The Xiradis View

Michael Pascoe: What's the secret to successful investing?
Paul Xiradis: What it’s all about I think is consistency but the way that.. but they also say property that the three most important things that you should look for is location, location, location. As far as investment management is concerned it’s the 3 Ps. So it’s People, Process and Product Performance and that’s what we’re all about.

MP: You’re a [style] neutral funds manager, what does that mean.

PX: It means that we’re.. style neutral in our definition means that we don’t restrict ourselves by segmenting ourselves by just looking at certain parts of the market. There is a lot.. over the years there’s been a development of a lot of value managers or a lot of growth managers and they just look at value stocks and growth stocks. By being style neutral it allows you to invest.. look in the whole [investment] universe to look for value in the marketplace for opportunities in the marketplace.

MP: Does that make it hard. I mean if you’re just growth or value, it reduces your universe, makes it a little bit easier to cover doesn’t it.

PX: Look I don’t think so. I think the name of the game is coming up with the selection of stocks. That is likely to deliver outperformance over the coming period. We do have.. our processes is very focussed on that and what we do really focus on is the underlying earnings. Maybe it’s not the momentum but the earnings profile of the company so it will be very much earning-centric. Because our belief is that what really drives share price at the end of the day is the earnings and earnings revision, so our core focus is on that.

MP: Can you walk me through an example of how about you go about choosing a stock.

PX: It’s a pretty involved process but I’ll try to give you a bit of a thumbnail sketch of how we go about it. We unashamedly as an investment manager always like to believe.. or we start in order to establish an investment portfolio or pick a stock you need to actually have a pretty good understanding of the investment environment you’re in and also the likely change that will occur from an economic perspective and why is that important? We think that most companies obviously do try to actually deliver and operate as efficiently as possible but clearly there’s always going to be outside focuses which influence their performance, and clearly one of those factors is the underlying economic environment. So before we actually establish a position in a stock, we want to understand the economic environment we’re entering into for the period ahead and try to identify where the opportunities may lie from a sector point of view and then apply that to each stock. So our start point is understanding the macro-environment, understanding how that influences a sector which a company actually operates within and then try to pick the best stock within that sector. And that’s how we go about picking our stocks. So it really is all about trying to identify those stocks which have the best potential of delivering good underlying earnings and the potential to surprise on the upside.

MP: I’ll come back to the sectors and the companies in a minute but in terms of macro-economic environment at the moment, what do you see.

PX: Look we’re still reasonably optimistic on the outlook as far as the domestic economy’s concerned and also the global economy. And that’s certainly been if anything it’s probably a surprise on the upside, certainly from the global perspective and that’s despite the interest rates moving up globally, particularly in the US and also uncertainty surrounding one off events such as the cyclones and other things, so despite all that, things are [ ], the global economy’s performing quite well. Asia is performing incredibly well and there was a fair bit of uncertainty or skepticism if that was going to be the case this year. China again has actually been stronger than expected and one of the economies which is probably very much a surprise but it’s actually been recognised now, is Japan and Japan is actually recovering quite strongly and inasfar as it being an important trading nation to Australia that’s certainly the case and hence that’s quite beneficial for Australia. But domestically here we’re still quite optimistic. We think that we have.. we did have a slow down earlier this year, but looking forward over the next 12 months we think the economic environment here will be reasonably positive.

MP: Well from that macro-economic picture, where do you put your money. What sectors have you identified from that view of the world.

