In an industry which is very focused on performance, an investor who has read any fund manager reports will often see references to the ‘benchmark’ and how a certain Fund has performed versus its relevant benchmark.
What is a benchmark?
Benchmarks are used in the investment industry as a point of reference to monitor how various portfolios are performing relative to their target over a set period of time.
The most commonly used benchmark in Australia to monitor the relative performance of Australian share portfolios is the ASX 300 index, which measures how the top 300 stocks perform. Other benchmarks which are used to monitor smaller companies’ portfolios are things such as the Small Ordinaries Index which measures how stocks outside the top 100 in Australia are performing.
These indices are market weighted indices i.e. the larger a company is, the higher its weighting in the index. Index managers (also known as passive managers) seek to exactly replicate the index’s performance by buying stocks precisely according to their weight in the index that they are looking to replicate. Active managers, such as Investors Mutual, seek to outperform the index over the long term by selecting a portfolio of quality and value stocks after undertaking fairly exhaustive research that, in our view, will provide better risk adjusted returns than the index over a market cycle.
While some investors and advisers have a preference for using passive managers, in our opinion many are unaware of the issues arising when a portfolio is constructed to strictly track an index as one’s benchmark in the sharemarket.
These issues include:
Many popular market indices are often over-concentrated in some sectors
Thus, if one looks at the Small Ordinaries Index as an example, at 31 January 2019 the Small Resources sector made up just over 22% of the Small Ordinaries benchmark. This means that any investors or fund managers closely following the benchmark – such as passive managers – will have over a fifth of their small cap portfolio invested in small resource stocks. This sector is made up predominantly of very risky, speculative exploration companies the vast majority of which are loss making. IML’s Smaller Companies Fund currently holds only 6% in the Small Resources sector as we believe the benchmark weight of 22% is not suitable for the prudent investors on whose behalf we invest.
Source: Iress; January 2005 -January 2019
As chart 1 above shows the Small Resources Index actually reached a peak of 45% of the Small Ordinaries Index in 2011 as Resource stocks soared as the iron ore price rice rose to a record USD180 a tonne at the time. Any Smaller Company Fund that tracked this index closely would have worn huge losses if they had 45% invested in the sector because as the iron ore price fell to levels closer to USD50 a tonne, the Small Resource Index tumbled by almost 80% as small resource stocks were sold down heavily. At the time the IML Smaller Companies Fund had around 10% in this sector at its peak – meaning that our Fund fared far better than most as the Small Ordinaries fell heavily led by the huge fall in the Small Resources sector.
The higher a stock goes in price, the higher its weight in its index and there are no qualitative filters when it comes to what is included in an index
Tracking an index closely means that managers such as index managers will end up owning more of the stocks whose share prices have appreciated strongly. This can at times mean that if one follows an index too closely that one can end up having too large a weighting in popular but very low-quality companies or sectors in the index which have gone up substantially.
Thus, during the internet boom of 2000-2001, News Corp’s share price soared after internet provider AOL used its over-inflated share price to bid for media group Time Warner in the US. At its peak News Corp represented 18% of the All Ordinaries Index. During this period share prices of other technology, media and telecomms (TMT) companies such as Onetel, Solution 6, Sausage Software and Ecorp also soared and the sector as a whole became a large part of the ASX All Ordinaries Index. During this time, Investors Mutual’s portfolios held no News Corp shares, or that of any other of the TMT companies mentioned, as we could not justify holding them due to their very poor quality and their massive overvaluation.
However, at the time it meant that many managers who were tracking the Index closely (or those worried about short term performance) ended up buying and holding these low quality and hugely overvalued stocks at the peak of the internet boom. As a result, most investors who tracked the index closely suffered huge losses as these stocks fell significantly when the bubble burst, with many trading at fractions of their peak share price a year or two later.
The above examples highlight clearly how following a well recognised Index such as the Small Ordinaries Index today, or the All Ordinaries Index can point investors in the wrong direction when constructing their share portfolios and at times it will often lead to very volatile and poor returns for the conservative long-term investor.
What then is the benchmark that most investors seek to emulate when they are investing in a potentially risky asset class like the Australian shares?
Based on the thousands of advisers and investors that we have met during the last 20 years since IML started, the needs of most clients, and hence their benchmark, appear to be as follows:
Capital preservation
The tolerance for negative returns is very low for the majority of retail clients. Clients expect their share portfolios or fund managers to minimise negative returns in falling markets and to try to achieve less volatility than the overall sharemarket over the longer term.
Long term capital growth
Whilst everyone loves double digit returns year in year out, in truth this is unrealistic and the majority of clients would be happy with a reasonable return when sharemarkets are rising, as long as their portfolio holds up when the sharemarket falls. In an ideal world most investors would be satisfied with a long-term return of 6% to 10% p.a. delivered with less volatility than the overall sharemarket.
Income
Many retail clients need their share portfolios to produce a consistent level of income as this is often the part of their portfolio that they may access to live on in their retirement. For those investors who do not need the income in the short term, the benefits of compounding of dividends in a share portfolio was illustrated in Lesson 14. In addition, many investors enjoy the benefits of imputation credits and the associated franking rebates from the income received from their Australian equity portfolios.
