Spotting cashed up LICs

I go away for one week and look at the mess I find when I return. Over the last four months the market has been trending down from its near 6000 high in April. In the last two weeks the decline has picked up more speed than yours truly did when thrown down an intermediate ski slope after 20 minutes of lessons. This analogy will be bang on if we find the market feigning injury and sitting in front of a fireplace for the rest of the week.

As you are all aware, China is slowing more rapidly than anticipated, commodity prices continue to fall and QE-fuelled markets have run out of steam. At the same time our August reporting season was below expectations with earnings failing to come through for equities trading on inflated PE ratios. All culminating in the correction we are witnessing and giving newspapers an excuse to roll out their favourite market-related headline last week: “$60 billion wiped off markets today”.

If you have cash on hand like the LIC model portfolio does and want to take advantage of the selloff through LICs there are two ways you can do it:

• You can look to average down into fully invested portfolios like BKI, or
• You can look towards the LICs out there that have plenty of cash.

Not only will these LICs give you an opportunity to take advantage of falling markets, but they will provide you with a smoother ride through the uncertainty.

Last week I spoke with four cashed up LICs who are on the LIC model portfolio watchlist. All are worth a look. What is interesting to note is the majority are approaching this market with caution and all state that they don’t expect a quick rebound from what we have just experienced. Even if you are not an LIC investor hearing the thoughts of these portfolio managers and reading their updates via their ASX announcements are invaluable to help you navigate through this period of uncertainty.

It is important to highlight there are LICs with long track records who have actively chosen to move towards cash like Clime Capital (CAM), WAM Capital (WAM) and WAM Research (WAX). But there are also LICs that through the good fortune of timing have completed a capital raising at a fortuitous time like Contango Income Generator (CIE). Saying that, what matters is what they do with the cash for shareholders and not how they came about it.

Recapping the LIC model portfolio

Before looking at the watchlist LICs let’s have a brief look at the LIC model portfolio’s current holdings.

BKI: BKI felt the brunt of the correction on Monday (August 24). This presented a great buying opportunity for those who were ready to average down. When presented with sharp pullbacks and invested in a large cap portfolio averaging down on the dips is a good way to get an edge on the market. Be prepared for the next one and remember you don’t have to get your total allocation all at once. Be patient – as you’ll read below none of the portfolio managers believe this is the end of it.

MFF: MFF also felt the full force of the market gyrations as it reacted in a similar fashion to BKI with Tuesday (August 25) being the day it was most significantly down before gradually rising to be just below $1.90 again at the close of the week. Portfolio manager Chris Mackay has spoken about global issues for a long time in his monthly musings attached to the monthly NTA announcements. If you don’t read them I highly recommend you do. Generally only two or so paragraphs, they provide great insight into his thought process. Right now Mackay is keeping a level head as per usual choosing to see through this cycle by sticking with his high conviction quality names.

Here’s an excerpt from July’s report: “Simple, low risk actions do not exist in these market conditions. More companies are stretching their businesses, stretching their accounting and stretching their manner of presenting their results to gain or retain market favour.” I will consider adding to the MFF position on further pullbacks as well.

CDM: Cadence has fared well throughout the volatility. On the pullbacks it did not pull back nearly as much as the market. I believe this is on account of two things: a well-diversified portfolio and the mandate flexibility to short sell as well. On August 31 (today) their options also expire with a strike price of $1.43. If we see the market hold up through the end of the week I expect to see the share price hovering on or just above that price come market close. If the options are exercised this will give CDM a cash injection at a handy time and also a chance for investors to buy at a discount to NTA which has been a rare opportunity lately.

PAF: The PM Capital Asian LIC has been the main drag on the portfolio despite still having 14 per cent cash when it last reported in its annual report on August 13. With a bottom-up approach focusing on businesses rather than markets you would expect the team to be deploying that into markets right now. I believe the pullback in price has more to do with the liquidity of the stock. Investors need to keep in mind as well PAF has been quite clear that it has not held and has had no interest in holding China A shares in the portfolio. It’s a long term portfolio with cash in a falling market. As investors we should look through the cycle and consider adding to the position when opportunities like this appear.

WAX: Speaking of LICs and cash the team at WAM have bucket loads of it at the moment and this has helped smooth the ride for shareholders. But do not expect portfolio manager Chris Stott to be wading in and buying stock hand over fist in the downturn. The WAM portfolios in general have always held large amounts of cash and it is in times like this it has helped them outperform. Speaking with Stott last week he reiterated they are not seeing great value yet, pockets yes but not great value. Also they have not seen the earnings growth to justify the inflated PEs. They’ve done a little buying but really won’t be deploying capital until they see growth pick up or greater value for the names they are targeting.

Now let’s take a look at the watchlist.

