Wearing protection

More than the English, the Germans are known for quelling their emotions. The Euro crisis rises at the apex of this national trait. If the Germans really want to save the Euro, they’re doing a bloody good job of hiding it.

A few months ago, even the most jaded observer, riled by Eurocracy and its over-reaching instincts, would be hard pressed to imagine a breakup. Now that possibility seems all too real.

One senses a dénouement. Last week in Berlin, Poland’s foreign minister, Radek Sikorski, crashed through the artifice of international diplomacy, saying in a Financial Times editorial—not your typical diplomatic back channel—that, ‘If we are not willing to risk a partial dismantling of the EU, then the choice becomes as stark as can be in the lives of federations; deeper integration or collapse’.

Indeed. The Germans can either save the Eurozone or, in not saving it, create an apocalyptic crash.

Current discussions—and the Europeans do a lot of that—regarding fiscal union among Eurozone countries may (eventually) address the long term issue at the heart of the crisis. Whether the debt is addressed is another matter.

Central bankers took matters into their own hands last week, developing a mechanism to help US dollars support the European Central Bank. With Sarkozy and Merkel discussing a renegotiation of the Lisbon Treaty, markets, preternaturally wired to volatility, scorched upwards last week.

As of last Friday, the ASX 200 was up 7.6%, the best week in three years.

GFC Mk 2

If all of this seems a little remote, the comments of recently liberated former CEO of Commonwealth Bank, Ralph Norris, suggest otherwise. In an interview with Business Day, Norris said, ‘This has potential to be significantly worse than the Lehman Brothers collapse and the subprime crisis because now we are talking about nation states.’

Markets, he said, had ‘effectively frozen’ and that it ‘doesn't matter how good your name is, you are not going to be able to access markets’. Norris looks to have timed his exit to perfection. How do these bankers do it?

Two things of note occurred in the banking sector as a result. First, as testament to the extent of the problem, the conservatively financed Commonwealth Bank had to pull a covered bond issue, adequately demonstrating how this seemingly remote crisis has a very considerable local impact. If the crisis deepens, Australia will not escape it.

Second, the big four banks slipped close to the prices at which our recommendation guides suggest we would upgrade them. Under these circumstances, though, that’s unlikely. The prices in these guides assume a fairly normal international credit market and, at present, it’s anything but. Don’t expect us to upgrade any of the banks any time soon.

Meanwhile, James Shugg, Westpac’s London-based senior economist, inadvertently challenged one of the shibboleths of his profession: so worried is he about the crisis, he’s quite rationally taken up smoking. ‘Things are even worse than you are reading about’, said James, reaching for the nicotine patch. Quite.

Surely the time is ripe to sell up, pack up and emigrate to, err, Poland, which at least has the advantage of a sensible, plain-speaking foreign minister?

Different this time?

Not yet. There are a number of reasons why—and one cannot resist the phrase—it’s different this time.

First, you should be far better prepared for a severe downturn, and the opportunities it will bring, than you were in 2007. Much of the past 18 months has been about positioning your portfolio for exactly this scenario.

We’ve repeatedly made the case for cash, recommended you limit your exposure to the big banks to no more than 10% of your portfolio, steered clear of certain resources stocks, sought international exposure (see our recent series on opening an international trading account) and recommended defensive stocks like Woolworths, Metcash and Spark Infrastructure. That’s sound preparation.

The year got underway with the two-part series Protecting what’s yours: Top risks for 2011 which underlined these themes. The repetition of them in this very column (see Preparing for uncertainty and Boy scout investing) is surely stretching the patience of Job. We shall assume your preparation all but complete and dwell on it no longer.

Second, whilst Sell recommendations get far less attention than Buys, this year they’ve been especially notable.

For a decade—yes, it really has been that long—we recommended subscribers avoid Bluescope Steel and OneSteel, a view for which we’ve been regularly criticised. The stupendous share price falls over the past few years demonstrate the benefits of buying good businesses over poor ones.

Rio Tinto isn’t necessarily a bad business but it is overly exposed, like Fortescue Metals to iron ore. Since the publication on 29 Nov 10 of Why you should sell Rio Tinto (Sell - $83.65) it has fallen 21%. The general avoidance of the sector has paid off. With cracks appearing in the supercycle, or at least the economy that’s been driving it—China—it’s a sector to continue to avoid.

