Teele's Long View

You might have heard of Bruce Teele and his $4.2 billion Australian Foundation Investment Company, an 80-year-old listed investment company closely linked with stockbroker Goldman Sachs JB Were. But it would be a dangerous mistake to make assumptions of how this dividend-hungry investment company operates. In many ways, AFIC's deep commitment to long-term investments in Australian shares '” a commitment that is now rare among fund managers '” often finds this conservative company taking a tack of its own on the ASX.

AFIC's top 20 shares (see table below) shows the fund is still a big believer in bank stocks, even though bank stocks have slipped from favour among many investors over the past year. The fund has avoided stocks where risk and leverage levels have risen beyond conventional levels; Macquarie Bank is nowhere to be seen among the bigger holdings on the AFIC list. Also missing are listings related to Babcock & Brown or Allco. However, mining companies are growing in favour at AFIC and its not just BHP Billiton, Rio Tinto, Alumina and Woodside; just below the top 20 holdings sits a string of medium-sized companies including Oil Search and Origin Energy.

As the man at the helm of the biggest Listed Investment Company in the local market, Teele steers thousands of private investors through the equities market each year. He also steers a star-studded board that includes former NAB managing director Don Argus and former Amcor managing director Stan Wallis.

As fund managers increasingly come under pressure for reaping large and unwarranted fees from small investors AFIC boasts a management expense ratio (MER) of just 0.12% '” compared to 1.5–3% at many fund managers. The performance of AFIC, along with a string of smaller rivals including Argo Investments and Milton Investments, often captures the tempo of the Australian equity markets better than a slew of broking reports.

In the year to June 30, 2005, AFIC reported a 28% increase in profits to $159 million; in the half-year to December 31, (reported earlier today), AFIC posted a powerful 44% increase to $118 million.

As a value-based manager AFIC has an enviable record of beating the market. Over any 10-year spell in its eight-decade history, AFIC has outperformed the market '”and that's after management fees and tax.

AFIC's history shows the company is favoured in bear markets and avoided in bull markets. That historical pattern is easily decoded by the relationship between AFIC's share price and its asset backing. AFIC trades at a discount to net tangible assets (NTA) in bull markets and it can be at a premium in bear markets. After trading at a discount in recent years to NTA, Teele has noticed that the relationship has recently moved into tandem: AFIC's NTA (at about $4.61) and its share price (at around $4.56 ).

Is this a sign that private investors might be getting cautious about the extended bull market in Australian stocks? Never one to make a rash comment, Teele says: "I do wonder whether maybe it’s a reflection that people are looking for something that’s a little bit more defensive."

AFIC is the definitive long-term holder of Australian stocks. What AFIC does, says, supports or declaims makes waves in the market.

In recent months, Teele's views on some of the big pragmatic issues facing Australian companies have been widely quoted. For example, he believes that annual general meetings in their current form are wasteful and AFIC itself splits the event into a formal AGM, where technical issues such as voting on legal contracts are dealt with, and a separate shareholder's meeting, where investors get a chance to talk to management about operational issues.

Eureka Report wanted to know what Teele and his team are thinking about the stockmarket, and Teele had plenty to say.

James Kirby: Looking across your top 20 holdings '” which you very usefully provide on your website '” I noticed that you are still very focused on the banks, the big four: CBA, NAB, Wespac and ANZ are in your top 10.

Bruce Teele: Yes, well, essentially we don’t buy and sell. That’s our number one rule. But, number two, we take a much longer-term view and we were interested through all that trouble to try and make an assessment of what we thought the franchise was worth.

Take NAB: what is the bank's business worth, rather than what will the market pay at the margin? And we were absolutely convinced, and still are, that the business franchise is hugely valuable and if chairman Michael Chaney and chief executive John Stewart don’t do it, somebody else will do it.

There’s another aspect too. With a stock like NAB, if they’re in your books at say $5 [NAB shares are currently trading at X], to reinvest the proceeds after tax you’d have to really get a much higher gain.

Our biggest recent purchases have been Commonwealth Bank and St George. We formed a view that CBA and St George were the banks that we preferred for new money.

You’ve got Toll sitting there as your eighth-biggest holding. What do you read of that situation and the future for Toll?

Well, if you look at our portfolio, you’ll see we’ve got Toll but not Patrick. And we’ve done very well out of Toll. We believe that it’s a really good business and a good business model. We’ve got confidence in Paul Little and his team and it’s not based on whether this Patrick takeover goes ahead or not. I’m sure it would make life easier for them if they just called it off, but basically we’re very supportive. We have noticed that the broker analysts have become negative about them, but it’s a wonderful business '¦ well run.

