weekly review | ISSUE 325b | 30 july–5 august 2011

CONTENTs In this issue... STOCK REVIEWS STOCK ASX CODE Recommendation PAGE AWE AWE Speculative Buy 9 James Greenhalgh Bega Cheese BGA Avoid 3 Over the past 18 months we’ve recommended you increase your Fantastic Holdings FAN No View 5 Kathmandu KMD No View 5 cash holdings. Today is a day when you might want to deploy some OrotonGroup ORL No View 5 of it. This is where to look... (see page 2) Premier Investments PMV No View 5 Super Group SUL No View 5 The Reject Shop TRS No View 5 James Greenhalgh stock UPdates Bega Cheese is definitely not the cold cabinet equivalent of Coca Australand Holdings ALZ Long Term Buy 11 Cola. Welcome to one of the worst floats in years... (see page 3) Macquarie Group MQG Buy 11 Rio Tinto RIO Sell 12 features John Addis Opportunities amid the falls 2 Does mid-2011 feel a little like late 2006? Many things could go Apocalyptic horsemen and their prices 4 wrong but one salient fact points to courage over fear... (see page 4) Doddsville blog | Want to avoid the next crash? Avoid the cranes 12 extras Podcast & Video links 13 James Greenhalgh Twitter links 14 Ask the Expert Q&As 14 In the final part of our retail review, James Greenhalgh examines RecomMendation changes which small retailers might prosper, which won’t, and the prices at which they’re worth revisiting... (see page 6) Australand upgraded from Hold to Long Term Buy Bega Cheese coverage initiated with Avoid Macquarie Group upgraded from Long Term Buy to Buy Santos upgraded from Hold to Long Term Buy Gaurav Sodhi PORTFOLIO CHANGES The revolution that has transformed the American energy market There are no recent portfolio transactions has reached AWE. Shale gas is here, AWE has it and no one has noticed... (see page 9)

Nathan Bell

On a sunny August day in 1929 failed presidential hopeful Alfred E. Smith gathered the New York press and announced humble plans to build the world’s tallest skyscraper... (see page 12) Intelligent Investor

Over the past 18 months we’ve recommended you increase your cash holdings. Today is a day when you might want to deploy some of it. This is where to look.

Buffett famously said, ‘be greedy when others are fearful’. But it’s easier said than done. With the US market falling around 5% overnight, ‘being greedy’ might be the last thing on your mind. But cast your mind back to March 2009. When everyone was panicking, some of the best buying opportunities in a decade arose amongst the turmoil. This sell-off may offer some equally good bargains.

But why are people panicking in the first place? The recent panic, which has seen some companies’ share prices tumble to 2009 lows or below, is the result of a flood of disappointing news. First, the US manufacturing sector, and the economy as a whole, isn’t recovering as expected. Second, the Japanese have had to intervene in their economy to weaken the Yen and finally, the European Central Bank has announced it will re-enter the bond market to buy debt from troubled countries (Greece and Spain).

Reignite fears This has combined to reignite fears about both the health of the global economy and government’s ability to manage spiralling deficits. While the problems are real—governments do need to rein in spending and the economy isn’t recovering as fast as expected—in many cases share prices reflect the bad news. Our market is today following the global lead. This is a perfect opportunity to deploy some of the cash we’ve been encouraging you to hold. What follows is a number of key recommendations and the prices where we’d be willing to upgrade. It’s not necessarily comprehensive, as we’ve produced it quickly this morning. Bear in mind that you shouldn’t fire all your bullets at once—better opportunities may be round the corner. And don’t forget to stick to the portfolio limits which you can find in each stock review. We’re holding fire on the banks in particular and reiterate you should keep bank holdings to less than 10% of your portfolio and financials to less than 25% in total (much less if you’re conservative). Opportunities like today should be used to deploy cash (sensibly, of course). Use the watch list that follows to focus your attention.

