Top three stocks, one year on

In 2005 we began a stock-picking experiment where we asked each of our analysts to pick three stocks to hold for three years. It proved very popular and, seven years on, we’re a year into our third contest.

Of course three stocks is too few and three years is too short to make it much more than a lottery, but it’s better than the usual one stock for one year stock-picking contests. Most importantly, though, it gives our analysts the opportunity to ‘express their individuality’, as they say, and maybe highlight some stocks that, for whatever reason, we haven’t formally covered.

In both the first two series, our analysts averaged greater returns than the All Ordinaries Accumulation Index (-1% per year compared to -3% for the market in Series 1, and 19% per year compared to 12% for Series 2).

Just over a year into the current series, we’re almost bang in line with the index, with a gain of 10.6% compared to 10.7% for the index. But there’s a wide disparity in the individual performances – as you’d expect from three-stock portfolios – with Tony Scenna leading the way with a 53% return, thanks largely to a 156% gain in Sirtex Medical, and Jason Prowd bringing up the rear with a 24% loss, due in large part to a 67% loss in Enero Group, formerly Photon Group.

Still, we know from the first two contests how quickly things can change. So, to get an idea of how everyone is travelling we’ve asked them to provide an update on their selections. We’ve also asked which stock they’d pick right now as an addition to their portfolios, although these won’t be included in the final reckoning.

Steve Johnson

We’ll start with last year’s winner, Steve Johnson, chief investment officer of Intelligent Investor’s Value Fund.

‘It's a stressful way to eke out a return,’ says Steve. ‘Out of a three-stock portfolio I've had two duds and one stock that has almost doubled.

‘QBE Insurance has been particularly disappointing. And that's not because the share price has fallen. I had held Frank O'Halloran in high regard but his lack of disclosure over the past 12 months and the skeletons falling out of the closet since his departure have left my confidence in the underlying business waning. We still own the stock in the Value Fund but it wouldn't be one of my top three picks from here.

‘You wouldn't know it looking at the 67% price decline, but Enero Group is in a much stronger financial position today than it was 12 months ago. The sale of its field marketing business left the company with excess cash and no debt, a far cry from the $300m-odd of debt three years ago. Unfortunately, the performance of the businesses it still owns has been horrendous. We think the stock price is very cheap but it will likely remain that way until there are some signs of stabilisation.

‘Fortunately RNY Property Trust has been a star performer. Not only is the stock price up 90%, but the underlying value has increased by just as much. I expect further improvement over the next 12 months and, with some luck on the currency front (RNY’s properties are all US-based), we could double our money again from here.

‘My addition today would be opthalmology business Vision Eye Institute. This stock is a former dog that almost didn’t survive the financial crisis due to a debt-funded acquisition binge. We think the underlying business has merit, though, and a recent capital raising puts the balance sheet issues to rest. That should allow a return to fully franked dividends within 12 months and an associated recognition of the value on offer.’

Note: Vision's share price has risen around 30% over the past week following a capital raising, while Steve is still happy with the inclusion, the value on offer has now reduced.

New selection: Vision Eye Institute

Tony Scenna

Instead of Steve’s two duds and a star, Tony’s managed two stars and a dud, and it’s been enough to push him into an early lead. Still, he’s keeping his head and maintaining a Zen approach.

‘The most challenging aspect of this exercise is self discipline. It focuses the mind and forces you to pick businesses you would be happy to hold for three years. In that regard you want to be sure that the business has the stamina (read balance sheet strength) and resilience (read moat-type qualities) to not only survive but ultimately prosper.

‘One year on and two of my three businesses have continued the good work of recent years, justifying my decision to keep them from series 2. In both Flight Centre and Sirtex Medical, management have the runs on the board and their results thus far have been achieved despite a difficult economic backdrop. I expect both to continue growing their respective businesses, with particular emphasis on offshore markets where considerable capital and effort have already been invested.

‘The results to date have not been so kind for my third pick, Whitehaven Coal. Whilst the assets are still in place, valuations have shifted and forced action. Obviously owning a coal producer at the moment is not without issue, but the company enjoys a strong industry position and I expect it to benefit at the expense of others.

‘My additional pick today would be NIB Holdings. Listed in 2007, this health insurer has delivered on its commitment to grow the business sensibly and return excess funds to shareholders. While acknowledging the twin risks of governments meddling with the industry and management looking to grow by acquisition—both of which have occurred in recent months—I suspect that in this industry the strong will survive and that NIB will be an important player.’

