Underperformance has a good side
Over the long run you’ll do just fine investing, at rational prices, in extraordinary businesses. An extraordinary business is one that can retain a meaningful proportion of its profits each year and reinvest those retained profits at an attractive rate.
Think of a bank account with $10 million deposited, earning 20 per cent interest and reinvesting the interest each year; In 10 years there will be $63m in the account. Auction the bank account in a decade’s time and you’ll do just fine. You can now turn the big auction room, which is the stockmarket, off. Sure, the risk of a so-called Brexit, China, or the Middle East may all have an impact on prices in the short term, but in the long run, prices cannot help but reflect the increase in the worth of that bank account. And you don’t need to be particularly skilled at forecasting the markets or the economy either. Feel free, however, to heed my warnings about house prices.
So why am I telling you this? Because I need to remember it myself. Inevitably the investing strategy outlined above goes through periods of underperformance — a word I hate. It means the broader market index has done better than my funds at Montgomery. And it means Blind Freddy could have closed his eyes, bought the stockmarket index — with all the rubbish companies that constitute it — and done better than a team of professional, hard-working analysts.
Worse still, it gives ammunition to the promoters of index funds who actually recommend you act like Blind Freddy, close your eyes and just buy the index — an artificial list of big-but-not good companies that aren’t growing and whose prospects are challenged by maturity and disruption. They ask you to ignore all the facts but have faith that their share prices will just go up.
A step back, however, reveals that the share prices of companies like Telstra, NAB and AMP today are all lower than where they were in 1999. That is 17 years with no capital appreciation. And what about the index itself? The S&P/ASX 200 is where it was in 2006. So much for claims that the stockmarket always goes up. And so much for the simplistic advice to invest for the long run. The longer you remain invested in mediocre businesses that pay most of their earnings out as a dividend, the more likely your purchasing power is going to be eroded.
Over the past 12 months, the ASX 200 is still down about 12 per cent, even after rising 7 per cent from its February 2016 lows. The recent strength, however, is due to a rally in the materials sector with leveraged mining stocks up by double digits in the week, having already more than doubled since February. Iron ore prices have jumped to $US69 a tonne, from just $US37 a tonne last December.
Having missed the run-up in material stocks, one might wonder whether Montgomery should have been positioned differently. The answer, however, lies not in recent stock price performance but in the long-run economic performance of businesses in the materials sector.
Trying to consistently and correctly predict the relative performance of different sectors, or stock prices themselves, is tantamount to correctly betting on black or red at the casino. It’s simply a mug’s game. Instead, investors should focus on the business.
BHP is consistently applauded as Australia’s resource success story and speculation about the iron ore price bottoming may tempt some investors to believe they should think about buying the stock. But take a quick look at the business and you might wonder why so much attention is paid to BHP at all.
• Ten years ago BHP earned $14 billion on shareholders’/owners’ funds of $32.5bn and total borrowings of $12bn.
• After 10 more years in business the company has $84bn of shareholders’ funds and $50bn of borrowings, so you would reasonably expect it to also be earning a lot more than it did 10 years ago.
• But BHP, now run by Andrew Mackenzie, is forecast to earn just $1.5bn in 2016, down from $14bn in 2006.
Short-term underperformance makes a fund manager look bad compared with the index but one needs to appreciate such relative performance is inevitable because the prices of good businesses don’t always go up and the rubbish that I don’t own occasionally does. And rather than asking whether the iron ore price will continue to rise or reverse, I just ask: are we invested in high-quality businesses? If the answer is yes, we should be delighted when the prices of great quality businesses underperform because it represents opportunity rather than risk.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Andrew
:
Hi Roger,
A small dose of healthy self-examination never does any harm. However, we do believe in your investment strategy & are sure, in the long run it will beat “Blind Freddy” hands-down. By the way, “Blind Freddy” also beat other high quality fund managers in the last quarter, including Hyperion & Magellan, so you guys aren’t the only ones.
Cheers
Andrew
Roger Montgomery
:
Thanks Andrew.
simon
:
Hi Roger
Weve spoken before about property (the topic regularly keeps coming up).
Seeing you are so negative on the property market and property prices even after the surprise rate cut, would it be fair to say you are talking your book being short banks and property developers ?
Roger Montgomery
:
Not short either Simon. We’d always let you know our position and always have.
Phil Crossan
:
Your warnings on house prices in Australia have become more direct in recent weeks. How much work have you and your team done on this? They’re similar to the warnings from many years ago regarding iron ore prices.
Roger Montgomery
:
Hi Phil,
I suspect they appear similar because they are fundamentally based on supply and demand. Keep in mind we could be 100% wrong so be sure to seek and take personal professional advice.
David Ibbotson
:
Hi Roger,
A stock you were quite bullish on a year or so ago was Ainsworth Gaming and as I understand it formed part of the Montgomery Fund. Is it still a holding and what is your take on the Novomatic share transaction?
Roger Montgomery
:
Hi David,
I am thinking it was a little longer than year ago. We no longer own it.
Guy Davis
:
Maybe underperforming during the recent “Crap Rally” should be a badge of honour. I couldn’t agree more about owning Buffet style quality companies, however the prices have largely become so prohibitive that establishing new positions has been very difficult.
It was also interesting to see The Oracle himself spruiking ETFs over the weekend and reminding us that continued outperformance isn’t something to be taken for granted.
Roger Montgomery
:
Thanks Guy.
Donald Krsticevic
:
Hi Roger
I imagine one of your stocks that will continue to perform in your fund would be Challenger (CGF). I understand the Government made some changes in the budget around annuities. What is your understanding of these changes and will it benefit Challenger?
Roger Montgomery
:
Hi Donald, Here’s a neat summary from The Oz “From July 1 next year, the tax exemptions on earnings in the retirement phase of superannuation will be extended to products such as deferred lifetime annuities and group annuity products.
The government has also agreed to consult on how annuities can be treated under the aged pension means test.
While Australians may still have reservations about tying up all their superannuation savings in a deferred annuity accounts, the changes will help improve the attractiveness of the annuity products, which are more popular in other countries.
The government said the changes would “remove barriers to innovation in the creation of retirement income products”.
Australia’s largest provider of annuities, Challenger already has $60 billion in assets under management and provides annuity and post-retirement products for a range of other financial players including some industry super funds.
But the expansion of the annuity market in Australia to date has been hampered by tax impediments, which the Treasurer last night indicated that the government would be changing.
Challenger and others in the financial services industry had been hoping for a more comprehensive announcement from the government on the future development of post-retirement income products — in line with the recommendation of the 2014 Murray report into the financial system. That will now have to wait until after the election.”
Donald Krsticevic
:
Thanks for the follow-up Roger, CGF is a funny one it’s so hard to get a decent valuation and it seems to be one of those stock you either love or hate. Can I ask what you think its current value and 2yrs out? I apologise if this is not the right forum for such question but I thought i would ask anyway.
For some disclosure. I have been a CGF shareholder for the last 10 years or so and that’s before they incarnated into what they are. Thanks in advance.
Donald
Roger Montgomery
:
Hi Donald, our own estimated IV is around $9.00. Of course that could change at any time if and when new information comes to hand or we change our own opinion and/or view on the outlook.