Table 1: The watch list Company Last Review (Reco - Price) uPGRADe? Abacus Property (ABP) Hold—$2.21 Long Term Buy at $2.20 ARB Corporation (ARP) Hold—$7.80 Long Term Buy at $7.00 Brickworks (BKW) Long Term Buy—$10.10 Buy at $9.00 Computershare (CPU) Long Term Buy—$9.19 Buy at $7.00 CSL (CSL) Long Term Buy—$32.82 Buy at $25.00 Insurance (IAG) Long Term Buy—$3.27 Buy at $3.00 Macquarie Group (MQG) Buy—$25.05 Strong Buy at $23.00 MAP Group (MAP) Long Term Buy—$3.44 Buy at $2.80 News Corp non-voting (NWSLV) Long Term Buy—$14.10 Buy at $12.50 Perpetual (PPT) Buy—$24.64 N/a Platinum Asset (PTM) Long Term Buy—$4.74 Buy at $3.60 QBE Insurance (QBE) Buy—$16.65 Strong Buy at $15.00 Sonic Healthcare (SHL) Hold—$12.63 Long Term Buy at $12.00 Westfield Group (WDC) Long Term Buy—$8.61 Buy at $7.50 Westfield Retail (WRT) Long Term Buy—$2.69 Buy at $2.30 Woodside (WPL) Hold—$38.92 Long Term Buy at $35.00 Woolworths (WOW) Long Term Buy—$26.20 Buy at $24.00

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Bega Cheese is definitely not the cold cabinet equivalent of Coca Cola. Welcome to one of the worst floats in years. Key Points Brand benefits have been sold off Commsec boldly declares Bega Cheese ‘an opportunity to invest in a highly recognised Serious conflicts of interest, low quality business Australian household brand’. If only that sentence weren’t so loaded. High float price Powerful consumer brands enjoy massive pricing power and can be fantastically profitable. If Bega Cheese is the Nike, Apple or Coca Cola of the cold cabinet, why wouldn’t you be interested? The point is rammed home on the Commsec website, where the Bega float is prominently featured, and in the prospectus itself (see page 8 and 12, for example). The problem is that the pictures tell one story and the facts quite another. There are so many things to dislike about this float it’s hard to know where to begin. But let’s start where the promoters would like us to; with the brand. Whilst Bega appears to be a brand-driven business, it’s actually a low margin, contract dairy manufacturer. It buys milk and makes it into things like cheese, milk powders, infant formula, butter and cream, which are sold to powerful customers like Kraft, Fonterra and Aldi, all of whom excel at squeezing the very last cent from their supplier. The result is that what should be a high margin brand-based business actually generates pitiful net profit margins of around 2%. Bega Cheese | BGA It’s worth explaining why. Bega Cheese technically owns the Bega brand but it sold the economic rights to it (in Australia) to Fonterra 10 years ago. In return, it received a one-off Price at review $2.00 payment of $35m, now long since spent, and an ongoing royalty of 2.5% of sales revenue a year. Review date 1 Aug 2011 If you can imagine Coca-Cola licensing its brand name for a woefully small sum and then business Risk 4 buying up bottling plants in order to use it, you get an idea of the Bega Cheese strategy. Share price risk 4 Who knows what was going on a decade ago but Bega must have been desperate. Our View Avoid Conflicts of interest Table 1: Key information The second major reason not to invest in this float is that, as a shareholder, the company probably won’t be run in your interests. If you find that hard to believe, turn to page 14 of Prospectus date 18 July 2011 the prospectus, where it is spelled out. Close of retail offer 16 August 11

Since 1899, Bega has been owned by dairy farmers. The scale of operations has Listing date 29 August 11 expanded (see Table 2) but not much else. With farmers holding 85% of the stock after the No of shares (m) 18.4 (of 127) float, they will be pulling the udders and the strings. The basis of public companies is that List price ($) 2.00 managers are expected to act in the interest of all shareholders but as it says in black and white on page 14, ‘[Farm shareholders] may take a different view [to other shareholders] Market capitalisation ($m) 254 as to what is in the best interests of the Company’. 2011 PER* 16.7 2011 Div. yield (%)^ 2.90 Milking the benefits ^Based on pay out ratio of 50% This astounding admission makes some sense, if you happen to be a farmer and current Bega shareholder. You see, farmers sell their milk to Bega. They may choose to make their Chart 1:BGA FY2011F Production money from this business not from building the value of their shareholding but by selling Cheddar Cheese 10% milk to their company at above market prices. Cream Cheese 7% Indeed, farm gate prices in the Bega region are some of the highest in the country. If String Cheese 1% retail shareholders want to complain about it, good luck. Active dairy farmers hold five of High Fat 3% the seven board seats. Powder 15% Even the one possible escape route for minority shareholders has been closed off. MPI 2% One way to make a low margin, manufacturing business more profitable is to increase Butter 2% production volumes. Bega would be a perfect target for a larger player like National Foods Nutritionals 9% Natural Cheese packed 27% or Parmalat. But that ain’t going to happen. Page 49 of the prospectus explains how, through Processed Cheese packed 24% stock ownership limits, a takeover isn’t possible for at least 10 years. Bega may even trade with a ‘non-takeover discount’ as a result. Source: Bega Cheese 2011

