The China crisis portfolio—Pt 2

The primary purpose of last November’s special report, The coming China crash, was to prepare for the impact of a China slowdown on members’ portfolios.

That was addressed in two ways. First, by limiting exposure to stocks that were highly exposed to China—an issue addressed last week in The China crash is here: What now? Pt 1. Second, through a China protection portfolio featured on page 13 of the report, we offered specific stock recommendations for members wanting to take out insurance against a China crash.

Now we’re going to find out how that portfolio has fared and make a few adjustments to it in light of recent developments.

Since the publication of the special report on 23 Nov 11, the All Ords Accumulation Index has returned 10.8%. As of 26 Sep 12, the China crash protection portfolio has returned 16.1%. A major factor in this outperformance has been the flight to safety.

Last year, we found some very attractive pockets of value. The original portfolio featured 15 stocks, only one of which wasn’t a buy of some form. High quality stocks with very little exposure to a failing China, including the likes of News Corp, Woolworths, CSL and Sydney Airport, were attractive Long Term Buys.

With their respective prices rising 55%, 20%, 47% and 22%*, these and a few other stocks have been downgraded to Hold. Such is the price of safety. With China fears now manifest, there are now seven holds in the portfolio and seven buys, including two additions, which we’ll discuss shortly. Let’s begin with a quick look at each stock in the portfolio.

Downgrades to Hold

Infigen Energy, originally a Speculative Buy below $0.25, was the only Hold in the original portfolio. Not much has changed since. The company’s wind farms continue to generate cash, adding to equity value. There remains significant potential upside and limited downside but at today’s price the punt is less attractive than it was below $0.25. It remains a HOLD but we’d happily upgrade if it fell back below $0.25.

Formerly known as MAP Group, and adjusted for the special distribution of 80 cents paid in late 2011, Sydney Airport is up 22% since the special report, paying attractive normal distributions of 21 cents per year. Ironically, strong passenger numbers from China and South East Asia are a big contributor to the group’s performance, although Sydney Airport is diversified by passenger source. It remains an excellent asset. HOLD.

News Corp has worked out as well as we could have hoped. Financially, the group has thrown off the stench of the News of the World scandal, has aggressively bought back its own stock and made plans to split its troublesome publishing assets from its bigger and better media and entertainment assets. The stock is up 55% since the China Crash report, highlighting the benefits of diversification and of owning cheap assets. It too is a HOLD.

Although it was recommended at prices higher than appeared in the original report, Challenger Infrastructure has performed well. The group sold its two infrastructure assets and is in a process of liquidation, returning between $1.30 and $1.42 to securityholders, plus the final distribution of five cents. From capital gains alone, the China Crash buyer is up 23% in less than a year and can add almost another 10% in income received. HOLD.

Blood products manufacturer CSL is up 47% since the report, with the business performing strongly and a share price to match. Above $50 there’s a case for selling but this isn’t a stock one should sell lightly. It’s another HOLD.

Fisher & Paykel Healthcare hasn’t done so well, with a share price down 7% from the time of the report, although the dividend will have offset most of this decline. Our fears of lost market share look overdone—look out for a review next week—and, with sticky revenue this business should be able to grow earnings regardless of what's happening in China. Currently a HOLD, at around $1.50 we’d consider an upgrade.

Current Buy recommendations

There’s not much point in going into detail on those stocks classified as a Buy in the original report and still featuring that recommendation. Origin Energy and Santos have fallen in price, perhaps due to their (minimal) exposure to the resources sector. We’re sticking with Long Term Buy on both although Gaurav Sodhi is currently investigating the case for an upgrade of Origin.

For the latest on the other current buys, read the latest research on QBE Insurance, Computershare—the epitome of a great business trading at a reasonable price—and WHK Group.

New Buy recommendations

We’re adding two new stocks to the portfolio from our current Buy list. The first, ASX Limited, was upgraded in ASX: Into the light from 08 Jun 12 (Long Term Buy – $29.87). We’ve been waiting a long time to get an opportunity to buy this monopoly business and it’s nice to have our patience rewarded.

The same goes for ALE Property Group Stapled Securities, last reviewed on 1 Aug 12 (Buy for Yield – $2.09). On a current yield of 7.4%, this situation also has some attractive capital appreciation potential. Note also that should the price of GPG Group fall to 38 cents, we’d add this stock to these two new buy recommendations.

Stock removals

We’re removing two stocks from the portfolio. The first, Spark Infrastructure, has delivered total returns of 19% since downgrading it on 20 Apr 12 (Sell – $1.42). In truth, we were reluctant sellers of this fine business, fearful of management's expansion plans. Eventually, this business will probably require a capital raising if those plans come to fruition. The share price has continued to rise since selling out but this recommendation is now ‘completed’ and will be a happy inclusion in our performance report for the year.

The same cannot be said of Metcash. This stock appeared in the original portfolio at a price of $4.04 but on 31 Aug 12 in The Metcash earnings hole (Sell – $3.68), we explained how the problems in the business were intensifying and management lacked a clear strategy to address them. The stock price remains largely unchanged since then, and we have no regrets about its removal.

Lastly, although we no longer offer coverage of Templeton Global Growth Fund, it has retained a place in the portfolio as a reminder of how you can get overseas stock exposure at a reasonable price. See Shopping for international exposure, published on 8 Aug 11 for more information. LICs are relatively simple stocks to analyse and this article tells you how to go about it.

Patience, not banks required

Overall, the performance of the China protection portfolio has been as good as we could have hoped, outperforming the comparison index by 5.3%. It remains nicely positioned, although it’s worth making some general points about what we can learn from it.

First, the attractive returns have been achieved without any exposure to the Australian banking sector. It’s an article of faith among many Australian investors that banks should be a major part of your portfolio. The performance of this portfolio challenges that assumption.

At a time when high yields are difficult to find, the banks look tempting but that's no reason to load up on them. We recommend members have no more than 10% of their total portfolio in banks, including any hybrid products. That need not damage your returns and may well add to them.

Second, this outperformance has been achieved without taking on extra risk. Indeed, its purpose was the very opposite—protection rather than performance. Having a portfolio of large, reliable stocks purchased at attractive prices will always stand you in good stead, no matter what the future may hold.

And finally, the abundance of buy recommendations of November last year, and the relative lack thereof now, highlights the necessity of acting early and preparing your portfolio before everyone else follows suit.

With fewer bargains around, we'll need to be patient and keep turning over the rocks. Your analytical team has a list of the businesses they want to buy and the prices they’re prepared to pay for them.

It’s worth waiting for these opportunities—and they will come, just as they did last year—instead of buying low quality businesses and putting your portfolio at risk. Right now, the message is to protect what you've got and wait for the right opportunities.

As the list of stocks in Table 1 shows, it would be far harder to build a portfolio of this ilk today than it was just 10 months ago. Let your stock purchase decisions be driven primarily by an assessment of value and you’ll be well ahead of other investors. The biggest determinant of your future returns is the price you pay. The performance of the China crash protection portfolio makes that point very nicely.

*Adjusted for the 80 cent per security capital return paid in Dec 11.