The following interview featured in the Financial Review, Smart Investor, May 2011
For super-charged returns, smaller companies are usually the go, but right now could also be a great time to buy the country’s largest telco, Clime’s CIO, John Abernethy tells Patrick Commins from the Financial Review.
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The following text is an excerpt of the interview.
What’s your investment philosophy?
For want of a better word, it’s value based. The valuation methodology is founded on a return on equity model; we’re looking for companies with a high, sustainable ROE consistently in excess of 20 per cent. The measuring is slightly different from a financial controller or analyst. We don’t just look at profit over average equity, we look at profit plus franking distributed to shareholders over average equity. We look for companies that can retain equity through their profits, reinvest back into the business, and compound it at high rates of return.
That’s a high benchmark. Do many companies meet it?
Out of 2500 in the sharemarket, about 500 companies have generated a profit in one of the past five years.
When we get down to the profitability measure, which is the ROE, you get fewer than 100 stocks in the market.
And that’s crucial to understand: less than 4 per cent of the market has achieved a profitability that attracts us as an investor. From that, we’re trying to find 15 to 20 stocks to buy. If [a company’s] price falls below our valuation, then they become a stock of more interest.
What’s an example of a company you like?
McMillan Shakespeare (MMS) is a company that we can see going from a $500 to $600 million [market capitalisation] now to being a $1 billion company in three or four years.
It has two businesses. One is salary packaging. It works with the government health sector, so for instance it has a contract with the Queensland government to go into hospitals and sit down with doctors and nurses and arrange their salary on a pretax basis to ensure they maximise their after-tax income. That’s of benefit to the employer and it’s good for the employee.
At the height of the GFC, McMillan bought Holden Leasing Company, which leased all the Holden fleets in Australia. It was a subsidiary of GM America. [When] GM went into control by the American government, all non- American assets were sold and this asset became available at a discount.
It’s apparent now, 18 months into the acquisition, that there are tremendous synergies between leasing cars and arranging for leasing in salary packaging. The management team has managed big companies. So that’s quite exciting for us.
Do you still see any value in those emerging companies servicing the miners?
It’s hard. They have had a strong run. We’ve met a few of the companies in recent weeks. The outlook is probably stronger than the market expects; the cycle is very powerful. Which companies did you visit?
One we saw was Forge Group (FGE), which has had a dramatic lift in price, profitability and profit. They’re generating tremendous cash flow, they’ve got no debt. Their biggest issue is what to do with their excess cash – do they go and buy another company, do they return it to shareholders, or do they use it to generate growth? They have way more equity than they need at present. But the outlook is very good and it’s an extraordinarily good management team.
So the value is generally at the smaller end of the market, but you want to watch what management is doing with capital and that they’re not growing beyond their means or growing for growth’s sake.
How do you put together the Clime Australia Value Fund?
We’re around 20 per cent cash – that’s the first decision we make. If we’re confident, we’ll be 90 to 95 per cent invested, if less confident we’ll be 30 to 40 per cent, so 20 per cent [in cash] is a little bit on the fence.
[We also put] 20 per cent on yield securities. We’re chasing yields of 10 per cent-plus on securities we don’t think have much risk; some smaller utilities [such as] Ethane Pipeline [Income Fund], which is a small trust run by APA Group (APA). [It’s] generating a yield of 12 per cent but it looks to us like it will go to 15 per cent in 18 months’ time – a very high return on a lowly geared trust managed by one of the biggest pipelines.
Do you think that now is a good time to be looking at Telstra?
It’s very hard when you talk to long-term investors in Telstra (TLS) because they’re all looking at price, not at value. We’ve only been investing in the company for the past 18 months; we got particularly interested [during] the sell-down by the Future Fund. On our average price of acquisition of around $3, we’ve managed to get a yield of around 9 per cent; with franking added, it’s around a 12 per cent return.
But you don’t end there; you have to consider the outlook. The company is going through a rapid transformation caused by the National Broadband Network. It’s going to go from a fixed-line service provider to a mobile service provider. When it gets away from regulations somewhat, there’s no doubt the company will move into other areas and [capitalise on] its client base, which it’s developing through its mobile network, and its inherent brand names like Telstra, BigPond and Foxtel.
It will move into other areas of media, communications, entertainment and sport. I suspect it will develop itself rapidly in the next two or three years away from its traditional business, but coming off a strong distribution and brand base.
Sounds like Telstra is going to become more like a “normal” business.
It’s very hard to get a company that has such tremendous market reach at such a low price.
There’s going to be pressure on management and the board, [but] our suspicion is that when the NBN goes through, we will see a lot more entrepreneurial activities coming out of Telstra. In this hiatus period, it’s not the time for Telstra to come out all guns blazing, so we would expect the company to do things next year which we wouldn’t talk about today.
What’s the next big thing?
I have a cautionary note: the next big thing for the world is the unwinding of quantitative easing in America, Europe and Japan. It’s a policy which adds to speculation because it causes a low cost of debt. But that has to stop at some point. So the next big thing is for all investors to be aware of that and to reflect on what it might mean for markets.
Certainly, it’s not a time to be overly bullish. It’s a time to be very, very careful about your valuations. If that support is taken away, then markets will have to find another support mechanism, and the only one is valuations and buying stocks under value.
Source: The Australian Financial Review, 20 April 2011
