How to take the emotion out of investing

This week’s Fund Manager interview is with Manny Pohl of Flagship Investments, the listed investment company. He’s actually got three listed investment companies that he manages under the banner of EC Pohl & Co, Flagship Investment, Barrick Street Investments and The Global Masters Fund. We’re talking mainly about Flagship because Barrick Street is an offshoot of that. A couple of really interesting things about Manny, he has some strong views about how to invest and he’s got methods about how to get the emotion out of investing which is definitely worth doing. He’s got three things that he watches which he explains in the interview. 

But also, there’s a bit of a lesson in how to look at listed investment companies because he says that the performance since inception of flagship is 12.5% per annum. However, if you look at the share price over that period and add in the dividends that’s been paid, the compound annual total shareholder return over that time in actual terms is 4.26%. He says the difference is tax, which seems to me to be a big difference, between 12.5% and 4.26%, but there you are. I think it’s an important lesson to learn about LICs that the return that they claim is not necessarily the return you get, and the difference is tax. 

Here’s Manny Pohl of Flagship Investments, as well as Barrick Street and Global Masters Fund.

Perhaps we better just start at the beginning.  You’ve got a business called EC Pohl & Co, you’ve got three funds that you manage.  Flagship Investments, Barrick Street Investments and the Global Masters Fund.

Yes.

I was just looking at the Flagship Investments, that’s 20 years old, inception 1998.  Was that the first thing you did?

Yeah, so you can hear from the accent that I come from another planet and I did that some 24-odd years ago.

What were you doing in South Africa?

I was a partner in a firm that’s now Merrill Lynch.  It was a broking firm that Merrill Lynch bought out.  I mean, there was a whole extended history of it but essentially it was Merrill Lynch at the end of the day.

Okay, you came to Australia…?

Yeah, I came to Australia.  The industry in South Africa was different to Australia in the respect that here in Australia rank and file mums and dads were investing in the share market primarily through unit trusts offered by the banks.  Private portfolio management didn’t really exist here in any shape or form, the brokers sort of did a little bit of it but not much.  Whereas, in South Africa the major brokers all manage money for their high net worth clients.  They manage portfolios, they’d report to them quarterly, pretty much like the AEMO industry is in Australia today, but we’re talking 24 years ago.  When I arrived here, what I wanted to do was actually do that here in Australia.  I joined Wilson HTM at that stage, had this idea of running money for high net worth individuals, along the sort of a process similar to what portfolio managers would do.  So we obviously had the licences but in order to attract people we needed to go out into the wider world and every time I spoke people said to me, well you’ve got a funny accent, you’re working in a broker and you’re up in Queensland and you think we’re going to give you some money, you’ve got to be smoking something.  So, the only way we could really attract money was to – and without the distribution because in those days you needed to get on platforms and that was hard and you needed people on the ground. 

I looked at the ASX and said the easiest way is obviously through a listed investment company.  Wilson HTM went to a whole lot of its clients, offered them some stock in this new LIC and that was the way we went.  It made it a lot easier, because it was listed you didn’t need asset consultants to tick you off, you didn’t need research houses, once it was listed you were kind of in the public domain.  That was the first vehicle that we setup but it was primarily because we needed a track record of what we could do and that was the only place we could get it, it was like a catch 22.  You can’t get people to sign off on you because you’re not managing money and you can’t get the money because you’re not signed off, so that was why we went down the LIC route. 

You called it a Wilson Investments Taurine Fund to begin with, why taurine? What was that?

[Laughs] We originally were looking at some version of Wilson – but Jeff Wilson had just started at the same time as Wilson Asset Management and we were in a presentation and we were looking at obviously various names and Taurine was – and correct me here and I’m probably totally wrong – but I think it was an amino acid that was really one of those that the body needs to function properly.  I was busy talking at a health conference and some guy was talking about these and I thought, oh that word sounds interesting so we just put it in there.  What it meant was, this was a fund that people needed to improve their financial wellbeing and in the human body taurine is something that you need to make sure your body functions properly.

It’s a major constituent of bile, as it happens.

Oh right.  [Laughs] Okay, you know more about it than I do.

