In thIs Issue... The same policies that got the world economy into

weekly review | ISSUE 320a | 14–20 may 2011
CONTENTs
In this issue...
STOCK REVIEWS
STOCK
News Corp Class A
News Corp Class B
Origin Energy
RHG Group
ASX CODE
Recommendation
NWSLV
Long Term Buy
NWS
Long Term Buy
ORG
Long Term Buy
RHGHold
PAGE
7
7
4
6
stock UPdates
Catalpa
CAHHold
Commonwealth BankCBA
Hold
WHK Group
WHGBuy
9
10
10
features
The Greenspan Putsch 2
Investor’s College | How to be a debt detective 8
Doddsville blog | Correlation or causation?
11
Extras
Bulletin board—MAp Group
Blog article links
Podcasts & Videos
Twitter article links
Important information
Ask The Experts
12
12
12
12
12
13
John Addis
The same policies that got the world economy into trouble are
being used to dig us out. We’re in unchartered waters, it’s time to
prepare... (see page 2)
Gaurav Sodhi
This energy giant sits atop an industr y with favourable
characteristics and growing retail prices. So far, few investors have
noticed the potential... (see page 4)
Steve Johnson
RHG has been the gift that keeps on giving, but all good things
come to an end. RHG is no longer a straightforward proposition...
(see page 6)
RecomMendation changes
Gareth Brown
Origin Energy upgraded from Hold to Long Term Buy
WHK Group upgraded from Long Term Buy to Buy
Ignore the headlines, as the Cable Network Programming division
produced another stellar result... (see page 7)
PORTFOLIO CHANGES
There are no recent portfolio transactions
Nathan Bell CFA
Off-balance-sheet debt bankrupted numerous financial engineers.
This is how to avoid other businesses pulling the same trick... (see page 8)
Gareth Brown
A common mistake in investing, and in the broader economy, is
to confuse correlation and causation... (see page 11)
The Intelligent Investor
The same policies that got the world economy into trouble are being used to dig
us out. We’re in unchartered waters, it’s time to prepare.
Key Points
Quantatative easing is old fashioned money printing
There is a cast of villains that led to the near-collapse of the global banking system
and the crisis that ensued.
Republicans blamed Bill Clinton for ‘relaxing’ controls on Fannie Mae and Freddie
Mac, encouraging dirt poor people to get their first mortgage on terms they couldn’t
afford. Democrats blamed him too, for signing into law the repeal of the Glass Steagall Act
(sponsored by two Republicans). Lowly-geared retail banks could now purchase highly
leveraged investment banks, with depositors wearing the risks. Others blamed the fraudsters
that sold the mortgages and the bubble machine makers on Wall Street.
Almost all of them got away with it. After the Savings and Loans crisis of the 1980s, there were
2,000 prosecutions. The global financial crisis (GFC), a greater and more systemic collapse, has
produced a parsimonious crop. Lee B. Farkas has been the only successful prosecution thus far.
The GFC wasn’t Farkas’s fault. His role in a long running $2.9bn fraud was the GFC
equivalent of stealing a Freddo from a newsagent. If anyone is to shoulder a greater burden,
it’s the man formerly known as the world’s greatest central banker, Alan Greenspan.
Monetary stimulus policies are exhausted
High sovereign debt levels threaten stability
The Greenspan effect
At every stage of the economic cycle, from crises in Mexico, Asia, Russia and Argentina,
to the collapse of Long Term Capital Management in 1998, from the dotcom crash of 2000
to 9/11, Greenspan’s response was the same: make money cheaper.
In the short-term it worked. Everyone could ride the various booms and, at the first sign
of trouble, Greenspan would walk down the steps of the Federal Reserve waving cheap
money to bail out the feckless and the stupid. Traders, brokers and fund managers rejoiced.
There was now a floor to foolishness and no gate on greed. It was one helluva party.
This policy, known as the Greenspan Put, lasted from the late 1980s to 2006, coinciding
with his term as Chairman of the Fed. Many also believe it was central to The Great
Moderation when the previously resistant boom/bust nature of the business cycle finally
succumbed to the policymaker’s will. Keynes was dead. Monetary policy was king.
It was a false God, of course. In continually preventing crises over the short term,
the inevitable long term crisis was made worse. Excessive risk taking wasn’t curtailed;
misallocation of capital wasn’t punished; and salutary periods of slow or negative economic
growth, which can rid the system of bad debts, didn’t happen. The ‘great moderation’
became a giant IOU to the next recession.
Chart 1: US Federal Reserve total
assets (US$bn)
3,000
2,500
2,000
1,500
1,000
500
2
May 08
May 09
May 10
May 11
Helicopter’ Ben rides in
When that IOU fell due during the GFC, Greenspan was gone. His replacement, Ben
Bernanke, was better armed. Whereas Greenspan had one tool in his armoury Bernanke had
two—interest rates and a giant US dollar printing press. In the form of a new administration,
he also had a willing accomplice in using it.
These tools allowed the bankers to be bailed out on a scale hitherto unknown. The debt
that the US banking system should have written off, through bankruptcies and defaults,
was worn by less wealthy, recently foreclosed citizens, a growing army of unemployed and
a reduction in public services. Private debt, and not just in the US but in Europe too, had
been socialised. The profits of the boom had been kept largely for the exceedingly rich;
the pain of the collapse was to be shared.
The bailout didn’t just bring back from the dead zombie banks, it also exhumed John Maynard
Keynes and the idea that government spending was again a useful economic tool. Interest rates,
which by now were near-zero (see Chart 3 below), had lost their usefulness. Arguments for
Weekly Review | Issue 320a
kickstarting failing economies with debt-financed programs were made, including Kevin Rudd
and the Building Education Revolution. Trillions were spent. And much of that money was
simply created with a rolls of paper and a printing press, conjured from thin air (see Chart 1).
