Why the Future Fund has got it wrong…

The following is an excerpt from an article voiced by Clime CIO, John Abernethy, that appeared in the Australian on Wednesday 1st February.

The core of the article was the assertion that both the investment strategy AND the number of consultants employed were not in the best interests of the holders of the Fund.

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“The fund just keeps buying everything, spreads its investments too widely and hopes,” John Abernethy, the executive director of Clime Investment Management, said yesterday.

“Once you start doing that you are going to get mediocre returns.

“Why don’t they just try to invest and select stocks without buying the index?

“It is just another big pension fund being mismanagement by asset consultants.”

Mr Abernethy’s comments come after the $73 billion Future Fund released details of its portfolio as at the end of last year.

Its latest portfolio update shows the fund has substantially increased its holding of cash, from 8.8 per cent at the end of June to 13.8 per cent at the end of December.

It has cut back its stake in property from 6.5 per cent in June to 6 per cent at the end of December and its holding of debt securities from almost 20 per cent of the portfolio in June to 17.8 per cent.

The total value of the fund has fallen from just over $75bn at the end of June last year to just over $73bn at the end of last year, with its exposure to Australian equities down from 11.2 per cent to 10.8 per cent at the end of last year.

Its total return fell from 12.4 per cent over the year to June to only 1.6 per cent for the calendar year 2011, following a negative performance of 3.1 per cent in the last six months of 2011.

Mr Abernethy said the fund should employ its own in-house investment staff who bought shares directly rather than relying so heavily on such a wide range of different fund managers.

The fund’s latest statement shows it now has 14 different advisers for equities, 20 different advisers on private equity, 10 advisers for its property investments, seven advisers on infrastructure investments, 13 advisers for debt investments, 19 advisers for alternative investments, two advisers for its cash investments and five advisers for its “overlay strategy”.

“If it was a proper future fund for Australia it would not be making index-type decisions, it would be making investments in resources and infrastructure for the benefit of Australia,” Mr Abernethy said.

Mr Abernethy said the latest figures also highlighted the fact that the fund should not have dramatically cut its stake in Telstra.

“Selling Telstra was a pretty awful decision. They hammered the Telstra share price down. Now they have finished selling, the price is moving up.”

The fund had 2.1 billion shares in Telstra in February 2007. It held almost $1bn in Telstra shares as of June last year, a holding of about 320 million shares.

On August 15, it announced it had reduced its holding to what it calls a “market weight” of only 100 million shares.

Telstra shares were down to $2.60 in March last year, but have recovered in recent months to close yesterday at $3.33.

UBS head of investment strategy George Boubouras said yesterday that the move to a higher weighting in cash was in line with what most other superannuation funds had been doing in the last half of last year.

“It is indicative of a retail and pension industry in itself, which ties into a more cautious consumer post the global financial crisis,” Mr Boubouras said.

UBS funds were currently at 12.5 per cent cash for moderate investors, but he said it might be time this year to start moving some of the cash into equities and corporate bonds.

(The Australian, Wednesday 1st February 2012)

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…the approach might be indicative of the industry at large, but is it right?!!!

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MACA Limited looks pretty interesting

Clime analyst Adrian Ezquerro has written up an interesting mining services company called MACA Limited (ASX:MLD). MLD is a leading supplier of mining and civil services to clients in the mining and construction sector, primarily in Western Australia. It provides “mine to mill” contract mining services for open pit mining including loading and hauling, drilling and blasting, crushing and screening, and civil works.

MLD’s balance sheet is strong, with cash on hand of $50m and debt of $37m. Normalised return on equity is forecast to be above 40% in 2012 and 2013. Operating cash flow has been strong in recent years and well exceeded reported profits in FY2011.

A few points from the report:

MLD is well placed to take advantage of the record level of resources capital expenditure, and we expect significant growth in profit and a high level of profitability. It has a strong order book with work in hand, tenure of contracts, and cross selling opportunities.
MLD predominantly services mid-tier mining projects across a range of commodities, and has a workforce of 600 employees and subcontractors. The business is comprised of three complementary operating divisions: contract mining (90% of 2011 revenue); crushing services (10% of revenue); and the recently formed Civil Works division, which provides professional expertise and machinery to build infrastructure for mining and civil infrastructure projects.

As a contract miner, MLD is exposed to risks including reliance on the mining industry, commodity price risks, ability to win new contracts, contractual risk, disruption or discontinuance of operations.

Currently MLD is trading at $1.84, which is a reasonable discount to our assessed value of $2.59 and value looks to be growing in the medium-term.

