Finding the gap

It’s been a good few years since Intelligent Investor hit the road. So as the show rolled into Hindley Street, Adelaide, the city’s strip joint strip, we weren’t the only ones feeling a little naked.

We shouldn’t have worried. Despite a financial crisis, the threat of a China crash and the metronomic ability of Euro politicians to disappoint—and let us not forget the odd poor recommendation—our members remain a gracious, smart and interesting bunch. It was a pleasure to meet so many of you.

Before getting into some of the event’s major themes, let’s first recall the situation just 15 months ago. Blue chips dominate best buys, an article from 9 Aug 11, featured 23 buy recommendations. By early November, there were 34 companies on our Buy list, many of them attractively priced blue chips offering generous dividend yields and strong competitive positions. Heady days, soon over.

Chart 1 plots the relative performance of the market’s largest sectors over the subsequent 12 months. Resource stocks have continued their general decline. With a long-standing negative recommendation on Rio Tinto and a focus on energy companies like Origin and Santos, members should have largely avoided the bloodletting in this sector.

In contrast, financials have pulled away. A year ago, the major banks were offering grossed up yields of up around 10%. In a market awash with hybrids and investors seeking safety (and travelling up the risk curve to find it), it was too much to resist. The ASX 200 Financials Sector Index is up nearly 15% in a year, while the broader ASX 200 index has risen 5%.

As Nathan’s presentation made clear, great franchises like Woolworths, ASX, Coca-Cola Amatil, ARB Corp and News Corporation should form the bedrock of almost every portfolio.

Last year, we had opportunities to buy most of these stocks cheaply. No longer; lower interest rates and money printing have seen to that. Money is being diverted away from term deposits into reliable blue chip franchises paying healthy dividends. What was once cheap is no longer.

Only ASX and Woolworths remain on the buy list, the latter at prices 20% higher than when we upgraded it to Buy on 9 Aug 11 (Buy - $23.89). See Put some Woolies in your basket from 23 Oct 11 (Long Term Buy - $29.20) for the full story.

Not only has our buy list been cut from 34 companies to 15 in a year, its constituency has changed. Almost half of the stocks remaining on the list are speculative opportunities. A year ago, most were blue chips.

What chance does an ordinary investor have of building a profitable, conservative portfolio in a market like this?

On the roadshow, Nathan Bell unveiled his Lindsay Lohan strategy (please, don’t ask), the first prong of which is to see opportunity in crisis. That’s something you should be well schooled in by now. If you’ve acted on the recommendations of the past year or so, the predicament we now all face—what do I do with spare cash?—is a function of the success of this approach.

The second prong is to build a portfolio founded on high quality blue chips purchased at attractive prices. Again, give yourself a tick. His third point is more pertinent to the times. With a high Australian dollar and cheap stocks more readily available in Europe and the US, we should be using these circumstances to build an exposure to overseas opportunities.

Nathan suggested two ways to get it. First, purchase local stocks generating a high percentage of earnings offshore. Cochlear, Computershare, ResMed, CSL and QBE Insurance are but five examples. Again, we’ve had the chance to purchase some of these stocks in the past year and two currently reside on the Buy list.

The second is to invest directly in overseas blue chip businesses like Lowe’s, Walmart, Tesco and McDonald’s. Tesco, claims Nathan, is especially interesting. This is the company that Woolworth’s has modelled its growth strategy on yet it trades on a 4.5% yield and a PER of less than 10, versus 16 for Woolies.

The recently published Ripe for the picking: Overseas stocks to buy now contains research on 10 overseas stocks, a potential gold portfolio, an investing overseas survival guide and recommendations on the best brokers through which overseas stocks can be purchased. The Home and Away portfolio, featuring the best of local and international stocks, was especially well received. It’s well worth a read.

Other speakers alluded to the theme of international investing. In Melbourne, Peter Wilmshurst of Templeton Global Fund said there are plenty of French global blue chips trading at very attractive prices, more so than almost anywhere in Europe.

Peter also foresaw a successful resolution of the European crisis but made the point that countries are not companies, and that there was value in technology stocks and pharmaceutical stocks such as GlaxoSmithKlein.

Erik Metanomski of Lanyon Australian Value Fund wasn’t so optimistic. He’s 50% in cash and has deep concerns about the unorthodox monetary responses to the crisis. However, his large cash holding was more a reflection of high stock prices than anything else. When valuations creep too high, says Erik, poor performance and capital losses follow. This is an issue close to our hearts and one we’ll return to.

In Sydney, Kerr Neilson of Platinum Asset Management was asked to imagine that he’d suffered a personal financial calamity and that he was down to his last thousand dollars. The question was: which of his funds would he put his last thousand dollars into? His immediate response: ‘The Japan Fund for sure. It’ll either make you a lot of money or you’ll not make much.’

The approach taken by Intelligent Investor Value Fund’s Steve Johnson was slightly different. Large blue chips and attractive growth stocks were a heavily fished pond locally, argued Steve, but asset plays were a more lucrative and profitable area. No one was much interested in them because they were too small.

Whilst Erik Metanomski made a powerful case for Village Roadshow, Steve talked the audience through RNY Property, an Australian-listed but US-based property fund. Both were intriguing arguments. To find out more, a video recording from the first Sydney evening can be found here and the presentations can be downloaded here.

Perhaps the most salient advice came from Kerr Neilson, who said that, ‘the stockmarket owes you nothing. You think the stockmarket is there to make you rich. It is most certainly not. It is there to deprive you of wealth. But if you are cunning and if you are of independent mind it need not.’

And the best way of doing that is to work out where ‘the gap’ is, because ‘that’s what we’re buying. We are buying the gap between (a company's) costs and the revenues. Understand what creates that gap and sustains that gap. That is the essence of making money.'

Of course, there is also a gap between periods of frenetic activity and dispassionate disinterest in acquiring new stocks, largely due to their unattractive pricing. For many of us, that means sitting atop a pile of cash earning an unimpressive return.

That shouldn’t concern you too much. The value of cash comes from its deployment during the occasional flood of cheap stocks, not in the regular trickle of a term deposit. Think of it as a weapon for occasional deployment, not an investment in itself.

The response to the roadshow was such that we’ve already committed to doing it again, once we’ve caught up on some sleep. In all probability, we’ll visit every capital city once every two years so please, try and come along to the next one.

Finally, if you’re considering investing in Steve’s Value Fund, you can download a pds here. For those seeking advice on tax, SMSFs and the like, take a trial to Richard Livingston’s Super Advisor.

A special thanks to our guest speakers, Erik Metanomski of Lanyon Australian Value Fund, Peter Wilmshurst of Franklin Templeton Investments and Kerr Neilson of Platinum Asset Management. Consider their talents if you’re looking for a fund manager. And next time you’re in Sydney, check out the White Rabbit contemporary Chinese art collection—it’s both fascinating and free, made possible by the donations of Judith and Kerr Neilson.