Head to Head - Michael Pascoe and John Sevior

MP: How are you feeling about the rest of the year?

JS: After two years of 20-odd per cent returns '” and that hasn't happened a hell of a lot in the past 100 years '” I think it is going to be a lot tougher in the next 12 months to make the kind of returns people have made in the past two years.

MP: Everyone thought that at the beginning of this calendar year. Everyone has been surprised in the first six months or so.

JS: I think they have. Obviously, the growth cycle has lasted longer than people expected, and the conundrum in all of this is that companies in Australia are in the best financial shape they've been in for the past 15 years '” while personal finances might be poor relative to where they've been in the past '” which is why you're seeing a raft of capital management initiatives, buybacks, special dividends, increased dividends, so it actually underpins the cash levels within the market. Despite the fact that we're probably at peak cycle in a lot of industries, companies are in very sound shape. While you mightn't see the strong returns of the past 12 months, two years, you can still expect to see reasonable returns.

MP: What do you call reasonable?

JS: Probably the dividend yield of the market is 4 per cent looking out 12 months, and a bit of growth on top of that, so maybe 8-9 per cent, which is half the past year but still not unreasonable given that inflation is at 2 or 3 per cent.

MP: Which sectors do you like most at this stage?

JS: Companies in the strongest positions are those in the materials sector. Resources in particular have benefited from abnormally high commodity prices. What is different about that industry from previous occasions is that there has been consolidation, which means there's a lot more discipline on the supply side and a lot more discipline on the capital management side. So I think you're probably likely to see, more or less, violent commodity price swings and, with strong cashflows being generated and a more consolidated industry, I think there's the prospect for more sensible sustainable returns from that sector.

MP: If you're looking at a total return of 8 or 9 per cent, does that mean the resources sector is going to significantly outperform that figure and another large part of the market is going to underperform?

JS: I think it can outperform a bit. It has outperformed strongly over the past couple of years. The banking sector '” the bank and insurance sector or financial services '” which is more than 30 per cent of our market, has really had a tailwind for the past 10 years, driven by a long-run decline in interest rates, a quantum leveraging of personal balance sheets in Australia, and a long-run cost-cutting program. A lot of those benefits have exhausted themselves. The banking sector is going to have a much tougher run in the next two or three years. It can still provide reasonable returns but, if you had to pin me on resources or materials sector versus bank sector, I think probably the former is likely to outperform the latter in the next 12 to 18 months.

MP: Resources is a broad church. Which areas in particular?

JS: The major resource companies really cover most of the sectors. BHP and Rio have interesting approaches to commodity prices and where that sector is going. BHP is more aggressive and more optimistic in terms of commodity prices, which is why it bid for Western Mining Resources even though it's at a high point in the cycle. Rio '” while interested in Western Mining, tactically and strategically, particularly for Olympic Dam '” thinks prices are well above the long-run average and decided not to participate in that bid. So Rio's got a more muted outlook for commodity prices. BHP is a little more optimistic. Between both companies, most commodities are covered in terms of oil and a mix of other commodities, so I don't think you need to look too far outside the majors.

MP: Is there very far to look outside the majors? Is that one of the problems with the Australian resources industry '” the sector's shrunk so much?

JS: It's probably a misnomer even to call it the Australian resources industry because both those companies have very large overseas shareholdings. They are dual listed on the London stock exchange. They really are global companies. They're not Australian companies. And, in terms of consolidation of the industry, there are very few companies of real scale and quality in which to invest. That is part of the reason there's been far more discipline on the supply side as we run into higher commodity prices. Typically, what happens is every marginal producer, everywhere in the world, brings a mine on line. At this point in the cycle, that hasn't happened. I think that's why prices are probably staying a little higher a little longer than most expected.

MP: Sounds pretty easy for a funds manager then. You just have to put your money into two resources stocks and it takes care of itself?

JS: Those two account for about 12 or 13 per cent of the market and, obviously, you've got to find other things to invest in. There are other investments, but you asked for the most prospective area of the market, and I think that's one area of the market that could do well.

MP: So you're overweight in BHP and Rio?

JS: We are.

MP: Significantly?

JS: We have a meaningful position in those companies.

MP: Are you overweight in any other sector?

JS: We feel a little uncomfortable talking about sectors in the market because it's not really how we go about investing. We try to spend a lot of time with management to understand the motivation and level of passion that management have in running companies; the level of discipline and genuine focus on the interests of shareholders. So we try to weed out the companies that are going to best serve unit-holders' interests through a mix of sensible growth and capital management. If you look through our portfolios historically, you'll find a disproportionate share of pretty dull, unexciting companies that have a very strong history of just doing sensible things by shareholders. That's all we can really do.

MP: How do you gauge something as ephemeral as management that has passion and is genuine?