Read the full report on MACA Limited

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Mining services company Forge Group Ltd looks interesting

Clime analyst Alex Hughes recently completed an analysis of the mining services company, Forge Group Ltd (ASX code: FGE). Forge provides a range of diversified services to the resources, building and infrastructure industries. Some points highlighted in Alex’s report:

• Since listing, FGE has displayed a consistently high NROE, averaging 42.7%:
• Compound annual growth rates since listing are revenue (+54.7%), NPAT (+95.3%), Dividends (+43.1%) and Equity (+70.0%);
• The business is conservatively financed with strong cash holdings ($78.3m), minimal debt ($8.2m) and moderate goodwill ($15.6m, 12.6% of equity);
• FGE has a low payout ratio of 20-25% of earnings, evident through the low dividend yield of 1.9%. Strong cash holdings provide an extra buffer against the cyclical and lumpy nature of cash flows within the contracting industry;
• Forge recently acquired CTEC Pty Ltd, a WA based contractor providing engineering, procurement and construction (EPC), operations and maintenance to the energy and utilities sector;
• FGE has been trading around 3 times its equity base. This represents an attractive price if the business is able to sustainably earn and compound at rates above 40%. At present the market is giving little value to the growth potential of the business.

Alex’s conclusion: “Forge is a competently managed business that is well placed to gain from the current mining capex. The shares are currently available at an attractive price on the market. We are happy to buy a stake in the business when the market is in a bad mood and the shares are trading at a significant discount to our valuation.”

Read the full report on Forge Group Limited

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Most Chinese Are Now Urban Dwellers

Fascinating article in the Wall Street Journal (Asian edition) this morning, well worth a read. Discusses the historic milestone announced yesterday by China’s National Bureau of Statistics that urban dwellers now account for 51.27% of China’s population. That is 690 million people out of the total population of 1.35 billion now live in cities.

“When rural residents move to urban areas, they tend to do more economically productive work, learn more skills, earn more money, and buy more goods. They also boost demand for urban infrastructure and housing, which can boost economic growth.”

The political, social and economic consequences of urbanisation are enormous and will have an impact far beyond China’s borders – not least upon our own economy, dependant as it is on the high prices we receive for our commodity exports to China.

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Upcoming Elections

The uncertain investment environment is closely coupled with the uncertain political environment. Investors require certainty, and how does one have confidence in a rapidly changing political environment? It is obviously difficult to anticipate the toppling of dictators and revolutions such as we have seen in the Middle East and North Africa, but we can anticipate the timing of elections in democratic countries (shown in the chart above).

Social tensions and political change are at perhaps their highest level in decades, reflecting high levels of unemployment, government austerity programs, high food prices, the advent of social media and globalised access to the internet, the end of communist regimes in Eastern Europe and elsewhere, and of course many other factors. In Europe alone, we’ve already seen changes in government in Spain, Greece and Italy just in the last couple of months, with the French Presidential elections due in April.

The most important election from the media point of view will of course be the US Presidential election, which looks to be a race between Barack Obama and Mitt Romney. But there are many other political changes afoot, not least the leadership transition expected in China in October this year.

How will all these elections affect policy? As elections approach, the political rhetoric tends to heat up. In an environment of currency and trade disputes, increased protectionism and uncertainty around trading blocks, the political uncertainty adds one more dimension to investor unease.

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Is this the most important chart in Australia?

On the 3^rd January, the Reserve Bank of Australia released its monthly index on commodity prices, possibly the most important chart for the Australian economy at present. The index showed a slight decline of 1% in the series for the month of December, following a 0.2% decline in November. Note that the index is priced in SDR terms (Special Drawing Rights) rather than in AUD, better reflecting the composition of global trade.

The price of gold declined in the month, as did the prices of coking coal and iron ore, as they continue to adjust to lower spot and contract prices. Over the past year, the index has risen by 11% in SDR terms. Much of this rise has been due to the earlier increases in iron ore, coking coal and thermal coal export prices.

In Australian dollar terms, the index fell 2.5% in December, but has risen by 10% in AUD terms over the past year.

The Index provides a timely indicator of the prices received by Australian commodity exporters. With exports now equivalent to around 25% of GDP, developments in export prices have a significant influence on economic activity. Since 2005, commodity prices have taken off and Australia’s exports to industrialising Asia have soared.

But is the ride over? Have the prices of Australia’s commodity exports peaked? With China likely slowing somewhat – from over 9% growth a year ago, to perhaps 8% in the next year – will the speculative money depart commodity markets and look for the next big trade? Is the boom in commodity markets over? In our view, not likely. But the index, reflecting as it does the prices of our major commodity exports, may well have peaked, albeit at very high levels. This is one chart to keep a very close eye on.

