weekly review | ISSUE 354b | 6–12 OctObEr 2012

CONTeNTs

StOcK rEVIEWS

sTOCk AsX CODe reCOmmeNDATiON PAGe

Australand Holdings ALZ Sell 4bendigo and Adel. bank cPS bENPD Avoid 2F&P Healthcare FPH Hold 5resMed rMD Hold 5

StOcK UPDAtES

billabong International bbG Speculative buy 9David Jones DJS Hold 9Macquarie Group MQG Hold 10

FEAtUrES

Investor’s college | Speculation: No ordinary gamble 7Doddsville blog | the seven immutable laws of investing 10

ExtrAS

blog article links 12Podcast links 12twitter links 13Ask the Experts Q&As 13Important information 15

rEcOMMENDAtION cHANGES

Australand downgraded from Hold to Sellbendigo and Adelaide bank cPS coverage initiated with AvoidDavid Jones upgraded from Avoid to Hold

POrtFOLIO cHANGES

POrTFOliO sTOCk BUy/

DATe NO. OF PriCe vAlUe

sell sHAres ($) ($)

Growth Australand Sell 9/10/12 2,180 2.98 6,496

Growth Macquarie Group Sell 10/10/12 140 29.17 4,084

Growth billabong International buy 12/10/12 3,000 0.847 2,541

iN THis issUe

Battle of the CPS: Bendigo vs Suncorp richard Livingston

The Suncorp and Bendigo CPS offers are similar, but there are some key differences that make one more attractive than the other … (see page 2)

Australand: Sold Jason Prowd

With a total return of 48% since our original Buy recommendation in January 2010, Jason Prowd explains why he’s happy to sell now and not wait for the perfect exit … (see page 4)

How to profit from sleep apnoea Jason Prowd

Two leading sleep apnoea machine manufacturers hail from Australasia. But which is the better business and which is worth buying now? (see page 5)

Speculation: No ordinary gamble Gaurav Sodhi

Speculation doesn’t have to be a gamble. Gaurav Sodhi explains how thinking about specs differently can reduce risk and increase your returns … (see page 7)

The seven immutable laws of investingJason Prowd

James Montier—who works alongside Jeremy Grantham at GMO—is my favourite investing author. He writes with a verve and clarity that’s missing from most in the industry … (see page 10)

intelligent investor share Advisor

2

Income security | Richard Livingston

Battle of the CPS: Bendigo vs Suncorp

the Suncorp and bendigo cPS offers are similar, but there are some key differences that make one more attractive than the other.

Bendigo and Adelaide Bank CPS is an almost identical offering to Suncorp CPS2, reviewed in Suncorp CPS2: Hybrids change gear (see page 7). It features similar structural improvements over earlier offers and an even higher indicative margin (see Table 1). But it isn’t enough for us to be able to recommend it, for reasons that will become clear.

If you are considering Bendigo CPS, please read the article on Suncorp CPS2 because here, we’re just going to focus on the differences between the two.

margin

The Bendigo CPS prospectus highlights an indicative margin of 5.0% to 5.5% a year. That sounds juicier than Suncorp CPS2 but was an exercise in puffery; the actual Bendigo CPS margin was—surprise, surprise—set at 5%.

Whilst Suncorp CPS2 was also set at the low end of its range (4.65%), there isn’t much difference in the final margins. Bendigo’s marketing department may have ‘puffed’ harder but a choice between the two should not be made on this basis alone. There are more important considerations.

Conversion mechanism

The Suncorp review highlighted the lower 20% ‘relevant fraction’ for calculating the ’Maximum Conversion Number’—the cap on the number of shares into which the CPS can convert—and how this reduces the risk of loss. Bendigo CPS includes similar terms, except that the switch to 20% (from 1 January 2013) is both locked in at the outset and applies to all conversions.

TABle 1: COmPArisON OF BANk HyBriD seCUriTies BeNDiGO sUNCOrP CBA Perls vi wesTPAC CPs ANZ CPs3 CPs CPs2 (CBAPC) (wBCPC) (ANZPC)

PriCe ($) 100 100 100 99 98

OFFiCiAl rANkiNG Preference Preference Perpetual Preference Preference share share note share share

risk CHArACTerisTiCs Equity-like Equity-like Equity-like Equity-like Equity-like

DisTriBUTiON rATe 3m BBR + 3m BBR + 3m BBR + 6m BBR + 6m BBR + 5% 4.65% 3.8% 3.25% 3.1%

DisTriBUTiON TyPe Cash + Cash + Cash + Cash + Cash + frkg credits frkg credits frkg credits frkg credits frkg credits

COmPUlsOry DisTriBUTiONs No No No No No

CUmUlATive No No No No No

PriNCiPAl rePAymeNT BEN shares SUN shares CBA shares Westpac ANZ or cash or cash or cash shares shares

mATUriTy DATe* 13 Dec 19 17 Dec 19 15 Dec 20 31 Mar 20 1 Sep 19

CAPiTAl TriGGer eveNT Tier 1 capital No Tier 1 capital Tier 1 capital Tier 1 capital <5.125% <5.125% <5.125% <5.125%

NON-viABiliTy TriGGer eveNT Yes Yes Yes No No

yTm (ON CUrreNT PriCe) 3m BBR + 3m BBR + 3m BBR + 6m BBR + 6m BBR + 5% 4.65% 3.8% 3.6% 3.7%

* Date on which mandatory conversion to ordinary shares is expected to take place.

BeNDiGO AND ADel. BANk CPs | BENPD sUNCOrP CPs2 | SUNPC

PriCe AT review $100.00

review DATe 8 Oct 2012

OUr view AvOiD

key POiNTs

Suncorp CPS2 and Bendigo CPS are almost identical securities

Bendigo offers a slightly higher margin but greater risk of conversion

Suncorp is a better bet for investors keen to take the plunge

Weekly Review | Issue 354b

3

Bendigo deserves a pat on the back for providing greater certainty to investors, although it’s unlikely to be material to the relative merits of the securities (except in the unlikely event Suncorp didn’t switch to 20%).

Similarly, whilst the application of the 20% relevant fraction to all conversions is helpful, it’s not critical. The conversion on a trigger event is a bigger concern.

Trigger events

So let’s examine that. A ‘trigger event’ is where APRA can force a conversion of CPS to ordinary shares. Bendigo CPS is back to having two triggers—the ‘Common Equity Trigger Event’ and ‘Non-Viability Trigger Event’, giving APRA two chances to impose losses on you compared with Suncorp CPS2’s one.

A fall below a Common Equity Tier 1 Ratio of 5.125% will automatically trigger conversion of Bendigo CPS. Suncorp CPS2 is only triggered upon ‘non-viability’, a fact that also applies to Bendigo’s offer.

What constitutes ‘non-viability’ is impossible to say. Investors are (worryingly) relying on APRA to tell them what that means. So far it hasn’t, nor is it clear when it is likely to. APRA would rather determine the meaning of ‘non-viability’ at the time than be pinned down by awkward criteria on which investors might happen to make important financial decisions.

In the end, the opacity may work against the regulator. When a government body seeks to impose financial losses on retail investors (and voters) there will be a lot of political heat if the circumstances are anything but clear, or truly dire. APRA not disclosing what may constitute a ‘non-viability’ event now may in the end undermine its ability to impose it.

