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Q4 Portfolio Review

By Rob Marstrand on January 13, 2012

Each quarter we take a look at how the Family Wealth Portfolio is performing. This not only helps us get a better picture of the portfolio, it is also an opportunity to revisit the investment case for each of our legacy investments.

The current investment environment is highly volatile. But we remain focused on big picture trends and our long-term profit goals. Right now, our main priority is wealth preservation. That is to say we are concerned with the return of our wealth more than a return on our wealth.

For this reason we continue to recommend a high allocation to tangible assets outside the financial system. In last week’s review, I wrote about just one aspect that concerns me about the banking systems in Europe and the US: excess leverage.

But there are other causes for concern too. Such as the over-indebtedness of developed world governments. This is why we continue to recommend you park a high percentage of your family wealth in long-term safe havens such as gold and real estate.

Gold – A Core Allocation

Since we first opened our doors to non-family members in September 2009, we have recommended you hold 20% of your total wealth in gold. Gold has risen from $1,017/oz on September 18, 2009, to $1,561/oz on December 31, 2011 – a 54.5% increase.

All else being equal, if you followed this “beta” recommendation, this has added 10.7% to total wealth (measured in dollars) over 27 months. It also means that if you have not sold any of your gold, your allocation to the yellow metal has increased from 20% to nearly 28%.

If you have been holding a large allocation to gold for a long time, it’s time to review your allocation. If your gold allocation has risen above 25%, consider trimming your position and re-allocating to another asset class, such as real estate.

Last year, gold rose 10.7% (from $1,410/oz to $1,561/oz) – a more modest rise than we’ve seen in previous years. But the fundamental reasons for holding gold have not changed.

We expect more money printing in the developed economies (particularly in the US, Europe, Japan and Britain), along with more financial distress and more gold buying by emerging market central banks and consumers. Gold will remain a core long-term holding until this picture changes.

How Have Gold Miners Performed?

On October 21 we made an important change to our gold allocation. We recommended switching 3% from bullion and into gold miners by way of the Tocqueville Gold Fund (NASDAQ:TGLDX). (This leaves us with 17% of total assets in a mix of psyical gold, coins and gold-backed ETFs.)

We made this switch on advice from our strategic partner in the resource sector, Rick Rule. You can find the October 7 interview with Rick here.

Gold mining stocks started significantly underperforming bullion during April. In my June 23 review I argued that it was too early to make an investment in gold mining stocks. Gold mining stocks are affected by the gold price and by general stock market moves. I believed that the downside risk to stock markets was still too great at that time.

But world stock markets had fallen significantly by October (although not in the US). So we felt it was time to make a small switch into gold mining stocks, expecting a catch up to bullion in the medium term.

Since we made the switch on October 21, the Tocqueville Gold Fund is down 5.2% against a fall of 4.6% for gold bullion. If gold mining shares fall sharply lower, we may increase our allocation from 3% to 5%. Otherwise, we will stick with our allocations as they stand now.

Real Estate – Still a Safe Haven

The other long-term safe haven asset that we recommend is real estate. Our 35% asset allocation of real estate and private investments includes real estate, privately owned businesses and collectibles such as fine art.

Our biggest tactical asset allocation decision last year was to raise our allocation to real estate and private investments by 10% (from 25%). This reduced our assets held within financial system. You can read my original report here.

With a current 25% allocation to “home currency” cash, a 20% allocation to stock market investments and a 3% allocation to a gold mining fund, total assets held as paper money, cash deposits or financial securities make up 48% of total wealth. The remaining 52% is in tangible assets – in gold (preferably mainly held as physical bullion or coins) and in real estate and private investments.

Of course, if you hold most of your gold allocation in ETFs…even physically-backed ETFs such as the World Gold Council-sponsored SPDR Gold Trust ETF (NYSE:GLD)…the level of assets held truly outside the financial system decreases. How you hold your gold is up to you. But for maximum security and peace of mind, physically held gold (in bullion or coins) is best.

Cash – A Prescient Move

“Home currency” cash has made up a substantial portion of the Family Wealth Portfolio since 2009.

When I joined Bonner & Partners in October 2010 the recommended cash allocation was 30% of total wealth. But last February we recommended you increase your cash allocation to 35%. We did this by selling our “beta” play on the emerging markets, the Vanguard Emerging Markets ETF (NYSE:VWO), which at the time made up 5% of total assets.

