In This ISSUE... China's Property Market, on Which

ISSUE 319a | 30 april–6 May 2011

CONTENTs In this issue... STOCK REVIEWS

STOCK ASX CODE Recommendation PAGE APN News & Media apN Coverage Ceased 6 Nathan Bell CFA Fairfax Media FXJ Coverage Ceased 6 China’s property market, on which Australia’s resource sector, Foster’s Group FGL Hold 7 exports and strong currency rests, appears more bubble than West Aust. Newspaper WAN Coverage Ceased 6 supercycle... (see page 2) stock UPdates ANZ Bank aNZ Sell 9 Aristocrat Leisure all Buy 9 Carnavon Petroleum CVN Speculative Buy 10 Gaurav Sodhi Computershare CPU Hold 10 Why, in the midst of the greatest commodities boom in history, do Westpac Bank WBC Hold 10 we have only a handful of positive resource stock recommendations? features Gaurav Sodhi explains... (see page 4) Director’s Cut: Chinese bubble trouble 2 The commodities conundrum 4 Notes from the Berkshire Hathaway 2011 annual meeting 11 Nathan Bell CFA extras The newspaper industry is shrinking into decline. Despite Blog site links 12 newspaper stocks suffering large share price falls recently, value Podcast links 12 remains elusive... (see page 6) Twitter site links 13 Ask the Experts Q&A 13 Important information 14 Gareth Brown RecomMendation changes The demerger is good news for Foster’s beer business. But there Aristocrat Leisure upgraded from Long Term Buy to Buy are some looming threats to its incredible margins... (see page 6) PORTFOLIO CHANGES There are no recent portfolio transactions

Greg Hoffman Warren Buffett and Charlie Munger provided plenty of food for thought for Australian investors at the weekend. Early on Buffett mentioned that Berkshire had made around $100m on foreign exchange transactions in 2010 in just two currencies... (see page 11) The Intelligent Investor

China’s property market, on which Australia’s resource sector, exports and strong Key points currency rests, appears more bubble than supercycle. China/resources supercycle looks like a bubble Prepare for every possible outcome now By Chinese standards, Ordos isn’t a big city. Situated in Inner Mongolia, a long way from the coastal plains where the apartment construction boom first took hold, it’s a vivid Diversify overseas, buy high quality stocks, minimise speculative exposures reminder of where, even in the remote interior of a vast country, the fortunes of Australian resources companies rest. Cities of this size usually take centuries to evolve. Ordos was built in a few years. Subdivisions, littered with duplexes more Californian than Mongolian, pepper the landscape. There are government and commercial office towers, apartment blocks, public libraries and a museum beautiful enough to grace any European city. Only one thing is missing: inhabitants. Ordos is a ghost town, a city without life and in no way unique. Even in China’s biggest cities, huge numbers of buildings lie vacant. On the morning of a solar eclipse, a Chinese university professor rode his bicycle through the streets of Beijing. Amid the smog and gloom, he noticed something rather odd: Many of the office skyscrapers he passed were unlit. They too were vacant. The South China Mall, east of Guangzhou, is the second biggest in the world by gross leasable area. Only 1% is occupied. The parking lot, untroubled by vehicles, now features an impromptu go-kart racing track. No one shops in malls like these because no one lives in the nearby apartments. In a six-month period, it was reported that 65 million homes, enough to house perhaps 200 million people, didn’t use any electricity at all. The authorities, which don’t maintain official statistics on vacancy rates, at least not publicly, deny these figures. And yet the anecdotal evidence is plentiful. One only has to look. In a centrally planned economy, these bridges to nowhere could be officially mandated over-supply but a more coherent explanation looms: The Chinese have turned their construction sector into a casino, taking Australian resources stocks with it. Companies that once made shoes now develop real estate. State owned enterprises that mined salt now build office parks. Housemaids are getting ‘divorced’ to buy second apartments. All the signs are there: China has the hallmarks of a vast, speculative bubble. The statistics, scant as they are, offer more conclusive evidence. Vitaliy Katsenelson, Chief Investment Officer with Investment Management Associates, claims that at the height of the Japanese property bubble, the housing affordability ratio, calculated by dividing the property price by annual disposable income, was nine times. In Beijing that ratio is now 14. In Shanghai it’s 12. At the peak of the US housing boom, property investment as a percentage of GDP never exceeded 6%. During the Japanese speculative frenzy it reached 9%. In 2009 in China it was 10%. Even real estate developers—presumably not those that once made shoes—think Chinese real estate is a bubble.

Stronger for longer? In a crushing blow to the purveyors of the stronger-for-longer position, only the Economist Intelligence Unit disagree with the bubble argument. In a report titled Building Rome in a Day, the EIU says, ‘there are few signs that the seemingly insatiable appetite of Chinese consumers for bigger and better housing will slow substantially.’ No, no signs at all. As long as everyone keeps on buying houses rather than actually living in them, everything will be just fine. China, perhaps more so than the US in 2006 or Japan in the late eighties, is ripe for a