The trigger events are the critical terms of these instruments. Bendigo CPS is, at best, no better than Suncorp CPS2 and, at worst, far worse. On this factor, Suncorp CPS2 is a clear winner.

The issuers

Another key difference is in the issuers. Again, Suncorp wins. It’s a much larger institution ($12bn to $3bn market capitalisation) with a higher credit rating (A+ versus A- according to S&P) and a more diversified business.

Both companies have made a similar investment in residential mortgages (over $30bn) but in Suncorp’s case the investment is only a third of its balance sheet. For Bendigo, it’s approaching 60%. Suncorp’s insurance business could be hit by a series of natural disasters but a diversified exposure beats putting it all on mortgage default rates, which is what Bendigo has done.

Let’s spell it out. A hit of less than 3% to the value of Bendigo’s residential mortgage book would eliminate its ‘excess’ Tier 1 Common Equity of $839m and probably lead to a ’Common Equity Trigger Event’. A 10% hit would exceed their entire market capitalisation and, most likely, wipe it out.

In the case of Suncorp, a 10% hit to its residential loan book would be bad but not necessarily disastrous. Dividend payments may cease but depending on other circumstances and APRA’s interpretation, it may not even trigger the ‘non viability’ clause of the CPS2, let alone destroy the entire company.

Ordinary share comparison

Suncorp CPS2 offers a dividend yield similar to Suncorp ordinary shares, making it a sensible alternative for those investing in Suncorp shares for yield, especially those looking to lock in recent price gains.

This analysis doesn’t hold for Bendigo. The ordinary shares are trading on a much higher yield than the CPS and ordinary shareholders are more likely to be sitting on losses given the poor recent performance than trying to lock in gains. Bendigo is another case where you should stay away or, if you are a fan of the business, buy the ordinary shares for the yield and upside.

Nothing to offer

Bendigo CPS offers a slightly higher margin than Suncorp CPS2 but it’s not enough to entice Suncorp fans away or get Bendigo ordinary shareholders to make the switch. Whilst we’re not recommending either of these hybrid issues, Suncorp CPS2 wins hands down on a head-to-head comparison. AVOID.

Richard Livingston is Managing Director of Intelligent Investor Super Advisor, Intelligent Investor’s new publication about tax and SMSF investing. For a free trial, visit super.intelligentinvestor.com.au.

APRA not disclosing what may constitute a ‘non-viability’ event now may in the end undermine its ability to impose it.

intelligent investor share Advisor

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Property trust | Jason Prowd

Australand: Sold

With a total return of 48% since our original buy recommendation in January 2010, Jason Prowd explains why he’s happy to sell now and not wait for the perfect exit.

Progress is cumulative in science and engineering,’ warns Jim Grant, ‘and cyclical in finance’. Again and again, investors refuse to learn this painful lesson.

Sharemarkets are complex systems and inherently unstable. But the more distant the last crisis becomes, the more investors act like goldfish, forgetting history and repeating past mistakes, albeit slightly differently.

In the aftermath of the GFC, stocks carrying high debt were cast aside. Infrastructure stocks like Sydney Airports and Spark Infrastructure, both generating reliable profits to service that debt, were available at bargain prices. Yes, those were the days.

Australand Holdings, boasting a $2.1bn portfolio of fully tenanted commercial and office property, fell into this juicy fruit basket, which is why we upgraded it in Pouncing on downtrodden developers from 22 Jan 10 (Long Term Buy—$2.375*).

Investors, weary after several capital raisings, were steering clear of Australand despite its safer financial position and 8.6% distribution yield. All three stocks have since delivered excellent returns.

selling out

Australand’s total return of 48% (or 16% per year) compares favourably with the measly 6.5% return of the All Ordinaries Accumulation Index. You may have fared even better had you followed more recent recommendations.

The remarkable thing about this high return is that absolutely nothing has changed except investors, previously sceptical of any business with high debt due to painful memories of the GFC, are now desperately bidding up any stock sporting a decent yield with scant regard for the risks.

Australand’s recent capital gains and the popularity of the recent batch of hybrid income securities shows that once again investors are falling for the same trap of ’reaching for yield’ that caused so much grief when the GFC struck. Like the average holding period of a stock, financial memories are shrinking to unbelievably short periods and it’s time to lock in our gains and sell out.

Transformation

Over the past decade, Australand has been transformed from a risky property developer into a more reliable property owner, culminating in its inclusion in the A-REIT Index last year, alongside giants such as Westfield Group and GPt Group. The company now owns a $2.1bn commercial and industry property portfolio, built from largely from scratch over the past decade.

Australand usually only develops buildings for tenants prepared to commit to space prior to breaking ground, which reduces the risk of vacancies. It also means it can bank development profits before enjoying a relatively steady stream of rent that grows with inflation.

Growth will likely slow in future, though. Its properties are almost full so there’s only one direction vacancies can go. Also, Australand’s portfolio is far larger than it used to be, so each development has less of an impact on profits and distributions. Despite the expected completion of the $180m building at 357 Collins Street this year, distributions are expected to remain flat at 21.5 cents.

The company’s residential development division is its problem child. Like battered rivals such as AV Jennings, Devine and Sunland, Australand hasn’t produced satisfactory profits due to lower property prices and demand, miserly credit growth and onerous development costs, a fact the company is keenly aware of.

In 2009, chief executive Bob Johnston outlined a goal of increasing the residential division’s return on capital employed ‘to at least 12%’ by 2012. As 2012 draws to a close, returns remain stubbornly low at 8.4%, below the five year average of 8.8% (see Chart 2).

key POiNTs

Australand has produced total returns of 48% since January 2010

Returns from the residential development division are lousy

Downgrading to SELL

AUsTrAlAND HOlDiNGs | ALZ

PriCe AT review $2.98

review DATe 9 Oct 2012

mArkeT CAP $1.7bn

12 mTH PriCe rANGe $2.31—$3.12

BUsiNess risk Medium

sHAre PriCe risk High

OUr view sell

$0

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

Oct 12Oct 11Oct 10

LTBLTB

LTB

Hold HoldSell

Hold

CHArT 1: THree yeArs wiTH AUsTrAlAND

Weekly Review | Issue 354b

5

Profits aren’t expected to increase substantially from here, either. It would be better if the division were sold or wound down and the cash used to reduce debt, expand the portfolio or returned to securityholders.

It doesn’t look as though that’s going to happen. Until profits from this division increase substantially, Australand deserves to trade at a 14% discount to net tangible assets per security of $3.46.

weak case to Hold

With the security price increasing 25% since the original Long Term Buy recommendation, the yield has fallen from the original 8.6% to 7.0%. Compared with a bank term deposit, that might appear attractive but with a reliance on volatile development profits and relatively short-term bank debt, it comes with plenty of risk.

A more appropriate comparison is Westfield retail trust, an altogether safer proposition, which trades on a yield of 6.3%.

The case for holding on is therefore weak. Interest rates would need to continue falling, returns from the residential development business would need to rise and the possibility of further capital raisings would need to be low to warrant a Hold recommendation.

Having lamented missing the opportunity to sell at a similar price around 18 months ago (see The buy and sell strategy, issue 300), we’re not going to miss the chance this time. Progress in finance is, as Jim Grant says, cyclical. We may get another chance.

If the security price falls back to levels that compensate us for the risks, perhaps at around $2.50, we’ll look to upgrade once again but with the price increasing 8% since 30 Jun 12 (Hold—$2.77), we’re banking our profits. SELL.