The result is a more fragile environment than almost anyone cares to admit and a policy
bind that is unlike any other in contemporary US economic history. In effect, two of the
most powerful weapons in the US government’s arsenal are a spent force.
Pushing the limits
US interest rates are now so low that borrowing costs are effectively free. Bernanke has
also flooded the US economy with almost $2 trillion dollars. We’ve had Quantitative Easing
I and II—which is how the Fed describes it’s money printing—and QE3 looms.
Investment, in a textbook definition of a liquidity trap, remains unresponsive. Corporations
are sitting on huge capital sums. If they are investing, they’re doing so overseas. Individuals,
worried about the future, are saving in an almost unamerican way. And yet the financial
system is awash with cheap money. Bernanke’s problem, and therefore almost everyone’s,
is that banks don’t want to lend it out and customers don’t or can’t borrow it.
It was once thought that the idea of monetary policy, the foundation of Greenspan’s
wonder years, becoming utterly ineffective was fanciful, a distant, theoretical outpost of
academia. The US proves it wasn’t. ‘Pushing on a string is all too real’.
The Keynesian weapon of government spending also faces challenges. Five years ago,
US debt stood at 63% of GDP. It’s now above 93%, as you can see in Chart 2. The case
that the US is at risk of default is weak­during World War II debt increased to 122% of
GDP—but if enough people come to believe that view, financing the US deficit will become
more costly, perhaps debilitatingly so. Bill Gross of Pimco and head of the world’s largest
bond firm recently sounded the alarm by selling out of US Treasuries entirely.
The political environment is such that cutting the deficit, rather than expanding it to help
increase economic activity, seems a more likely course. Residents of the United Kingdom
are getting a taste of how this can curtail a recovery and cause immense social damage.
Chart 2: US federal debt as % of GDP
15,000
100
12,000
80
9,000
60
6,000
40
3,000
20
0
Challenging future
The US may not have been here before but Japan certainly has. After the bursting of
its property boom, the government reduced interest rates to near-zero and indulged in
massive pump priming. The systemic bad debt was covered up, never expunged from
the system. The result has been a 20-year recession. Government debt, at over 220% of
GDP, is now the highest in the developed world and a recovery seems as distant as ever.
The US hopes to avoid that fate but in attempting to do so grapples with another risk:
inflation. As the experience of Weimar Germany attests, flooding an economy with printed
money rarely ends well. No one knows how China might react to its US$1,160bn of US
foreign reserves being continually devalued by US policies either. The market reaction to
an outbreak of inflation is also a great unknown, as is the commodity price boom.
Whether the US and Europe can chart a course between Japanese-style deflation
and rampant inflation is guesswork. The authorities rarely get it right. What is clear is that
this is an exceptional time. The economic policies that stretched from the early 1980s to
the end of the last decade were of the same model. Your investment approach is almost
certainly based on that model.
Right now, that model is broken. What got us here, as they say, won’t get us there. The
question is how you can prepare your portfolio for a time of sluggish economic growth,
devaluations, currency wars, deflation and/or inflation.
The monthly Director’s Cut feature will continue to address these questions, and help
you distill our recommendations into a cohesive and intelligently diversified portfolio. Next
month we are introducing another regular feature focused on broader economic and investing
issues. We are yet to agree on a name, but this review is one example of what you can expect.
Many bottom up value investors have historically paid scant attention to broader
economic issues. But investors need to be aware of external factors, as government and
central bank policies will impact your portfolio’s returns until the deleveraging process runs its
course. As Seth Klarman warns, ‘Bottom-up value investors would not wish to bet the ranch
on a macroeconomic view, but neither would they be wise to ignore the macroeconomy
altogether. Disaster hedging—always an important tool for investors—takes on heightened
significance in today’s unprecedentedly challenging environment.’
1960
1970
1980
1990
2000
2010
0
GDP–US $ billion (LHS)
Gross public debt-fed % of GDP (RHS)
Chart 3: Federal funds rate (%)
20
15
10
5
0
1980
1990
2000
2010
First published online 18 May 2011
3
The Intelligent Investor
This energy giant sits atop an industry with favourable characteristics and growing
retail prices. So far, few investors have noticed the potential.
Key Points
Wholesale electricity prices expected to rise
Origin retains cost advantage
LNG project holds latent value
Origin energy | ORG
Price at review $16.09
Review date 20 May 2011
Market cap.
$17.2bn
12 mth price range Fundamental Risk Share price risk Our View $14.11—$17.20
2.5
3
Long Term buy
Very occasionally, a great company with high returns on capital, a resilient business
and a strong balance sheet becomes available at an attractive price.
Recognising value in such situations is a matter of metrics. That has been the case
with, say Cochlear or ARB Corporation in the past and QBE today (see QBE upgraded: A
classic buy, issue 298). At other times, however, simple numbers and ratios can flatter to
deceive, disguising quality and hiding value. Such is the case right now with Origin Energy.
On most measures, this stock is a pig. Its return on assets is low and you can make a higher
return on equity by sticking your cash in the bank. Origin also consumes monstrous amounts
of capital. On paper it looks more like Bluescope Steel than Cochlear. And yet, in this first of
a two part analysis, we’re about to recommend it as a Long Term Buy. We will flesh out our
valuation in part two but, before we can do that, we need to know something about electricity.
Where does electricity come from?
Flicking a light switch is a simple act. Converting raw materials into energy and delivering
it to homes isn’t. Before energy can be used in gadgets, it must be found, extracted and
transported to users who are then billed for consumption (see five stages of electricity
box). The transmission and distribution parts of this cycle are what’s known as natural
monopolies; it makes no sense for different businesses to build a competing set of wires,
so what the owners of those assets can charge is regulated (see Spark’s WACCed up
returns, issue 275, for an explanation of how this works).