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misallocation of resources on a truly astonishing scale. Statistics are unreliable; corruption is rife; local governments, which don’t levy property taxes, earn revenue from land sales; officialdom is distant and unaccountable; and there is no independent media. There exists in China every incentive for self-delusion, to pretend that this time, it really is different and no channel through which that view can be challenged. In Australia, for reasons no more edifying than simple self-interest, we seem happy to tag along. The managements of BHP Billiton and Rio Tinto, and just about every other miner making out on Chinese demand for resources, head the list of local China cheerleaders. But one man’s supercycle is another man’s bubble. If you must play with it—and we’d advise against it—do so with intelligence rather than greed. The diversified miners like BHP and Rio Tinto are sitting on vast cash piles and typically produce high volumes at low cost. But the stocks getting all the (speculative) attention—Sandfire Resources, Lynas Corporation and CuDeco for example—lack the diversity and asset quality of the giants. If the bubble does burst in the next few years, these are the sort of stocks that will be savaged. The big miners will be whacked too, but they will survive and, when China’s industrialisation resumes, which it almost certainly will, are well positioned to prosper once more. If, like many of your analysts, you wish to steer clear of these stocks altogether, consider acting on some of the themes regularly featured in this column: hold cash; build your holdings in defensive stocks like Woolworths, Metcash and Westfield Group (see our buy list for more); look for local companies with good overseas earnings (like News Corp and QBE Insurance); and consider international diversification in countries where stocks are cheap, like the US and Europe, rather than expensive (a podcast interview with There are other manifold Templeton Global Growth Fund portfolio manager Peter Wilmshurst due to be published soon discusses the current opportunities in the US and Europe). worries—there always are—but If international diversification appeals, please don’t subscribe to a poor product like China’s property bubble is Exchange Traded International Securities. Gareth Brown’s scathing review reveals how vital a bigger threat to Australia information can be manipulated and disguised to disadvantage investors, and still be well and its investors, than it is for within the law. Frankly, it shouldn’t be allowed. Gaurav Sodhi made an original and compelling argument in The Case for LNG Part 1 almost any other country. (see issue 317), suggesting that renewables and nuclear wouldn’t replace oil as the energy of the future. Instead, liquid petroleum gas would. Part II reiterated a couple of current buy recommendations and unearthed two potentially attractive stocks. Expect more research on those soon.

Complex affair Investing is becoming an ever more complex affair, made more taxing by demergers, buybacks and share issues. The documents accompanying these proposals are truly terrifying, which is why in recent weeks we’ve allocated analytical resources to making sense of them. The upshot has been Foster’s demerger survival guide (see issue 317), where we’re hopeful of an opportunity to buy the wine business after listing, the JB-Hi Fi buyback (see issue 318) which, in the way of the BHP Buyback calculator (see issue 316), also featured a useful spreadsheet. Members seem to appreciate this service and we hope to deliver more of it, where appropriate, in the future. Ultimately, though, our primary role is to bring you well-researched, profitable new stock ideas. This month, while we haven’t published any new opportunities, we have a number in the works. But we have reiterated a few current buys. A good example was Eight reasons to buy Westfield (see issue 318) and Westfield Retail Trust on Sale (see issue 317) by yours truly, and Macquarie Group, which investors now seem to be pricing as a utility-orientated dividend play. All are worth reading if you haven’t yet done so. The first two especially, along with Woolworths and Metcash and Newscorp, have attractive defensive qualities. In the event of a China-induced currency collapse, they should fare better than most. The same goes for Spark Infrastructure and CSL. At times such as those now enjoyed by Australians, it’s difficult to imagine what might go wrong and even harder to plan for it, which is why I’ve taken the opportunity in this Director’s Cut to warn you of the biggest threat to your investments. There are other manifold worries—there always are—but China’s property bubble is a bigger threat to Australia and its investors, than it is for almost any other country. The threat should not be taken lightly. Finally, to a little housekeeping. This month will see the launch of our new website. It

3 The Intelligent Investor

has many new features, easier navigation, better presentation and a host of other things we hope you’ll like. But it is a big change on the current version. Please take a few weeks to acclimatise to it and then let us know your thoughts. This project has been two years in the making and we want to make sure it works for you. In April we also launched a new podcast, Doddsville. Value investors have traditionally avoided big picture discussions about economics. We’re not of that view. Especially at the extremes, such issues can have a massive impact on investment performance. This new fortnightly podcast is a forum for those discussions, accompanied by the launch of a new monthly column in mid-May. Watch out for it and listen to the latest episode of Doddsville here. You can also leave comments and ideas for future podcasts on the Doddsville website.

Why, in the midst of the greatest commodities boom in history, do we have only Key points a handful of positive resource stock recommendations? Gaurav Sodhi explains. Commodity prices no longer reflect fundamentals Prices are being driven by macro events Want to rent a house in a mining town? Be prepared to stump up thousands of dollars Conservative investors should stand aside a week for a modest dwelling. Fancy a coffee in Perth? That’ll be the highest price in the land, thanks. Want a hotel at short notice? Forget it. Kalgoorlie’s ladies of the night know it all too well and probably saw it first: the good times are back. China has much to do with it. As late as 1990 Shanghai, the Chinese commercial Shanghai 1990s capital, was modest, almost quaint, in appearance. Today, it’s a jungle of towers and steel. Across dozens of provinces, hundreds of cities and a billion people, the scale of China’s transformation is something to behold. It’s led to the mightiest resources boom in history. Never before have resources—from cotton to zinc, coal to neodymium, phosphate to wheat—been so expensive. Australians call it the two-speed economy; the RBA calls it ‘a terms of trade shock’. China calls it modernity. Whatever its name, the scale is monumental. Fortunes have been made, empires built and reputations forged. Yet venture to the coveted buy list of The Intelligent Investor and Shanghai 2010 resource stocks barely rate a mention. Why? The answer is simple, the explanation much less so. Commodity prices are no longer being driven by supply and demand. Instead, they reflect a unique series of macroeconomic factors.

