optimism = fees, corporate bonds and the great de-leveraging · 2014-10-12 · every published...

E v E r y p u b l i s h E d a r t i c l E f r o m t h E i n t E l l i g E n t i n v E s t o r w E b s i t E

optimism = fees, corporate bonds and the great de-leveragingIt was the Australian sharemarket’s

strongest week since it moved swiftly off its March lows some four months ago; a 5.2% gain. And with a whiff of investor optimism in the air, the investment banks and private equity firms can smell fees. As a result, they’ve been hard at work planting stories in the media about possible floats. Free ads, framed as editorial, were run to test out investor interest in floats such as Link Market Services (a share registry provider), Ascendia Retail (incorporating the Amart All Sports and Rebel Sport chains) and PBL’s stake in carsales.com.au.

Corporate bonds have been back on the agenda this week, in another sign of life returning to the credit markets. Dow Jones reported that the big four banks had been actively sounding out professional bond investors on behalf of Leighton Holdings, which is apparently keen to replace some of its bank debt with bonds. These are a more secure form of financing from the company’s point of view (a lesson Rupert Murdoch learned the hard way almost 20 years ago).

Spark Infrastructure, which featured in our recent special report The case for essential infrastructure, has also stuck its beak into the corporate bond market; or, more correctly, its

49%-owned investee company ETSA Utilities has. With $750m of senior debt falling due in April next year, ETSA began its fund raising efforts by seeking around $200m from US bond investors. It’s ended up with US$500m (or around $625m of the $750m it needs to refinance) over three maturities, being 5, 7 and 10 years. So the grease of credit seems to be oozing its way more liberally around the cogs of commerce, which is a positive trend for sharemarket investors.

Speaking of the big trends for investors to be aware of, you’re probably getting tired of hearing about ‘the great de-leveraging’. But it’s an important one. In the boom years, lots of companies and individuals took on too much debt (to buy the wrong kind of assets at the wrong prices, in many cases) and they’re now in the process of reducing it.

In consumer-land, official data from the Reserve Bank of Australia (RBA) show that personal credit has now fallen, month-on-month, for 11 consecutive months. That’s never happened before in the history of RBA statistics, which stretch back to 1976. And in the corporate world, announcements from two Macquarie Group satellites graphically illustrated the effects of this de-leveraging process.

Macquarie Infrastructure Group (MIG) treated its investors with contempt by dropping some big news in an embarrassingly poor announcement on Thursday. In well under 200 words, MIG disclosed that it had revalued its portfolio of assets to $5.1bn. Securityholders had to search through their historical statements to uncover the extent of the writedowns, which were in excess of $1.5bn.

Macquarie CountryWide Trust, meanwhile, managed to find a buyer for US$1.3bn of US property. In a somewhat more lengthy announcement than its cousin, Macquarie CountryWide detailed the highly conditional transaction. CEO Steven Sewell summed it up in corporatespeak; ‘Whilst the transaction will negatively impact the Trust’s earnings and net asset backing, gearing and debt will be substantially lessened, providing the Trust with greater flexibility to strategically respond to the continuing challenging market conditions.’ In other words, ‘we’ve lost a lot of money and we’re coming home with our tail between our legs.’ As Claire, The Intelligent Investor’s new French bookkeeper says; Plus ça change, plus ce le même chose (the more things change, the more they stay the same—Tuesday was Bastille Day, after all).

publishEd this wEEK

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Ask the Experts 9Bristlemouth: The Great Monetary Ponzi Scheme 8Preparing to battle Goliath 6

DetaILeD StoCk revIewS StoCk aSX CoDe reCommenDatIon page

Amalgamated Holdings AHD Hold 2

upDateS Commonwealth Prop. Office CPA Better Value Elsewhere 5CFS Retail Prop. Trust CFX Avoid 5Cochlear COH Long Term Buy 5

reCommenDatIon ChangeSamalgated holdings upgraded to hold from Ceased Coverage

11 - 1 7 j u ly 2 0 0 9

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2 the Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 [email protected] www.intelligentinvestor.com.au

wARninG This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary.The Intelligent Investor and associated websites are published by The Intelligent Investor Publishing Pty Ltd (Australian Financial Services Licence no. 282288).

diSClAiMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation.COPyRiGHT The Intelligent Investor Publishing Pty Ltd 2009. No part of this publication, or its content, may be reproduced in any form without our prior written consent. This publication is for subscribers only.

diSClOSuRE In-house staff currently hold the following securities or managed investment schemes:AAU, AEA, AHC, ANZ, ARP, AWE, BEPPA, CBA, CDX, CHF, CND, COH, COS, CRS, CXP, DBS, FLT, GMPPA, GNC, HVN, IAS, IDT, IFL, IFM, IVC, KRS, LMC, LWB, MFF, MMA, MQG, NABHA, NHF, OEQ, PTM, RHG, ROC, SAKHA, SDI, SFC, SGN, SHV, SIP, SOF, SRV, STO, TGR, TIM, TIMG, TIMHB, TLS, TRG, TRS, TWO, WBC, WDC and WHG. This is not a recommendation.Thanks to IRESS for the charts and price information.

important information about The intelligent investor

amalgamated’s attractive assets

while its more aggressive brethren entered this downturn geared to the eyeballs, tourism and leisure conglomerate amalgamated holdings has plenty of financial firepower. having $760m worth of property assets on the balance sheet helps, too.

amaLgamateD hoLDIngS (ahD) $4.35

16 Jul 2009SECOnd linE induSTRiAl

$561m $3.81–$5.05

3.5 3.5

HOld

INFORMATION CORRECT AT

STOCK CATEGORY

MARKET CAPITALISATION

12-MONTH SHARE PRICE RANGE

BUSINESS RISK out of 5 SHARE PRICE RISK out of 5

OUR VIEW

Like the human variety, corporate marriages don’t always last the distance. Instead, the best formula for corporate success seems to be something akin to ‘living in sin’. Take Washington H. Soul Pattinson and Brickworks, which eschewed a merger for a cross-shareholding that has survived 40 years. This mutually convenient arrangement kept suitors—such as Ron Brierley—at bay and allowed each company to flourish.