The five stages of electricity
Production —
Extraction of coal, oil and gas
Generation — Raw materials are fed into powerplants that produce electricity
Transmission — Electricity is transported in bulk over long distances from generators to substations
Distribution — Electricity is transported from substations to users via ‘poles and wires’
Retail — Selling to consumers, metering, billing
Origin operates in the non-regulated parts of the sector. While retail prices are regulated,
there’s a twist. Regulatory bodies such as IPART in NSW set the maximum price that retailers
like Origin and AGL can charge customers. But in urban markets, for example, where the
cost of supply is low, price competition means Origin can fight for customers and charge
less than the regulated tariff, yet earn higher returns than most regulated businesses.
Origin’s real competitive advantage, though, lies in an area where there is no regulation
at all; power generation. Under the intelligent stewardship of Grant King, who realised early
that energy assets would become more valuable, Origin assembled some of the biggest and
best gas and generation assets in the industry at a fraction of what they would cost today.
With a massive pool of cheap production and generation capacity, price regulation isn’t
a big deal. Origin’s growth has come not from the (largely) regulated price at which it sells
energy but from the low costs of producing it.
The results are clear to see in Chart 1. Since breaking off from Boral a decade ago,
Origin has thrived.
Origin can supply customers with power from two sources; it can venture into the
National Electricity Market to buy wholesale power or it can use its own resource base; at
three times the generation capacity of its rival, AGL (see Chart 2), it’s the largest power
4
Weekly Review | Issue 320a
generator in the market. This is a key point. If wholesale electricity prices rise markedly in
the years ahead, Origin, through its integrated business model, has protection baked in.
That’s just as well. In The Case for LNG Part 2 (see issue 318), we argued that as
huge gas export hubs are built on Australia’s east coast, gas prices will rise. Installing new
capacity and displacing coal with gas power will also force higher prices. Origin can afford
to be less concerned about this trend than its main competitor, AGL.
Two factors now make Origin an even more attractive proposition. The first is the
purchase of NSW’s electricity customers from former state hands; the second the signing
of a large LNG deal with Sinopec. Let’s look at each in turn.
Chart 1: Underlying profit ($m)
600
500
400
300
200
100
Favourable industry structure
In the early 1990s electricity markets were largely disconnected and regional. Governments
owned distribution, generation and retail functions but market share was split between many
competitors. Privatisations dramatically changed that. State-owned companies, accused of
only being interested in market share, have been sold to private, profit-driven operators.
The results are striking. Origin has increased its share of customer accounts from 4%
in 1999 to 33% today, largely through acquisitions like the recent purchase of the retail
arms of Integral Energy and Country Energy from the NSW Government.
Origin is now the largest energy retailer in the land. In a business where scale matters, this is
another crucial advantage. TRUenergy, the smallest of the retailers, recently complained that the
regulated tariff is too low to earn a decent rate of return. Origin has been very successful on the
same tariff, highlighting the benefits of building scale. The threat of new entrants is also remote
and the industry is taking on the appearance of a cosy oligopoly dominated by AGL and Origin.
Whilst the market appears worried that AGL, having lost out on the last big expansion
opportunity, will start a price war, that’s not the way oligopolies usually work. Just look at
banking or supermarkets. AGL also knows that Origin has a cost advantage and that anything
it can do, Origin can do cheaper. AGL may talk aggressively, but it will act rationally. The
threat of a price war in the retail market is overstated.
0
‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10
Source: Company presentation, 2011
Chart 2: Market share of
generation capacity in NEM (%)
Origin
TRUenergy
Macquarie Gen
Snowy Hydro
IP
AGL
2
4
6
8
10
12
Source: Company presentation, 2011
The best of LNG
The second factor concerns Origin’s coal seam gas (CSG) joint venture with ConocoPhillips,
an LNG project known as Australia Pacific LNG (APLNG). Long before it became fashionable,
Origin pegged prospective CSG ground for almost nothing. In 2008, it sold 50% of its
resource to the American giant for an unprecedented $9.6bn, including $6bn in cash.
The partners plan to develop a project to rival the mighty North West Shelf. As APLNG
is the biggest and best CSG resource in Queensland, this is a real possibility (see Chart
3). Recently, Sinopec signed up as a major customer to take all the output from the first
processing facility (or train) from APLNG. Sinopec also took an equity stake in the project
that valued it at $10bn (Origin’s stake is $4.25bn) but as the project expands and gets
closer to production, this figure may well increase.
Developing APLNG is a mammoth task that will consume tens of billions of dollars of
capital. Origin doesn’t have to spend a cent until ConocoPhillips spends the first $2.3bn,
but we expect that Origin will raise equity at some stage. For that, it will receive a big stake
in a project that will generate revenues for decades. In time, APLNG could become Origin’s
largest asset. Right now, it’s barely factored into the share price.
The origin of value
That Origin is trading bang in between our bear and best guess estimates of value (see
Table 1) paints a telling tale; this is no screaming bargain.
But Origin has spent a decade carefully assembling a prime suite of assets. That work
is now bearing fruit. Over the coming years, as the structure of the industry and Origin’s
dominance of it becomes clear, financial returns will improve. The value unleashed from
APLNG, currently mute in the company’s valuation, may also prove immense.
Now, when there is scepticism about the company’s LNG ambitions and concerns
over retail competition, is the time to begin building a stake. We’re recommending an
initial stake of about 2% of your portfolio, allowing you to top up should Origin become
cheaper or raise capital.
In part two of this review, we’ll flesh out the valuation in Table 1. Seeing value in Origin
right now isn’t obvious; over time it will be. LONG TERM BUY.