Note: The Growth portfolio is selling 2,180 securities at $2.98 each netting the portfolio $6,496.

For more on Australand tune in to our recent Boss Talk interview with Bob Johnson Australand’s managing director found in the podcast section of the website.

*Adjusted from the 5 for 1 consolidation in April 2010.

Disclosure: Staff own securities is Westfield Group and Westfield Retail Trust but they don’t include the author Jason Prowd.

Blue chip industrial | Jason Prowd

How to profit from sleep apnoea

two leading sleep apnoea machine manufacturers hail from Australasia. but which is the better business and which is worth buying now?

Australia lacks global brands. There is no Australian McDonald’s, no P&G or Toyota. But there is a specialised global niche where Australia punches well above its weight: Global healthcare.

Alongside remarkable growth stories cSL, cochlear and Sonic Healthcare sit two of the world’s leading sleep apnoea machine manufacturers—Fisher & Paykel Healthcare and ResMed. Both are highly profitable, cyclically immune, growing businesses and exactly the type of blue chip stocks you should aim to own.

In the past five years, ResMed has grown earnings per share by 33% per year while F&P Healthcare has managed a still respectable 11%. As Table 1 shows, figures for both companies on gross and earnings before interest and tax margins and return on equity are impressive. ResMed in particular has delivered 70 straight quarters of revenue growth. That’s over 17 years of continual growth.

ROCE ROCE Average

Source: Company reports

9%

0

2

4

6

8

10

12

20122011201020092008

CHArT 2: rOCe resiDeNTiAl DivisiON (%)

AlZ reCOmmeNDATiON GUiDe

lONG Term BUy Below $2.50

HOlD Up to $3.00

sell Above$3.00

key POiNTs

Both companies are very high quality that investors should seek to own

Whilst ResMed is a better business, F&P is more attractively priced

A fall in the AUD would bring down PERs. Both are Holds for now

intelligent investor share Advisor

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There’s a reason for that: Less than a quarter of sleep apnoea sufferers currently receive treatment, a nice starting point for an investment case.

Obstructive Sleep Apnoea (OSA) is a collapse of the throat during sleep which causes the sufferers to wake. Linked with stroke, hypertension and heart attacks, it affects an estimated 20% of the population. In a recent study by Harvard and McKinsey, the global costs associated with the condition are at least $50bn a year. This is no small problem.

There are three primary ways to treat OSA; surgery, mandibular splints and ‘Continuous Positive Airway Pressure’ (CPAP) machines. It’s in this area that F&P Healthcare and ResMed have carved out very lucrative businesses.

CPAP machines deliver constant air pressure through a facial mask, keeping the throat open during sleep. One sufferer, George, explained on an apnoea support website after using a CPAP machine for the first time, ‘The results were amazing! I slept through the night from day one. My blood pressure went down. My energy level went up, and I stopped snoring.’

The concept is simple enough, but the complexity of the technology shows up in the price people like George are prepared to pay for it, and the margins machine manufacturers make.

Pumps cost between $1,500–$2,500 and rarely need replacing but the masks and tubes cost between $100 and $400 and require replacement at least every year. That makes for a satisfying business model; a fat sale up front and high margin ancillary sales for as long as the patient lives.

size advantage

ResMed’s market capitalisation of $5.7bn is over five times that of F&P Healthcare’s, a disparity mirrored in their respective revenue, profits and market share. Size is a definite advantage for manufacturers.

ResMed’s gross margin—the difference between what it pays to produce its products and what it sells them for—is greater too because it can charge a premium for industry-leading products, the fruit of ResMed’s US$92m research and development (R&D) expenditure, representing 7% of its revenue.

In comparison, F&P Healthcare spends 8% of its revenue on R&D but as it is far smaller—with a market share of just 10% compared with ResMed’s 40%—it only amounts to US$34m compared with ResMed’s US$92m. The smaller company has to work far harder and smarter just to keep up with the market leader’s innovations.

ResMed also benefits by focusing on a more lucrative customer base: Individual patients that aren’t price sensitive. Many receive reimbursement for their machines from a health insurer while features such as heated air, comfortable masks and silent operation, rather than price, drive their purchase decisions.

Half of F&P Healthcare’s business is selling respiratory care products in hospitals, a more competitive environment where buyers exert more power and are less prone to overspend.

misleading disparity

Price insensitivity and high margins are a lovely combination but meaningless to investors if they don’t deliver higher returns on capital. Let’s look at that.

F&P Healthcare produced an impressive average return on equity (ROE) of 23% over the past five years whilst ResMed achieved 14%. The disparity, though, is misleading.

To compensate for its smaller size and to accelerate growth, F&P Healthcare uses debt to boost ROE. It sports a net debt-to-equity ratio of 31% whilst ResMed boasts a net cash balance of US$558m. An ROE of 15% achieved without the use of debt is more impressive than a figure twice that produced with a substantial slug of it.

It also makes for a more stable and lower risk business. If either company were required to fund a product recall—as Cochlear did in 2011—ResMed would be far better placed.

So why doesn’t ResMed use its market position to squeeze F&P Healthcare? And if this is such a profitable industry, why isn’t there new competition?

The first question is easily answered. In a growing market, why worry about crushing your rivals when there’s easy money in new clients?

The second relates to industry structure. Making a new CPAP machine is one thing, having the distribution network to sell it quite another. ResMed and F&P Healthcare have built decades-long relationships with sleep specialists that a newcomer would struggle to break.

wANT TO kNOw mOre?

For more information on OSA see Keep sleeping on ResMed (issue 231), F&P Healthcare’s healthy diagnosis (issue 295) and the government’s Health Insite website (www.healthinsite.gov.au/topics/Sleep_Apnoea).

F&P HeAlTHCAre | FPH

PriCe AT review $1.82

review DATe 11 Oct 2012

mArkeT CAP. $970m

12 mTH PriCe rANGe $1.45—$2.05

BUsiNess risk Low–Med

sHAre PriCe risk Med–High

mAX. POrTFOliO weiGHTiNG 3%

OUr view HOlD

resmeD | RMD

PriCe AT review $3.91

review DATe 11 Oct 2012

mArkeT CAP. $5.7bn

12 mTH PriCe rANGe $2.37—$4.01

FUNDAmeNTAl risk Medium

sHAre PriCe risk Medium

mAX. POrTFOliO weiGHTiNG 3%

OUr view HOlD

TABle 1: FPH vs rmD FPH rmD

FOUNDeD (yr) 1934 1989

siZe ($m) 983 5,715

mArkeT sHAre (%) 10 40

reveNUe ($m) 415 1,345

GrOss mArGiN (%)* 53.2 59.9

eBiT mArGiN (%)* 19.1 20.9

ePs GrOwTH (%)* 10.8 33.3

DiviDeND yielD (%)^ 6.3 0.8

GeAriNG (%)# 31 –35

rOe (%)* 22.6 14.1

* Based on 5 year average, ^ Both unfranked, # Net debt to equity

Weekly Review | Issue 354b

7

massive growth

Given that both business are extremely profitable and have massive growth potential, F&P Healthcare’s price to earnings ratio (PER) of 18 isn’t a surprise. ResMed, a stronger, bigger business on a PER of 23 and measly dividend yield of less than 1%, is even more expensive. F&P Healthcare sports an unfranked dividend yield of 6.3%, but it pays out virtually all its profits as dividends and dividends will be held flat until earnings increase and gearing levels fall.