Tourism and leisure companies Amalgamated Holdings and Village Roadshow had a similar, but significantly more complex relationship. Instead of simple cross-shareholdings, both set up a network of cinema joint ventures which to this day run 36 sites across Australia under the Greater Union and Village brands. Over time, though, the two companies’ other relationships have been largely unwound, with Amalgamated selling its shareholdings in Village and its unlisted parent company, and Village buying Amalgamated’s 50% stake in movie distribution company Roadshow Distributors in 2007. The two companies had become increasingly strange bedfellows, and Amalgamated’s management wanted to distance itself from Village’s increasingly aggressive approach.

brilliantly-timed saleThe sale of Amalgamated’s Roadshow Distributors

stake in 2007 was highly significant, and important

to understanding how divergent the two companies’ strategies had become. For Amalgamated, the $129m sale was a major milestone in the simplification program begun by managing director David Seargeant after his appointment in 2002. The brilliantly timed sale left it virtually debt-free right before the meltdown in global financial markets.

Village, by contrast, hoovered up three major assets in the 2008 financial year at a cash cost of $207m, including the Roadshow Distributors stake and the then-listed Sydney Attractions. While Amalgamated produced operating cash flow of more than $100m in 2008, Village finished the same year with $870m of net debt and all of its cash flow consumed by interest payments. While Village has not been spared the sharemarket rout, it is Amalgamated’s share price fall, from above $7.00 in 2007 to around $4.35, that has piqued our interest.

To fully understand Amalgamated Holdings, it’s necessary to consider its various divisions. We’ve already mentioned its Greater Union cinema business which, including its various joint ventures, operates 54 sites (and 461 screens) across Australia. Over the past five years, a strong run of popular films has meant the division has been consistently very profitable. Despite the ostensible threat from piracy and home theatre, Greater Union has managed to reinvent the cinema experience through concepts such as Gold Class, which offers premium seating and a food and bar service.

KatastrophenkinoThe company’s foray into German cinema exhibition

in 1998, by contrast, was less successful (why are we not surprised?). While overbuilding of ‘multiplex’ sites dogged the German business for years, its Cinestar brand is now the largest exhibitor in the country (with 70 locations and 519 screens). Combined with its small Middle Eastern cinema operation, which has 4 sites and 40 screens, the division has been profitable since 2007.

Amalgamated is also the operator of the Rydges four star hotel chain, which manages 38 hotels, mainly in Australia and New Zealand. Running hotels is a highly competitive, capital intensive and difficult business, but Rydges has nevertheless carved out a strong niche.

3the Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 [email protected] www.intelligentinvestor.com.au

The Intelligent Investor 11–17 Jul 2009

Profit from Amalgamated’s hotel division almost doubled between 2004 and 2008 but buoyant economic conditions obviously helped.

table 1: Divisional eBIt 2008A ($M) 2009E ($M)

Cinemas—Aust. 34.3 35.0

Cinemas—int’l 6.3 15.0

Hotels 30.9 25.0

Thredbo 14.9 15.0

leisure/Attractions 1.0 1.0

Property 2.7 3.0

Other 0.6 -1.0

discontinued 2.1 0

Corporate -13.1 -13.0

Total EBiT 79.7 80.0

underlying net profit 56.7 57.0

The company’s last major division is the Thredbo Alpine Resort. Under a highly favourable lease which still has 48 years to run, Amalgamated operates the ski resort and accommodation. Thredbo’s good reputation and investment in snowmaking machines have meant it has been consistently profitable over the past five years, with little sign that global warming has affected the business yet.

the stability of propertyAmalgamated also operates the State Theatre and

Featherdale Wildlife Park in Sydney (which it has tried to sell without success), and a couple of small film-related businesses. But it’s the company’s extensive property holdings that are particularly valuable. The company owns about one-third of its hotel properties, as well as various cinema properties. As well, Amalgamated owns a significant redevelopment site in central Sydney (including the State Theatre and the Gowings building), as well as several other investment properties. Altogether, the group’s property interests are in the books at $404m, but have been valued at $763m.

So how should we think about the valuation? With its various cinema, hotel, leisure and property interests, a sum-of-the-parts valuation makes intuitive sense. For Amalgamated Holdings, though, this is harder to calculate than you might think. For one thing, it’s difficult to get a grip on the underlying profitability and returns from the cinemas as they are held mainly in joint ventures and partnerships.

Then there’s the allocation of property assets between divisions. Management won’t split out the value of its properties by division (we asked). Perhaps this is because, like Brickworks, it doesn’t want corporate raiders sniffing around its asset-heavy balance sheet. This makes it more difficult to work out the imputed rent to deduct from divisional profit.

paying the rent fairyThis is necessary when a company occupies property

that it owns. We estimate the company has about $652m of owner-occupied property including, for example, the

freeholds of Rydges Cronulla and Rydges Bankstown, which it purchased in 2007, and the Rydges Sabaya in Port Douglas, which it acquired in May. While the company could sell all of its properties to a third party—through a sale-and-leaseback transaction, for example—it would then need to pay rent to the new owner.

