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> Abernethy's View

John Abernethy is the Chief Investment Officer (CIO), Executive Director of Clime Investment Management Limited (Clime Group) and Chairman of Clime Capital Limited. With over 25 years experience in funds management and corporate advisory services, Abernethy's common-sense approach to investing and forthright opinion has earned him a loyal following of investors.

As CIO of the Clime Group, Abernethy leads a team of six analysts and has consistently delivered outstanding results for the company. Clime has three different investment vehicles, the Clime Australian Value Fund (CAVF), Discrete Share Portfolios (Individual Managed Accounts) and MyClime, Clime's online stock valuation and research service.

The CAVF has consistently outperformed the market over the past five years, resulting in CAVF recently being awarded a S&P Three Star 'New' rating and named a top performing fund in its category* by Morningstar.

Prior to establishing Clime, Abernethy's roles included 10 years at NRMA Investments as the head of equities, where he successfully managed investment portfolios of approximately $2 billion.

Abernethy is a regular contributor for CNBC, The Australian and The Australian Financial Review. Abernethy and his team are also regular commentators in The Eureka Report, The Sydney Morning Herald and Smart Investor.

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Abernethy's View
Abernethy's View
post Posted: Apr 13 2012, 03:46 PM
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"... to our mind it is more sensible to focus on that which is more predictable - the likely changes to the economic environment over the next 3 to 5 years. From this we can focus on what is important to do now to position portfolios."

The confusing daily commentary of unfolding events across the economic world surely test market confidence. Naturally investors' perceptions about the investment outlook are at best wary, at worst panicky. However, much of this is focused on the short term. We have commented in the past that whilst the short term outlook is clouded the longer term is much more certain.

To summarise our longer term view, it is clear that Australia (we) will continue to grow due to our strong trade engagement with China and our predictable population growth. In the last five years Australia has grown by about 13% (economic growth), our terms of trade have reached record highs, our export volumes have grown to record levels and our population grown by over one million people. The outlook for the next five years is for more of the same. However, we are constantly confronted with questions such as - What will Europe look like following the sovereign debt crisis? How long will it take for the USA to recover? Is Japan in terminal decline, and will China fall into some sort of recession?

These questions and their ultimate answers do matter and to answer them at this point is really difficult. Thus, to our mind it is more sensible to focus on that which is more predictable – the likely changes to the economic environment over the next 3 to 5 years. From this we can focus on what is important to do now to position portfolios.

Therefore, in this week's Investing Report we make some predictions of the more distant future. In particular, we outline what we think are the more obvious likely economic or market events. In doing so we suggest that you ask yourself – are you prepared?

Prediction 1

Bond markets generally and the US bond market in particular will correct heavily in the next 3 years.

There are many reasons to predict this but it appears overpoweringly logical to suggest that a 3% yield on a 30 year US Government bond represents irrational stupidity. Further, across the US bond curve we observe that 5 year yields are below 1% and 10 year yields are below 2%. The logic of investors accepting negative real yields (i.e. below inflation) for prolonged periods does require much analysis. Indeed, a proper explanation may only be possible many years after the correction. Does anyone actually know why the Nasdaq Index went above 5000 points (today 3040) in the year 2000?

Bubbles eventually burst and the US bond market is a bubble. People may point to Japanese bond yields to draw comfort and suggest the sustainability of US rates. However, the US has nearly 40% of its bonds (loans) owed to China, Japan and OPEC countries. In comparison the Japanese have only raised about 5% of their debt from foreign investors. The Japanese have not, to this point, had the international market properly assess its true risk.

Our prediction is simple. US bond rates will correct. So too will Australian bonds and thus investment portfolios should be positioned to withstand this risk. Investment in debt securities should be floating rate and bond exposure kept minimal and very short in duration. The pricing of long term infrastructure assets from the long term bond yield is highly dangerous at present. We maintain that required returns for equity investments should not be based on current bond yields.

Another factor sure to affect bond values is emerging inflation from China - see below. A rising bond yield, when it comes, will mean lower PERs and lower equity multiples for intrinsic valuations. High double digit PERs are simply not acceptable given this outlook. Further, companies with ROE at about current bond rates will be disasters – of course, they already are but no one wants to admit it!

Prediction 2

The Australian dollar stays stronger for longer.

We make this prediction based on a simple observation. The US, European Union, United Kingdom and Japan are engaging in quantitative easing and we aren't. If they print currency and we don't then it is likely that our currency remains strong. Indeed this is reinforced by a trade surplus and a strong fiscal position.

Further, the provision by Central Banks in these regions of massive low cost loan facilities, will take many years to repay. The repayment will come from economic growth. Policies that maintain weak currencies will be paramount in stimulating growth.