New Selection: NIB Holdings

Gareth Brown

It caused quite a stir last year when Gareth snuck in US-listed Berkshire Hathaway when no-one was looking. It feels a bit like getting Ricky Ponting to fill in for you in a game of backyard cricket, but we’ll let it go. The selection of Berkshire completed a triumvirate of internationally focused stocks that will be hard to beat if the Aussie dollar were to stumble.

‘QBE was selected by numerous analysts, so I won’t double up on the commentary,’ says Gareth. ‘The share price has disappointed and I’m increasingly concerned about the potential for a dilutive capital raising. But I expect to do okay over the years as long as QBE maintains underwriting discipline and I’m able to take a pro-rata stake in any raising (no guarantees).

‘Computershare is up a little over the year, but I remain very comfortable with its prospects – it’s one of only a handful of Australian companies that completely dominate their industry globally. For those able to take the long-term view, the stock also looks cheap. We reiterated the case for it recently, in Computershare: Global leader on sale on 18 Oct 12 (Long Term Buy – $8.55). It’s portfolio bedrock material.

‘Last year I had the rules bent a little [Quite a lot actually: Ed] to accommodate a foreign stock purchase. I’m concerned about the possibility of a fall in the Australian dollar and also like the sector diversification that international stocks can add to a portfolio. Berkshire Hathaway, the insurance conglomerate run by Warren Buffett, was really cheap last year and, despite rising 15% over the year (in US dollar terms), it remains attractive today.

‘Asked for another pick, I’d start by noting that the opportunities are less widespread and less compelling than a year ago. Pressed for a name, though, it’s a toss-up between Origin Energy, a beaten up blue chip, and ALE Property Group. I know the latter better and, despite the recent price rise, it remains a lower risk, higher yielding investment with interesting inflation-protection characteristics. We recently reiterated the case in A still-tempting ALE on 30 Oct 12 (Buy for Yield – $2.25).’

New selection: ALE Property Group

Nathan Bell

Nathan Bell’s 10.6% return is bang in line with the Intelligent Investor average and includes gains of 45% from Macquarie Group and 11% from Computershare, offsetting the loss of 24% on QBE.

Nathan’s new pick, RNY Property Trust, adds weight to a left-field selection of Steve Johnson.

‘We’ve written enough about QBE’s performance this year to fill a small book, so I’ll skip to Macquarie Group. Macquarie’s performance has also been lacklustre, yet it’s still managed a handy 45% total return for the year given investors were treating it as the financial equivalent of the plague a year ago.

‘In the short term this stock will continue to trade based on market sentiment, but if/when the global economy finds its feet, Macquarie should be capable of producing much higher profits than it is producing today. The dividend yield isn’t too bad for an investment bank, either, and franking should increase in a year or two.

‘Computershare is up slightly despite falling profits, but it remains one of the few blue chip businesses that has emerged from the global financial crisis in better shape. Computershare now has a dominant market share in the US registry business thanks to an opportunistic acquisition the company had waited many years to consummate. This won’t show up in Computershare’s results until corporate activity recovers, but the 3.2% dividend yield makes it easier to wait despite not being fully franked.

‘My pick for 2013 is a company that Steve has already recommended in this competition, RNY Property Trust. Almost every stock in my personal portfolio has at least some overseas exposure, but for RNY to work out really well it needs astute management to handle the financing arrangements to preserve the equity in the highly geared assets. As Steve highlighted at this year’s national roadshow, the company’s progress this year suggests there’s still plenty of value in this tiddler despite the higher share price.’

New Selection: RNY Property Trust

Greg Hoffman

Like Nathan, former research director Greg Hoffman has Macquarie Group to thank for overcoming a loss on QBE Insurance. But a 24% return from his third selection Woolworths has elevated him into third place and shows that steady performers can have a place in this contest.

‘The gains on Macquarie have more than offset the losses on QBE so far but, with two more years to run, there’s plenty more water to flow under the bridge.

‘I’m the only contestant to have picked Woolworths and it’s performed much better than I’d hoped. I doubt it can repeat that impressive dose over the next couple of years but I’m very happy to hang on from here – adding some stability to my more volatile picks in the financial services sector.

‘Stocks I considered for my new pick included Collins Foods (see A contrarian strategy, tasty stocks and a worthy cause) and Treasury Group. But I’ve settled on Computershare for reasons that have been well laid-out by the team in their research over the past 12 months or so. It provides good foreign currency exposure and also the chance for substantial gains if corporate activity picks up over the next couple of years.’

