over time should trade around the value of those assets.

MP: You’re a big fan of listed investment companies. You’re on the board of five, you run three of them. It’s easy to see the appeal from an investment manager’s point of view: the fees are locked in; the fees don’t leave. But from an investor’s point of view '” well, some people paid $1 two years ago; now they’re worth 91.5¢ and that’s propped up by a big share buyback. After two years it’s not a flash performance is it?

GW: No it’s not. I mean the fact is, it’s not a flash performance. The fact is the assets have actually gone up to about $1.10 and we’ve paid out, I think, about 7.5¢ in fully franked dividends over that period of time so you’ve got to add that into the equation. And in terms of listed investment companies as structures: when you start one, particularly if you’re a traditional listed investment company and you want to give the investors the capital gains tax benefits of being a traditional listed investment company, then you’re actually buying for a three to five-year view.

So if you believe the market’s not cheap, then there’s no use investing in the market because you’ve really got to take a three to five-year view, you have to buy a stock with the intention of holding it for a medium period of time. All the listed investment companies that floated around the time we did have had the same problem; the ones that floated earlier '” the AFICs and the Argos '” they already had their portfolios set, so the they’ve benefited from the rise in the market. We’re in the process of setting those portfolios, and when they are all close to fully invested then they should perform in line with the old sector or better, depending on the stock selection.

One of the important things about listed investment companies, which I don’t think people realise, is that it’s easy in a bull market and when you’re under-invested of course you’re going to underperform in a bull market. But they really show their true colours in a bear market.

The reason I like listed investment companies, and I’m a very strong believer in encouraging more to list, is because they are a great mechanism for investors that isn’t influenced by the inflow of money or the outflow of money. With a traditional fund, when the market’s hot all the retail investors put their money in and they are forced buyers at the top of the market; and when the market’s in the doldrums you tend to find the flow of money is out of those funds and they’re a forced seller at the bottom of the market. You actually want to be a seller at the top of the market and you want to be a buyer at the bottom of the market. When you’ve got a closed pool of capital, you can do that.

The last thing about listed investment companies: Merrill Lynch in the US did a study, I think about 10 years ago, that looked at them over a 50-year period and showed that over a long period of time they actually outperformed the open-ended pool capital by about 1–1.5% per annum.

MP: With that LIC bubble two years ago that you were happy to be part of it '” do they need to be rationalised though? Too many on the market sitting on too much cash '¦ too big a discount?

GW: Like any market, when we float a Wilson investment fund we expect that we’d raise $30–50 million and we were the first float after Promina. There hadn’t been a float for six months. The market had turned from the bottom in March 2003 and everyone was looking for somewhere to put their money. I think we had close to $200 million worth of demand and we ended up raising about $160 million. Then, like an efficient market, other managers saw that and came to the market and we ended up having a number of them. They will all be invested over time and should they be rationalised. I actually don’t think that will achieve much.

MP: In the meantime, people have been paid good fees for sitting on cash. Is that rational?

GW: The easiest thing a manager could do is to be fully invested on day one and then just ride the market. But what do investors want from the manager? They want the maximum return with the minimum risk, and if managers believe that sitting on cash is a better investment than investing in the equity market at various points in time '” or they can’t find stocks '” they should get paid to sit on cash because.

I’m a sizeable shareholder in the Wilson Investment Fund. I own about three million-odd units, which I’ve (a) bought in the IPO, and (b) bought them subsequently. To me it’s very important that I have a reasonable equity in the listed investment companies we manage because I feel the pain like the other investors. We’ve not focused on fees; that’s not our number-one driver because with the Wilson Investment Fund trading at a discount, we’ve actually bought back nearly 17% of the company and we’ll keep buying it back. Why? Because every share we buy at a discount to NTA boosts the NTA for the people who are in there for the medium to long term.

MP: Well that NTA of $1.10 last month '” it will be less than that this month. Over two years of the biggest bull market, one of the biggest bull markets we’ve ever seen, it’s not very good is it?

GW: Well actually it’s better than that if you put the dividends, the 6.5¢ of dividends, in there fully franked. No I mean it is a very average performance, but if you look at how much we had in equities and how much we had in cash, we still have a significant cash weighting. If we can’t find investments then we’re being prudent: shrinking the size of the fund by buying back shares at a discount to NTA and continuing to look for investment opportunities and investing when we find them.

MP: Well what are you looking at? What looks promising, or is it still a matter of sitting on a whole pile of cash?

GW: We’re now over 60% invested and when you’ve had a market that’s rallied, that at its peak was up 72%-odd and still up 66–67% from the bottom in March 2003, the odds would have to be that things are going to slow down and the risk is on the downside. We tend to focus on the mid and small-cap area. We’re still looking there. A couple of stocks that we’re having a good look at the moment is Carter Holt Harvey, with the potential play with Graeme Hart in there; and we’re trying to find a few more of the defensive sectors. We’re having a close look at Tattersall’s.

There are two big risks at the moment. One is that the market doesn’t deliver, or the earnings don’t come through as people are expecting. The second is obviously interest rates backing up. If we had a 2% increase in interest rates then in theory valuations or price/earnings multiples should contract by 25–30%. So it’s a big risk and you’ve just got to have that in the back of your mind.

