The virtues of patience

There was a time when Macquarie Group’s securities arm delivered annual profits of over $1bn. In the latest result, it incurred a loss of $194m.

The world over, equities are out and bonds are in (see Chart 1). The 2010 ASX Share Ownership survey shows that the proportion of people owning direct shares increased from 25% in 2006 to 30%. It says nothing, however, about equity allocations declining over the same period.

Australia, it turns out, is an outlier. Over the past few years, the US and almost all European countries have suffered a decline in the number of people investing directly in shares.

Recent results from fund managers show how retail money is charging in to term deposits and other low-yield assets. On 30 August 07, Platinum Asset Management had almost $22bn under management. At the end of last calendar year it had just over $15bn. That money is going in ‘risk-off’ assets.

Platinum chief executive Kerr Neilson called this trend the ‘death of the cult of equity’, and he isn’t alone. In May, a Financial Times front page was headlined, ‘Death of equities?’, recalling a similar BusinessWeek cover from 1979. In May, Citi’s respected equity strategist, Robert Buckland, released a 28-page report titled ‘Equity cult still dying’. In it, he noted that:

‘Global investors spent the second half of the 20th century raising their equity weightings, mostly at the expense of bonds. The associated rerating culminated in the late 1990s bubble.

Since then, two 50% bear markets have taken their toll. On our measures, the equity cult is now dead in continental Europe and Japan. It is looking decidedly unhealthy elsewhere. A bond cult has risen in its place.’

The ducks appear to be lining up. Members with long memories may recall how the BusinessWeek cover from 1979 heralded a 20-year bull market, beginning just three years later. And who can forget Dow 36,000?. The primary US index was supposed to triple within 10 years. Instead, it fell almost 40% in two.

Diving in?

Excluding Gaurav—'I don’t see the point of Facebook, the iPad is a dud'—Sodhi’s technology predictions, aren’t these the best contra-indicators of all? Doesn’t that mean we should be diving in?

Not yet, no. The Eurozone, one way or another, is stuffed (see How to leave (or save) the Euro). Austerity measures are driving much of Europe into catastrophic recessions. Many European banks are either technically insolvent or would be were it not for taxpayer support. Even the IMF, the guardian of the flame of Austrian neo-liberalism, is worried about deflation.

The US is carrying gross and public debt at a level higher than at any time since the end of WWII. Treasury expects to hit its US$16 trillion borrowing limit in the fourth quarter of this year but, according to a spokesperson, can ‘stretch out the time before the government defaults on its debt by shuffling funds among accounts, as well as suspending some payments and programs.’

Nothing to worry about there, then.

Asia, excluding Japan—after two ‘lost’ decades that’s a given nowadays—is a bright spot. Still, our long-standing concerns regarding China are ready to bear bitter fruit. Famed Macquarie shorter and long time China bear Jim Chanos summed the view up when he said he’s ‘long corruption and short property in China’.

The global banking system seems terminally corrupt. The Libor scandal has 20 global banks under investigation, including HSBC, which has been laundering drug money on an industrial scale. Rogue traders need to hire the Millennium Dome to hold a get together. And still the huge salaries and bonuses continue.

If one sought to bring the global economy undone, concocting an interlinking series of calamities, malfeasance and ineptitude that looked exactly like this should do it.

And yet here we are, with Julia at the helm and Tony in the (water) wings, a safe haven. Just count the blessings: A crime-free banking industry; low government debt; inflation within prescribed boundaries; an economy growing rather than shrinking; and Clive Palmer!

Weight of institutional money

Institutions haven’t been slow to notice. The local dollar is trading at four-month highs and, while retail money is market shy, when windows of opportunity appear, institutional investors soon close them.

Spark Infrastructure, a supposedly boring, predictable utility, points the way. Since upgrading it to an outright buy on 11 Mar 11 (Buy – $1.09), it rose 39% before we sold out on 15 May 12 (Sell - $1.51), a result due mainly to the arrival of RARE Infrastructure and Fidelity on its register.

Much the same goes for those stable, predictable blue chips with which we’ve had some success over the past few years (see Table 1). The genuinely world-class, defensive businesses that we have managed to purchase at reasonably attractive prices—think Woolworths, Computershare, CSL and Sonic Healthcare—and those with international exposure like News Corp are no longer cheap. Everyone wants safe haven stocks in a safe haven country.

Even blue chips in Europe are still trading on price-to-earnings ratios above 15. Very few asset classes perceived as safe can also be called cheap. That’s why we haven’t seen the incredible bargains one might expect.

