The Hidden Risk of Investing in an Australian ETF

In this segment of the MarketFoolery podcast, host Chris Hill and special guest Scott Phillips of Share Adviser and Million Dollar Portfolio Australia talk a bit about the unusual nature of the Australian Securities Exchange and why exchange-traded funds that track it aren't as strong on the diversification front as U.S. investors might expect.

Turns out that just two industries account for the lion's share of the value in the ASX. They also dig into a few specific cases of gangbusters business down under. One involves a restaurant chain with a name familiar to Foolish fans, but there are a couple of surprise twists to the story of Domino's (DPZ 1.36%) in Australia. The other is a whole niche that has grown thanks to a very large neighbor that has been unable to trust its domestic providers.

A full transcript follows the video.

This video was recorded on Nov. 7, 2017.

Chris Hill: A starting point for a lot of investors in the U.S., when they're looking at other countries and thinking, "I don't know that I want to go into stocks there, because I'm not living there, I'm just going to look for some sort of exposure," for a lot of people, a basic ETF is a starting point, at least in terms of thinking. If you're buying an ETF in Australia, I'm assuming you're getting a lot of exposure to banks and commodities.

Scott Phillips: Yeah, you really are, Chris. Look, we love index funds at The Fool. We're the same in Australia. We would love to think you can simply buy a diversified index and get started investing that way, and that's normally our advice. But, as you said, almost half of the Australian market by market capitalization is banks and insurers. So, the idea of an index is, you're getting a diversified basket. You're really, in Australia, getting a concentrated basket, 45% is in banks, another 15% in commodities, in mining companies. So, almost $2 in $3 is in two industries, and that's the exact opposite of being diversified. For most investors in Australia, there are a couple of ways, I would say, people go about it. The first is, you can buy what we call our Small Ordinaries index. The All Ordinaries is the big market. The Small Ordinaries, a little bit of a play on words, are the smaller companies. And that gives you, yes, a bit more volatility on a company level, but a much broader diversification of industries. So, that's one way to look at it. The other way, quite frankly, is to think about, as we do, is stock picking. When I say to investors in Australia, diversify, I'm actually telling them to buy some U.S. indices to get that exposure. So, yes, buy the ASX 200 or the All Ordinaries index, but also buy the S&P. Buy something that's global or U.S.-based, because you get that diversification that we can't get it home. But, if you're going to be an international investor looking at Australia, if you want banks and miners, then great, make sure it's a small portion of your portfolio. If you don't, look at some of the other parts of the market, the smaller end of the market. The Small Ordinaries is the 101st-300th largest companies in Australia. So, you're avoiding that big, overweight banks and miners, and you're getting a really nice breadth of high quality, fast-growing but a bit more volatile companies in Australia.

Hill: I think it was either last year or the year before that your colleague in Australia, Matt Joss, was here in the studio, and one of the companies we talked about was Domino's, and how popular Domino's is in Australia, and how well that business is doing. What I didn't realize is that it's actually a different Domino's.

Phillips: [laughs] That's right.

Hill: I mean, it's related to the one in the U.S., and they may have started that way, but it's actually Domino's Pizza Enterprises. It's a separate company, and therefore a separate stock.

