InvestSMART Radio May 31st Transcript

Gaurav Sodhi, deputy head of research with InvestSMART returns to help break down the share market.

Steve Price: We’re very lucky to have our sponsors, InvestSMART in the studio. The team of course led by a name and face familiar right around Australia, their chairman Paul Clitheroe. He’s off travelling, and was with us a couple of weeks ago. Last week, I’m pleased to say, Gaurav Sodhi, InvestSMART’s deputy head of research was in the studio.  We had a very spirited conversation about where you ought to be investing your money, and given the hour that we’ve just had, talking about the mess that can be Canberra politics, if you are in the market for investing some money in the share market, there’s no one better than Gaurav to have in the studio with us. Great to have you with us. 

Gaurav Sodhi: Thanks Steve, nice to be here.

SP: Nice to see you again. 13 18 73 is our number. Gaurav can answer any questions about your share portfolio that you might have. You might want to have some advice on what to trade out of, what to get into, what to hang on to, and what not to go anywhere near. You’ve been talking with a lot of your colleagues about Telstra in the market. I know you’re a bit of an expert on telecommunications shares. Most Australians would have Telstra shares, wouldn’t they? From when it went from being a government owned entity to a private company?

GS: Yeah, chances are if you own direct equities, Telstra is probably part of your portfolio. It’s certainly part of almost everyone’s superannuation portfolio. So, one way or another, we are all exposed to Telstra. And that’s been a bad thing for a long time. Telstra shares have performed really badly; the business is under a lot of pressure. And it’s under a lot of pressure from two main fronts. On the fixed broadband front, we all know that the NBN is replacing the copper wire service, and that’s forcing margins lower, so the profits are falling from that part of the business. The crown jewel of Telstra is the mobile business, and there’s lots of competition. TPG has gotten a lot of publicity, it’s been very aggressive, and Telstra probably earns actually the highest margins in the world in mobile. And I think those margins are going to fall a long way, and the market is betting that the margins will fall a long way, hence the share price decline.

SP: They sold the copper network to NBN.

GS: Yes.

SP: So, was that a good deal?

GS: They got a very good deal. I think Telstra is extremely savvy, and the government paid a good price to Telstra for those assets. Those assets will be largely shut down. So, they got $11bn to effectively shut down the copper network, and move all their services onto the NBN. And they will continue to get about a billion dollars a year leasing out their other bits of their asset base to NBN. So, its’s actually a very good deal for Telstra. It’s a shame they haven’t reinvested that money very well.

SP: Have they gone as low to now be perhaps be attractive for buying shares?

GS: This is the big question, Steve. And a lot of people have been talking about this. There’s an expectation that when a big blue-chip company falls over a little bit, and starts looking cheap on the numbers, that it’s automatically a buy. And I want to reiterate that that is a dangerous notion. Simply because something has fallen, doesn’t mean it’s cheap. Simply because the numbers are low, doesn’t mean that there is value. And we want to be really careful about extrapolating the past into the future. Telstra has been earning too high rate of return for too long, and I think that the future is going to be quite different. It’s now up to Telstra to make some significant changes to their business, there is a lot of competition, and they have to do it better, do it leaner to restore some of the share price damage.

SP:  So are you saying hold Telstra shares, or get rid of them, or perhaps wait a little bit and what their business plan going forward is going to be.  

GS: I don’t think is the right time to buy at all. There is a wide variety of options for the business. Telstra is asset rich, it’s got a great mobile business, and there are levers they can pull to increase profitability. And so far, they have not shown any inclination to do that. Telstra is a business that makes all its money in mobile broadband and a few other bits and pieces. They have delusions of grandeur. They want to become the next Google, the next IBM. All this sort if crazy international tech stuff they want to do. If they came back home and focussed on the stuff that is profitable, the stuff that has made them money for years, I think it would be a better business for it. But so far, few signs of that.

SP: It’s in an area that is almost impossible to predict, because it changes so quickly. You know, you and I could have been sitting here five years ago - Netflix didn’t exist in this country.

GS: Very true. This is one of the key things about investing in a fast-changing industry, like telecommunications. You don’t want your decisions to be based on prediction. You want to be an investor not a soothsayer. Rather trying to predict which technology is going to be dominant, you want to invest in businesses that have enduring qualities. And for Telstra, its capital allocation – and by that I am referring to how it reinvests its profits – that’s been really poor. The returns they have earned for reinvesting their really strong profits, has been appalling. That’s one of the main reasons they are suffering. I would argue that they have paid out a too-high dividend for too long as well and that expectation for dividend has actually been detrimental for the business.