Fundamentals still matter Take copper. With the price rising 400% in less than two years, it’s now almost a precious metal. Enthusiastic souls are illegally ripping it out and selling it for scrap. Miners are scouring the earth to do the same. The copper price is now twice the estimated marginal cost of production. Strangely, there’s no shortage of it. The warehouse storage of the London Metal Exchange is brimming with the stuff and yet prices continue to climb. It’s the same with silver, zinc, nickel, wheat, phosphate and aluminium; Supplies are plentiful and prices are at record highs. It doesn’t make much sense. The market appears to think a massive demand shock, enough to sweep up surplus commodity supply, is just around the corner. With the developed world showing few signs of escaping the post-GFC malaise, there’s scant evidence for that view. More persuasive are the dots, adroitly joined, that lead to Ben Bernanke. Chart 2 shows the US ‘monetary base’, a simple measure of the money supply. Only actions by the Federal

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Reserve, rather than changes in the economy, change the monetary base. Bernanke’s Federal Reserve has been buying securities and pumping hundreds of billions of dollars Chart 1: Base metal stockpiles and prices at LME into the US economy to avoid deflation and to try and kick-start a recovery. The problem is the effect that has had on the US dollar. It’s been depreciating against LME stockpiles vs price: Aluminium a basket of currencies for a decade, but its decline over the past three years has been 5,000k $1.60 particularly swift (see Chart 3), a reflection of the flood of new supply created by Bernanke. 4,500k $1.50 $1.40 By repaying debts in depreciating dollars, the US is effectively defaulting on its debt 4,000k $1.30 3,500k by stealth. As this becomes clearer in the years ahead, foreign investors will be less willing $1.20 to finance US debts. This has already begun; Bill Gross, who manages the world’s largest 3,000k $1.10 bond fund, suggests that 70% of new US debt is now being bought by the Fed itself. 2,500k $1.00 $0.90 The world’s reserve currency is being debased. There is an incentive and, with the 2,000k $0.80 1,500k actions of the Fed, a mechanism, to encourage large scale inflation. No wonder investors $0.70 have decided they would rather put their money somewhere else. 1,000k $0.60 500k $0.50 That somewhere is resources. Demand from China and India is still important, but if 2007 2008 2009 2010 the US weren’t pursuing the policies it is, commodity prices would be almost certainly be Aluminum stockpiles (LHS) Aluminum spot price (RHS) lower. As long as the rich world remains mired in debt and zero interest rates, the prices of soft and hard commodities may continue rise. LME stockpiles vs price: Copper 600k $4.50 Flight to hard assets 550k $4.00 500k A flight to hard assets is a perfectly rational response when doubts surface about the 450k $3.50 viability of fiat (read ‘paper’) currency. But these higher prices do explain our reluctance 400k $3.00 to get more involved in the sector. 350k 300k $2.50 Over the short term, macroeconomic factors like these can lead to odd market pricing. 250k We’d argue that’s what’s happening now. The fundamentals are being ignored. In the long 200k $2.00 150k $1.50 run though, the fundamentals—supply and demand—determine prices. The focus will return 100k to fundamentals at some stage, although it’s a fool’s game to guess when. 50k $1.00 2007 2008 2009 2010

The exceptions Copper stockpiles (LHS) Copper spot price (RHS) There are two notable exceptions to this thesis; energy and gold. We recommend Source: London Metails Exchange and Zeal LLC exposure to both.

Is Grantham right? Chart 2: US adjusted monetary base ($bn), seasonally adjusted

3,000 2,500

2,000

1,500

1,000

Gold is a de facto currency, a store of value. Its current record price reflects concerns 500 about fiat currency. Since gold has no industrial use, its ‘demand’ is largely investment 0 driven (see The case for gold, issue 293). Despite rising dramatically in price over the past 1991 1996 2001 2006 2011 10 years, annual gold output is falling and the marginal cost of production rising. Source: St Louis Fed We’ve already recommended three small gold stocks, Integra Mining, Silver Lake Resources and Catalpa Resources to take advantage of these favourable fundamentals. Chart 3: US Dollar index 1986–2011 We’ll soon be re-examining the sector in search of new opportunities. Like gold, energy—oil, gas, LNG and to a lesser extent, uranium and coal—exhibit 120 115 favourable supply and demand fundamentals. Demand for energy is exploding as living 110 standards rise but supplies are weakening. Cheap, abundant energy is running out. See 105 The case for oil, The case for LNG and Gone Fission: An introduction to the uranium sector 100 for more details. That explains why our buy list features three energy stocks; AWE, Tap 95 Oil and Carnarvon Petroleum. 90 85 This boom may well continue. If developed countries persist with their flagrant monetary ways, 80 hard assets—commodities—will continue to rise. That’s a risk we are willing to take. Should a blip 75 appear in China (see Directors Cut: Chinese bubble trouble), or a policy reversal in Washington 70 Jan 91 Jan 96 Jan 01 Jan 06 Jan 11 occur, commodity prices and resources stocks could be savaged. That will be the time to revisit Source: Recreation of graph on Bloomberg website the sector. For now, we’re willing to wait out an extraordinary period in financial history.

5 The Intelligent Investor

The newspaper industry is shrinking into decline. Despite newspaper stocks suffering large share price falls recently, value remains elusive.

Fairfax Media’s share price fell 9% yesterday after the company announced revenues are tracking 4.5% lower than last year due to a slump in advertising. Full year earnings before interest, tax, depreciation and amortisation (EBITDA) are expected to drop to $600m, down from $639m in 2010.

COMPARATIVE INFORMATION

company | ASX code Price at review business RISK Share price risk our view

Fairfax media | FXJ $1.19 3.5 4 Coverage Ceased

West aust. newspapers | wan $5.00 3.5 4 Coverage Ceased apn news & Media | apn $1.45 4 4 Coverage Ceased

APN News & Media’s share price also fell 6% after the regional publisher announced that first half earnings before interest, tax (EBIT) would fall between $15m and $20m from $88m in the same period in 2010 (APN has a calendar year end). Management blamed the high Aussie dollar and weak New Zealand economy. But the fact that these lousy results have triggered ‘a round of restructuring initiatives’ and major cost cutting suggests that, as we explained in Sell newspaper stocks: Read all about it on 22 Oct 10, the newspaper industry is shrinking into decline. Throw in large licks of debt, like Fairfax has, and you have a recipe for dismal returns, if not disaster. The average share price decline of Fairfax Media, APN News & Media and West Australian Newspapers (soon to be renamed Seven West Media) since 22 Oct 10 is around 25%. Over time we expect the bleeding to continue. That’s why we have CEASED COVERAGE.

