THE WEEKEND AUSTRALIAN, OCTOBER 17-18, 2015

theaustralian.com.au/wealth 33V0 - AUSE01Z01MA

Spot the winners, shed the goners

Many investors want to know ifthe market is going up or down. Itdoesn’t matter.

What matters is that qualityand value are present in the com-panies you buy. Buy extraord-inary companies at rational pricesand, over the long run, you cannothelp but do well.

Many investors also want toknow who is going to win in thisera of disruption. That’s also hardto tell. But it is almost boringlyeasy to find those companies thatwill lose. In a moment I’ll explainhow to make money from those.

It’s clear to me that investorsare enamoured with Tesla. Theelectric car company is changingthe world one car at a time andhaving just installed their super-charging stations in Goulburnand Wodonga along the HumeHighway, it’s easy to get excitedabout the potential.

But BMW, which is also pro-ducing electric cars, sells 2 millioncars a year, while Tesla only sells50,000 cars a year. It makes nosense that Tesla’s market cap isalmost half that of BMW.

In this era of creative destruc-tion, transition and disruption,finding the winners can be a chal-lenge so it’s worth exploringstrategies that can win even if youcannot easily isolate the winners.

Suppose your neighbour had abrand new Toyota Camry andyou knew that the local Toyotadealership was going to hold aChristmas sale on Camrys at 50per cent off. If you borrowed theneighbour’s car and sold it at, say,$30,000 you’d put thirty grand inthe bank. If you then went alongto the car yard sale and bought anew Camry for $15,000, you couldreturn a new car to your neigh-bour and keep $15,000 profit.

When the “horseless carriage”first chugged past the blacksmith,it would have been impossible toknow which start-up carmakerwould survive and prosper. Itwould have been far easier to con-clude that the Blacksmith was a“goner” no matter who won therace to automotive nirvana.

By building a portfolio of ex-traordinary global businesses andsimultaneously selling a portfolioof blacksmiths, not only can youadd “alpha” (outperformance) toyour portfolio but you can alsoreduce your net exposure to thevicissitudes of the market.

For example, if you buy $100worth of outstanding businessesand sell a $60 portfolio of “black-smiths”, your net exposure is $40.If the market fell 10 per cent, youwould expect to see your portfoliodecline by only 4 per cent.

If you cannot find a prime bro-ker willing to allow you to build ashort portfolio of blacksmiths,find a fund manager that can do itfor you. In this age of low returns,investors must find reliable waysof generating returns beyondthose available from miserlyyields on stable low-growth com-panies. So who might be theblacksmiths of the world?

● McDonalds is struggling tofind its mojo and franchisees arewanting out. Despite thousandsmore stores being added to thenetwork over the last few years,revenue hasn’t risen a dollar.

● The coal company Teck Re-sources recently announced along-term streaming agreementto forward sell silver production.The problem is that at the currentrate of cash burn the money itearns from the deal will be gone in12 months. At the same time thecash it raises only reduces it debtby 8 per cent. Meanwhile, coal is inoversupply, China demand isweakening and costs are in a de-flationary spiral meaning supplywill not be cut for some time.

● Over at Prada, the companyhas been using store growth tomask deterioration in per-storesales, which equates to a deterio-ration in margins as operatingleverage works in reverse on aper-store basis. The company isalso negatively exposed to theBeijing corruption crackdown.

● Finally, at Barnes & Noble,the US-based brick and mortar re-tailer of books, CDs, DVDs andvinyl LPs, the company is in whatappears to be structural decline.

Instead of looking to predictthe direction of markets, find andbuy companies with the brightestof prospects and sell a portfolio ofblacksmiths. You will not onlyprofit from disruption but you canreduce your overall exposure touncertain markets as well.

www.montinvest.com

Roger Montgomery is founder and chief investment officer at the Montgomery Fund.

ROGER MONTGOMERY

Vitamins and formulas for stock price bubbles

It’s one of the great businessstories of our time: the dramaticrise in a pair of stocks — Black-mores and Bellamy’s — two food-related companies that havecaptured both the current oppor-tunity and the future possibility ofour links with China

You need only visit a shop inany international airport loungeacross Australia to see the changethat has taken place: where oncethere was whiskey and cigars wenow see shelves full of vitaminsand baby milk formula.

What’s going on? For Blackmores, Australia’s

largest dietary supplements com-pany, and Bellamy’s, a Tasmanianorganic baby formula brand, trustis the key attraction. Consumerswill seek out and pay a premiumfor brands they perceive offer thegreatest health benefits.

Australian food and dietarysupplements have premium statusin Asia because Australia has tight

food quality controls and its agri-cultural environment is perceivedas cleaner than Asia, where con-sumers are wary of domesticallyproduced food after a string ofproduct quality scandals.

