Inside a top manager's top stocks

A few issues back, in issue 209/Sep 06 (Long Term Buy—$10.90), we recommended Treasury Group, which holds investments in several funds management businesses. Treasury’s largest and most successful investment is a 50% stake in Investor’s Mutual, the funds management firm founded by Anton Tagliaferro in 1998.

Tagliaferro was one of the original subjects of the Masters of the Market, a book of interviews with some of Australia’s best investors (we recommend it to you, although the first edition was a better read than the current second). At a time when most fund managers were performing poorly, Investor’s Mutual was named best Australian equities manager in both 2002 and 2003 by Money Management magazine.

Investor’s Mutual’s long term performance has been excellent—its flagship Australian Share Fund has returned 16.3% a year since inception in June 1998, beating its benchmark by about 3% a year. But it hasn’t always been the best performer over short periods—Investor’s Mutual underperformed in its early years due to its refusal to buy technology stocks, causing Tagliaferro much grief.

Occasional underperformance

But, like us, Tagliaferro is a value investor, and the pain of occasional underperformance is the value investor’s lot. When markets are booming, they tend to underperform because they don’t follow fads or buy ‘hot stocks’. It’s in the tough times—such as in 2002 and 2003—that value investors really come into their own, while hot stock fund managers crash and burn.

Tagliaferro is currently worried about mining stocks, cyclical stocks, listed property trusts and many infrastructure plays. We’re ‘underweight’ these sectors too, being sceptical that the strong returns of the past few years can continue. Investors in the market’s more frenzied areas are perhaps riding for a fall.

In this review we’ll look at the stocks in Tagliaferro’s funds. There’s much to be gained by looking at another value investor’s portfolios, especially one with as good a record as his. So let’s take a look at three of his funds: the Australian Share Fund, the Future Leaders Fund and the Smaller Companies Fund.

Flagship fund

Investor’s Mutual’s Australian Share Fund is its flagship fund, with a portfolio weighted towards large stocks. You can see a list of the top ten holdings opposite. It’s a defensive and high-yielding portfolio with Tagliaferro preferring companies with recurring earnings and avoiding most cyclicals.

The portfolio is heavily weighted to the banking sector, with the Big Four banks occupying the top four slots and accounting for almost 25%. The Big Four’s effective cartel means that banking is a great business in Australia but a 25% weighting is a big bet. There’s no question that an economic downturn would hurt the banks’ profitability, especially given some evidence of a relaxation of lending standards in recent years. We’d be more comfortable with a 15% weighting, as we said in our issue 202/Jun 06 bank roundup titled Is your bank going broke?.

Unlike most fund managers, Tagliaferro has long been a supporter of Telstra, with the fund having about $130m invested in the telco. His reasons for liking the stock are exactly the same as ours—a dominant market position and its copious free cash flow.

Three of the other stocks are also very defensive. Former buy recommendation Publishing and Broadcasting and current hold Tabcorp derive most of their earnings from gambling, which is a very stable industry. So are toll roads, which explains the fund’s holding in Transurban, the owner of Melbourne’s CityLink, and Sydney’s M2 and M7 motorways. But while we like the idea of investing in these types of high quality, stable businesses, we find Transurban and Tabcorp’s acquisitive management teams unappealing. And the share prices aren’t cheap enough to attract us at the moment.

In the kennel

The portfolio holding we find most surprising is Amcor. Tagliaferro has been a long term supporter of Amcor because it trades on a relatively low PER and is one of the world’s largest packaging companies. By contrast, we think there’s a good reason why it’s cheap—it’s a capital intensive business with an inconsistent profit record. While Amcor has been the subject of some recent takeover rumours [What hasn’t?—Ed], in our view it belongs in the kennel with the other market dogs.

And while Tagliaferro is underweight resources, that doesn’t mean he eschews the sector entirely—5.5% of the portfolio is invested in BHP Billiton , which we reviewed last issue. Perhaps it’s a sop to those who exclaim, ‘Get aboard the resources supercycle before it’s too late’, perhaps it isn’t.

These ten holdings account for just over 50% of the fund’s value but there are, of course, numerous other stocks in the portfolio. Of course, just because Tagliaferro holds the top ten stocks now, it doesn’t mean he’d buy them at these prices.

Smaller companies

Tagliaferro’s other funds are the Future Leaders Fund, which mainly invests in stocks outside the top 50, and the Smaller Companies Fund, which invests in stocks beyond the top 100. You can see the top ten holdings of each fund opposite.

