2014 EOFY: Income Portfolio gets sporting chance

‘Wesco continues to try more to profit from always remembering the obvious than from grasping the esoteric. … It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying, “It’s the strong swimmers who drown.” Charlie Munger in Damn Right!: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger.

Borrowing from the 1975 essay, The Loser’s Game, by Charles Ellis, and Extraordinary Tennis for the Ordinary Player, written by scientist and statistician Simon Ramo, Shane Parish recently contrasted how amateur and professional tennis games are won.

In short, ‘Professionals win points while amateurs lose them’. Whereas professional players generally win matches with finesse like Roger Federer, or dogged determination and skill like Rafael Nadal, in contrast amateur matches are decided by the player who makes the least mistakes. Merely keeping the ball in play is a struggle for me, so anyone with the rudimentary skills and temperament (i.e. my wife) will inevitably win the game.

Despite its fair share of unforced errors, the model Income Portfolio has largely followed this playbook by simply being patient, acting with conviction when we find great opportunities and using intelligent portfolio limits. That’s produced a 13.5% annualised return since inception, comparing favourably with the All Ordinaries Index Return of 8.3% (see Chart 1).

Injecting the portfolio with more of our best ideas over the past year even if they don’t necessarily pay large dividends has also helped improve the portfolio’s recent performance (see Table 1 and 2013: Income Portfolio in transition).

In the six months to 30 June 2014 the portfolio produced a 6.1% return compared to the index’s 2.7% return despite holding 10-15% cash. The portfolio lagged over the past year, though (15.3% versus 18.5% for the index), as we explained in 2013: Income Portfolio in transition.

Although we build portfolios one business at a time, the broader themes within the portfolio have remained unchanged. First, we're looking for good quality businesses that pay attractive dividends or are likely to in the future. Second, we'll take international exposure when we can get it at a reasonable price to profit from a lower Aussie dollar. Third, we're avoiding resources stocks as the returns are too unpredictable for such a conservative portfolio. And lastly, we need to balance the need for income with faster growing stocks to protect the portfolio from the ravages of inflation. Let's now look at the best and worst performers over the past six months.

Best performers

After many years of patience, virtual office provider Servcorp put in a championship performance over the past six months, returning 23% including dividends (see Chart 2). While the company's Australian business continues to work its way through tough conditions and a few unforced errors of its own, its performance abroad is improving as recently opened floors begin to mature. The increasing overseas profits have also come at a time when they're worth more in terms of the lower Australian dollar. The company also boasts a pristine balance sheet and large insider ownership.

Bunnings Warehouse Property Trust’s share price has been surprisingly volatile for such a predictable business but it was up 13% for no particular reason, and returned 17% including dividends. It was followed closely by Amalgamated Holdings, with a 16% return, and Sydney Airport, 14% return, which both benefited from the market’s thirst for yield due to low interest rates.

On the flipside, Platinum Asset Management’s share price took a breather, falling 9%. After going through a lull a couple of years back the company’s funds have mostly been performing very well, which bodes well for future inflows (we highly recommend reading their quarterly reports for a global perspective and insights into the company’s investment process). We also took some profit at prices above $7.  

M2 Telecommunications’s share price fell 8% due to concerns that changes to the NBN Network would impact the broader telecommunications industry (see M2: Interim result 2014).  Trade Me’s share price also fell 8% as real estate agents in some parts of New Zealand rebel against the company’s new pricing structure (see Trade Me price guide reduced).

Playing a long game

Overall the portfolio remains diversified, the dividends continue to roll in (see Chart 4) and we’re waiting patiently for superior opportunities to increase the concentration of the portfolio in our best or new ideas. With only about a third of the portfolio currently invested in stocks sporting a Buy recommendation (see Chart 3) we’d be happy if the portfolio returned 10% annually until Mr Market provides a more prospective set of opportunities.

While we prefer to be fully invested with a concentrated portfolio of cheap stocks you can only make the most of what the market is giving you. Force the issue and you end up doing something stupid that you’ll regret in the long run, as Munger warns.

Although we’re content waiting to take advantage of other people’s mistakes, the price in the short-term can be taxing: potential underperformance and the frustration of having more money than intelligent investment ideas.

To help you avoid any unforced errors we highly recommend reading Jeremy Grantham’s latest quarterly that explains the scourge of being a value investor (remember to save it if you want to read it again one day as the commentaries don’t stay on GMO’s website for long).