The truth is that tracking an index closely in a bull market may satisfy many investors’ needs, but clearly when indices fall heavily it can cause havoc with many portfolios, as they have over periods such as 2011-2012, or more recently in the last quarter of 2018.
So how does IML seek to meet the most clients’ expectations while seeking to outperform the index over the longer term?
At IML we aim reduce the volatility of returns of our portfolios, while at the same time seeking to meet our clients’ benchmark, as defined above, by doing the following:
1. We only hold stocks in our portfolio whose valuation we can justify and that meet IML’s qualitative research criteria – irrespective of any stock’s index weighting. This may lead to short-term underperformance in a strongly rising market as speculative or thematic stocks charge higher. However, it also means that when the inevitable reality check occurs in the stockmarket, good quality portfolios like IMLs tend to hold up a lot better than the overall sharemarket – as occurred in the sharemarket downturns of 2001-2002, 2008-2009 and 2011 -2012.
2. We never hold large weightings in any highly volatile stocks or in ‘concept’ stocks – this is particularly so as many of these stocks can often rise to ridiculous levels as investors chase a fad with the momentum of buying often pushing these stocks to be large weights in the index. Thus, in recent times high-tech stocks like software provider Wisetech (WTC) in Australia have soared as the Nasdaq in the US hit record highs.
Despite growing quite strongly in the last few years (aided by the rapid-fire acquisition of an incredible 30 different software companies in 18 different countries around the world since the company listed less than 3 years ago), we find it very hard to justify an investment in WiseTech given its very high share price and the huge integration risks of integrating 30 IT companies into one! Because WiseTech’s share price has risen rapidly in the last 18 months its current share price gives the company a stockmarket value of a not insignificant $ 5.8 billion.
Source: IML; all numbers are at 28 Feb 2019
WiseTech’s overvaluation is illustrated in the table above that compares WiseTech’s forecast EBITDA of $103 million and net profit after tax of $53 million for the year ending 30 June 2019 – which puts the stock on a Price to Earnings ratio (P/E) of over 100x 2019 earnings – to other well-established smaller company stocks listed in Australia.
As the table above illustrates, WiseTech’s current valuation of $5,796k is almost $1billion more than the combined total of a collection of well-established companies selected above made up of Events (one of Australia’s largest hotel and cinema companies and a large property owner), GWA (owner of the Caroma bathroom brand), Pact Group (Australia’s largest rigid plastic packaging company) and Southern Cross Media (Australia’s largest FM radio network).
This is despite WiseTech’s EBITDA and net profit after tax being a fraction of these four well established companies combined – which in our view is quite incredible. We believe this clearly shows how WiseTech’s share price has been caught up in the Nasdaq hype making the stock massively overvalued. The stock is held by many small cap fund managers as its weighting in the Index has soared with its share price in the last 12 months. For the reasons given above IML holds no WiseTech in any of our Funds.
3. We tend to shy away from large holdings in the Resource sector and highly cyclical stocks like Sims Group or Bluescope Steel as by their nature these companies have highly unpredictable earnings that are largely dependent on continued strong global economic activity to perform well. These stocks tend to be extremely volatile, and while they may perform well when investors are bullish and positive about future economic prospects, they can perform woefully when investors become cautious about the economic outlook and markets correct.
We would rather have a large percentage of our portfolios in far better quality, and less volatile stocks, such as Amcor, Transurban, Woolworths and Tabcorp as the mainstay for our portfolios.
4. We are not afraid to hold a higher than normal cash weighting if we cannot find value in a particular market.
This is best illustrated if we look at IML’s Equity Income Fund cash levels over the last 12 months, illustrated in Chart 2 below. The Fund is allowed to hold a maximum 50% in cash should it wish. The chart below shows that the cash level for this Fund (as represented by the blue bar) rose as the ASX (as represented by the orange line) rallied into August 2018 where it peaked and where it was harder for us to find good value. As the market corrected in the December quarter the cash levels fell to closer to 15% as there was more value apparent. More recently the Fund’s cash levels have risen again to the 30% level as the ASX rallied strongly through January and February 2019.
Chart 2: Effective Cash levels (%) of IML’s Equity Income Fund
Source: IML; March 2018 – Feb 2019
Holding cash is not a decision we take lightly, however, when value is hard to find in the stockmarket we will at times make the decision to hold a higher percentage of cash in our portfolios as a means of preserving capital in what we assess as overvalued markets.
As we explained in our thought piece in September 2018, the next 3 to 5 years may be very different to the last 3 to 5 years. At this stage of the cycle, with many of the higher risk sectors such as Resource stocks, and Technology stocks like WiseTech zooming ahead, it is important that investors are very discerning and selective in their stock selection. Blindly replicating the index at this point may not enable most investors to perform in line with their benchmark of capital preservation, some long-term growth and a consistent income stream.
Conclusion:
While closely replicating an index may suit some investors concerned with tracking an index, for many others following popular indices may not satisfy their needs as it may lead to more volatile returns than anticipated. It is thus important for investors build a quality portfolio of stocks or invest with an active manager that can produce less volatile but healthy returns over the longer term as well as a consistent level of income.
Source: By Anton Tagliaferro and Michael O’Neill – Investors Mutual Ltd