The demerger is good news for Foster’s beer business. But there are some looming Key points threats to its incredible margins. Foster’s is now able to focus on its world-class beer portfolio In Foster’s demerger survival guide—4 April 11 (Hold—$5.76)—we examined how this After demerging, it should offer a high yield company’s beer and wine operations were to be separated. There are threats to its high profit margins Now we’re going to focus on the beer, cider and spirits business (a full review of Treasury Wine Estates is due next week) because, from 10 May 2011, the fortunes of Foster’s

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Group will be driven solely by its ownership of Carlton & United Breweries (CUB). For the first time in decades, (New) Foster’s will be focused on beer. Foster’s Group | FGL Let’s look at six key questions: Price at review $5.57 Review date 4 May 2011 1. What assets will ‘New’ Foster’s own? 12 mth price range $5.14—$6.35 It will own Australia’s biggest and best beer business, with a portfolio of 30 brands. Fundamental Risk 1.5 CUB makes about half the beers consumed in this country, and a small amount for export (the rights to produce Foster’s in most important international markets having been sold share price risk 3 years ago). Our View Hold Marquee brands include Victoria Bitter—Australia’s best selling beer—Carlton Draught, Pure Blonde, Crown Lager and Cascade Premium. It also distributes some big global brands within Australia, including Corona, Stella Artois, Asahi and Carlsberg and owns many faster growing new style and craft beers, such as Carlton Dry, Fat Yak and Beez Neez. In addition to beer, CUB, through Strongbow and Bulmers and other brands, owns more than two-thirds of the small but growing cider market. It also owns or distributes a smaller portfolio of spirits brands, including Cougar bourbon and Black Douglas scotch. All up, CUB sells nearly 115m cases of alcohol a year, or 125 bottles (375ml) of beer for every man, woman and child in Australia. Yes, there are some big drinkers out there. The company’s beer business is incredibly lucrative—see Dumb questions for Intelligent Investors—Foster’s Group of 19 Mar 10—generating higher margins than any of the big, international brewers (see table 1). Those margins have risen from less than 30% in 2004 to 37% today, a result of the ‘premiumisation’ of the beer market. While drinkers have cut back on VB, for example, many have instead reached for a higher margin Pure Blonde or Corona brand. Whilst this has generated substantial value for shareholders, in the past that value was hidden by the concurrent value destruction in the wine business.

2. What are the key risks? Over the coming decade, total Australian beer consumption is likely to remain flat, as it has over the past decade. Significant population growth has been offset by rapidly falling per capita consumption. As far as volume is concerned, this isn’t a growth market. The trouble for New Foster’s is that, with an explosion of beer varieties on offer, the Australian beer drinking palate has become more sophisticated. New competition has emerged. Foster’s off-premise beer market share fell from 54.0% in 2006 to 50.3% last year as a result. Rapidly growing second tier players like Coopers and Pacific Beverages (a joint venture between Coca-Cola Amatil and international beer giant SABMiller) and a plethora of smaller boutiques, including Little Creatures and Gage Roads (25%-owned by Woolworths), are eating into Foster’s market. Concentration of retail power, especially through ‘big box’ liquor retailers like Woolies- owned Dan Murphy’s, isn’t helping. A reduced market share for Foster’s and Lion Nathan could crimp their revenue growth and margin expansion. Despite these pressures, Foster’s margins have expanded from about 27% in 2004 to 37% in 2010 (both adjusted for corporate costs). The opportunity to sell higher margin Table 1: World leading beer margins premium beers has more than offset a falling market share, although this is a trend that’s Sales EBIT Margin probably run its course. AB InBev (US$m) 36,297 11,165 30.8%

Our best guess is that margins will fall over the coming decade. For evidence, see SABMiller (US$m) 26,350 4,381 16.6% Table 1. It shows the EBIT margins of some of the world’s largest beer companies. Those Heineken (EUR m) 16,133 2,476 15.3% of Foster’s are astonishing. Retailers, governments, drinkers and other brewers are all, in Carlsberg (DKK m) 60,054 10,249 17.1% their way, working to cut this back. The recent scrap between Foster’s and liquor retailers is one indication how this battle is playing out. Molson Coors (US$m) 3,254 408 12.6% Grupo Modelo (peso m) 85,019 21,694 25.5% 3. What are the opportunities? Foster’s (A$m) 2,395 885 37.0% Fortunately, investors don’t need rapid growth to make the case for an investment. The stock when it lists is likely to offer an attractive starting yield. There’s also a turnaround underway. For too long the company was focused on its problematic wine operations. With the demerger, that distraction has gone. CEO John Pollaers’ main task is to continue to upsell customers to higher margin beers and minimise loses to other brewers. Past successes like Pure Blonde prove how Foster’s can do it but more is required.

7 The Intelligent Investor

Cider, whilst less than 5% of the size of the beer market, is another opportunity. Foster’s is the largest cider maker in the country and the market is set to grow.

4. What will the share price do post-demerger? Because the wine assets are being moved to a new entity, the Foster’s share price will fall to reflect that fact. Here’s our stab at what that figure might be and where value rests. We’ve previously provided a ‘Reasonable’ valuation for Foster’s beer business using an enterprise value to earnings before interest and tax (EV to EBIT) multiple of 12 times. Table 2: Valuation This translates to an ungeared price-to-earnings ratio (PER) of roughly 17 and an enterprise Cheap Reasonable value for CUB of $10.6bn. EBIT ($m) 884.5 884.5 Let’s now consider a ‘Cheap’ valuation that uses an EV to EBIT ratio of 10 times (an

Multiple (times) 10 12 ungeared PER of 14) for an enterprise value of $8.8bn. Now we need to deduct net debt of $1.9bn (the bulk of the Foster’s existing debt will EV ($m) 8,845.0 10,614.0 stay with New Foster’s). Debt ($m) (1,883.3) (1,883.3) That leaves an equity value per share of $4.50 and $3.59 for our ‘Reasonable’ and Equity value ($m) 6,961.7 8730.7 ‘Cheap’ valuations respectively. The former is as good a guess as any for where the shares No. shares (m) 1,940.8 1940.8 might trade on 10 May. But it is only a guess. Equity per share ($) 3.59 4.50 5. What will the yield be? Yield % (23c div) 6.4 5.1 That depends on the share price, although directors have given two clues about the Yield % (25c div) 7.0 5.6 likely dividends to flow from New Foster’s. First, they intend to target a payout ratio of not less than 80% of the company’s underlying net profit after tax (90% wouldn’t be a stretch). Second, shareholders should receive the same total 2011 dividend that they would have if there was no demerger. Our best guess for dividends for the year to 30 June 2012 is therefore between 23 to 25 cents per share, fully franked. This would make for an attractive yield of 5.1-5.6% based on our ‘Reasonable’ valuation, and a juicy dividend of 6.4-7.0% on the ‘Cheap’ valuation (see table 2).

