A Review Of The Recent Past

During September last year, markets were capitulating under a weight of worry flowing from a potential default by Greece plus the deteriorating fiscal positions of both Italy and Spain. There were more concerns in October when the German Administration “seemed” determined to stop the implementation of quantitative easing in Europe. The month of December saw the agreement to develop the so called “fire wall” around Europe and soon after we witnessed the first “unlimited” loan facility from the European Central Bank to European banks.

Thus, support mechanisms have now been put in place to protect the European economy from the potential of a serious recession caused by the collapse of commercial banks. The implementation of the economic strategies noted above, ensured that the recent March quarter was set to be a fairly buoyant one for investment assets. Whether this was actually a relief rally or liquidity based rally, does not really matter – for yet again the world economy has managed to move through another crisis.

In retrospect and in our documented views to our investors and members of MyClime, what was predictable was that Europe would adopt the strategies that proved so successful in the US in 2008/09. Publicly the Germans and French seemed reticent. However, they could not overtly alert the markets to their intentions at a time when they were forcing through fiscal adjustments in highly indebted countries. This is important to understand as it is clearly folly to believe anything that we are told by world leaders. It is vitally important to maintain confidence in the economic environment and interbank markets – therefore telling the truth would probably not support the economic agenda at present.

To put the markets into true context, it is worth reflecting on the economic strategies that have been implemented around the world post the GFC and during the current European debt crisis. In doing so it is absolutely essential to acknowledge that there is no historic precedent for the scale or breadth of the policies which have been adopted in the US, Europe and Japan. Indeed it is extraordinary to observe that about 60% of the world’s economy, as measured by GDP, is still being supported by:

1. Quantitative easing;
2. Low interest rate settings;
3. Large fiscal deficits;
4. Depreciated currencies; and
5. Unlimited Central Bank support for banking systems.

As there is no historic precedent for what we are experiencing or witnessing, then we (Clime) and others, must be speculating when we attempt to predict the economic and thus the market outlook. However, Clime has proven to have been fairly adept at foreseeing the economic responses and therefore the market responses before they have been contemplated by many others in the market. Indeed, our published economic assessments have been consistently rational, prescient and pragmatic.

The truth of our assessment is best exhibited by our actual portfolio decisions. These include our decisions to:

1. Keep our clients moderately invested in equity markets throughout 2011 and into 2012;
2. Invest based on stock selection utilising our value based methodology; and
3. Focus a significant part of our portfolios in high income producing assets.

These decisions were made against an oscillating investment climate where we have witnessed investor sentiment shift between impending doom (a re-run of 2008) and predictions of some sort of miracle recovery in stock prices (back to 2006/07). In contrast throughout this period we have maintained our view that economic growth and thus profits would remain constrained. Thus, the equity market in Australia would remain fairly steady with a slight upward bias as it moved towards our index valuation target of 4600 by end 2012. Further, we maintained our view that there were attractive income securities available in the market which offered better, risk adjusted returns compared with many company ordinary shares.

As for our current view – it is for more of the same. Indeed, we do not see a dramatic change in our portfolio structuring in the coming quarter. Whilst we are comforted by the recent upward revision in world growth forecasts by the IMF, we remain skeptical about the integrity and capability of short term forecasting in the current climate. We remain positive on the long term growth prospects of Australia, China and much of the developing world. However, we are just not convinced that Europe or Japan has strategies that will deliver sustainable recovery. As for the US, we acknowledge that growth is picking up but it is supported by such massive stimulatory economic levers that it hardly looks solid at this point.

Clime Australian Value Fund Performance to 31 March 2012

Annualised Performance figures provided in the table. Past performance is no guarantee of future returns.

What follows are our background views on:

• Value investing versus other investment methodologies;
• The growth of Central Banks – good or bad; and
• The ageing population – game changer for markets?

Portfolio structuring and Value based investment
We undertake portfolio management with a “value based” investment approach where maintenance of capital and solid income generation is a primary focus. We absolutely acknowledge the power of compounding and therefore income generation and reinvestment is important in a low growth environment.

