A cracker year but resist complacency

In the aftermath of the latest prime ministerial parlour game, something small but remarkable happened. For years, Australian investors have been schooled into thinking that China’s economy is a ‘miracle’ and that the resources boom wasn’t an ordinary boom but a ‘super-cycle’.

It wasn’t just the ignorant that fell for it. Think Marius Kloppers at BHP Billiton and the inventor of the BRIC acronym, Jim O’Neill of Goldman Sachs. We all want to believe in a better future, especially if we’re invested up to our eyeballs in it.

On becoming the country’s 26th and 28th Prime Minister, Kevin Rudd’s speech challenged that orthodoxy. ‘The global economy is still experiencing the slowest of recoveries. The China resources boom is over’, said Rudd. After years of waiting alone, fretting about what lies ahead, it’s nice to have some company.

The last few years have been good to us all (we’ll get to the crowing and mea culpas soon enough). But for a long time, we’ve been suggesting the probabilities of the resources boom ending badly, of the dollar falling, and the possibility of an Australian recession were greater than most imagined (see Macro Investing: Recession risk?).

Well prepared

The last year has been about preparing for these threats, and positioning your portfolio to profit from them should they eventuate. Save for the forthcoming publication of some special reports, that job is all but complete. So instead of looking forward, let’s look back at some of the highs and lows of the year, and the lessons we can take from them.

Analyst James Carlisle is pleased he didn’t upgrade Fleetwood last December. ‘Credit here to the dragon’s den and analytical process which led to an Avoid rather than a Buy’, says James. ‘The stock is down 61% since the risks were highlighted on 17 Dec 12’. The embedding of our analytical framework over the past few years has helped us avoid many a blow-up and has been a big improvement in the business.

Monadelphous, a company that appeared atop the 2010 Top 10 Businesses special report, was another timely miss. ‘We've received plenty of puzzled questions about why we've repeatedly avoided this stock,’ says Gaurav Sodhi. ‘The numbers pointed to an obvious buy: Return on equity of over 70%; plenty of cash and no debt; a great reputation; and a cheap valuation. Yet the decision to stay away was the right one. No one should invest on quantitative facts alone.’ The company’s share price is down 40% since its February high.

Mistakes, some by omission, others through commission, have been painful but manageable. Three times in the past 12 months we’ve suggested you avoid Perpetual. During that period the facts changed for the better, proving our analysis too negative. We should have reverted to a Hold sooner than we did and missed an opportunity to add it to the buy list.

Kingsrose Mining has fallen more than 70% since we first recommended it on 28 May 12, although it remains a Speculative Buy (see the brief on 25 Jun 13). The lesson is not to necessarily avoid such situations altogether but to remember that they can and do go wrong. Keep alert to the downside when it seems most unlikely and manage the risk of it through strict portfolio limits (Kingsrose has a 2% portfolio limit for the ‘highly risk tolerant’). Spreading your speculative investments across a handful of stocks is also smart.

Billabong did even worse, falling almost 80% since the upgrade to Speculative Buy on 5 Oct 12. Jason Prowd says it’s been ‘my worst recommendation at Intelligent Investor (so far) and my worst personal investment ever.’ Yes, turnarounds are tough, doubly so when there's debt and strong personalities involved. We all learn this lesson, and then we must learn it again.

High quality winners

By and large though, the winners have more than offset the losers. Our focus on high quality businesses has been a fruitful one, allowing us to upgrade ResMed on 25 Jan 13 (Long Term Buy - $4.52) and Cochlear earlier this month in what now appears to be a short-lived opportunity. This financial year was also the one where some long standing positive recommendations came good.

Since first upgrading Sunland on 22 Jan 10 (Long Term Buy -  $0.78), it rose 115% before we sold out on 16 May 13. The market finally started to appreciate that these assets shouldn't be trading at a 60% discount and rerated the stock, allowing us to sell (ironically, on the same day one of our competitors upgraded it). As Nathan Bell says, ‘If there's value there the market will work it out eventually, it just takes time.’

That’s certainly been the case with News Corp, Computershare, IAG and Macquarie Group. As Table 1 shows, once out-of-favour blue chip stocks are back in fashion. Buying at the point of maximum uncertainty has paid off, proving once again the resilience of high quality businesses.

What might we take from the performance of this group of stocks? Nathan says Macquarie taught him ‘that a growth stock can become an income stock at a cheap enough price. I regret not adding it to the model Income Portfolio when the unfranked dividend yield reached 5%'.

QBE Insurance offers an even bigger lesson. Like Macquarie, it was one of two Strong Buys made on 5 Aug 11. But QBE’s share price plummeted after that recommendation. The eventual outcome is proof that it's the decision you make after a stock has fallen 50% that matters most. Investors that bought into the gloom have fared very well in a short period.

Now that interest rates are increasing in the US and the Aussie dollar is falling, brokers are jumping back on board QBE. Here’s a little of Bell’s wisdom on the experience: ‘It's always most profitable to buy when a stock is unpopular but, like running back with the flight of the ball in a game of Aussie rules, it takes guts to stick with it when everyone else is saying you have it wrong.’

Buy list stars

Then of course there are the stocks that have already done well but should continue to do so; stocks such as Computershare and ALE Property Group, Spark Infrastructure and Woolworths, all still on the Buy list. As for Village Roadshow, up 48% since 6 Dec 12, we’re in no rush to downgrade it. The experience shows what can happen to a stock price when expectations are very low and a few things fall in its favour.

There’s another lesson here; we almost didn’t upgrade it because the price had already risen strongly. We shouldn’t be afraid to buy a stock after it’s doubled as long as the case stacks up. Thankfully, we backed our analysis and weren’t swayed by the share price chart.

These successes and failures add up, expressed most clearly in our soon-to-be-published and audited annual Recommendations Report (formerly known as the Performance Report), but also in our model portfolios. Tables 2 and 3 show the performance from 31 May this year all the way back to inception (look out for the regular semi-annual review in a fortnight):

Whilst the All Ords Performance index is up 24.8% in the financial year to date (as of 31 May 13), the income portfolio has delivered 28.8% and an outperformance of 5.8% per year since inception in July 2001. The growth portfolio performance hasn’t been quite as strong but still, 29.3% for the year and an annual outperformance of 2.1% since August 2001 really adds up.

More importantly, we feel these portfolios are very well positioned to take advantage of any market tumbles, but have been structured to be resilient to them.

So this is a plea for caution over complacency. It’s been a very good few years but if you haven’t yet prepared your portfolio for the potential risks ahead, please set about doing so. The four special reports that will be sent to you as part of our end of financial year campaign will help you do exactly that.

If you haven’t yet taken advantage of the end of financial year offer, you’ve got a few hours left to do so. Renew your subscription in advance to take advantage of the $180 saving on an annual membership.

The next 12 months are likely to be just as interesting as the last and your analytical team is looking forward to being of service.