We made this recommendation because we believed that emerging stock markets were richly priced in the face of a weakening economic picture and that the risk was to the downside. Chris also spotted a worrying “double top” formation in VWO (reprinted below).

This proved prescient. Since February 11, when we sold out of VWO, this ETF is down -12%.

Should we have further decreased our stock market allocation at the time? Perhaps. But we need to balance our investment outlook with the need to stay diversified at all times.

This is why, however much we like gold as a store of wealth, we restrict ourselves to a 20% recommended allocation (adding together bullion and gold mining stocks). Likewise, however much we see short-term downside risk in stocks, we must always keep in mind that we could be wrong.

Sentiment changes quickly. The fund managers who dumped emerging market stocks in 2011 can just as quickly start piling back in this year. Besides, I am comfortable that our legacy stocks were bought well below fair values. In the long run, this means they should deliver excellent profits.

How Has the Portfolio Performed?

These quarterly performance reviews measure the part of the Family Wealth Portfolio that we can track. This includes our allocations to gold, cash and stock market investments, but excludes our allocation to real estate and private investments. It takes account of price moves, dividends and interest in the financial portfolio.

Excluding the 35% allocated to real estate and private investments means the financial portfolio is only 65% of the total family wealth portfolio. This means the weightings are different when looking at the financial portfolio alone. Below is a table which shows the adjusted weightings.

You can see that the 25% allocation to cash in the Family Wealth Portfolio equates to 38.5% in the financial portfolio. And our gold and stock market investment allocations – each 20% of total wealth – increase to 30.8% a piece.

We track the Family Wealth Portfolio against a “typical” portfolio. This consists of 10% cash; 45% stocks, represented by the S&P 500); and 45% bonds, represented by the iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT). The average maturity of bonds held by TLT is just over 28 years.

The S&P 500 and long-dated Treasurys have had a strong run since I started tracking our performance in October 2010.

The S&P 500 rallied during the last quarter of 2010. But it was about flat for 2011. Including dividends, I estimate the pre-tax return was 13.2% over the past 15 months.

TLT fell until February 2011, recovered a little up to late July and then took off like a rocket during August and September. It had a more choppy performance during the last quarter of 2011.

Including coupons, I estimate total pre-tax return at 19.2% over 15 months. (This drops to around 9.7%, if the bond allocation was spread evenly across all maturities, and not just in the long bonds.)

I have assumed that cash balances return 1% a year. Put this together and our benchmark has returned an estimated 14.7% over 15 months. Over the same period our portfolio of  of cash, gold and (mainly emerging market) stocks has fallen 1.5%.

This is disappointing in the short run. But it is important to keep in mind that the Family Wealth Portfolio is designed to protect and grow wealth over the ultra long term. That means we must therefore resist the temptation to chase short-term price moves, like the big surge in Treasurys we saw last year.

We have a diversified portfolio of cash, gold, gold mining stocks, value stocks in growth markets and, of course, real estate. And it has kept losses to a minimum, despite extreme levels of market volatility – an important achievement.

I continue to believe we are well positioned for success over the long run. I also believe the benchmark portfolio is unlikely to continue its strong run for much longer.

That said, we must give ourselves a “Grade B-” for performance here. We have protected wealth against an uncertain economic and financial backdrop. But our aim is to beat the benchmark, not lag behind it.

A Look at Our Stock Recommendations

Now on to our individual legacy recommendations. As it stands, our legacy stock market investments have an average 74% upside to their (conservatively estimated) fair values. They also have an average dividend yield of 4.9%.

This excludes Chaoda Modern Agriculture (Holdings) Ltd. (HK:682) / (PINK:CMGHF), which is currently delisted in Hong Kong pending further investigations of the fraud allegations made against it (see below).

Sterlite Industries India Ltd. (NYSE:SLT)

Sterlite’s main source of profit is zinc mining and smelting in India. This stock has been in the Family Wealth Portfolio since October 2009. But it has been a disappointment so far, despite fast-growing profits.

There has been a good deal of concern recently about the outlook for industrial metals prices in the face of a weakening global economy. But zinc is essential for construction and transport – two areas that India is likely to spend a great deal of money on in the future.

