Five ways to invest overseas

Regular readers will know that right now I’m a big fan of diversifying away from Australia into overseas markets. In my quest to promote this idea I decided to find five ways you can get offshore without learning French or catching the dreaded Delhi belly.

1. Managed funds – No kidding you say, but what sort? I think a good active manager should be able to pick which international markets are on the up in the medium term (I like Europe and Asia over the US). Long term most of the active guys will probably come back to the pack but now I think the timing is right for actives because international index funds are often based on MSCI ex Australia so will have too much in the US for my liking. I always check the fund manager’s view on hedging. Most funds provide the manager with a discretionary range to hedge (e.g. 30-70%) while others have a firm policy.


2. CFDs – plenty of alternatives are available here. If you're not familiar with CFDs get a flavour from one of my previous posts. Depending on the provider you can go from FTSE to DJIA through to indices in India and Shanghai. Most will offer a crack at straight index plays or get into the noxious world of binaries (a.k.a. bet options). And speaking of bet options…


3. Betfair – I’m not joking, provided you’re not an AFL footy player you can bet on financial markets, including overseas interest rates and stock indices. Granted, it’s not exactly long term investing when you’re playing the hourlies, but you can do it. The Financials forum often has some spicy conversations with punters railing against rogue bots amongst many other things. This is strictly for entertainment.


4. Index warrants – listed on the ASX with market makers happily making a price on either side for you. Call and/or put warrants are usually available over the Nikkei, S&P500 and Nasdaq.


5. Overseas companies listed on the ASX – News Ltd is a great example of a stock where the drivers are primarily international. James Hardie and Rinker are two more. Also look at some of the property trusts, Babcock & Brown Japan is one example, Macquarie’s Prologis and DDR are two others that come immediately to mind (and please remember these aren’t recommendations, they’re examples)

Personally I’ve preferred options 1 and 5 for true investing leaving 2 & 3 for dabbling and entertainment.

Strategy & outlook

Amongst the lively prose in this week’s RBA’s quarterly Statement on Monetary Policy were some useful figures on equity market valuation and the outlook for share market drivers.

PE ratios and yields seem to be around about long term average levels. Our PE ratios are consistent with the rest of the world but yields measurably higher; likely a reflection of our dividend imputation system.

According to the RBA, analysts are forecasting EPS increases of 14% for the ASX200 in the 2006/07 year but only 7% in 2007/08.

Meanwhile leveraged buyout (LBO) activity is seen as a key driver of recent performance with the central bankers citing the relatively low cost of debt compared to ROE. Even though we saw three rate hikes last year, long term bond yields remain low. The Bank believes excess demand is the primary reason long term rates remaining so low (10y yields 40-45bp under cash). Reflecting some level of concern about the private equity jockeys the bank points out that excessive leverage increases the risks to macroeconomic stability.

The outlook for commodities, specifically metals and energy is of critical importance. In the past three months we have seen 25% falls in copper and oil, partially reflecting a deflating speculative bubble but also some changes to the supply/demand dynamics. Growth in copper production now exceeds growth in demand. With new supplies for coal and other commodities coming online in the next 12-18 months the Bank believes we are unlikely to see much more price growth from any of these minerals.

Lastly, the outlook for inflation has the headline rate expected to fall below 2% by mid year. If this occurs then my pick is that rates could begin falling sometime late in 2007 or early 2008. With overseas rates increasing (Europe, for example) and a likely drop off in commodity prices over 2007/08 the AUD can be expected to fall over 2007 making this an excellent time – as I’ve mentioned before – to start diversifying out of the Australian equity market and getting into overseas markets, unhedged, or choose stocks with significant offshore exposure and revenue streams.

While the profit growth prospects for the Australian market generally are good for 2006/07 results, 2007/08 is modest (7%). From about now on, markets will be looking to 2007/08 numbers for valuations. If the outlook statements from the current reporting season suggest earnings growth greater than expectations then the market should hold up for another few months but beyond that I think we have to seriously question where additional growth and momentum in earnings – for the market generally – is going to come from.

The ‘weight of money’ thesis argues that the large volume of funds pouring into super and other investment vehicles will keep the market buoyant. That’s true but only to a point. As soon as returns disappear or the risk increases the money will look for a better home. Right now the tolerance for risk is high, evidenced by very low credit spreads and low volatility in the markets so the money is flowing in but that could reverse quickly – don’t get caught looking the other way when it does!

Currently I’ve got 20% international equities, 65% Australian equities and 15% cash. I’d be happy seeing overseas rise to 25% or even 30%. Disagree? Leave a comment!

Why I sold one of my small cap stocks this week

This week I sold out of one of my small cap stocks, a small Australian manufacturer. I bought into them in December 2005, attracted by strong dividends – a yield of 10%, fully franked – that were fairly well covered by earnings, and my assessment the shares were worth perhaps 95 cents instead of the 76 cents I paid. This assessment was made using an EBIT multiple relative to similar companies. In hindsight I think it was flawed and I should have used DCF (see an earlier post for more info.

Growth prospects were reasonably good in their sector and in adjacent markets; the company possessed some new technology that customers were in the process of adopting.

Of course, high yield generally reflects higher risk and this case was no different. Two customers – notorious hard cases for their suppliers – represented 80% of revenue. But the firm was diversifying and actively growing alternate revenue streams from ‘bolt on’ acquisitions.

I saw the yield as my reserve chute; even if the capital gains didn’t materialise in the next 12 months I could be happy to sit on it provided the yield wasn’t put at risk.

However patience finally got the better of me. In late January – 3 or 4 weeks from the next reporting date – the dreaded asterisk next to the stock code…and the “trading update” header on the announcement. Yep, profits going to be down for various reasons, and dividend to be cut. Since that was my primary reason for holding the stock I put the sell order in straight away, but not before it had lost 10%. Luckily, it had put on some capital gain recently and the 10% brought it back, literally, to my entry level. I made a grand capital gain of $0.35, but also kept my dividends which gave me an IRR on the stock of about 13%. It’s not a wipeout by any stretch but the market’s put on over 20% in the same time frame and I did have two opportunities to get out close to 90 cents but greed got the better of me.

I’m reminded of some important pieces of investment wisdom – taking these on board earlier would have resulted in a tidy overall return, ahead of the market.

1. Don’t buy businesses with bad economics – this particular case the company didn’t have any pricing power with their suppliers and were forced to increase their working capital quite a bit (i.e. using up more cash) when one of the major customers simply decided to lengthen payment terms


2. If your primary reasons for holding a stock or position change, then change your position


3. Cross check your valuation – whether it’s with a broker’s report or by using another method, don’t just rely on multiples or DCF

Overall a good reminder and I was lucky to still come off in front.

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