PX: It’s been pretty consistent I guess. We haven’t changed too much from where we were maybe 6 months ago. Certainly from an international perspective but domestically we have and I’ll come back to that. We’re still quite optimistic towards those companies which are associated towards that global growth environment and mainly resource issues, we think that the outlook for resource companies still remains quite positive indeed and if you look at the underlying commodity prices today and compare that against market expectations, commodity prices are way above market expectations so we think that earnings are likely to surprise on the up over the coming 12 month period so we’re quite comfortable with that which comes back to our core belief and process that earnings and earnings [ ] are the clear driver so very comfortable with an outlook and we are looking for signposts for that to actually turn down but every time we look for and analyse the economies again, all we see is surprise on the up so we’re very comfortable with that view. Domestically here we are of the view that despite a bit of a slow down earlier this year we think that retail is an interesting place to be right now. Expectations out there for the retailers is very very low indeed as far as sales are concerned and certainly from a returns point of view and the price you pay for these retailers is actually quite low so we as a house have been building up our position towards retail sector only recently after being very aggressively underweight that sector for quite some time and again it’s on the belief that the domestic economy is improving and the beneficiary of that, one of the beneficiaries of that from a sector point of view is the retail sector. We’re also of the view that housing activity as far as numbers are concerned has probably bottomed as well. We’re not expecting real estate.. real estate values to increase but we believe that activity will actually start picking up in 2006. The reason for that is that housing starts over a very very low number at this point, I think sitting around 140, 150,000 and we think it should be around 170,000 given the underlying demographics of Australia so we’re quite optimistic towards the building materials sector as well.

MP: Having identified those three sectors, what do you look for in the companies that you’re going to overweight in.

PX: Oh look there’s a number of key attributes. I mean clearly one of the things that we do actually look for is the quality of management and that’s one of the things that we do spend a fair bit of time with. We actually go out and interview management on a regular basis and that’s our investment team so that’s our starting point. We also look at the Board to see the composition of the Board to see if they’re actually of a worthy composition.

MP: Can I interrupt you there. What do you look for on the Boards.

PX: Look it’s not one thing. It’s just because when you actually put a Board together there’s obviously got to be a complimentary of skills. There’s got to be also some industry association as well so it’s a number of things. I mean if you actually look for people that have actually had working experience in those particular industries or if the composition of the Board is such where they can provide some very good input to management we think that’s important, so it’s a very difficult thing to actually identify is one particular thing you’re looking for. It’s more of the composition of the Board that we look for. So.. and hence that’s one of the things that we do look at when we invest in companies.

MP: Is that easier to express in a negative way. What do you look for to avoid in a Board.

PX: Well I think that clearly we don’t want people that have not too much experience in the particular fields that the company is actually associated with. we certainly don’t want them just to be there because they have a large investment in a company. Clearly I think they need to bring something to the party rather than just money, and also we also want to make sure that there is a very good blend of internal directors and also external directors which have broad based industry experience.

MP: So you look at the Boards. You meet the management.

PX: We then determine probably our point of view what the market is expecting from it from an earnings outcome point of view and look at the reasons and the factors behind that. We also then do our own independent work as well, come up with our own earnings numbers to work out what is likely in the companies to [upcoming ] period and if there is large variance we explore why that could be the case. And then conclude, and then come up with a conclusion if the market perhaps is under-estimating or over-stating those earnings and therefore there is an opportunity for us to either buy or sell that stock based on that analysis. So we believe that the market’s actually under-estimate the earnings potential of this company over the coming 12 month period and that’s the time horizon that we look at when we actually analyse the earnings profile of companies. We do look longer term but we think the most important thing is always the coming 12 month period. If there is a large variance it is a signal for us to either buy or sell that particular company.

MP: It almost sounds like a forward value style. Rather than style neutral. You’re looking for value but you’re looking for it 12 months out.

PX: Oh look I think that the reason why we call ourselves style neutral is because we look at a lot of sectors and we don’t want to actually restrict ourselves in any way, shape or form but yes it’s always forward looking because the market is always forward looking. You always buy on a stock on its potential rather than what it’s actually doing in the past and the way that you actually get added value I guess or improvement over and above the benchmark is by finding those stocks which are likely to surprise both on the up and down. And if you actually can identify those stocks which might surprise on the uptick you obviously get a delivery out-performance and if you avoid those ones which are likely to deliver negative returns or disappoint, again you also delivery out-performance from that point of view.

