Short-term hype needs a long-term eye

The market is firing on all cylinders … but some long-term perspective is needed in the search for value.

Summary: Most investors and advisors are not investing with an eye to the future but reacting to interest rate settings that are neither normal nor derived by the free market.
Key take-out: By not understanding the economic cycle, and being reactive to price movements, investors are increasing their risk of failure.
Key beneficiaries: General investors. Categories: Growth and Income.

A Saturday morning ritual of mine is to read Alan Kohler’s Eureka Weekend Briefing email. Frankly I prefer to catch up with Alan’s insights rather than spend hours wading through the newspapers on a Saturday morning.

Last Saturday Alan made what I believe is one of the most important observations for retail investors to understand. Simply stated, Alan noted that many fund managers of equity funds will buy shares for their clients that they would not buy for themselves. A very telling comment, and one that I agree with. His observation is supported by the proliferation of “index type” investing that turns off the human mind, common sense and integrity.

So before I start on this week's column, let me assure you that the stocks I have chosen for our growth and income funds are overwhelmingly held in the Clime Managed Funds. Further, I myself have the majority of my superannuation equity investments in Clime managed funds or in the Clime Group shares.

There are no shares in these portfolios that I would not own myself.

The outlook for 2013

In thinking about the outlook for markets in 2013 I am taking the liberty of revisiting my article published in Eureka Report in October 2011 (The further you look, the better it gets). At that time, both investor and market confidence was being rocked by serious financial disruptions in Europe but I argued that while the short term was difficult to predict, the longer term was much more certain. I believed that much of the bad news had already been priced into equity markets, and so it was a good time to accumulate equities against the tide of perceived uncertainty.

Today I am still absolutely certain that the longer-term future is more predictable than the events that will occur over the next 12 months. Further, I doubt that the recent market moves (20% rally) have anything to do with this longer-term outlook. While the rally in the equity market has some aspects of logic, there is also the constant pressure coming from impatience, greed and stupidity. Unfortunately nothing will change these perverting influences on the market. My view is that these characteristics are, and will remain, constant forces in the pricing and mispricing of securities for the foreseeable future. That is certain!

The ASX over the last three years – “is it going anywhere?”

Having made those background comments, let me now share with you my view of the longer term. In doing so I absolutely dismiss the claim that economic forecasting is prone to be wrong. Rather, what is difficult to predict is the cumulative behaviour of investors and the timing of reactive market behaviour. 

First, I am absolutely certain that China and therefore Australia will have bigger economies in three and five years than they have today. China’s economy will likely grow by the actual size of Australia’s economy ($1.6 trillion) in the next five years. The Australian economy will grow through its engagement with China and the compounding growth of its population. Australia will likely have 1.5 million more people in five years than it does today. This type of growth is good for our equity markets because it should translate into higher profits and dividends. Whether it is good for equity prices will be determined by what is happening in the bond market and the outlook for inflation (see below).

Second, while the US economy will also be larger in five years’ time I have no confidence to forecast the same for the United Kingdom, the Eurozone or Japanese economies. This is because those countries are in financial distress and actually have no means or capacity to repay their massive government debt. This debt will need to be compromised and the terms of compromise have not even been debated at this point. So they are a long way from a solution and their low growth outlook is compounded by low birth rates and low immigration.

Third, there is an ageing demographic wealth problem across the developed western world. The poor distribution of wealth is starkly seen in the aggregation of wealth in the population that is over 50 years of age – the burgeoning baby boomers. In contrast, those under 40 years old have too much debt to support a lifestyle that has come too quickly and too easily. The fiscal imperative of governments to withdraw from aged income support has led to the increase in private savings and a curtailment of debt-funded consumption. The consumption-led growth cycle of pre 2007 is unlikely to return to developed countries but we may see it in the burgeoning middle classes of Asia and South America in about 10 years’ time.

Fourth, the quantitative easing (QE) programs of the US, Japan, the Eurozone and the UK will have come to an end. While that is certain, it is uncertain how they will come to an end and what the repercussions will be. However, what is certain is that central bank asset purchases will result in those authorities owning a massive amount of government debt. For instance, we know that the Federal Reserve of the US already owns about 15% of all US government issued debt, and so the question becomes – will they sell it or write it off? If they sell it then who will buy it and at what price? If they write it off, then will this event create a new cynical economic paradigm where markets become permanently infected by a perceived government safety net?

Finally, the end of QE, the continuation of growth in China and the recovery of the US economy will see a recovery in the US dollar and therefore an uplift in the Chinese yuan. The decision by China to improve the economic lot of the lower middle class worker, through higher wages, is now a policy. It will result in China exporting inflation from its manufacturing sector. The inflation will be compounded by a lifting of the Chinese and US currency against the Australian dollar. A decade of Chinese export deflation is coming to an end. The developed world, and particularly Australia, has closed down too much of its manufacturing capacity to stop the likely inflation surge. When this becomes apparent then governments, central banks and markets will react. Based on history the first sign of problems will be observable in bond markets, which invariably smell inflation long before equity markets. Given that bond markets are dramatically overpriced now, due to QE, then the bond correction could be severe.

