Quarterly Report: Australian Fund December 2011

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Portfolio commentary

Each quarter, we’ll be producing a report much like this one; featuring three sections covering performance, portfolio commentary and a few general observations. As we only hung out our shingle in November, the performance thus far is no guide as to our competence or otherwise (I promise I would have said the same thing were the returns the other way around). For the record, the unit price is up 1.8% since inception while the All Ordinaries Accumulation Index was up 5.7% in the same period.

So far, we’ve invested approximately 50% of the $10m cash contributed to the fund during the first two months. The investments mostly consist of large, liquid infrastructure funds. Together, Prime Infrastructure (our largest holding), MAp Group (the old Macquarie Airports), Australian Infrastructure Fund, Spark Infrastructure and SP Ausnet represent 32% of the fund and 66% of the invested portfolio. With the exception of Prime Infrastructure securities, which ended the quarter in line with our average acquisition price (adjusted for a distribution before the recapitalisation), all are showing unrealised gains. MAp, in particular, ended the December quarter up 14%—despite paying an 8-cent distribution—and Spark Infrastructure closed up 12% on our purchase price.

We expect good, but not spectacular, long-term returns from most of these stocks. Spectacular short-term returns, should they make an appearance, will be attributable to luck.

You should, however, sleep well at night knowing that every time someone shuffles through a major Australian airport, uses electricity in Victoria or South Australia, exports coal from Queensland’s Bowen Basin or harvests a wheat crop in Western Australia, a tiny slice of the revenue generated comes back to you.

RHG Group was sold off heavily in December after announcing it had lost a court case and would suffer financial losses. Having conducted extensive research on the company over a long period, we felt comfortable with acting swiftly to take advantage of what we perceived was an over-reaction in the stock price and added RHG to the portfolio.

A subsequent announcement indicates that the final financial impact will not be as substantial as many, including us, feared. Thus far, this has not been reflected in the stock price, which continues to languish around 8% below our average purchase price.

With hindsight we could have purchased stock more slowly and achieved a slightly lower average entry price, but we’re nonetheless glad to have established a modest position in this company at a price that we believe will prove to be very attractive.

In addition to the stocks mentioned above, we have taken small positions in another five companies. These are all small to mid-sized companies in diverse industries. We’re very keen to own more of these stocks at the right price or—in the case of the smallest—as we are able to find stock to purchase. That’s why we believe it is in unitholders’ best interests that we do not disclose these positions at this time.

General commentary

Many Australian investors feel that the capital raising frenzy of the past 12 months was a gift from God. ‘Free money’ I heard it described as and, in some cases, it was. Small shareholders that were offered $15,000 share purchase plans at substantially discounted prices were sometimes able to make more than their initial investment simply by participating.

But shareholders as a whole cannot ‘win’ out of a capital raising without the capital being put to good use and having it earn above average returns. Most of the capital raised over the past year has been expensive equity used to repay what was once very cheap debt. The net result for investors is a loss, not a win, and this will become obvious to all shareholders over the next year. The cost will manifest itself in substantially lower earnings per share.

Ignoring growth, franking and other complicating factors, when a stock is priced at 8 times pre-tax earnings, investors are demanding a return of 12.5% (1 divided by 8). If you raise equity at a cost of 12.5% per annum and use it to repay debt that was costing 5% per annum, there is going to be a lot less cash left over on a per share basis.

You won’t read about that in the press releases. Most PR savvy companies will probably follow Wesfarmers lead and focus their attention on growth in ‘net earnings’ while failing to mention a decline in the more important earnings per share. But for those prepared to do a little digging, the cost of last year’s rush for capital is about to become painfully apparent as reporting season rolls around. You can read more about the impact of capital raisings on earnings per share in my recent Bristlemouth blog post.

We’re not going to generate sensational returns with half the portfolio in cash. Our goal is to be mostly invested, most of the time. While we’ve made a good start, we’re treading very carefully. That’s partly because most prices look reasonably full. But it’s also because we remain extremely concerned about the global backdrop.

The problem the world economy faces is that none of the underlying imbalances that caused the most recent crisis have been corrected. In a recent article in the Financial Times, John Kay summarised my thoughts much better than I could: Governments, and particularly the US government, reacted on each occasion by pumping money into the financial system in the hope of staving off wider collapse, with some degree of success.