MP: Well still pushing the example down, having done all that, for example what resources stock do you like, what retailers do you like. To invest in.

PX: Sure. In the resources issues we’ve been very exposed and quite along the likes of BHP for quite a number of years. Rio is another stock that we’ve invested in quite heavily over down. Drilling down some further [pure] plays there is Minara Resources is one which we think looks interesting at this point in time. And Zinifex is another stock which looks interesting but getting back to the likes of BHP and Rio, these are stocks which are really leaders in their field. They have quite a diverse earnings base, they don’t actually rely on one particular commodity and as a consequence of that there is a bit of balance I guess in the earnings profile but the other factor that we have noticed with these particular companies is that the cash generation has been very very strong indeed and these companies const.. well when I say consistently over the past couple of years despite their very very strong earnings growth have been selling at a discount below that of the market where we believe they should be trading at least at market levels.

MP: So how much upside are you expecting on those two leaders.

PX: I don’t want to embarrass myself by saying what the actual upside target is but we do believe that there is a good margin from [ ] for out performance. We certainly have a higher target for both those particular stocks and the reason for that is going back to those two reasons. We think the cash flow generation is very high indeed. The prospectivity of those two companies increasing their payout ratio or buying back stock because [ ] is quite high but we also believe the earnings is still very much under-baked or under-cooked by the market.

MP: The retail space is [all met]

PX: Sure.

MP: is it harder to pick?

PX: Look it is. I mean the retail space is not.. it’s not an easy space to analyse but on what we have noticed over the past 12 months because the retailers had to support it and that was particularly being in the first quarter this year where the earnings styles or forecasts were actually well below expectations and that continued a little bit into the June quarter. But as a consequence of that under-performance, the market is not assigning a high probability of them actually bouncing back. We are seeing a little bit of evidence that is occurring at this point. It’s only early days but we are seeing evidence of that occurring but the price you’re paying for that bounce back is very low. In fact there’s still price for disappointment in our view because they’re selling at quite a large discount to the market so what we are looking for I guess is some of those companies which we think have a good prospect of delivering some out-performance. You may recall that I indicated that we are of the view that the property cycle as far as construction activity is likely to pick up. One of the beneficiaries of that from that point of view would be the likes of a Harvey Norman. Because that’s a group which has been a little disappointing. The stock has not actually performed all that well for the past 4 years. It was trading at a premium at one stage, now trading at a discount and we think the earnings profile of the company is probably not well understood by the market and likely to surprise on the upside so that’s a stock that we have been picking up a holding in. [Just] Group is another stock in a smaller cap area. We think that the way that they’ve actually remodelled the business to the extent where now that the retailers are very much pushing back the cost of holding stock back to the manufacturers, only ordering stock as they sell it means that the impact on non-sale or sales is actually less and less from an earnings point of view and we think they’re managing that business quite well so we see some upside there. And Coles Myer from a valuation point of view we think is interesting as well.

MP: Because they are a price disappointment still.

PX: Oh not really. I’m hesitant to.. if you compare Coles Myer to Woolworths, Woolworths is a great company, don’t get me wrong, but you are really paying top dollar for the likes of Woolworths where you look at Coles Myer, it’s still improving. I think that Fletcher’s done a very very good job in turning that business around but the multiple you’re paying for that business is far less than you’re paying for Woolworths where I think over the next two years that the earnings profile of both companies is almost equal.

MP: The flip side of the coin, what sectors don’t you really want to have much to do with.