Phillips: Yeah, entirely different business, but it started in the same place. It paid a royalty to the U.S. business. I think that's done now, so it's an individual business. But, this is such a stunning company. People talk about it as a tech company that happens to sell food. I think that's a bit much of a stretch. But, Domino's has pushed down the price of pizzas. It sped up the pace of delivery. It has absolutely destroyed Pizza Hut in Australia. When I was a kid, it was all about Pizza Hut, and Domino's was a small challenger brand. Over the last 15-20 years -- I mean, it's been a little bit longer than that since I was a kid -- they've absolutely destroyed the rest of the competitors by being cheaper, by being faster, by being hotter, all those things that ... they say retail is detail, and I kind of feel like for food delivery, it's kind of the same thing. And they've driven prices down, they've improve the quality of the food. They're just giving a much better experience. Their social media stuff is brilliant, their app stuff is brilliant. They've learnt all of those lessons and said, "Yes, we're a food company, but winning is not just about a pizza, it's about all the stuff that goes with it. It's fast delivery, it's cheap, it's easy, it's quick, it's online." They've absolutely put the other guys to shame in a very, very big way. Unfortunately for me, I was very clever. I bought Domino's at $6. It's now $45, which is brilliant. Except I sold it at $13. [laughs] Any Motley Fool Australia Share Advisor members listening to this are throwing things at their phone, they're feeling my pain. We thought we were really clever. We saw same-store sales grow nicely, shares doubled, and then same-stores sales started to decline, the growth rate started to decline just a little bit. And I thought, "I'm clever. I can see this coming. I'll sell." And you know what the key lesson is here? I massively undervalued the quality of management. And it's a lesson that has paid, often, in spades since then, because we've had a lot of multi-baggers since then where I've gone, "You know what? I'm not being scared out of this by some growth or a P/E that might look a little bit too expensive. This is high quality business, high quality management team." Sure, sales will ebb and flow, but if you're onto a good thing, you want to stick to it, you want to stay with the great businesses, the great companies. Domino's isn't quite Amazon. It's not quite Tesla or Facebook. But it's a really high quality Australian business that I kick myself every second day for having sold.

Hill: What did you do with the money? Because that's always the thing. One of the things we say is, sell a stock when you feel like you have a better place for the money. Did you take the money and put it into something better? Or --

Phillips: Look, I will --

Hill: I'm not trying to rake you over the coals. I'm genuinely curious when that happens.

Phillips: [laughs] Listeners, Chris is getting me back first having a go at him before the program started. Just for the record. Chris is taking the opportunity to slowly drag me across the coals -- no. Look, I don't know specifically what I did with that cash. I will say, without bragging too much, Share Advisor in Australia is doing very well. Members have been well served despite my stupidity on that one. Corporate Travel Management, one of our better picks, is up, it's a ten-bagger for us, which is kind of cool. So, we've had some good successes, I'm happy to say. I don't know exactly what I did with that particular money, but fair to say it would have been harder to offset the four-bagger since I sold, so I'm probably still behind just a bit.

Hill: One of the industries, obviously not as big as banks or miners, that you were telling me about this morning that's really taken off -- and just to close the books on Domino's Pizza Enterprises --

Phillips: [laughs] Thank you.

Hill: -- that's a stock that's done quite well.

Phillips: Oh, yeah, it's been fantastic.

Hill: But, infant formula.

Phillips: Yeah.

Hill: The infant formula business has taken off in Australia, and as a result, infant formula stocks as well.

Phillips: If The Graduate was made today in Australia, Chris, it would be, "Buy infant formula." Not plastic, it's all about infant formula.

Hill: "Ben, I have two words for you. Infant formula."

Phillips: There, see? You've got it right there. The big trend here is China. And we all know that China's story has been going for a long time. And most people think China, they think iron ore or copper or the industrial commodities that power China's economy. One of the big stories, I think, over the next 10 or 20 years, will be the growth of the middle class there. And that's not new news. But it's playing out in Australia with infant formula. The Chinese, who have had their own challenge with the tainted infant formula in the past with Chinese-made formula are looking somewhere else. And for better or worse, Australia is seen as clean, green, high food standards, regulatory authority and testing that's really second to none. So, China is looking at that and saying, "I'll have some of your infant formula, thanks very much." So, the companies that have made a run in China was infant formula -- Bellamy's is one, a2 Milk is another in Australia, and a couple of little guys that are trying, Bub's Australia is a third, they're trying to tap that market. And we all know, if you make it big in China, you'll do very well. But, for small Australian companies who have found a beachhead there, that's really been a big part of the story. And they've done spectacularly well over three or four years.