Update No. 2 – 10/04/11

 

EGP Fund No. 1 Pty Ltd.  Well, another week has passed (the private investment company has now operated for 6 trading days), and so we update. We have managed to add the full purchase of 2 stocks to our portfolio, and partial purchases of 2 others.  We are still substantially in cash of course 84.15% of our assets as at 5pm Friday.  The benchmark is still leading us, this week the margin has widened slightly to 0.43%.  We have tried hard to deploy our cash but without as much success as we had hoped, given our massive cash balance, I am actually very pleased with how narrow our deficit on the benchmark is.  We shall continue to judiciously deploy our cash over the coming weeks, remaining slightly bewildered (I do believe it is generally undervalued however – see below) at the unwavering upward march of the markets, despite several notable headwinds (Oil at US$110, war in Libya and general North African & Middle Eastern unrest, ongoing debt issues with some EU economies, even a fresh Earthquake on Thursday in Japan).

 

EGP 20.  The EGP20 index has moved up by 1.05% since launch.  There are a couple of stellar performers in the group, but a few laggards are holding the group back, we remain confident that time will see the group catch and eventually pass the benchmark.

 

S&PASX200TR The benchmark index is up 2.13% since April 1 launch. This is a fairly rapid advance; I always like to bring it back to the context of a business owner.  This means that collectively, the owners of the underlying 200 businesses in this index believe they are $24.45 billion more valuable than they were 6 business days ago.  To put this in further context, holding all things equal (i.e., forgetting about the time value of money and dividend payments etc.), it means that in order for the market to return to its high on November 1st 2007 (ASX200 price index – 6,828.71 points), the market from its Friday close would need to become $448,000,000,000 more valuable in the eyes of the investing public.  Were this to be the case, assuming only Australians owned the ASX200 companies (this is obviously not the case), then on average, every man, woman & child in Australia would become $19,843.68 wealthier.

 

At the moment, there are 404 stocks we generate quantitative valuations for; this is from a field of over 2200 ASX listed stocks.  We do an in-depth valuation of the market twice a year, just after the release of half-year and full-year earnings.  The valuation process takes Dave and I nearly 2 months to work through and it is from this ‘quantitative analysis’ we derive a list of companies we then do our research on.  When we completed our most recent iteration of the valuation, I found some things of interest I thought I might share with you this week.

 

Firstly, it is my view that the market is trading on the cheap side of historic averages, P/E ratios and forward P/E ratios indicate this, but I believe it can be demonstrated in a number of other ways.  The quantum (of the undervaluation) in my view is somewhere in the range of 10 – 20%; now if the market falls, don’t point the finger at me, it very rarely behaves in a perfectly sensible manner, often over-reacting in the short/medium term to factors which ultimately have only moderate long-term effects.  What I find most interesting is that based on my view of the undervaluation of the market, of the 404 stocks we valued, I find only 160 I expect to outperform the market and 244 that fall below my expectation of the broader markets performance.  Given this statistic, the valuations would seem to contradict my summation the market is undervalued.  This is not the case; the reason in my experience is that slightly more than half of companies usually fall within a price-range where my performance expectation is within about 2.5% of the broader market when followed for a 10 year period, that is to say the market is usually priced approximately right for the majority of stocks.  Now basically, to come up with an assessment of undervaluation, I strip these out (those close to the mean), of the remaining companies, I expect those that outperform will sufficiently outperform that they will cover the underperformance of the others and leave the broader market in an out-performance situation.  As I have stated, something in the order of 1 – 2% p.a. over the next 10 years.  You may remind me in April 10^th 2021 (but not before), and I will review the performance of my forecast. Talk next week – Tony Hansen 10/04/2011