In a remarkable twist on thetraditional export picture, Chinesetourists and residents are buyinglarge quantities of product inAustralia and forwarding it toChina; Blackmores estimated thisaccounted for 14 per cent of salesthis year, almost as much as Asia-based sales.

But is it wise to buy an expens-ive stock hoping someone else willpay even more to take it off you?This is the risky game investors areplaying in Blackmores and Bella-my’s Australia, which arerespectively 345 and 450 per centhigher than a year ago — evenafter respective corrections sinceSeptember. There are two out-standing problems:

● Both stocks are pricing inbullish scenarios, which most like-ly can’t be achieved.

● Buyers at current prices aremomentum-trading the sharesand face capital loss if either stockdisappoints.

Ironically, the operationsbehind both these stocks are absol-utely fine: both are quality busi-nesses selling into boomingdemand in Asia, where Australianhealth foods and supplements arepopular with the fast-growingmiddle class.

But popular stocks rarely makegreat investments.

Unfortunately, outstanding

stock performance reduces poten-tial profits by borrowing fromfuture returns and thus tends topredict future ordinary perform-ance. If everyone likes a stockthere is a significant risk the shareprice will fall if the market changesits collective mind and everyoneruns for the exit.

Momentum trades like Bella-my’s and Blackmores can endbadly with a sharp correction on aslight disappointment or they canjust reach a point of exhaustion

among buyers. The worst-placedparticipants are those armed onlywith a strong narrative, no sense ofwhat the share price implies andno valuation against which tobenchmark.

So for Blackmores and Bella-my’s it pays to be cautious andinvestigate whether expectationsimplied by the share prices arerealistic.

● Here’s the Blackmores situ-ation: at a reasonable 11.3 per cent“required return”, the discount

Blackmores and Bellamy’s are great, but overpriced, plays

DAVID WALKER

to margin compression as aggress-ive trading terms may be sought bychemist retailers. Although Asiaprovides a significant long-termgrowth opportunity for the busi-ness, execution risk remains andBlackmores’ implied 91 return onequity forever is impossible.

Blackmores’ share price is abubble and the 6 per cent shareprice fall on Monday this week is areminder of how quickly stockscan fall when the market wakes upto overvaluation.

● Here’s the Bellamy’s situ-ation: the smaller Tasmanian-based specialist in infant formulaled Laura McBain by looks ex-pensive — it floated in at $1.00 andyesterday they were trading at$7.64.

Using a 12.5 per cent requiredreturn (similar to other mid-capagricultural stocks such as BegaCheese, Warrnambool Cheeseand Freedom Foods), andadopting a dividend payout ratioin line with company guidance,

Bellamy’s share price assumes thecompany reinvests a large 65 percent of earnings at a very high rateof return of 50 per cent intoperpetuity. I’d suggest nocompany can do this.

Increased competition fromlarger global players like Nestleand Mead Johnston could erodethe high returns and Bellamy’s willeventually exhaust investmentoptions and increase its dividendpayout ratio, which would makethe stock less valuable.

Possibly the company will betaken over before then by a foodmajor seeking an establishedAustralian brand in Asia.

There is a lot to like about ourtwo superstar food stocks but thebullish cases are priced in. Greatcompanies, excessive share prices.Superior investments are thosewhere a bearish case is unfairlypriced in.

David Walker is senior analyst at StocksInValue.com.au

Blackmores, Bellamy’s and the S&P/ASX200

Source: Bloomberg

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BLACKMORESBELLAMY’SS&P/ASX200

2014 15

Past year (percentage change)

rate that summarises the level ofrisk to the investor, and aconservative dividend payoutratio Blackmores shares arepricing in a return on equity of 91per cent in perpetuity (forever)when the company achieved areturn on equity of 63 per cent thisyear, that’s probably unsustain-able.

For context the return on equi-ty of the All Ordinaries Index is 10per cent. Higher returns attractcompetition and profitability gen-

erally reverts to the average. InAustralia, where Blackmoresmade 70 per cent of sales in FY15,CEO Christina Holgate facesstrong competition from Swisse,recently acquired by Hong Kong’sBiostime.

There is also the pressure creat-ed by the constant rollout of gen-eric products or house brands bythe dominant retailers. Consoli-dation of pharmacies, particularlyby Chemist Warehouse and Price-line. Sooner or later this could lead

ROSS MARSDEN

Bellamy’s CEO Laura McBain has seen a sevenfold increase in the babyfood company’s stockprice

Glenda Korporaal reports on the unsavoury business of ‘elder financial abuse’ and how to stop it in WEALTH on TUESDAY

Will Hamilton asks if residential property investors really have anything to worry about with rising rates and escalating valuations in WEALTH on TUESDAY

Hard economic numbers will beat soft sentiment any day

Galileo, the Italian renaissancescientist, said that if he were tobegin his studies again, he wouldhave followed the advice of Greekphilosopher Plato and begun withmathematics.

