Stocks to Take You Higher

After a good run in leading Australian equities, it is not unusual for investors, and particularly traders, to start suffering from a little "altitude sickness". Altitude sickness usually makes you a little short of breath, a little bit dizzy, and generally makes you want to descend to a lower altitude. It's basically an uncomfortable feeling, yet it can be overcome if you stay at the altitude long enough and you body adjusts to lower oxygen levels.

The common investing response to "altitude sickness" is to take profits, as that is the remedy that will make you feel comfortable again in the short-term. The easiest thing for me to do as a stockbroker is recommend taking profits when investors are starting to feel altitude sickness. I know I can persuade people to do it, because it comes down to basic psychology. It's very easy to tell people what they want to hear. It's an easy brokerage generator, but it's not the cure to the illness; in fact it may make you more ill if the market climbs in the medium term.

The biggest mistake you can make as an investor is to confuse "overbought" with "overvalued". There is a clear difference between a stock being short-term overbought from a trading perspective, and medium-term overvalued from a fundamental perspective. There's no doubt that stocks are regularly "overbought" from a trading perspective, but that doesn't mean they are "overvalued".

There have been numerous occasions over the past two years when major resource stocks have been "overbought" from a short-term trading perspective, but they were never "overvalued". In fact they were, and remain, "undervalued". The trading corrections from overbought short-term levels provided excellent medium-term undervalued investing opportunities. I must have written dozens of times over the past few years to "buy the trading dip in quality". Value, quality, and balance sheet strength always wins out in the medium-term.

I used to be a "trading junkie", but now I just don't see the point. I spent years chasing my performance tail with short-term trades, yet at the end of the day I would have been further ahead if I just bought on bad index days and held the leading stock I was trading in. For eight years the ASX200 was stuck in an 800-point trading range, yet now we have clearly and permanently broken out of that, and I think excessive trading will cost you performance. Real wealth is generated by medium-term investment; trading is a very crowded space, and I don't like being in a very crowded investing space.

The far less crowded space is now "investing". The pressures to be short-termist are enormous, so if you can resist the pressure, you have less investing competition. Many of you will think this is an arrogant attitude, but if the market is obsessed with short-term performance, I want to focus on taking advantage of short-termism with genuine long-term, bottom-up investing. I want to be a long-term investor and capital partner for quality companies. I want to back high-quality people running high-quality assets and I want to stay the course with them. I want to focus on sustainably high ROE (return on equity) companies, and live off the income these high ROE businesses generate. I don't want to be obsessed with global macroeconomic or geopolitical issues; I want to invest in quality at a stock specific level. I want to think global, and act local. That strategy again worked in January, with the ASX200 up 3.5% and the US equity markets flat.

There is no shortage of leading and emerging Australian companies I am happy to be an investor and long-term capital partner to, but to maximise my performance I need concentrated bets. I'd rather have 10% of my money in each of 10 high ROE companies, and pay no attention to index weights. Sure, no fund manager will hold such a concentrated portfolio, but I'm convinced diversification and "over-trading" leads to lower long-term returns.

I am pushing a "barbell strategy" this year; that is, being overweight in the two big sectors of resources and "traditional" financials. You can be overweight both this year, as interest rates peak globally, margins and ROEs stabilise in the financial sector, and some large mergers and acquisitions break out. We see clear visibility of earnings from both sectors.

"Traditional" financials underperformed the broader market last year as resources and investment banks took over the running, but I think their underperformance is selectively providing solid medium-term buying opportunities. The relative switch is from investment banks and geared financials (infrastructure) '” where everyone is overweight and earnings growth is peaking '” to traditional "old-school" financials.

