Sunday, January 28, 2007

Building a portfolio from scratch

In late 2003 and early 2004 as the market emerged from a period of malaise I began to get more serious about putting together a reasonable investment portfolio. I really wanted to get some scale and some structure rather than the fairly rag-tag random bunch of stocks and cash holdings I held. I also was – and remain – primarily interested in shares rather than bonds or property.

This is because I really have trouble paying what I think are massive entry/exit costs for investing in direct property – not to mention the ongoing maintenance or fees payable – and bonds, frankly, aren’t that exciting. That said, no doubt bonds will have their day in the sun some time in the next couple of years as I think Aussie rates will begin to fall.

Looking back, after several years of really strong market performance, it’s interesting to review the decisions and seek improvement. For anyone who does want to get serious about putting together a decent investment portfolio I hope there might be some ideas or help here. Firstly, here's how the asset allocation looks now:



I started with a sliver of my own equity – and I do mean a sliver, only a very small amount – comprising shares and a bit of cash, to which I added a margin loan. My initial LVR was 67% versus a loan limit of around 70% so there was some risk that a short term market correction could have screwed everything up.

I considered a number of risks that would be common to many other retail investors, and considered how I could manage them. My primary concerns were:

  1. Not earning at least a market return (particularly with a margin loan) – this was equally a concern for buying into a managed fund as individual stocks
  2. Buying at a peak and having to suffer for a couple of years
  3. Lack of confidence in my stock selection methods
  4. An unwillingness to pay entry fees on managed funds – it’s a total waste of money at with some of them looking to charge up to 4% expensive
  5. Dealing with a margin call

I decided to deal with point 1 by putting just over 50% of the margin loan proceeds into Vanguard’s Australian share index fund with the remainder into an Australian industrial share fund, avoiding the entry fee on the latter by downloading the forms from their website. I spent a fair bit of time thinking about whether it was better to put all into the index fund or to chase some of the other ‘hot’ managed funds at the time. I decided that it was preferable to go for the index fund because of the gearing. I felt that in my situation I simply couldn’t run the risk of an underperforming fund manager in a bull market. I think this is a common fear for many investors that I’ve spoken to.

For point 2, I decided that a key part of my strategy would be to add to my investments regularly although I didn’t setup a regular savings plan with the managed funds, preferring to pick and choose where the money went each quarter. Three months gave me enough time to save a reasonable amount.

Point 3 was interesting. Of additional investments made since commencement, maybe 30% have been in managed funds – actively managed international shares – so I’ve been selecting local stocks to fill the rest. I’ll deal with how that has gone in a later entry, but suffice to say I am a lot happier with my methods now: bull markets are great for confidence.

I wasn’t that worried about margin calls but I maintained – and still do – cash readily accessible just in case. I have a worksheet linked up to the ASX and fund manager websites so I can get valuations almost real time (if necessary – it’s not) and my key risk measures are LVR and % fall to trigger a margin call. It’s easily managed.

As far as operating the portfolio I’ve tended to reinvest distributions/dividends where possible. As mentioned, maintaining a watch on LVR means I have targeted a gearing of 55-60% so when it slips under I can add to investments. If it goes over too much I just work to bring it down.

There’ve been a few hiccups on the administrative side and I have learned to follow up every written instruction to my margin lender with a phone call.

Overall I'm quite happy, the original 'sliver' of equity has increased by almost 7x on the starting point (this includes capital gain, income and savings contributed to the portfolio).

My focus now is to continue increasing my exposure to international equities, a strategy that I began in 2005/06 and have been pursuing for as long as the AUD remains strong. As mentioned above, I have the view that the differential between local and overseas rates will fall in the near term – 12 months – causing the AUD to fall as well. I’m buying internationally-orientated companies and actively-managed international share funds. Additional investment on the ASX is on a very stock specific basis right now.

Comments and questions welcome

Tuesday, January 23, 2007

BHP - what's it worth?

Reading through the plethora of picks for 2007’s top performers, or favoured stocks by brokers in the paper each week, one company seems to be this season’s must have and that’s BHP

Looking up BHP I’ve found that of 15 brokers submitting their estimates to Thomson Financial, 6 have it as a ‘strong buy’, 7 as a ‘moderate buy’ and 2 say ‘hold’. The median EPS forecast for 2007 is 286.3 rising to 294.2 for 2008. So it looks like that BHP, trading at $25.33, is on a forward PE of just 8.8x. By comparison, RIO is on a forward PE for ’07 of 9.3x consensus estimates.

Yet BHP has underperformed the All Ords in the last 12 months – yes, in one hell of a commodities boom, the chief commodity company on the bourse hasn’t delivered a market return. And it’s not just underperformance, BHP shares basically haven’t moved since Jan-06 while the market has put on perhaps 18-20% (BHP in blue, All Ords in red in graph below from Yahoo Finance)


There could be a few reasons for this. Maybe it’s just cheap, taking a breather after performing well the prior year, or is this just indicative of a market at the top of the cycle where PE ratios are low because the market doesn’t think earnings are sustainable. I am probably leaning toward the latter.

One of my favourite tactics when assessing if a company is cheap or not is to reverse engineer the share price, that is, what sort of growth rate is factored into the current price? I was at a presentation from Investors Mutual where they talked about how they use a variant of this strategy and identified that stocks like CSL and Brambles were effectively priced for 0% sales growth over the next 10 years. I’ve also used it successfully for stocks such as Super Cheap Auto recently and, believe it or not, Telstra.

I’ve used figures from a major institutional broker as the backbone of my own ‘back of the envelope’ calculations for BHP (note that the broker’s DCF valuation for BHP is $20.92 and they have a ‘neutral’ rating). Anyway, using the broker’s figures out to 2011 as a base then applying a simple growth factor beyond, and calculating a terminal value, it tells us that to justify a price of $25.33, BHP only needs to grow free cash by 2.5% p.a. from 2007 to 2016 (assuming an AUD/USD rate of 0.7850). Increasing the annual growth of free cash flow over the period to 3.5% increases the current value to $26.85 or +6%.

These aren’t demanding growth targets but commodities are by nature a volatile market; witness the large swings in prices of copper, for example, on a regular basis. I’ll be keeping an eye on the former Big Australian to see how things pan out. Maybe the shares will outperform in 2007, keeping the tipsters in bread and soup for another year.