QV Equities (QVE)

QVE is a relatively new LIC from the team at Investors Mutual run by portfolio managers Simon Conn and Anton Tagliaferro. The portfolio's mandate is to invest in ASX-listed securities outside of the ASX 20. This means during the recent correction QVE, by its mandate, was not holding any banks. On top of this from its last update to the market on released on August 26 Tagliaferro said the portfolio held close to 25 per cent cash.

Why were they sitting in cash? Tagliaferro and his team have been holding approximately 25 per cent cash for some time now on the basis of stocks being overvalued and he pointed out this is still the case despite the pullback we have seen. Being ex-ASX 20 they are not in the business of buying markets: “We look at stocks and we try to see if there is anything worthwhile buying and if not we’d rather hold cash. We don’t feel compelled to buy”.

Have they been actively deploying cash now? “Yeah we’ve been buying a few things but we aren’t rushing in,” Tagliaferro says. The reason for this patient approach extends beyond just the Australian market. The economies of many countries are slowing and if you look at earnings it is very hard for companies to grow them in developed markets right now.

It is hard for the mid-cap investors to get overly excited right now as the business environment in Australia and the world is fairly tough. “Many companies are struggling to grow their earnings organically; it is very difficult to grow their top line,” Tagliaferro says. What he and his team are looking for are stocks at the right price with the right story and that means cost outs and acquisitions.

The outlook for QVE & the market? As always the market is difficult to predict but as Tagliaferro suggested, “Volatility tends to last a little longer than three days.” For the market in general Tagliaferro believes it will be supported somewhat by dividend yield given the low interest rate environment we are currently in but it is hard to see much upside.

Right now they are seeing current price levels as okay but find it hard to get excited about them due to the lack of earnings growth as mentioned. However saying that there is a little bit happening outside the top 20 in terms of acquisitions and companies consolidating the industry they’re in which has caught QVE’s eye. Tagliaferro pointed out Sonic Healthcare (SHL) has been growing over the last year by repeating its consolidation of the Australian pathology market globally in Germany, the UK, US and Switzerland. Another business growing by acquisition in the QVE portfolio is packaging manufacturer Pact Group Holdings (PGH). On a yield play QVE has bought regulated utility AusNet Services (AST).

From speaking with Tagliaferro you get the feeling they have been nibbling at stock with their cash but on the whole through this correction have kept their powder dry. “It pays to be patient and wait for the right stocks at the right price to come your way.”

Perpetual Equity Investment Company (PIC)

Second only to the brand spanking new Contango Income Generator when it comes to percentage of cash is Perpetual’s latest offering PIC. The mandate is to be benchmark unaware with the portfolio having the freedom to invest in Australian equities (predominantly mid- to small-cap stocks), international equities (up to 25 per cent) and cash (up to 35 per cent). However, in the company’s first annual report it stated a cash balance of 48 per cent as at August 14.

Why does PIC still have so much cash? When the company listed on December 18 the board gave portfolio manager Vince Pezzullo six months to invest the portfolio and be in line with the maximum cash balance of 35 per cent. The market had other thoughts in mind and didn’t give Pezzullo and his team the opportunity to sensibly deploy the capital. The board extended the six months to twelve. Following his value investing philosophy and wanting to build positions with a margin of safety, Pezzullo has patiently waited on the sidelines and now for the benefit of shareholders that patience has paid off.

Is the PIC team buying? When speaking with Pezzullo he was cautious to say too much about his buying activity, rather preferring to stick to stock stories already discussed with the market like the team’s Bluescope Steel (BSL) purchase sub $3 (price now of $4.11) and international purchases eBay and Bank of America towards the start of 2015. But have he and his team been buying in the last few weeks? “With the market pull back we have started to put some money in and we’ve continued to invest as they’ve rolled back.” So as a value investor is the team seeing value emerging from the market? “Absolutely, a lot of stocks are trading at where we think is below fair value.” I get the feeling (and I could be wrong) the team at PIC are having more than just a little nibble at stocks on their watchlist. I’ve hung around value investors long enough to know when there’s blood on the streets and they have cash at hand they are usually dancing into the office.

The outlook for PIC and investors? Does this correction have further to run? Pezzullo believes we have seen a fair move here in Australia and thinks resources have probably found their base. “From day to day now we may probably still see movements of plus or minus 1 per cent. I’m seeing absolute value right now but I try not to call the market as you will just tie yourself up in knots,” Pezzullo says.

What Pezzullo prefers to focus on, and what we at Eureka Report with the team’s model portfolios also try to focus on, is the individual stocks based on the valuation and the company’s ability to grow and add value to a portfolio. Rather than having to buy stocks just to track a particular index or match a sector weighting. Hence why PIC does not hold any of the big four banks. “If you look at the portfolio it is a genuine stock picker’s portfolio and the stocks in there are reasonably uncorrelated to each other so they don’t move together.”