If we assume that rental costs are 7% of a property’s value, then the imputed rent we must deduct from Amalgamated’s forecast 2009 earnings before interest and tax of $80m (see Table 1) is $46m. This more than halves forecast earnings before interest and tax to around $34m. Making this deduction prevents us from double-counting the value of the owner-occupied property in our sum-of-the-parts valuation in Table 2.

table 2: amalgamated holdings valuation REvEnuE EBiT* lOw HiGH lOw HiGH. 2009E 2009E MulT. MulT. vAl. vAl ($M) ($M) ($M) ($M)

Cinemas—Aust. 270 19 5 8 95 152

Cinemas—int’l 320 8 0 100

Hotels 125 4 5 8 20 32

Thredbo 50 13 5 8 65 104

leisure/Attractions 8 1 3 5 3 5

Prop.—owner–occupied 489 652

Prop.—investment 10 3 83 111

Other 5 –1 0 5

Total value 755 1,161

less corp. costs –13 7 7 –91 –91

less net debt –44 –44

value of equity 620 1,026

no. of shares (m) 129.9 129.9

value per share ($) 4.77 7.90

* After adjusting for imputed cost of rent

Bear in mind that the adjusted EBIT for each division is a very rough estimate. As we said, management doesn’t break down the value of the property, so we’ve had to estimate underlying divisional profit. Running through each major division after making this deduction for imputed rent, we can make a couple of observations.

First, Australian cinema exhibition remains reasonably profitable. Amalgamated owns about half of the total business, so doubling our high end valuation gives around $300m for the whole. That compares with the $440m paid by private equity fund Pacific Equity Partners in 2007 for Hoyts, which has slightly fewer screens but a couple of other businesses. The international exhibition business has more screens than in Australia but is less profitable and operates in a more competitive environment, so we’ve valued it between zero at the low end and $100m at the high end. With some evidence that the problems that dogged the business are under control, though, there could be substantial upside here.


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difficult businessThe profitability of the hotel business falls significantly

once imputed rent is deducted. This makes intuitive sense, as running hotels is a difficult business that typically produces low returns. The management of Thredbo, by contrast, produces much higher margins partly due to its market niche and pricing power.

The bulk of Amalgamated’s value lies in its property assets. We’ve taken the directors’ valuation of $763m (including both owner-occupied and investment properties) as our high valuation, and deducted 25% for our low valuation. Despite the travails of the property market, it’s possible even the high valuation is conservative given the redevelopment potential. Alan Rydge, the company’s chairman, noted in the 2008 annual report that ‘the property division is increasing in significance every year’. And Rydge knows a thing or two about bricks and mortar, his family having gradually acquired six adjoining properties in Sydney’s exclusive Point Piper over the past 50 years.

Making a deduction for corporate costs and the company’s small amount of net debt, Amalgamated is, on rough estimates, worth between about $4.80 and $7.90 a share. As that range compares favourably to the current share price of $4.35, the stock seems pretty good value. But there’s another issue to throw into the mix.

returns

3%

6%

9%

12%

15%

I2008

I2007

I2006

I2005

I2004

I2003

I2002

I2001

Return on assetsReturn on equity

Amalgamated Holdings has tended to produce only average returns on equity and assets in recent years, as you can see from the chart. Its asset-heavy nature means it is not a high return business, although there has been some improvement under managing director David Seargeant. The unremarkable share price performance over the long term confirms this.

rising dividendsCounteracting this, though, has been the consistent

free cash flow the company has produced over the past five years. We approached our analysis of Amalgamated expecting it to be a fairly capital intensive business, but cash flow has been strong enough to fund capital expenditures—such as hotel refurbishments and the Gold Class rollout—with ease. Indeed, management has stepped up dividend payments to reflect the strong cash flow, with annual dividends rising from 13 cents in 2004 to 30 cents in 2008.

Amalgamated Holdings, then, is probably best viewed as a yield and asset play. There’s some potential upside from property redevelopment, or perhaps from selling the international cinema exhibition business, to which the market seems to be attributing little value. Thanks to the company’s excellent financial position, it’s also well-placed to acquire assets if Village Roadshow or Living and Leisure Australia, for example, get into difficulties. Amalgamated has already bought hotel properties, including the Gold Coast International Hotel, from distressed sellers this past year.

Conversely, there’s downside to profitability should the strong run of film product end, or if the hotel business suffers during the economic downturn. Both are high fixed cost businesses, so lower revenues have a disproportionately large effect on profit. Management has already confirmed the hotel business has weakened, but then so has the share price.

We’re re-commencing coverage on Amalgamated Holdings after a five-year absence. Management’s conservative philosophy is appealing and, while future share price growth is likely to be unexceptional, we see value in the company’s assets and strong yield (which may however be temporarily under threat). It’s also interesting that several directors have bought shares around current prices, including chairman and major shareholder Alan Rydge.

While some companies choose to live in sin others, like Amalgamated Holdings, try to remain virtuous. But we’ll wait for the full year accounts—and in particular the results from hotels and international cinema exhibition—before considering an upgrade. For now, we’re re-commencing coverage with HOLD.

Note: You can download a spreadsheet of financial and valuation data under the Special Reports tab if you want more detail on the numbers referred to in this review.



values for the moment.Still, $376m of revaluation losses have cut net tangible

assets per unit from $2.14 to $2.02, and gearing—the ratio of total liabilities to total assets—has increased from 30.7% to 32%; though still well below the 50% limit mandated by lenders.

