Perpetual goes hunting

Australia's biggest – and possibly most influential – value manager is back bargain hunting in the market. Perpetual Asset Management, led by head of equities John Sevior, has been picking up BHP Billiton, Rio Tinto, CBA, Westpac, Macquarie Bank, insurer QBE and diversified chemicals company Orica over the past fortnight.

As the ASX Top 20 tests new record levels the $23 billion Perpetual group has clearly been taking advantage of recent equity market volatility.

Perpetual's singular view of the market, expressed in today's interview with Sevior, reveals a big-time value manager operating to exceptionally strict internal rules – no leverage, no REITs and no infrastructure stocks. Its capacity to hold up to 15% of any company in the top 300 gives Perpetual a deal of influence over corporate decision-making.

And Sevior is not shy about expressing an opinion. In the tradition of his immediate predecessor Peter Morgan (see our interview of August 15) Sevior is an outspoken manager. He says the past year has been tough for value investors, and Perpetual has been no exception. But the recent weakness in the market has provided a window to buy a few stocks that had been too expensive.

Despite the recent sub-prime debt crisis, which has triggered wild fluctuations in global equity markets, the fund has not been reweighted in favour of cash or international equities.

In fact, Sevior is a true stock picker: Where other managers try to beat the pack and find it safer to replicate market performance, opting instead to manage portfolios that replicate the returns of the market or enhance returns by putting some funds in absolute returns, Perpetual backs its judgment with big stakes: the fund’s ability to go to 15% of any company means it can be 8% above index weight. In Rinker’s case it was 6% over index weight at one stage. These are big deviations in the tightly controlled weightings system of leading fund managers.

With its wide influence across the market, Perpetual has been the “invisible hand” behind the success of Cemex takeover of Rinker and the failure of Tony O'Reilly's bid to privatise APN. Sevior says he is not interested in the Coles and Wesfarmers saga because he owns neither, but when it comes to a stock he owns, such as Orica or Tabcorp, he makes his feelings known. It is understood that Perpetual was influential in Orica's recent rejection of a private equity bid and supportive of “regime change” at Tabcorp where Matthew Slatter has been replaced as chief executive by Elmer Funke Cooper.

Sevior has been running Perpetual since 2002 when he took over the high-profile role from superstar Peter Morgan, who had walked out the door with a bunch of clients and $2 billion of funds.

Now five years later, Sevior is steering a $23 billion fund. The fund has a management expense ratio on the high side, of 1.95%, and investors can invest in almost any of the Perpetual funds for industry minimum levels of about $1000.

The interview

Adele Ferguson: What is your total funds under management?

John Sevior: We have $23 billion in funds under management.

How would you describe the fund?

We are stock pickers. We invest in a value-biased style, or bottom-up approach, to stock selection. This means we do research on individual stocks and put portfolios together by looking at two characteristics. First, the quality of the business, which means the quality of management, the soundness of the balance sheet, the history of earnings and the quality of the business. The next job is to say: is it good value?

Our valuation approach is to assess every company on these tests then try and put a valuation on the company and weed out these companies. We then create a universe of these quality stocks then pick the best value, and that can be based on a variety of measurements. If it's a conglomerate we might do a sums-of-the-parts valuation. If it is a miner we use DCF (Discounted Cash Flow). It can be a straight P/E (price/equity ratio).

Given the recent volatility have you re-weighted your portfolio towards cash, international securities or new sectors?

No we have actually taken advantage of the weakness in the market and picked off selective opportunities. For instance, we went big on QBE, it is up 28% from an intra-day low. It’s astonishing, really. We went in and also bought up BHP Billiton, Rio Tinto, Commonwealth Bank, Westpac and Orica.

What is your outlook for the market?

Here at Perpetual we always said we don’t have any skill in forecasting outlooks. We try to pick stocks. But we have found it hard to find value in the past 12 months. The pool of opportunities became minuscule and there were only six or 12 names we were buying. Now we look at the market, 6200, plus dividends and it is close to its peak again, which is unbelievable.

What has your performance been like in the past few years?

We have had pretty ordinary performance in the past year because the market has been so expensive. But at the end of the day we think common sense prevails. [The latest figures from Intech, to July 31, show the fund recorded a 26.83% return over a year, 25.41% over three years and 21.93% over five years. Over the same periods, the S&P/ASX 200 was up 28.19% over a year, 19.69% over three years, and 13.96% over five years.]

How bad is the hedge fund liquidity crisis?

It is hard to gauge because by their very nature hedge funds are opaque and complex – a lot of leverage added to the system, a lot of derivative activity and a lot of excesses have been built up in the system.

Did you ever invest in the private equity absolute return area?

No. We compete against the S&P/ASX 300 index so we didn’t get into that area. A large number of funds use leverage to enhance their returns and so recently we have seen some forced selling as margin calls occur on some stocks. For instance, Orica had a takeover bid at $32 and so hedge funds took it to $35 in the expectation that the bid would be upped. It didn’t happen, the stock got as low as $23. If you are leveraged into it on that basis and it didn’t turn out it wouldn’t be pretty because you aren’t buying on fundamentals. We buy stocks on their fundamentals.