SP:  I want to talk to you about that, because Australians more so than any other investors in the world always seek out dividend-paying stocks, like the banks and Telstra. We’ve been told to do that though, by superannuation funds. And particularly people who set up self-managed super funds. The advisors they go to go, well let’s get in here. We’ll get some capital growth out of the shares that you buy, but we are also going to earn an income out of the dividends. That’s a peculiar Australian thing, isn’t it?

 

GS: You’re absolutely right. That is a uniquely Australian phenomenon. Australia actually pays out the highest portion of profits as dividends in the world, we have the highest yielding market in the world. And you’re correct that it’s all driven by our superannuation system and the desire to seek income for retirees. I think a lot of income investors make the mistake of equating a high yield with safety or with certainty. And a yield on a stock, on an equity, is not the same as a yield on a bond or a fixed-interest asset. It’s not certain, it’s full of risk, and there is no reason that the yield you got last year should continue this year. So, you should be very careful when you are investing. In fact, a high yield can be a warning sign. It’s not something to be salivating over. It’s something to be fretting over. So if you look at very high yields as the first warning sign that a company prospect’s may be faltering.

SP: We are very lucky to have in the studio with us from InvestSMART, Gaurav Sodhi, who is the deputy head of research. If you would like some advice, 131 873 is our number. We would love to take your calls on those issues. I mentioned the banks there, the Royal Commission is back up and running again. Are the banks a buy? Have they dropped far enough that you’re starting to look at them?

GS: Banks are very interesting. I’d say they are probably more interesting than Telstra at this point. We’re not buying banks, in fact -

SP:  You’re not buying anything!

GS: It’s that kind of market, Steve! I think in this sort of market; it rewards patience over greed. And doing as little as possible is sometimes a very good strategy. And I think we are in that kind of market now. The share market has gone up a long way over a long period of time, growth is good, and there is a lot of enthusiasm out there. This is the time to temper your expectations, and be a little bit cautious. The banks, look they’re ok. We are holding some banks. We severely underweight banks, and I think that’s probably the right position to be. There are still a lot or risks surrounding banks. Everyone reckons our banks are really high quality, and really profitable. And I’ll tell you a little secret – our banks make the exactly same return on assets as every other bank in the world, about 1%.

SP: So why do we have this mythical idea that they are the best banks in the world, the most solid, the most reliable, and the most profitable?

GS: The trick is, where they actually loan money, is different to where most other banks in the world loan money. We uniquely have banks that are filled with mortgages. They are uniquely filled with property exposure. And the regulations allow you to lever up property exposure much more. So, the Australian banks are about ten times more levered as its international peers. And they are able to do that because all their loan portfolio is in property. So, its property, and in particular mortgages, that allow Australian banks to look a lot more profitable. It does not mean that they are necessarily less-risky or better businesses than international peers. 

SP: What would have to happen in the property market for that to be a risk to the banks?

GS: All you need to have is a crack in repayments. And so far, for twenty years-

SP: - So interest rates going up?

GS: Interest rates going up, wages -

SP: - staying stagnant?

GS: You probably need a bit more than that. You probably need wages to start falling or some other external shock.

SP: So, a recession? 

GS: Yeah, a recession. And that’s something we have not seen. The banks haven’t been tested by a recession in a long time.

SP: Most people listening to us would remember the recession we had to have under Paul Keating. But there would be a lot of people listening to us, anyone under the age of 40, who have never had a recession.

GS: Yeah, you’re pointing to me. I don’t remember a recession. And a lot of market participants wouldn’t remember a recession either. And overseas, the GFC was a big reminder for every bank investor internationally that banks investments are cyclical and risky. And all that leaning was not picked up in Australia, and we haven’t learned those lessons.

SP: A few people might need to go back and watch those documentaries created about the global financial meltdown. It might remind them of just what it was like.

GS: It’s a good thing to keep in mind from Australia’s point of view, because we were able to benefit from the experience without feeling the pain. And that’s very useful if we can keep that in our long-term memories and gain some understanding for it.

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SP: Thursday night, Gaurav Sodhi is in the studio with us. So this should be simple, this whole share investing thing. We know that the biggest companies in the world are Apple, and Google, -

GS: - And Microsoft now.

SP: Amazon, and Microsoft - so why don’t we just put all our money in to those companies and watch it grow? I’m sure you’ve had this question before.

GS: Look, it’s an intuitive response. But unfortunately, investing is a counter-intuitive activity. To do better than everyone else – and that’s the aim of the game. If just want average returns, just want to do exactly what the market is doing, you can save yourself a lot of money just by being a passive investor. Go buy an index fund, or an ETF and sleep nicely at night, pay very low fees, and you will get index average normal returns.

SP: And you can do that through InvestSMART if you want to?

GS: Yep. Our website gives you access to all sorts of ETFs, and you can happily invest in those. And I think a lot of people should do that – it’s a great way to do it.