MP: Do you think there is a potential for such a big rise in interest rates when Australia is so indebted?

GW: I actually think there is a big risk for a rise in interest rates. I was talking to an economist the other day and he said if you actually measured inflation like they used to measure inflation say 10 years ago, then inflation is running at close to 6–7%. Not the actual stated figure '” the government figure. What has that done? It’s transferred an enormous amount of wealth to the corporations at the expense of the worker. We’ve got a high oil price, high raw material prices, nearly full employment. You’d have to assume that there has to be inflation starting to creep in and if that’s the case then the risk is that interest rates back up further.

MP: So what do you invest in if you have that sort of a fear?

GW: Well we’re a very much bottom-up investor and we always look at stocks on a case-by-case basis. What we’re trying to do is find stocks that are, say, trading on a P/E of 10 and growing at 20% per annum '” a well-managed stock generating strong cash flow, and that just takes time and it takes time to find them.

MP: Your portfolio has quite a lot of quasi debt, quasi equity convertibles in it.

GW: The logic of having them in there was that when we were building the portfolio initially there’s no doubt that the investor '¦ what does the investor want? The investor wants a good yield, a growing yield and our plan was always to get 4% fully franked and then grow it from there. To build that yield we’ve actually taken the opportunity over the past two years to put in some of those fully franked high yielding hybrids. At the moment we won’t be adding to the hybrid sector of the portfolio; we’re just focusing on pure equity investments because the hybrids just help you with that run through '” the flow-through yield. But we’ve got enough in hybrids.

MP: But in a mature portfolio you looked at a percentage in hybrids.

GW: We’re looking to build the portfolio into three main groups. One is a yielding portion of the portfolio, and obviously we’re looking for as high a yield as possible there, and that’s from the 5% fully franked to, I think, our high one is 12% unfranked. That’s in the hybrid sector.

In the other two sectors, one is the research-driven investments, which I talked about earlier '” stocks that are growing their P/E and are well managed. We’re looking for a catalyst that’s going to change the valuation of those companies and that’s our entry point. The third area of the portfolio is what we call investment-driven, and that’s companies that have great franchises and are well managed. They tend to be the larger companies, and the companies that fit into that and that we’ve bought, include the Australian Stock Exchange and the Sydney Futures Exchange '” those type of businesses '” so it’s really those three pools what we’re focusing on to invest the money into.

MP: What happens to the capital value of those hybrids if you do get a rise in interest rates?

GW: In theory, the capital value declines with the rise in interest rates. But when we’ve looked at those hybrids, we’ve looked at holding them to fruition. The first lot '” actually the 12% hybrid that we’ve got, the convertible note '” that actually rolls off I think in March or April next year. We had a position in Harvey World Travel, which got taken over, so as companies get taken over and the hybrids get converted, then it actually gives us more cash and, in theory from the takeovers, it gives us more flexibility to pay out high dividends as well.

MP: The correction we’ve seen in the market the past couple of weeks '” do you see it going further?

GW: Yes. I think there is still sizeable risk to the market. Two or three weeks ago it was just getting ridiculous. Where you were having companies that were uranium companies, or companies that were announcing that they had gone into uranium mining '” what’s that one, Fast Scout '” going from 2¢ to 15¢ in two days. The stock had rallied up to 21¢ and they did a placement at 18¢, and they came back on at 24¢. I mean that’s real bubble territory and at least some of those excesses have been taken out of the market. I still think that [the correction] has just taken the extremes out. I still think there is quite a bit of risk in the market, particularly if there is any potential for interest rates to back up.

MP: Isn’t that something of a “hot snow” load though, on the idea of a 2% rise in interest rates. The impact on the economy would be such that the Reserve Bank really doesn’t want to cause a recession.

GW: No, I agree with that, but always in the back of my mind is interest rates backing up, because I remember rolling a mortgage in 1982 at 17%. I’d just started as an analyst at Potters then and I think the average multiple for the market was 6 or 7 times, and there’s a direct correlation between market P/Es and interest rates, so you’ve always got to have at the back of your mind that if interest rates back up then P/Es are going to decline and that will be brutal for the market. Over the past 20 years we’ve seen a secular decline in interest rates, which has corresponded to a secular expansion in P/Es, so I think it’s incredibly important to always be aware of interest rates and have it in the back of your mind.

MP: When you’re looking for companies to invest in, is that part of the criteria '” how they would handle an interest rate rise?

GW: Definitely, but also you’re looking for companies whose profitability is running below trend. Over the past 12 to 24 months most companies’ profitability is above trend, and so therefore the risk is that at some point profitability will go back to trend and if that occurs you could get hit with a double-whammy: you get hit with the profitability coming back to trend, so a reduction in profit; but also if there’s a reduction in profit then the market tends to reduce their P/Es because the growth they’ve extrapolated out isn’t going to be met.

MP: How do you see the Australian market at the moment, compared with international alternatives?

GW: The international alternatives are looking quite good at the moment. One of the big drivers of the Australian market is compulsory superannuation, so when you look on a global basis you’re actually seeing companies in Australia that are trading on higher P/Es than elsewhere in the world. If you go back 10 or 15 years, it was actually the complete opposite, where global companies traded on much higher multiples than the Australian equivalent.