If the Aussie dollar fell substantially, these PERs would fall but right now F&P Healthcare is more attractive, although only suitable for members prepared to buy businesses that aren’t dominant industry players.

If you’d rather wait for a cheaper price, a view we favour, consider opening a 1%-2% position now and increasing it if and when valuations fall. F&P Healthcare’s share price has risen 8% since F&P Healthcare: Show us the money from 29 May 12 (Hold—$1.68) and remains a HOLD. Note that we’ve slightly increased the prices in the recommendation guide as the company’s new masks appear to be gaining market share.

As for ResMed, its share price has risen 21% since 21 May 12 (Hold—$3.23), and at current prices its closer to a downgrade. But we are increasing the prices in the recommendation guide to reflect its growing quality. It too is a HOLD.

Disclosure: Staff have interests in CSL, but they don’t include the author Jason Prowd.

Investor’s College | Gaurav Sodhi

Speculation: No ordinary gamble

Speculation doesn’t have to be a gamble. Gaurav Sodhi explains how thinking about specs differently can reduce risk and increase your returns.

There are few industries where a success rate of six out of ten is considered a glorious achievement. Pilots or doctors with such a strike rate would be deemed criminal, and yet the best fund managers routinely boast of being right just 60% of the time. That means that about 40% of all investment decisions end up costing money. And that’s if you’re very good. For most investors, the strike rate is lower. If nothing else, investing is a humbling enterprise.

For those pursuing speculative stocks, it is more humbling still. Deciding to invest in a speculative situation is often thought of as a punt, a gamble. In many ways, it is. While traditional investing will yield a success rate of perhaps 60%, spec stocks will generate a success rate of perhaps 20%.

Investing in specs demands a different mindset from traditional investing. Thinking about specs not in terms of hope but in terms of probability will help you manage risk and boost returns.

Before that, however, you need to be mentally prepared for the anguish of being a speculator.

manage expectations

Attach the name ‘speculative’ in front of a company and people’s behaviour changes. To some, the prefix is a license to throw rationality out the window and have a gamble. Yet hope is not an investment strategy. Be extremely selective with speculations and avoid buying for hope alone. We recommend buying specs only when the probabilities involved are extremely attractive or when something will change to alter the market’s verdict.

The best investors think in terms of what is possible, not just what is likely. Low probability events shouldn’t just be scenarios dismissed as outliers; they should be pondered over

rmD reCOmmeNDATiON GUiDe

lONG Term BUy Below $3.00

HOlD Up to $5.00

sell Above $5.00

FPH reCOmmeNDATiON GUiDe

lONG Term BUy Below $1.65

HOlD Up to $3.00

sell Above$3.00

key POiNTs

The most likely outcome of speculation is a loss

With those odds, a different strategy needs to be employed

Take small, more frequent positions

intelligent investor share Advisor

8

and feared because they can have enormous impacts on returns.Before the GFC, for example, the statistical models all said that the risk of a nationwide

downturn in US house prices was puny. House prices had never fallen simultaneously across the US and that was enough for most finance ‘experts’ to confirm they never would. We know how that turned out. Successful investing is about thinking about—and avoiding—such low probability events.

Our position on the banks is such a case. In most scenarios, they will survive and perhaps make reasonable returns. But there is a small chance of huge losses, and our strategy is to lower portfolio limits to take that possibility into account. In other words, we wish to minimise our exposure to a small probability event.

risk on

Spreading your bets in a world of blue chip investing is specifically about trying to limit the impact of low probability events; an earthquake, a fraud, a tsunami or a financial crisis. This has two impacts; it reduces risk but it also reduces potential returns. Remembering that top investors generate success rates of about 60%, diversification and limiting portfolio sizes are acts of conservatism.

Investing in speculative stocks is an inversion of this. To buy spec stocks is to court exposure to the small probability event, not to avoid it. Nicholas Taleb advocates (and practices) exactly this type of investment strategy. At any one time, he suggests being 90% invested in the most conservative investments (for example, bonds), and spread the remaining 10% across many high risk situations that might yield a spectacular outcome. The Taleb approach is extreme but it illustrates that seeking exposure to small probability events should profoundly change expectations and strategy.

If we are buying for a small probability event then, by definition, we expect to lose money most of the time. The hope is that, over time, the ones that work out outweigh the ones that don’t.

As our performance report highlights, our record on Speculative Buys has produced average annual returns of 9.5% per year. That’s far from terrible but it’s below the returns from lower risk Long Term Buys. Of course, that single number disguises a lot of variation. Investors in rHG, Silver Lake resources and Integra Mining have made multiples of their initial outlay in quick order. Other calls, such as Azumah resources and carnarvon Petroleum, have fared disastrously.

Betting against the market, which is the idea behind a speculative buy, hasn’t proven to be an outstanding strategy for one simple reason; the market often prices probability correctly.

There are two essential lessons to be learnt from our experience. Firstly, adhere strictly to small portfolio limits. Doubling down when prices have fallen is an attractive proposition in blue chip investing because we can be more certain about outcome. In a speculative situation, the market’s verdict on probable success is right more often than it is wrong. So if a 2% position falls by 50%, doubling down isn’t a good idea; better to buy two tranches of 1% to preserve the portfolio limit.

Secondly, instead of concentrating our portfolio in a few ideas, which can lead to higher returns and less risk in ordinary investing, a speculator should seek to diversify more often. Remember the range of possible outcomes of a speculation are vast, by placing more ‘bets’ you’re giving yourself the best possible chance of eliminating luck and obtaining favourable returns. This is the approach we have advocated in the gold sector, for example (see An instant gold portfolio, issue 345).

Speculation is perhaps the hardest way to make money on the market. If you plan to do it, follow a strategy that calls for more frequent positions of smaller size. By doing so, life can still be sunny without the mourning.

Disclosure: The author, Gaurav Sodhi, owns shares in Integra Mining. First published online 10 Oct 2012.

OUr sTrike rATe

Our Performance report reveals that, from 91 Speculative Buy recommendations made, 43 made money and 48 lost money, a strike rate of 47%. Those recommendations generated a return of 9.5%p.a, a respectable but less than spectacular outcome. With returns from Spec Buys lower than those from more conservative Long Term Buys, is there a case for abandoning them altogether? Perhaps. But, as gains from the likes of RHG and Silver Lake Resources illustrates, a successful Spec Buy recommendation can transform portfolio returns in a way traditional recommendations can’t. We’ll continue issuing them selectively.

’BlACk swAN’ eveNTs

Low probability events aren’t black swans. They are events that are foreseeable today; they are possible, predictable but statistically unlikely. Black swans are events that no one has—or possibly could have—foreseen.

Weekly Review | Issue 354b

9

Stock updates

Billabong International | Jason Prowd

Yet another private equity proposal has fallen over, with TPG officially withdrawing its conditional proposal to acquire Billabong International for $1.45 per share. Billabong’s share price has since fallen 16%, as those betting on a deal getting done rush the exits. Though we wouldn’t rule out another suitor coming along, shareholders are currently at the mercy of management’s turnaround plans announced in August. Our ‘speculative buy’ recommendation has always been a bet that a sensible strategy could produce large capital gains over the next four or so years, with any attractive takeover bid simply a bonus. Billabong has done so much wrong over the past five years that with a decent amount of sales to work with, even an average manager should be able to salvage a decent amount of value from today’s price.