PX: Look the sectors that we’re a little bit concerned about and we have been concerned about for quite some time has been the banking sector. We think that competition in this country’s only going to increase or intensify but having said that, the banking sector has performed reasonably well over recent months but we think that performance is coming to an end. The reason we’re concerned about it is primarily the competition environment here in Australia. The likes of HBos is very aggressive in this marketplace, increasing market share. The [form] of BankWest and we’re seeing them advertise quite aggressively. There’s no two ways about that, and they’ve utilized what HBos did in the UK as far as increase their market share. They’ve really competed on price quite aggressively and we think that’s going to be likely here in Australia. We think the GE Group in Australia with their recent acquisitions and their greater presence, and I think they’re very ambitious to grow their market share, so again the way they will compete is again on price, so consequently we see margins continue to be under pressure for the banking sector so that’s an issue as we see it. Also we think the rate of lending growth has been very very strong over recent years. We think it’s going to still be positive but the rate of growth is going to slow so therefore from a volume point of view the volume is going to slow in an environment where competition is going to be pretty intense so we see some earnings pressures there for the banking sector over the longer term. Other sectors that we dislike at this point or are actually quite concerned about is the listed property trust sector or the REITs. The reason for that is we find it very hard to actually find value in that particular sector. Previously the listed property trust sector used to trade at a discount to its NTA, net asset backing. Today it’s actually trading at a premium to its net asset backing and that’s the environment where they’re actually now fairly heavily geared. Previously they were under-geared, now they’re very heavily geared to there’s an interest rate risk. They’ve also been operating or expanding outside of Australia and expanding internationally so therefore they have not only a regional risk but they also have a currency risk as well and that’s an environment where the pricing of these [securities] have actually increased rather than decreased in value so we think they’re a little bit vulnerable particularly on the belief that we think interest rates are likely to increase over the next 12 months rather than decrease. So that’s an issue. And because of that, that’s another reason why we’re actually quite concerned about the infrastructure sector where we think in a rising interest rate environment the infrastructure sector is far less valuable. And actually quite vulnerable to further margin pressure.

MP: When you say you think it’s more likely interest rate will rise than fall is that a strong bet or just a balance of probabilities.

PX: It is a balance but we are favouring more on the upside and that’s.. I’m not trying to answer myself here but I mean clearly you can’t really.. with 100% certainty believe the interest rate will go up but everything that we see at this point indicates that bond rates.. we’re not talking about nominal rates here, we’re talking about bond rates in particular are likely to increase. The reason we say that is global growth continues to be quite strong. There is some concerns about inflation creeping into the system and while we think inflation’s going to remain reasonably under control we think the inflation [ ] will move up after being at very very low levels so as a consequence we see the long bond rates will actually move up with that as well. So we think that the long bond rate both in Australia and the US is likely to increase which has some pretty serious ramifications for these infrastructure stocks and also listed property trust stocks potentially borrow on those long bond rates.

MP: From that negative aspect still, you identified listed property trusts as an area you’re not too keen on, within that sector though there would be some property trusts that aren’t geared, that aren’t looking overseas. Do you still consider those or once you discount a sector you stay out of that sector.

PX: Oh no we don’t.. I mean, that’s a very good question. We don’t.. I mean certainly from a sector point of view we actually come up with the characteristics that each sector actually exhibits and actually examine those but what we do do, is also have a rating system that we developed internally which actually ranks stocks within each sector and then what we do do is we look at each stock which is ranked very high within a sector so if a stock is actually ranked, like the listed property trust sector, if we find a stock that’s rated quite highly within the sector it means that we’ve got to do some further work because there is obviously company specific reasons why that is the case and so we don’t exclude it from that point of view.

MP: Can you give an example of that.

PX: Not in the LPT sector unfortunately. The only one.. I mean the one that we perhaps liked, and we still like but we haven’t got a very active position at this point because we see a bit of value elsewhere has been Westfield Holdings. That is an integrated system. An integrated listed property trust but it does have those characteristics that I just described. That it has international exposure, currency risk and interest rates so as a consequence of that, we have a very small exposure in fact in most portfolio it’s nil.

MP: How active a trader of stocks are you?

PX: You would think by being style neutral as I described we are fairly active. In fact on a comparative basis we’re not all that active. Our average turnover in our portfolio sits between 40 to 50 percent per annum so our average holding period is around 2 years for each holding, so I mean we think long and hard before we position ourselves in stocks and sectors.