JS: You look for track record. One of the criteria is a company's got to have at least five years' earnings history before we invest in it. The tech boom came and went and we didn't invest in any of those companies because none had a track record . . . We've stuck to those basic principles over a long period and we've tended to be well rewarded for it.

MP: Walk me through a little bit of that process?

JS: I spend time with management. That's the best part of the job, meeting the people running the businesses. We try to meet a good mix of management, from the managing director, finance director, to line managers, who, I guess, are less tainted by the constant barrage of investors, analysts and fund managers asking them questions about the business. So we'd like to get a feel for the people that are actually running the divisions, making the day-to-day decisions, as well the people higher up that are thinking more laterally or strategically about the business and the industry.

MP: In some ways, you're sort of doing the job a non-executive director should be doing with a company.

JS: Yes. There's been a lot of comment about the role of non-executive directors and what they should or shouldn't do. The best comment I've read in the past few years was from, inevitably, Warren Buffet. He talks about directors having a proprietorial interest in the business, and that means owning shares and understanding the effect of good and bad investment decisions. If you talk about the ideal non-executive director, well we are intimately connected in that way in terms of making good and bad decisions, and the effect that our unit-holders feel.

MP: There are obviously parallels between what you've outlined and the Buffet method of going for good management. What about the businesses themselves? What do you look for in a business, all other things being equal on management?

JS: We look for businesses that are sustainable, that have a history of making money. And we look at that history through good and bad times through the business cycle. We look at companies that have good balance sheets. At this time, the aggregate interest cover in our portfolios is about double the overall level of the market, so we invest in very conservatively financed companies. That, inevitably, provides opportunities for companies either to make sensible acquisitions or to manage their balance sheets more aggressively. So we look for companies that have market positions that are unique, either in terms of oligopolistic markets, like Australian banking, or duopolistic, like brewing, or in commodity businesses that are well placed. So we look for sustainability of the business, a history of earnings and a history of companies making sound capital management decisions.

MP: Does that strategy come unstuck with a change of CEO, given that we tend to turn over our CEOs pretty quickly? Is there always a danger for you when you see a change of CEO?

JS: It can go both ways, but that's part of the challenge for us to make an assessment of the new CEO and, inevitably, in the good companies, the succession is well planned and there's a tier of executives with experience and ability that are doing their fair share of the work, anyway.

MP: Is that one of the things you look for, a succession plan, someone fairly obvious who is likely to take over?

JS: In any sustainable business '” and we do look for sustainability, sustainability of management '” succession of management is an important part of that.

MP: So, in a mob like Telstra, like the Commonwealth Bank, where there was uncertainty in both of them, there were negatives?

JS: It's probably too early to tell about the new CEO at Telstra, but Telstra is a very difficult business to run in terms of the dynamics of the industry, particularly with regard to the regulatory hurdles it has to face . . . It requires a pretty deft touch to manage that and also manage the interests simultaneously of the Government and the broader external shareholding base. So he's got his challenges cut out. CBA is a wonderful business and it's probably a much easier transition. Ralph Norris ran a very good bank in New Zealand over a long period, a standout bank among its peers, so I shouldn't imagine that his succession to that job, albeit on a bigger stage, will present too many problems for him.

MP: Given the concerns you outline about the business of running Telstra, that would make you sound a little bit uneasy about the start Sol Trujillo's had?

JS: I've only really read some of the commentary surrounding his questioning, some of the regulatory issues, the position Telstra has in the bush, and that constituency. So my observations probably really don't amount to much on that front. I'd like to meet him and . . . talk about his plans for the business outside managing the regulatory challenges.

MP: Are you under, over or market weight Telstra?

JS: We're underweight Telstra.

MP: Why?

JS: We think there are better opportunities. It's obviously a good business, but it's got limited growth possibilities. It pays a good dividend yield. It has a place in the portfolio. And at a certain price it's attractive. At certain prices it's not attractive. In a total-portfolio sense, we've got more good ideas than Telstra.

MP: That sort of $5.40-a-share target figure of the T3, does that make sense to you?

JS: I think the Government would struggle to get the deal away at that price. Certainly we would not be buyers for any "sell now" at that price.

MP: Sounds like you're not really a buyer over $5.

JS: The deal could be done in the mid-$4s with some success. But anything north of $5 would be a real struggle, given that, if they did what they needed to do on the capital management front '” such as a big buyback and paying out excess cash to get the boost of dividend '” that would be an artificial way of boosting returns. It's still a business that has significant dynamic challenges ahead of it, and it has quite a large capital expenditure bill. If the Government pushes it to a point where it overgears, I think that would be a concern.

MP: What you're saying is pretty scary for anyone who has Telstra shares now. If the Government is determined to privatise the rest of it, and it has to go below $5, the share price is all about downside, not upside.