Against this view we note that there are always economic stabilisers at work. Thus, it appears to us that the $A will rise further against the US dollar but it will go higher against the euro, pound and particularly the yen. As most of our international trade and finance is US dollar based it is apparent to us that the Australian economy is severely affected when our currency approaches US $1.10. We suspect the RBA knows this and so intervention will likely occur from the RBA if our currency pushes aggressively upwards against the $US.

As for the cross rates against the pound and yen, we suspect the $A will rise further. The current economic numbers from the UK are very poor (despite its devaluation) and our view on Japan is rapidly becoming one of concern - see below.

Prediction 3

China will revalue the yuan more aggressively following the US election and worldwide inflation becomes an issue.

China has pegged its currency very tightly to the US dollar for many years. Indeed, it is perverse to realise that the $A has actually appreciated by around 10% against the yuan over the last 5 years.

However, this policy is surely tested by rising oil and commodity prices. China has successfully developed manufacturing export industries through an undervalued currency. It has thus created tens of millions of jobs for a burgeoning middle class. To maintain growth of the internal economy, inflation must be checked on imported goods, services and inputs. A rising yuan will achieve this.

The checking of inflation in China through a rising yuan will reverse the deflation that previously flowed to its trading partners (Australia benefited here). A lift in imported inflation in the US and a rising oil price (subject to gas alternatives) suggests inflation (possibly stagflation) could occur in the US. Indeed, maybe the Fed and the US Government would regard inflation as a means to deflate the US debt? If that is so then that is another reason to move out of bonds as an investment.

But a rising yuan also benefits Australia. Inbound tourism is increasing from China and a rising yuan will help this. The wealthy Chinese middle class is developing rapidly. James Packer has worked this out and explains his sudden desire to position himself in Sydney casino and hotel assets.

Thus, one investment theme to consider is the potential of quality Australian tourism assets that are attractive destinations for inbound Asian tourists.

Prediction 4

Japan will be seen as in terminal decline and the yen devalues at an extraordinary rate.

The following chart suggests what everybody knows but is afraid to discuss.

Figure 3. Japanese Population (1870 - 2100)

The declining Japanese population, its ageing profile and its extraordinary level of government debt are serious concerns.

But it is the recent trend developments in the Japanese trade account (moving to a deficit) that suggest to us that the Yen is about to commence a major downward adjustment. Indeed, it may have already occurred if not for the decline in $US and euro.

A declining yen in the next five years will have ramifications for Japanese inflation. As a large energy importer, the effect on the yield of Japanese bonds will be significant. Devaluation may induce Japanese investors to repatriate funds and investments from overseas markets. From an Australian perspective it suggests that the Japanese will be continual sellers of Australian property in coming years. The question is whether Chinese investors will replace them.

Prediction 5

China's growth is secure for the next 5 years because of its ability to stimulate growth through fiscal measures if required.

The changing pattern of China's current account surplus (consisting mainly of exports minus imports) in the next 3 to 5 years will be a key determinant for the global economy. China's highly competitive manufacturing sector will continue to power ahead, to expand exports and to gain global market share. At the same time, China's domestic economy should continue to grow fairly rapidly, thereby drawing in imports. However, how this plays out will largely depend on how much progress is made with re-balancing the economy, from the single-minded focus on exports of previous years to growing internal consumption.

The International Monetary Fund's latest assessment on the Chinese economy (December) reflected the worsening external environment and accordingly it suggested that China's economic growth for 2012 be revised down from 9% to 8.25%. But this is short term and it is more sensible to consider longer term trends and the relative size of the Chinese economy.

So let's put expectations of future growth in perspective. China's economy expanded 10.4% annually in the past 10 years, about five times the pace in the US, as the government boosted spending on roads and rail, ports and bridges and manufacturers exported everything from toys to trains to the rest of the world. The economy grew at 9.2% in 2011.

Even assuming a significant moderation in Chinese growth, over the next three years China is likely to grow from around 46% the size of the US economy (China at $6.9T compared with the US at $15T) to 52% by 2015 (China up to $8.5T, the US up to $16.2T). That assumes a growth rate in China of 7.2% (with below 6% regarded as a hard landing) and growth in the US of 2.6%.

China still needs to re-balance its economy away from building up productive capacity and towards growing internal consumption. Figures assessing the level of internal consumption are notoriously rubbery, but a best guess is that consumption in China accounts for about 40% of GDP, a bit more than half the ratio in the US. Recent growth in China has been built upon the surge in investment, rising from 42% of GDP in 2007 to 48% in 2011. This raises sustainability questions. China is exposed to Europe and other countries through trade (the eurozone is the largest destination for China's exports): its global exposure has risen, with its share of global exports in 2011 rising to 10.5%, up from 8.8% in 2007.