There’s a fair bit of overlap between the two funds’ top 10 holdings, so we’ll look at them together. First up is Campbell Brothers, the largest holding in the Future Leaders Fund by some margin. While Campbell also has chemicals and services divisions, its best business is laboratory services, which has been growing by acquisition. While Tagliaferro isn’t keen on cyclicals at the moment, much of Campbell’s recent growth has come from the resources boom, which is why we switched to Sell a while ago (too early, as it turns out).

Both funds also hold two infrastructure plays—ConnectEast Group and Australian Infrastructure Fund. Tagliaferro has previously criticised the high debt levels and exorbitant fees associated with infrastructure funds, although we suspect he was referring to the Macquarie Bank satellites. While we can’t see too much value in either ConnectEast or Australian Infrastructure, we prefer the assets in the latter.

One stock we definitely agree with, though, is Cabcharge. We upgraded the taxi payments company in issue 206/Aug 06 (Long Term Buy—$6.43) and, since then, the stock has risen 37%, which unfortunately means we’ve decided to downgrade it this issue (see page 14 ).

Takeover bids

Another source of profits from owning small companies is that they are often on the receiving end of takeover bids. Two of the companies in the top ten, Adsteam Marine and Vision Systems, are currently under takeover, with Vision in particular having been a standout winner. Investor’s Mutual has been a big supporter of Vision, with the fund manager owning more than 17% of the company before the bid.

We went close to upgrading rubber products company Ansell a few months ago as cost pressures hit profits, but couldn’t quite bring ourselves to do it. And Spotless is another company where cost pressures have been evident, although we’re not fans of its business.

The top two holdings of the Smaller Companies Fund are also noteworthy. Credit Corp is pretty much the only successful listed debt ledger purchasing business, although as a sixteen-bagger since its 2000 float at 50 cents, it no longer looks cheap. And while Tagliaferro has generally ignored what he considers to be the overpriced media sector, his one pick is Prime Television.

Prime is typical of Tagliaferro's penchant for companies with loss-making divisions. His view is that the market often attributes ‘negative value’ to loss-making operations, rather than ascribing them the value of their eventual sale price. In Prime’s case, its loss-making New Zealand division was sold for NZ$30m in February, with Investor’s Mutual increasing its holding in the company to 12.8% in April.

Once again, these are just the top ten stocks. But what has Tagliaferro been buying lately? With a bit of digging we’ve managed to unearth where he has been investing the cash from recent takeover bids.

Recent acquisitions

In short, he’s been buying down-and-out stocks. Investor’s Mutual has just acquired more GrainCorp, bringing its holding to 10%. Clearly, Tagliaferro thinks that the drought is a good opportunity to buy, a view we agreed with in our upgrade in issue 209/Sep 06 (Long Term Buy—$7.68). Another drought-affected recent acquisition is salt and stockfeed company Ridley Corporation. Investor’s Mutual now owns 18.3% of the company, showing that it’s not afraid to buy big licks of a company’s stock. Yet another sector going through tough times is the automotive industry. The manager recently boosted its holding of automotive parts and industrial supplies company Coventry Group to 16.8%. It has also lifted its holding in HPAL to 16.2%, showing less concern than us about it being left behind as Telstra unravels its labyrinthine billing systems.

Common themes

There are some common themes running through the Investor’s Mutual portfolios. Each, on average, have lower PERs and higher yields than the market, reflecting Tagliaferro’s strict value investing approach. There’s also a definite contrarian and counter-cyclical flavour to some of his recent purchases with the acquisition of stocks in the bombed-out rural and automotive sectors.

Tagliaferro is perhaps an ‘old-fashioned’ value investor, being less concerned about capital intensive businesses than might we—thus his holdings in Amcor and Adsteam Marine. And he seems less worried by expansionist management teams, such as those at Transurban and Tabcorp.

The performance of the Investor’s Mutual funds has suffered from largely avoiding hot sectors like resources, infrastructure and listed property, but we like the focus on defensive companies with recurring earnings. This should serve the portfolio well in a less buoyant market. While returns from higher-risk stocks are strong now, the tide can turn quickly, which is why Tagliaferro’s funds are primed to avoid the worst of any downturn.

Disclosure: The author, James Greenhalgh, owns shares in Spotless, Telstra, ANZ Bank and Commonwealth Bank, while other staff members own shares in Macquarie Bank, GrainCorp and Telstra.

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