I’m just looking up Wikipedia as I speak to you and that’s what it tells me.  It’s to be found in the large intestine.

Okay, so it’s really important in the large intestine, there we go.  I knew there was some medical thing.

You changed the name in 2012 actually to Flagship.  Was that when you took over the management of it from Wilsons?

No, Wilsons never managed it, I was always the manager and when I setup Hyperion, Hyperion was appointed the manager.  But I was the major shareholder in it and there’s a number of South African friends of mine who put some money into it in the early days as well.  When I sold my stake in Hyperion, I negotiated with them to obviously let me continuing it through EC Pohl, continue managing it.  When I left, that was just one of the things that I took with me.

Tell me about what it invests in.  I’ve just been looking at your current portfolio, it seems to be a fairly eclectic mix of large and small cap investments.  What’s the investment philosophy? 

I’ll run through the whole thing and if I’m not making sense, please stop me.  Coming from the sell side, one of the things that happens when you’re on the sell side is – and I came through the research side.  What you’re doing all the time is you’re researching companies, you’re getting a look at well structured companies, companies that you think can grow, add to the person’s economic footprint.  That was what we wanted to do with Flagships.  We wanted to create a portfolio of what we thought were the best businesses. 

For us, best businesses have three traits and you can see I’ve got a few degrees behind my name, I had spent a bit of time academically researching these things and we ended up at the space where the three things that we wanted to see in a business was, one, obviously a proven business model and that the management team that were running the business had put some runs on the board.  We said a measure of a good business model and proof that runs are on the board as return on equity.  If you’re holding the equity you want to see some return on it, so that’s the one measure that we thought was important.

Then the second measure was we wanted to see businesses that were expanding and the way to get a simple measure of that is just have a look at the revenue line and if it’s expanding faster than GDP and something that is doing better than the economy as a whole.  The last one was one that actually stood me in really good stead from a fund management point of view, was balance sheet strength.  The traditional academic view of balance sheet strength, and I’m going back 20-odd years, was sort of look at the debt to equity ratio.  But over many years being in the industry, one realises that – and specifically in this country, maybe not so in the US, but the debt is finite and the banks will hound you until you repay it.

The equity is the balancing item between what the market says the assets are worth.  Debt to equity is really not anything that you can hang your hat on.  I remember reading a book by Graham Dodds who wrote a book at the time of the great depression and Benjamin Graham is a name that most people know and Buffett always refers to him.  He said that one of the key metrics that helped him through the great depression and through that stock market crash was ensuring that businesses had their balance sheets well structured.  He looked at the interest paid on the debt, covered by some multiple by the cash flow.  That was the third metric that we looked at, is that operating cash flow should exceed the interest paid on the debt by 4 times. 

Those three metrics give you a way to look at all the companies that are listed on the stock exchange and then strip out those that don’t comply and you end up with a short list of maybe about 150 companies and that’s what we said we were going to invest in, was these what we deem to be decent businesses, but that was just the starting point.  That stripped out a lot of the…

What ROE are you looking for?

Greater than 15%.  That’s a three year average, so it could be slightly below that and above that.  But that’s just a starting parameter for us to whittle out what we want to look at, because there’s clearly – what’s it?  2,500?  I don’t know the number on the stock exchange.  That’s just when you’ve got limited resources and when I started off I was a one-man-band and then added various people into Hyperion and added a whole lot of chaps into EC Pohl.  If you want guys that are talented and you want to get them focused, how do you do that?  That’s how we get people focused.  Out of that universe we then look at things like sustainable competitive advantage and the Porter analysis and go into the businesses and along the way, from that list that we now have of say, 150-200, more companies will fall by the way as we don’t like what we see in terms of analysing the business.  Then we end up with a portfolio that is finally structured with companies that we like and that’s what you see in Flagships.  It’s a structured way to end up at a portfolio which is very different to the way most other managers do things and the way most other management companies are comfortable to do things.  What I mean by that is that if you’re a big business and you’ve got a couple of fund managers doing things, sometimes you’re worried about business risk and you don’t allow them the flexibility to take a really large position in something that they think is fantastic, because if it goes wrong it impacts on a much large business than just the fund management component. 