Like the last decade, a key driver of economic growth over the next decade will remain urbanisation as millions more people move to the cities in search of higher-paying jobs. China recently announced that people living in its towns and cities now outnumber those in the countryside, making it a predominantly urban nation for the first time in Chinese history.

City dwellers represented just 11% of China's population in 1949, when the Communist Party took power, and 19% in 1979, when Deng Xiaoping launched market reforms. Today, urban dwellers account for 51.3% of China's entire population of 1.3 billion - or a total of 690 million people.

We expect the trend to endure for some time. McKinsey, the consulting firm, forecast last year that the country would have one billion urban residents by 2030 - its urban population growing by more than that of the entire US in just two decades.

Unfortunately, there is a downside to the urbanisation thematic. Mass migration places an increasing strain on urban housing, transport and welfare, and fuels pollution, social unrest and demands for political reform. Finding a balance between GDP growth, urbanisation and farmers' rights will be one of the main challenges facing a new generation of party leaders.

Moreover, urbanisation is hardly the only demographic trend sweeping over China. At the same time as more workers are moving into the cities, the size of the Chinese work force - those aged 15 to 64 - is peaking as the work force ages. More than 30% of the population is expected to be older than 60 by 2050, producing an increasingly heavy economic burden on those in the work force.

Unlike most other countries, however, China has the policy space to contain the negative spillover should such risks materialise. A fiscal stimulus package in the order of 3% of GDP could hold growth up above 7%, much as China's preemptive policy action in 2008 eased domestic vulnerabilities.

China could use any significant slowdown in the coming year or two as an opportunity to boost consumption, including through helping the most vulnerable, strengthening household income and social services. This would also help reduce China's reliance on investment and support a more sustainable internally balanced economy.

Gain further insight in today's markets. The following report is a summary of "The View" written by John Abernethy. The View is a weekly macroeconomic report provided by MyClime - an online stock valuation and research service. For a free two trial to MyClime, click here.

Abernethy's View
post Posted: Feb 10 2012, 10:55 AM
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Political Leadership Is One Thing, But What About Our Business Leaders?

As the developed world's consumers maintain a process to vigilantly reduce debt, it is likely that the only event that will change their collective sombre moods would be a spirited recovery in political leadership. In other words a sense that the world's leaders see the problems, can accurately describe them and have the answers or solutions. It would be good to have a message that we are in safe hands and that we can all participate in the recovery process in a tangible way. A sense that our leaders can uplift the souls of the population and encourage us all to assume an economically assured future.

In Australia there is no such assurance. Here there is an unfortunate paucity of economic thought leadership and this confronts us each day. How often do you hear the question from friends, "how did we end up with these people as our politicians and leaders?". We suspect it is exactly the same question being asked in places like Ireland, Greece, Italy, Portugal and Spain!

In our view the leadership we have is the result of the apathy and the indifference that came from a sustained period of economic growth that was created by excessive credit. The growth was both real and artificial. It was real because tangible fortunes have been made by a few. It was artificial because it was not sustainable. It created apathy and indifference because in its early period all of us appeared to be better off. It felt like a new economic dawn where we appeared to have achieved a better standard of living that was affordable due to easy credit. Better still, there was no need to lift productivity. We could all be paid more and we deserved it because we needed to service our debt to maintain our standard of living. Accessing and then servicing debt was our fundamental right and our employer was obliged to pay our increased costs of living. If not, then our politicians could be relied upon, because they needed to keep us happy to gather our votes.

So as the curtains come down on the debt charade of the last 15 years there are now serious questions and tests being put to our political and our business leaders. Their responses will set the scene for economic environment in 2012/13. The answers will stimulate or stymie markets and they will affect or support individual businesses.

Why will the questions be asked? Simply because we have hit the debt brick wall and the emergence of the overwhelming power of the new communication medium called the internet. The connectivity of people now allows communities to instantly and widely communicate. Its power is potent and dangerous. It is potent if people can drive change which is beneficial to communities. It is dangerous when dynamic thought leaders abuse the internet for ulterior motives. Both negative and positive sentiment can be wildly distributed through the net!

So we now have a quandary as investors. We appear to be in or heading towards an economic quagmire and there are so many opinions which are garnished with negative predictions. There is a massive appetite for change developing, but nothing is on offer. There is a growing perception that things aren't sustainable, but many governments are broke and fiscally cannot deliver change. Those that can (i.e. Australia) seem dominated by individuals who are more concerned with maintaining power than doing anything with it.

The difficult world economic outlook is also creating a real test for our business leaders and their current responses are somewhat disheartening. We are seeing businesses beginning to address costs in response to clear signs of slowing economic and credit growth. The initial response of the leaders of banks, financiers and retailers is to retrench labour. From an owners perspective this may be justified as it supposedly holds profits. However, if service industries en masse decide to cut employment then, what will be the economic result? Will profits really be sustained with lower employment and thus consumption? What do our political leaders have to say about these developments? What is their plan? Is there a better alternative?