Chart 3: CSG reserves by project,
3P (2011)
15,000
12,000
9,000
8,200
8,000
0
APLNG
QCLNG
CSLNG
GLNG
Source: Company presentation, 2011
Table 1: Valuation per share ($)
Bear case Best guess
APLNG 3.80 9.65
Exploration & Production
2.00 2.70
Generation 4.00 4.25
Retail 4.20 5.95
Contact 1.35 1.70
Debt (2.45) (2.45)
Corporate (0.95) (0.95)
11.95 20.85
Total 5
The Intelligent Investor
RHG has been the gift that keeps on giving, but all good things come to an end.
RHG is no longer a straightforward proposition.
RHG Group | RHG
Price at review Review date market cap.
12 mth price range $0.485
16 May 2011
$142m
$0.47—$1.32
Fundamental Risk 3
Share price risk 3
Our View Hold
Can there be any more ways to make money out of one stock? Whether you’re a risk
tolerant cigar-butt lover, a conservative long-term investor, an arbitrager or a franking credit
trader, unlike the Federal Budget, RHG Group has had something for everyone. With the
stock currently trading at 48.5 cents after going ex-dividend, for those who bought shares
at or below $1.25 due to RHG finally gets the message (Hold—$1.28) or RHG: A Laydown
Misere for SMSFs, you can take your place in the smug camp.
The question now is whether you should buy, hold or sell at today’s price. Updating
our valuation table is relatively straightforward. Just subtract the cash and franking credits
that have been distributed from the previous valuation.
Table 1: Total value
Pessimistic
Base
Optimistic
Default casecasecasescenario
Existing assets
76 97117
Future profitability
58 7286 15
Franking credits
Total
Shares on issue (m)
6
38
45 5565 21
179 224268
74
306 306306 306
Value per share—100% of franking credits
0.58 0.730.88 0.24
Value per share—50% of franking credits
0.510.640.77 0.21
Value per share—0% of franking credits
0.44 0.50.66 0.17
As you can see, we think the business is worth between $0.44 per share (in a pessimistic
scenario assuming you can’t utilise the franking credits) and $0.88 per share (in an optimistic
scenario assuming full utilisation of the franking credits).
This range of scenarios doesn’t include the ‘default scenario’, where the company is
unable to refinance its warehouse facilities. Nor does it include a super optimistic case, where
a purchaser attributes significant value to RHG’s customer list. For Bank of Queensland,
for example, RHG’s mortgage book would presumably be a useful springboard into the
southern states. But a large percentage of the expected outcomes lie within the range
provided above.
With the share price at $0.50 and the bottom end of the range, it doesn’t look
screamingly cheap. But there is likely more upside yet, particularly for those investors who
can fully utilise the franking credits.
For all investors, our recommendation is HOLD. For super funds and investors on low
tax rates, RHG still looks attractive for a small part of your portfolio if you don’t already own
it. Please take particular note of the portfolio limit. With RHG paying out all of its cash, it is a
much riskier proposition than when its entire market capitalisation was sitting in the bank.
This will be my last review of RHG for Intelligent Investor. If you want to find out more
about the other stocks currently in the Value Fund, you can read the latest quarterly report,
register for Bristlemouth email updates or, even better, invest in the fund.
Weekly Review | Issue 320a
Ignore the headlines, as the Cable Network Programming division produced
another stellar result.
News Corp Class B | NWS
$17.03
Price at review At the risk of sounding as predictable as a James Cameron plotline, we again implore
investors to skip News Corp’s third quarter headline profit figure and head straight to the
division breakdown.
The company’s crucial Cable Network Programming division has grown earnings before
interest and tax (EBIT) at 30% -plus annually in recent years, and we’ve called for more
subdued but still impressive 15-20% growth over the next few years. So it was pleasing to
see third quarter Cable Programming EBIT growth of 25%—to US$735m—on 13.5% revenue
growth, although some of this strength must be attributable to US dollar depreciation which
increases reported earnings from non-US subsidiaries. Filmed Entertainment delivered an
expectedly lower EBIT, down 50% to $248m because the comparable period included a big
boost from Cameron’s Avatar blockbuster. In contrast, Television continued its impressive
turnaround from recessionary lows, with EBIT of $192m versus $40m a year earlier.
Since the start of 2011, the price of our preferred pick of the two classes of shares—the
Class A non voting shares (ASX code NWSLV)—has increased 15% while the voting B share
(ASX code NWS) has increased 6%. But the rising Australian dollar has disguised a bigger
move in the underlying US securities, which are up 18% and 10% respectively. So News
Corp shares have become comparatively less cheap, but they’re still quite cheap. And the
industry and currency diversification News Corp shares can offer Australian portfolios is
as attractive as ever.
Both classes of share remain a LONG TERM BUY for, in combination, 5% of a welldiversified portfolio. But we retain our preference for the cheaper non-voting A shares
(ASX code NWSLV).
17 May 2011
Review date $13.8bn
market cap.
12 mth price range $15.54—$18.70
Fundamental Risk
2
Share price risk 3
Our View
Long Term Buy
News Corp Class A | NWSLV
Price at review
$16.39
Review date 17 May 2011
market cap.
$13.8bn
12 mth price range Fundamental Risk Share price risk Our View $13.60—$17.39
2
3
Long Term Buy
Want to know more?
Bulletin board
7
The Intelligent Investor
Off-balance-sheet debt bankrupted numerous financial engineers. This is how
to avoid other businesses pulling the same trick.
Key Points
You won’t always see all of a business’s debt on its
balance sheet
Hidden debt can be very dangerous
This article explains how you can deal with it
Table 1: Eastfield balance sheet
100
Assets ($m)
Liabilities ($m)
80
Equity ($m)
20
Table 2: Enrun balance sheet
Equity accounting Consolidation
Assets ($m)
Liabilities ($m)
Minority interests
Equity ($m)
12100
080
0–8
1212
If you looked at a business’s balance sheet, you’d probably (and reasonably) expect
to see a list of all its assets and liabilities. Sometimes you will but at other times, some of
those liabilities will be hidden. In this article you’ll learn where and how to look for them.