Our major concern is not CFS Retail’s financial position, but rather the paltry returns on offer. Although $507m of developments due for completion by December should shore up distributions, a forecast yield of 6.9% doesn’t offer much protection against higher vacancies and lower rents, should the music stop at K-Rudd’s spending party. CFS Retail’s unit price is up 4% since 23 Jun 09 (Avoid—$1.68) and we’re sticking with AVOID.

Nathan Bell

CoChLear (Coh) $53.86

15 Jul 2009BluE CHiP induSTRiAl

lOnG TERM Buy


STOCK CATEGORY

OUR VIEW

Hearing implant manufacturer Cochlear has announced that it expects revenue to increase by 13% to $695m for the full year, and net profit to increase by 12% to $131m. That’s despite revenue and net profit falling by 5% and 16%, respectively, in the second half; following the Aussie dollar’s significant rise against the major currencies.

Cochlear sold 9,283 implants in the half year to 30 June (consistent with the previous two periods), despite not selling any devices as part of a donation supply agreement in China to sell 15,000 implants by 2013. After selling 700 devices in 2008, and only around 1,000 in total so far, we’re left wondering whether the remaining total of 14,000 devices is likely to be reached.

It’s also noteworthy that China and other Asian nations are serious about developing their own implants, although this will likely take many years. And we wouldn’t be surprised if Cochlear kept its full year dividend steady to help fund a new $80m head office being built by Watpac at Sydney’s Macquarie University.

While the 2009 result is below management’s aim of 15% annual earnings growth, new product upgrades are slowly gaining worldwide regulatory approval and should provide earnings growth for years to come. The share price is down 8% since 5 Jun 09 (Long Term Buy—$57.67), which makes Cochlear a more attractive LONG TERM BUY.

Disclosure: The author, Nathan Bell, owns shares in Cochlear, as do other staff members.

CommonweaLth prop. oFFICe (Cpa) $0.845

17 Jul 2009PROPERTy TRuST

BETTER vAluE ElSEwHERE


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OUR VIEW

Office property landlord Commonwealth Property Office Fund, which counts its manager, Commonwealth Bank, as its largest tenant (providing 20% of its income), is another one to have had each of its 29 office buildings independently appraised in the half year to 30 June.

The average capitalisation rate has skipped out to 7.7%, from 7.0% at 31 Dec 08 (and a nadir of 6.3% at 31 Dec 07), causing $364m of revaluation losses. Net tangible assets per unit have fallen from $1.41 To $1.14, due to dilution from a $192m capital raising and $151m of asset sales, which reduced gearing—the ratio of total liabilities to total assets—from 37.2% to 29.1% (a further 1.5% increase in capitalisation rates would likely put Commonwealth Property in breach of its covenanted gearing level of 40%).

Given the low level of interest rates, property managers are hoping capitalisation rates, and therefore valuations, will stabilise. ‘However a continuation of the current weak underlying office market fundamentals’, said Commonwealth Property fund manager Charles Moore, ‘will likely see asset values continue to fall, albeit at a slower pace than the past year.’

A forecast 9.1% yield is tempting but, despite the unit price falling 3% since 23 Jun 08 (Better Value Elsewhere—$0.87), we’d feel more comfortable with a larger margin of safety. BETTER VALUE ELSEWHERE.

Nathan Bell

CFS retaIL property truSt (CFX) $1.74

17 Jul 2009PROPERTy TRuST

AvOid


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OUR VIEW

Retail property landlord CFS Retail owns a swag of prized assets up and down the eastern seaboard and has had each of its 26 shopping centres independently appraised in the half year to 30 June.

The average capitalisation rate has risen to 6.45%, from 6.09% at 31 Dec 08 and a nadir of 5.74% on 31 Dec 07, bringing valuations into line with GPT Group’s comparatively high quality retail portfolio. With K-Rudd spiking the consumer spending punchbowl, retail valuations are holding up better than office and industrial

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A relatively new, small investor can certainly shoot for a similar return, but they’re probably exposing themselves to unwanted risk in the process. It’s much better to aim for an average return and make up or eclipse the difference via savings.

Banking $100 every week, an investor is able to accumulate more than $5,000 per year. If his or her portfolio is worth $200,000, that’s the equivalent of an extra 2.5% in investment returns, while on a $100,000 portfolio it’s an extra 5% and on a $50,000 portfolio it’s 10%. Now re-do the numbers if you can manage to sock away $150, $200 or $300 per week. A small investor with humble aims and a well-executed savings plan will be able to grow their wealth both faster and more certainly than almost any investment giant, at least for a few years. While Buffett’s wealth accumulation is totally reliant on investment earnings, yours doesn’t need to be.

guerrilla tacticsA savings strategy is by far the most deadly and

reliable weapon in the small investor’s arsenal. It should be your main focus, because it can ensure rapid wealth accumulation even with average or mediocre investment returns. But if you’re also hell-bent on achieving above-average investment returns, you’ll need to use other weapons.

Most of your advantages stem from an ability to skirt the disadvantages—natural and self-imposed—inherent in managing large sums of money. Large investors have to deal with headaches that we don’t have to worry about. Many institutional investors, for example, have a restricted mandate—they need to own Australian blue chip stocks, or resources stocks, or dividend-paying stocks. Unlike Goliath and his adherence to social conventions, you can sling your savings at whatever is safe and cheap. And whereas many institutions simply had to own inflated stocks like News Corp in 1999, or Rio Tinto in 2007, you didn’t.

the small investor’s arsenal

Savings

Can search high and low for value

Freedom to hold cash

Can achieve optimum diversification

Small investors are also able to make quicker decisions than most large investors. And while institutions are ultimately reliant on the patience of underlying investors, you get to call all the shots. You can buy in the middle of a storm, when institutions are often forced to sell because of investor redemptions. You can take a long-term perspective while an institution is often forced to care about next quarter’s returns. And you can buy into interesting but uncertain situations safe in the knowledge you don’t have to explain your reasoning to the boss

australians love an underdog victory, except when we’re the favourite. But few of us have put thought into how underdogs can deliberately cultivate an edge.