A cursory review of published and internet editorials of recent weeks as these events unfold, shows a glaring gap in both the business response and the political review. The gap is obvious and uncomfortable for our business leaders. In our view the reduction of business costs must begin at the top of a business. Simply the CEO's and Boards of businesses, who now perceive that economic difficulty requires a cost adjustment, must start with their own costs. Indeed many of the costs that reside at the top of major companies are the legacy of the debt era. It was a time where mediocre managers looked brilliant. However, it was due to the debt environment rather than their skill base.

By setting an example at the top then maybe the whole of an organisation and the community may follow. We question as to why this has this not even been contemplated and why our politicians have not focused on this. Is it not a widely held community view that executive salaries are wildly excessive? Is it not abundantly obvious that many businesses that grew with the credit binge from 1995 - 2005 have simply faltered in the last seven years? Worse still, the shareholders (which are in the main large public super funds) of many listed and large companies have seen their capital diminish even as business leaders meticulously achieved continuous pay increases. Too often these increases seem to have been based on a perceived right rather than an achieved outcome.

Let us explore this further by doing a simple analysis of major companies today and in 2005. What dividends were paid in calendar 2011 and how does this compare to 2005? This may give us an insight into which companies have suspect business models. It may also identify those companies where executives have been well rewarded for producing mediocre or poor returns. Finally, it may confirm our thoughts that good businesses will over time produce increasing returns to their owners.

Why the comparison to 2005? Well the share market today is trading at the same price index level as 2005. Thus, index investors have achieved no capital gains in this period and have totally relied on their returns to have been derived from dividends.

We have split our reviewed companies into the Good, the Average and the Bad.

The Good

BHP dividend in 2005 was 36.3 cents fully franked (ff) and last year it paid 98 cents (ff). BHP has not undertaken a DRP and it has had two significant buy backs. That is clearly a good outcome and the current outlook is positive. It remains a fundamental part of a value portfolio.

CBA paid $1.97 (ff) in 2005 and lifted this to $3.20 in 2011. A DRP was utilised in 2005 and shareholders reinvested at $36.00. That is a good growing return but the outlook is now for lower growth for the next year. It is a company that is worth owning but the entry point for buyers should be yield focused at say 7% franked.

WBC paid $1.00 (ff) in 2005 and this grew to $1.56 in 2011. That is similar dividend growth to CBA and we suspect it would have been much faster had WBC not acquired St George Bank in 2008. A DRP at $22 in 2005 has produced no capital gain for those participating shareholders. The outlook is for low growth in the coming year. Again a buy price at a yield of 7% franked seems appropriate.

WOW paid 51 cents in 2005 (ff) and has lifted this to $1.22 in 2011. That is very impressive for a supposedly low growth company! WOW had a DRP in 2005 at $15.70 and that has rewarded participating shareholders. Since then WOW has undertaken buybacks and sailed through the GFC. The outlook is for more steady growth. Definitely a core portfolio holding managed by superior executives.

ORL is a great recovery story from 2004. In 2005 the dividend was 12.5 cents (ff) and in 2011 it was 50 cents. ORL has not raised capital in the intervening period. No need for a DRP and shareholders have a received a steady flow of growing income. With Asia rolling out the outlook looks good.

MMS is another company who has steadily raised dividends with no capital raisings until the recent employee option exercise. In 2005 a dividend of 4 cents (ff) was paid and in 2011, this grew to 50 cents. A tremendous rate of compounding cashflow to shareholders! We expect more growth in 2012 and this is one company whose executives have deserved their rewards.

MND probably rates as the best of the best in terms of dividend growth without requiring shareholders to reinvest. Dividends have grown from 19.25 cents (ff) in 2005 to 95 cents in 2011. This is astronomical growth and has not needed to be supported by a DRP at anytime. With the resources boom continuing there is clear evidence that this well managed company has more growth ahead - plus senior management are major shareholders.

The Average

ANZ rates behind the other majors (above) based on dividend growth. In 2005 $1.10 (ff) was paid and lifted to $1.40 in 2011. A DRP at $22.50 in 2005 has been followed by successive raisings. ANZ now has a growth profile in Asia which will need to be successful to compensate long term shareholders for a mediocre return.

DJS is now in a quandary after a successful business recovery in the last 10 years. Dividends paid in 2005 were 13 cents (ff) and these lifted to 28 cents in 2011. That's impressive but the recent downgrade and the impact of the Internet suggests that dividends are about to decline from here.

NAB paid $1.66 in 2005 and grew this to just $1.72 in 2011. In 2005 NAB issued DRP shares at $32.00 and those who took that reinvestment opportunity have been poorly treated. Here is the worst of the big 4 on any measure and shareholders should rightly question the growth of remuneration packages for it's senior executives.