Let’s start with a simple example of how and why debt can lurk off-balance-sheet.
Eastfield is a property group whose sole asset is a $100m shopping centre. As you can see
in its balance sheet in Table 1, it’s funded with $20m of equity and $80m of liabilities (debt).
A second company, Enrun, owns a 60% stake in Eastfield. How would Enrun carry
its investment on its own balance sheet? There are two intuitive approaches that its
accountants could follow.
The first is to use only the net value of Enrun’s investment. Eastfield as a whole is
worth $20m; its equity value. Enrun owns 60% of that equity. So let’s pencil in a $12m
asset on Enrun’s balance sheet.
But hold on. That doesn’t tell the full story. Enrun’s 60% stake in Eastfield represents 60%
of a $100m asset and 60% of an $80m liability. Applying this reasoning, Enrun’s balance
sheet would show a $100m asset offset by an $80m liability and minority interests of $8m
(40% x (100m—80m)). In other words, Enrun absorbs all of Eastfield’s assets and liabilities
and backs out the minority stake that it doesn’t own in order to produce equity of $12m.
Equity accounting versus consolidation
The first approach describes ‘equity accounting’. This methodology is generally used
when a business owns 50% or less of an investment and doesn’t have control over it.
The second is called consolidation. It’s applied to investments which are more than 50%
owned, or which are controlled in some other way.
While equity accounting is a sensible treatment for small, unleveraged investments, it’s
misleading with larger and highly leveraged ones. In the example above, equity accounting
makes Enrun look far better capitalised and less risky than it actually is.
That’s a big problem. When investors don’t realise they’re exposed to such debts, they
can get into a lot of trouble.
Where are you most likely to find off-balance-sheet debt? The most troublesome areas
are listed infrastructure stocks, property groups and financial companies.
Typically, property and infrastructure groups enter joint ventures (and use equity
accounting) when they can’t afford to buy an entire asset. This means that precisely when
a business is financially stretched, investors can’t see all its debt on the balance sheet.
Banks and other financial institutions, on the other hand, can use off-balance-sheet
debt to achieve greater leverage without breaching capital adequacy requirements.
Crouching tiger, hidden debt
Having identified the problem and why it arises, let’s now fix it using a real life example.
Table 3: Goodman Group balance sheet
Assets($m)Liabilities and equity($m)
Current assets
1,020
Current liabilities460
Equity accounted investments
2,279
Non-current liabilities2,416
Other non-current assets
4,299
Total liabilities
2,877
Equity
4,722
Liabilities + Equity
7,598
Total assets
8
7,598
Weekly Review | Issue 320a
Table 3 is a simplified version of Goodman Group’s balance sheet as at 30 June 2010.
Like the first version of Enrun’s balance sheet, only the net value of Goodman’s equity
accounted investments in associates and joint ventures are shown.
In Table 4, though, we’ve adjusted Goodman’s balance sheet by splitting the $2,279m of
equity accounted investments into $5,055m of assets and $2,776m of liabilities. Acquiring
those figures required hunting through Note 13 of Goodman’s accounts and finding the
assets, liabilities, and proportional ownership of each of Goodman’s 34 joint ventures and
associate entities. This sort of accounting detective work takes time but is very necessary.
Table 4: Goodman Group adjusted balance sheet
Assets($m)Liabilities and equity($m)
Current assets
1,020
Current liabilities460
Prop. assets of JVs and assoc’s
5,055
Non-current liabilities2,416
Other non-current assets
4,299
Prop. liabs of JVs and assoc’s2,776
Total assets
Total liabilities
Equity
10,374
Liabilities + Equity
5,653
4,722
10,374
Arcane accounting rules mean these figures are close estimates rather than exact
amounts. But the big picture is clear: Goodman’s financial position is far less flattering
when all its liabilities are brought on-balance-sheet. Its $4.7bn of equity actually supports
$5.7bn of liabilities, double the $2.9bn that its balance sheet shows.
A serious concern
Investors can get away with not knowing most accounting intricacies but it’s crucial
that you understand this one.
The fates of Babcock & Brown, Allco Finance Group and the Rubicon suite of funds
explain why. All had opaque balance sheets and off-balance-sheet debts. That’s not why
they went broke; any old debt would have done the trick. But it’s probably the reason that
these risky and leveraged businesses reached the heights that they did, and why so many
investors got wiped out as they imploded.
With off-balance-sheet debt, what you don’t know can really hurt you. But if you apply
these concepts, you can avoid these painful and potentially disastrous mistakes.
Rival gold miner St Barbara Mines has presented Catalpa Resources with a ‘merger’ (read
takeover) proposal valuing the company at around $1.92 per share. Catalpa shareholders
would receive 50% in cash and 50% shares in St Barbara, with management telling
shareholders to sit tight while it considers the deal.
The takeover price is significantly below our fair value estimate of between $2.30 and
$2.50, discussed on 6 Oct 10 (Speculative Buy—$2.06). To justify that valuation, though,
Catalpa must overcome a series of operational setbacks at its main asset, the Edna May
mine, which have cut production and Catalpa’s share price. As Edna May is a low grade
Catalpa | CAH
Price at review Review date Our View $1.66
16 May 2011
Hold
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The Intelligent Investor
mine, production falls can savage profits, and lower output has increased costs dangerously.
Salvation is at hand, though. New discoveries of high grade ore underground can be
blended with existing low grade ore to boost production. We’d prefer to see a few quarters
of higher production before deeming Edna May’s troubles at an end. But with the worst
likely over and production levels set to increase, St Barbara’s bid appears opportunistic
and, in our view, undervalues Catalpa.
The share price is down slightly since 31 Jan 11 (Hold—$1.72) and, while we wait for
further news, we recommend you HOLD.