Do you expect to see more hostile takeovers this year?

In the current market, I would imagine there’ll be more. I would say there’d be a lot of people working in investment banking businesses developing these sort of deals.

But I have an issue with takeovers. It should be about a proper valuation of a business rather than an evaluation of a business on a two-year future earnings stream, which the so-called independent experts focus on. For instance, we weren’t at all keen to sell our Western Mining shares during the BHP Billiton takeover because our timeframe was 10, 20, 30 years. Really good business franchises have been stolen. I'm thinking of companies such as United Energy '¦ BankWest.

I've heard you say this market is priced for perfection. Do you still think that is so?

I think there are many stocks that are priced for perfection and if they don’t deliver, the merest hiccup like Macquarie and Healthscope can cause trouble. The challenge for us is to try and look through that. It’s very old-fashioned approach..

What about the weight of money argument? I see this trotted out all the time, that the market will remain strong because of the weight of money coming in from compulsory superannuation. Do you believe this argument?

I think it’s one factor, though if companies don’t perform it won’t matter what the weight of money is.

It strikes me there are two distinct views on resources. There’s the traditional school that says this is resources having another one of its great cyclical runs, and then there’s a school that says we're in a new era, a super cycle, where there will be an extended bull market. What do you have to say about that?

Well, when we look at a market we communicate benefits to our shareholders through dividend streams, so growing sustainable income is really what we’re looking for. For instance, we don’t trade gold stocks. We do tend to be underweight the resource stocks, much to our sadness. I had somebody at the annual meeting saying, 'Why don’t you sell some stock and put it into Woodside?’ It would have been brilliant, but our shareholders want some yield

A lot of conservative investors '” and you would be typical '” shied away from resource stocks because they had poor yields and unreliable dividends. Is this changing?

We’ve got some Alumina and you can see through that, that that’s about sustainable earnings. We’ve got some Origin Energy. We’ve got Woodside. At the present time, we wish we had more and more of those. And we’ve got Oil Search '¦ quite an investment into Oil Search because we believe it’s not very far out before that will develop a very sustainable stream of earnings and dividends. If you go back to previous mining booms, the old MIM, the Broken Hill Company '” the dividends and profits were all over the place.

So are you saying the big resource companies are nowdays trying hard to create reliable dividend streams?

I believe so.

Talking about dividend streams '¦ the great dividend stock on the ASX is Telstra. What do you think of the Telstra story so far?

I’ve lived through an era where if you said utility, that was a dirty word. And yet we’ve seen in the past 10 years huge value in those income streams, those revenue streams. When we look at Telstra we don’t know about all the ins and outs. Clearly, there’ve been some things that look like mistakes, but the first thing is we try to look for is the cash flow.

Were those mistakes you refer to made in the Trujillo era?

No, no, no. I think previously they spent a lot of money offshore, which may not have been done in today’s circumstances. But in comparison with the telcos of the world, they’ve been outstanding.

The new team are doing a very good job because they’re focusing on an issue that has to be resolved. In a sense, the copper wire is history but if they’re charged with the running of a company that is contemplating investing $5–10 billion in a new network, I can’t believe that anybody could responsibly do that on any other basis than proper commercial judgement.

So the big issues at Telstra need to be resolved. We feel very supportive and my personal view is the market has significantly undervalued the business. Anyway, in the meantime, they pay us a very good cash flow and a high fully franked dividend.

If the Government, as rumoured, were to launch a heavily discounted rights issue would it be welcomed by Telstra investors?

Yes, although I think the market would need to be convinced about this other issue.

Did AFIC take up any stock in the three $1 billion private equity floats of recent months: AEP, Babcock & Brown Capital and Macquarie Capital?

No, we generally we don’t really like the leveraged products either. Because it doesn’t relate to our risk profile.

Would you make an attempt to describe the Australian equities market as we enter 2006?

You know, I can’t remember a time when we’ve seen such huge generation of free cash flow and that's hugely healthy because it means Australian companies are not rushing off to buy things all over the place. One of the very significant changes over the past few years is the payout ratio, which is lifting. And in the market at the moment there is a lot more capacity to divert cash flow to dividends. You've seen a couple of companies already this season '” GUD and Alesco '” lift their payout ratios.

Well of course in this market, if companies have good cash flows and don't raise their dividends they could get a takeover merchant knocking on their door. Would you agree?

Well, looking at Wattyl, they’re going to be subject to other people buying the asset, re-leveraging. That’s an interesting situation and at the margin I think it’s a fairly important factor in the marketplace. We see those situations out there and we’ve got our dividend collecting butterfly net out.