Intelligent Investor Equity Income - June 2017

Despite political instability around the world, markets have taken it in their stride – but the resulting high prices have created their own problems.

It’s been said that markets climb against a wall of fear and it’s rarely been more true than in the 2017 financial year.

Crucial elections were held around the world, in Italy, the Netherlands, the US, the UK and France. Results were mixed, but the US and UK produced major shocks. There were of course no elections in North Korea, but the rogue state served up its own brand of instability.

Markets took it all in their stride, though – even managing to turn Donald Trump’s election as US president into a positive, which must be the purest form of seeing a glass as half-full. The high prices that have ensued have caused their own problems, with good opportunities thin on the ground.

Table 1: Performance - Intelligent Investor Equity Income (to 30 Jun 2017)
  1 Mth 3 Mths 6 Mths 1 Yr 2 Yrs S.I. (p.a.)*
Intelligent Investor Equity Income Portfolio (before fees) 1.18% 3.06% 5.65% 18.42% 15.29% 15.26%
Intelligent Investor Equity Income Portfolio (after fees) 1.11% 2.86% 5.23% 17.50% 14.30% 14.28%
S&P/ASX 200 Accumulation Index 0.17% -1.58% 3.16% 14.09% 7.11% 7.10%
Excess to Benchmark 0.94% 4.43% 2.06% 3.41% 7.19% 7.18%
* Inception date is 1 Jul 2015.

In the face of such difficulties, the best response for long-term investors – as ever – is to seek the sanctuary of a bunch of decent-quality and undervalued stocks. That’s largely what our Equity Income Portfolio has done over the past year (much like the year before in fact) and by and large it’s turned out OK.

A run down the list of holdings shows (with only a few exceptions) a collection of cash-generative companies, with competitive advantages in important areas. While the market might fret about the near-term prospects for stocks like ASX, Ansell, Computershare, Seek and Sydney Airport, we’re happy to back their ability to deliver a growing stream of cash over the long term.

Of course such businesses don’t grow on trees, and it’s even harder to find them at bargain prices. So once we’ve bought them we tend to hold onto them – at least until we find something demonstrably better. This was the case recently, for example, with the shift of some of our holdings in Computershare into a new position in Navitas.

Too much tinkering, though, will hurt your returns. Most obviously there’s a cost in terms of brokerage and taxes; more insidiously, though, it can suck you into the market’s short-term thinking and thereby negate the biggest advantage you can give yourself.

During the year, we’ve sold and reinvested a bit less than 20% of the portfolio. That’s in line with the previous year and implies an average holding period of about five years, which is about what we’d expect in the future.

Although the portfolio has a bias towards quality (the long-term merits of which are often undervalued), markets are dynamic and offer different types of opportunity at different times. We therefore try to be flexible in our approach and will buy any kind of stock so long as we think it’s sufficiently undervalued.

PMP is an example of a lesser quality business bought at a very cheap price, and so far it has served us well, returning 47% since our purchase in 2015 (including 44% over the past year).

We’ve also had some situations that have turned out to be more speculative and/or lower quality than expected – to put it politely – a category that would include GBST Holdings and OFX Group. In both cases we overestimated the quality and overpaid, but in GBST’s case we think the basic investment case is still on track and have held on, while with OFX we’ve taken what’s left of our money and run.

In GBST’s case we’ve now made a loss of 30%, including 29% over the past year. With OFX, we got out with a loss of 30% (incorporating a loss of 37% in the past year).

Overall, though, such mistakes have been relatively few in number. Out of the 33 stocks held since the portfolio started accepting real money two years ago, we’ve only made losses on five (with two of those in single digits). The one double-digit loss not already mentioned was in Origin Energy which lost 16% before being sold this year.

These losses have been more than offset by the likes of Trade Me (up 35%), South32 (up 46%), ASX (up 23%) and Sydney Airport (up 21%), which have combined healthy gains with larger weightings to deliver the greatest dollar gains for the portfolio.

Of course these performances have been helped by a buoyant sharemarket, with the S&P/ASX 200 Accumulation Index returning 14.1% over the past year and 7.1% per year over the past two. However, the Equity Income Portfolio has more than matched this, with gains of 17.5% over one year and 14.3% per year over two (after costs).

Since it began as a model in July 2001 it has returned 12.6% a year, after assumed costs of 0.97% a year (matching the real costs since 2015), compared to 8.0% a year for the index.

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