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So why are farmers selling in the first place? Ostensibly, to reduce Bega’s $138.5m debt burden (listing will net Bega a mere $31.5m) and gain access to capital markets to Table 2: Key businesses finance future growth. But there’s a less explicit reason. Currently, there’s no ready market Processing facilities for Bega shares. That makes it hard for farmers and their families to sell out. The float gives Lagoon St (Bega, NSW), Ridge St (Bega, NSW), them a ready mechanism to do so. Could it be that Bega management is more interested Coburg (), Strathmerton (Victoria) in making a market than capital management? Strategic investments Too expensive 70% stake in milk processor Tatura (TMI) 25% stake in CCFC joint venture with Dairy Farmers You’d think that a float with as many fleas as this one would be priced cheaply. Not so. Bega, knowing that institutional investors would see through the guff, are targeting unsuspecting 15% stake in ASX listed dairy producer Warrnambool Cheese & Butter retail investors through Commsec and hitting them up for a ludicrously high multiple. At $2.00 a share Bega is being offered on a PER of 16.9 and a EV/EBIT of 10.9. Not only are those numbers higher than listed peer Warrnambool Cheese & Butter (on a PER of 11.6 and EV/EBIT of 9.4), they’re comparable to higher quality businesses like Woolworths, Metcash and CSL (all of which reside on our buy list). As John McEnroe once said, ‘You can’t be serious.’ Table 3: Proforma financials But wait, there’s one more astounding fact to accompany this appalling pitch: Not only 2008 2009 2010 2011F has the company failed to provide any sort of financial forecast for the next few years, it

Revenue ($m) 701.2 803.6 834.2 942.9 hasn’t even offered one for the current financial year. It’s impossible to say why, although on a per share basis earnings are likely to fall this EBITDA ($m) 47.3 33.3 48 46.6 year due to stock being issued to buy out the remaining 30% of current subsidiary TMI. EBIT ($m) 42.6 18.5 34.2 31.9 Better try and keep that one quiet, eh? EBIT margin (%) 6.1 2.3 4.1 3.4 Individually, any of these reasons are enough to run a mile from a float like this. Sadly, Profit before tax^ ($m) 36.7 10 24.4 25.5 it will probably get away. The pushy advertising, the current penchant for agri-businesses and its small size mean there are probably enough unsuspecting investors that will see

the logo and not much else, which is exactly what the promoters want. Make sure you’re not one of them. Keep the prospectus—it may one day become a collector’s item—but whatever you do, don’t fill out the application form and send it back with a cheque. AVOID, AVOID, AVOID.

Does mid-2011 feel a little like late 2006? Many things could go wrong but one Key Points salient fact points to courage over fear. There are plenty of reasons to worry about what might go wrong There are meant to be four horsemen of the apocalypse. So far, the congregation at Many defensive businesses are priced accordingly, the church of fatalistic tendencies (see Director’s Cut Jun 11: Pessimism Buy or sell?) can which makes them attractive see only three. And one of those is a pantomime horse. This is no time to be cavalier. Stick with best-of-breed Neither of the two possible outcomes from the childish political feud over the US debt companies ceiling would have been pleasant. The debt ceiling will be raised but government spending on the most vulnerable will be cut and tax revenues won’t increase. The US is already struggling to emerge from the worst recession in 70 years. Two years out from the depth of the crisis, growth should be returning. It isn’t. Consumer spending is static and, for the March quarter, US GDP growth has been revised down from 1.9% to 0.4%. Raising the debt ceiling, whilst it won’t make matters worse, won’t improve things either. At some stage, we’re likely to be put through this all again. Next time, if the debt ceiling isn’t raised—still an unlikely event—the situation isn’t as serious as some imply. The fact

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that 10 year US treasuries currently yield a pitiful 2.74% suggests as much. Even with an agreement, a downgrade to AA+ remains a possibility. Some institutions won’t be able to buy US paper but there are few alternatives. Should a downgrade occur, AA+ will become the new AAA and life will resume, at least until we’re asked to endure the whole charade again. This might be reckless political theatre but it’s theatre all the same; a huffing, puffing pantomime horse. Europe is more donkey than horse. At a time when one might hope the Europeans could compensate for weak US demand, they’re succumbing to the same politics of austerity; the price of failing to let bankers in Frankfurt, London and Paris carry the cost of their own foolishness.