SP: Sorry to interrupt your thought process there, but is that an age specific thing? The older you get, I think the more conservative you become in your investment strategies. So, for some of our older listeners that’s probably a smart thing to do. So, they can go to bed at night not thinking that if they wake up in the morning and Wall Street has crashed, that they’re ruined.

GS: There is certainly that element as well. People have different risk profiles, and age has a lot to do with that risk-profile. Also, sometimes people are just more conservative. My wife, for example, would be horrified to invest in equities, but I’m quite happy to do it. It just depends on individual to individual. Now, if you want better than average returns, the only way to do better than the crowd is to do something different to the crowd. So just buying the most popular stock, the most popular story, is never going to get you outsized returns.

SP: Like betting on the favourite at the races?

GS: Yeah. I mean, you may well win –

SP: Yeah, you probably will win, but you get a smaller return.

GS: And the share market is probably even more insidious than that. By following the crowd, and doing what everyone else is doing, you’re lowering your upside but you’re also taking on additional risk. You’re purchasing something that has been bid up and is already very popular. The downsize is actually exposed under that sort strategy. If you’re going to be a successful investor, it almost always requires you to be a contrarian, and to do something very different. And you’re right that investing is very simple, but it’s not necessarily easy. 

SP: And you have to spread the risk. I mean, I made the comment there that you could take all your investment money and put it into something like Facebook. But then you see that Facebook gets hacked by Analytica – Facebook could fall over like that if Mark Zuckerberg made a stupid statement.

GS: You’re absolutely right. And no one would see it coming. Everyone would agree that Facebook is a brilliant business, and that in 90% of scenarios you would probably end up making money out of it. But we’ve got to learn to think about not the most likely scenario, but the tail risks. The unlikely scenario that ends up wiping you out. That’s the stuff that kills investors. In all the crises we’ve seen over the years, it was the small probability high-impact event that causes a problem. And you only need a problem to happen once in your life, and that can affect your finances for years, or decades. You may never recover from it.

SP: We talked about the global financial meltdown, and there would have been people clearly in your field in the US warning people that these mortgages that were being written for people that had no income on properties that were basically worthless, that it was all going to at some point come crashing down. Surely there were people ringing the bell a long way out?

GS: There was a lot of people. There’s a terrific book, and it’s been made into a movie now – what’s it called Steve?

SP: Um I know the one –

GS: I can’t believe I’ve forgotten it.

SP: We’ll look it up.

GS: Well the book catalogues some of the people that were warning of trouble. And I think deep down a lot of investors would have realised that they were taking on a lot of risk, but they were just getting so much reward. And this is something to understand, that a lot of professionals inside the system don’t necessarily have the same incentives as an external retail investor does. Their incentives are often to sell product, to sign you up to something, or to write business, and to not necessarily do nothing. Inevitably, doing nothing is sometimes better than doing something. And yet, professionals are awarded for activity rather than thought.

SP: When you start to research a company that you think may be potentially worth investing heavily in, it must be quite a task to get the inside information about what’s happening in that company, right?

GS: Yeah, look. There’s –

SP: And you’ve got to work out what the risks are, and what the benefits are?

GS: Yeah. To buy something cheap, means buying something that other people are selling. If other people are selling a stock, its usually because there’s a wart on it, that something has gone wrong somewhere or that these is some sort of problem. So, the question we find ourselves answering is not ‘is this a good business?’ but the question becomes, ‘is the problem today fixable, is it permanent, is it short-term?’ And that’s often the question that requires addressing. Investors are very simple beasts – they are motivated by fear and motivated by greed. If you can control your fear and control your greed, and look at situations without emotion and with clear rationality, you can often make better decisions.

SP: Let’s talk about InvestSMART’s now. You’re working towards setting that up. Explain what that is?

GS: So, for about 17 years we’ve run an income portfolio.  

SP: The Big Short! Is that it?

GS: Yes! It’s the Big Short! That was going to bug me all night. Thanks for that.

SP: We got it! I didn’t get it – our very, very good producers here worked that out.

GS: Well done gents. Now it’s not going to bug me. 

SP: The Big Short. And that was a fascinating look at what the big banks were doing. 

GS:  And what it tells you, The Big Short, is that all these people that were warning of problems was often weirdos or outsiders. They weren’t in the system. It’s very hard when you are in the system trapped by its inducements to recognise problems. And external people, outsiders, are the ones who call out the problems.

SP: So, the Australian Equity Income Fund.