QBE paid 63 cents (partly franked) in 2005 and grew these to $1.28 last year. However, a rapid expansion to the US and successive capital raisings have seen ROE tumble and dividends become un-franked. The recent downgrade will see dividends reduced and more offshore acquisitions await shareholders. A DRP of $14.80 in 2005 is now below water. QBE is the best of a bad bunch of insurance investments but, do we really need to own any of them?

TLS actually paid 40 cents (ff) to shareholders in 2005. This was the contrived special payouts that allowed the government to divest more shares through T3. Since then dividends have been rock solid at 28 cents. The recent share price recovery is only partially recouping the falls of the previous 6 years. But positively there has been no capital raised and a steady cashflow to shareholders. The outlook is reasonable should the NBN ever be sanctioned by the ACCC. Telstra is now managed by executives who are paid substantially less then the American dream team whose main focus was on selling the government's shares.

The Bad

FXJ has been a disaster for shareholders and the outlook remains poor. Dividends have declined from 23.5 cents (ff) in 2005 to just 3 cents last year. Do you remember the $4.59 DRP in 2005? The current outlook does not look any better.

BLD has managed to deliver declining dividends as well as a declining share price. Dividends were 34 cents (ff) in 2005 and just 14.5 cents last year. The $8.60 DRP of 2005 must send shudders down the spine of the poor souls who took it up!

IAG (the former NRMA) is a telling example of why a successful and community focused mutual should never have become a public company. In 2005 a DRP at $5.40 was undertaken to support dividends of 26.5 cents (ff). Last year dividends continued there decline to just 16 cents. Insurance companies remain great places for employees but owner returns are less predictable.

SUN has been a shocker for shareholders. This bank assurance company has never delivered the much touted promises supporting a succession of acquisitions. 2005 saw a dividend of $1.47 (ff) supported by a DRP at $19.40. Last year the dividend fell to just 35 cents and investors must surely question a to why any insurance company should be regarded as a sensible long term investment.

MQG has always been lucrative for executives but now is a poor investment for long term shareholders. In the boom times of 2005, a dividend of $2.30 (90% franked) was paid and shareholders were invited to reinvest their dividend at $60. In 2011 the un-franked dividend dropped to $1.65. This followed massive capital raisings in recent years and a rapidly declining ROE.

QAN has taken its dividend rate down from 19 cents (ff) in 2005 to nothing over the last two years. Meanwhile the executives have negotiated higher salaries and have not been seen to be buyers of their shares despite their desired MBO in 2005! The message is simple for investors - look elsewhere.

WES dividend has fallen from $1.45 (ff) in 2005 to $1.35 (ff) in FY11, a 6.9% decline. This is despite a tripling in net operating cash flows and the businesses equity base now being 9 times larger. NROE is a third of 2005 levels as a result of the large capital raising to acquire Coles in 2007. However, the MD's (although he is admittedly different to the MD of '05) performance package is now worth twice as much as then. Again it seems that management remuneration is not adequately tied to shareholder returns.


The above shows that business performance and thus shareholder returns are wildly divergent across the market. The growing levels of executive salaries seem unrelated to business performance as some executives of BAD performers get paid consistently more (relative to market capitalisation) then those at GOOD performers.

Further, investors must and are sensibly becoming more focused on dividend growth as a major means of achieving satisfactory returns from the share market. Thus, executives and boards must be clearly given the message that steady business growth is preferable to growth by acquisitions or the reinvestment of capital into businesses at sub optimal returns on equity.

It is our view that the folly of short term remuneration packages based on total shareholder or relative shareholder returns has been exposed as another means by which wealth is transferred from the many to a few.

Thus, remuneration packages based on shareholder returns are clearly important but:

They can only be assessed on a long term basis of at least 5 years and probably more likely over ten years; and
Relative returns against an index or peer group should be junked. The proxy of outperforming a poor performing peer group is a receipt for mediocrity and the world has way too much of that at present.

Finally, it may now be time for a national business summit hosted by the Prime Minister. President Obama this week set an agenda for businesses to bring jobs back to the US. Our Prime Minister needs to set an agenda whereby our businesses do not lose jobs for Australia.

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Abernethy's View
post Posted: Nov 24 2011, 12:14 PM
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A notable feature of the recent trading on the Australian Stock Market has been the dramatic drop in daily turnover. Whether this is important or not for the market or for us as investors, is subject to much debate. The turnover is low compared to what? Were previous periods normal? Does mindless turnover really matter and if you are not a seller should you care?

Obviously for those businesses and individuals that rely on turnover to generate commission or revenue, the drop in volumes is confronting. A recent report in the Sydney Morning Herald noted suburban pockets of rising unemployment. These job losses appeared to be flowing from the financial services industry with commercial and investment banks reducing staff. The rise in unemployment was observed to be dampening down the prices of residences in high income areas. The effects of the GFC and the European debt crisis were hitting home.