6. Should income investors buy? Again, that depends on price. Given the company’s market-leading position, world-leading margins and return on capital employed that is higher than any other large business in the country (50%+), one could easily argue the case for paying an EBIT multiple of 12—or an ungeared PER of 17—implied by our ‘Reasonable’ valuation, or even more. But there is also reason to believe that the future won’t look like the past. Given some of the concerns highlighted earlier, it would need to trade closer to our ‘Cheap’ valuation fgl Recommendation guide before we’d consider upgrading. (post demerger) But we’re not in a rush to sell, either. Foster’s management seems to be facing its Long Term Buy Below $3.75 problems head-on and from a position of strength. Hold Up to $5.50 (Old) Foster’s share price is down a touch since Foster’s demerger survival guide of

Sell Above $5.50 4 Apr 11 (Hold—$5.76) and our recommendation remains HOLD. After the demerger, we’d expect our recommendation on New Foster’s to also be HOLD from 10 May 11. We will confirm that after the event.

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ANZ’s interim results look impressive on first blush. Compared to the same period last year, revenue increased 11% to $8.4bn, underlying net profit increased 23% to $2.8bn, ANZ Bank | ANZ earnings per share (EPS) increased 20% to 109.6 cents and the interim dividend was Price at review $23.80 lifted from 52 cents to 64 cents, fully franked (ex date 12 May). Review date 4 May 2011

Compared to the prior half, though, revenue and earnings both increased by a meagre Our View Sell 3% and EPS increased just 2%, largely due to a 9% fall in provisions for bad debts. The dark side of the commodities boom is that higher interest rates and living expenses, and now falling residential prices, are curtailing credit demand and lending growth. anz Recommendation guide Asia is expected to account for up to 30% of ANZ’s profits in a few years, up from Long Term Buy Below $18.00 an initial target of 20%, and around 15% currently. This will require bigger and riskier Hold Up to $24.00 acquisitions, and butting heads with formidable opponents like HSBC in unfamiliar territory. Sell/Avoid Above $24.00 It’s a risky strategy, but we’re ready to pounce if a mistake produces a compelling opportunity. The stock price has fallen 5% since 18 Feb 11 (Sell—$24.95) and we’re sticking with SELL.

Aristocrat Leisure | ALL

Price at review $2.73

Review date 3 May 2011

Our View Buy Aristocrat Leisure’s US rivals WMS Industries and Bally Technologies recently cut their respective earnings outlooks due to soft demand. And while industry giant IGT’s latest quarterly result showed a 21% increase in earnings per share year over year, top line Want to know more? revenue growth was a far more anaemic 1.1%. Despite US gaming revenue increasing year over year for the past three reporting quarters, Aristocrat can’t gamble on a cyclical tailwind in its largest market to revive its fortunes.

In addition to the spectre of regulatory changes in Australia, the rampant Aussie dollar is inflicting further pain on Aristocrat’s share price. If it continues, chief executive Jamie Odell’s forecast of 10–20% profit growth in calendar 2011 (that was reiterated at today’s annual meeting) will be in jeopardy.

The outlook is far from rosy, but Aristocrat’s share price has fallen 14% since 25 Feb 11 (Long Term Buy—$3.18), and has almost halved in the past year. A quick turnaround was never on the cards. But Odell doesn’t need to be a genius to turn this ship around. Aristocrat boasts strong market shares, a worldwide distribution system and connections all Recommendation guide with the world’s major casino operators. It just needs to rekindle its technological edge. Buy Up to $2.80 We’re upgrading Aristocrat to BUY for up to 5% of a risk tolerant and patient portfolio. Long Term Buy Up to $3.50

Hold Up to $6.00

Take Part Profits Up to $7.00

Sell Above $7.00

Carnarvon Petroleum’s share price has dropped 37% since Carnarvon Petroleum strikes water on 25 Feb 11 (Speculative Buy—$0.35), following lousy production performance Carnarvon Petroleum | CVN and several exploration dusters. Given production levels are currently running below 2,000 Price at review $0.22 barrels of oil per day (bopd), our initial estimate of 6,000 bopd was optimistic. Flooding Review date 6 May 2011 was the chief culprit, and reserves have been cut slightly to 20m barrels of oil. Our View Speculative Buy Potential solutions include producing more oil from conventional sandstone reservoirs. That Carnarvon boasts a $24m pile of cash and no debt also provides flexibility. At Carnarvon’s current share price, Mr Market is valuing its oil at just $8 per barrel. The company pays high taxes, has complex reservoirs and its ‘waxy’ oil is discounted. But given oil prices are currently around US$100 per barrel, the company’s reserves are undervalued. It’s possible production could deteriorate further, but the share price currently reflects

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a very bad outcome. We’ve adjusted our recommendation guide to reflect lower output, cvn Recommendation guide but with directors recently increasing their stake in the business, Carnarvon remains a Speculative Buy Up to $0.35 SPECULATIVE BUY for up to 2% of a risk-tolerant portfolio. Hold Up to $0.60

