Go Australia

There is a lot of debate about at the moment about whether to allocate a larger percentage of funds to direct overseas investment. The theory is that the Australian equity market has broadly outpaced the world, and that the world will now play catch up.

I don't think the answer is increasing direct investment in foreign markets; I think the answer is increasing exposure to Australian listed global earners, particularly those that are global leaders of consolidated, or consolidating, industries. These include BHP Billiton, Rio Tinto, Woodside, Cochlear, CSL, ResMed, News Corporation, Brambles, Computershare, Sims Group, Qantas, Lend Lease and Foster's Group.

Direct foreign investment increases means many increased risks, related to currency, politics, tax, regulations and corporate fraud. I can't see the reason to directly allocate a greater percentage of funds to offshore investments when we have the most consistent performing equity market in the world, right here in our back yard.

I know historic performance isn't a guide to the future, but there is some guide in the consistency of return a given market generates on a long-run average. Over the past 13 years of global stockmarket total return performance (not currency adjusted), Australian equities have offered on average 10% capital growth and a 4.5% dividend yield per annum. What's wrong with a 14.5% total return each year for more than a decade '” more when you include the value of franking credits?

In 2005, Australian equities outperformed their long-run average in terms of capital growth and dividend yield. Capital growth in 2005 was double the long-run average of 10%, so it's fair to expect some sort of reversion to the mean over the next year; yet 10% capital growth and a 4.5% dividend yield will be a more than acceptable return from the overall market in 2006.

The point I am getting to is that even if Australian equities only match their 13-year average performance, we can look forward to 10% capital growth and a 4.5% dividend yield, and for an Australian based investor subject to Australian tax law, that will be the best risk adjusted return you can find anywhere in the world.

Remember that Kerry Packer amassed his great fortune without every really venturing outside Australia for his investments in any scale. His great success was based on taking advantage of Australian opportunities.

I think there's a real lesson in his success, and that asset consultants, global brokers and financial planners are only urging "global diversification" to get investors trading and generating fees.

I'm biased because I'm a massive bull on Australia's long-term prospects as a nation and an economic power in the region. We hold all the cards in natural resources in the region, and leveraging that natural resource position into the broader economy will ensure another decade of consistent economic growth.

So, you can either use your natural advantage as an Australian and invest in Australia, or you can move up the risk curve and take pot luck overseas. Your natural advantage is that you shop at your investments, you travel with your investments, you read and watch your investments (media), you bank with your investments, you insure with your investments, you consume your investments '¦ you can even drink your investments.

As an Australian investor, you can see and touch your investments at work every day of the year, and that is a massive advantage. I strongly believe in "Peter Lynch Theory", that being that the best ideas you see with your own eyes. That's why I am going to spend more time away from the desk this year. I don't believe in "efficient market theory", I believe in highly inefficient market theory (resources over the past 24 months).

I also don't believe diversification reduces overall risk; it just reduces overall returns. I believe in highly concentrated investing in quality long-life assets, run by the highest quality people, and producing high-quality cash flows. Investing in high-quality assets actually reduces risk, and that's why I can't work out why so many people are running such high cash levels inside equity portfolios at the moment, particularly when there's so much equity dividend yield available. I'd even own Telstra over cash. I've only been back at work two days, but 80% of my conversations with institutional investors are about how their "cash" is killing their performance.

The key is to focus on companies with a rising return on equity (ROE). Many of the people I respect most in business and investing have pointed me in the direction of ROE being the key, and back-testing of recent performance says they are absolutely right. If you have a portfolio full of rising ROE stocks, you will outperform.

Wesfarmers under Michael Chaney was the first Australian company to genuinely focus on ROE, and now we see even the resource sector focused on ROE. I remember just three years ago having conversations with "growth" based investors who said "how could you ever buy resource stocks when the ROE's are single-digit for eternity?" Well, the ROE's have quadrupled in the resource sector due to consolidation, better financial discipline (management), and commodity price strength. The ROEs have quadrupled, and so have many share prices in the sector.

This is not simply about commodity prices; it's more about the return on equity these companies can now sustainably generate, and that is why we believe they will move to a market multiple over the next few years. If the sustainable returns they can generate are better than the market, why should they command a price/earnings discount?

If these resource stocks can sustainably generate returns above the broader market, they will not command a discount to that broader market. That means they have another 50% share price upside, even with flat commodity prices from here in the medium term.

I keep writing this, but I still believe the vast bulk of Australian investors are overweight banks, and underweight resources. I'm pretty sure that is not the right way to be positioned, particularly as commodities are now an asset class.

It's only the start of January, yet already this year is starting with plenty of price action and plenty of debate. That equates to plenty of opportunities for those who are prepared to invest, and back a medium-term outcome. I reckon you're going to get a big-cap takeover in the next few weeks, and that will throw a real spanner in the works. If it happens, it will be in a large-cap laggard.

I reckon IAG is a sitting duck. That's the big-cap stock I reckon looks vulnerable to takeover, and the share price has been very firm in recent weeks, yet is still a big laggard on a one-year view. I like IAG's chief executive, Michael Hawker, but I think his stock is very vulnerable.