That said, turnarounds—especially in retail—are risky. The portfolio limit remains unchanged at 2% and we look forward to hearing more about why TPG baulked at acquiring Billabong in the coming weeks as the details leak to the media. If you haven’t already, we highly recommend reading Sun rises of Billabong wipeout from 9 Jul 12 (Speculative Buy—$1.09) before following this recommendation. We’ll publish a full analysis of management’s turnaround strategy in due course. With the share price falling 22% since 5 Oct 12 (Speculative Buy—$1.08), we’re sticking with SPEcULAtIVE bUY.

Note: We’re adding 3,000 shares to the Growth portfolio at $0.847 per share for a total cost of $2,541.

David Jones | Jason Prowd

Like the ailing fortunes of that other famous Jones, the misery of retailer David Jones continues. Recently released full year results confirmed the torrid trading conditions facing retailers. Sales revenue fell 5% to $1.9bn whilst net profit collapsed by 40% to $101m. So much for former chief executive Mark McInnes’ claim that ‘David Jones’ business model is designed to deliver [profit] growth throughout downturns in the economic cycle’. Investors have fled the stock; David Jones’ share price is down 15% over the past year.

So is it cheap enough to buy? In short, no. We estimate the company is worth between $1.44 and $2.78 a share—with the swing factor being the valuation of the retailing business (see Table 1). At around $2.00 per share we’d considering upgrading to Long Term Buy.

David Jones though, has some significant advantages over its listed peers—principally Myer—that mean existing owners needn’t rush and sell. Firstly, it owns four prime retail properties—worth $612m at current market prices, or around half the current market capitalisation. Secondly, it has a highly profitable financial services business which, even after earnings fall post the expiry of the current American Express contract, should still earn the group between $20m–$25m in earnings before interest and tax each year. Finally, current chief executive Paul Zahra is in the process of improving the operations. If successful, those changes could help win back shoppers and halt the retreat in margins.

As over half the group’s value comes from property and financial services, it’s almost wrong to think of David Jones as a retailer. Yet it remains our pick of the sector.

Indeed, David Jones recent revaluation of its property assets and new strategic plan means corporate activity is now much more likely. This could result in a takeover by a private equity group or the sale of its property, yielding owners a special dividend. Either way, it’s unlikely that David Jones will remains in its current form. Despite David Jones’ share price rising 8% since 23 Mar 12 (Avoid—$2.37), we’re upgrading to HOLD.

BillABONG iNTerNATiONAl | BBG

PriCe AT review $0.84

review DATe 12 Oct 2012

mAX . POrTFOliO weiGHTiNG 2%

OUr view sPeCUlATive BUy

BBG reCOmmeNDATiON GUiDe

sPeCUlATive BUy Below $1.10

HOlD Up to $2.00

TAke PArT PrOFiTs Above $2.00

DAviD JONes | DJS

PriCe AT review $2.55

review DATe 8 Oct 2012

mAX . POrTFOliO weiGHTiNG 3%

OUr view HOlD

TABle 1: DAviD JONes vAlUATiON ($m) BeAr BAse BUll CAse CAse CAse

PrOPerTy 500 600 700

FiNANCiAl serviCes 125 175 225

reTAiliNG BUsiNess 250 450 650

eNTerPrise vAlUe 875 1,225 1,575

NeT DeBT 115 115 115

eqUiTy vAlUe 760 1,110 1,460

eqUiTy vAlUe ($ Per sHAre) 1.44 2.11 2.78

DJs reCOmmeNDATiON GUiDe

lONG Term BUy Below $2.00

HOlD Up to $2.75

sell Above $2.75

intelligent investor share Advisor

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Macquarie Group | Nathan Bell, CFA

Macquarie Group’s share price has increased 20% since the previous update on 26 Jul 12 (Buy—$24.36), as investors bid up share prices due to lower interest rates at home and central bank money printing abroad. With our margin of safety thinning, once again we’re downgrading to ‘Hold’ and selling 140 shares from the model Growth portfolio to reduce the position size to around 4%. If you made Macquarie a large position in your portfolio at lower prices you might consider selling some shares to reduce the risk within your portfolio. Large position sizes should be saved for less leveraged businesses and those with cheaper valuations.

The range of outcomes for this stock remains wide. Macquarie’s three market-related businesses are barely profitable, but profits could increase substantially if companies start spending their huge cash piles on acquisitions and bid up asset prices. Macquarie’s current 16% discount to book value (around $35) and 4.8% unfranked dividend yield show Mr Market has low expectations for this former market darling, which is why we’re keeping a healthy weighting in the Growth portfolio despite a lacklustre outlook while governments and central banks fail to resolve the sovereign debt crisis.

We’ll review the company’s interim results for 30 September when they’re announced in three weeks. For now, we’re downgrading to HOLD.

Note: We’re selling 140 shares from the model Growth portfolio at $29.17 per share, raising proceeds of $4,083.80.

Disclosure: Staff have interests in Macquarie Group, but they don’t include the author, Nathan Bell.

Doddsville blog | Jason Prowd

The seven immutable laws of investing

James Montier—who works alongside Jeremy Grantham at GMO—is my favourite investing author. He writes with a verve and clarity that’s missing from most in the industry. In simple, easy to understand language he debunks many theories finance professionals hold dear (such as CAPM). He’s written a number of books including the Value Investing: Tools and Techniques for Intelligent Investment and Behavioural Investing among others.

Here I’ll focus on his recently published paper: ‘Seven Immutable Laws of Investing’.They are:1. Always insist on a margin of safety2. This time is never different3. Be patient and wait for the fat pitch4. Be contrarian5. Risk is the permanent loss of capital, never a number6. Be leery of leverage7. Never invest in something you don’t understandLet’s focus on two ‘Always insist on a margin of safety’ and ‘Be leery of leverage’.

‘Always insist on a margin of safety’

That is, don’t overpay. Successful investing involves admitting you’re fallible and insisting on only buying stocks that are trading at a discount to your estimate of intrinsic value. Of course this idea didn’t start with Montier but the father of value investing, Ben Graham (see Chapter 20 of Intelligent Investor).

ONliNe COmmeNTs

John said: Buffett helps popularising the tenet of margin of safety. However, the more I practice value investing, the more I realise a more fundamental tenet is “insist on asymmetric risk/reward”. Having a large margin of safety is just one of many ways to achieve asymmetric risk/reward. Taleb’s approach to investing, as mentioned in Gaurav’s recent article, is synthesising asymmetric risk/reward.

mACqUArie GrOUP | MQG

PriCe AT review $29.17

review DATe 10 Oct 2012

mAX . POrTFOliO weiGHTiNG 5%

OUr view HOlD

mqG reCOmmeNDATiON GUiDe

lONG Term BUy Below $29.00

HOlD Up to $35.00

sell Above $35.00

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Indeed, overpaying is what causes most permanent losses of capital. Montier provides a useful example. In 2000, Forbes published a ‘Ten Stocks to Last the Decade’ portfolio, which included Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley and Genentech. The results have been disastrous, if you’d followed Forbes’ advice you would have lost around 75% of your capital. The principal sin wasn’t picking terrible businesses—most in the list have grown earnings over the past decade—it was paying far too much for them, the average PER at purchase was 347!

Investors in the recent Facebook IPO face a similar problem. There’s no doubt Facebook will be larger and more profitable in 10 years time, but it has to grow at an amazing clip (circa 40% a year) just for investors to break even, let alone make any money.