Note: The Growth portfolio owns shares in Catalpa Resources.
Commonwealth Bank | CBA
Price at review
Review date Our View $52.06
19 May 2011
Hold
Portfolio point
WHK Group | WHG
Price at review
Review date Our View 10
$0.88
13 May 2011
Buy
Commonwealth Bank’s recent third quarter update showed cash earnings of $1.7bn,
which would’ve been $1.4bn without a $300m fall in bad debts. In the 2010 March quarter
the bank earned $1.5bn despite $500m of bad debts, so the underlying result wasn’t as
good as it first appears. Still, having produced cash earnings of $5bn for the first three
quarters, Commonwealth is on track to exceed its 2010 full year profit of $6.1bn.
That’s good news for future dividends, but comments from chief executive Ralph Norris
summed up our dim view of the potential for capital gains from here; ‘Fragile consumer
and business confidence is reflected in subdued credit demand’. We’re not betting that
this will change quickly, given the recent round of bank profit results showed signs that
consumers were struggling with debt.
While Australia’s economic performance is remarkable, it’s unbalanced due to the
resources boom. Retailers, for example, are struggling. We’re lowering the prices in the
recommendation guide to increase our margin of safety but, with the share price falling
5% since Commonwealth enjoys the best of times on 9 Feb 11 (Hold—$55.07) we
recommend you HOLD.
WHK Group’s share price has fallen 16% since its relatively poor interim result discussed
on 22 Feb 11 (Long Term Buy—$1.05). The imminent departure of Kevin White–WHK’s
managing director since 1996–also creates uncertainty. Though parts of the Australian
economy remain sluggish, and we’re not expecting a dazzling second half result, we still
expect the company to pay a 4 cent final dividend, fully franked. That would bring the
annual total to 7 cents, putting WHK on an attractive 7.9% fully franked dividend yield.
Though accountancy and financial planning are staid businesses, one estimate suggests
self managed superannuation funds will account for 38% of the financial planning industry’s
revenues in three years (up from 25%), with 81,000 new funds opening annually. WHK is
well placed to capitalise on this growing trend, but don’t expect rapid profit growth. Overall,
WHK is a mature business operating in fairly mature industries.
Provided the economy remains relatively strong, investors don’t need much in the
way of capital gains to produce a respectable return. As the recent pullback in the share
price looks overdone given the company’s relatively stable cashflows, we’re increasing the
portfolio limit to 6% and upgrading to BUY.
Weekly Review | Issue 320a
A common mistake in investing, and in the broader economy, is to confuse correlation
and causation. Correlation means that two phenomena tend to go hand in hand. Say, a
recession and higher unemployment. Or high ice cream sales and drowning deaths (thanks
for the example Wikipedia).
Causation, on the other hand, means we go so far as to say that a change in one variable
caused the other. Sometimes that’s right. But often we assume we understand causation
when we’ve merely identified a correlation.
If I say that high ice cream sales caused an increase in drowning deaths, the mistake
is obvious. But perhaps you’ll believe me when I say that a recession caused the
unemployment, when the reality might have been the other way around. Or they might
have independently moved in the same direction. Or perhaps a little slip in one started a
trend where they’re both feeding off each other.
As a registered member of the Australian house price bears’ club, I’m always coming across
what I believe is a confusion of correlation and causation on the topic. Take this recent article
on BusinessDay websites across the country: Real estate slump will leave banks in pain, too.
I don’t want to single out Ian Verrender, he generally provides high quality commentary,
including most of this article. But there’s an all-too typical misunderstanding in there, one
you can find most days in the newspaper. When talking about the potential for a bursting
house price bubble in Australia, Verrender says:
Given we are approaching full employment and with our terms of trade at record levels,
the chance of that happening are slim, in the near term at least.
In my opinion, and in the opinions shared in some of the comments below the article,
this statement mistakes correlation for causation. It suggests that a strong economy caused
the high house prices (causation). Ergo, house prices can’t fall substantially unless or until
the economy comes off the boil.
Few would argue that there’s a correlation between high house prices and a strong economy,
although I haven’t crunched the numbers to see how strong the correlation is. But I agree
it’s unlikely that we can have a significant house price correction without a weaker economy.
But it’s not a one-way street. Rising house prices—fuelled by a borrowing binge—can
strengthen an economy (at least apparently), boosting construction and retail spending
and creating a positive feedback loop, until something (anything) upsets it.
Similarly, overpriced houses—or any other overpriced asset for that matter—can run
out of steam by themselves. They have a tendency to eventually self-correct. The process
of self-correction, on its own, can lead directly to job losses in construction and the real
estate industry, and potentially second order job losses in the retail sector as consumers
shut their wallets as house prices fall (negative wealth effect), and further weakening as
a real economic slowdown and further house price falls contribute to another positive
feedback loop, this one on the downside (until it too stops).
Of course, it might not work this way in 2011. House prices mightn’t fall at all. Or they
might fall because of an exogenous shock—the sort that most pundits believe is the only risk
to house prices. There is a lot to worry about in this area, and most concerns point to China.
But I can also envisage a house price correction coming first, followed by a slowing domestic
economy. In fact, as the first commenter below Verrender’s article points out, that’s what seems
to be currently occurring in Perth and Brisbane. The US housing and economic slowdown also
seemed to work in that order—house prices started falling before the economic slowdown kicked in.
House prices and economic conditions are a little like the chicken and the egg—they
generally go together, but it’s hard to know which came first. Sometimes it’s one, sometimes
the other, and sometimes we can’t know. That implies correlation only. Those who confuse
correlation and causation are missing the bigger picture. And they’ll only recognise the
bursting of the bubble once its shows up in the unemployment numbers.
ONLINE COMMENTS
Dave
davinci7
james
First published online 17 May 2011 at our Doddsville blog.
