Last week I took a look at a handful of LICs that had a good amount of cash on hand prior to the market correction (see Spotting cashed up LICs, August 31). I also spoke with the managers of those LICs and discussed what they were currently doing and all were selectively deploying cash into this market.
The LIC portfolio has cash at hand and it is going to take its own advice. I am going to be buying on the dips and buying one of my cashed up comrades. I am also going to take my own advice from an early piece where I said I am not here to time markets, or pick corrections or make currency calls. I am going to let the experienced managers take care of this and not second guess them. This is why I am bringing in the Perpetual Equity Investment Company (PIC).
At July 31 the team at PIC were cashed up and good to go. Some 54 per cent of their portfolio was still cash. This has come down significantly in the last two weeks. Let’s take a look at why this team stands out to me.
Assessing the people
When assessing a fund or LIC there are two key things to look for: the people and the process. When you look at the names that have been involved with the Perpetual investment stable like John Sevior, Anton Tagliaferro, Peter Morgan and Matt Williams you get a good sense of the type of investors it produces. The team there now with Vince Pezzullo, Paul Skamvougeras and Nathan Parkin have been with the investment team at Perpetual for an average of nine years apiece – you would expect the names before them have passed down a fair bit of investment knowledge.
What do they do?
PIC is a concentrated portfolio of predominantly mid-cap Australian equities with a maximum allocation of 25 per cent to cash and to international equities. Portfolio manager Vince Pezzullo and team take a value investing approach. The portfolio is built stock by stock and is completely sector, size and region unaware. This allows Pezzullo and co to invest in their best ideas. If they do not like the banks or certain resource companies they simply won’t hold them. When they talk about not holding banks, they don’t mean holding banks and just being underweight to the market. They can avoid holding them at all. Pezzullo was very passionate about this point. “This LIC is set up for SMSF holders in mind. They don’t care about a benchmark, they just want to make a return. If that’s here in Australian stocks or returns from international stocks who cares. If you want to make money you have to focus on high quality companies that generate cash flow and wait to buy them at the right price – that takes discipline and patience.”
The team members at PIC are 100 per cent fundamental stock pickers and will only hold between 20-40 stocks at any one time. The majority of the stocks they are targeting in the Australian market are mid-caps. But they are not exclusive, this is just where they are finding the most mispriced stocks right now. “If Woolies fell to $20 we’ll definitely have a look at it because you have to look at your return relative to risk. You’ve always got to think about the adjusted risk when you’re building a portfolio.”
To come to their investible universe the PIC team runs a four step filtration process with each designed to identify quality. The four are: net debt to equity (no specific percentage was mentioned but Pezzullo did mention the companies in their investible universe had on average half the market average level), EBIT (once again no specifics mentioned), quality management team with a depth of industry experience and recurring earnings. Pezzullo is not interested in companies that have gone into losses a few times. A history of consistent profitability is important.
Pezzullo stressed the importance of meeting with management and the eyeball test. It is also where they get the opportunity to ask about industry structure. It is also a chance to ask about changes technology may bring, and issues that could affect the company three to five years from now. It’s the long term PIC is interested in and not the next six-month numbers which management teams usually clam up about anyway.
With this view in mind it is important to note in this falling market PIC has not just been buying the market. The market is almost irrelevant to what they do. What it has caused is some indiscriminate selling to stocks they have identified as quality and from my previous conversation with Pezzullo they were seeing “absolute value” now in those names. So yes, that cash balance is coming down dramatically.
As mentioned PIC is a value-based LIC. When it comes to buying they are not looking for a share price catalyst or an upward trend. They are looking for their targeted stocks to trade below their assessment of fair value. They do not have any hard and fast rules when it comes to buying e.g. 2 per cent first and wait etc. If the stock is offered at a price they are comfortable with and the liquidity is there to get set then they will take it. “Trying to pick the bottom is near impossible and I don’t mind buying a little early. The lowest liquidity you will find is at the bottom at the turning point. I’m looking to buy a company I want to hold for the next five years, I am not going to care about paying an extra 5 cents at the bottom.”
