2015: End of year wrap - part 1

Shares go up, shares go down, goes the expression, and it pretty much sums up the Australian sharemarket experience in 2015. From its level of 5,389 at the beginning of the year, the All Ordinaries raced up 10% to 5,955 by the end of April, before slumping all the way back to 4,984 at the time of writing – 8% below where it started. When you consider dividends, investors have finished the year with a small loss, which is not as bad as the headlines would have you believe.

The reasons for the market's run-up sowed the seeds for its fall. Investors became increasingly desperate for yield as bond yields contracted, with the 10-year Australian Government Bond (AGB) falling from 2.83% at the end of 2014 to as low as 2.32% in March. The realisation that rates may start to rise sooner rather than later sent the 10-year AGB yield back up to its current level of 2.80%.

Shanghaied

All this was pretty sedate, though, compared to the goings-on in China, where the Shanghai Composite rose 60% between January and June before giving it all back, and more, in the space of about 10 weeks. It has recovered almost 20% since its low, though, which curiously enough means it has beaten the All Ords for the year.

The problems in China contributed to a wretched year for resources as commodity prices continued the slide from their 2012 peak. The worry for investors now is that many commodities still look like they're at elevated levels compared to historical pricing.

Two of the worst hit stocks have been Santos and Origin Energy, which we upgraded to Buy just around a year ago based on our view that over the medium to long term, oil prices will recover. We're still of that view, but we underestimated the impact that weak prices could have in the short term on two companies that carry a lot of debt.

Both companies have had to raise equity and it has caused a lot of pain for ourselves as well as our members, with Santos down 75% since 2 Oct 14 (Buy – $13.48) and Origin Energy down 61% since 18 Dec 14 (Buy – $11.41). The falls for these stocks are well founded, so we've taken them off our Buy list, although we continue to recommend that you Hold.

Outstanding opportunity

The pain has been almost as bad among the miners, with our two main recommendations here being BHP Billiton, which is down around 43% since we gingerly upgraded on 27 Jan 15 (Buy – $28.91), and its progeny, South32, which has fallen 55% since we upgraded it on 19 May 15 (Buy – $2.20). These two are financially more resilient than their energy peers and we remain confident of the long-term potential of their assets, as Gaurav Sodhi explains in our end-of-year special report due later this week.

As such the two stocks remain Buys and South32, in particular, looks like an outstanding opportunity at these levels. Keep in mind, though, our maximum recommended portfolio weightings of 8% for BHP and 7% for South32, and our recommended limit of 15% for the mining sector overall.

During the course of the year our portfolios have increased their holdings in BHP Billiton and South 32 from nothing to about 5% and, as a central banker might put it, we have a bias towards increasing that.

Bank dividends under threat

The other major sectoral theme for the year has been the banks, with the big four racing up to all-time highs in March on the back of their high dividend yields, before investors took on board that, with high payout ratios, slowing growth and a heap of capital being raised, their dividends may not in fact be sustainable.

After hitting a high around $96 in March Commonwealth Bank slumped to $70.15 in September, within an ace of our $70 Buy price. ANZ briefly traded below our $26 Buy price after losing entitlement to its 95 cent final dividend, but we held off.

Maybe we missed our chance, maybe not. It seems counter-intuitive that the banks could be offering a buying opportunity while bad debt charges are at historical lows and we're happy to wait.

The concentration of giant stocks in the resources and banking sectors means those with more of a focus on merely large, as well as small and medium, capitalisation companies should have done well, particularly in the latter part of the year.

Portfolios ahead

The timing was opportune, then, for our Growth and Equity Income portfolios which opened their doors for direct investment as separately managed accounts on 1 July and have so far rewarded investors (including our parent Australasian Wealth Investments) with total returns of 5.8% and 6.2% to the end of November, compared to a loss of 2.1% for the All Ordinaries Index. You can find out more about investing in these portfolios here.

The major contributors to the portfolios' performance have been OzForex, which returned 53% between 1 Jul and 30 Nov thanks largely to the recent bid from Western Union, Virtus Health, which returned 25% and Sydney Airport, up 21%.

With the market's tumble in August, the portfolios also had a great opportunity to add some other quality stocks such as Computershare (which has subsequently gained 14%) and Seek (up 13%).

Detracting from the portfolios' performances have been the already mentioned Origin Energy, BHP and South32. As bad as these – indeed perhaps worse due to the more 'unforced' nature of the error – has been GBST Holdings, which has fallen 30% since we upgraded it on 30 Mar 15, although the losses have been closer to 20% for the portfolios after topping at lower levels.

With the benefit of hindsight we went into this one without a sufficient margin of safety and overestimated the scalability of the company's business model. Still, the market has corrected the former problem for us, and the stock now looks excellent value.

Other themes for the year include the continued fall of the Australian dollar, the continued 'disruption' of established businesses by technology upstarts and the resilience of the healthcare sector.

Private equity bombs

Last but not least were the private equity bombs, most notably Dick Smith and Spotless. We were pretty scathing about both these stocks when they listed, opining on Spotless that 'someone somewhere must be happy to buy [its] shares … but it isn't us and we have no idea why they would'.

Ironically, though, we actually found an opportunity in the previous cause célèbre of dodgy private equity floats, Myer Holdings. Not surprisingly, we steered well clear upon listing and have maintained a safe distance as the stock fell from almost $4. But we recently sensed an opportunity below $1 with new management in place and fresh equity having been raised.

We upgraded the stock in Is Myer still a Pariah on 11 Nov 15 (Speculative Buy – $0.943) and it even made it into our Top 5 Stocks for 2016 special report although, by the time of publication it had already passed through $1 and earned itself a downgrade.

So it's been an up-and-down year for our stocks selections, but overall, we hope you've found that the good has outweighed the bad, as it has for our portfolios.

Themes for 2016

So what themes might we be talking about this time next year? When I put this to our analytical team, responses included the potential for rising US interest rates, further falls in the Australian dollar and the flow-on effects of that (including foreign takeovers), dividend cuts, economic weakness and weak residential property markets.

I wouldn't argue against any of those, but most of all it will turn on whether and when the US Federal Reserve and other central banks start to raise interest rates.

No-one knows the answers to that and investors' best guesses are already discounted in prices. Trying to second-guess the market on such matters is a waste of a value investor's resources. As the great investor Peter Lynch once put it, 'if you spend more than 13 minutes a year analysing economic and market forecasts, you've wasted 10 minutes'.

Buying value

What matters to share valuations is the yield on long-term bonds – over ten years or preferably much more – and this isn't directly affected by short-term interest rate movements, because rates that are too low now will probably mean higher rates down the track, and vice versa.

What matters more is smart economic management, so that the economy can sustain reasonable growth and reasonable real interest rates across the cycle – and, well, good luck with that. The politicians gave the power over interest rates to their central banks, but continue to force their moves with economic policy designed to please the crowds rather than keep things stable.

As John Addis explained in his article last week, the pleasing side effect of all this is unpredictable markets, and the trick to dealing with them is to embrace it. Instead of running when markets start to tumble, we'll set about buying undervalued stocks which offer us good odds of success whatever the economy throws at them. It's worked for us in the past and we're confident it will continue to work in the future.

Note: Our Growth and Equity Income portfolios own shares in many of the stocks mentioned in this article. For a full list see their portfolio pages. Find out how to invest in these portfolios directly.

Disclosure: The author owns shares in GBST Holdings, Virtus Health and Seek.