Manager Insights - Allan Gray
by Allan Gray
In late 2013 and after much research, Financial Keys introduced contrarian investment manager, Allan Gray into its stable of approved investments. By way of background, typically a contrarian investor is one who attempts to profit by investing in a manner that differs from conventional wisdom, when the consensus opinion appears to be wrong.
Financial Keys recently caught up with the investment managers of Allan Gray and asked for their current view on the markets. Please take the time to read their current thoughts below.
Investors can make a big difference to their wealth by making (or avoiding) investments at price extremes. Anyone that has the foresight or luck to invest at lows in a share price can enjoy impressive subsequent returns. On the other hand, getting drawn into speculative markets and then panicking in the subsequent collapse can destroy comfortable retirement for even a prudent saver.
Investors often rely on past return data to guide their decision making. But even looking at returns over five or ten years can get them into trouble. The following graph shows the Australian sharemarket price index (adjusted for inflation) since 1970. It also shows some fundamental measures of value – earnings, dividends, and net asset values for the overall market.
The best opportunities to invest were the mid-1970s, 1982 and (to a lesser extent) in 2009. At the same time it was really unwise to commit more capital to shares in 1969, 1987 and 2007.
Source: Allan Gray
The best time to invest was in 1974. Over the next five and 10 years, investors experienced annualised returns of 27% and 20% respectively. But in 1974 the historic returns for an investment in shares looked terrible.
Table 1 – Historic sharemarket returns in 1974
|Length of Time||Annualised Returns 1974|
Source: Allan Gray
It would have been a hard sell for an adviser to recommend an asset that lost 13% per annum over the past five years. At the same time inflation was running at 15% per annum.
The popular press was no better. Very few investment writers were advocating an investment in shares and those that did were probably out of a job by then.
Contrast this with the conditions in 2007. Any period you liked to look at showed glowing returns – even if you looked back 20 years. Almost no-one had lost money in the market over the past two decades.
Table 2 – Historic sharemarket returns in 2007
|Length of Time||Annualised Returns 2007|
Source: Allan Gray
Investor sentiment was generally bullish with record flows into equity funds. Yet, as we know now with hindsight, it was a really risky time to enter the sharemarket with falls of over 50% just around the corner.
Historic returns, even for 10 years or more, are no guide to the future. In fact, they are often very poor indicators, advocating more investment near major market tops and actively scaring investors away from generational opportunities.
Given this historic perspective, it does make sense to ask where the really depressed investment area in Australia (or the world) currently is. The sad truth for investors is that there is really very little that is very low by historic comparison. Both bond and equity markets around the world have generally been kind to investors recently. Even the local property market has joined the ‘fun’.
The best we can do is to look for investments that look less extended than most.
One such example that we currently hold is Newcrest Mining, Australia’s largest gold mining company. It has many of the characteristics of an investment we find interesting – the share price has fallen significantly from its peak over three years ago, it is widely disliked by the investment community, and is facing challenges. Yet at the same time it owns some of the best (long life and low cost) gold mining assets in the world.
The typical way in which most stock brokers analyse Newcrest is by building very detailed models of each of Newcrest’s five mines predicting gold and by-product production levels, operating costs, capital spending requirements and overheads. Models are usually in the form of huge spreadsheets with hundreds of lines of code on multiple sheets. The gold price and currency exchange rate forecasts are obtained from their group economist. The method appears to be very scientific and thorough with the minutest of details of each mine being incorporated. It involves many hours of analysis, management interviews and model building. But the end result is a castle built on sand. The most dramatic change in Newcrest’s modelled value is not from variances in mined output or operating cost assumptions (the source of all the painstaking detail) but rather from small changes in the gold price assumptions. Yet, forecasting the behaviour of the gold price with any accuracy is near impossible and certainly far more difficult than the individual gold mine analysis. We think it is doubtful that anyone has had much luck in gold price forecasting, especially over any time period of a few years or less.
As it always should, the real proof lies in the output of these models. Three years ago when Newcrest was flying high and the shares were trading at over A$40/share, it was one of the most liked shares on the Australian sharemarket with ‘price targets’ well in excess of A$50. Yet a few months ago when you could buy the same assets for a quarter of the price, it was widely vilified with price targets below A$7 share price. The graph below shows Newcrest’s share price (red line) and the average analysts recommendation (grey line), essentially whether they thought the share was worth more or less than the prevailing share price.
Graph 2 – Newcrest share price and analyst sentiment
These are largely the same pool of analysts with the same models. The only significant change has been in the gold price expectations fed into the Newcrest models. Today, gold analysts are far less optimistic than they were three years ago when gold prices were universally expected to increase into perpetuity.
