Home / Analysis / The benefits of blending a global approach to Aussie shares

(pictured: Hugh MacNally) 

Income and capital preservation are two of the main aims of many investors, especially retirees, but in recent months, with the drop-off in performance of the banks, investors are being prompted to seek out new core stocks for their portfolios.

According to Hugh MacNally, founder and chairman of Private Portfolio Managers (PPM), the show may not be completely over for the Australian banks but the risks are rising. MacNally says that the Australian banks were looking unattractive because of their concentration in housing and their leverage, compared with overseas counterparts. As mining companies do well when commodity prices are high banks do well when the economy is growing and employment is high, but when these conditions change the previously happy situation can change dramatically. The banks are highly leveraged to their economic environments. This is the reason they traditionally trade at a discount to the rest of the market – something that should not be forgotten.

Rather than look around the ASX for similar yield-producing large-cap stocks, investors may well be advised to go offshore to an alternative exposure to banks. Even after taking account of the lack of franking credits from offshore bank stocks, some UK and US banks look significantly more attractive on lower valuations.

PPM, which was founded in 1995, has an established client base of high-net-worth individuals, many of whom are retirees, as well as charities and small institutions. MacNally says that some of the assets it manages for clients are held almost “in perpetuity”. The objectives of protecting the capital base and earning a rate of return are very important.

With this in mind, PPM has been running global strategies within a number of its equity portfolios since 2007. The manager’s style is to favour concentrated portfolios of about 20 stocks so it decided to diversify away from the inherent concentration in the Australian market.

“There’s not much genuine diversification in the [Australian] market,” MacNally says. Looking globally for a part of the portfolio has the added advantage of providing a new point of comparison too, in the analysis of Australian companies, such as the banks.

Peter Reed, a PPM director and portfolio manager who has been with the firm since 2007, says that when you look internationally you can take advantage of different cycles. Australia, he says, has not had a recession for 25 years and therefore, with respect to the banks especially, this has been a benign period.

“The Australian banks have not been through a big washout to the extent that the international banks have. So, rather than buying our banks at higher valuations we’re buying European banks, after taking account of the lack of franking credits in the analysis.”

PPM adopts a long-term patient approach to its investments which it believes suits most of its clients. It favours out-of-favour stocks similar to a traditional value manager but with a couple of important additions. You can have good news or good prices, but rarely both, we’d prefer the latter.

“The three tenants of our investment philosophy with stocks,” MacNally says, “are: financial strength, to avoid high gearing or financial stress; reasonable valuations, judged by low P:Es and other return metrics; and, protection from excessive competition.”

Attractive industry characteristics, PPM adopts an approach similar to Michael Porter (author of Competitive Strategy”) when assessing a company’s prospects.

“We spend about 50 per cent of our time thinking about risk,” MacNally says “In our view it is one of the most difficult concepts to deal with, to think of it merely as volatility of return is so superficial, risk is always forgotten about when returns are high, that I suppose is one reason why market reversals tend to be so sharp. We willingly give up the last 10 per cent in exchange for 20 per cent of protection on the downside.”

He says that risk avoidance should be a very high priority in the investment process. PPM defines this as avoiding permanent loss of capital rather than the usual risk measurement of volatility. Volatility is so superficial, in banking parlance it’s like using value at risk as a measure as a measure of risk.

What this means is that PPM has two added strings to its bow in the assessment of stocks over the average value manager. It not only judges the stock price, which it calls ‘pricing risk’ for value, it also looks at the stock’s ‘financial risk’, which means quality, and ‘industry risk’ for a top-down overlay.

MacNally says a lot of individual investors were wary of buying international stock prior to the global financial crisis, and some still are. There are the missing franking credits, which PPM looks to adjust for, and additional transactions costs to consider. However, when the Australian dollar sunk to US65c in early 2009 it made people think again. MacNally says that the Aussie had been mainly in a US65c-80c range for the last 30 years, so when it hit parity, there was cause for concern.

For PPM, stocks have always been assessed firstly in their native currency on fundamentals. Currency does not drive the stock selection process but it is an influence at the total portfolio level. Of course, PPM is not alone in combining a small proportion of international stocks – typically less than 20 per cent of a portfolio – with its Australian stocks, however it can be as high as 50%. Other Australian-based managers have recently followed the trend. Globalisation of the stocks they invest in, alongside Australian investor demand, will probably prompt more to do so.

As part of its risk-control process PPM limits its investment in any one stock to 10 per cent and in any one industry to 25 per cent. Once a stock’s P:E gets above 20 times the managers start to become wary. Fitting its philosophy of favouring out-of-favour stocks, some pharmaceutical producers have recently become attractive because of valuations.

“We look for industries where there is a long-term growth path but, for one reason or another, the pricing is low,” MacNally says. “Pharmaceutical companies are trading on mid-low double-digit P:Es. But we think there is definitely long-term growth for them because of the demographics of aging populations and rising middle classes in the developing nations. Companies such as Merck [US] and Shire [a UK biopharmaceutical company] look attractive.”

Big pharma, as it is known, has been through a period of patent expiry and generic medicines have cut their margins to shreds, MacNally says. But that situation is running its course and many companies have a number of “game-changing” drugs which are starting to emerge, particularly in cancer treatments.

“It’s all working its way through the system,” MacNally and his team believe. “Looking out to about 2020 we see some exciting prospects for the sector.”

On a specific company’s prospects, PPM has been a holder of AGL for the past couple of years, after noting back in 2012 that its takeover of the Australian assets at Loy Yang in Victoria of Tokyo & Electric, which was a forced seller after the Japanese earthquake. The company had operated the nuclear facility in Japan and AGL bought the assets at a “bargain basement price”.

Peter Reed says: “We took note of this. Up until then the stock had been trading in a fairly narrow range and its value was not being recognized, in our view…. Then in 2014 the NSW Government sold the Macquarie generation assets in the Hunter Valley [to AGL], which was a big-base load-generation operation at the very low end of the cost structure. We thought they were quite unique and very valuable assets. We started to buy… Those assets have now set the company up for the future, in our mind.”

And the story continues to progress for AGL, with other structural changes in the energy supply industry, in which AGL is in a prime position to take advantage of.

MacNally offers a word of warning though. Managers should always be ready to sell at the right price or changed circumstances. He says that managers should not fall in love with any of their stocks. “It’s unrequited love,” he says. “The stocks don’t love you back.”