‘Be leery of leverage’

Leverage, or ‘debt’, should always concern investors. There are a few ways debt can get investors into hot water, and some are less obvious that others.

First the sheer quantum of debt can be far too high. For many businesses, such as services companies (e.g. Enero, UXC, Monadelphous) the correct amount of debt is zero—operating conditions can change swiftly and when they do the consequences can be disastrous. Balance sheets are important, and it pays to keep a close eye on gearing. The question should always be: ‘Does this business have too much debt? ’

A second less obvious risk relates to refinancing, what I call ‘roll over’ risk. Companies that use debt need to regularly go back to market to refinance it. And if capital markets dry up, as they did in 2008/9, a company can go under regardless of the underlying performance of the business.

This is exactly what happened in the A-REIT (property trust) industry during the GFC. The assets continued to perform—rents kept rolling in—but no banks were willing to lend and shareholders were mercilessly diluted causing permanent loss of capital.

This lesson shouldn’t be soon forgotten. Whenever you’re considering an investment that involves debt, check when it’s due, typically longer dated debt is better. Property groups such as Stockland, Westfield and GPT Group are inherently less risky than smaller companies such as Abacus or Australand because they can lock in long dated (often 10 years +) debt.

Just following these two rules will save you a stack of money—let alone all seven. I’ve pinned the list up on my desk as a constant reminder. It wouldn’t hurt to do the same.

First published online 10 Oct 2012 at our Doddsville blog (blog.intelligentinvestor.com.au).

Successful investing involves admitting you’re fallible and insisting on only buying stocks that are trading at a discount to your estimate of intrinsic value.

Blog links

below is a list of blog articles published by our analysts this week.

Gravy Train blog | Don’t take financial advice from a newspaper

Podcast links

below is a list of podcasts published to the website during the past week

Stock Take podcast | Tesco, Sony, Goodwill and more

12

intelligent investor

sCA Property Group

Would it be right to assume you’ll share your thoughts on the ScA Property Group offer as it unfolds from the Woolies umbrella? And, by the way, thanks for the great service. I seem to have barely time to scratch let alone send complimentary notes, but that doesn’t mean it isn’t deserving. And for what its worth the OS analysis is really helpful. Jeff K

10 Oct 2012—Jason Prowd: Afternoon Jeff. Thanks for the kind words, I’ll pass them on to the rest of the team. Yes, I’m currently sifting through the SCA Property Group prospectus—expect to see a review next week.

No interest in virgin

Dear Sirs, I would like to have an opinion about Virgin Australia’s performance in the financial year ended 2012.

10 Oct 2012—Gareth brown: We’ve never had a positive recommendation on Virgin, and in the 11 years that Intelligent Investor has been a value-investing publication (ie since Greg Hoffman become research director in 2001), we’ve not had a positive recommendation on Qantas either. The reason is that the business economics of airlines are simply horrific, and we’d rather steer clear rather than punt on the occasional turnaround that may or may not eventuate. To quote Richard Branson, ‘if you want to be a millionaire, start with a billion dollars and launch a new airline.’We ceased coverage on both stocks a few years ago and don’t put a lot of thought into them now—though we occasional revisit airlines (see the recent article Qantas: A tempting trap?). We think there are easier ways to make money than owning an airline for the short term or long term, and will focus on those other avenues. See our buy list for what we think are more attractive ideas.

Thoughts on Ale Group recommendation

Gareth, based on the convincing arguments in your excellent 2nd May article “ALE Property;Down in One”, I subsequently bought some ALE Securities “for yield”. With long-term inflation-protected leases to the strong Woolworth’s-controlled entity

ALH, the critical variable for valuing ALE is the rent adjustments on the 87 hotels in 2018 and 2028.

Using the figures mentioned in your article of 5% and 15% respectively, my attached spreadsheet shows the stapled securities might be worth up to $3, based on a discount rate of 9%. this discount rate, 6% points above the 10-year Government bond rate, seems quite reasonable for this pretty safe investment.

As long as rents do not actually go down in real terms in 2018 or 2028 (unlikely given ALH has spent some $250m on improvements) buying ALE Securities at prices well above your recommended $2.10 still gives attractive Irrs. For example a price of $2.50 gives an Irr of just over 9%.

If my assumptions and calculations are OK, and given interest rates are coming down making this somewhat bond-like investment more appetising, might you not raise your recommended “buy for yield” price? Alternatively you might mention the pretty big safety buffer at $2.10. robert N

11 Oct 2012—Gareth brown: Thanks for your feedback Rob. Though I don’t want to give the opinion that I’ve endorsed your valuation—we don’t tend to think of ALE Group in (nominal) NPV terms but it terms of a range of potential ’real’ (inflation-adjusted) rates of return for today’s buyer, which I’ll get to in a moment—we’re in broad agreement about the attractiveness of the opportunity.

We’re more focused on the ‘most likely’ and ‘at least’ outcomes, rather than the ‘up to’ outcome. As far as ‘most likely’, the stock offers a pre-tax (though currently mostly deferred) starting yield of between 7.0-7.5%. I’ve argued that this should grow roughly in line with reported CPI, so we can think of it as a ‘real’ yield of 7.0-7.5% (ie, we’ll collect inflation plus 7% over the long sweep of time). Add in the effect of the moneys ALH has been investing in Dan Murphy’s and pub expansions, which boost the value of the assets and the cash flowing to ALE mainly from 2028. I can conservatively make the case this will add a few percentage points in overall annual returns for today’s buyer, but we’ve tried to be conservative about this in our estimation. But I’d say that our ‘most likely’ outcome for today’s buyer is perhaps 8-9% real (CPI inflation adjusted) return. Yes, it’s an attractive situation.

The ‘up to’ valuation is heavily influenced by whether ALH

Twitter links

below is a list of this week’s article links posted by our analyst team to our twitter page.

In the Nine battle, the media has a slight Goldman slant. Not sure the sub debtholders have a leg to stand on market folly.

The world’s biggest hedge fund is run by Apple! Who knew?

The Iranian Rial has fallen 30% against the USD since Sunday! Looks like trouble is brewing in Iran.

A Chinese firm makes a takeover offer for copper producer Discovery Metals.

Ask the Experts

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

Weekly Review | Issue 354b

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continues to commit its own capital to expand the assets on ALE land. While recognising there will be some more such investments over the years and they’ll add to ALE’s value in the process, probably most of the free kick money has already been spent by ALH—the closer we get to 2028 the less ALH will spend if it’s acting rationally. So I don’t want to rely on any continued substantial growth capex—let’s call it free blue sky though.

But I think we also need to recognise the ‘at least’ scenario too, this situation isn’t without potential downside. Firstly, there’s some risk of a drop in current yield because of a change in hedging. I’d argue it doesn’t affect the overall value too much (less income now in exchange for more income and capital growth down the track) but the market mightn’t see it that way. If the stock falls on any such situation, though, we’ll be ready to upgrade. See this Q&A response for more detail on the potential hedge change.

Also, I’d be careful of thinking of the situation as ‘somewhat bond-like’. I certainly agree the likely cash flow characteristics fit that description, and this is lower risk than most equities—but the risk profile is higher than most bonds. ALE Group still has plenty of debt. We’ve argued it’s manageable but debt always increases risk. It’s why we’ve suggested fairly modest portfolio weightings despite the fact we like the situation.