When it comes to exiting Pezzullo says they play a “tight loose game”. This means they are incredibly tight on the fundamental and value reasons for buying a stock but when it comes to exiting they look at a number of factors before taking profit. This could be if something far exceeds value, where the stock is sitting in the current cycle or if there is a better opportunity with greater valuation upside available.
While on the subject of the investment process it is important to state the role of the international component in the portfolio. The flexibility to include international stocks is not there for the purpose of diversification. The international stocks are there to provide performance only. If the team sees greater valuation upside in an international stock then they will invest in it and will not hold international stocks simply because they need to have a certain allocation.
PIC will actively manage the currency exposure with its international positions. Currently the portfolio is unhedged, though Pezzullo did state if the dollar dropped to 60 cents you would see them take some insurance out and hedge. He did go on to say, however: “Typically when the dollar is as low as 60 or 55 cents the Australian market is very cheap so the best hedge you could do would be to sell your international and go 100 per cent Australian because it’s cheap.”
Dividends and LICs’ natural advantage
From the outset PIC have stated they want to get their dividend to approximately 3.5 to 4.5 per cent pa and then look to increase it gradually. One of the major benefits of an LIC over a traditional managed fund is the ability to lock away profits in its profit reserves and pay it out over a number of years ensuring consistency of income. Managed funds typically operate as unit trusts so must pay out all income and profits booked. This tends to lead to lumpy payouts and they cannot smooth out the distributions to unit holders so when the leaner years come (and they always do) the distribution will drop accordingly. PIC aims for steady, consistent dividend growth and always fully franked through the benefit of being able to take profit on international stocks, pay tax on it and build up franking credits for the dividends to come.
This leads into why Pezzullo believes PIC will be able to maintain a tight handle on the constant battle LICs have with premiums and discounts to NTA. “A reliable dividend stream is important,” he says. “Investors will wear some volatility in the NTA – because that is life and there will be volatility from time to time – if we can produce and maintain that fully franked yield.”
On top of the yield PIC hopes its level of transparency will help investors have a level of comfort with the LIC. PIC calculates and updates the market with its NTA on a daily basis. Investors are never left wondering the value of their holdings. Additionally when the portfolio is closer to fully invested expect to see the monthly updates to include the bulk of its holdings.
Perpetual has clout
Yes this is a brand new LIC but this isn’t this team’s first rodeo. Perpetual historically has run many traditional unit trusts and private wealth. Perpetual has a total of $23 billion of funds under management and with that comes benefits. Normally a fund with a market cap of $250 million isn’t a top priority for brokers when they have lines of stock to move. Unless that $250m is nestled in with $23bn. PIC has an unfair advantage over you and I. They are able to get the volume or flow as it is known in the stock they are targeting before you would even know it is available. Perpetual as a group would be one of the first ports of call for any broker when they have a meaningful line of stock come through.
How does this help? Instead of taking weeks to build a meaningful position in a stock they are able to get set a lot quicker. Yes it is unfair to the average investor out there on their own but there’s a lot of things out there in the market that aren’t fair. Don’t fight it, join them. At the end of the day the beneficiary is the shareholder.
Additionally you have a very experienced team who have worked under some of the best investors in Australia. When buying into PIC you are buying all of this. People often point to fees and complain about paying them or avoid LICs unless their fee structure is 0.15 per cent etc but I am happy to pay 1 per cent for these benefits. Let’s not be cheap about it.
One more point as well, let’s not get caught up by the $23bn of funds under management and the Perpetual name and think this LIC is a behemoth. At $250m this portfolio does not come with those disadvantages of scale. At $250m it is incredibly nimble with every chance to outperform.
Why does it fit into the LIC model portfolio?
For me it is pretty simple why PIC fits into a portfolio at this point in time. Having such large chunks of cash at a time when the market has corrected and volatility abounds – on a longer term view PIC should provide some significant performance.
Yes the model portfolio already has mid-cap exposure and international exposure, but our other mid-cap manager uses a very different investment approach and PIC uses a very different approach to CDM who combines international exposure as well. I’m comfortable with bringing in 10 per cent right now.