The price at recommendation was $17.55 against $6.93 at the end of 2011. That’s a net loss is 59%. (The price fall has been slightly offset by dividends.)

My latest estimate of fair value for this stock is $13.59. This is 96% above the current level. This is based on a target P/E ratio of 11.2.

Given this upside to fair value, Sterlite is a “hold” for now.

Altria Group Inc. (NYSE:MO)

Altria sells cigarettes in the US market, most famously under the Marlboro brand. Since we recommended this stock in June 2010, the total gain has been 59.8%, including 11.7% of dividends.

There are better growth stories in the tobacco sector. But Altria is a solid company with a 5.5% dividend yield.

On a P/E of 17.1, I estimate this stock is fairly priced…or even slightly over-valued. But tobacco is a stable business that throws off plenty of cash. So we are keeping Altria in the portfolio until we can find an alternative value play in the sector.

Altria remains a “hold” for now.

Suntec Real Estate Investment Trust (SIN:T82U) / (PINK:SURVF)

Suntec owns high quality office space and retail malls in the developed economy of Singapore.

The company’s market capitalization is roughly S$2.5 billion (US$1.9 billion). It also has a dividend yield of over 9%. This makes it a high quality yield play. There is also the potential for currency gains if the Singapore dollar strengthens in future.

In late October, Suntec announced it had plans to refurbish its flagship Suntec City development in the heart of Singapore’s financial district. This will involve an investment of S$410 million (US$317 million). Work will start in mid-2012 and is scheduled for completion in mid-2015.

Suntec’s stock price has fallen 28% since late July. But since we added it to the Family Wealth Portfolio in August 2010, Suntec has paid out 9.5% in dividends in US dollar terms. Due to the recent price weakness the total return has been a loss of 9.4%.

I fully expect this stock to recover its recent losses. Suntec trades at a steep discount to book value. The price-to-book (P/B) ratio is just 0.6. If P/B rises to 0.95 – still a modest discount to liquidation value – the upside is 57.7%. In the meantime, Suntec continues to pay high dividends.

Suntec remains a long term “buy” recommendation.

Chaoda Modern Agriculture (Holdings) Ltd. (HK:682)/(PINK:CMGHF)

Chaoda is a leading producer of vegetables in mainland China. The stock has been listed in Hong Kong for 11 years.

But a group called Anonymous Analytics – an offshoot of the Anonymous computer hacker collective – accused the company of fraud in September. This occurred shortly after the stock had been suspended from trading in Hong Kong due to alleged market misconduct on the part of the Chairman.

The company is currently investigating these allegations. But so far, it has failed to produce financial reports for the year ended June 30, 2011. Communication from the management of the company has been poor. And we find the situation to be frustrating in the extreme.

But as I said in my recent special update, we are essentially stuck in a holding pattern here. Either Chaoda is a fraud and we are forced to take a loss. Or it isn’t and this is a case of extreme discounted value.

My initial assessment was that the fraud allegations were probably false. But the longer we have to wait for financial results to be produced, the more suspicious I become. You can read more about Chaoda here:

The stock was suspended at a price of HK$1.1 versus my estimated EPS of HK$1.46. This means the P/E ratio would be 0.75.

At a fair value P/E of 8, the price would be HK$11.68 – a gain of 962%. We’ll just have to be patient and see how this situation evolves.

Chaoda is a “hold” for now.

Lippo Malls Indonesia Retail Trust (SIN:D5IU) / (PINK:LPDMF)

LMIRT owns retail malls in Indonesia and is our “back door” into this booming emerging market (often referred to as the “fifth BRIC”).

Recently the company raised new capital by way of a rights issue. The company has used the cash it raised to buy new properties. Full details can be found in my reports of October 28 and November 18:

As with all discounted rights issues – where new shares are issued at a lower price than the market – the stock price has fallen. But as I have explained in detail in my earlier reports, this doesn’t result in a loss to shareholders.

You can either buy the new stock issue at an even cheaper price and get an instant gain, or you can sell the rights to buy the new stock (the “nil-paid rights”) for an equivalent amount of cash.