We try and avoid making short term gold price or currency forecasts. This may seem counterintuitive given that even we would acknowledge that the gold price plays a dominant role in the company’s fortunes. Our investment case for Newcrest doesn’t rely on hard-to-forecast variables and instead focusses on the following observations:
Gold will continue to be a sought after commodity. Gold has a longer history than almost anything else. Its allure dates back to ancient civilisations and its association with wealth is common to many cultures throughout the world and has been for many centuries. It is unlikely that a 5,000 year plus trend will change in our lifetime.
Newcrest is an efficient producer of gold. Newcrest is in the bottom half of industry cost curves and fares well relative to other large gold mining companies (refer graph 3).
Newcrest’s position on the cost curve is likely to improve in the coming years. Newcrest’s large mines are almost fully developed and have very long lives. In contrast, a lot of the gold industry faces falling grades and short lives. Also, Australia has faced significant mining wage pressure (especially when converted into US$) over the past five years. There is ample sign that this pressure is moderating as the mining boom wanes.
There have been very few major new discoveries of significant gold deposits in the last decade. One of the biggest is Wafi-Golpu in Papua New Guinea. Newcrest owns half of this deposit.
Graph 3 – All-in cash costs 4Q13
Source: CLSA, Newcrest Mining Report, March 2014
With this background it is reasonable to assume that over time gold would be priced such that an efficient producer can make an economic return on the capital it has to invest. We expect Newcrest to produce about 2.5 million ounces of gold next year as well as about 100 thousand tonnes of copper. If we assume 1 tonne of copper is worth 5 ounces of gold (the long-term average ratio of the two), Newcrest effectively produces 3 million ounces of gold equivalents next year. We think this is sustainable and likely to grow in future years.
At around A$10/share for Newcrest, the Fund is buying a long-life and efficient producing portfolio of gold mines at what appears to be a reasonable discount to the cost of building the mines and infrastructure, let alone the costs of finding the deposits in the first place. At this price the Fund should hopefully be in a position to get an above economic return on its investment, attractive in a market trading at multi-year highs.
In the near term the share price of Newcrest will be dominated by gold price movements. As the last few years have shown, these can be quite volatile. At Allan Gray we have no ability to predict short term movements in the gold price and the resultant fluctuations in the Newcrest share price. The best we can do is to sell the share when a rise in the gold price results in the share starting to trade at replacement value or higher and to buy more for the Fund when a weak gold price leads to a larger gap between Newcrest’s price and its underlying value.
S&P/ASX 300 Accumulation Index
The source for the S&P/ASX 300 Accumulation Index is Standard & Poor’s. ASX 300 is the trademark of ASX Operations Pty Limited (ASXO); ‘S&P/ASX 300TM’ exists pursuant to an arrangement between ASXO and Standard & Poor's (S&PTM is a trademark of Standard & Poor's, a division of The McGraw-Hill Companies, Inc.).
Fund returns are gross of all income, net of all expenses and fees, assume reinvestment of distributions and exclude any spreads that might be payable on some transactions, i.e. on a ‘mid-to-mid’ basis.
Past performance is not indicative of future performance. Each Fund's unit price will fluctuate and each Fund's performance is not guaranteed. When making an investment in any Fund, an investor's capital is at risk.
US and European Persons
The Fund does not accept US persons as investors and is not marketed in the European Economic Union (EEA). Investors resident in the EEA can only invest in the Fund under certain circumstances as determined by, and in compliance with, applicable law.
Equity Trustees Limited AFSL No. 240975 is the issuer of units in the Allan Gray Australia Equity Fund and the Allan Gray Australia Opportunity Fund (together Funds). Allan Gray Australia Pty Limited AFSL 298487 is the Fund's Investment Manager. Each Fund's Product Disclosure Statement and Information Booklet, as applicable (together PDS), are available from www.allangray.com.au or by contacting Client Services on 1300 604 604 (within Australia) or +61 2 8224 8604 (outside Australia). You should consider the relevant Funds' PDS in deciding whether to acquire, or continue to hold, units in the Funds.
This report is not an offer to sell, or a solicitation to buy, units in any Fund. Where the report provides commentary on a particular security, it is done to demonstrate the reasons why we have or have not dealt in the particular security for a Fund. It is not intended to be, or should be construed as, financial product advice. This report is current as at its date of publication, is given in good faith and has been derived from sources believed to be reliable and accurate. It does not take into account your individual objectives, financial situation or needs. Any implied figures or estimates are subject to assumptions, risks and uncertainties. Actual figures may differ materially and you are cautioned not to place undue reliance on such information. Subject to applicable law, we do not provide any warranty of accuracy or reliability in relation to information in this report or accept liability to any person who relies on it. Fees are exclusive of GST.
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