Last year you changed your constitution so that you could invest in international equities. Are you doing much of that and if so where?

Yes. Last year we decided to expand the portfolio so that we could invest up to 20% of our funds overseas because we were struggling to find value in the Australian market. We had quite a bit of success in overseas stocks such as Hendersons (the former AMP offshoot in the UK) and Rinker but, to be honest, it is a very slow process.

The decision was as much about education as money-making opportunities. We have realised that there is a lot more to know about individual stocks and individual markets. We have about 2% of our funds under management in international stocks, and that has ranged between 2% and 4% over the past year.

A lot of fund managers are starting to see Asia as an area of opportunity to invest in equities. Do you agree?

We don’t look at regions; we look at industries and stocks. So we don’t have a view on Asia. But looking at what we invest in, we don’t buy too many stocks in Asia.

In Australia, what sectors do you like most?

We like the banks, financial services and resource stocks. We are very enthusiastic about financial services. In the pecking order, we put CBA and Westpac first because they are sound businesses, they have a strong domestic focus, a good mix of businesses, and have a lot of stuff still to do internally, so that means a lot of internal benefits ahead that they can generate returns from.

Westpac has a good spread of businesses and has been reasonably prudent in the past few years. We believe the appointment of Gail Kelly will make a difference.

ANZ is a good company. It has a pretty good record, and the new chief executive has a strong Asia background. It has a mix of businesses in Asia but we want to hear what the new strategy is before we get too excited.

With Macquarie Bank it has had a lot of bad news so when the share price went down recently we saw it as a fantastic opportunity at those prices and bought some stock.

QBE is another stock that we have been buying. When the share price fell in the past couple of weeks we started buying up. It is a strong company, with a strong record and strong management team. Its latest results were excellent.

We also own Suncorp because it has simple strategies and good management.

Infrastructure stocks have taken a beating in recent weeks. Has that enticed you to buy up?

No. We have a zero weight in infrastructure stocks because we think they are overvalued and their gearing is too high. They don’t fit our criteria for our universe of stock picking.

What about the mining sector. Do you believe in the “stronger for longer” theory regarding commodity prices?

We make sensible assessments for the outlook of commodity prices, and so we have sensible assumptions about the stock levels. This means we don’t go in for the 'stronger for longer’ theory. We do own some Rio Tinto and BHP Billiton and, to a lesser extent, SimsMetal and OneSteel, but few others.

What we like in the mining sector is the big diversified miners because they have long life assets, good management, low gearing, a strong balance sheet, and a broad base of commodity exposure.

What about smaller miners such as Fortescue? Ever tempted to invest?

People have made a lot of money in the low end of the market. It doesn’t fit how we think and so we have missed out on the big valuation rises. We have had a few one-off exceptions such as New Hope Coal, OneSteel and SimsMetal, which is scrap metal but in the second-tier miners we don’t own many stocks: Having said that we made good money out of Oxiana.

We have missed the whole Fortescue ride because again it doesn’t fit our philosophy. Fortescue hasn’t made any money yet so we haven’t bought any shares. I don’t want to be seen as poo-pooing the company because after all the stock has gone from 50¢ to $35, so we missed out on that, but it doesn’t fit our criteria. It hasn’t an earnings history and it has a lot of debt.

Do you have a view on Telstra?

We are neutral on Telstra. We think there is value in the stock at a price point but neutral right now.

In the latest reporting season a lot of companies are doing share buybacks. Are you in favour of these sort of capital returns or are too many companies doing it to lift the share prices?

We like buybacks if they are priced sensibly.

What is your maximum holding in a company?

We don’t go beyond 15%.

Do you have a stronger weighting at the big end of the market or the small cap end?

We have a mix of companies throughout the ASX 300. We are stock-selective, so don’t make big calls about sectors or big versus small caps. We really go on a company by company basis. What we do is keep analysing companies across the board and when value comes up we invest.

How do you analyse companies?

We made 1000 direct visits to companies. We look at the management, operations, competitors and we look at valuations such as price/earnings ratio, EBIT, sum of the parts, DCF for resources companies. It isn’t rocket science. Our investment philosophy is rooted in common sense and being disciplined in what we do.

What about listed property trusts?

We aren’t interested. We have zero investments in that area. We think they are too expensive. We have felt that way for a couple of years so we were wrong for a couple of years and missed out on the upside.

Do you see any value in the healthcare sector? If so, what stocks?

We are underweight in healthcare. We think CSL and Cochlear are too expensive. We have Ansell and a few Healthscope but that’s about it. Again, we haven’t been in CSL for a while so missed the rise but we stuck to our principles, that it is overvalued, so haven’t been tempted to go in.

You have been very active in voicing your opinion about a number of stocks in terms of management and takeovers. Do you see that as important for fund managers?

It has always been something Perpetual has done and when we have a big stake in a company we feel it is our duty to speak out. We sold Aristocrat because management were not telling us what was really going on, so they failed the management test we have. We had built a decent stake at close to the bottom and got very concerned about what management was doing, and about the balance sheet, and sold almost at the bottom. It was around $2 then. The stock went up and we missed out but we stay true to what we believe.