Like Suntec, LMIRT looks dirt-cheap right now. It’s on a P/B of 0.61. If that rises to 0.95 – a small discount to book value – then the share price would rise 56.1%. Add the estimated 10.1% dividend yield and LMIRT remains an attractive long-term holding.

LMIRT is a “buy” recommendation.

Vietnam Opportunity Fund (LON:VOF)/(PINK:VCVOF)

VOF invests in listed stocks, private equity and real estate in Vietnam. Although it is a single stock, it can be thought of as a country fund. Over time the emphasis appears to be shifting towards more listed stock and less private equity.

We recommended VOF in November 2010 at a price of $1.86. The initial performance was strong. But large devaluation of the local currency, the dong, in early 2011 and a general sell-off in emerging market equities during the year pushed this stock down. Also, Vietnamese inflation has been running at a rate of about 18% for the past year.

Since we added VOF to the Family Wealth Portfolio, it has fallen 31.6% to $1.27. This is comparable to the fall in the MSCI Vietnam, which was down 31.2% over the same period.

But Vietnam continues to undercut China for wage costs. And the discrepancy is set to increase, as China shifts further towards encouraging domestic consumer demand.

VOF’s book value per share (BVPS) is $2.23. This is the net asset value (book value) of the company divided by all the shares. At the 2011 year-end price of $1.27, this puts VOF on a P/B of 0.57. This means there is 76% upside to fair value.

Meanwhile, the Vietnamese stock market remains on a relatively low P/E of 8.4 times last year’s earnings, despite fast growing profits.

VOF does not pay dividends. But the company started a share buyback program in November, aimed at reducing the price discount to BVPS. The total book value of VOF was $719 million at the end of November.

VOF is a long term play on Vietnamese growth and remains a “buy”.

Petroleo Brasileiro preferred stock (NYSE:PBR-A)

Petrobras is a state-owned Brazilian oil major that is in the process of developing its offshore oil reserves.

The company has a market capitalization of $179 billion. This compares to shareholders’ equity (also known as net assets or book value) of $174 billion at the end of September.

As one of the largest stocks in the Brazilian market, the price is influenced in the short term by flows into and out of Brazilian country funds. So despite a strong oil price during 2011, its share price has fallen, as portfolio managers have moved out of emerging market stocks.

Petrobras announced third-quarter results on November 11. For the nine-month period, operating income was up 20%, net income was up 28% and cash flow from operating activities was up 50% (measured in US dollars). But EPS fell 13% from $3.02 to $2.62.

As I explained in the previous quarterly performance update, Petrobras issued a massive $70 billion share offering in September 2010. Because there are now many more shares the profits are split many more ways.

This has caused EPS to fall year-on-year. But as Petrobras continues to invest the proceeds in new production, earnings should grow over time.

Based on nine-month earnings, annualized EPS is $3.49. This means Petrobras prefs were trading on a P/E of just 6.7 at the end of 2011.

My fair value estimate is for a P/E of 12 (a slight premium to other oil majors). This indicates a price of $41.92 – 80% above the year-end price of $23.31.

Also, Petrobras has an attractive dividend yield of about 4.5%, based on payouts over the last 12 months. These are likely to grow in future.

Petrobras preferred stock is a “buy.”

Gazprom OAO (PINK:OGZPY)

Gazprom is the dominant Russian gas producer in a country with about one quarter of total global gas reserves.

Russia is strategically located between Europe and Asia (in particular, China). This should ensure a ready market for gas delivered via pipeline in future. Pipeline gas is much cheaper to deliver than liquid natural gas, which tends to be shipped across oceans in tankers.

Gazprom’s main markets are currently Russia, former Soviet Union countries (FSU) and Europe. But shipments to China are set to increase in future.

Gazprom released results for the six months to June 30, 2011, on November 9. Measured in Russian roubles (RUB), sales were up 37%, operating profit was up 47% and net profit rose 55%. This result was mainly driven by increased sales volumes and prices across all major markets.

Meanwhile, the rouble strengthened 11% against the dollar between June 30, 2010, and June 30, 2011. So operating profit was up 63% year on year in dollar terms (147% times 111% = 163%).

In Russia, gas sales volumes rose a modest 2.3%. But rouble prices rose 13%. This rise in the price of gas was part of my investment case for Gazprom. The Russian government has been allowing deregulation of domestic gas prices.

