Peter Morgan - The Transcript and Audiotape

Michael Pascoe (MP): A bit of a scary time at the moment with the markets. What do you think’s happening?
Peter Morgan (PM): Oh I think you’ve got to put it in the context of what the market’s have done over the last 18 months or two years Michael. I mean if you go back to September 2003 the market hasn’t had a losing quarter since then and at the end of September it was up 80% since that starting point and I think if you look just at the month of September the market was up 5%. We’ve been in a very strong, bullish market based a lot around liquidity in the last few months and I think.. it was overdue for a breather but I think you’re also finding that with some uncertainty with regards to oil prices and the performance of the US market particularly you’re starting to see some rationality come back in the marketplace.

MP: Overdue for a breather? Is that all it is?

PM: Well it’s potentially more than that if.. the thing that scares me and us at 452 Capital is the amount of liquidity that’s gone into the system. Interest rates have been low for a long period of time. Interest states are starting to edge up globally and the cost of money is going up so liquidity is tightening. The sophistication of products in the marketplace, in the world, and even in Australia has been incredible. A lot of products today are being sold based upon yield but yield may not be there when times start getting tough. I think it’s going to be an interesting time going forward.

MP: Perhaps the easiest window into your investment thinking at the moment is Century Australia the listed investment company which you are the investment manager of, it’s about 16% in cash.

PM: Yes, we’ve been quite cautious. Century’s been going since.. for 18 months approximately now. For most of that time we’ve carried between 15 and 20 percent cash which is quite large for an investment vehicle and the problem we’ve had is we’ve had a lot of trouble trying to rationalise some of the valuations in the marketplace so we’ve taken a cautious approach. Up until the end of September we’ve been wrong but going forward, we’re still cautious and happy to be cautious.

MP: It sounds like you think this corrections’ got'¦

PM: '¦well the other thing, I mean you’ve had four or five years of very bullish conditions here in Australia if you look at it in those terms and I think there’s a lot of people in the marketplace, there’s a lot of investors in the marketplace that haven’t gone through tough times and I think..supplemental to that the valuations in Australia are not cheap and I’d suggest are actually high. You often get quoted in the press that the Australian P/E ratio or P/E ration of the Australian market is 15½ times and everyone says well that’s too far different to what it was 5 years ago. The problem you’ve got in Australia is the heavy skew towards financial companies and resource companies. Now if you go back 5 years ago the banks still had some room to move with regards to bad debts. ie bad debts could go lower and costs could go lower and the revenue streams were quite robust. Today the situation is almost reversed. Bad debts can’t go too much lower. The costs are well down on where they were five years ago and the profitability of banks have never been better. Again on the other side the resource sector is enjoying a commodity boom. Commodity prices have never been higher so what I’m saying, what I’m trying to get across to investors is just be a little bit careful of the comparison in terms of evaluation if the overall market today was five years ago because Australia is a very cyclical market. We are at a cyclical high point.

MP: You still do find value though?

PM: At the margin we are finding value but it’s still not that compelling. We’re happy.. we’re happy to be patient. And I think if one thing’s been shown in the last month, the market will bounce at some point but again, if there’s one thing been shown in the last month is that there is a lot of volatility around and when the panic does start, you do start seeing opportunities thrown at you. And I hope it goes on for a little bit longer in terms of enjoying the hunt for value.

MP: You’re seeing any at the moment? Any opportunities?

PM: Oh look, I mean, we’ve built up a few positions. Insurance Group of Australia we’ve taken a position in and are happy to hold that on a longer term basis and we’re looking quite closely at some of the bigger corporates that are being thrown out with some of the rest but.. but it’s being patient. I mean I don’t think this is any time to rush.

MP: There’s an argument of course that there are very good reasons for the resources stocks to be high. That this boom could be going on for quite a while.

PM: Well it could go on but I think the optimism.. I mean, the pricing of a security or the pricing of anything its often got a lot built into it and I think.. and a lot of the optimism with regards to resources has been built in. I mean the revenue line is very well focused upon. Every day the copper price or the gold price goes up, resource companies react to it. There’s very little focus on the cost line and you know, if you go back to the early 1980s resource companies represented 40% of this market. From that point onwards almost it was a downward trend and I think you know, commodity companies go through cycles. Now again China and India have been powerhouses, they are power houses but let’s not forget things aren’t perfect forever and I think caution, when prices have done what they have done with resource companies, it’s perhaps warranted.

MP: You mentioned Century LIC, it was one of a rash of them that floated when LICs were at a premium. Now they’re at a fairly deep discount and remaining so.

PM: Well I think.. you know, I think the sector overall is interesting in terms of value. I mean if you look at Century, you know, we’re trading at approximately a 15% discount to net tangible asset backings. When we came to the market and another came to the market, we were trading at parity or a bit of a premium. I think if you compare listed investment companies with the mutual fund industry you don’t.. you obviously don’t get a discount when you go into a mutual fund and you are with Century.. I’m not trying to promote the stock, I’m just saying it’s at a reasonable discount with a reasonable cash weighting in the portfolio.

