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OUTPERFORMING WALL STREET, IN AUSTRALIA

 

How to outperform Wall Street & the ASX 200

 

Investment professionals have an immense task on their hands when trying to outperform the share market index. It’s always hard to for investors to know which companies share price will go up more than the index on any given day and add to their total performance or which companies will under perform and detract from their performance.

The index in Australia. The ASX 200.         Average performance 8% growth and 3% dividend yield. 11% total return.

Young Australian’s; with more then 10 years left of work, should consider this point very closely. Did your super fund yield 11%?

For Australian investors, an index investment in the ASX 200 can be obtained, by investing in the Vanguard ASX 200 index. The cost to do so would be very low at 0.3% per year.

Just to give you an example of how powerful some extra return to your super or investment account could be, consider BOB on $80,000 with a super balance of $80,000. Bob is 38 and has 22 years before he can access super. His old fund return was 7%. Bob decided to take control of his investment and invest his super funds in the ASX 200 index.

Old super fund balance at 60 $662,000 growing @ 7% pa

New index investment super fund $1,233,808 growing at the index return after fees.

Nearly double the retirement balance has accrued to Bob, because of his decision.

It is wise when being a young investor to ask, what would Warren Buffet do?

“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S & P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors.”Warren Buffet, on what advice he would give to the manager of his estate on his death.

“Ok Warren, this is great advice for many people, but if I invest in the index, won’t I always be just, average? I mean, that’s not how you got rich Warren, but I see what you mean.”

My thinking is this. The ASX 200 is not the 200 best companies in the Australian stock market. It is the 200 biggest companies and big does not mean good. In fact, big, often by definition means slower growth. There is less room for these companies to expand within their industries because they are already big. Clearly some big companies do poorly. Some of these companies only erode shareholder value. Their managers raise capital, and slowly erode it, to the next date they raise capital. The ASX 200 also has some above average companies. Any average, has those that fall below the line and those that are above the line, that’s what makes it the average. So If you list all the companies in the ASX 200 and their weighting in the portfolio and just subtracted the businesses that clearly erode shareholder value, one must agree that this is pretty convincing that this portfolio would outperform a portfolio that includes companies that are clearly bad investments, but are big and included in the ASX 200 index.

For Example in 1999 Qantas stock price was $4.50. Today it is just $1.15. So clearly some companies that are in the ASX 200, one would be better off without. However it’s unfair to pick on QANTAS and their management, they are just in an industry with poor economics and they are by no means the worst company included in the ASX 200. AMP, DUET, also fall into that camp.

The Banks in Australia are the most profitable banks in the world. However the managers of these banks, are not significantly more skilled than QANTAS executives, banks just happen to have great economics. This is based on their return on equity. They are highly profitable. An investment in the ASX 200 includes 27.29% exposure to the Big 4 Banks. Commonwealth, Westpac, ANZ and NAB.

Is this too much exposure to banks?

Ask yourself, Where does your money go each week? Which companies are you spending your money with? Do you really spend 27 % + of your net salary on bank fees and products like mortgages. I don’t. Some do. When the banks outperform the market in terms of share price gains, 27% exposure is great, however when bank shares are over valued, this percentage is too high. But one can not afford to not have exposure to banks, so what is the minimum exposure you would have to the banking sector? My minimum is 15%. Some where between 15% exposure to banks and 27%.

“It’s not what you buy but how much of what you buy that really effects your performance.”

To put this in perspective $100,000 that goes into the ASX 200 index fund $27,000 ends up invested in the Big 4 Banks. My question to any investor in banks is this; why would you want to have as much exposure to the second best bank as the top performing bank? Forget the bottom two, why have any exposure to the second most profitable bank at all? Commonwealth Bank’s return on equity is 18% Westpac’s return on equity is 17% NAB return on equity is 13% ANZ banks return on equity is 11% As you know from reading my other posts that sustainable growth in a share is determined by the profitability of the underlying business and how much of that profit was reinvested in the business or paid out as a dividend. Earnings per share growth, ultimately, is the only thing that matters in share investing, over the long term. For my clients portfolios, somewhere between 15%, and 27% would be invested in the top two banks, with the vast majority only going into Commonwealth Bank depending on the relative valuations between the top two at the time of the investment. In saying that, even the worst performing bank ANZ has a profitability equal to the average of the ASX 200 Companies 11%.

The next biggest holding in the ASX 200 is BHP with 8.16% exposure. $8,160 of the original $100,000 would go into BHP, in an index investment. BHP is an exceptional business. It is the most profitable mining company in the world. I have no problem with the level of exposure. Return on equity is 20.79%, which is a long way above the average for the entire ASX 200 index, which is 11%. So 5 companies amount to 35.45% of the ASX 200. BHP and the Big 4 Banks. $35,450 is now accounted for, and its attribution analysed.

ASX 200 exposure to Telstra 4.48%. 40% of the ASX 200 is just 6 companies. Whilst Telstra does have a a highly profitable business, it can not seem to grow the equity base with the earnings it retains, meaning the managers are not doing an effective job with the earnings they retain for growth. Telstra’s share price has fallen from a high of $9.00 down to $3.00 just a few years ago. Is this a business you want your money in? I would not put 1cent into Telstra.

Growth and why its important to the overall portfolio. Sustainable growth in a share is determined by the profitability (return on equity) of the underlying business and how much of that profit is reinvested in the business or paid out as a dividend. Earnings per share growth, ultimately, is the only thing that matters in share investing, over the long term. After all this and this alone is the only sustainable way to grow the value of a share.This is driven by, retaining earnings for reinvestment into profitable projects, paying down debt and growing the business. Equity per share growth, and the managers maintaining the profitability of the business given the larger equity base. Valuation multiples also affect share prices, but these ebb and flow with investment fashion. A rising P/E ratio may not be sustainable. It can not rise for ever, like earnings per share can.

