Weakness from resources sector spreading

Founder and Chief Investment Officer of Montgomery Investment Management
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On Peter’s show last week, I mentioned that The Montgomery [Private] Fund’s cash weighting moved to over 40% a couple of weeks ago as we took profits on stretched valuations among many of the high-quality companies we prefer to invest in.

Since then, share prices for many companies have slumped and naturally, we have since been asked by several subscribers how we go about deciding when to invest and when to step aside.

The role of the fund manager

To begin answering this question, we should start with the understanding that most funds cannot swing so flexibly between cash and shares. The structure of the funds management and financial planning industry has long favoured the idea that the fund manager must stay fully invested and that a research house or asset consultant decides, on behalf of clients, how much to allocate to cash and to shares.

Fortunately, the GFC combined with long-term underperformance has resulted in two trends emerging. The first is a big shift to index funds and index ETFs: as Warren Buffett observed, if you aren’t prepared to be a know-something investor, index funds may be the best alternative. For what it is worth, we think it’s relatively easy to beat an index over the long run, when the index is based only on size or sector.

The second trend that has emerged is a recognition in the industry that in some cases, the fund manager, who is at the coal face, may be the best person to decide whether to be in cash or shares. As an investor there is no doubt that you want your fund manager to preserve your capital and go to the safety of cash, if he or she was of the strong opinion that the market was at risk of a sharp correction, for example. Up until recently such an option has not been available.

Risky business

When we looked at our portfolio of high quality businesses, we realised that even though we had no exposure to mining or mining services companies for over a year (they have fallen as much as 60 and 70%), there were still risks present.

The combination of share prices at or above valuations and a resource sector slowdown – that could morph into a more serious wider economic slowdown meant that lofty share prices might not be justifiable. And in any case, the fact that prices were at or above our estimated intrinsic value, the upside was limited and the downside risks were growing.

Many fund managers disagree with our interpretation and that is ok by us. Every time we buy shares, the seller disagrees with us too.

In essence, we are concerned that the 1.5% contribution from mining capital expenditure to our GDP growth rate of 3.1% may be severely curtailed, if the Bureau of Resource and Energy Economics forecast of a 75% decline in capex by 2017 becomes reality.

Company downgrades

And before you decide to believe those who proffer a ‘things-are-just-fine’ argument, think about the 127 companies one of our brokers tells us have reported downgrades. Make that 128 if we include Cochlear in their list!

Here’s their list, in alphabetical order:

Ariadne, Australian Agricultural Company, APN News and Media (second downgrade), ASG Group, Ausdrill (second downgrade), Ausenco, Australian Power, Bisalloy Steel, Blackmores, Boom logistics (second downgrade), Bradken, Breville, Cabcharge, Cardno (second downgrade), Calibre, Clarius, Clean Seas Tuna, Chandler Mcleod, Chongherr Investments, Coffey, Coventry Group, CPT Global, CSR, DTQ, DWS, Elders, Ellex, Emeco (third downgrade), Engenco, Enero, Fantastic, Fleetwood, Greencap Ltd, Global Construction Services, GR Engineering, GUD Holdings (second downgrade), GWA Group, Hansen Technology, Hills Industries, Hudson Investment, Hunter Hall, Integrated Research, Jumbo Interactive, Konekt, Korvest, K&S Corporation, Lycopodium, Macmahon Holdings (third downgrade), Mastermyne, Matrix Engineering (second downgrade), Melbourne IT, Miclyn (second downgrade), Moko.mobi, Mothercare, Noni-B (second downgrade), Norfolk Group, NRW Holdings, Nuplex, Oakton (third downgrade), Objective Corporation, Peet, Pharmaxis, Platinum, PTB Group, QXQ, Redflex, Reece, Regional Express, Resource Equipment (second downgrade), Ridley, Rubicor, Ruralco, Saferoads, SAI Global, Sedgman (third downgrade), Servcorp, Service Stream, SMS Technology, Steamships Trading, Stokes, Structural Systems, Tel Pacific, Transpacific Group, Transfield (second downgrade), Virgin (second downgrade), VDM Group (second downgrade), Villa World, Vision Eye Institute, Warnambool Cheese & Butter, Watpac, Webjet, WHK Group (second downgrade), WDS Limited, World Reach, Zicom.

The dust storm

We reckon the facts are pointing to economic weakness spreading from the resources sector to the rest of the economy, and from Perth across the Nullarbor to the Eastern Seaboard of Australia. We hear, for example, that a couple of years ago when a Perth-based stockbroker was looking for another mining services analyst, they couldn’t find a single person to fill the role. Recently a place became available…and almost 50 mining engineers applied. That dust storm is on its way.

Some fund managers are suggesting you should be looking at the value that is now emerging in the market, particularly in the mining and mining services sector. We thinks that’s like being a minnow fishing for food in a bathtub that has had the plug pulled – you run the risk of being sucked down the drain.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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