MP: There’s an opportunity there. How often.. not just Century but how often do you get to buy something at a 10 – 15 percent discount.

PM: You know, I mean, we are in a.. Century will to some extent reflect what happens in the sharemarket but it has got conservative characteristics to it. I think that the sector as a whole is interesting from a valuation point of view in a market that is.. is at a high point. So I mean, it’s [ ] but I’m not trying to promote the stock. I mean I think it’s there and at the end of the day the stock price will look after itself.

MP: Is that a sector though that has some arbitrage, [ ] funds that should be taken out or should be wound up.

PM: Well like a number of companies in the listed sector, Century does have a management agreement in place. Ours is not as perhaps as tough as others but it is one area that needs to be overcome if the group was to be wound up or the like.

MP: So not as greedy as Macquarie Bank but along those lines.

PM: Oh not necessarily. I mean if you look at Century the management fee that we’re charging is 1%. I mean that compares favourably with other listed investment companies. We do have to perform to get the management fee, ie we’ve got to beat the market by 3%. We haven’t done that. We’re a fair way behind on the last 15 months. At the end of the day I think value will be reflected but the market will set that value.

MP: Do you look at any of the other'¦

PM: Yeah, we’ve got a position in Premium Investors which is traded at between a 10 and 15 percent discount and again, they’ve got a very conservative style. And we’re happy to trawl the market for those opportunities.

MP: Instruct me about how you’re doing your investing. It’s just the basics of what you look for in a stock. How you make the decision of what’s value and what’s not.

PM: Well if I go back a step Michael, I was very luck that I came into this industry in the early 1990s having worked for a stockbroker towards the end of 87/88 and the learning curve that I had with Perpetual was based around the problems of the 1980s. And one thing that was taught very early on that you want to invest in companies for the longer term that have got sound balance sheets. The companies that you understand have got sound management. And over the next 10 years I lived and I worked through the dot com bubble and we avoided at Perpetual a lot of the dot com companies that made no profits. Well I think we’re actually entering a period now where that debt test, but focussing on companies that are conservatively geared that aren’t engineering their balance sheets by excessive gearing and drawing on borrowings to pay dividends will stand us in good stead and stand our investors in good stead as times get tougher. As I said at the start I think liquidity is tightening and I think there’s been a lot of sophistication at the margin where investors are being sold short term yields that perhaps won’t be there in the longer term. I mean with a lot of infrastructure assets you’re seeing incredibly strange things being done. You’re seeing'¦

MP: For example'¦

PM: ..well you’re seeing returns being paid to investors out of revaluations. Implicit in the Corporations Code in one section for a listed company is a fact that a company cannot pay dividends if it doesn’t have profits or it doesn’t have retained profits. We’ve had a whole sector develop here in Australia based around stapling of securities and the like when you look at the underlying assets, the assets themselves are not generating a profit yet distributions are being paid and the leverage that has put into some of these vehicles is quite incredible. Look if Michael it all might be plain sailing for a long period of time but at some stage there will be creativity that goes too far and the bubble will burst. I honestly believe there’s a bubble developing at that end of that market, that infrastructure or that creative end of the market.

MP: Developing, already there.

PM: Personally I think it’s there but that’s for others to make their judgment. I just think it’s time for buyer to be beware with products being sold just upon yield where there is some creativity going into asset revaluations and the actual structure of the vehicles that are being created.

MP: That’s what you don’t like. Can you give me some examples of what you do like.

PM: Well we’re encouraged by what’s going on at Telstra. We continue to build our position in Telstra. When I say that, I think for the first time in a long time that management is showing some signs of having a bit of backbone and is prepared to fight for shareholders rather than for the other interested parties that are out there. I mentioned the Insurance Company of Australia, we built on a position there. And there are hopefully going to be some opportunities at the smaller end of the market when liquidity starts playing its part at that end of the market. Small caps do have some liquidity constraints and I think as times get tougher over the next 3 or 4 months in the industry as a whole I think opportunities will present themselves.

MP: What is about IAG that appeals to you.

PM: Well I think number one it’s a company that’s.. it’s an insurance company that’s very well capitalized. It’s got excess capital on balance sheet. You’ve got a good management team in place, the valuation on a through the cycle earnings profile for us is around about 12½ times earnings. The yield is about 5½ percent. Management is committed to growing that and it’s prudently.. looking offshore, and it is risky to go offshore for value adding acquisitions and I think that the company at the current price is perhaps a little bit overdone.

MP: I’ve seen you express regret over Newcorp.

PM: Yeah. Well I think you get caught up in things and you make mistakes and I think it’s been disappointing. The introduction of the poison pill has been disappointing. It wasn’t really discussed at the time it was being done. Softly I can see some of the rationale for the Murdoch family or Rupert himself being a little bit worried about John being on the register and the potential of getting control but at the end of the day companies have to sort that out and they have to sort that out properly and all shareholders should be treated.. I think equally. And I think.. A lot of fund managers here in Australia should have gone a lot harder when the delisting was taking place.

MP: Did you consider taking part in the action against the board and the directors?