It is our observation that the effects of a poorly performing equity market is affecting the ability of many advisors to generate an adequate return for their clients. This should have had an effect long before now but time and poor performance are now converging. So what is causing this and how bad is it?

To answer these questions we note the following observations drawn from the ASX website:

1. The ASX 200 Index is currently 4350 points with a total market capitalisation of $1.260T;
2. The ASX 200 Index was also 4412 at the end of October 2005 with a then market capitalisation of $1.026T;
3. Net new equity raised in the market (i.e. Primary issues) over the 6 years approximates $230B; and
4. New floats over 6 years amount to about $66B.

Whilst we note that there have been some companies taken from the market, it is observable that the market capitalisation today approximates the market capitalisation of October 2005 after new capital raisings are added. All this has occurred in an economy which over 6 years has grown from $1.16T (GDP 2004/05) to $1.31T (2010/11) or about 13%. From the above we can see that:

• The Australian Equity market as a whole has generated no capital gain for index investors in 6 years.
• Worse still the market has achieved no gain or revaluation from the capital raised or from the new companies that have been floated.
• Importantly the suppliers of capital or the gate keepers (the fund managers) have supplied capital to companies who have not converted it to value creation; and
• Finally and crucially the managers of the capital, the CEO's and their teams, have been paid huge salaries and bonuses to achieve incredibly mediocre returns.

The whole of Australia has grown at about 2.2% pa compound over the last 6 years but this economic growth barely matches inflation. With population growth of 1.5% p.a., the low GDP growth suggests an anaemic level of improvement in productivity.

Worse still - when the economic growth from the resources sector is subtracted, it leads us to conclude that the rest of Australia’s productivity must actually be going backwards. So what is the rest of Australia? Well ignoring the production generated by agriculture it is dominated by service industries such as financial, tourism, health, education and public service. The fastest growing sector of the last ten years has been the financial sector.

Clearly something is wrong and frankly the rewards being received by our top executives are not being translated into wealth creation for the broader population. There is no dramatic productivity improvement under their management and the returns on employed equity are not rising. So on what basis are these people being remunerated and is there any evidence to suggest that extra pay actually translates into a higher level of performance?

Thus, questions must be asked as to why we as a community are paying so much for such mediocre results. Further, are not the actions of these people directly responsible for the poor returns of equity markets in a period of sustained economic growth? Why have the returns on the over $300B of new equity that has been invested in companies not produced an adequate return to justify a lift in value of the market? Are we actually sure that the new capital that is invested into companies is going to those that can achieve the best returns on equity?

As an aside, what the above does show is that the investment phenomena known as indexing, has turned into an economic disaster. Have we allowed consultants and experts to stupefy our capital markets (through pushing indexing) to the point where the markets are no longer proxies for growth? Individual companies are growing (and that is Clime’s focus) but indices aren't and so maybe we are observing the downfall of indexing as a legitimate investment process – if indeed it ever was! Investment Managers who do think and can value companies will add value for their investors so long as they are not stopped from plying their trade.

Thus, the observation that so many financial service employees are losing their jobs may not be solely because turnover is falling. Rather it is a symptom of poor business leadership at the very top of Australia’s management tree. If companies are not improving their economic performance then ultimately the market will reassess their value. Those advisors who cannot properly value companies cannot foresee the likely ramifications on the investment returns of their client portfolios. Possibly clients on mass are realising that their advisors and brokers cannot offer value in a market where the ability to value a company is paramount.

So much for advisors, but the above analysis shows why shareholders are rightly looking at highly paid executives. Importantly they should focus on of 5 and 10 year returns and if they do they will conclude that very few executives have added value and thus they are excessively remunerated.

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Abernethy's View
post Posted: Nov 15 2011, 11:36 AM
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The recent economic developments in Europe are not unlike those that confronted investors in late 2007 and early 2008. With Investment Banks collapsing in the US, the substantial interest rate cuts by the Federal Reserve and the pending resetting of teaser rate subprime mortgages, there was enough evidence to suggest that investors should have been concerned about developments.

How these developments would then translate into pricing movements on the Australian share market was a little more obtuse. However, none of the those developments could possibly be interpreted as positive. Thus, those investors that did lift cash levels or maintained cash were well positioned to benefit from the substantial price falls of 2008/09. Those who didn’t raise cash and maintained exposures are to this day still attempting to recoup their losses.

Thus, it is incumbent upon investors to maintain a close watch and understanding of the economic developments in Europe as they do have the potential to send markets into a tailspin. Specifically there have been some substantial moves in the yields of European bonds and this is a situation that deserves close attention. Over the last 6 months the bonds of Greece, Ireland and Portugal have all devalued against the German bond despite them being issued and traded in Euros. But these are small countries. In the last two weeks the bonds of Italy ( a member of the G8) have slumped with their yields lifting to 5% above that of a German bond. This is clearly a more significant situation.