Back to breaking down the ASX 200. We have talked about 6 companies (BHP, CBA, WBC, NAB, ANZ, TLS) and that was 40% of the ASX 200 or $40,000 of a $100,000 investment into the index fund.

The next two biggest holdings are Westfarmers 3.31% and Woolworths 3.17%.

Woolowrths is more than 2.5 times as profitable as Wesfarmers. WOW return on equity is 25% and Wesfarmers just 9%. So the logic of equal ownership is beyond me. I would sooner own 6.48% of Woolworths and 0% of Wesfarmers, but my personal belief is that retail margins in Australia are too high. ALDI has realised this, Costco too and margin pressure on both these businesses is sure to place strain on retailers in this space.

 

ASX 200,8 companies equals over 46% of the total exposure. So what about the other 192 companies?

A further 9 companies have over 1% each for a total exposure to the ASX 200 of 13.47% 17 companies equal 60% of the ASX 200, some of these I believe we are better of without, for reasons argued previously.

183 companies equal the remaining 40% of the ASX 200. To put this in perspective $283 per company of the original $100,000 is placed in the remaining companies. The percentage ranges from 1% down to 0.01%, from $1,000 down to just a measly $10.

I have to ask the question, how diversified is too diversified?

Risk and diversification

Billionaire Mark Cuban He says portfolio diversification “is for idiots.” You can’t diversify enough “to know what you’re doing,” he adds. You’ve got to do your homework and play your best bets, according to Cuban.

Mark’s a billionaire, so he can call Warren Buffet is an idiot, but we know his not, right?

So somewhere between an index fund of 200 big companies, and an index, less some poor companies, in poor industries, has to perform better, right? The logic seems correct. What if Harry Markowitz father of all modern financial theory was right and we only need to hold a few companies, like 20. What if Mark Cuban was right and we only need to hold less than 20 shares, as low as 10. What portfolio would we build? What portfolio would be likely to outperform our objective, the ASX 200 performance?

Well if we listed all the companies on the ASX 200 in terms of their profitability and strike a line through every single company whose profitability is lower than the market average, would leave only businesses that are above in terms of average long term profitability and above average return on equity. Then from this list of 40 odd companies only include companies that are currently priced below their current valuation, or as much units of return on equity per dollar.

Remembering that earnings per share growth is the only sustainable way for a share price to rise we need to find companies that have high levels of growth. As we discussed some companies have great economics and some companies have poor economics. This is determined by high levels of return on equity, as long as the debt levels are sustainable. You see, return on equity can be magnified by high levels of debt. So if return on equity is high and debt is low or sustainable then this company has great economics. You don’t need to know everything about balance sheets and profit and loss statements, accounting or economics for that matter. Simple division of NPAT / Equity  and averaging it over 5 years, or if your lazy and trusting type BHP ROE into Google and you see a fairly reliable number in which to start your analysis.

BHP 8% makes sense if BHP is correctly valued in the market, however if BHP was undervalued we could over expose ourselves to BHP in order to increase our longterm returns. “The price you pay determines your return.” Warren Buffet. This is because what the underlying company BHP can actually achieve over time is fixed by the economics of the business and industry in which it operates. The return we get as an investor in the share market is ultimately determined by the price we pay for the share to begin with.

Some where between 15% and 27% in banks seems appropriate. I personally use 15% as the preferred weighting, but I would not hesitate to put 100% of my own personal funds into Commonwealth Bank at prices we saw in 2009. 25% in CBA and BHP would form the foundation of most Australian share portfolios. I would not have any concerns with that. The other 75% of the investment portfolio would come from ASX 200 and ASX 300 listed companies, in accordance with the industry weightings of the ASX 200 index.

 

ASX 200 Industry Weights

 

 

We already hold 15% in Financial via CBA and 10% in Materials via BHP. So What companies are we looking at for the remaining 75% of the Australian Share portfolio. Companies with exceptional economics and profitability

  • Flexigroup, MMS, Challenger

  • Breville

  • Seek, Realestate.com, carsales.com, computershare

  • ARB, Fleetwood, ALL

  • MND

  • JBHiFi, Katmandu,

  • Blackmores, Invocare, Cochlear

  • Retail Food Group, Crown

  • Slater and Gordon

All of these businesses have exceptional economics. Some of them are currently undervalued in terms of their share price and some are currently overvalued. We only buy into companies with exceptional economics and previous track record and above average earnings per share growth rates and we only buy into them when the price to book ratio, is justifiable by the return on equity and earnings growth rate. Sometimes we can buy great business at bargain prices. This is obviously the aim, but usually the market within about 30% either side of the true intrinsic valuation. Units of return on equity is the aim of the game. The better annual return you get the bigger your investment balance at the end of the day.

 

Ask yourself, did you get 11% over the last 10 years in your super?

 

If you want to invest in the ASX 200 index with cash, or via your super I can help you do this. If you have any questions fill out my form below and I’ll point you in the right direction.

If you think you deserve better than average returns then I can also assist you. If you have any questions fill out my form below and I’ll point you in the right direction.

Happy Investing.

If you want to improve your investment performance, or ask any question at all, fill in my form below and i’ll point you in the right direction.

 

James Howarth Principal of Mathon Capital Financial Advisers

 

www.mathoncapital.com.au