Recently, we came across an article in The New Yorker magazine by Malcolm Gladwell, author of The Tipping Point, Blink and Outliers, three excellent books. The article, How David Beats Goliath, is a fascinating dissection of underdog success in war, sport and other endeavours. It prompted us to write this article on the numerous advantages small investors hold; advantages that most small investors probably aren’t even aware of and rarely utilise effectively.

In short, Davids can and regularly do beat Goliaths, but only by breaking conventions and playing to their own strengths, rather than following established practice. In the biblical battle, David’s guerrilla tactics were two-pronged. Firstly, and most famously, he was armed with five stones and a sling rather than the traditional sword and shield. Secondly, and perhaps more importantly, he unexpectedly charged Goliath rather than following the Philistine tradition of crossing swords. The big fella didn’t know what hit him—David was a dirty fighter.

According to the article, another recurring and key ingredient in underdog victories over time—from freakish success by skill-deficient sporting teams to T.E. Lawrence’s ransacking of the Ottomans—was ceaseless effort. As Gladwell put it:

We tell ourselves that skill is the precious resource and effort is the commodity. It’s the other way around. Effort can trump ability…because relentless effort is in fact something rarer than the ability to engage in some finely tuned act of motor coordination.

For most of us, investing is rarely analogous to warfare; although some may be prepared to take up arms after receiving their superannuation statements this month. But the stockmarket can be viewed as a multi-front war of attrition unavoidably influenced by Goliaths—after all, someone had to be on the opposite side of the trades that made investors like Kerr Neilson fabulously wealthy. Fortunately, however, small investors can avoid unnecessary head to head battles, and have some huge natural advantages over large investors. But we need to act like insurgents rather than participate in conventional warfare.

savings battle planIn a display of effort trumping skill, small investors

should initially focus on the amount they can save rather than their investment earnings. Over time we expect the stockmarket to provide total returns in the vicinity of 8-10% per year (although 2008 is a good reminder that it won’t be a smooth ride). A very talented investor like Neilson or Warren Buffett might hope to eke out a 2-5% advantage over the index, bringing their total return up to 10–15%.

preparing to battle goliath

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your portfolio, the most important benefits of a sensible diversification strategy have been obtained by the time you thoughtfully add a 10th or 15th stock to your portfolio. When an institutional investor is forced to put money into their 50th or 100th best idea, they’re almost guaranteeing average results. It’s not a strategy you’re forced to follow.

If you’re looking to soundly beat big, successful and more knowledgeable investors, you need to play to your strengths and remember the lessons of David’s victory. As Buffett said a decade ago, if he were managing a very small sum, he’d be doing things ‘almost entirely different’ to what he does today. If you’re looking for further guidance, Peter Lynch’s two books, One Up On Wall Street and Beating The Street, are almost solely dedicated to helping amateurs use their advantage to whip the professionals.

But it’s also worth remembering that wealth has a declining marginal utility—having a few years’ salary worth of surplus assets tucked away adds to our security and contentment in a way that the next million can’t match. In other words, most of us are simply content to have a bigger nest egg than the Joneses, rather than take on Goliath. A low-risk investment strategy aimed at achieving average returns, combined with a disciplined savings plan, will almost certainly achieve that goal over time.

If you’re relatively new to investing and are looking to improve your approach, we’d recommend two feature articles from our vault as useful additions to this article—Why investing is a loser’s game from 16 Mar 05 and Build your own financial fortress from 25 Apr 06.

Disclosure: The author, Gareth Brown, owns shares in ARB Corporation and RHG Group. Other staff members own shares in RHG Group, Servcorp and Westfield Group.

(except, perhaps, the one you share the bed with).

ability to store dry powderWhen you can’t find any stocks that are attractive,

you can put your money in the bank until you do find some. In the absence of bargains, you can go to 20% or 50% cash, whereas the Colonial First State Australian Share Fund—which has a benchmark cash holding of 0% and a maximum of 10%—cannot. Of course, theoretical advantages can turn into disadvantages if poorly executed, but less restriction should be embraced as it can serve you well over time.

Even incredibly successful large investors with no self-erected restrictions run into natural obstacles. Bigger investors, by their very size, have to focus on larger stocks. So while such an investor might have the top 100 or top 200 stocks as a hunting ground, your hunting ground is much more extensive (there are more than 2,000 listed stocks in Australia).

While size is often relied upon as a proxy for safety, it’s far from a perfect indicator. Some of the most acute cases of overpricing we’ve seen have been in larger stocks, and some of the most certain bargains we’ve come across were in smaller stocks. When stocks like QBE and Westfield Group are going cheap, they’re probably suitable for all investors. But when blue chip bargains are scarce, the small investor can often still grab great opportunities in high quality second line stocks like ARB Corporation and Servcorp, or cheap asset plays like RHG Group.

a crack unit versus an unwieldy battalionBeing smaller also allows the optimum diversification

strategy, and this can make a crucial difference. As explained in our special report Building and managing


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working now.But my question to you is: where does it end? Interest

rates are near zero and consumers’ ratio of debt to disposable income is the highest it’s ever been. When interest rates hit 5% in the US and 7% here, it sent the economy into a tailspin. By the time this rescue package is complete, your government is going to have one of the highest ratios of debt to GDP in the world. At some point, surely, throwing more money at the problem is no longer a viable solution?