Sell Above $0.60

‘A long time coming’, is how Computershare chief executive Stuart Crosby described the US$550m acquisition of BNY Mellon’s shareowner services business. Subject to regulatory Computershare | CPU approval, Computershare’s US market share will reportedly jump from around 30% to Price at review $9.60 70%. Crosby clearly expects a favourable result, agreeing to pay BNY Mellon a US$30m Review date 3 May 2011 break fee if the acquisition doesn’t proceed within twelve months. On paper it’s a shrewd acquisition. Computershare knows the industry inside out. It Our View Hold is expected to increase earnings per share in the first year, and cost savings are expected to reach $70m in the third year as Computershare migrates BNY customers onto its own systems. A transitional bridging loan is currently in place to pay for the deal, but will cpu Recommendation guide eventually be replaced with a longer dated US dollar loan if the deal is approved. Buy Below $7 ‘It provides a wonderful opportunity to further demonstrate our technology and

Long Term Buy Up to $9 processing capabilities to a new group of clients’, said Crosby, and ‘It also provides Computershare with additional opportunities to participate in the inevitable upturn in Hold Up to $14 corporate actions and the global interest rate cycles.’ Our recommendation guide already Sell Above $14 gave management some leeway on the acquisitional front so, despite the share price falling slightly since 9 Feb 11 (Hold—$9.80), Computershare is a HOLD for up to 4% of a well-diversified portfolio.

Westpac’s interim result was a more upbeat affair than ANZ’s a day earlier. ‘We are Westpac Bank | WBC seeing smaller businesses taking up debt’, said chief financial officer Phil Coffey, and Price at review $ 24 .11 ‘Business growth is expected to recover, although the timing remains uncertain’. Unlike Review date 5 May 2011 ANZ boss Mike Smith, Westpac is confident that businesses can adapt to a higher Aussie

Our View Hold dollar. We’re in the more sceptical camp with Smith. Though revenue fell 3% to $8.3bn compared to the same period last year, underlying cash earnings per share increased 6% to 105.6 cents and the interim dividend was lifted Portfolio Point from 65 to 76 cents, fully franked (ex date unknown). The statutory profit increased 38% to $4bn, chiefly due to a 47% drop in provisions for bad debts to $463m.

The net interest margin–the gap between what a bank charges on loans and pays on

borrowings–fell from 2.26% to 2.21%, due to intense competition for deposits and funding costs that are expected to keep rising until 2012, but the ‘rate’ of growth is ‘starting to plateau’. Provided the economy and residential prices hold up, Westpac is well placed to meet the new regulatory capital watermarks and should keep increasing dividends (we’re wbc Recommendation guide not expecting much in the way of capital gains). The share price has fallen slightly since 16 Feb 11 (Hold—$24.63) and we recommend you HOLD subject to the caveats laid out Long Term Buy Up to $22 in the Portfolio Point. Hold Up to $30 Note: The model Income portfolio owns shares in Westpac. Take Part Profits Above $30

10 Weekly Review | Issue 319a

Warren Buffett and Charlie Munger provided plenty of food for thought for Australian investors at the weekend. Early on Buffett mentioned that Berkshire had made around $100m on foreign exchange transactions in 2010 in just two currencies. Later he revealed that the Australian dollar was one of those currencies, a fact reported by several media outlets. But arguably the most interesting comment (heavily marked in my personal notes) came next. Buffett feels the Australian dollar could be in for a huge movement, ‘and it could be quite dramatic in either direction. I don’t know which. That’s why (Berkshire no longer has a large bet).’ That struck me as quite a statement from a man whose tendency is to say less rather than more on such matters (Buffett typically prefers to stick with sharemarket and general business matters). Yet say it he did. Vice-chairman Charlie Munger then added an open-ended comment to Buffett’s remarks; ‘Australia has these fabulous open pit mines, which (is great) when Asia is booming.’ This could be interpreted as him saying that Australia’s continued success is highly conditional on events in Asia; a topic Doddsvillagers have discussed at length in the past (see Commodity super cycle: No room for fence sitters and Chanos on China, for example). If Asia’s development continues apace and America keeps printing money like there’s no tomorrow, it’s possible that another billionaire investor—Jim Rogers—might be right. Rogers has suggested the Australian dollar could reach US$1.40. Yet it’s easy enough to see the downside; China could stumble, or our property prices might fall dramatically. Either of those eventualities would likely see the Australian dollar ONLINE COMMENTS weaken markedly. Justin S For those, like myself, who eagerly await any recommended reading from Buffett and Munger, the latter recommended a book about Google called In the Plex by Steven Levy, a long-time technology reporter.

Munger said he liked learning about engineering cultures that are ‘quite peculiar and interesting. Will I use it?’ he asked, Rudd-like, ‘probably not, but I enjoyed learning it and that’s important. You should aim to go to bed every night a little wiser than when you woke up.’ (After which Buffett quipped that he was ‘just trying to hold my own.’)

If you’re interested in the world of banking, Buffett recommended the annual reports of M & T Bank which feature commentary from its straight-shooting chief, Bob Wilmers. He also described the annual letter from JPMorgan Chase’s Jamie Dimon as a ‘tour de force on banking and the economy.’

Buffett also weighed in on commodities after one Berkshire shareholder complained that the company’s share price had barely kept pace with inflation since his purchase in 2006, while his gold holdings had performed spectacularly.

Buffett pointed out that when he took over Berkshire, its share price was equivalent to ¾ of an ounce of gold; ‘So gold—even at US$1,500—still has a way to go’, implying a comparison with Berkshire Hathaway’s current price of more than US$120,000. He could have left the topic there but, instead, he treated the audience to a succinct lecture on what he sees as the three categories of investments.

The first is anything denominated in a currency, such as cash, bonds or current accounts. ‘Any currency-related investment is a bet on how the government will behave in future,’ Buffett explained, citing Zimbabwe as an example.

The second category of investment is ‘items you buy that don’t produce anything but that you hope someone will pay you more for later on.’ He then spoke at length about the uselessness of gold.