Internationalised TARP Instead, those long-lunching, Mediterranean types, and the gullible Irish, are carrying the can. The Greek bailout transfers German public funds to German bondholders, via Athens. The Irish bailout does the same thing via Dublin—an internationalised Troubled Asset Relief Program. Fortunately for the Spanish and Italians, not even the Germans have the resources to assist. Whether debt is public or private, it has to be purged from the system before growth resumes. Thus far, the Europeans are just carting it around to sustain a flawed economic ideal of a single currency. A 1990s-style Japanese future looks more possible now than it once did. The third horseman, unlike the first or second, is astride an animal neither pantomime, limping nor lame. ’s problems are those concealed by a three-decade race to modernity (see Director’s cut from 2 May 11 on Chinese bubble trouble). Australia, to really stretch the metaphor, fills the nosebag of this gallivanting beast. Our continued prosperity rests on the belief that China will be the first country in history not to experience a recession after 30 years of incredible growth. This isn’t pantomime, it’s fantasy. In the aftermath of the GFC, China embarked on a US$568bn stimulus package and a huge lending program. We might be about to find out the delayed effects. Jin Libin, of inner Mongolia, had interests in supermarkets, mining and transport. He also had private debts of US$191m plus another 150m yuan in government loans. The Economist reports that, before setting himself alight, he was paying 5m yuan a day in interest. Such are the effects of China’s credit tightening. Before you retreat to the forest with a sleeping bag and a car load of tinned beans, contemplate for a moment the one major difference between where we stand now and the precipice upon which the world was perched in 2006.

Prices account for risk On 22 Feb 07 CSL, one of the best businesses in the land, was trading at $77.65 (or $25.88 after adjusting for the subsequent 3-for-1 stock split), translating to a PER of 28. Published on 20 Jul 11, CSL: Profiting from plasma (Long Term Buy—$32.82) explained how, despite a small increase in share price over the following four years, the PER had fallen to 18 because of explosive earnings growth. Macquarie Bank, currently being researched with a view to upgrading, hit $97.10 on 18 May 07. It’s now trading at $27.60. Westfield Group has suffered in much the same way. The current environment may have a certain end-of-days feel to it but, unlike the preamble to the GFC, the prices of many stocks already account for the risks. There are reasons for optimism amid the gloom. There’s another factor to consider; Not only have the price falls in some of our favoured stocks been enticing, the businesses themselves are improving. Spark Infrastructure for example, has benefited from the internalisation of its management and the achievement of regulatory certainty for the next four years. As explained on 21 Jul 11 in Welcome home MAp (Long Term Buy—$3.44) MAp is focusing on Airport and has seen traffic numbers increase. Computershare may well be transformed if its US acquisition is approved. High quality businesses tend to improve in tough times; these three stocks certainly have. Some of the stocks we’ve upgraded in July endorse that point. The phone hacking scandal has produced an opportunity in News Corp (see News: Moral failings, better buying (Long Term Buy—$14.58)) and Gaurav Sodhi surveyed the gas industry in Gas giants’ giant problems (see page 13), producing two Long term buy recommendations.

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In Perpetual’s talent train (Buy—$24.64), James Greenhalgh explained why this first class stock was the cheapest it’s been in decades. Your research team has also uncovered a number of interesting speculations, including Sunland and two undervalued oil stocks (see Forgotten oil stocks meet blue sky).

Best of breed Our extensive review of the retail sector, whilst reiterating buy recommendations on Billabong, Metcash, Woolworths, Westfield Holdings and Westfield Retail Trust, also caused the downgrading of JB Hi-Fi to Sell and Harvey Norman to Hold. The cyclical downturn in consumer spending is masking deep strategic issues to which these stocks are especially exposed. This is a challenging environment for all investors and, despite the abundance of opportunities, it’s no time to be cavalier. If you’re a conservative investor, ignore our speculative buys altogether. There is less reward and far more risk in buying cyclicals and speculative companies right now. In contrast, best-of-breed companies, many of which sport attractive prices and have found a place on our Buy list, offer defensive qualities and a far gentler ride. This is no time to be riding bareback.

In the final part of our retail review, James Greenhalgh examines which small Key Points retailers might prosper, which won’t, and the prices at which they’re worth We’ve examined six small retailers revisiting. Most are still at risk from the retail downturn In part 8 of our review of the retail sector, Ill winds hit JB Hi-Fi, and DJs from Premier Investments is on the watchlist 15 Jul 11, we examined the threats to major listed retailers from online competition and the retail downturn. It concluded that, even in the face of plummeting share prices, David Jones, Myer and JB Hi-Fi were Sells or Avoids. Now it’s time to cast open the windows on six smaller retailers, all with market capitalisations above $200m. Without issuing any formal recommendations (see Christmas trimmings: Introducing the new nifty 50/50), Table 1 indicates a price where we suggest they’d be worth another look.