Intellectually incoherent perhaps but, to me, your solutions have the smell of one giant ponzi scheme.

Steve Johnson

the great monetary ponzi scheme

apologies for the lack of love, Bristlemouthers. I’m finally finished our end of year special reports and, thankfully, have time to think about something other than infrastructure stocks and inflation.

I read a lot of Nobel Prize winning economist Paul Krugman’s stuff over the past couple of months, including his recently updated book The return of depression economics. This article on Slate, though, really wound me up (if you read it first and then come back, this post will make a lot more sense).

I’m one of the ‘intellectually incoherent’ who believe that ‘the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion’. And I’ve got a few answers to questions Krugman claims the incoherent ones don’t have an answer to.

Krugman accepts the fact the we have investment booms and that they necessarily lead to busts. But why, he asks ‘should the ups and downs of investment demand lead to ups and downs in the economy as a whole?’

Don’t say that it’s obvious—although investment cycles clearly are associated with economywide recessions and recoveries in practice, a theory is supposed to explain observed correlations, not just assume them. And in fact the key to the Keynesian revolution in economic thought—a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles—was John Maynard Keynes’ realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.

Well, Paul, the reason is that investment booms and consumption booms go hand in hand. In both your country and mine, consumers have been spending more than they earn for a large part of the past decade. Why? Because the investment boom has enabled them to go on a consumption boom. Not only do they feel wealthier, but they’re convinced the 20% returns they’re making year on year are going to pay for their retirement.

Yet you’re surprised that a collapse in asset prices leads to a collapse in the wider economy? What else do you expect consumers to do when they discover they’re not half as rich as they thought they were? They are going to save more and consume less, and that is going to cause a recession.

You go on to say that ‘nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present’. The answer to that seems fairly obvious to me as well: the investment boom created capacity and jobs to service an unsustainable level of demand. While we wait for the true demand to catch up, we’re going to have surplus capacity.

Of course, your ‘easy way out’ will work. Borrow money, print money, do whatever you need to do, but don’t let that idle capacity remain idle. It worked in the early 1990s, it worked in the 2001 recession and it’s

onlinE commEnts

mars: And this guy won a Nobel prize? If ever you needed proof that rationality and fundamental understanding are not pre-requisites for pre-eminence, especially in soft sciences such as economics, then you need look no further. Austrian theory obsolete? What a laugh.

gareth Brown:Merton and Scholes won the 1997 Nobel Memorial Prize in Economic Sciences for their option pricing model. In 1998, their hedge fund Long Term Capital Management blew up. I just thought that was worth remembering!

Justin o’kane: Krugman is right.Why should so much of the economy come

to a halt just because some people have over extended themselves and dusted some cash while others have had their portfolios shrunk to 2005 levels (where we all poor in 2005?). And the answer is cash.

Look on the ground level for proof (not something economists like doing)–it is everywhere. For example Cochlear’s announcement yesterday was sales growth down on the back of customers de-stocking. Over investment isn’t related to people wanting improved hearing yet COH sales drop as their network of customers (I’m not talking about the consumer) increase working capital to protect themselves from the GFC i.e. get some cash. They probably had the right level of working capital in the first place and will have to return to it at some

BRISTLEMOUTH



that most australians have a deficit in—a subject for another day’s discussion). we agreed to match his savings with a view to investing in shares. the recent article on the 10 Best Businesses is a great help, however we are pondering the merits of warrants rather that Fpo shares. what do the collective brain of II have to say on this? Chris C

Greg Hoffman: Congratulations, Chris (and to your wife as well). Instilling work and savings ethics are among the most wonderful gifts parents can give to their children, in my view (and they’re gifts that will keep on giving for the rest of their lives).

With regard to warrants, they are simply a way of leveraging your exposure—something we’re generally averse to. These products are usually put together by sophisticated investment banks that are earning hefty amounts of interest (implied in the price—you almost never see it explicitly).

We can’t give personal advice but I’d encourage you not to lose sight of your original objective. Your nightmare in buying warrants is that they magnify any losses to the point where your child becomes discouraged with the whole process (why bother saving and sacrificing when all that happens is the price of my warrant just falls in half?).

On a somewhat related topic, I think the article Gareth published yesterday is outstanding: Preparing to battle Goliath.

please note that the member questions below have undergone minimal or no editing and appear essentially as they do online.

anZ capital raising

anZ how does the huge retail raising affect things for anZ and its share price in your view? It seems a very positive thing and yet the market’s first response is to discount for the dilution. I’ve used the issue to reach the weight I want in anZ, so I don’t want to sell and I’m hoping the other “mums and dads” are thinking similarly. I guess time will tell. But on your account of things, we should take the arbitrage (if any is left), yeah? ewan C

James Greenhalgh: Hi Ewan. It doesn’t change our negative view. Gareth said to me he thought ANZ was always likely to raise as much as they could get, and this obviously has a fairly significant dilutionary effect. What we’re worried about is an ongoing blowout in bad debts that is showing all the signs of only getting worse, and the strong possibility that Mike Smith is going to blow up plenty of the capital he has just raised buying assets in Asia.

Encouraging kids to save: warrants vs ordinary shares

hello people. my wife and I are attempting to instill a saving mentality into our 9 yr old and to date he has done very well. (a saving mentality is something

stage anyway. Exactly the same is happening at Billabong with its network retail customer–destocking for cash flow reasons.

These are just two micro examples but this process is flowing all the way through the economy–some of it justified and much of it reactionary to preserve cash flow. In fact too much will prove reactionary hence the investment opportunities present. And in the meantime unnecessary unemployment occurs and productive time is wasted as everybody backs off.