JS: It is. I don't think it's going to fall in a hole. It's still a sound industry and it's still got a very strong market share with strong margins, and a lot of the characteristics of the business we like. It's really a function of the pricing, and the pricing with regard to the challenges ahead of the business.

MP: But if 51 per cent of the company's going to sold for $4-something, you wouldn't want to be buying it today at $5?

JS: No, I think there's better buying, or there's a better price at which to own a company.

MP: Getting back to the process you use at Perpetual: it's been used for a while, it's performed well over time. The time ahead, do you think that's going to suit that methodology? Whereas the last year, the out-performance there in the market, perhaps didn't?

JS: It's an investment philosophy we've used for 20 years, and there are periods where it struggles, particularly where there's a speculative air to the market, and we've had better years. We had a reasonable year last year. The last six months were probably a struggle, probably our toughest period since the period running into the peak of the tech boom. In those types of markets, there's a lot of excitement, there's a lot of froth, there's a lot of expectation. We do tend to struggle because it's a pretty dull, pretty predictable, pretty basic, common-sense oriented investment philosophy. There's no rocket science behind it. The beauty of it is that it's sensible, and we execute it in a disciplined fashion, so we don't pretend to be winners in all market environments. But it's stood us in pretty good stead over an extended time.

MP: In terms of overall portfolio, are you comfortable with the Australian market being overweight, or that's not a call you have to make?

JS: It's not a call I have to make. I don't make investment decisions about Australian companies in a vacuum, and I mention that companies like BHP and Rio are really international companies, so you've got to be aware of international pricing for assets. One observation I have made is that, over the past 10 years, the Australian market has traded at a discount of roughly '” in terms of a p/e (price/earnings ratio), which is the basic investment tool '” 15 per cent to the global market. It now trades at the global market p/e, or at a slight premium. So the Australian market has re-rated significantly against the world in the past few years.

The question Australian investors might be asking themselves is, is that about as far as it goes, or will the Australian market re-rate even further relative to the rest of the world? I think there are peculiarities in the Australian market that have driven that. One is justifiable, that the economy is well managed and has grown consistently and steadily and strongly over the past 10 or 15 years. That has contributed to the re-rating. Also I think the structure of the industry in Australia '” a strong flow of funds in the Australian market, not a lot of new capital raised, a lot of money given back through capital management. I call it the effect of a lot of money going down a very narrow choke, and I think that's been a strong factor, an intangible factor, and it's causing the Australian market to lift in value.

The other thing has been very strong allocations from industry super funds, not just industry funds but super funds generally. Money tends to go where it's best rewarded, and the Australian market has been a very strong performer relative to the world '” so there's that kind of halo, a good feeling effect, and the money stays here. Eventually, there'll be a period where overseas markets perform better than ours, and maybe that's coming a little sooner than people think.

MP: In your personal finances, what sort of weighting are you giving Australian equities?

JS: The tracking error I would have over my own funds is quite different from what most people would have in terms of their investments. So, in a more sensible approach, I'd have a higher level weighted to overseas equities from this point than I've had in the past few years.

MP: So you're probably as slack as everyone else in terms of not putting more money into international markets at this stage of the cycle?

JS: I'm not as slack, but it's something that's kind of exercising my mind. I spend 98 per cent of my time managing other people's money, and it's a bit like the doctor managing his own health: I tend to get rewarded for looking after other people's money, and that's what I do, and the rest looks after itself.

MP: To the structure of the industry for a moment, seeing ASIC having a crack at financial planners in the past week. As a funds manager, do you think this industry has to evolve a lot further a lot faster? There's a lot of money, as you say, going into it. Is it being allocated efficiently?

JS: The money being allocated efficiently?

MP: The money going into funds.

JS: That's a big question. As a business, we look at where fees are generated. We look at the fee we earn for investing money. We look at fees that intermediaries generate along the value chain, as people would call it. I think there's probably scope for some general fee reduction in the industry . . . The wholesale investor doesn't really have to deal with a lot of middle people, so they generally have a lot of buying power, so they generally get a pretty efficiently priced product in terms of fee for the asset management and other fees. A retail investor?I think there's probably scope for those products to be priced more efficiently and more attractively.

MP: Has that got implications for the industry, particularly for the banks that have invested so much in funds management?

JS: Probably. The banks have a very large client pool and it's probably even more powerful than they realise. I think they're pretty well placed . . . They have very strong distribution platforms. The fees paid to fund managers are trending downwards. I don't know how much further they can go. So there's some general tightening in that end of the market, but I think, as a general observation, we look at where, in terms of the total basis points that a retail investor pays, there's probably scope along that chain for that to be reduced. I don't quite know where it all gets done, but the gap between wholesale and retail probably is too low. It's coming down quite rapidly. It's probably got a bit of scope to come down further, which is good for retail investors.

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