We feel selected traditional financial stock consensus earnings are underestimated for this year and next, and that also means dividends, capital management, and ROEs are underestimated. I would put Commonwealth Bank, Suncorp-Metway, St George Bank, Bank of Queensland, Bendigo Bank, AMP, Insurance Australia Group, Henderson Group and AXA Asia Pacific in this list of potential earnings and dividend surprise candidates for the next two years. There's also a truckload of fully franked dividend streams from the list above and, as you know, I think the price paid for fully franked dividend streams will rise, in terms of price/earnings (P/E) multiples, after May when we get generational income tax and superannuation tax reform.

So I am happy to be strategically overweight big cap "traditional" financials and big-cap resources, and we also want some concentrated bets in big-cap global growth.

My core strategy remains to be leveraged to the strong outlook for the global economy, by accumulating a portfolio of Australian listed growth stocks with foreign earnings. In addition, I want companies that possess "pricing power" by virtue of their dominant industry positioning, have a rising ROE profile, and high quality management with a proven track record. I think the best way to play the global theme is to invest in Australian stocks rather than direct investment in foreign equities. It makes little sense to relinquish a higher yield and the tax advantages of franking credits, assume increased currency risk and surrender management accessibility, by direct investment in international equities

I want five big-cap global growth stocks in the portfolio. They are Brambles, Cochlear, News Corporation, Lend Lease, and Qantas.

The "buy more when it's working strategy" has been the backbone of quant and momentum fund investing, and although I think they generally tend to do it all a little bit too aggressively in both terms of time and price, there is merit in the strategy.

I had a horse run at Wyong yesterday. It was her second run, and she improved to finish fourth, from seventh in her first outing. It was a highly encouraging run, and it makes me feel next time that her improvement may lead to a win. It makes me want to own a greater percentage of her, and also have a wager on her next time.

The point is that my initial investment in this horse was basically a punt on her good breeding, but now I know she can run, I want to invest more in her even though her "share price" has risen. The betting odds when she runs next will be lower, but she's actually a lower-risk bet now and genuine chance of delivering me a "return".

This strategy is very applicable to equity market investing. Too often when investors are considering taking profits, they should actually be considering buying more of the given stock because it is performing. The idea of increasing exposure as a stock meets or exceeds a given financial set of benchmarks is a very good strategy in my opinion, and one that is not used enough in Australia.

In the right stocks, this relatively aggressive strategy will work very well, and you shouldn't be worried about paying a higher price than your initial investment. It's basically a "confidence" strategy, where you commit more capital to a stock as you become more confident you're right about the company's medium-term prospects. It's a like an investing "campaign", based on financial benchmarks being exceeded by management.

The current interim reporting season is a good time to test this "buy more when it's working" strategy. While everything that is reported in the next few weeks is "historic", it does give you a guide to which management teams are delivering superior returns. A genuine earnings or outlook surprise will attract support this reporting season, unlike this time last year when the market basically bought the rumour and sold the fact.

Don't get me wrong; I think the interim reporting season is the most ridiculously over-analysed event of the year, with 300-page "preview" documents all over the market. These documents are about as useful as teats on a bull, because they are in effect "previewing history". You give me reporting season preview for February 2007, and I'll make you money.

You'll get hundreds of phone calls from brokers over the next month about interim results that were "1% below our analysts forecast", and all they are trying to do is solicit a trade from you. You're far better to let the trading dust settle, go to presentations with management teams, and work out if they deserve more capital from you for the next 12 months.

And here's my theory on fully franked dividends: I believe the Federal Government will deliver generational income tax reform with the May budget. By generational income tax reform I mean lower marginal tax rates, and fewer tax brackets. I believe the top marginal tax rate will be dropped to 40%. Therefore, the difference between the top marginal tax rate and the corporate tax rate will narrow by 7%, which basically means investors who own fully franked dividend streams will have to pay less "top up tax".

I believe that as the "top up tax" requirements fall for individuals, that the price, in P/E terms, that individual investors are prepared to pay for those consistent fully franked dividend streams will rise. If you can find stocks that are growing fully franked dividend streams, you will get the double whammy of a higher price being paid for those growing dividend streams.