Banking on long-term value

Westpac retains a spot in our model growth portfolio after posting a solid half-year result in a tough market.

PORTFOLIO POINT: In the first update on our new model growth portfolio, Westpac’s half-year results are put under the microscope.

As you know, I have launched two model stock portfolios for Eureka subscribers – the value growth portfolio and the value income portfolio.

I have decided to do so not because I’m responding to a theoretical need for such a facility; rather I’m doing it because, in the real world, investors desire and need different portfolio arrangements at different times of their lives.

There are, of course, some arguments against the idea of such a split. However, there is equally a mountain of evidence that says that as you grow older, you are less likely to need risk and growth-style assets. Rather, you require capital maintenance and income.

Indeed in business, as opposed to retirement investing, this is also the case. Consider Berkshire Hathaway, which owns one of the world’s largest insurance companies. To run this business, it must have an income portfolio that matches the actuarially-assessed claims of its insurance business. It is not unlike the requirement of ageing investors who need income to match their liabilities (expenses), ideally without eating into their capital. My model income portfolio was designed for this type of person.

What’s more, the arguments which criticise the notion of income and growth portfolios are simply too narrow. This is because they mistakenly focus on listed equities and ignore the other listed securities issued by excellent Australian companies. When we delve into the listed securities market, our universe of opportunity includes listed ordinary shares, preference shares, convertible notes, options, debt securities, property trusts, infrastructure trusts and hybrids. From these, we design a value growth portfolio focused on equity-type investments and an income portfolio focused on all those other securities that theorists often do not acknowledge.

Thus my plan for Eureka subscribers is to reveal to them the wider world of investing, especially in the income portfolio where we delve deeply into a range of fixed-interest and hybrid securities, which are ever more important in this post-GFC climate. My philosophy does not promote a box-fitting approach to portfolio construction.

By utilising a value-based methodology and identifying good companies offered in the market at a discount to value using MyClime, my growth portfolio should be able to achieve the fairly moderate feat of achieving at least a 10% p.a. compounding return over three to five years. My target return for the value income portfolio, which focuses on income-type securities, is 8% p.a. compounding over three to five years.

What is value-based investing?

The description "value-based" does require further explanation, as it is a much used and abused term in investment markets. Indeed, in a simplistic sense, most investors believe they are value investors. This is because, in the main, a purchaser of an investment asset is generally buying securities which they believe are undervalued. That is logical, for why else would you buy a security? However, where "value-based" becomes misused or abused is where an investor does not have a logical or consistent approach in assessing value. Beauty may be in the eye of the beholder, but the assessment of value of an investment asset is not!

It is therefore important to understand that the market price of a security at any point, as derived by many buyers and sellers acting simultaneously, will not derive value. Indeed, much market price activity is the result of many investors acting independently in guessing, or hoping, or charting, or attempting to front run, or following, or comparing and/or speculating on value. All of these activities create a market price, but the true assessment of value occurs away from the market and is independent of price.

The Portfolio

The banking sector is currently in the middle of reporting season and so far the results indicate that the major commercial banks have grown steadily in a low-credit-growth market. Each bank has indicated that its retail deposit growth exceeds its retail lending growth. The rebalancing of funding lines is a positive, given the wholesale funding concerns emanating from European debt markets.

Investment bank Macquarie Group Ltd (ASX:MQG) reported its results last week and maintained its appalling return on equity. MQG will continue to address costs as more staff are retrenched. New business opportunities will be targeted, but clearly the old model is broken. The bank’s capital management decisions are mind-boggling. The Australian Prudential Regulation Authority (APRA) has approved a buyback on certain conditions. The company will continue to declare unfranked dividends, supported by a dividend reinvestment plan (DRP). It will then sanitise (buy back) the equivalent of the DRP share issue and undertake a general buyback at some point in the future. All of this is hopefully going to lift ROE by reducing capital. Crikey! Why not simply declare a return of capital in cash? Ah, there must be a reason for not doing the obvious and we can only speculate on why that is and in whose interest these decisions are being made. Clearly, MQG is not in our portfolio.

Our main focus is Westpac Banking Corporation Ltd (ASX:WBC), which is in our value growth model portfolio. For Westpac, we note the following key financial results (released May 3):

· NPAT: $3,001 million, down 24.9% on pcp
· 31% increase in impairment charges
· Interim dividend: 82c per share (up 2c), fully-franked
· Customer deposits: Up 11%
· Lending: Up 5%
· Cash ROE: 15.1%
· Net interest margin: 2.17%, down 6bps on 2H11
· Expense to income ratio: 41.1%, improved 10bps
· Tier 1 capital: 9.81%, up 28bps

Figure 1. Performance & Valuation: Westpac Banking Corporation
Source: MyClime

Overall, it was a pretty solid result, given a tough credit market and slowing economy. The result did not dramatically affect my valuation for WBC, which is derived from a forecast “owner return on investment”. The owner return is approximately 20% and is higher than the stated ROE of 15.1%, because it acknowledges the franking credits flowing to shareholders from dividends. My required return of 12.3% is well above the risk-free rate of return and is appropriate given the difficult times we are experiencing.

-Clime Model Growth Portfolio (prices as at May 3)
Company
Code
Purchase Price
Market Price
June 2012 Value
M.O.S
GU Yield
BHP Billiton
BHP
$ 35.50
$ 36.25
$ 54.63
50.70%
4.06%
Commonwealth Bank of Australia
CBA
$ 50.78
$ 52.68
$ 58.94
11.88%
8.57%
Westpac Banking Corporation
WBC
$ 22.02
$ 22.91
$ 27.57
20.34%
9.29%
Blackmores
BKL
$ 27.55
$ 27.50
$ 28.33
3.02%
0.57%
Woolworths
WOW
$ 25.85
$ 26.85
$ 31.53
17.43%
6.44%
Iress Market Technology
IRE
$ 6.75
$ 6.29
$ 7.28
15.74%
8.25%
The Reject Shop
TRS
$ 12.04
$ 11.75
$ 14.51
23.49%
3.77%
Brickworks
BKW
$ 10.45
$ 10.57
$ 12.33
16.65%
5.54%
McMillan Shakespeare
MMS
$ 11.01
$ 10.70
$ 11.42
6.73%
4.94%
Mineral Resources
MIN
$ 11.77
$ 11.77
$ 14.00
18.95%
4.98%
Rio Tinto
RIO
$ 66.60
$ 65.65
$ 84.06
28.04%
2.59%
OrotonGroup
ORL
$ 8.64
$ 8.63
$ 9.48
9.85%
8.28%
 
* Shares purchased as at close April 19 2012.
* Market prices as at close May 3 2012.

Given a portfolio size of $120,000, equally weighted, each stock is allocated $10,000. Since inception, the portfolio has increased in value by 0.1%.

Clime Investment Management is one of Australia’s top performing fund managers specialising in income and growth portfolios for wholesale and sophisticated investors, particularly self-managed super funds.Register here for a free two-week membership to MyClime.

John Abernethy is director and chief investment officer of Clime Investment Management. John has 30 years' experience in equity markets and has been named fund manager of the year during his career.

* The portfolio assessment only provides general information and does not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment or personal advice. Under no circumstances should investments be based solely on the information herein as they are of a general nature.

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