That’s where you get a lot of fund managers who are supposedly active as either value or growth managers, but they’re not really active because they have a sizeable component of their portfolio determined from the index.

Right, but you’re very conscious of the index, it’s not as if you’re index unaware, surely?

Oh no, we know what’s in there but we don’t put any stocks in there on the basis of whether it’s in the index or it’s not or what its weighting is in the index.

What’s been your performance since inception?

The actual number since inception is 12.5%.

One of the things you said was – I liked the way you said – something to do with 15 years, that you didn’t think it was statistically material until 15 years.

[Laughs] Yes.  Well that comment actually came out of [Thales] Watson.  We were talking about the difference between skill and luck, and they said, ‘Well, there’s statistical evidence to prove that you need to get to at least a 15 year track record and at that point you can start to assume the manager’s got some level of skill and it’s not just luck.’

I just need you to help me with the performance statistics.  You say 12.1% I think you said?

12.5%.

If I look at your share price 20 years ago, which was $1.28, your share price now which is $1.76, and add in all the dividends you’ve paid over the 20 years, which is $1.19 in dividends, I come to a compound annual total growth rate of 4.26%, so what am I missing?

Okay, there’s a couple of things that you’re missing, one is tax.  The 12.5%, the portfolio performance, there was a rights issue which was done at a massive discount about two-thirds of the way along, it was done at about a 30% discount if my memory’s correct but I’d have to check that.  We did an audit, interestingly enough, for the board recently.  We asked a question about last year given the performance of the portfolio and where it went.  The two key metrics which you quite rightly point to, the two key metrics are obviously the dividend that we pay out, the other large one is the tax and the third one in our life, there was a material rights issue at a big discount just at the start of the GFC. 

But it is fair to say, isn’t it, that if anyone bought Flagship shares ago, what they would have got actually in their hand was 4.26% per annum growth.

Over and above the dividend?

Well, no, including the dividend, because the share price went from $1.28 to $1.76 and along the way you’ve paid $1.19 in dividends, so that’s what an actual shareholder would have got, even though your kind of internal growth rate was 12.5%.

Yeah, yeah, I know, that’s obviously the facts of the matter, one can’t argue with that.  But unfortunately you can’t exclude the tax component which is material.

The 12.5% is before tax?

Yeah, yeah, absolutely.  That’s the performance of the portfolio as one would report it in a unit trust, as one would report it in any mandate.  That’s one of the things that in reporting, LIC performance versus unit trust performance versus a straight portfolio that somebody might be managing for you or I might be managing for some high net worth individual, the portfolio return is what we return to that individual thereafter the payment of the tax, etcetera, etcetera, is all excluded from and where in an LIC, it’s all in.  One of the other ones we do is Global Masters, that has an investment in a London LIC called Affinity Trust, which I’m the Chairman of. 

The important thing about the London LICs is they’ve got a different structure and if the shareholding falls within certain rules they are untaxed, whereas our LICs are taxed.  It’s a slightly better model, I believe, but anyway, we’ve got to live with what we’ve got.  So the tax is an important consideration.  

When you look at companies and assess their ROE and so on, you presumably look at after tax numbers.  Don’t you think it would be better to talk about your after tax return?

Yeah, well we do.  We talk about NAV and we talk about what’s happened to the NAV.  But when you’re talking to the wider world, you obviously have to compare unit trusts and ETCs that they’ve got in the market which are all untaxed entities.  When you’re discussing in the wider world trying to attract people into the company, you’ve got to compare it with other things that they’re looking at and you’ve got to make sure you’re talking in the same language as what other people are talking, otherwise you shoot yourself in the foot from an LIC perspective.

Fair enough.  What does Barrick Street do differently to Flagship?

If you look Flagships, it can invest in anything on the stock exchange and we have a universe and we whittle it down to what it actually holds which is about 35 stocks.  If you exclude those that are in the ASX50, what remains is what’s in Barrick Street.

Of the 35?

Yeah, that’s right.  If there’s like 10 that are all in the 50, then Barrick Street would have 25 stocks.

