When boring is a turn-on

What makes a boring stock beautiful and a ‘sexy’ stock a fizzer?

Of course, different stocks perform better at different parts of the market cycle, but how to pick their timing?

The current boom in the sharemarket has more mum and dad investors believing in the power of a micromanaged equities portfolio, frequently falling into a growth trap where they believe that the competitive or ‘sexy’ attributes of a company may last forever.

According to market experts, the notion of a higher risk stock is pretty persuasive for the less sophisticated but what’s hot today may well be tomorrow’s overpriced proposition if grounded in strong analysis.

In a recent briefing note to financial planners, IOOF’s Lee Mickelborough, investment manager for its perennial growth shares trust, points out that growth investing is about finding companies that can achieve sustainable (and profitable) growth.

Companies post above-average returns if they possess a competitive advantage. This could be superior products, a better brand or smarter management. But this advantage can fade fast.

To avoid over-paying for a stock, IOOF uses a lifecycle valuation model, which assumes that at some point in the future a company will only earn its cost of capital, no matter how impressive the returns.

'We use this model because most competitive advantages fade quickly. Tastes change. New technology and new products appear. Competitors enter industries enjoying bumper returns and squeeze margins,' says Mickelborough.

Companies try to beat this fade, he says, pointing to the new products or strategies developed by corporates such as Coca Cola Amatil.

'Westfield Group has skirted the fade so far. It’s hard to replicate a business of building, owning and servicing an array of malls. In our model, the company gets twice the average fade in terms of time.’

'BHP Billiton is another that has a longer than average fade because of its large and easy-to-access ore reserves in the Pilbara. Transurban Group, with 28 years to go on a lease on a Melbourne toll road, is another that avoids the short-term fade.

Companies caught in the fade can be found aplenty in the biotech and healthcare sectors. For example, CSL, which develops, makes and markets products such as vaccines and antibiotics that are derived from human plasma.

'The technology impressed people a few years ago. In 2002, CSL shares touched $52 after the company signed an agreement with the US military.'

But, he says, CSL attracted emulators who now produce these products and synthetics have emerged with two European competitors entering the US market, eroding CSL’s share.

'CSL shares fell as low as $11.37 in 2003, a plunge of nearly 80 per cent from their peak, after the company’s growth slid from more than 15 per cent per year to about 10 per cent.

'Growth managers who avoid these growth traps can do well for their investors,' Mickelborough adds.

Commsec’s quantitative research team recently took all the stocks in the ASX200 and sliced and diced them into four groups according to accumulation indexes.

What came up clearly was that the low risk, low beta stocks beat the high risk, high beta stocks hands down over a 16-year period. Beta is the extent to which a firm’s stock return moves in unison with the market. Firm-specific ‘risk’ is the volatility of a firm’s returns after the market effect has been removed. The Commsec paper points out that firms can move in and out of the top 200 and also migrate from one group to another over time. The experiment sought to mirror an investor’s rebalancing of a portfolio every six months.

So essentially, what happened is that while the broad index increased by 400 per cent, the low beta, low risk index rose by 800 per cent and the high beta, low risk index was up by 550 per cent. That’s right, boring is brilliant.
 
According to Dale Gillham, share trader, author and founder of investment advisory company, Wealth Within, the top 200 stocks are not only a safe haven but profitable for traders. His model shows that achieving better returns favour the top 100 and not the cheaper, illiquid stocks.

'Generally, small caps are less liquid with lower levels of participation which means the managed funds, which make up 60-70 per cent of the market, don’t buy in. In fact, 55 per cent of transactions are personal investors but the institutions still control the sharemarket.

'They may only invest in the top 100 or 200 stocks but the two best sectors in the past 12 months have been the energy or mid-cap sector, which is made up of stocks ranked in the 51-100 in the All Ords Index, or energy sector with stocks such as Resmed, Caltex and Macquarie Airports and Macquarie Infrastructure. Santos, Hardman and Oil Search have done exceptionally well.

'These types of companies making good profits are better resourced and can pay for better management teams. Smaller companies can’t compete against this.'

Gillham points out that it’s better to trade the solid, more predictable larger caps, which have been proven over time, rather than smaller stocks, which may not last the distance.

Sexy is about being a market darling, says Angus Geddes, CEO of FatProphets, an online sharemarket tipster which is in the business of picking ‘darlings’ before they become famous.

'Darlings attract a huge following because of their momentum. People make the mistake of extrapolating the past as the future and because these stocks carry huge valuations, they get clobbered.

'Brambles is a good example. After a 75 per cent share price fall, it takes a long time to win back confidence and that’s when we buy the ugly ducklings at a cheap price.'

Geddes says a corporate performance or the impact of restructure can move more swiftly than you think.

'AMP is looking good but the market looks ahead. You need to be ahead of the crowd; no prizes for being behind. You have to get positioned,' he says.

'The whole re-rating process takes time and that’s the story with Southcorp. The point to make about these turnaround situations is that prices remain depressed until something happens, such as an improvement in the operating margins and profits improve, which is often the catalyst that triggers a re-rating.

'For Southcorp, the US wine market has been a problem but it’s a matter of time before there’s a recovery. They have much operational leverage and therefore potential for recovery when revenues begin to rise again. Our typical turnaround play takes between six and 12 months.'

Geddes says the banking sector is no longer sexy. 'Six months ago, we called a correction; the heyday is over. We’re going to see margin erosion for the next 18 months and that will bring bank share prices down. We still like the super and wealth management businesses; I think AMP looks good now; we were very prominent recommending insurance stocks but again you wouldn’t buy them now; their autumn has arrived.

Michael Hawkins, chief investment officer at Goldman Sachs JBWere says equity markets are driven by interest rates – the lower the better – as well as profits expectations and by investors’ willingness to take on risk, known as the risk premium.

'In the US in the late 1990s, risk was out the window and tech stocks went through the roof. In the tougher times of recent years, people are taking a more conservative approach; the price for the risk premium is high. A high-growth low risk investment means you can conceivably justify large price earnings multiples but if you assume strong growth and high risk then a fair value price earnings multiple will be around 15 times.

So the sensitivity is huge and that explains why companies may be generating higher profits but relative to the 1990s, the share price performance looks suppressed.
'We think that the markets are fairly valued. The ASX 200 has been basically going sideways for four years and when it recently hit an all-time high, it did so with more comfortable valuations than those in early 2001. The Australian economy may be late cycle but the earnings are there for 2004 and the earning expectations for 2005 should hold up for the current earnings season.

Hawkins says that unlike fund managers, retail traders have the luxury of a longer time horizon and don’t have to be governed by where the index suggests you should place your investments.

'Our clients are quite contrarian. They’re more inclined to buy falling stocks and take profits on the rise. You can analyse stocks in different ways but human nature creates noise and retail investors are never completely immune.'

This article was written by Julianne Dowling, a freelance finance writer.

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