New selection: Computershare

Gaurav Sodhi

Given its performance in recent years, it was a potential masterstroke of Gaurav’s to include a Gold exchange traded fund (ETF). If things go from bad to worse in the global economy, that pick could come into its own. That’s not how it’s played out over the past year, however, with Gold falling 8% over the period.

‘From a field that includes a tiny shale oil producer and a commodity ETF,' explains Gaurav, 'it’s been the regulated utility that has performed best.'

‘Spark Infrastructure’s share price has risen 30% over the year and it has paid generous distributions too. Progress from Antares Energy has also been impressive and I’m happy to stick with that and my gold exposure.

‘In my own portfolio, I’ve trimmed my position in Spark but I haven’t sold out completely. If given the chance, I would do the same thing here. Alas, rules are rules (unless you’re Gareth Brown) and we’ll have to see how it travels.

‘I do have my eye on a few stocks, among them are Aristocrat Leisure, Computershare, ASX and Origin. Origin and ASX were tempting additions but those businesses require the ability to respond if things change. Locking them up in this portfolio, without the ability to change position size or sell, wouldn’t be ideal.

‘Aristocrat is a dangerous flirtation considering the damage it wrought in Series 2. Its business, however, is hard to kill, and has explosive profitability under the right conditions. It finally appears to be turning the corner and would be the stock I'd add to my existing trio.’

New selection: Aristocrat Leisure

Jason Prowd

‘Wow, what a year,’ says Jason. ‘My portfolio has returned a mighty -24%. This market-lagging performance was led by sharp falls in the share prices of both QBE Insurance and Enero Group.'

‘Others have written about QBE and Enero, so I won’t go into too much detail. But safe to say I may have underestimated the company-specific issues facing QBE, and a year of large catastrophes hasn’t helped.

'Enero, meanwhile, has struggled to re-engineer its business following the disposal of numerous divisions over the past few years. Whilst the advertising market hasn’t been strong, falling revenue isn’t a great sign. Still, at today’s prices, I’d argue both companies remain cheap.

‘The portfolio’s performance has been saved by accountants WHK Group, which did exactly what I expected: paid handsome dividends and generated a reasonable capital return. Today it is no longer as cheap, but I think this staid business will hold me in good stead over the next couple of years, particularly as a counter balance to my two riskier choices.

‘I’d add Billabong International to my portfolio if given the option today. I’ll happily admit it has the potential to drag my performance even lower, but it could also have the opposite effect. This brand-owner-cum-retailer has put almost every foot wrong over the past few years. Now, with new management in place and a clear turnaround plan in progress, not much has to go right for earnings to improve.’

New selection: Billabong International

James Carlisle

James returned to Intelligent Investor during the year, after a three-year absence, so he missed the start of the current series. But he has form in this competition having won the inaugural event, albeit by only four hundredths of a percentage point.

‘With low growth and interest rates around the world, most of the talk over the past year has been about yield, but I think the best relative value may be in stocks with strong businesses and clearly defined growth prospects.

‘ResMed, for example, has a strong market position in products for the management of sleep apnoea, and it’s an area that adds a lot of value – significantly improving quality of life and reducing the risks of disease. Far more people are thought to suffer from this condition than realise it and there should be plenty of growth to come, particularly with the move to home diagnosis.

‘Of course the share price reflects this to an extent, with a historic price to earnings ratio of 24, but continued growth will quickly bring that down. More likely the PER will remain around the 20-mark, perhaps a little higher, and the growth will come through in the share price.

‘Servcorp is another fast grower following heavy investment in new floors over the past few years. Earnings per share of about 27 cents are expected in the year to June 2013, up from 15 cents in 2012 and there should be more growth to come in 2014. There are risks of course, which is why we downgraded the stock on 29 Nov 12 (Hold – $3.42), but I have considerable faith in management.

‘In a similar vein, my third pick is Seek. The company has a strong position in the local online job search market and this is supplemented by stakes in developing businesses overseas – in countries which might actually see some growth. Seek’s associates have No. 1 positions in Brazil, Mexico, Indonesia, Hong Kong, Singapore, Thailand, Malaysia and the Philippines, and it’s No. 2 in China. The continuing shift to online job searching should see decent growth in all these markets, more than justifying the PER of 18.’

Note: The model Income and Growth portfolios own many of the shares listed in this article. For full listings, see the relevant portfolio pages on our website.