Building a portfolio from our Buy list

In 2009 Martijn Cremers and Antti Petajisto of the Yale School of Management analysed the performance of several different investing styles. Eugene Robin, an analyst at US hedge fund Cove Street Capital, recently summarised the results:

‘What seems fairly obvious to us is that widely diversified portfolios that hug their respective indices are either the outcome of excessive amounts of money under management or a firm’s business decision to stay close to an index and take advantage of a whole host of behavioural finance flaws that enable fee paying mediocrity.’

Let’s translate that for you: Despite evidence that investors can outperform the index with a thoughtful and idiosyncratic portfolio, more professionals are indexing to protect their lucrative fees.

Chart 1 offers proof. As Robin says, ‘The 2008 crash has driven many asset allocators to seek out ETFs and indexers while converting many formerly active managers to indexing as a way to stay competitive in the asset sourcing market.’

The higher the percentage range in Chart 1, the less the portfolios resemble the index. For example, assets with the least resemblance to the index that are represented by the 80-100% range (i.e. the stocks in the portfolio vary from the index by 80-100%), have fallen from 60% of total mutual fund assets in 1980 to just 20% in 2009.

The dominance of resources, energy and banking stocks, which account for 63% of the local market (see Chart 2), only adds to the danger of this approach.

Not safe

Many investors now have a large proportion of their portfolio in highly leveraged banks and extremely cyclical resources companies and mining services companies. They think this is safe but is far from it.

Aside from a plethora of Sell and Avoid recommendations in the resources sector—a place where selectivity is paramount—we also recommend keeping banks to 10% or less of your portfolio, including any income securities issued by banks.

One should retain a healthy respect for the business and economic cycles that drive banking and resources profits and remember that blue chip is not a synonym for safety or value.

So, if you can’t load up on banks and the big resource stocks, where do you put your money?

Answering that question is made harder by the fact that only a dozen or so of Australia’s 200 largest stocks currently earn a positive recommendation (see Chart 3). Compared with around 20 this time last year, value is becoming harder to find.

Let’s start with the basic premise that, especially in a market such as this, finding value typically means owning an unconventional portfolio that varies significantly from a popular index. Our 50/50 approach is tailored to ensure you are invested in our best ideas, some of which now lie in smaller stocks (see below), not the biggest stocks.

The current buy list in Table 1 shows recommended portfolio weightings and dividend yields. This is not a call to blindly buy them all but there’s enough here to embark on building a high quality, robust value-oriented portfolio. Let’s analyse the choices.

Blue chips buys

Blue chip stocks should form the base of a sound portfolio. Fortunately, some of Australia’s best businesses are trading at their lowest valuations in many, many years.

After conservative income investors lost small fortunes bidding up highly geared A-REITs and infrastructure stocks during the boom, it’s remarkable that Woolworths and Metcash, two defensive, high quality businesses, currently offer enticing grossed up yields of 6.9% and 10.0% respectively.

Whilst these mature companies won’t reproduce the incredible growth of the previous decade, they are very reliable cashflow rainmakers.

There’s an added bonus for current buyers: As their price-to-earnings ratios fall, both can create value by using surplus cash to buy back shares at attractive prices. Few companies can respond to slower growth in such a beneficial manner, which explains why both model portfolios own both stocks.

As explained in Woolworths keeps Metcash at bay, Woolworths remains the superior business but you may favour Metcash’s higher dividend yield if you’re prepared to trade lower potential growth for a higher current yield.

QBE v IAG

Past reviews of QBE Insurance could fill a small book. With its share price rebounding 37% since reaching $9.88 on 12 Jan 12, the company shares a price-to-book value of 1.6 with rival Insurance Australia Group (IAG).

QBE’s outright Buy recommendation reflects our view that it offers higher potential returns than IAG. QBE’s greater international exposure could also increase returns should the Aussie dollar fall from current lofty levels.

While IAG is nearing a downgrade to Hold, it shares a dominant 70% market share in Australia with rival Suncorp and offers less exposure to catastrophic insurance losses. The company’s underlying performance is also improving under chief executive Mike Wilkins. IAG, unlike QBE, also pays fully franked dividends. Again, the model Income portfolio owns shares in both.

As with the banking sector, we recommend keeping your total exposure to the insurance sector to no more than 10%. The combined limit increases to 25% for financial services companies in general, including banks. [For more on the insurance sector, watch out for a special report to be published in late June].

