Telstra, NAB, AMP show dangers of index picking

Bad stocks can rise and great stocks sometimes falter.

Andrew Mackenzie’s BHP is forecast to earn $1.5 billion this year, down from $14bn a decade ago. It makes you wonder what the fuss is about. Picture: Aaron Francis

Over the long run you’ll do just fine investing, at rational prices, in extraordinary businesses. An extraordinary business is one that can retain a meaningful proportion of its profits each year and reinvest those retained profits at an attractive rate.

Think of a bank account with $10 million deposited, earning 20 per cent interest and reinvesting the interest each year; In 10 years there will be $63m in the ­account. Auction the bank account in a decade’s time and you’ll do just fine. You can now turn the big auction room, which is the stockmarket, off.

Sure, the risk of a so-called Brexit, China, or the Middle East may all have an impact on prices in the short term, but in the long run, prices cannot help but reflect the increase in the worth of that bank account. And you don’t need to be particularly skilled at forecasting the markets or the economy either. Feel free, however, to heed my warnings about house prices.

So why am I telling you this?

Because I need to remember it myself. Inevitably the investing strategy outlined above goes through periods of underperformance — a word I hate. It means the broader market index has done better than my funds at Montgomery. And it means Blind Freddy could have closed his eyes, bought the stockmarket index — with all the rubbish companies that constitute it — and done better than a team of professional, hard-working analysts.

Worse still, it gives ammunition to the promoters of index funds who actually recommend you act like Blind Freddy, close your eyes and just buy the index — an artificial list of big-but-not-good companies that aren’t growing and whose prospects are challenged by maturity and disruption.

They ask you to ignore all the facts but have faith that their share prices will just go up.

A step back, however, reveals that the share prices of companies like Telstra, NAB and AMP today are all lower than where they were in 1999. That is 17 years with no capital appreciation.

And what about the index itself? The S&P/ASX 200 is where it was in 2006. So much for claims that the stockmarket always goes up. And so much for the simplistic advice to invest for the long run. The longer you remain invested in mediocre businesses that pay most of their earnings out as a dividend, the more likely your purchasing power is going to be eroded.

Over the past 12 months, the ASX 200 is still down about 12 per cent, even after rising 7 per cent from its February 2016 lows. The recent strength, however, is due to a rally in the materials sector with leveraged mining stocks up by double digits in the week, having already more than doubled since February. Iron ore prices have jumped to $US69 a tonne, from just $US37 a tonne last December.

Having missed the run-up in material stocks, one might wonder whether Montgomery should have been positioned differently. The answer, however, lies not in recent stock price performance but in the long-run economic performance of businesses in the ­materials sector.

Trying to consistently and correctly predict the relative performance of different sectors, or stock prices themselves, is tantamount to correctly betting on black or red at the casino. It’s simply a mug’s game.

Instead, investors should focus on the business.

BHP is consistently applauded as Australia’s resource success story and speculation about the iron ore price bottoming may tempt some investors to believe they should think about buying the stock. But take a quick look at the business and you might wonder why so much attention is paid to BHP at all.

• Ten years ago BHP earned $14 billion on shareholders’/owners’ funds of $32.5bn and total borrowings of $12bn.

• After 10 more years in business the company has $84bn of shareholders’ funds and $50bn of borrowings, so you would reasonably expect it to also be earning a lot more than it did 10 years ago.

• But BHP, now run by Andrew Mackenzie, is forecast to earn just $1.5bn in 2016, down from $14bn in 2006.

Short-term underperformance makes a fund manager look bad compared with the index but one needs to appreciate such relative performance is inevitable ­because the prices of good businesses don’t always go up and the rubbish that I don’t own occasionally does.

And rather than asking whether the iron ore price will continue to rise or reverse, I just ask: are we invested in high-quality businesses? If the answer is yes, we should be delighted when the prices of great quality businesses underperform because it represents opportunity rather than risk.

Roger Montgomery is founder and chief investment officer of the Montgomery Fund.

www.montinvest.com