In Europe sales volumes grew 13.5%. And prices increased 25.8% measured in US dollars. In FSU countries volumes were up 48% year on year. And average dollar sales prices rose 17%.

Capital expenditure also increased 25% for the six-month period to RUB469 billion ($16.7 billion).

Based on first-half earnings, Gazprom traded on a P/E of 2.2 at the end of 2011. And it’s on a P/B of just 0.49. This is clearly extremely cheap on both measures.

The dividend yield is 2.3% at this level. Dividend payouts are still low in relation to profits. But Gazprom has indicated its intention to increase dividends in future. This could provide a catalyst for an upwards re-rating of the stock.

I estimate fair value using a P/E ratio of 8 and a P/B ratio of 1.5 and take the average of the two. These are consistent with annual profit growth of just 10% and the high return on equity of 15%. I then discount my fair value estimate by 20% due to perceived Russia risk. In other words, this is a conservative estimate.

This gives me a fair value of $35.49 for the stock – 232% above the December 31 price of $10.68.

Gazprom is a “buy.”

AFP Provida (NYSE:PVD)

In Chile, pension saving is compulsory. And Provida has the largest market share in Chile in the business of pension administration. The company charges an average 1.54% fee on the monthly pension contributions of over 30% of their Chilean salary base.

Provida’s pension funds fell in value during the most recent quarter when measured in dollars. This was due to falling stock markets and also the falling value of the Chilean peso (which lost 10.5% between September 2 and September 30, as global investors de-risked). This meant the size of pension funds fell from $45.0 billion to $38.8 billion.

Headline net profit for the nine months to September 30 was down 23.6%. But this was almost all due to unrealized losses on the mandatory investments that Provida must make in its own pension funds and an increase of the Chilean corporate tax rate from 17% to 20%.

But I calculate that the much more important core cash earnings (which exclude the unrealized gains or losses on mandatory investments, goodwill amortization and certain other extraordinary items) were up 11% – even after charging the higher tax rate. (The recent losses on mandatory investments are likely to reverse when financial markets recover. So this non-cash effect is only temporary.)

Fee income on pension contributions was up 8.6% year on year, whereas costs were up a much lower 3%. Costs excluding goodwill were 43.2% of fee income and remain well controlled.

At the year-end share price of $65.42, Provida traded on a P/E of 10.5 and a P/B of 2.6. Using a target P/E of 15.3 and P/B of 4.1, and taking the average, I estimate the fair value to be $99.57. This represents 52% upside from current price levels.

This upside will increase, if the Chilean peso rebounds against the dollar in future. Eventually, I expect this to happen due to the strong state of Chilean government finances and the poor state of US government finances.

Currently, Provida has an estimated dividend yield of 7.1%. This is highly attractive in a world where the 10-year Treasury note yields less than 2%. Dollar equivalent dividends will also increase if the peso strengthens again.

Provida remains a “buy.”

Hess Corporation (NYSE:HES)

Hess is an oil and gas producer headquartered in the US. But much of its production comes from the emerging markets. Hess is an “old friend” that we added back in to the portfolio in August after the stock price took a slide.

Hess reported third-quarter results on October 26. Production volumes were disappointing. This was partly due to disruption of operations based in Libya. With annualized EPS of $7.2 (based on results for the first nine months) the stock traded on a P/E of 7.9 at year end.

My estimated fair value gives the stock a P/E of 10 and a price of $72. This is 27% above its year-end level. And if production volumes pick up again then the fair value estimate will increase substantially.

The same is true if the oil price rises significantly. This is something we expect to happen over the medium term due to persistent demand and constrained supply. And, given the escalating situation in Iran and around the Strait of Hormuz, the oil price could spike in the short term as well.

Hess remains a “buy.”

Conclusion

We have taken some knocks in our stock holdings. But I remain confident that these will pay off handsomely over the long term, especially given the steep discounts to fair values that exist right now in most of our holdings.

And I said earlier, our overall performance has lagged our benchmark, which is something we aim to reverse over the coming quarters.

But I want to be clear that we are primarily in wealth protection mode right now. That means we must resist the temptation to chase short-term gains at the expense of long-term peace of mind.

Until next week,

[ilsig rmarstrand]Rob[/ilsig]

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