GS: So, for about seventeen years, we’ve run a model income portfolio. And that’s generated about 12.5% annual returns net of fees. For the last four years or so, we’ve made that an investable product that’s generated about 11% per annum net of fees. We’re now turning that fund, which you could invest in by sending in a written application for which is a bit of a lengthy process, really fast, just buy it on the ASX. So, if you’re interested in that, you can head to our website and be an investor in the income portfolio. In the Income Fund, the big competitive advantage of the fund is that we don’t just go out and buy the highest yielding stocks on the market. What we want to buy is mispriced stocks. We are looking for opportunities where the yield can grow significantly, and by doing that, we actually reduce our risk and nottrade buy those companies whose yield is actually under threat.

SP: Do you have some examples?

GS: One of the companies we have in the Income Fund, in fact one of the largest holdings, is a business called Trade Me, and Trade Me is a bit like CarSales, realestate.com and Seek all wrapped into one platform. It operates in New Zealand. It dominates the New Zealand marketplace for classifieds and used goods.

SP: Did News Limited own that at one time? 

GS: Fairfax owned it. And they spun it off, and it now lists on the exchange.

SP: Another genius idea by Fairfax.

GS: Exactly right? They kept the worst parts of their business and spun off the best parts.

SP: Why is that not surprising? They are the majority shareholder of this radio station.

GS: Wow we’re – and don’t they do a fine job.

SP: So, what does Trade Me do?

GS: Trade Me runs the New Zealand website which is classifieds and second hand businesses online. It is incredibly difficult to compete with. eBay ventured in to New Zealand, and then ran away because they couldn’t compete with Trade Me. It’s the second most visited website in New Zealand after Google. 

SP: Is it because New Zealanders have grown up with it and trust it? Or is it an innovator?

GS: Look, it is an innovator. But that’s not really the source of its advantage. The source of its advantage is that everyone is already on it. So, if you’re a seller of a good, you have to put your good on Trade Me. And if you’re a buyer, you have to go there. And each additional buyer actually increases the value of the network to everyone else. So, for an outsider to come and break into that network is actually really difficult. It generates lots and lots of cash. Now over the last few years, it’s actually been investing that cash into new products and innovations – things like a mobile app and new products. It looks, to the untrained eye, like profits are stagnant and that dividends have not been rising. That is because of new investments. 

SP: So they’re investing their profits back into the business?

GS: Exactly. Which is a sensible thing to do.

SP: Kiwis always teach us sensible things. So that business is, as you say – we have either realestate.com or Domain, we have caradvice.com, carsales.com which News Limited own, and then we have the general non-car and non-real estate websites where you can go buy stuff. That’s all in one? So, they’ve only got the one destination?

GS: Correct – it’s a really powerful platform. And the best thing is that you can buy this really high quality business today at a really attractive price. And it’s attractive because of the investing decisions made by Trade Me make the accounts look relatively unattractive to the short-term investor.

SP: So you’re the head of research though. Do you not at some point wake up in the night and think, well, what if someone does aggressively go into the New Zealand market and does come up with an alternative to Trade Me that works? 

GS: That’s why we don’t buy one stock. That’s why our income portfolio doesn’t consist of Trade Me alone. You know, when you’re investing, you are taking on risk and you’re always exposed to innovation, to disruption, and to random acts that happen in the world. That’s the risk you take on as an equity investor.

SP: Imagine being a major shareholder of Malaysian Airlines. One year they have a plane shot out of the sky, and the next year they have a suicide maniac pilot who flies it out to the southern-ocean.

GS: And their revenue collapses, and it hasn’t recovered. And that is irreparable damage. No one could have predicted that. So, to protect yourself from that sort of event, don’t just buy one business. You have to put together a portfolio and manage it sensibly. And that’s what the income fund is about.

SP: Sounds like a good place to park your money to me. Now, you’ve got some upcoming events. The InvestSMART forum continues. The team will be in Canberra I am reliably informed next Thursday, which is June 7. The topic is ‘Building a portfolio to weather any storm.’ It’ll be interesting to see what kind of crowd turn out in Canberra. They’d be pretty savvy investors given they’re all public servants. 

GS: Yeah, I’m interested to see that myself. I’ll be there on Thursday. We’ve done Sydney today, we’ve done other cities and regional centres earlier this month, and we’re winding it up now. So if you can get to Canberra, the details are on the website.

SP: If you’d like to go along you need to register. You go to investsmart.com.au and click on the events page. In general, would you describe the market as being in a fairly docile mood at the moment?   

GS: It’s actually quite exuberant at the moment. There is a lot of enthusiasm at the smaller end. You wouldn’t know it from the index. I mean banks haven’t been great, Telstra and Wesfarmer’s haven’t been doing great, but beneath that there is a lot of enthusiasm. I would suggest that at this point of the cycle, when everyone else is greedy and enthusiastic, the sensible investor should remain calm. This is probably a good time to do very little.

SP: Great advice, thanks very much for coming in again Gaurav.

GS: Thanks Steve.

 

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