Market Update - May 2013

Investors have a general tendency to seek out certainty and predictability, as is evident in the current trend of the ‘hunt for yield’. By contrast, Platinum seeks to exploit neglect and uncertainty, and the approach works. Investment specialist Douglas Isles explains why.

The hardest part of communicating what we do, is that what we have to say isn't “warm and fluffy”.

We don’t take comfort in predictability, certainty, or familiarity. We seek neglect, which often entails uncertainty, and we manage risk of loss.

Seeking neglect equates with avoiding fashion. Currently the “hunt for yield” is the talk of markets but when does this become risky? CBA is now the world’s most expensive bank, yet globally banking is viewed as cyclical. Institutions shunning Telstra below $3 perversely seem more enthusiastic at five. Many risk overpaying for apparently “safe” household names.

At a point in time, our portfolio illustrates where we think there is mispricing.

This can be uncomfortable, and often, we are early – we can’t know when the market will reappraise a fallen angel, or notice structural change. Six months ago, many wondered why 15-20% of our International Fund was invested in Japan – although it was the cheapest major market in the world, trading below book value coupled with the most expensive currency. Demographics and deflation were the buzz words. All of a sudden, talk of inflation and wow, what a change! Fast forward six months and our Japan Fund is up around 60%. As Jacob says, others may only now be “dusting down” their Japan files.

18 months ago; a similar story was being played out in Europe. It was in turmoil – many thought it was un-investable. What a great opportunity and it remains our largest regional exposure. Our European stocks have been fantastic – up over 30% in the last year. We still own Lloyds Bank with 25% of the recovering UK mortgage market, a long way above our entry, on one quarter of CBA’s valuation. Spain’s Amadeus, the global leader in travel software, is a victim of its domicile. While Spain still poses a real threat to markets, as its 2015 elections approach, the stock is travelling very well.

So what can we get excited about now?

As everyone avoids risk, it suggests that’s where the opportunities lie. Predictability is hot, but we can still find mispriced structural growth. The scars of the tech bubble run very deep. Long held, successful investments like Samsung, Microsoft and Google should not please clients because they use their products. The comfort is that the market does not appreciate their potential as data and mobility become endemic, even in Kenya as Kerr recently saw firsthand.

In Japan, we are rotating from initial beneficiaries of the lower Yen, the exporters; Toyota has doubled. We are looking at domestic winners from micro-reform that Japan acknowledges must be undertaken to stay competitive. Electronics retailers like Yamada Denki (think Harvey Norman) will benefit as exporters pay their home-based workers more. Sleepy conglomerates (like Sumitomo Chemical) may be agitated by activists searching for hidden value.

In North America, our capex theme is developing nicely. Most chemical plants were built in the ‘50s; low cost natural gas directly helps builders of pipelines, refineries, chemical plants and we will see more manufacturing facilities planned. Engineers such as Foster Wheeler are well-placed and will continue to perform.

Drug stocks are another sector offering great value – defensives, but not expensive. Great change in the industry, particularly as companies streamline for the future means global leaders, like Sanofi, on low-teens multiples are only just starting to be discovered.
Recent visits to Africa and India inspire, but won’t likely comprise huge parts of the portfolio – trip notes are on our website, and worth a read.

Tourism is growing and duopolist Carnival Cruises highlights how bad news provides entry opportunities. Unglamorous companies like FedEx and Ericsson have great businesses as the backbone of internet retail distribution, and data networking respectively. While clients may not be familiar with them, they likely use their dominant products, sometimes unknowingly.

Take Fedex for example – business trends in air express are weak primarily due to trading down in a soft economy. But Fedex’s business mix has been shifting, and ground based parcel delivery - packages that never touch an airplane - now comprise 60% of profits. Trucks and vans are not as sexy as planes, but ground express is the sweet spot – the US ground market is a duopoly, and Fedex is winning market share from unionised UPS, whilst parcel growth is supercharged by the delivery of online purchases to consumers.

Extrapolating past returns is dangerous.

Australians investing abroad have faced a currency headwind for a decade. A resources boom, high interest rates, and strong government finances have all boosted the Australian dollar, though the windfall may not have been harvested for challenging times ahead. Our hypothesis is the attractive features of our currency are fading while positive changes benefit huge economies and populations in Japan, China, India, ASEAN, Africa and the US. Implicit in China’s positive reform is a rebalancing, from over-allocation to investment, towards consumption. Beneficiaries of the prior trend may suffer.

Having lived in Singapore, it is clear that Australia needs Asia more than Asia needs Australia. For the Chinese who may choose to buy our education or tourist offerings, Sydney is physically as distant as London, Paris or LA, with their lower wage structures. Ford last week succumbed to the challenge. But already, we even see China losing manufacturing jobs to ASEAN on cost.

With this in mind, since early May when our dollar bought 102 US cents we have been short. The International Fund was yesterday 112% exposed to overseas currencies.

Only a few months ago, Apple was many people’s favourite stock. The iphone5’s weak battery power, a new dock connection, and $250bn have been wiped off its value. One wonders how many similar lessons investors will be taught when the current hunt for yield is exhausted. While income is important for many, as we buy out of favour companies, and manage currencies and risk, our distributions are more volatile than underlying company dividends. Distribution estimates for this tax year are on our website under the “What’s New” area.

The paradox of markets is that which is least comfortable is often most profitable.

Indeed as several of our themes have started to work, returns in the International Fund exceed 30% this financial year. And now, we believe the biggest opportunities for Australian investors lie overseas. Consumers here are aware it is a great time to holiday abroad, and know that buying things online from foreign websites make sense for them (and for FedEx). It is time to use the strong Australian dollar to participate further in global stock markets. Our fear is it will take a fall in the currency to remind many of the opportunities that abound.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.