How to emulate Big Value’s Big Cap portfolio of 15 to 25 stocks
Recently I spoke with Under the Radar’s portfolio manager Sam Ferraro about setting up a Big Value portfolio of 15 to 25 of the big ASX listed companies.
You could call it “high conviction” because that is the buzz word in financial markets. If you don’t perform as an “active” manager, you get the bullet.
Ferraro’s background is as a senior strategist with Goldman Sachs and these days he advises fund managers around the world on the big ASX listed stocks and the sectors.
To kick off your portfolio, he said that you start at the top: “In the Australian market, the key question is whether your portfolio is under or overweight in banks and resources; they represent such big parts of the market; close to 50%, in fact. To answer this question we rely more upon what we think is happening with the economy, rather than the fundamentals of each bank or mining company.”
What is market weight?
This refers to the proportion a stock or sector represents of the total market capitalisation of the benchmark, which in most cases is an index. In this case we’re using the S&P/ASX 200 Index as the benchmark, which represents the biggest 200 companies listed on the ASX by market capitalisation. This is standard practise. Over-weight positions or under weight positions can refer to a sector as a whole or a stock. For example, the banks as a whole have a weighting of about 40% in the index, while the biggest bank, the Commonwealth Bank (CBA) has a weighting of just below 10%.
Overweight in banks and resources
Big Value is overweight in the banks, in spite of the prospect of stronger capital requirements from Australia’s regulatory agency APRA. On our numbers the major banks are trading on low price to book multiples, on a historical basis.
We’re also overweight in resources, because we believe that the growth in China is supportive of rising commodity prices, in the near-term at least. Although there is a lot of hype surrounding the “One Belt One Road” infrastructure plans throughout Asia which is a sort of the modern day Silk Road being touted by Chinese President Xi Jinping, it makes a great deal of sense.
The question therefore is, how much “overweight” does Under the Radar’s portfolio make them? We know that we want to own the banks and miners more than the market owns them, but how much is enough, or too much? The answers to this depend upon the key risks around the outlook for this sector.
Risks to banks
The key risk is that rental yields are at historical lows, which puts residential properties in the firing line. As it happens, however, commercial rental yields are also at record lows. For residential property, we believe that it’s only a matter of time before prices fall and there is growth in rents, which means that yields return upwards.
The rental yield is simply the rent divided by the cost of the house. Put simply, the numerator (rent) has been growing at slower rates than the denominator (house value). House prices have been spirally out of control, which reflects low interest rates and their tax preferred status vis-a-vis other assets.
Problems have occurred because rents have flat-lined and are growing at their slowest rate in two decades, which should continue to be the case as a glut of apartments continue to come onto the Sydney and Melbourne markets over the next three years. This actually increases the prospect of rents falling!
It's all about market timing
The end result will be that house price growth either slows down and rental yields stabilise, or they come off and rental yields start to increase. This is a capital issue because banks have started to tighten the purse strings and have stopped lending at this point on interest only loans, but Under the Radar suspects this trend could spread. About two thirds of investor loans are interest only; while for owner-occupier, this is about one quarter. Says Ferraro:
“What this means is that you want to be careful having too big an overweight position in banks,” says Ferraro. “We don’t’ think that’s coming yet; it’s about market timing. Once we get the signal that property prices are slowing, we’ll move to a neutral and then sell to an underweight.”
The Big Value Portfolio currently contains three big banks and is overweight in all of them. For example, the ANZ it has a 13% weighting in the portfolio, whereas its weighting in the ASX 200 is 6%, which means the portfolio is overweight 7%.
Risks to Resources
On this sector Ferraro says: “We’re still confident about China growth being well supported by government spending on infrastructure, which is the key macro call for resources and is reflected in our overweight position in BHP Billiton (BHP) and Rio Tinto (RIO) which are our two big ones. We’ve also got significant positions in the diversified operator South32 (S32) as well.”
The big resources or materials companies represent about 10% of the ASX 200, which doesn’t include energy stocks.
Under the Radar’s Big Value Portfolio also holds what we call “second derivative resources” stocks, which includes the steel maker Bluescope Steel (BSL) and Monadelphous (MND).
ROE is at the centre of Under the Radar's valuation philosophy
Now is a good time to talk about what underpins the valuation philosophy of Big Value, which differs in important ways from our Small Caps methodology for choosing stocks.
Under the Radar is hunting for value in both philosophies and we are always looking for cheap stocks. A key difference, however, is that because small caps have a much thinner capital base, we are looking first and foremost for companies that can reinvest their earnings. We’re not so concerned about this factor at the Big end of the spectrum. In fact, it’s more of a concern if they don’t give back money!
Below are the three attributes Big Value looks for in a company:
- The company is not expensive on a Price to Book ratio. You are simply looking at the share price divided at the net assets per share. This methodology comes up with the same result as the simple PE or price earnings ratio, but is preferred because it is more easily comparable across industries. This involves some work because you are stripping out a lot of accounting related non-cash profits and expenses.
- Strong operating profitability. Under the Radar focuses on cash flow return on assets because it’s similar to Return on Assets but is more focussed on cash flow. Once again we are stripping out the non-cash accounting related effects to get back to what a company is really getting as a return from its past investments.
- At the big end of town Under the Radar avoids companies that are heavily reinvesting excess cash flow or free cash flow back into the business. We don’t like big “capex humps” coming up where a company is set to spend huge amounts on assets.
To find out more on Under the Radar Report's full Big Value portfolio and their small cap stock recommendations, visit Under the Radar Report's website.