As it stands today, we think of ALE Group as a great stock for income investors able to accept a bit of risk (as long as they follow our weighting suggestions), because it meets that investor’s need for current income while offering pretty good growth potential for free or very cheaply. As you mentioned, ALE Group has quite a significant ’safety buffer’ at today’s price. Whether it meets the return hurdles of a more aggressive investor is where it gets trickier. We stand ready to upgrade to outright Buy on any substantial fall but are sticking with Buy for Yield for now. Thanks again for your feedback.

Top-down or bottom-up?

Hi Gareth, the market seems to be rolling along in a merry way especially the banks right now. What is your opinion of the market right now, with generally a slow down in all the world’s economic engines. Europe is still struggling (maybe be stabilized a little), the USA has bottomed but not too sure it is on a up curve either, china is slowing...... interest rates are falling, share market is rising for no real reason. What is the best strategy for investment right now? I think doing nothing does right either? I am finding this a very difficult market to analysis. What is you thoughts? Eric c

10 Oct 2012—Gareth brown: We really don’t approach investing in this sort of top-down manner, we never know which way the market is going to move next but it hasn’t stopped us stringing together a perfectly fine track record over a long period of time. We certainly consider ‘macro’ issues as a form of risk management—ie we want to form a broad opinion on the copper price if we’re considering buying a copper miner, and we want to be wary of heavily indebted companies if we have particular concerns for the debt markets, for example. We might even let macro concerns partly shape things like a willingness to hold cash (though this is more likely to be driven by an absence of bargains). More broadly, though, we don’t start our investment process by having/forming an opinion on such matters, many of which we consider unknowable (at least by us and probably by all). It’s not an area where a superficial understanding provides any investment edge.

Instead, we look for stocks that offer above average rewards for the risks incurred, which we most often find by knowing the individual

businesses better than other investors (or by being prepared to take a longer term view). If we find a few handfuls of good ideas and construct them into a sensible portfolio, we’ll be well placed to endure any coming macro icebergs. Seth Klarman puts it in a way with which we thoroughly concur. In his 2011 letter to investors (we’ve only seen the excerpts, in Value Investor Insights Feb 12), he wrote:

‘In short, while our macro view remains one of serious concern, we are determined to stay focused on the identification of bottom-up, low-risk opportunity, and to invest solely on that basis. When we find great bargains, we buy them.’

Rather than worry about whether the US has bottomed, we’ll just keep looking for attractive individual opportunities (though mindful of the macro risks). When we find them, we’ll present them to you for consideration in your own portfolio.

infigen debts

If Infigen (IFN) gets into trouble with its $1 billion debt facility in Infigen Energy Limited, is it possible that IFN will have a capital raising, rather than formally breach the loan covenants? What would be a likely scenario if this occurred? PS thanks for the forthright commentary. rob & Julie A

12 Oct 2012—Gareth brown: Oh absolutely, if management thought it wise and can convince shareholders to fund it, the company could raise equity and inject it into the global facility. But if Infigen does that it’s likely to be at a big discount to today’s price and our recommendation will have likely proven a mistake in the process (we’d need to stump in more cash at the same time that the upside case gets diluted). Sailing through without the substantial dilution of a major capital raising is the basis of the upside case. A substantial equity raising is a fairly undesirable outcome rather than a saviour of the investment case. It would only make logical sense for Infigen to inject more equity into the facility if, in the process, it was able to completely secure its stake in the 23 windfarms—half a recapitalisation would be a risky move. Otherwise, in the instance of things not falling in our favour, they’d be better off playing hardball with the lenders. There are no guarantees they’ll play it that way, though, so dilution is a risk unfortunately (as discussed in Downdraught prompts Infigen upgrade).

Profiting from Alan Jones’s big mouth?

Hi guys, an idea for ideas lab? MrN. Drop of 15% since Alan Jones’s gaff (why anyone is surprised is a surprise to me). No doubt the sponsors will come back, his listeners are loyal and people do have short memories and I doubt they would dump him (but not impossible). Down 55c from 12 month high of 95c (trouble in media is well known but 2Gbs audience isn’t likely to disappear online but would be ageing). thought it would be good ideas lab as its under 100m cap and is quite topical, good opportunity to poke fun at Alan Jones, although some of your older subscribers may like him? Joe S

10 Oct 2012—Gareth brown: Thanks for the suggestion Joe. It’s a bit of an unknown for me, I haven’t followed the story closely. If one is convinced that the sponsors will come back, it might be worth looking at. But it’s not something I feel I have the answer to and it would be quite different from most of our Ideas Labs (which are generally takeover arbitrages, privatisations, special dividend arbitrages or other situations where the upside/downside proposition is fairly easy to grasp). As for Jones, I can’t even answer why it was this

intelligent investor share Advisor

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the risk to the long term use of this treatment is suggested as a lack of global supply of IVIG.

Given cSL has such a significant share of this market how important do you think these results, if confirmed in stage III testing, could be for cSL? I have included links here and here to the study below but there are plenty easily available through a simple google search. Paul S

5 Oct 2012—Jason Prowd: Thanks for the question and the article links. It’s something I’ve been following with interest. I agree that if IVIg therapies were proved to help Alzheimer’s suffers CSL would be very well placed to capture part of that market. The difficulty is knowing exactly what it’ll mean for CSL’s bottom line, but the general case is very clear—it would increase CSL’s profits. I’m reluctant though, to pay much for the prospect of it going through, and consider it more akin to a ’free option’ or a ‘nice bonus’ for any investment in CSL.

It is definitely very interesting and I’ll continue to watch the developments out of Baxter closely.

what is Goodwill?

this is deliberately an open ended question because I’d really like your guidance on what the question should be, but what exactly is Goodwill? conceptually, what is it supposed to represent? How does a company acquire/spend Goodwill? Why is it valuable? What should you be aware of when analysing a company with a lot of Goodwill, or when it has a large Goodwill write-down? Apologies for the vague question, but I have yet to understand the bare fundamentals of Goodwill and would really appreciate the guidance. thanks!

9 Oct 2012—Nathan bell, cFA: Hi W. This sounds like an Investor’s College article, but it seems we haven’t written anything in the past to explain it. Note that we also decided to answer your query in this week’s edition of the Doddsville podcast which is currently being edited.

Goodwill is usually the difference between the amount you pay for a company in a takeover and the value of the acquisition’s net assets (Assets less Liabilities or simply Shareholders Equity). If you pay $10bn and the company’s net assets are only $1bn, for example, then somehow your chief financial officer needs to balance the books. He does that by adding an asset of $9bn to your balance sheet known as Goodwill.

All things being equal, Goodwill is usually larger when you purchase a services company as opposed to a capital intensive business like an A-REIT. A service company won’t have many ’hard’ assets where as a property trust owns many buildings that you wouldn’t usually pay a large premium for, so goodwill should be minimal.

Investors are wary of companies with large amounts of goodwill because often takeovers produce poor results for the acquirer. Research shows that most of the value in a takeover falls to the shareholders of the company being acquired given the takeover premiums involved, which is why Goodwill is often written-off.

The financial damage of overpaying for acquisitions usually shows up when an expected increase in earnings fails to materialise. Writing-off Goodwill is merely an accounting entry, as the cash went out the door when the company was purchased. The problem is that writing off Goodwill often triggers a capital raising because companies usually borrow lots of money to make the lousy acquisitions.

