Intelligent Investor Equity Income Portfolio - September 2018

Defensive portfolios typically underperform late in the business cycle. We’re comfortable owning a portfolio of businesses that have proven themselves through business cycles before, provided weaker relative returns in the short run means higher returns once valuations for higher growth stocks return to earth.

During the quarter New Zealand online classifieds business Trade Me justified its position as the portfolio’s largest holding. The share price increased 13% after announcing an encouraging annual result following a couple of years of heavy investment that have pressured margins and profits. The stock’s total return was 20% once a special dividend was included.

Despite minimal increases in property, job and car listings, classifieds revenue increased 12% as customers spent more on premium ads. Though not before time, the company is following the hugely successful premium ad strategy used by REA Group. Customers will willingly pay more for premium ads provided it produces profitable sales. Trade Me is only starting to flex its pricing power muscles.

Newscorp, which is a cheap, indirect way to own REA Group amongst other assets, was the quarter’s worst performer, falling 12%. The old-style media businesses that rely on advertising continue to struggle, but newer online housing classifieds businesses such as REA Group and Move, and venerable mastheads like The Wall Street Journal, which has successfully moved online, are growing nicely.

Education provider Navitas was the only stock sold during the quarter. The company’s trend of falling earnings over the past four years was supposed to be rescued by the company’s big US push, which is showing increasing signs of failure.

Spin-offs

Spin-offs occur when a company demerges a business division to be listed independently. Recent examples include Wesfarmers spinning off Coles and BHP’s spin-off of South 32.

Historically they’ve been wonderful investments, as the smaller stock often gets sold off heavily, as most investors are either forced to sell it due to liquidity issues or are only interested in owning the larger parent company. As newly motivated management releases the value in the business the returns can be astounding.

A similar situation is unfolding at Unibail-Rodamco-Westfield. With French property owner Unibail-Rodamco’s acquisition of Westfield, the Westfield stock has been replaced by the Unibail Chess Depositary Interest (CDI).

Technical issues, such as French transaction taxes, and research houses not wanting to cover a French business, means Australians have been dumping their shares for reasons that have nothing to do with their value – just like the spin-off example.

We believe this is a mistake. With a starting 6.4% distribution yield; a gold standard property portfolio that provides our portfolio with valuable overseas diversification; and one of the industry’s best management teams; we took advantage of the selling and added it to the portfolio.

We also added Clydesdale Bank to the portfolio, which was spun off from former parent National Australia Bank (NAB) a couple of years back. Clydesdale recently acquired Virgin Money, creating the UK’s sixth largest bank. The stuffy old Clydesdale brand will be replaced by the Virgin Money brand, which has more appeal to younger customers.

Clydesdale Bank is trading around tangible book value (TBV) and is run by one of the most highly rated management teams in the UK. If management hits its 2019 aim of double-digit return on equity, then there is room for the multiple to expand over time if higher interest rates fatten profit margins, or as profits grow from a combination of attracting new customers and cutting costs. The company could also eventually become a takeover target, unlike the five major UK banks.

Hayne inquiry

On a final note, Commissioner Hayne recently submitted his 1,000-page report following the Financial Services Royal Commission. Instead of prescribing solutions, Hayne acknowledged a litany of issues and asked vested interests for their potential solutions, which will be a combination of fines, changed business practices and regulation.

Since the report was released, we’ve increased our holdings in Commonwealth Bank and Westpac, whose share price recently hit a five-year low. For the first time in many years bank valuations are starting to compensate for a tougher decade ahead as credit growth slows.

This scenario was unavoidable, which explains why for so many years we’ve been very underweight the big banks. We also preferred Commonwealth, Westpac and Macquarie Group (which we don’t currently own due to its high valuation) to ANZ Bank and NAB. The two-pronged strategy has worked well.

Commonwealth and Westpac have the largest exposure to mortgages, but as a combination they also have less relative exposure to riskier investment loans and business loans than ANZ and NAB. As the two largest Australian banks, they also have more wiggle room on loan and deposit pricing to help increase profits and raise capital if needed.

Lastly, we prefer the big four to the regional banks even though they're statistically cheaper, as they’ll be more likely to receive financial assistance in a crisis. History shows it's usually better to pay a premium for quality during periods of elevated asset prices.

 Find out more about the Intelligent Investor Equity Income Portfolio