Understanding and noting bond yields is important as the bond yield is the so called “risk free rate of return”. If risk free rates rise then it is a confronting development for the assessment of value of other assets.
Attached Image

Remarkably, Italy has had a substantial debt to GDP ratio for many years and debt markets ignored the risk that this presented to lenders. A high debt to GDP ratio exposes lenders when there is an economic downturn and that is exactly what presents itself in Europe right now.

Italy’s 10-year notes traded above 5.5% for 40 days before breaching the 6% mark on 28 Oct and closed just below 7% last night. Greece, Ireland and Portugal followed a similar trajectory, consistently averaging above 6% for about a month before crossing the 6.5% barrier. After that, it took an average of 16 days for yields to pass the unsustainable 7% level. Portugal and Ireland had to seek bailouts after their yields rose to over 7%.

The following simple example gives us an insight into the immense problems confronting Italy.
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Figure 1. Public Debt

Source: Economist Intelligence Unit

Let’s assume that we translate Italy’s economy to the following. It has GDP of $100 and net sovereign debt of $120. That is it has a Debt to GDP ratio of 120%. (That is where Italy stands today).

A review of the tax collection to GDP of most developed economies suggests it could sit at around 40% for a fully employed economy. Australia has a legislated cap on revenue of about 23% of GDP (and we think we are highly taxed!) but let’s assume Italy sustains its government revenue at 40% of GDP.
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Figure 2: Government Revenue to GDP

Source: OECD Charts 2009/10

Despite its level of debt, Italy paid (on average) only about 3% interest on its debt of $120 in the year 2010. Therefore, across its debt maturities (1 month to say 10 years) it was paying $3.60 of interest. Thus, the revenue collected exceeded interest by over 10 times and this is akin to an interest cover ratio. Further, the interest bill approximated Italy’s fiscal deficit of 4% of GDP. In other words Italy was borrowing to pay interest. This is why its debt has lifted by over 10% (against GDP) in the last 3 years.

Following the troubles in Ireland, Portugal and the collapse of Greece the credit markets are being forced to reassess risk. With 120% debt to GDP the assessed risk of an Italian default has lifted. This in itself has lifted interest costs to Italy from about 3% to well above 6%. Over time Italy’s cost of funding its debt will rise as it issues new debt and rolls maturing debt. Last night the yield on new issue one year Italian paper rose to above 7%. Italy clearly has no capacity to redeem debt.

Based on the above we see that the cost of servicing Italian debt has risen to over $7 pa. On the assumption that tax revenue is maintained at 40% of GDP (or $40) then the revenue to interest ratio drops to under 6 times. The increase in interest cost is $3 pa and unless expenditure is cut then the Italian fiscal deficit will rise to 7% of GDP. This deficit is funded by more borrowings and debt will increase again.

As you can see the country could enter a debt spiral due to rising interest rates and costs. Once it commences it becomes difficult to stop. If say interest rates rise above 10% (as in Greece) then default becomes probable rather than possible and the Government will be forced to substantially cut expenditure. This in itself causes more economic hardship and stymies economic growth.

Italy now sits at the precipice. Its debt to GDP is over 120%, its unemployment is 8% and its fiscal deficit is rising in the face of austerity promises. With the market reassessing the required yield on its bonds it has become the first G8 country to face rapidly rising costs of sovereign debt. What does this mean for countries such as France, the United Kingdom, Germany and the United States? Each of these countries have sovereign debt to GDP over 80% and each has its ten year bonds trading at yields between 2% to 2.5%.

Clearly Greece is a sideshow compared to the risks associated with the Italian economy and the economic response of European Leaders will have to be swift and significant. One obvious response is for Germany to consent to the European Central bank to print Euros. This quantitative easing would steady bond markets and give European governments time to implement much needed policy changes. It may even give Europeans time to dismiss and replace their leaders with people who can meet the difficulties through a capacity to “think anew and act anew” (quote from Abraham Lincoln, December 1862).

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post Posted: Oct 28 2011, 02:30 PM
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In Reply To: Abernethy's View's post @ Oct 28 2011, 02:12 PM

The future is now clear. Debt is going to be repaid. Consumption has slowed and speculation will be curtailed. Importantly the perceived value of all investment assets will be reassessed. Some assets will be worth more and many less. Those assets that rely on debt or speculation will fall in perceived value. A rationale and conservative assessment of sustainable returns will result.

As investors with capital with a longer term focus, the market will present to you an abundance of growth opportunities.

IMO---Got it in one, but the road will be painfull for many.