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Value investing & the consideration of changing business conditions

The recent collapse in the share price of JB Hi-Fi Limited (ASX:JBH) has stung many investors whilst highlighting the pressure on retailers in Australia.

If you have followed our value investing blogs and reports for a while, it’s likely you’re aware of our preference for retailers with quite specific characteristics. We’re looking for a powerful brand, the ability for store rollouts both here and abroad, and a strong online presence.

The problem engulfing JBH could well be more specific though. Price deflation and margin pressures are currently hurting, but is the long term danger ultimately a structural shift? With JBH, I suspect it’s the changing of business conditions that has longer term value investors – like us – concerned.

Reviewing the numbers from a quantitative view is one thing, but considering the longer term qualitative view is another thing altogether. If you are going to invest your hard earned capital in a given business, it makes sense that you must believe in the long term future of that business.

Thinking about this reminded me of a similar discussion from early 2011.

Early last year I was interviewed by the guys from www.student2trader.com about value investing. In this interview I was asked a few questions that relate directly to the macroeconomic environment and changing business conditions. Here’s an excerpt:

Q: How important is historical business performance when valuing a company? How important is the effect of changed business conditions? Would you ever invest in an unproven business with solid prospects?

A: Generally I like to invest in companies that have a good track record and are run by capable owner-managers. The existence of good quality historical business performance gives one more confidence when making an investment decision. That said, I’m always trying to think ahead to ensure the company/ industry will not become redundant. For example, being the best CD retailer in town might not count for much in a few years when we are all downloading music online.

Fast forward 12 months and here we are. Like the vinyl record before it the CD appears largely headed for a dirt nap, on the scrapheap of redundancy. Throw in DVDs and video games, and a significant hole in future earnings may quickly be developing. The question now becomes; how do JBH and others evolve their offering to stay relevant?

Charles Darwin had a theory about evolution. I have a feeling retailers might be listening.

Follow Adrian Ezquerro on twitter

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Australia’s Terms of Trade

Australia’s terms of trade (the price of its exports relative to the price of its imports) is on a 140 year high. This is a huge positive for Australia, in the sense that we can buy more imports for a given level of exports.

Average 1869/70 to 2010/11 = 100. Source: ABS; Gillitzer and Kearns (2005), RBA Research Discussion Paper, Jarkko Jääskelä and Penelope Smith, Dec 2011.

The RBA has released an interesting discussion paper about Australia’s terms of trade, titled “Terms of Trade Shocks: What are They and What Do They Do?”

http://www.rba.gov.au/publications/rdp/2011/pdf/rdp2011-05.pdf

The paper describes and quantifies the macroeconomic effects of different types of terms of trade shocks and their effect on the Australian economy.

“One of the most significant influences on the Australian economy over the past decade has been the booming terms of trade which has risen by almost 80%. The terms of trade are currently around their highest level of the 140-year history of the series. The current boom is comparable in magnitude to the wool booms of the 1920s and the 1950s but has been sustained for much longer.”

Three types of terms of trade shocks are identified in the paper, based on their impact on commodity prices, global manufactured prices, and global economic activity. The first two shocks, a world demand shock and a commodity-market specific shock are fairly standard. We appear to be enjoying the third type of shock, “a globalisation shock”, that has resulted from the increasing importance of China, India and eastern Europe in the global economy. The globalisation shock is associated with a decline in manufactured prices, a rise in commodity prices, and an increase in global economic activity.

The main conclusion of the paper is that a higher terms of trade tends to be expansionary but is not necessarily inflationary; the floating exchange rate has provided an important buffer to the external shocks that move the terms of trade.

Editor’s warning: this article is most likely of interest to the economic policy wonks among us.

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Notes for the New Year, with a focus on housing markets

Looking ahead at prospects for the share market in 2012 provides both reasons for optimism and notes of caution. Quite clearly, the inherent economic weaknesses of most western economies are still with us, and some weaknesses from the growth stories of the developing world are also starting to cause concern. We’re still going through the “work-out” phase of the great leveraged debt binge of the pre-2008 decade. What we saw in the US with their sub-prime mortgage debacle, and the sovereign debt imbroglio in the Eurozone at present, is all part of that work-out, and of course it is not over yet.

Housing: some good news out of the US?

Perhaps surprisingly, the outlook from the US is probably better than the market expects. Positives emanating from what is still more than a fifth of the world economy include a possible US housing recovery, a turnaround in US manufacturing, and good news on exports and on the energy front.

US housing is most important, and there are some indications that a recovery could emerge after excess homes get absorbed by the middle of 2012. There are indications that excess home supply is dwindling, and that could provide a floor in home prices, mortgage losses, construction industry job pressures, and consumer confidence. After six years, the housing bubble deflation may be close to an end.

Housing: some bad news out of China?