BKW v. Soul Patts

Brickworks is cheaper than Soul Patts right now because its building products division is suffering from a downturn in dwelling approvals while the latter stock is enjoying the fruits of the coal boom—it owns a 60% shareholding in coal miner New Hope.

Those members seeking higher resources exposure may favour Soul Patts but please read the past reviews to fully understand these complicated businesses before acting, especially Cross shareholding riddle revealed, which explains the incestuous relationship between these two stocks.

Origin Energy and Santos both offer exposure to gas, oil and LNG but are not directly comparable. Origin also owns a reliable and inimitable gas and electricity retail business but may need more capital to fund its share of a massive LNG project if it decides against selling it.

Santos is currently on the cusp of a downgrade to Hold but, given our long-held expectation of lower commodity prices, these stocks have been specially selected to obtain resources exposure without being fully dependent on Chinese growth.

Computershare

Computershare currently trades on a price-to-earnings ratio of 17 and, due to the dearth of corporate activity and low returns from its cash holdings in key markets like Canada, earnings are expected to fall in 2012.

These are temporary issues. The registrar business is humming along, boosted by the company’s US$550m acquisition of BNY Mellon’s US registry business, which hands Computershare a potential 70% market share in that country.

Computershare is unlikely to be a multi-bagger like our recommendations following the tech wreck, but holds plenty of appeal for patient growth investors.

Second-liners

Very conservative investors can stop reading now. These second-line stocks carry larger risks than our blue chip recommendations.

Challenger Infrastructure Fund’s 9.8% distribution yield reflects a return of capital rather than a sustainable distribution. Please don’t consider it an income stock.

The company is currently shopping its assets to bridge the gulf between its last reported net asset value of around $2.19, 79% above its current market price of $1.225. The swing factor is the value of the highly geared UK utility connections business, Inexus.

Challenger’s reliable storage tank business also offers some downside protection should Inexus fail to attract a decent price—a case of heads we win, tails we shouldn’t lose too much.

Virtual office provider Servcorp has graced our buy list for many years. Now the overseas expansion is finally showing signs of promise. Unlike staid accounting company WHK Group, which is mature and sports an attractive 8.1% fully franked dividend yield, Servcorp has more appeal for growth investors.

Fisher & Paykel Healthcare is an excellent business, operating in high growth ventilation and obstructive sleep apnoea markets. The price-to-earnings ratio of 19 looks high due to the strength of the New Zealand and Australian dollars. But as explained in F&P Healthcare’s headwind, it could fall quickly if these currencies weaken and underlying profits keep growing at current rates.

Speculative stocks

Due to the risks involved, speculative stocks should only be bought with money you can afford to lose.

Take Alumina for example. On the face of it, it looks a ghastly business. But a change in the way alumina is priced could turn this pumpkin into Cinderella. Alumina: Lousy business, hot opportunity makes the case.

AWE is a speculative play on higher oil prices and exploration success and Azumah is our latest gold speculation.

The owner-managers of property developer Sunland are creating value buying back stock with gusto at a large discount to net tangible assets. Dividends are still a long way off but if you have a large exposure to Australian residential property then you may be better off with an uncorrelated speculation, like liver cancer treatment company Sirtex.

An ode to cash

Even if you invested in every stock based on the recommended portfolio limits (not something we’re advocating), you’d still have a large cash holding (see Table 1).

There are four reasons why that should not concern you.

First, most members should by now own some high quality businesses that we’d only recommend you sell at exceptionally high prices. Second, you might own other financial assets like gold which can help preserve your purchasing power against inflation.

Third, if you haven’t yet purchased any high quality overseas stocks, you may need some cash for a special report published at the end of June that examines many overseas investment opportunities. In preparation, read A world of opportunity: Your overseas survival guide and Overseas Brokerage.

Finally, consider legendary investor Seth Klarman’s advice:

‘Some argue that holding significant cash is gambling, that being less than fully invested is akin to market timing. But isn't a ‘yes’ or ‘no’ decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can't or won't say ‘no’ forgoes perhaps the most valuable tool available to investors.’

Building a robust portfolio takes time. There is no need to rush it. And holding cash when prices are unattractive means you’ll be prepared when the next correction comes. Don’t let it burn a hole in your pocket. The time will come when you’ll need it.