I’m not sure there is a sytemic problem here. It is right for governments to rebalance the system in the same way a cop moves everyone on who slows down to look at the crash scene.

mars: This is confusing cause and effect. The problem was one of unnecessary employment during the boom, not unnecessary unemployment after the crash. If during the boom we had too much economic activity in areas that were really not particularly beneficial or sustainable, then how can we rectify this without causing short-term unemployment? The villain here is the boom, not the medicine that follows the crash.

ASK THE EXPERTS

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adjust for things such as spin-offs, rights issues and the like—rather than trying to figure out how somebody else has accounted for such corporate actions.

australia’s best businesses; dps vs Eps

I would just like to echo the comments of David p on the “australia’s 10 Best Businesses” article. It came at a great time for me as I was just about to commence a review of my portfolio based on similar metrics. I would love to see you add a ‘great business index’ metric to your reviews that would help provide more insight into whether it is a great business at a reasonable price vs just a really cheap business. I did have one query though—I was curious that you used growth in DpS rather than epS as your first metric; I normally use epS but with the proviso that the company must pay some dividend. matthew C

Greg Hoffman: Thank you, Matthew. The report took a lot of research to put together and I’m glad you enjoyed it. With regard to adding a ‘great business index’ to our reviews, it’s something we could consider on a case-by-case basis where appropriate. I’ll encourage the team to include it where possible.

With regard to the use of dividends (DPS) rather than earnings (EPS); dividends are harder to ‘fudge’ over a sustained period than earnings. The accounting rules are sufficiently elastic that a devious and crafty accountant could probably pump up earnings over a decade. On the other hand, dividends require cold, hard cash (except where DRPs are involved—in which case the dilution typically dampens the growth rate over time). If you trust the accounting, then EPS should be fine (though I like your proviso that some of the cash comes out as a dividend). If you have any doubts about the accounting, then DPS is probably the safer option.

cabcharge uncertainty

greg seemed at odds with erik metanomski’s contrary view on the potential impact of the aCCC’s investigation on Cabcharge, and I think I can explain why. But first to recap, about 30% of all taxi fares are paid using electronic means. this attracts a surcharge, which is currently 10% plus gSt on top of the original fare. this applies to Cabcharge accounts, bank-issued cards (direct debt cards, mastercard & visa) and third-party issued cards (amex, Diners Club). the former represents about 43% of all total transaction revenue (ttv represents taxi fares paid by electronic means, inclusive of surcharges and gSt; see notes 3h and 3I of the 2008 CaB statutory accounts). But because Cabcharge doesn’t have to share any of the take as commission to third-party issuers, presumably Cabcharge accounts

australia’s 10 best businesses

australia’s best 10 businesses I have to say wow, this is the best article i have read anywhere for a long time. I have to say i wish you would create more articles like this one. hint hint: what about australia’s best 10 businesses from the next largest 100 companies (ie the bottom 100 of the aSX200)? these types of articles are so valuable. there are two secrets to ‘intelligent investing’, get the stock right and then get the price right. often patience is required for the second, however with this sort of article, we can create a ‘master sheet’ of best companies, and just buy selectively as they move into a positive price range. I dont know about other members, but these sought of articles are diamonds. the primary purpose of a portfolio in my opinion is to create long term wealth where one can eventually live off the dividends. For myself i prefer to stick with ‘long term winners’, often as you mentioned these types of stocks have sustainable businesses models. again i really appreciate this article and again i hope you can do one for the next 100 in the aSX200. David p

James Greenhalgh: Thanks for the feedback David. We agree—it’s great to focus the mind on the sorts of opportunities that Buffett had in mind for his ‘life time punch card of 20 stocks’ idea.

data gathering for best businesses report

I enjoyed the longer-term focus on stocks in your special report on australia’s 10 Best Businesses, and noticed that you referred to 300 dividend data points and 200 individual years of financial data. having been inspired by graham’s the Intelligent Investor (and Security analysis), I have been interested in conducting similar research for my own portfolio, but was daunted by the prospect of gathering all the data. my question is: how did you collect all of the financial data required (e.g. individual company reports, or some kind of central database)? I note that CommSec has ten years of financial statistics for companies, but wasn’t sure how reliable the data are. Bradley m

Greg Hoffman: Hi Bradley. I’m glad to hear you enjoyed the report. I extracted the dividend data from our (rather expensive) professional information provider IRESS, which provides a summary of publicly available information. For the individual company data, I simply slogged through the annual reports, collecting the data for each year (using 5- and 10-year summaries where I could find them). The Commsec data, I think, is drawn from the Aspect database. For the most part I’m sure it’s relatively accurate, but I’ve had enough problems with that data in the past to prefer extracting it straight from the source documents. That way you also know exactly what you’ve done in your own calculations to



they’ll redeem half in late 2009 and half in June 2010, but we’re also fine if they wait until mid 2010 to redeem the lot. We’ve assumed the latter case to be conservative.

With the equity raising, bear in mind that this is not an SPP but a institutional placement and a non-renounceable entitlement offer. The entire $250m raising is fully underwritten, which means that if unitholders don’t cough up the cash for new shares, the underwriters (JP Morgan and UBS) will. So the money is ‘in the bag’ and won’t be influenced by what the HDF share price does over the coming weeks, which is reassuring for TAPS holders.

taxation, dcfs and asset values

regarding your DCF calculation for transurban, taxation is not mentioned anywhere but I think this does have an impact on the value of the corporation. as an extreme example, a tax rate of 100% would reduce the intrinsic value of the business to zero but I do not believe this is reflected in the model. a tax rate of 30% does not have as extreme an effect but it should still reduce valuation. Jarrod m

Greg Hoffman: Ultimately, we’re all trying to compare competing investment alternatives and choose the best ones. If we had a tax rate of 100%, then all assets would be worth zero. With the Australian system of franking credits, most investors should end up paying tax at their own personal rate. So by conducting a DCF on a pre-tax basis, it allows you to compare the output against other alternatives (such as a government bonds, savings accounts or any other investment).

does currency devaluation cause inflation?