Combining Fundamental comments with Fundamental charts.
Abernethy's View
post Posted: Oct 28 2011, 02:12 PM
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Over my morning coffee on Saturday I was confronted by the following front page headlines of two of Australia's major newspapers:

"World on the brink"… The Sydney Morning Herald (SMH); and

"Now it's getting scary"… The Australian Financial Review (AFR)

Both headlines obviously reflected the editor's perception of their readers concerns for the European sovereign debt crisis and the declining equity market. Both headlines and the numerous accompanying reports expressed no real insights into the future (uncertainty was clear). The plethora of expert writers proposed no suggestions or solutions for the economic mess, except for Nouriel Roubini on page 62 of the AFR.

Having read these reports and headlines, my immediate thought was to try to put these headlines into context. They expressed a view that there was no hope. They suggested an imminent impending disaster which I could neither see nor describe. I could see that people could well be scared by these headlines, but in the cafe it was business as usual and I noted that most of the people weren't reading the papers!

My initial reaction was to conceive of a real disaster headline so that I could put these "real" headlines into a proper context. So I designed the following and tried to imagine the scene as if there was a real disaster coming.

"The world readies for imminent destruction as massive meteors are just a week away from impact. There is no hope".

The SMH reported that all trading on the world's equity markets ceased yesterday after the dramatic market declines of recent weeks. NASA made a final declaration of the impending unavoidable collision. All world banks were closed as people prepared themselves for the inevitable. "There was no point in trading or investing" said Australia's Treasurer, a recent and now the last recipient of EuroMoney's Best Finance Minister Award. "There is no future and people should stay at home with family to focus on that which is important to all of us as humans". Finally, the editor and staff wish everyone peace in these final days.

Now that is a headline. It is clear and unambiguous. It puts the future into context. There is clearly no solution to that impending disaster. Suddenly and importantly, the real value of investments is defined by the observation that there is no tomorrow. Suddenly even cash has no value and there is no price for gold!

Coming back to the present, we can immediately see that there is a future. Whilst the short term future is unclear, the further out in time we look, the future actually becomes clearer. Thus, whilst there may be a recession in Europe or the US in the next six months, Greece may default and some more banks collapse, it is clear that the world will achieve economic growth over the next five years. It seems clear that China in five years will be substantially larger than it is today. Indeed China could grow at half its current growth rate and still be 20% bigger in five years. Australia will have over one million more people in five years time and will be supported by China's growth. When you look to the next ten years, all of the above forecasts of growth are likely to be compounded. Whilst the short term future is unclear – the longer term economic growth outlook is certain. That is why we invest and our aim is to capture this growth.

What is even clearer is the cause of the current market decline. The world is undertaking a massive restructure of its economic and social framework. Excessive debt is now seen as an unsustainable stimulant to economic growth. It brought forward consumption, it created excesses, degraded moral behaviour, stimulated greed and actually destabilised long term economic growth. In some respects the GFC of 2008 was the "economic collapse we had to have".

The future is now clear. Debt is going to be repaid. Consumption has slowed and speculation will be curtailed. Importantly the perceived value of all investment assets will be reassessed. Some assets will be worth more and many less. Those assets that rely on debt or speculation will fall in perceived value. A rationale and conservative assessment of sustainable returns will result.

As investors with capital with a longer term focus, the market will present to you an abundance of growth opportunities.

For many months now we have been advising and managing clients' capital on the basis of:
  1. There is no hurry to invest. Markets will generally be weaker over the short term. We have maintained relatively high cash levels to be ready when market opportunities present themselves and sentiment is irrationally negative;
  2. We suggested that there is no logical basis for index investing. We are not buying markets but we are purchasing parts of businesses on clients' behalf. Stock selection and a focus on yield are vitally important. Companies that can produce high levels of profitability and convert current profit into future growth are our targets;
  3. We were hopeful that our selected stocks would be offered at attractive prices due to market volatility. We use the market volatility to acquire targeted stocks at prices below our assessment of value. We will continue to buy slowly and average down wherever possible; and
  4. We have a rationale assessment of the world's economic problems and we have put them into context in assessing investment risk. We do see solutions and have no doubt that decisions will be made by those in power to alleviate the situation.
In recent weeks our clients would have noticed that our buying activities on their behalf have stepped up a notch. Their individual stock weightings and their time with us will to an extent determine the level of activity.

Right now it is our investment team's belief that the Australian share market is approximately 15% undervalued as a whole. Individual stocks are being presented at greater or lower discounts and we are building portfolios along the lines that we have consistently outlined in our recent briefings.

In our view, the market will remain at these discounted levels for at least the next six months. We will use this weakness to improve the cost of acquisition of client portfolio as we can see that the world, in particular China and Australia, will grow over the next five to ten years. The medium term future is certain and starkly different to the weekend headlines.

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