I see.  That’s interesting because I’m just looking at your portfolio, the biggest holdings you have are – this was at June 30 – Macquarie Group, number one; Rio Tinto, number two; and Commonwealth Bank, number three. 

Yes.

Does that mean they are your favourite stocks or they just happen to have grown to the point where they’re sort of taking 5.5-6.5% of your portfolio?

No, the way we construct the portfolio is once we’ve decided on the business that we like, we then go and model it like any analyst would model it and we have a five year projection of income, cash and balance sheet.  From that, we get a dividend profile that we expect the company to pay and then clearly at the end of the five years we will take some view on what we think that company is worth and we calculate an internal rate of return.  The internal rate of return is today’s share price, this dividend flow, plus the terminal value.  Internal rate of return is exactly the same calculation as a yield to maturity in the bond market.  If you go today and you buy a New South Wales T corp or something, the yield to maturity is an internal rate of return calculation, which is the six-monthly coupon that you will get and then the face value at the end of the period whenever it matures. 

We then compare the internal rate of return for each of these companies to what we believe the fixed interest markets are offering and we clearly look for a premium above that for the risk of going into equities.  Then depending on the resultant outperformance we’re going to get in terms of a return, we weight the portfolio according to – we put the most money into the best return and the least amount of money in the portfolio into the worst return of the universe that we’re looking at.

Does that mean you invest the most in – in fact, only invest in dividend payouts?

No, because the terminal value obviously is one of the big drivers of the internal rate of return.  At the end of the five years we value the business, that could be a multiple of earnings or an inverse of a dividend yield.  That is a material component of the calculation.  But dividends obviously are a big part of it.

Yes, because I notice you own a few, not that many, Xero Limited, and they don’t pay dividends yet.

Yes, so that’s where the terminal valuation comes into play.  Once we’ve done that internal rate of return calculation, you then have say an internal rate of return going from say 10% to 30% or 40%.  We then adjust in for risks to us, things like liquidity, the confidence around their terminal valuation.  You just pointed to Xero, or Wise Teq, I mean those have got massive businesses, proven in terms of people but there might be something else where it’s still a relatively new business and the views around what it’s worth in five years’ time amongst our investment team might have quite a large divergence.  That would mean that that valuation is slightly more risky than say for example, a CBA in five years’ time.  Although, given what’s going on with the Royal Commission, that might not be the case. 

But just for purpose of argument, we would say that the value that the guys in my team put on CBA in five years’ time, we’re probably going to be close to the money compared to one of the others where we might be further, apart from what actually eventuates.  We would then adjust this internal rate of return for these risk measures and then we would weight it.  The stock that has the highest risk adjusted internal rate of return, it would get the highest rating in the portfolio. 

What comes into play with Rio and Macquarie and less so CBA is that, particularly the CBA, it’s got a dividend profile that we believe we’re fairly comfortable that we’ll get right and the value of the business from where it’s going now to five years’ time, we think a lot of the bad news has been taken and our view on the industry means that probably we think the value is still going to be there, so that’s why it’s got the weighting it does.

If I asked you your three favourite stocks in your portfolio, would they be those three or another three? 

Yeah, that would be the three risk adjusted, but if you asked me are those going to be the ones with the highest potential return based on the way we see things, I would say, ‘No, not necessarily, it’s probably some of the smaller ones.’   Up until this reporting season it would have been things like Afterpay and Wise Teq which have just gone crazy.

What stocks do you think will produce the best returns over the next five years that you own?

Well, we’ve got to look at it from a risk adjusted perspective.  I would say that right now on a risk adjusted basis, Rio is probably the best performing investment that we’ve got.

Okay, what about non-risk adjusted?

Okay, I’ll just pull up a schedule while we’re speaking and then I can tell you in order what they would be.

I want you to pick three stocks for us out of your portfolio.

Like I said, this reporting season has turned it all on its damn head, we’ve had stocks in the past six weeks that have been up like 20% and 30% which is driving me insane because we’ve got to continuously be looking at things, whereas normally it’s a bit quieter.  Right now the highest IRR stock in our portfolio is a small little specky thing called Megaport.

Right.  This is Bevan Slattery’s business.

