Brickbats and bouquets – Part 1

We can learn more from our failures than our successes, but John Addis has asked the team for recent examples of both.

A solitary number can hide many a tale. So it is with the performance of our model portfolios. Since inception in 2001, the growth portfolio has returned 10.2% per annum and the equity income portfolio 13.3%, both beating the 7.5% annual return from the ASX All Ordinaries over the period.

Buried within those figures lie some lovely winners, a few horrible losers and plenty of rapid swerves wide of disaster. The bragging is the easy bit. Your analysts have instant and total recall of those recommendations that worked out as planned. But with the pain of remembering an encouragement to forget, the screw ups and disasters spring less readily to mind, which is why I like to remind them.

Asking each analyst to recall their winners and losers over the past few years is a bit like having a back massage while someone jabs needles into your backside. But we learn more from the painful than the pleasurable, so treading the broken ground of failed recommendations is essential. As for basking in the warm glow of successful stock picks, that too has a purpose.

Key Points

  • A few big winners do not a reputation make

  • How we got Woolies wrong

  • Learn to pay up for quality

Frequently, what turn out to be our best performing recommendations are first made against a background of negative media headlines, earnings downgrades, scandals and tumbling share prices. We hope that reflecting on some of our the winners will give you the confidence to buy stocks we’re recommending that almost everyone else is manically running away from. That in itself is not easy but buying cheaply also happens to be the first step in picking winners.

Here, we’ll focus on research director James Carlisle and senior analyst James Greenhalgh, with Gaurav Sodhi, Jon Mills and Andrew Leggett baring all next week.

James Carlisle, research director

I’m going to get the painful stuff out of the way first. My biggest mistakes have probably been Woolworths and GBST. When we first upgraded Woolworths a few years ago - see Put some Woolies in your basket (Long Term Buy - $29.20) on 23 Oct 12 - I saw the outsized supermarkets EBIT margin of 6.5% as a sign of quality rather than as something ripe for a fall.

Even so, the gap with Coles on like-for-like sales growth appeared to narrow to nothing in the 2014 financial year, before blowing out again. That was the real warning sign. We made belated and slight amends in November 2014 by slashing the price guide as a result of our three-part series, but still stopped short of saying ‘sell’.

In retrospect, Woolies was simply earning too much, pushing customers into the arms of Coles. I’m far more confident in our current Buy recommendation on the stock but there’s no escaping the magnitude of our initial error.

James Greenhalgh now covers this stock and the approach we’ve taken since then emphasizes our long term focus. We upgraded again in Woolworths take tough decisions at $24.70 but flagged there might be more share price pain to come. That’s because, as James says, ‘we buy value even if we think the market’s likely view on a stock will remain negative for a year or two.’

Woolworths might yet prove a mistake if we’ve under-estimated the likelihood of a grocery price war or market share gains by discounters. The stock has continued to decline but, as it stands, we’re becoming more positive about likely future returns as the share price falls. James Greenhalgh again: ‘We’re closer to a more emphatic ‘Buy’ recommendation than the equivocal one we issued in October.’

The interesting (and costly) thing about GBST, initially upgraded on 30 Mar 15 (Buy - $5.75) was that I was feeling the sting of missing out on too many highly priced growth stocks that had kept growing and rising in price. In retrospect, whilst I spotted the high quality nature of this business, I think I also fell victim to FOMO (fear of missing out).

I decided to push the boat out on GBST with our Buy price of $6.50, representing a PER of 25. After project delays and the loss of a chief executive, it now stands more than 30% below that initial recommendation. I left little margin of safety and we’ve paid the price for it. The lesson here should be drawn from one’s investing psychology rather analytical skills. Had I not had the experience of being too cautious with other highly priced growth stocks I doubt I would have pulled the trigger when I did.

On to happier territory. Everyone loves a stock that has doubled or more in price and we have enjoyed plenty of those over the past few years. M2 was first recommended on 18 Oct 13 (Buy - $6.02) and doubled to $12.17 when it ceased trading in February due to its all-share takeover by Vocus Communications, which has since risen a further 25%. On a free cash flow yield of about 8% if it continued to grow it was cheap. It did and it was. Easy.

Nanosonics has almost tripled since we upgraded it on 10 Mar 14 (Speculative Buy - $0.785), as has Somnomed since our first positive review on 5 Feb 14 (Speculative Buy - $1.33). Both were classic cases of GARP investing – growth, rapid in both cases, at a reasonable price. Sirtex Medical, first reviewed on 8 Nov 10 (Speculative Buy - $5.90) was another example of a successful pick in the healthcare sector, up 423% and currently a Hold.

These gains are not to be taken lightly, nor should they be up in lights. Make enough recommendations and even poor investors will enjoy big winners like these. To market one’s stock-picking ability, as some companies do, on a few five-baggers is not necessarily an accurate reflection of skill. That’s why I want to call member’s attention to what I think is a better indication of our abilities, one that better illustrates what people want from our service.

Just over two years ago we published the ‘high yield & safe’ mini-portfolio. With the Reserve Bank reducing rates the rush for yield was in full flight. The prices of stocks like the big banks, Woolworths and Telstra rose while the value didn’t change much at all. And yet the returns on alternative investments like cash changed very much. Investors were being asked to accept lower returns from cash and fixed interest or take on more risk by increasing exposure to equities.

