Ann: Trading Update, page-49

@travelightor,

Thanks for your considered comments, from which all investors can surely learn.

(Would that you had expressed your misgivings about SDI before the downgrade, instead of afterwards, it might have saved some people from some losses.)


At the risk of labouring the discussion, which I missed over the weekend, given that I am one of SDI's proponents I thought it appropriate for me to add my tuppence ha'penny's opinion.


There are a few points with which I have a differing opinion to those expressed in preceding posts.

Firstly, like you, I also have a preference for owning high-quality businesses and, as you mention, I also own many of the ones you have listed, as well as other "expensive" stocks such as ASX, AUB, CSL, DLX, NHF, RHC, SNL, WFD.

But, possibly unlike you, I look at the capital appreciation in the value of those companies in recent years and I think that we have just been lucky in relation to a very large element of the capital profits we've enjoyed... lucky because we have been beneficiaries of a very significant, decade-long phenomenon of unprecedented global monetary policy which has caused capital to become very, very cheap, and which has translated into company valuation multiples rising to several standard deviations above long-run averages.


Because, for most of the stocks you have listed, the organic earnings growth has actually not been that stellar in the past 5 - 7 years, especially in the context of their longer-term history:

CAGR Growth in EPS (2011 to 2017):
ARB = 3%pa
BRG: 7%pa
ONT: 4%pa
REH: 10%pa (but that was undoubtedly due to the ~20%pa growth boosted by the housing boom in 2016 and 2017)
NCK: 21%pa (but that was during an aggressive store roll-out program and we know what the sort of operating leverage results from store maturation plays)

So, yes, buying and holding "quality" as an investment has worked in recent years, but mostly because of some extraneous forces that no-one would have been able to predict.

I often wonder how many investors think they are investing guns today because they look at the performance of their investment portfolios in recent years and conclude that they are truly gun stock pickers.

I'm looking forward to seeing how all the 20-something P/E stocks are going to fare over the next 5 years. (I own more than just a few of them, and I don't have too much in the way of elevated capital growth expectations from them; all I expect is that they award me with inflation-beating "pay rise" every year.)


Second, the implied notion of only inferior-quality companies being accident-prone, as opposed to high-quality companies being immune from financial mishaps (self-inflicted or otherwise):

I can recall being a shareholder in each of the companies listed above when they at some stage had their own "SDI-moment", which significantly impacted financial performance, and not just for short periods either. Needless to say, the share price impacts were not pretty. I remember them clearly.

When it comes to investing in publicly-listed companies, there are a always a number of un-know-ables, irrespective of the company in question. Sure, for some less-than-stellar companies such as SDI the potential torpedoes could be more frequent, and the damage they inflict could be more meaningful than in the case of superior companies such as ARB or BRG or ONT. But that's why SDI and its ilk are only valued at less than half the valuation multiples as ARB, BRG, or ONT.


Finally, the matter of portfolio construction.

This is the length-of-a-piece-of-string debate. No size can possibly fit all. Personal financial circumstances, family circumstances, age, personality, attitude to risk, investment objectives... all have an influence in different ways.

For example, someone who is in his/her fifties, retired with a strong disinclination to re-enter the work force will, and with teenage dependants, meaning that what he/she requires from his/her investment capital is income (and particularly growth in income) would have an entirely different approach to stock concentration in an investment than someone in his/her early thirties who is still in the capital accumulation phase of his/her investing career.

Given that I:

- invest overwhelmingly for income generation,
- have a low-ish tolerance for risk, and
- operate on the basis of that no single business is completely bullet-proof,

I could not countenance too many a good night's rest if I had 30% of my wealth committed to just one company, irrespective of how much conviction I had in its financial prospects.

Put another way, owning 13 stocks, or even 23 stocks, sits far more comfortably with me than 3 stocks. Even if they were 3 stocks that I thought were almost infallible.

The other factor that influences portfolio construction is the asymmetric structure of the Australian equity market where, following a few tens of truly liquid stocks, there is a long tail of stocks in which liquidity is quite limited. Some investors would be precluded from building high conviction holdings if it required them to sit in the market doing 20% of ADV for weeks on end.

But the most influential argument, I think, why the notion of running a concentrated portfolio is somewhat flawed one is because of the distortions created by the taxation of capital gains, which has the inevitable effect of inducing a natural creep in the number of stocks in any portfolio that features investment successes.

By way of a simple example to demonstrate this, consider the following hypothetical high-conviction portfolio, comprising 5 stocks, each representing 15% of the portfolio, plus 25% in cash.

ARB
BRG
NCK
ONT
REH
Cash 25%

Assume that the investor in question has a strong disinclination to sell his/her shares because it would make no financial sense to do so due to the capital gains tax consequences.

Assume, also, that the investor in question has a disinclination to hold cash, because of its poor characteristics in generating real returns. So, he/she really wants to have just a 5% cash holding, but has been unable to find anything sufficiently undervalued to buy, including his/he existing holdings which appear overvalued.

Then, one day, an opportunity presents itself (RWC), and he/she puts 15% of the cash to work, thereby adding another new stock to his portfolio.

The portfolio now looks like this, ceteris paribus:

ARB
BRG
NCK
ONT
REH
RWC
Cash 10%

Some time later, the investor finds that his cash holding has risen back to close to 20% (e.g., he/she received an ex-gracia payment from his/her employer as well as dividends and interest in the intervening period).

But all of the stocks in the portfolio still appear too over-valued enough to buy, but another more attractive opportunity (CSL) presents itself. So the investor buys CSL, and the portfolio now looks as follows:

ARB
BRG
NCK
ONT
REH
RWC
CSL
Cash 5%

The point being made here is that optimising portfolios to reflect only the highest conviction investment opportunities at all times is practically only possible when the cost-to-transition the portfolio is zero.

But, as long as there exist distortions induced by tax implications, upwards creep in the number of stocks in a portfolio is a natural consequence.

I have experienced it first-hand over the course of my investing career and I'm not sure how it is to be avoided.