PM: Well it’s a funny thing, as a shareholder we weren’t actually asked and I’m not sure you know, whether that’s necessarily appropriate. I’m not 100% convinced on. At the end of the day you’ve got a right as a shareholder to vote and do that sort of thing and fight that way and that’s the way I’ve always done it. I’m not a big believer in seeing people full stop. I never have been. I’m happy to fight a fair fight and I stress the word fair.

MP: Newscorp sells at a discount in its sector.

PM: A very big discount to Australia too when you look at the media companies.

MP: And that’s a reflection of dissatisfaction with Rupert?

PM: Well I think it’s partly that at the moment. It’s partly a reflection of the fact that global investors are a little bit unsure as to what’s going on in a corporate governance sense at the organization but I also thing it’s also a factor that it’s a bigger pot out there now. It’s not the localized Australian market where you’ve got 20 or 30 analysts following it. It’s a bit part of this index. I think the company to its credit has gone into a tougher playing field and it’s a matter of getting credibility among.. we’re [ ] now, not just this Australian marketplace where it was dominated particularly by its size in the index.

MP: There’s not some weariness with just non-delivery for so many years?

PM: Look I mean I think we’ve all been around long enough that at the end of the day of the company’s fundamentals stack up we can draw our conclusions on that with News Corporation. If they do stack up valuation will be realized, as long as it’s not destroyed. If the underlying fundamental valuation is there, and shareholder value is there, and as long as it’s not destroyed over time it will play itself out but obviously the critical factor there is the maintenance of shareholder value.

MP: You’re [finding 452 Capital Fund].

PM: Oh the first year is incredibly enjoyable. When you’re under performing like we have and you go through a bull market like we have, I mean it gets tough. I enjoy it. I still enjoy it. I’ll never ever regret doing what I did and having a go at it. I think if I didn’t do it I’d be still thinking about why I haven’t had a go at doing it myself given that there’s not too many industries, particularly here in Australia where you can set yourself up in a industry that is growing but it’s a performance industry. I mean it’s like.. I’ve always said it’s like a sport. You’re only going to be playing as long as you perform over the medium and longer term.

MP: And where does 452 evolve.

PM: Well I mean it’s a great little business now. We’re having despite the under performance we’re having a lot of fun. The people here are now mature as a group and we have a lot of fun. I still enjoy it. A little group of people around me. It’s a small.. it’s not bureaucratic. We’ve got a relationship with Commonwealth Bank that you think back and you hear all the negativity with regards to big brothers and that sort of thing. I mean, they haven’t interfered yet. We had a relationship from the day we started in terms of distribution and I think personally as time goes on, particularly with regards to things like compliance and if we do go into tough times that relationship will be [ ] because we can tap Commonwealth Bank or Colonial on the shoulder and say are we best practise and we do that constantly with regards to compliance and is this what you’re doing and that sort of thing. But there’s a lot of small.. small boutiques out there that I don’t think you know, have got that business relationship that I think will be very important going forward and it is a business relationship. It’s not.. the staff and myself still control this company.

MP: You mentioned tough times again. And that conservatism of your stance, do you put odds on it, that things do get significant when you [have it].

PM: Let me just preface it by saying I’m a pessimist at heart so I suppose I wake up in the morning wondering if it’s too sunny, is it going to rain. But.. and having also adding to that I think in terms of a fiscal sense, Australia is in a very good position. I think that companies generally speaking, the listed corporations generally speaking, not the sophisticated investments that have been created recently, are in very good shape. Their balance sheets are strong and the like. But having said that, I still have in the back of my mind that it has been very easy to get credit and it’s been very easy to get liquidity. Interest rates have never been lower. Unemployment is very low here in Australia which is a great.. which is a good thing but things going through cycles, the good times don’t always last and I’ve also got the fact that valuations are a lot higher today than they were previously in the overall market. Added to that, I think you’ve got a generation of investors that have not been through difficult times and I came in late to the 1980s but I see so much going on in this market up to September that it’s not too far removed from the 1980s. If you look at the entrepreneurs of the 1980s, before they ran into tough times and some of them turned into crooks, they had two things at their base. They were deal makers and they were using debt. Now I don’t think that’s a lot different in some areas to what’s going on today. There’s a lot of deals being done. There’s a lot of gearing being done. And at the end of the day and I don’t know where it is, that music stops and the tough times come. I think you know, when you’ve had a market that’s been so strong for so long and I’ve been wrong for the last year, but I’m just cautious I suppose is what I’m saying and I’m happy to be cautious.

MP: Maybe it’s not just investors. It’s also a generation of managers who’ve not been managing something during a genuine [down ]

PM: Well that’s who I’m referring to as well. The fund managers as well. I mean as I said, I’ll be the first to say I was there late in 1987 late. I wasn’t there in the build up to it but I will never ever forget that learning experience that I had at Perpetual and we went back and looked at what we had in a portfolio and why we survived 1987. It was based around a sound balance sheet, a sound management team and companies that.. that I could walk into and guys like Anton and others that had been so successful he could walk into and understand and as I said, things do go through cycles.

ENDS