The three stocks shown in table 1 indicate our suggested solution to that problem. Yes, they were more risky than cash but these three picks were also high quality, ‘offering a nice mix of distributions and acceptable capital growth over the long term’ plus inflation protection. As the table shows, things have worked out better than even we expected. To the returns we can also add an attractive yield.

Table 1: The high yield and safe mini portfolio
Company Original Recommendation (1 Feb 13) Yield at the time Latest Recommendation Latest Price Percentage change
BWP Trust (BWP) Long Term Buy - $2.34 5.90% 17 Mar 16 (Sell - $3.42) $3.42 46%
ALE Property (LEP) Long Term Buy - $2.33 6.60% 3 Apr 16 (Hold - $4.07) $4.19 80%
Sydney Airport (SYD) Long Term Buy - $3.18 6.90% 18 Feb 16 (Hold - $6.59) $6.71 111%

The key was in seeing the potential for distribution growth, especially in the case of Sydney Airport, and an attractive yield. Falling interest rates were a bonus but much of the performance was growth driven. In the case of ALE, for example, we saw the significant under-renting of the properties and have merely been patient, waiting for the market to catch up.

We’ve been recommending Sydney Airport on and off over the years, including on 16 Mar 09 and recommended ALE originally on 2 May 12, but reiterated both in this article. Much as one might enjoy big winners like M2, CSL (first purchased at $31.30 on 19 Jan 10 and now $104.25) and ResMed, this is our bread and butter – attractive returns delivered from safe, stable stocks that the market has passed by.

The other aspect of successful portfolio performance is getting out of stocks at the right time. Woolworths was certainly one we got wrong in this regard but there are some good examples, too.

In August 2013 Coca Cola Amatil was trading around $12.30. After picking up on worrying management commentary that suggested the company was more interested in shoring up Australia’s manufacturing industry than making money for shareholders, we got out. The shares have subsequently fallen below $9.

Platinum Asset Management is a rather different case. A buy at much higher prices in the run up to the GFC, this can be regarded as a mistake. But we did not compound the error, reiterating our Buy recommendation many times between 2007 and 2011 before selling out on 4 Feb 15 (Sell - $9.06).

This was just a call on its valuation. Recent earnings growth had been boosted by the fall in the Australian dollar but the currency effect was a one-off benefit, as was a large part of the performance fees. Many investors were instead capitalising these one-off benefits by paying a PER of 25. Since then the A$ has stopped falling and the performance fees have dried up, leaving that PER looking rather expensive. Easy to say in hindsight, of course, but we also said so at the time. Such is the benefit of using valuation as one’s guide, rather than price targets, momentum or chicken livers.

James Greenhalgh, senior analyst

Over time I’ve been training myself to pay up for quality businesses. There was a time where I’d never pay 20 times earnings for a stock but I find myself doing so more frequently now.

A number of the online classified businesses fell out of favour last year as short-term profit growth slowed significantly. Trade Me was one example where profit growth had slowed to almost nothing. We first said bought in on 19 Feb 14 (Buy - $3.54) and kept re-iterating that view as the price fell. On 14 Aug 15 (Buy - $2.77) for example, and again in June 2015 at $3.04 when we topped up the holdings in our portfolios. The price has now risen to $4.05. It’s a good indication of how to approach falling share prices, especially in good business going through challenging times.

Seek was similar, reporting three profit downgrades in 2015. After the third, and a 33% price fall since the peak, we upgraded to Buy at $12.06 in Seek finds success overseas. Nevertheless, picking the price close to the bottom was dumb luck. Profit warnings and/or slowing growth are often a source of mis-pricing, particularly when the business is of a very high quality.

Despite the upgrade, Seek never looked ‘cheap’ as such, so there was no sense of inevitability about the success of this recommendation. I was quite concerned – and still am – that a deteriorating Australian economy could hit the employment classifieds market. As it has turned out, Seek Domestic has recently reported surging profits because of past product investments by its impressively long-term focused management team. With more than a 30% return in just over six months it’s too early to call this a winner but it again illustrates the approach to falling share prices.

Perhaps one of the biggest problems for value investors – and me specifically – is that I find it difficult to pay up for quality stocks unless there has been some recent bad news. This applied to two stocks that I worked on in 2015. New listing IDP Education went through a Dragons’ Den before listing – followed by our review titled IDP Education’s ultimate test – but I was reluctant to pay above $3.00. It never hit that price and is now up 41% since the review. Navitas is another education provider I did plenty of work on but the price increased before I was comfortable.

Missing out is a pretty common experience in value investing. For every Buy recommendation, I’d estimate there are probably three promising situations that get away before we’ve done sufficient work to establish the extent of the opportunity. That’s not to say that for every Buy three slip through the net, only that one has to focus one’s resources on the best opportunities, work through them and be prepared to let others go. You don’t need to pick every winner to be a successful investor, just a few.

Next week: The rest of the team ‘fess up and gloat about their losers and winners.

Note: The Intelligent Investor Growth Portfolio owns shares in GBST, Nanosonics, ResMed, Seek, Sydney Airport, Trade Me. The Intelligent Investor Equity Income Portfolio owns shares in GBST, Seek, Sydney Airport, Trade Me and Woolworths. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

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