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The Intelligent Investor
Below is a list of Doddsville and Bristlemouth blog articles published by our analysts this week.
Doddsville blog | A commodities bubble is brewing
Bristlemouth blog | Return on equity: A quiz
Bristlemouth blog | Why News Corp Needs to Grow and Telstra Doesn’t
Below is a list of podcasts published to the website during the past week
Stock Take podcast | Fisher & Paykel Healthcare, Treasury Wine Estates and Centrebet
Dumb questions video | MAp Group
Below is a list of this week’s article links posted by our analyst team to our Twitter page.
An interesting take on the now famous Grantham letter.
George Soros has been selling down his gold ETF’s. China is The Mother of All Gray Swans and Japan is Past The Point of No Return. High rise luxury apartments in the Pilbara? This will end badly. Oaktree Capital Chairman Howard Marks discusses the “human side of investing”. .
David Nierenberg (D3 Family Funds) says equity markets will likely remain in a long-term bear phase.
How Bruce Berkowitz stumbled with AIG. How they failed to catch Madoff.
Germany looks like phasing out nuclear power altogether. The Japan effect has been underestimated.
Jeremy Grantham recommended this Rolling Stone article on TALF handouts.
Important information
The Intelligent Investor
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[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 2011. 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: ABP, ALL, ALZ, APH, ARP, AVG, AVO,
AWC, AWE, BBG, BER, CAH, CBA, CFE, CIF, CMIPC, CND, COH, CRC, CSL, CUE, EBT, ELDPA, FGL, FLT, HVN, IAG, IDT, IFL, IFM, IMF, IVC, JIN,
KRS, LMC, MAP, MAU, MFF, MLB, MQG, MTS, NABHA, NBL, NWS, PLA, PTM, QBE, QTI, RCU, RHG, ROC, SDG, SDI, SFC, SGN, SGT, SHL, SKI,
SRV, STW, TAP, TGP, TIM, TIMG, TRG, TRU, TWO, VMS, WBC, WDC, WHG, WRT. This is not a recommendation.
12
Weekly Review | Issue 320a
Please note that the member questions below have undergone minimal or no editing and appear essentially as they do online.
Harvey Norman’s land holdings
Hi Nathan, in relation to your response regarding Harvey
Norman below, should there be a property crash in Australia or a
downturn, how will this likely impact Harvey Norman in relation
to its property portfolio? Are we looking at potential asset write
downs? I would assume a residential property downturn would
also impact commercial property? "But Harvey Norman is the
safer bet as it owns a large property portfolio (which Gerry
Harvey discussed in this podcast interview). Billabong has no
such safety net."
19/05/2011, Nathan Bell CFA: That’s quite possible, although
the cap rates on many of Harvey Norman’s are already quite high.
That said, Harvey Norman owns land in regional areas that would fall
faster than higher quality real estate in the major cities. If you haven’t
already listened to it, I highly recommend listening to the discussion
of this topic in the Boss Talk podcast interview.
QBE debt issuance
Hi team, I see QBE has issued US $1 billion of long term
debt today. The amount is impressive, but the interest rate of
7.25 seems less so. Given their cash reserves are early 1–2% on
short term money markets at the moment, does this rate seem
high? Karl W
18/05/2011, Gareth Brown: Points 1 and 4 in the announcement
explain why the price of this debt appears high for US dollar debt. As
the debt is exchangeable into ‘similar debt notes’ at ‘QBE’s election’,
it seems that this debt cannot force the company into insolvency,
which I think is why it fits APRA’s definition of lower tier two capital.
This debt is more of a hybrid than a bond, and deserves closer to
equity-like rates as a result. This money is probably earmarked for
funding acquisitions, and should be thought of separately to the cash
QBE needs to keep at hand for insurance payouts.
More on Billabong International
Hi Guys. Do you see the continued relative strength of the AUD
having a dramatic impact on the future earnings of this stock and
will the continued US Consumer lack of confidence further dent
the forecast earnings? Further to this earnings risks what other
downsides are on the horizons for BBG given that one could easily
foresee debt levels increasing rather than decreasing in the near
term future especially when looking historically at debt levels
increasing against EBITDA during its acquisition march whilst
retail sales have headwinds, where is the longer term upside?
19/05/2011, Nathan Bell CFA: I’d like to think that most of the
currency pain has been absorbed with the Aussie dollar so high. But
we’re open to all possibilities and perhaps another rate rise or two
will cause more pain. That would hurt Billabong in more ways than
one. It would further reduce foreign earnings translated to Australia
(assuming the Aussie dollar rose further), and it would depress the
local economy which is Billabong’s strongest division at the moment.
I think you’ve summed up the major risks well. As we’ve discussed
in past reviews, the relatively new bricks and mortar strategy means
higher debt levels and lower returns on capital, and numerous
acquisitions have diluted earnings directly related to the Billabong
brand. The upside rests with an eventual increase in consumer
spending and currency relief. Having spent so much on acquisitions,
management now needs to prove that the bricks and mortar strategy
can work by reducing costs, avoiding large discounting which devalues
its brands and skilfully executing its apparel design, advertising and
merchandising strategy to maintain the relevance of its brands.
Geographic expansion should also continue. It’s a tough ask in a
deleveraging global economy, but the share price is already factoring
in much of the risk.
Billabong International and Harvey Norman
Harvey Norman and Billabong seem both to be trading cheaply
at the moment. Is there anything that is causing you to hold off
upgrading your recommendation? Billabong in particular is well
below what you have valued it at. Would I be right in thinking that
Harvey Norman is a safer company, but Billabong could have a
lot of upside should our dollar weaken and the market for their
apparel pick up? Dean F
19/05/2011, Nathan Bell CFA: Hi Dean. Both stocks have only
fallen mildly into outright ‘Buy’ territory and, together with Aristocrat,
will be top of James’s list to review when he gets back from holidays
in two weeks. If Harvey Norman’s price drops further then we might
act sooner but we’re not in a hurry to upgrade Billabong as the prices
in the recommendation guide will probably be lowered to reflect the
recent strength in the Aussie dollar (the current exchange rate is well
above what management used to produce its earnings forecast and I
wouldn’t be surprised if the company announces a profit downgrade
for that reason).