The main point is to no think about Goodwill in a vacuum, rather think about the company being acquired, does it make sense, how much has the company paid, will future earnings justify the purchase

particular comment that set off the fury, as opposed to the many things he’s said over the years. The court of public opinion is fickle. Sometimes, reputations (and the cash flow from such reputations) are permanently tarnished, and I’m not certain that won’t happen here. Because I’m not convinced we know this one better than the market, we’ll steer clear. But it might be one for speculators who understand the situation better, it might well be cheap. Thanks for the suggestion and I definitely like the way you’re thinking on the matter, looking for a bargain in the mayhem!

Portfolio weighting in PrimeAg?

re. PAG, presumably GPG will be a willing seller of its 11%+ stake as well. On the assumption you already hold GPG do you have any advice on the size of stake you think should be allocated to PAG if the price was right to buy in? Paul S

5 Oct 2012—Gareth brown: I’d hazard a guess that this whole process was prompted by the big shareholders, and not just GPG who are obviously keen to liquidate (BTW, this is a nice but small boost for our previous positive recommendation on GPG). Australian Food & Fibre, also with 11%, was very annoyed by the 2011 entitlement issue (and rightly so!). With the exception of new addition Laguna Bay, I think most of the rest are keen sellers at the right price (IOOF and JCP both sold down below 5% subsequent to the announcement, effectively selling the stock that Laguna Bay bought). I wonder if AF&F withdrew its requisition last year to sack the board based on a promise by the board/chairman to do something if the price/NTA gap hadn’t closed within 12 months, the timing seems coincidental otherwise. I also note AF&F hasn’t traded a single share of PAG over the past 12 months, as would be expected if they knew something others didn’t. Just a theory.

As for portfolio weighting—well we haven’t even issued a recommendation on this stock, just put it out there for those able to do their own research and come to their own conclusion. So it would be irresponsible to start suggesting weightings on something we haven’t recommended. That said, I’d caution against betting heavily. The upside (and the downside) will be driven by the generosity of bidders. That’s a unique driver and hard to anticipate how it might work out. These sorts of situations also retain lots of market risk too, (for example, a stockmarket crash next week would surely impact bids). I think it’s only a little punt only if anything at all.

I wouldn’t be worried about your exposure to PAG through GPG, unless you have a massive weighting to GPG. PAG makes up 3-4% of the non-Coats assets of GPG, so an insignificant proportion of your own portfolio if you only have the recommended 4% weighting to GPG (perhaps 0.1% in PAG this way). I’d consider this as a separate case.

Csl to treat Alzheimer’s?

Hi, Following up from your comments in your April review of cSL I note a large number of recent (mid July) articles and follow up have been published regarding the success of baxter in using IVIG (Intravenous Immunoglobulin) therapy for the first time successfully to halt the progression of Alzheimer’s for more than 3 years in a clinical trial with human patients. baxter is now proceeding to its final stage III trials with a larger sample group. the research suggests this could be a US$8b a year market in the US alone and the treatment appears to be recurring (ie the procedure requires regular readministration rather than being a one off treatment).

Weekly Review | Issue 354b

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the picture. For most companies that borrow, higher rates mean higher interest expenses, and generally a hit to intrinsic value and increased risk they’ll be unable to pay their debts as they fall due. Computershare, however, control some US$13.7bn of client cash which doesn’t sit on its balance sheet. If rates go higher, the company will earn higher rates on approximately 1/3rd of this cash pile—the rest is either fixed, hedged or goes to the customer—swamping the extra payment of interest on its debts. So Computershare shareholders should be keeping their fingers crossed for higher interest rates—as these will increase, rather than decrease, the net cash flowing to shareholders. That makes it quite unusual among borrowing companies.

embelton too small for us

Hi guys, any thoughts on Embelton Limited (EMb)? 9 Oct 2012—Gareth brown: Embelton is a real tiddler, about

$14m market capitalisation and way below our strict $100m market cap cut-off (for liquidity reasons). Inside ownership of more than 50% of the stock, perhaps a good thing from an ’alignment’ point of view, further compounds the liquidity issue. This might be one for the microcap bargain hunter to at least take a glance at, but it’s not suitable for us I’m afraid.

TODHA—no capital return or tax loss available as yet

Any payments to date by liquidator or other on tODHA—timbercorp Orchard trust Debentures Have received none to date and have no material on which to claim capital loss. Who to contact re this matter.

9 Oct 2012—Gareth brown: Unfortunately, there’s been no payment as yet. All of the assets of the trust has been sold, as highlighted in this July 2012 announcement, netting about $23m, which works out to about $35-$40 per TODHA security. This might be considered a best possible outcome now. Unfortunately for TODHA owners, MIS growers are still arguing for a share of those proceeds, appealing a previous decision that went against them, and holding up the potential cash payment in the process.

Furthermore, until these funds are distributed to someone (hopefully to TODHA holders from our perspective), the security won’t be deemed worthless, failing to fulfill the basis on which owners can claim a tax loss. We’re hoping for progress soon, but at the moment owners are stuck in limbo in regard to both any final payment and also in regards to claiming a tax loss. All we can do is wait for now.

We follow the story on the Align Funds Management website, and you might choose to do likewise or wait for a review to pop up in Intelligent Investor eventually. You might wish to call Align directly but I suspect they’re unlikely to say anything other than confirm what we’ve written above.

or lead to a massive write-off and capital raising that will cause you to suffer large losses. While QBE has done a decent job over the years acquiring businesses, usually highly acquisitive companies are best avoided. Better to focus on companies with good businesses that don’t need to acquire other businesses to turn a decent profit.

iron ore spot prices

Hi, this may sound like a silly question, but as much as I try I can’t seem to find the daily spot pricing for Iron Ore on line. If it’s on the LME I cant seem to find it. Do you know where the daily price is reported? Stevie M

5 Oct 2012—Gaurav Sodhi: Hi Stevie. You need a subscription to Platts to get daily access or you can do what many others do; check the papers or news websites for daily quotes! It’s much cheaper that way.

various stocks

I am interested in your views on Sirtex (Srx) and Seymour Whyte (SWL). Also Greenland Mining (GGG) mentioned yesterday.

9 Oct 2012—Gareth brown: My apologies on the delay getting back to you. Seymour White (market capitalisation $58m) is too small for us, we avoid all sub-$100m market cap stocks for liquidity reasons, expect for the occasional Ideas Lab article. Greenland Mining is also too small and speculative for us, as Gaurav highlighted in response to your other query on the company. We cover Sirtex on a fairly regular basis, and you can read our past reviews and current recommendation by typing SRX into the search tab, or clicking this link.

Computershare’s debt situation

Hi Gareth I’m wondering what is the cost of debt that you have assumed when you were estimating the target price of cPU?

9 Oct 2012—Gareth brown: In case our past reviews have given the wrong impression, we’ve never issued a target price for Computershare (nor any other stock for that matter—please don’t confuse our recommendation guides with price targets, they are in no way a forecast but instead are an indication of how our recommendation will change with price, all things being equal). So the question is rather unanswerable. But, if you’re looking for more info on the debt of the company:

From a risk management perspective, head to printed page 88 (note 34d) of the 2012 Computershare annual report for the maturity profile of the debt. As for interest rate risk, some of that debt is fixed interest rate and some floating rate (see 34a on page 86). But we’re not terribly worried about the effect of higher interest rates on the floating debt, for reasons highlighted below.

From an intrinsic value perspective, though, that’s not even half

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