PIC has the advantage of an incredibly experienced team with the support of the broader Perpetual business. Further, a flexible mandate allows the LIC to include international holdings as well as being unconstrained by market cap with Australian equities. A large cash balance at a time of broader market weakness, may set PIC up to be one of the more successful LICs in the years to come.

Contango Income Generator (CIE)

CIE listed on August 14 with $71 million and the market sitting at 5387. In the next few days the market fell to an intra-day low of 4928, presenting a great opportunity for George Boubouras and the team. “Yeah, it’s going pretty well,” said Boubouras when talking late last week. CIE is the latest offering from Contango. As the name suggests the aim of the LIC is to generate income for shareholders and if you’re familiar with Contango’s other LIC then you may have guessed the portfolio will be made up of mid- to small-cap stocks. For more about the investment process see the Eureka Interactive with George Boubouras here.

Are they buying right now? Does Tom Piotrowski need a shave? Contango has a brand new LIC and the market dropped 300 points, the team is good to go and has been picking up names. But let’s not get carried away, Boubouras is quick to point out the caution he and his team are taking: “We have had and will continue to have a defensive stance.” Boubouras also pointed out they have been long traditional defensive dividend payers no matter the portfolio’s orientation, growth or income.

Where they have been actively deploying cash is into quality mid-cap companies who have reported and are cum dividend as they will need the dividend to distribute to shareholders early next year. What investors can expect to see is the concise investment philosophy spoken about throughout the lead up to CIE’s listing. “It’s about investing in low beta, low sensitivity to future earnings, sectors and stock names while trying to incubate and enhance as much income and franking through the cycle and help the shareholders blend this with their large cap exposure.”

The outlook from here? The team at CIE is seeing value in the market. Last Monday was an exception and they do not expect to see a day like that again however on a one-year view it would not surprise to see the market track lower. Boubouras noted he cannot see a notable change pointing towards a sustainable increase in commodity prices which is not good for the broader earnings of the major companies and corporate Australia as a whole. Additionally Boubouras noted the lower rate cycle: “We still believe the global rate cycle will need to permeate for much longer and while there are nuances in North America that would like to delay it, from a macro perspective there is nothing that spells out to us there’s a sustainable backdrop that earnings will expand considerably in the next one year to 18 months.” Hence the defensive stance.

Clime Capital (CAM)

The last 18-24 months have been tough on CAM shareholders and chief investment officer John Abernethy has not shied away from addressing this in the recent annual report and his quarterly updates throughout the period. The last two years have been a hard slog for value investors who target quality businesses with a high return on equity and try to buy them cheaply. The QE and low interest rate-fuelled markets have the limited the amount of value opportunities. Saying that, the Eureka LIC portfolio has not owned CAM. The last 24 months’ returns are inconsequential to us as potential investors, it’s the forward-looking returns we are interested in.

How much cash do they have? Abernethy and his team have sat on cash for quite some time now but unlike the other LICs mentioned they have had the cash split close to 50/50 in US dollars and Australian dollars. Instead of getting 2 per cent for their cash they have achieved a return in excess of 5 per cent on their cash. In total at their last report CAM had 20 per cent of the portfolio in cash. Additionally they have been downsizing past troublesome positions.

Are they buying? As mentioned CAM has been switching out of positions and has used that cash to buy into the pullback. The pullback has seen them target names like Caltex, Ramsay Health Care, Commonwealth Bank and other quality businesses that have been on their watchlist for quite some time but Abernethy warns, “You don’t want to be obsessively buying banks right now because you are taking on a lot of earnings risk if economic conditions continue to weaken.” On the international front the team has nibbled at UK listed beverage business Diago, but you still get a sense of caution here and feel the cash on hand will be gradually deployed on further weakness with a watchful eye. “We’re trying to build a portfolio but if stocks rally hard we’ll take profit.”

The outlook for CAM and the market? For Abernethy international markets remain very unstable and what we’ve seen over the last few weeks has been a correction off the back of QE pumped markets. “They’re just falling back because there’s no growth. All the pump priming has done is create asset bubbles and not growth.”

Right now Abernethy sees the Australian market as being the value pick out of international markets with a forward looking valuation on the market of 5650 for next year. “What we’ve seen is the US market fall from an excessive level back to be sitting on value, but the Australian market went from overvalued to being undervalued.”

From his own words in the annual report, you can expect Abernethy and co to trade around the edges of this volatile market but you’ve also got to think a value investor with cash on hand has to be deploying some of it now for the long term and to the benefit of shareholders.

Disclosure: Eureka Report and Clime have a formal association with Stocks In Value. Mitchell Sneddon was a Clime employee until June 30 this year, he now works full time at Eureka Report.