Billabong certainly has plenty of upside if the new bricks and
mortar strategy pays off, the Aussie dollar weakens against the Euro
and US dollar and if consumer spending picks up significantly from
current levels. But Harvey Norman is the safer bet as it owns a large
property portfolio (which Gerry Harvey discussed in this podcast
interview). Billabong has no such safety net.
AWE’s value
Hi Gaurav, Firstly thank you for your excellent analysis of
opportunities in the resource sector. I was just wondering about
AWE. With the significant recent share price fall, and in the context
of its latest quarterly production report, do you still see value in
the company. I am considering adding to my current position.
Thanks again.
17/05/2011, Gaurav Sodhi: AWE certainly looks cheap on any
measure, which is why we’ve retained a Speculative Buy on it. There’s
not a lot to justify recent falls, but perhaps a combination of tax loss
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The Intelligent Investor
selling and impatience (crucial testwork on Perth Basin shales is still
to be completed) are factors. The upcoming test results will be very
important and we’ll review the situation in more detail then.
Myer
Hi Team, Is MYR closing in on attractive; I believe we’ll need
to go below the $3 mark? I can’t seem to successfully search
your initial review of the MYR float through your new webpage. Fully franked annual dividends around the 20c would be
quite attractive at these prices, but unsure as to whether that is
sustainable, though I read they are now going to source more
products through China, which may reduce costs. Gladys J
16/05/2011, Gareth Brown: Thanks for letting us know about
your difficulty locating the report. I’ll let the IT team know and we’ll try
to get it on the company homepage soon. In the meantime, here’s a
link the article—Myer float on the stand, our float review from late 2009.
James Greenhalgh, who knows Myer better than the rest of our
analytical team, is currently off on vacation. I’ll need to defer to him.
But it’s my suspicion that Myer isn’t cheap enough for us yet. This
is a cyclical business and thus yield can be misleading—sometimes
the best time to buy is when the yield looks terrible. Retailers are
complaining that times are tough, but I’m not sure they’re that tough
yet. We’re likely to want to see more pain before we get interested.
But again, this is my opinion and might not be shared by James.
Tips for a new investor
Hi so I’m very new to this I don’t know much about stocks at
all but I do know that they take time I am currently 19 years of
age, a first year apprentice as a refrigeration engineer and am
living at home. I’m just wondering if I start investing in stocks
where should I start and what will help me out best to start
seeing results with in 5 years or so?
Gareth Brown: You’ve got three great advantages on your side—
you’re keen, you seem patient and you’re young. Keenness will help
you learn and gain experience, patience will help you avoid too many
mistakes during that process (although be warned, they’re inevitable for
all investors), and at you’re age you’ll have many years of compounding
ahead of you.
Each of our analytical team came to value investing in different
ways, but all sight similar books as formative influences—Warren Buffett:
The making of an American Capitalist, by Roger Lowenstein; One up
on Wall Street , by Peter Lynch; Common Stocks and Uncommon
Profits, by Phil Fisher and The Intelligent Investor by Ben Graham.
We’ve recommended many other books over the years, but these
are a fine starting point for a new investor. For Australian perspective,
of course, we couldn’t go past our own book, Value: The Intelligent
Investor’s guide to finding hidden gems on the market.
On our website, I’d point out in particular the New Members
14
Area and also the significant wealth of information in Investor’s
College where we try to explain important investing concepts in
easy to understand ways. That could be anything from nuts and bolts
accounting to important psychological understanding investors need
to maintain contrarian resolve, such as in The crowd will not make
you rich. There are many other useful things on the website, including
videos and podcasts.
And then it ’s a process of following our analysis and
recommendations, and potential making some small investments
when you feel ready. Then it’s a process of seeing what works and
what doesn’t, and trying to always understand why. If you’re interested
and work at it, it’ll all come together in time.
Holding period rule
Just reviewing the 45 day rule for franked dividends in the
investors college in 2006—its mentioned that it must be 45 days
prior to the ex-date or 45 days after (44 is not good enough).
I checked the ATO website and believe this may have changed
so that as long as you have held for 45 days from the date of
purchase (with the ex-date in there somewhere) then you can
sell and get the benefit of the credits? Thought the investors
college may need to be updated, or maybe I am not reading the
ATO correctly? Simon R
16/05/2011, Gareth Brown: I’m not sure whether there was a
rule change, or whether our 2006 explanation was incorrect at the
time. But I understand the so-called Holding period rule to work the
same way as you’ve explained it (45-days in total). We don’t adjust
old Investor’s College articles, but will be revisiting dividends in an
Investor’s College soon and will endeavour to explain it correctly.
Here’s a link to the relevant part of the ATO website—Holding
period rule—for those wishing to look closer.
Thanks for letting us know Simon.
Cellestis Shareholder Action Group
Do you have any opinion on the activities of the Cellestis
Shareholder’s Action Group, in particular their method of
valuation? It appears that your initiation of activism in the RHG
case has started something. Paul P
17/05/2011, Nathan Bell CFA: Hi Paul, it’s amazing what kind
of values you can create when you forecast 30% revenue growth for
a few years, followed by 20% revenue growth out until 2020. That
seems optimistic to us, and we’d be prepared to let the company go
at a price somewhat above the current takeover offer price, but well
below the $11.63 value produced in the spreadsheet. We’ll have more
to say as more news comes to hand, but it’s great to see this sort of
action. The Internet has given independent investors the opportunity
to get together, and it’s about time more investors started sticking
up for their rights.