I agree with the other member, matthew. the interview with Satyajit Das was brilliant. and filled with insights. But there is one thing puzzling me. on one hand, Das believed the case for inflation was weak. I believe he was referring to global inflation. on the other hand, he said uS currency was under heavy pressure because of tremendous gov debt. So, if the uS currency is devalued, doesn’t it directly translate to inflation locally? I think

“currency devaluation = inflation”... John yJames Greenhalgh: Like a lot of things economics-

based, I don’t think it’s quite that simple. Sure, imports become more expensive, but whether that filters through to inflation doesn’t seem to be linear. The Australian dollar fell from 80 cents to 50 cents between 1996 and 2001, for example, and yet we didn’t have an inflation breakout over that period.

represent a higher unspecified percentage of reported net revenue (i.e., once 3rd party commissions are deducted from the other payment forms). nathan’s primary concern is that the aCCC may regulate the quantum of the surcharge applied to all electronic payment forms. however, erik, and presumably the brokers he refers to, have only considered the potential impact of opening just the Cabcharge account market to competitors (the aCCC’s chief concern). most brokers have incorporated offsetting factors to would mitigate revenue loss, such as a 3% processing fee (charged to competitors by Cabcharge) and lower payments to the radio networks (currently one-quarter of the 10% surcharge goes to the networks, though CaB owns several so it’s not quite so simple as saving that portion). the brokers end up predicting a modest fall in profit of no greater than 10%, notwithstanding any one-off fines.thus, nathan’s analysis is focused on the potential reduction in the surcharge applied to all electronic payment forms, while the others have considered a reduction in surcharge revenue relating to just Cabcharge accounts. I’d posit that’s why nathan’s conclusion is so dire. however, one needs to consider the long term implications if Cabcharge loses its monopoly position in the Cabcharge account market. For instance, it may lead to a greater-than-expected loss of market share to competitors within the remaining bank-issued and third-party issued card payment markets. with Cabcharge payment terminals in 96% of all taxis, for now the majority of drivers exclusively use the Cabcharge system. For them it’s not worth the inconvenience of carrying a second (portable) competitor’s terminal when it can’t be used for Cabcharge cards and depending on the terminal, debit cards. either that or the economics just don’t stack up given the need to buy or hire equipment. But notionally more drivers may be willing to carry a second terminal once the market opens up for Cabcharge accounts. and if enough drivers have their own terminal then installation of a Cabcharge terminal may no longer be ‘mandatory’ in new taxis. alternatively, non-Cabcharge terminals may be fitted to taxis. this would reduce Cabcharge’s other forms of revenue, such as installation and rental fees. the final result would be analogous to nathan’s dire prediction. time will tell. mark w

Greg Hoffman: Thank you for the perspectives and numbers, Mark.

hastings diversified redeeming taps trust

FyI from the hDF Spp booklet “tapS may be repaid at two upcoming dates; up to 50% on 31 Dec 2009 and up to 100% on 30 Jun 2010.” Looks like that Spp may fall well short by current trades. peter g

Gareth Brown: Yes, HDF have the right to redeem half the TAPS in late 2009, and we’d be very happy with that outcome. As the option is all theirs, though, it wouldn’t be conservative for us to assume they’ll do that. It’s likely [ ContInueD on page 12 ]


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if timbercorp went bust before the options expired. that’s all history now but I would be interested to know what happens to options when the underlying company goes into administration and ultimately is liquidated. paul p

Greg Hoffman: None of our analysts have ever dealt in unlisted options, so I can’t speak authoritatively. But I assume you’d be able to exercise your options and ‘put’ (ie sell) your Timbercorp shares to the option seller at the strike price. If anybody has a more fulsome explanation (or, indeed, has information to the contrary) I’ll be happy to post it here.

dark blue sea and photon

hi team, any comments on the recent egm requested by photon? I believe a few subscribers own shares in the company, and the stock still shows as a decent holding in the staff portfolio. understand that DBS is too small to cover on an ongoing basis, but would appreciate your take on the situation. matthew D

James Greenhalgh: Greg’s a shareholder in DBS, and has had a bit of a look at the situation. While he’s not necessarily keen on Photon grabbing control of DBS without paying a takeover premium, he is inclined to give them a go to influence the management of the company.

discounted cash flow calculations

I am a new subscriber trying to get an understanding of how transurban was valued in the recent special report “the case for essential infrastructure”. point 5 talks about putting discounted cash flow skills to the test. It seems that after reading the suggested back issues and then trying to put some numbers and formulas into my spreadsheet I have very little skill to use. Could you run through a DCF for a single toll roads so i can see how to calculate the appropriate multiples? Dean F

James Greenhalgh: Hi Dean. Yeah, Steve made a bit of leap here, and DCF isn’t easy to get your head around (unless you’re a brainiac like him...). I’ve passed your comments on. We’re thinking we might do something to help people understand DCF a bit better and how certain assumptions translate into different multiples.

options exercise

Some time ago I was considering buying some treeS securities and insuring them by buying put options on timbercorp. I didn’t, in part because I found ComSeC’s terms and conditions very intimidating but also because I was not clear on what would happen to the options

optimism = fees, corporate bonds and the great de-leveraging · 2014-10-12 · every published...

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