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August 2016

By  Pengana Capital

While much has been said about the current investment environment, Pengana sees opportunities for smart investors who stick to the basics, remain vigilant and patient, and focus on research.

Opportunities are there, they just require a closer look

While the current investment environment is confusing, it does present opportunities if looked at in the right context. For example, the low interest rate environment is partly due to low inflation which implies that the actual real rates of return are higher. Furthermore, the low cost of money benefits certain companies, particularly those that can operate with lots of debt and pricing power. Pengana believes innovative research techniques to identify these companies should provide excellent returns irrespective of the investment environment backdrop.

One example is the opportunity presented by our observation that the regulators are forcing the Australian banks to ‘retreat’ into their core business of borrowing from and lending to home owners and businesses. As they withdraw from some of the adjacent niches - motor vehicle leasing, point of sale consumer finance and life insurance - they create profitable spaces that are being filled by nimble, focused and efficient small businesses. Our focus has been to identify the ‘tallest dwarves’ in these niche markets that are capable of thriving in the low interest rate environment – remember that if the widgets you make are loans to consumers then low interest rates equal an attractive consumer product and a low cost of sales. Examples include SG Fleet, McMillans Shakespeare, Clearview and Credit Corp.

Stay on target

We believe difficult or complex investment environments are best simplified by focusing on the basics. Most people invest to either create or maintain financial independence. In our view this can be achieved by firstly preserving capital in real Australian dollars and secondly, generating an acceptable return for the risk we are willing to assume. Innovating and moving away from these principles is dangerous because it implies that we may be diluting our objectives at a point in time when discipline is most needed.

Paradoxically we have found that when we are optimistic about the outlook it usually means that most others are too. Consequently when share prices are high, opportunities to generate future returns are scarce. Our default position in this environment is cash – a risk-free interest earning option to buy value if, and when, it emerges. The challenge in this environment is to remain disciplined.

On the flip side, rampant pessimism creates an environment that may be full of good opportunities. Having the courage to reach across the ‘abyss’ and deploy capital at prices that provide large margins of safety becomes the core skill requirement.

Look for ‘gifts that keep on giving’

Building a well-diversified portfolio of ever growing income streams will provide the stable, inflation beating cash flows required to service future expenditure demands. Our experience has been that good businesses, run by competent management, acquired at the right price, remain a reliable formula for finding these “gifts that keep on giving” irrespective of the investment environment.

Investors should remember that to achieve and maintain financial independence they should be in the business of preserving capital and generating acceptable returns, as opposed to beating the market.

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