11 The Intelligent Investor

If all the gold ever mined were melted into a single cube, it would be about 67 feet COMMENTS continued on each side and weigh around 165-167,000 metric tons. ‘You could climb on it, fondle it, polish it, stare at it. But it isn’t going to do anything. You’re hoping someone will buy it from you later on.’ The third category is productive assets. These are assets you can make a rational

calculation about and measure whether their performance over time matches your initial expectations. Buffett advised that, over time, speculating in commodities has not been the way to get rich; owning good businesses has been. This mini-lecture closed with a powerful illustration. Buffett said that all of

gold ever mined, at today’s price, would be worth around US$8 trillion. He invited the audience to consider what else that amount of money could buy; all of the farmland in the lower 48 states (which Buffett put at US$2 trillion), 10 ExxonMobils (which boasts a market value of more than US$400bn) and you could ‘stick a trillion in your pocket for Jim Kelley walking around money.’ While admitting to past investments in oil (at US$10 per barrel) and silver (which has industrial uses), Buffett took several other opportunities throughout the day to underline his preference for investing in productive assets over non-productive ones.

Another hot topic in the American media at the moment—the US debt ceiling—was also put on the agenda by a questioner. Buffett was adamant; not raising the debt ceiling ‘would probably be the most asinine act that congress has ever done … the U.S. is not going to have a debt crisis while we issue debt in our own currency.’

Buffett pointed out that the difference between being able to issue debt in your own currency and not ‘is night and day’. He mused further on the topic, saying ‘giving up the right to issue debt in your own currency is a huge step’ and then contrasted the situation in Japan (which issues debt in yen) with struggling European nations (such as Greece, David A which must be bailed out by the larger nations in their economic bloc). Elsewhere in the meeting, when discussing the outcome of America rescuing its large banks and auto makers, Buffett observed that Europe is currently trying to figure out whether entire nations are ‘too big to fail’.

On a related topic, Buffett noted several times throughout the meeting that he fully expected the purchasing power of the US dollar to decline over time but that the same is true of virtually all paper currencies. It’s simply a matter of which currencies will decline more quickly than others. ‘I have fears—and I’ve long had fears—about a rapid depreciation (of the US dollar) … we haven’t had runaway inflation but I fear it.’ Do you have any questions about the meeting? I took more than 40 pages of (very messy) notes and will do my best to answer any relevant questions posted here. (I’m currently holidaying in California but will aim to check Doddsville as frequently as possible over the next couple of days before heading into the wilds of Yosemite National Park.)

Blog links

Below is a list of Doddsville and Bristlemouth blog articles published by our analysts this week.

Doddsville blog | Can one ever read too much Seth Klarman? Bristlemouth blog | Melbourne Information Night Now on Video

Podcast links

Below is a list of podcasts published to the website during the past week Stock Take | Blue chip stocks to avoid, Foster’s demerger, Aristocrat Leisure and ETIS.

12 Weekly Review | Issue 319a

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

The psychology of cheating.

Learning from investing mistakes.

Rio tips commodity prices to fall.

Buffett explains the economics of the jewelry business.

Buffett discusses the Sokol affair.

How Bill Gross runs PIMCO.

David Einhorn’s quarterly letter.

Third Point first quarter letter.

The internet allows businesses to be built overnight.

Government intervention is becoming a risk for miners.

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

Aristocrat: don’t get anchored to the PER Despite 9 positive reviews/updates over the last 18 months, is extremely valuable in the right hands and is capable of producing I’ve never been convinced by Aristocrat. The investment case much higher profits than it is currently. As we’ve said in numerous seems to be built on a belief that a surge in economic activity reviews, it’s very hard to pin down a valuation when it’s unclear in the US will result in spectacular profit growth similar to the that Odell can right the ship, which is why we recommend keeping 2003-07 period. Weighing against this we have falling revenue, the portfolio limit to 5%. Clearly at the current price there are no mediocre management, poor products, aging cabinets, employee expectations that Aristocrat’s profits will return to boom time levels. cultural issues, entrenched competitors, regulatory threats, rising As for the psychological biases, the ones you have mentioned AUD, P/E around 26 etc. So what’s the value of the company? and plenty more were laid out in Aristocrat Leisure: A case study in Reading back through the reviews I can’t see where the value psychology. Unfortunately being aware of them doesn’t make you investing philosophy has been applied and there seems to be right. All you can do is keep questioning your assumptions and weigh some anchoring and confirmation bias in play. If Aristocrat was up price and value. presented in the Dragons’ Den as a new idea would the outright Buy recommendation be likely? Thanks for providing a great service, I learn more when I disagree... Why Macquarie over ANZ? Nathan Bell CFA: Thanks for the kind words. There are plenty of I truly question your long term buy on MQG as opposed to a reasons to dislike Aristocrat, all of which are widely known. That’s why sell on ANZ with a ROE of over 16% . MQG appears to be doomed the share price is below $3. There is also no doubt that the original and with die an look death, its business model is now flawed. Long Term Buy just below $7 was a mistake, as Aristocrat’s major It looks as though sell in May and go away proverb is playing problem has turned out to be a loss of competitiveness rather than out somewhat again is this just a co incidence or something just a general industry downturn. deeper. Ian P The price to earnings ratio currently looks astronomic, but I’d Nathan Bell CFA: Hi Ian. We don’t pay much attention to the be very careful about using a simple PER to value a company in a calendar, as we invest for years not months. But I can see why it turnaround situation. The current earnings are fairly meaningless. The looks strange that we’re prepared to back one horse over another question is whether new management can bring the right people that is essentially following the same strategy. Macquarie has some together to produce some competitive games. Casinos will still buy experience overseas, and we currently hold Nicholas Moore in higher plenty of games if they are the right ones. It is quite possible that regard than Mike Smith who is a career-executive that doesn’t have Jamie Odell is not the man for the job, but Aristocrat’s market share any skin in the game. Moore is an internal appointment, has been