We think it is worthwhile keeping a wary eye on the property bubble in China. That may seem rather esoteric for Australian share market investors, but a collapse in Chinese residential property prices could have a huge impact on the Australian economy.

After a decade of soaring prices, the signs are there that China is facing its first real estate crash. House prices in Beijing have risen by about 150% in the past four years. Across the country, from the big cities to the regional towns, new housing developments have sprung up in recent years as developers and local governments have rushed to capitalise on the frenzy for property. But now, following a 10 year boom and nearly two years of attempts by the central government to cool the overheated sector, the market appears to have turned down. Sales volumes have slid and prices are falling as developers try to tempt reluctant buyers with discounts.

The prospect that this sector could come to a screeching halt has serious implications, especially for commodity exporters like Australia. Last year, property construction accounted for 13% of GDP in China, and for more than 25% of all investment in an investment-dependent economy. Property directly accounts for 40% of Chinese steel use, making it by far the most important buyer of inputs such as the iron ore and metallurgical coal that Australia exports.

Steady as she goes in Australia

Back to Australia, and a grateful acknowledgement that we have been very lucky. We weren’t too caught up in the debt binge, and we enjoy strong export markets for our goods. We have relatively low unemployment, and a growing population. We have a strong currency, and neutral interest rate settings. We have a strong banking sector and a good regulator. And our housing market is reasonably stable.

We expect the market to remain quite volatile for the next year, but it is impossible to be precise with these things. Within the next year or two, we should have remedied quite a few of the “work-out” issues and at that stage would anticipate a stronger market. But “no-one rings a bell”. In order to cope with volatility, one should adopt the following strategies: retain reasonably high cash levels; stay away from excessive debt; focus on value and on quality; look for sustainably high yield; and focus on domestic Australia where we have fewer headwinds to contend with. And remember, market volatility creates opportunity: to buy high quality company shares below intrinsic value and selling above it.

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IBM’s “The Next 5 in 5” – Innovations that will change our lives

At the end of each year, IBM examines market and societal trends expected to transform our lives, as well as emerging technologies from their labs, to develop a multi-year forecast called “The Next 5 in 5” – five technological innovations that will change our lives in the next five years.

The one I like, because I am so forgetful, is “You will never need a password again”. On the other hand, some of their forecasts from previous years seem a little way off. Share your thoughts…

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Minutes from the RBA’s meeting of 6 December

The Minutes from the RBA’s monetary policy setting meetings usually make interesting reading. Here are some extracts from their meeting held on 6 December, which resulted in official rates being cut from 4.5% to 4.25%.

“In the global economy, the recent news had been mixed. The data for the US economy had been better than in earlier months. China’s growth had been slowing, as policymakers there had intended, and most other economies in Asia had also slowed as trade in Asia was seeing some effects of the significant slowing in economic activity in Europe. Nonetheless, growth rates in Asia remained solid. The news on Europe, however, had been notably weaker and it remained unclear as to how the current situation would be resolved. It seemed highly likely that the sovereign credit and banking problems would weigh heavily on economic activity there over the period ahead, and there was a non-trivial possibility of a very sharp contraction. Global financial markets had experienced considerable turbulence, and financing conditions for banks had become much more difficult, especially in Europe. Overall, members concluded that growth in the world economy was likely to weaken over the coming year.

“Domestically, some of the recent economic data had been more positive than a few months earlier, and overall growth was consistent with trend. However, conditions varied significantly across sectors. Investment was picking up very strongly, and measures of household and business confidence had improved in recent months, though liaison reports suggested consumers remained cautious. The unemployment rate had been broadly steady, at a little over 5 per cent, after rising around mid year. The financial side of the economy remained relatively subdued, with soft credit growth and declining asset prices.

“Against this background, the Board considered the question of whether a further reduction in the cash rate would be appropriate following the reduction in November. On the one hand, there had been further evidence that a major investment boom was in progress and the overall economy was expanding at a pace broadly in line with trend. Australia’s main trading partners were also still recording solid growth. This did not suggest any strong need to cut interest rates. Against this, developments in Europe continued to pose downside risks to the global economy and, consequently, also to Australia. These risks had, if anything, increased though the timing and magnitude of any effects that might flow from them remained very difficult to predict. “

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Picture tells a thousand words

The BBC has an interesting series of graphs selected by well regarded economists designed to capture the big stories of 2011. The graphs are euro-centric as one would expect from UK economists, but as Europe has been the big story of 2011, they are relevant to us all. Some of the graphs shown: interest rates on government bonds since the introduction of the euro; private sector debt in the UK; unit labour costs across the eurozone.

http://www.bbc.co.uk/news/in-pictures-16090055

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