The above discussion is my view of the macroeconomic trajectory in the next few years. I believe that the current economic environment is neither stable nor sustainable. Further, and importantly, I suspect that investors and advisors today are not investing with an eye to the future. Rather they are reacting to interest rate settings that are neither normal nor derived by the free market. By not understanding the economic cycle, and being reactive to price movements, then investors are actually increasing their risk of failure.

While there are short-term gains to be made over the next year, I believe that the claims of a return to a sustained bull market echo the calls of a distant past that “there is gold in those hills”. I believe there is always gold in the sharemarket to be found. It is called “value”, and to find it you must know what “value” looks like.

How to manage capital in this environment

In constructing the income and growth portfolios I believe I have adopted a rational approach to valuing investment assets. I strongly believe that it is foolhardy to transact in the equity market without a solid base for valuing securities and shares. The intrinsic valuing of shares empowers an investor to buy shares in growing companies at below the assessment of forward value. The companies of interest identify themselves through their audited history of achieving high returns on equity. Intrinsic valuation therefore aids me to create model portfolios of stocks and securities that I believe will generate a superior return over a longer time frame.

Intrinsic valuation is not new. It is not a black box or a software program. Rather, it values companies based on their projected return on equity. The valuation is actually a multiple of equity that adds an income value to a growth value. It is fairly logical and simple. It is not as simple as price earnings ratio, but it is more logical!

In managing capital in this environment I have two simple rules and I believe you should consider them for your investing.

First, be realistic about what the equity market can and should return to an investor. Over a long term the market index returns about 7% p.a. This is a reasonable benchmark, but using a value-based stock selection process you should expect to achieve a higher return. To my mind a 10% p.a. return is a reasonable target and this should satisfy reasonable investors.

Importantly, a 10% p.a. return with reinvestment would generate a return of 100% over seven years. Think about it carefully – would you be happy to double your capital every seven years?

Second, remain patient and rational. Value can appear at any time and for any reason. As a fund manager I do not feel compelled to be fully invested because I prefer to buy value, and so cash is a vital component of a portfolio. There is no rush, and often those who rush up the hill to stake their claims often step over the gems that were slightly hidden.

Yes, this note is full of caution. That is intentional because the market has rallied by over 30% since my article in late 2011. Let’s remember our targeted investment return. Think seven years and you will be as patient as me.

The Reject Shop (TRS) and McMillan Shakespeare (MMS)

Two phenomenal share price performances from our growth portfolio have been TRS and MMS.

Both companies met market expectations for their interim earnings and therefore achieved my expectations for reported profitability or return on equity. In recent days the team at MyClime have updated the forecasts from leading broker analysts and attended company presentations. So below is my estimate of forward value for both companies based on this research. I once again draw investors’ attention to my adopted required returns for each company, which acknowledges the continuing low level of long-term bond yields.


Clearly, based on the forecast values for 2014, I remain a happy holder of both stocks in the growth portfolio.


John Abernethy is chairman of Clime Capital Limited, ASX:CAM (Clime’s Listed Investment Company). Read our analysts’ summaries on the current Earnings Season with MyClime. Register for a free two week membership. Click here.

Clime Growth Portfolio

Return since June 30, 2012: 34.82%

Returns since Inception (April 19, 2012): 25.36%

Average Yield: 5.47%

Start Value: $111,580.24

Current Value: $150,434.01

Clime Growth Portfolio - Prices as at close on  28th February 2013

CompanyCodePurchase
 Price
 Market
Price 
FY13 (f)
GU Yield
FY13
Value
Safety
Margin
BHP BillitonBHP$31.65$37.074.51%$43.6717.80%
Commonwealth BankCBA$53.38$67.277.58%$64.96-3.43%
WestpacWBC$21.29$30.778.08%$29.45-4.29%
BlackmoresBKL$26.48$31.805.93%$32.622.58%
WoolworthsWOW$26.88$34.935.48%$31.24-10.56%
IressIRE$6.60$8.035.83%$7.03-12.45%
The Reject ShopTRS$9.33$17.683.39%$15.33-13.29%
BrickworksBKW$10.15$12.794.58%$12.27-4.07%
McMillan ShakespeareMMS$11.88$15.344.84%$17.3012.78%
Mineral ResourcesMIN$8.98$11.276.34%$12.7413.04%
Rio TintoRIO$56.86$67.053.75%$64.98-3.09%
Flight CentreFLT$27.00$32.505.36%$28.35-12.77%

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