13 The Intelligent Investor

at Macquarie for over 20 years and isn’t trying to change the bank’s Tips for international investing discusses brokerage options (make culture, like Smith, which is extremely hard to do. Macquarie is also sure to read the comments section). Jeremy Grantham has also said statistically cheaper, trading at book value. We believe Macquarie’s everything you need to know about the current value of high quality track record deserves some respect, but both companies are highly blue chips. leveraged beasts and, together with the other banks, should be kept to no more than 10% of a well diversified portfolio. The other point worth making is that Macquarie’s earnings are currently suffering from Staff portfolio holdings a lack of market activity, where as ANZ is going to find it very difficult Hi Guys I keep an eye on the staff holdings and I think for to grow earnings in Australia without the tailwind of a housing and a long time it has been about $3m. I checked today and it has residential lending boom. Of course none of this means we will be dropped dramatically to about $2.25m even despite the RHG price right, but we’re more comfortable with Macquarie at current prices surge. Is there anything special happening in your portfolios or than we are with ANZ. are stocks just being liquidated to beef up cash holdings? Noel K Nathan Bell CFA: Hi Noel. The reduction is mainly due to removing the interests of Greg and his family. Wilson hasn’t sold off RHG to our knowledge Hi guys, It looks like Wilson has sold off RHG. Your thoughts? Ross O Matrix too pricey for now Gareth Brown: I don’t think ‘sold off’ is the right term. Wilson I was wondering when you were going to have a look at mce and Cadence were considered associates because they were trying as was mentioned in a earlier article. Mitchell B to influence the composition of RHG’s board, and so had to add Gaurav Sodhi: As we identified in The case for LNG part 2, Matrix their holdings together in a substantial shareholder notice (which is appears to be a surprisingly high quality business and its financial required only if you own more than 5% of a company). But Wilson performance has been exceptional. But at current prices it’s a pinch individually never held more than 5%, it was only in combination too expensive to consider buying. We’ve made the call that our time with Cadence. Because of last week’s announcement, Wilson and is better spent looking for new profitable ideas rather than writing up Cadence have withdrawn their requests for a meeting to get seats a company we have no desire to recommend. We’ll publish a review on the RHG board. So Cadence and Wilson are no longer considered of Matrix when its share price is at more attractive levels and we’re associates, and Wilson is back to its sub-5% holding and is no longer closer to upgrading it. considered a substantial shareholder. This is all described in the ASX announcement. It doesn’t appear that any selling has occurred. Of course, from today on Wilson could sell and wouldn’t have to report QBE Insurance: Internet threat it to the ASX given they hold less than 5%. I read today about insurance companies concerns with online pricing comparisons i.e. online aggregators such as Ratecity. Apparently, UK insurer’s margins have been significantly hurt by Aristocrat CEO Jamie ODell and International investing these sites. Has this been considered in your appraisal of insurers brokerage options such as QBE? Jim W Hi Guys, Looks like Aristocrat is moving into Buy territory or Nathan Bell CFA: Hi Jim. This is a great question. There are certain has the guidance range shifted as a result of the disaster in Japan? segments of the insurance industry that are more prone to the threat Did you ever get a response from Aristocrats management team of the Internet than others. Everyday auto, home and life insurance to the questions you submitted as part of the Doddsville blog? policies are certainly at risk. At the opposite end of the spectrum, Has anyone from the II team spoken to him at all to get a sort catastrophe premiums are unlikely to be threatened at least for a of gut feel as to the sort of guy he is? I am finding it very hard while (in fact these premiums are expected to rise in response to to pull the trigger on a diversification purchase of ALL for some the number of natural disasters recently). These are massive policies reason. I am not sure what form of bias I am suffering maybe that require lengthy negotiation. QBE has plenty of these policies, and plain old lack of trust? Sheamus M so is perhaps less exposed to the threat of the Internet than IAG or Nathan Bell CFA: Hi Sheamus. I’m aiming to publish a brief on Suncorp, for example. Aristocrat tomorrow. Unfortunately I didn’t receive a response from At their current respective share prices, we believe IAG and QBE are Jamie Odell (that wasn’t unexpected), and he refuses to give us his good value. But we are watching for the impact of new websites, such time to have a chat about the company. Our view is that this horse as iSelect, which help customers compare prices, as they are making it doesn’t need a great jockey, just a decent one ought to do. both easier and cheaper to switch policies. And there aren’t too many In regards to your query about international investing, loyal customers when it comes to insurance policies. Price matters.

Important information The Intelligent Investor warning This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking PO Box 1158 | Bondi Junction NSW 1355 advice from a financial adviser or stockbroker if necessary. The Intelligent Investor and associated websites are published by The Intelligent T 1800 620 414 | F (02) 9387 8674 Investor Publishing Pty Ltd (Australian Financial Services Licence no. 282288). [email protected] disclaimer This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek www.intelligentinvestor.com.au advice before acting upon any recommendation. copyright The Intelligent Investor Publishing Pty Ltd 2011. No part of this publication, or its content, may be reproduced in any form without our prior written consent. This publication is for subscribers only. Disclosure In-house staff currently hold the following securities or managed investment schemes: ABP, AEJ, ALL, ALZ, APH, ARP, AVG, AVO, AWC, AWE, BBG, BER, CAH, CBA, CFE, CIF, CMIPC, CND, COH, CRC, CSL, CUE, EBT, ELDPA, FGL, FLT, HVN, IAG, IDT, IFL, IFM, IMF, IVC, JIN, KRS, LMC, MAP, MAU, MFF, MLB, MQG, MTS, NABHA, NBL, NWS, PLA, PTM, QBE, QTI, RCU, RHG, ROC, SDG, SDI, SFC, SGN, SGT, SHL, SKI, SRV, STW, TAP, TGP, TIM, TIMG, TRG, TRU, TWO, VMS, WBC, WDC, WHG and WRT. This is not a recommendation.