Yeah, well he’s just gone out but certainly it’s one that he’s created and he’s the guy that we actually think has done a great job in what he’s put his hand to.  But yeah, that’s the exact one.

Okay.  And I note that your portfolio is 92.56% in total, is that unusually high or low?  That means you’ve got 7.4% in cash.  Does that tell us anything about your view of the market at the moment?

Yeah, not necessarily about the market at the moment but it tells you our view on particular stocks.  I’m coming back to this.  If you have a look at the increase in the price of stocks like Wise Teq, Xero, Afterpay… Since we’ve had them, during reporting season they went screaming up to the tune of like 20-30%.  As that happens, as you will appreciate from my explanation earlier, you’ve got this internal rate of return calculation.  If our view on dividends over five years and the value of the business in five years doesn’t change much, if you have the share price going up 20% it means the internal rate of return starts to reduce dramatically. 

Because we weight things according to the internal rate of return, we then have to down-weight those stocks as that internal rate of return is dropping.  We’ve had to, this reporting, quite a few companies’ share prices just go screaming up and we’ve had to wind back those positions.  Since we’re still in reporting season, we’re waiting for probably about 30-40% of them to finalise their reporting and then we would obviously allocate that cash.  But we’ve been taking some off the top because these stocks have just been flying.

But what’s your view about the market in general?

Unfortunately we look at our portfolio and we take a view on what we think is going to happen with that.  Right now, the return that we’re expecting from that portfolio is slightly south of 15% in times of trauma and as recently as probably four months ago when there was weakness in this area, it goes up to about 18%.  At the most optimistic time it’s been down as low as about 11%.  It’s fair value territory so I wouldn’t be necessarily nervous about the market, but certainly there are sectors of it, not that we look at sectors that maybe one should avoid.  But in the portfolio it’s looking reasonably priced at the moment.

Just the way you use internal rate of return, it sounds a bit like a sort of a professional version of dollar cost averaging.

No, I wouldn’t say that. 

Just the way you kind of constantly adjust for it.

Well, constantly yes, but constantly is probably the wrong word.  We look for a movement in the share price of at least around a per cent before we take any action.  But what we do want to do is have our money on the best bets at the time and this is a mechanism to do that.  The reason we ended up at this point is because I’ve been around a lot of people and unfortunately emotions comes into decisions of buying and selling things.  I wanted to devise a system that took that emotion out of it. 

When you’ve got an internal rate of return calculation and it’s a five year calculation, so what you’re doing is you’re taking a five year view out and if the market is more volatile than what you would expect, there is a bit of trimming and buying of the stock.  But we’re kind of in unusual times at the moment, but normally it’s not as volatile as that and you buy a position and you run with it for a couple of months and you might change it a bit along the way but it’s nothing as dramatic as what we’re seeing at the moment. 

Obviously the terminal value in five years’ time is a guess, I mean how do you come out with that?

Well, it is a guess because you’re taking a view on a PE multiple.  We’ve obviously got the E through the modelling that we do, so it’s a question of deciding what the multiple is that that E needs to trade on.  Each of the five members of my team have different ways in figuring that out.  Some of them have got dividend growth models, they all go about it differently.  Each member of the team takes the view on what he thinks that business will trade on in five years’ time and that goes into our database unseen.  I’m the only person who knows what all the forecasts are and those get collected and then the kind of weighted average is applied to the E at the end of the five years and that’s what the value is.

Right, well that’s fascinating and as you say, it takes the emotion out of it, I guess that’s an important part of investing.

Yeah, I mean, buy-side, yes, but more importantly is on the sell-side, because when you’ve done a lot of work like our guys do, gee, the number of meetings that we have and the number of reports that we put together, internal reports for other people of the team to be on the same page.  Unfortunately when you’ve gone into something the tendency is for you to fall in love with it.  And I’ve always tried to make sure that that’s not the case and definitely taking emotion out of is an important part of the process. 

Well, we’ll have to leave it there, Manny, it’s been great talking to you, thanks.

Thanks for your time, I really appreciate it.

That was Manny Pohl, the CEO and Founder of Flagship Investments, Barrick Street Investments and Global Masters Fund.