Value.able: Forget the index

Buying shares in the right businesses will help investors avoid being caught in an index that is going nowhere.

PORTFOLIO POINT: Investors should focus on A1 and A2 companies, watch cash flow and ditch them at the first sign of deterioration.

Houston, we have a problem. But it’s not what you think. It isn’t the fact the market has gone nowhere and is volatile. It’s the index itself.

Since 2005 the stockmarket index, the ASX 200, has returned precious little. Add to that the recent extreme volatility, the prospect of a reduction in taxes on interest earnings and the fact that the unprecedented, coordinated efforts of central banks globally to reduce borrowing costs shows only how close to the brink we are, and we have the ingredients for a level of disenchantment towards equities that hasn’t been seen for some time.

I cannot predict which way the market will go in coming months but a strong and sustained rally needs to start soon to avoid the kind of abandonment that makes shares cheap for a long time.

This week I have spoken with builders, providers of serviced offices and sports sponsorship managers and their comments justify the action yesterday of the RBA in cutting rates. Economic growth around the world is only sputtering.

Even Germany and Asia, for example, are on the brink of recession. The general expectation that demand for German exports will suffer amid lower global growth can be usurped as last night’s “revelation” demonstrated. Business confidence in Germany rose for the first time in five months in November and unemployment declined more than expected.

On the other hand, the Asia Development Bank this week noted in an interview with Bloomberg: “The cautiously optimistic outlook for emerging East Asia is subject to much greater downside risks now than just a few months ago.” It added: “The global economic recovery could flounder if the eurozone and the US fall back into recession, causing another global financial crisis.”

But before you get too gloomy – assuming you aren’t already – consider one of the reasons you may be becoming despondent. A moment ago I mentioned the market has barely posted a positive return since 2005. To produce that statistic I, and every other expert that does the same, used an index.

An index – the ASX/S&P 200, for example – is built on the back of the returns generated by a group of individual stocks. The most popular indices, not just in Australia but around the world, are constructed using the stocks and prices of the biggest companies. Whether you refer to the CAC, the DAX, the Dow, the S&P 500 or the ASX 200, you are referring to something based on companies that are merely big. Not good, just big.

Consider Telstra and Qantas. I have written about both companies here over several years and even longer if you include the work published in university accounting texts, so I won’t repeat my thoughts on these companies. What I would like to do is demonstrate the folly of taking your cues about when and how to invest from a broad index.

Both companies have produced returns that are nothing short of lousy. Telstra analysts are forecasting profits in 2013 that are less than the profits the company earned in 2002; don’t get me started on Qantas: its profits are less than they were 10 years ago and its produced that incomprehensively poor return with 50% more debt and 50% more equity contributed by shareholders.

Note that the solid intrinsic value line – which is automatically calculated and updated daily for changing expectations – has not changed on a net basis from 10 years ago. Unsurprisingly, the share price is not better than it was either (it was overpriced back then).

Like Telstra, Qantas’s intrinsic value has not improved on a net basis over a decade. You can cite all sorts of reasons for this result but the reasons don’t change the facts. And the index is based on the (non) changing prices of companies like these.

The intrinsic values of these companies have gone nowhere. Investors should be seeking A1 and A2 companies that have bright prospects for intrinsic value growth. Telstra and Qantas have had no intrinsic value growth over a decade. Unsurprisingly, there share prices have done very little or worse.

Because companies like these are constituents in an index, that index is going to perform similarly poorly.

But if you buy extraordinary businesses your returns over the long term will not reflect those of the indices cited by the commentariat as reflecting the poor returns on offer by the “market”. Despite GFC’s recessions, even depressions there are companies whose share prices will ultimately reflect improving individual performance and their own superior business economics.

So carefully consider constructing your own A1 index. How you do this is up to you. I can commend choosing A1 and A2 companies and keeping an eye on their performance and cash flows, removing them at the first sign of deterioration. Forget conventional clichés such as “blue-chip” and “defensive”. The most defensive investment is cash (and some might add, gold).

In the stockmarket, the only defensive shares are those of extraordinary companies, rated A1 and A2, and you have to maintain a long-term perspective because there is no defence against short-term share price volatility.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.