The description “value based” does require further explanation as it is a much used and abused term in equity markets. Indeed in a simplistic sense all equity investors believe they are value investors. This is because in the main a purchaser of equities is generally buying securities which they believe to be undervalued. That is logical, for why else would they buy a security? However, where “value based” becomes misused or abused is where an investor does not have a logical or consistent approach in assessing value.

It is clear that the market price as derived by many buyers and sellers acting simultaneously is not a process that derives value. Indeed much market price activity is the result of many acting independently in guessing, or hoping, or charting, or attempting to front run, or following momentum, or comparing, and/or speculating on value. All of these activities create a market price but the true assessment of value occurs away from the market and is independent of price.

At Clime we derive our valuations of listed securities from the actual and forecast financial performance of companies. We use a consistent and disciplined methodology to identify companies and securities of interest. This is best described as the investment universe. From this universe a portfolio is created of 20 to 25 securities and these are acquired when their market price is at a meaningful discount to the assessment of value. In other words, the market place is regarded as a place where there may be an opportunity to acquire good securities and companies based on performance and/or outlook. The chaotic nature of the market does often present us with an opportunity; however this is tempered by a constant assessment of macroeconomic influences.

We are keen to remind our clients that they do not need to be fully invested in listed securities for their portfolios to achieve long term growth and outperformance. Cash is regarded by us as working capital that also generates returns. Sometimes the macro overlay may suggest that higher cash (working capital) is more appropriate than employed capital (investment).

Our investment management process is high conviction and focused. Given the concentration of investments in limited positions we constantly monitor exposures to ensure that individual positions do not exceed reasonable levels.

The approach outlined above has worked well with our portfolio returns consistently outperforming equity market index returns over 1, 3 and 5 years. Actual returns for our clients, many of whom are self funded retirees, have been enhanced by a growing stream of franked dividends.

Two key themes to contemplate

World Central Bank balance sheets

The following chart shows the massive growth in Central Bank assets across the US, Europe, Japan and China. What is probably not appreciated is the size of the Chinese Central Bank which now has the world’s largest balance sheet. Its growth in assets has been enhanced by foreign reserve growth generated by Chinese trade and current account surpluses.

In contrast we can observe the massive growth in assets of the ECB and the US Federal Reserve. Their growth has occurred from quantitative easing policies where assets were acquired from the banking systems or governments.

Figure 1. Central Bank Balance Sheets (China, ECB, US and Japan)

Source: Bianco Research

Our observation is that the growth in Central Bank balance sheets is unprecedented and it is challenging many widely held economic dogmas. For instance- where is inflation? Well the inflation is not so much in consumer prices but possibly in asset prices. Quite possibly, inflationary pressures are being held at bay by high levels of unemployment. Equities do not appear to be elevated although they are supported by liquidity. However, the real asset price inflation is seen in bonds. Further, the prices of bonds are also supported by market interference by Central Banks and therefore we remain very concerned about long term bond returns for investors who have so called balanced funds.

Finally, on this issue we must acknowledge that the dramatic lift in Central Bank balance sheets has been undertaken at a time when many economies are becoming or are highly indebted. The level of bond issuance appears to exceed the capacity of the market to fund. Therefore, quantitative easing has been essential up to this point but it does beg the question as to when it will stop, and what happens then?

The Ageing Population

It is well documented that developed economies are experiencing an ageing of their populations as measured by average median age. Australia is no different although our median age is growing at a much slower rate than that of Europe or Japan. Our ageing demographic is tempered by higher birth rates and net immigration.

However, it is interesting to observe that as we age there is a discernible move in the distribution of household worth along age lines. Indeed, there is a trend for the corralling of wealth to those in or approaching retirement. On present trends it is likely that by 2020 about 60% of household net worth will be owned by people over 55 years old.

Figure 2. Australian Household Net Wealth (share held by 55+ age group)

Source: Roy Morgan Research 14+

This does throw up issues for our economic outlook and for individual companies. Two stark issues are developing. First, governments will feel the effects of lower tax collections from this age group as income and consumption tax decline. Older people change their consumption patterns and as those patterns change, the pressure on many up market retailers and service providers will be immense.

These changing dynamics are examples of the many issues that Clime considers in developing investment portfolios. They are issues which affect our views on the outlook for many companies and allow us to challenge market consensus.