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What’s your investment philosophy?

We are very much value-biased at Perpetual, with a quality filter running on top of that. We won’t invest in a business unless it passes our four quality filters ... management, recurring earnings, a quality business we can understand, and passing rigorous debt criteria.

What do you mean by recurring earnings?

We won’t invest in a business that doesn’t make money; it has to have a proven history of repeated cash flows. It seems like a very simple thing to say, but looking back to around 1999-2000, when I started at Perpetual, there were a lot of blue-sky internet stocks out there which promised huge rewards [but] no matter how sucked into the story ... our investment process simply did not allow us to buy those stocks.

How do you measure balance sheet strength?

Unlike the management test, which is a more of an art than science, the debt levels are quite scientific. We won’t invest in a business that has debt-to-equity of greater than 50 per cent. The other test, and probably the more relevant one, is that interest cover needs to be three times or greater.

How does that work with the banks?

Yes, the banks are slightly different in that interest cover’s not quite so relevant. We would look at capital adequacy ratios for the banks – the same way that the regulator [does].

What’s an example of a company that you invested in recently?

QR National is one that we’ve recently added to the fund. We actually missed it in the float and I think you have to be prepared to re-look at companies. I think a lot of domestic institutions missed out at the float. We went up to Queensland and I spent two days with the management, so we had a much better look at the management below the top level and we were very impressed with what we saw, so it ticked off on that management quality filter. The debt currently is very low and this is a gold-plated asset, which I think can be utilised a lot better going forward. Clearly, it makes good profits and has a very good market position, particularly in Queensland. So it ticked all the boxes. I think there’s a good long-term future as they utilise the assets and take costs out of the business.

Will the company be investing heavily in their infrastructure?

Yes, they will, and if you look at the growth plans for Queensland, they are incredibly significant in terms of coal exports. I think they’re going to take it from 300 million tonnes, roughly, to around a billion tonnes over the next little while and QR’s very well placed to help transport that stuff. For the Industrial Share Fund that I manage, this a great way of playing the volume growth in the resources sector without necessarily having the volatility around pricing. Whether the coal price is $200 a tonne or $100 a tonne, that growth is still going to come through and we like that for the stability of earnings.

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What about the potential for competition from the likes of Asciano or the big miners?

Asciano is a competitor in the above-rail component in Queensland and that’s to be expected. It’s a competitive market wherever you go. That said, the fact that QR does own the track in Queensland does give them some advantage and they are clearly the dominant player there. Over time the big resource companies, in particular, will look to diversify their supplies. But I think the growth is just so huge that there’s still a good place for QR to win contracts going forward and renegotiate their existing contracts, which are, at the moment, priced in some cases around cost.

I mean, if BHP can afford to run their own line and they think they can do it better then, so be it. But I don’t think that necessarily has a huge effect on what QR is trying to do.

What does the Industrial Shares Fund invest in?

It’s all the stocks in the ASX, apart from resources companies, and this fund, over a very long period of time, has provided very stable returns with very good dividends with high levels of franking. Commodity companies, obviously, have done very well over the past 10 years, as prices have rapidly increased, but those prices can come off very quickly and we’ve seen a little bit of that over the past 12 months. Owning no resources companies, the industrial share fund in the year to December dramatically outperformed the S&P/ASX 300.

But when you remove the miners you end up with a big chunk of your money in the big four banks – around 40 per cent of the fund is invested in the financial sector.

I agree – to have so much in what are in effect Australian mortgage banks does seem quite high and not without risk. That said, they are, thus far, in very good condition. They are strong institutions.

The rolling European debt crisis has the potential to cause financial markets to freeze up again. What impact would that have on your holdings in banks?

That is a key risk that we monitor very closely. Just that trust between the banks. They are all intertwined and clearly, while the funding mix has improved, Australian banks still require 20 to 30 per cent of their funding to come from offshore and some of that does come from Europe, so it is an issue for them. That said, I think things will continue to improve in that funding mix. I don’t think the European situation is going to be fixed in a hurry, but I do think that the banking system there will muddle through to some extent and that governments will support it.

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You don’t see any evidence of funding markets freezing up or a repeat of some of those first tentative steps that appeared prior to the GFC?

I think it’s very hard to know exactly what’s going on. But while the European government situation looks difficult and there political issues involved, in some of the big countries like Germany and France personal financial balance sheets are in much better shape. Even in Italy people are not leveraged on a personal level and in that sense the overall indebtedness is perhaps not as bad as people would think. So I think there will be a sense of muddling through. It’s not going to be fixed in a hurry, because of the political and geographic problems, but will it totally freeze up in the way that the US did with subprime? I don’t think so.

How do you evaluate whether a company’s dividend is sustainable?

Well, cash flow is the key. That personally is one of the things that I do a lot of work on, rather than looking just at reported earnings. A good example would be Telstra, which got ridiculously cheap. While Telstra was generating earnings in EPS terms around about the same as its dividend, it was paying out most of those reported earnings. The true cash flow that was coming through from the business, as [capital expenditure] came off a little bit, was far greater. I mean, this is a business generating $5 billion in cash flow and is only paying out around $3.5 billion in dividends and yet it was yielding 10 per cent fully franked. To a super fund investor that’s around 13 per cent return. That just seemed to me incredibly attractive.

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You completed a degree in modern history at university, what did studies in modern history bring to your investing?

To my mind, it’s a failure that everyone in Australia does law or finance or business economics. Studying history was actually fantastic for the job I do. Looking back and trying to learn from historic interludes was fascinating and very instructive. But, particularly for the job I now do, it is all about taking a vast amount of information and trying to condense it down into a strong, coherent argument.

When you’re making a strong buy or a strong sell investment case on a stock, it’s a very similar skill: to get rid of the noise and drill down to three or four key points on a stock to make your investment case.

What’s the next big thing?

Well, it’s interesting. The internet is still young. I lived through, as a telco analyst, the tech boom of 1999-2000 and a lot of the ideas that were formulated then by some smart people came to nothing, mainly because we didn’t have proper broadband or the devices to deliver the internet to people easily. That is now being fixed. You can see the proliferation of devices that are connected to increasingly higher broadband speeds changing the way we behave. For the domestic retailers, they’re seeing it loud and clear. It’s hard to know exactly how you invest in online retailing, but that’s one of the next big things, I think, which will continue to hit Australia over the next couple of years.