As qualitative and interpret-ative as finance has been allowedto become, at the end of the day,the maths is really all that matters.

For the arithmetically drivenglobal investor, September’s USFederal Reserve FOMC (FederalOpen Market Committee) meet-ing chaired by the “data-driven”chair, Janet Yellen, could fairlyhave been considered “quantitat-ively uneasy” and this unease ismotivating some to find new waysof redefining the rules of thefinancial road.

The most explicit example ofthis was seen last week, whenBlackrock, the world’s largestasset manager, proposed new andsomewhat radical rules for ex-treme sessions of market-widevolatility.

In response to August 24’s“flash crash mark II” — which sawextreme volatility, erroneoustrades and by the end of that trad-ing session, one in five exchange-traded products on NYSE Arcaplatform being suspended —

BlackRock proposed that regula-tors consider market-wide “circuitbreakers”, which, put simply,would see the entire S&P 500 shutdown on such days.

Such suggestions have danger-ous implications and fly in the faceof the free-market “price dis-covery” mechanisms upon whichthe US S&P 500 and AustralianASX 200 rely.

But the significance surround-ing the timing of this proposal isthat larger institutional marketparticipants, such as BlackRock,now believe that the FOMC’sSeptember ambiguity allows themthe scope to test new boundaries.

By the Fed acknowledging thatmarket “tantrums” can, and have,influenced their decisions, it isnow not unreasonable to expectmore changes to come, or, at thevery least, more being tested.

Such perceived carte blanchematters to Australian domesticstockmarket investors, who relyupon very similar rules to thoseestablished in the US and as ourASX’s Central Limit Order Book,or CLOB, is also built to facilitate“price discovery”, during bothcalm and volatile trading sessions,any change to this relative statusquo will affect how Australiansapproach investing — both in andoutside of superannuation.

The uneasiness surroundinghow Yellen and the FOMCmanaged September’s muchanticipated Federal Reservemeeting can best be seen in thegraph, which reflects aggregatedglobal PMI sentiment surveys,benchmarked against quantitat-ively objective hard data indices.

Interpreted at face value, even

though the economic numberspertaining to the performance ofthe US real economy look sound,the sentiment of both globalinvestors and US commerce isanything but.

The outgoing chief economistof the IMF, Oliver Blanchard, haseven suggested governments,rather than following QEprograms, might increase theirfiscal deficits by spending onnational infrastructure projects:central banks would then pur-chase the debt components ofthese projects with newly createdmoney.

In relation to the global inves-tor experience, although oftencalcified in their ways, this currentdebate has motivated the resolveof many Australian ultra high networth investors to reappraise

what continued distortions,caused by ambitious monetarypolicies, mean for their respectivewholesale investment allocations.

With specific reference to ASXminers, Goldman Sachs remindedclients this week that “given thedistortion of multiple and returnmetrics, we think cashflow andNAV valuations provide a betterindication of value”.

According to Koby Jones,

managing director of The SILCGroup and Larkin Group advisoryboard member: “We are seeing aheightened interest from Austra-lian wholesale investors to seekclarity in listed and unlisted mar-kets given the volatility and con-fusion around economic activityand global markets.”

Jones adds: “UHNW clients,more than ever, are seeking great-er accessibility and enhancedchoices in order to meet their riskand return objectives.”

Balancing the influence ofglobal and sectorial distortionsagainst the foreseeable trends inAustralian rates, real estate andequity markets, the comments ofRBA deputy governor PhilipLowe this week that a peak of thecurrent housing cycle was verynear, should be received particu-larly well.

This is because domesticcertainty — even if unfavourable— provides much needed stabili-ty, when set against the currentglobal financial and economicflux.

Coupled with the knowledgethat the risk of severe drought inAustralia and New Zealand hasrisen sharply and if eventuating,will lead to the historicallysignificant 20 per cent medianGDP decline, it is not difficult toforetell where our Reserve Bank isheaded.

Respecting the basic mathsadds up.

Larkin Group is a Wholesale Wealth Adviser focusing on high yielding global investments.

www.larkingroup.com.au

STIRLING LARKINGLOBAL INVESTOR

Source: Bloomberg

Sentiment data has been weak whilehard data has been resilient110

105

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95

90

85

80

75

102.3

101.3

100.3

99.3

98.3

97.32010 11 12 13 14 15

SentimentIndex (LHS)

Hard DataIndex (RHS)

Macro Data CompositeIndex (RHS)

It is now not unreasonable to expect more changes to come,or more being tested

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