The recommendation to avoid the rare earths boom proved as timely as the recommendation to avoid uranium stocks Palladin and ERA. Since The end of an ERA (Sell - $11.40) published on 10 Feb 11, the share price is down 86% and Palladin, reviewed on 25 Mar 11 (Avoid - $3.71) is down 54%. Since 16 Feb 11 in Leighton: Time to buy or exit (Sell - $31.69), that company’s share price has fallen 33%.

Finally, the detailed review of the retail sector bought members attention to the effects of a slowdown in consumer spending but explained the extent of the threat of internet sales to businesses like Myer, David Jones and JB Hi-Fi well before mainstream media grasped the issue (see Ill winds hits JB Hi-Fi, Myer and DJs) from 15 Jul 11. 

Good opportunities

The third factor working in our favour is that, unlike in 2008, the chaos is delivering some great opportunities among blue chip stocks.

As research director Nathan Bell says, ‘The difference this time around is that higher quality stocks have suffered as much as everything else. I didn’t think I’d see the day when Macquarie Group was trading on a yield of 6.7%, Metcash on 6.5% and QBE Insurance on (a slightly misleading) 8.9%.’

The preparation may have been 18 months in the making, but there were days this year when the need to act came with devastating speed. One such day was 5 Aug 11, when we published It’s time to buy: stay tuned and then Blue chips dominate best buys published four days later.

Already, and despite the fact that the ASX All Ords Accumulation Index is down 5.9% since the beginning of the year, some of these recommendations are developing nicely. Since the initial upgrade on 6 Jul 10 (Buy - $2.59), MAp Group is up 38% (including the 80 cents per security capital payment). News Corp and ARB Corp have also performed well despite the turmoil.

Even some of the lesser stocks we’ve recommended opportunistically have fared well. It took just over a year for Cellestis to return 69% since it featured on 16 Nov 10 (Speculative Buy - $2.25). Foster’s was another stock lost to a takeover, returning a total of 31% since Put some Foster’s in your cellar (Long Term Buy - $5.45) on 11 Mar 10.

Nor should we forget Centrebet, which, although not formally recommended, featured in an Ideas Lab on 13 May 11 (see Ideas Lab punts on Centrebet), and RHG, recommended repeatedly but most recently on 28 Apr 11 (Speculative Buy - $1.05). Since then it’s up 13% (including the 79 cents per share special dividend).

It’s also fair to say that our positive recommendations in the funds management sector and with Harvey Norman haven’t gone as we’d hoped. But overall, your analytical team is pleased with how some recommendations are already working out and others are very well positioned.

Buying stocks like Computershare, Challenger Infrastructure Fund—both down in price on our initial upgrade—and the host of attractively priced blue chips on our buy list means your portfolio should be well prepared for the current volatility and nicely positioned to take advantage of attractive valuations.

The overall quality of the performance shows up in the portfolios. Since the beginning of the year to 5 Dec 11, the Income portfolio is up 6.4% and the Growth portfolio down 2.5%. Both compare favourably with the All Ords Accumulation Index, which is down 5.9%.

Portfolio performance

Calculating the performance of our two model portfolios is quite straightforward. Doing so for all our recommendations is more problematic. The annual performance report lists every single recommendation on every stock ever made and, through a lengthy process of analysis and calculation, offers annual returns for each type of recommendation.

The methodology has its drawbacks; If a stock goes down 50% in one year it’s treated in the same way as one that goes up 50% each year for five years. We’re currently reviewing this methodology and will submit it to members for comment at some stage in January, after which we’ll get the figures professionally audited.

There’s no perfect way to calculate performance but the closer the methodology is to reality, the more useful it will be to you. We look forward to your feedback when we announce the proposed changes to you.

Lastly, if you haven’t yet responded to our special Christmas offer, which includes a very interesting book by Satyajit Das called Extreme Money and a special DVD, this is the time to do so.

It’s been a fascinating, troubled year but we’ve prepared well; cashed up and with a defensive orientation to our portfolios, we took advantage of the opportunities in July and August, what senior analyst Gareth Brown calls ‘a big swing’.

That’s a nice allusion to our current stance; poised and prepared to strike at the next opportunity.