It also appears that a potential bubble in safety is developing in fixed interest markets. The 10-year Government Bond is yielding just 2.7%, down from well over 5% a year ago, and is now well below the levels experienced during the GFC. The two and three year bond yields are around 2.2%, well below the official cash rate of 3.5%. Normally that's indicative of a looming recession, but it's also a function of the flood of overseas cash coming into Australia trying to escape zero percent interest rates at home. Perhaps we might not have to wait long for bargains to emerge.

It wouldn’t take much. Despite local banks attempting to reduce their reliance on international wholesale funding, a global credit freeze similar to that of 2006/7 remains a possibility.

Resources slowdown

Then there’s the slowdown in the resources sector. A few weeks ago a Deloitte Access Economics report claimed that, ‘The strong bit of Australia's two-speed economy won't stay strong for more than another two years or so'.

The response to either of these threats would likely be Greenspan-esque. A flood of money, either here or in China, may alleviate the impact in the short term but make it worse in the long run. Australia’s economic prosperity is more tenuous than it appears.

If the veneer cracks and the local dollar tumbles, opportunities that for the past 18 months have been sparse, may quickly become plentiful. What then?

Successful investing requires all sorts of skills but perhaps the ability to stand back, assess a situation and then do absolutely nothing is the most difficult to cultivate. Right now, the quality we most need is patience.

Buying opportunities, while infrequent, aren’t completely absent. In the past four weeks alone we produced three new buys: See Sun rises on Billabong wipeout (Speculative Buy – $1.05), GPG: Profiting from a breakup (Long Term Buy – $0.36) and ALE Notes 2: Another round at the bar (Buy for Yield – $100.50).

That’s not a bad haul and, with an expansion in the number of stocks we intend to cover starting this reporting season, we hope to land a few more in coming months.

Persistence paying off

While there will always be recommendations that aren't performing, such as Metcash and Fisher & Paykel Healthcare, or still have years to play out, such as QBE Insurance and AWC, thus far, our approach seems to be paying off. As Jason Prowd wrote in Growth portfolio: Persistence pays on 17 Jul 12, ‘Since inception in 2001, the portfolio has returned 8.1% a year, 1.8% ahead of the index’s 6.3%—a margin we aim to increase. In that regard, we've been on the right track in the six months to 30 June 2012, with the portfolio returning 6.8% compared to the index’s 2.9%.’ Jason outlined a similar case on 13 Jul 12 in Income portfolio delivers steady returns. Outsized returns in this market don’t have to mean outsized risk.

It's notable that the seeds of our recent performance were sown years ago. Infrastructure stocks, for example, such as Sydney Airport, Spark Infrastructure, Challenger Infrastructure Fund and Australian Infrastructure Fund have produced remarkable returns lately for such staid businesses. In 2009 these stocks were shunned for their high debt levels, now they're coveted for their reliable earnings. The key lesson is to act on your contrarian views when they are correct, and buy with conviction. Buying cheap stocks and holding until they reach fair value is how you beat the market.

The overall performance is consistent with our defensive approach. We don't expect to keep up with the market when it's in full flight but when it falls, we don't expect to lose much either. And of course, constant incantations of Nathan Bell’s shibboleths (see Director’s Cut: The subsidence of fear) means we’re not just prepared for market turbulence, we’re looking forward to it.

Perhaps there will be a few signposts in the upcoming reporting season, in which this year we’re adopting a slightly different approach. In addition to a soon-to-be-published calendar, we’ll be focusing on shorter, timely news-orientated briefs. Where the result suggests the need for more research, we’ll indicate it.

New video feature

You may have also noticed a new video feature on the website. Each Friday, Snakes & Ladders quickly covers the week’s big price movers and highlights interesting situations. Check out the latest version here.

The final thought goes to fund manager Bill Ackman, who had been loading up his US$10bn Pershing Square Capital fund with Citigroup shares. Then, ‘after one bad nights sleep’, he decided to pull the ‘rip cord’, noting that there are ‘much easier ways to make money’.

That’s not a bad acid test. If impatience gets the better of you but there’s a suspicion of a poor decision, don’t let the commitment principle get the better of you. Act patiently, cautiously and with good reason. Better to take a smaller loss now and reinvest in a safer opportunity than suffer a much bigger loss later on. The difference between being quietly confident and stubborn can mean tens, if not hundreds of thousands of dollars to your portfolio.

If ever there’s the sense of a mistake, don’t compound it by not paying attention to those nagging doubts. To paraphrase Danny Boyle, creator of the Olympic opening ceremony, ‘Choose safety over risk; choose patience over doubt; choose life over investing death.’