COMPARATIVE INFORMATION

company | ASX code Price at review Business risk share price risK Our view

Fantastic holdings | fan $1.95 High Med–High No view

orotongroup | ORL $7.30 Med–High High No view

premier investments | pmv $5.78 Medium Medium No view

super retail group | SUL $6.95 Med–High Med–High No view

the reject shop | trs $10.57 Med–High High No view Kathmandu | kmd $1.86 Med–High Med–High No view

Premier Investments Premier Investments, 42%-owned by retail doyen , owns the formerly listed Just Group and a 26% stake in listed appliance manufacturer Breville Group. Just

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Group’s brands include apparel chains Just Jeans, Jay Jays, Portmans, Jacqui E, Dotti, Peter Alexander and stationery chain Smiggle. Premier has three things in its favour. First, it has just appointed former David Jones chief executive Mark McInnes to manage its retail businesses (that is, Just Group). McInnes is well-respected, in retailing circles at least, and recently announced a strategic review under which significant cost savings should be achieved. He also outlined expansion plans for Peter Alexander, Smiggle and Just’s online business. Lew and McInnes, two of Australia’s smartest retailers, make a formidable management team. Second, Premier’s balance sheet features $198m of net cash, offering the ability to build new brands and make acquisitions at a time when retailers are struggling. Premier’s stake in Breville, worth $102m, is also ‘available for sale’ on the company’s balance sheet. Third, the stock doesn’t look expensive. Deducting the value of Premier’s Breville stake and net cash, the core business (Just Group) is trading on a 2011 underlying EV/EBIT multiple of 8.2. Just Group, as a vertically integrated apparel retailer (similar to Billabong International), isn’t fundamentally threatened by online sales (although there will be some erosion as its predominantly younger customers buy clothing online). It is, however, threatened by the entry of international competitors like Zara and Top Shop and will suffer if the retail downturn persists (as it probably will). Amongst the smaller retailers, Premier Investments is the ‘least worst’ of the six. New management, inherent diversification and its strong balance sheet mean it should suffer less than most over the next few years. It’s not enough to earn an upgrade—Table 1 shows the price at which we’d take a closer look—but you’re unlikely to lose a bundle in this stock.

Super Retail Group Like Premier Investments, Super Retail Group has capable management. Since taking charge in 2006, managing director Peter Birtles has grown sales by 78% and boosted the earnings before interest and tax (EBIT) margin from 5.5% to an impressive forecast 7.8% in 2011. The company now operates several brands. Its original chain, Super Cheap Auto, is a ‘category killer’ in automotive accessories. Building on its knowledge of the enthusiast market, Super Retail launched BCF (‘Boating, Camping, Fishing’) in 2005, acquiring Ray’s Outdoors in 2010.

Table 1: Retail beauty parade? 2011 PremieR super Oroton Reject Kathmandu^ Fantastic estimates Retail Group Shop

Sales ($m) 870.0 1,150.0 160.0 500.0 245.0 440.0

EBIT ($m) 73.0 90.0 34.0 26.5 51.2 28.5

EBIT margin (%) 8.4 7.8 21.3 5.3 20.9 6.5

EPS ($) 0.335 0.43 0.562 0.633 0.14 0.188

Key ratios No. of shares (m) 155.0 130.1 40.9 26.1 200.0 102.7

Share price ($) 5.78 6.95 7.30 10.57 1.86 1.95

Market cap. ($m) 895.9 904.2 298.6 275.9 372.0 200.3

Net debt/(cash) ($m) (300.0)* 70.5 5.6 24.5 62.1 14.4

EV/EBIT (x) 8.2 10.8 8.9 11.3 8.5 7.5

PER (x) 17.3 16.2 13.0 16.7 13.3 10.4

Closer look?

Price ($) 5.00 4.00 4.50 7.00 1.20 1.40

Super Retail’s products tend to be bulky or low-priced so online competition is less of a threat. Also, with an ‘everyday low prices’ policy and merchandise offer that attracts value-conscious customers, it’s been insulated from the retail downturn. The main concern is price. On an EV/EBIT multiple of 10.8, the company’s excellent record is more than factored into the share price. While Super Retail Group is at the quality end of the small retail sector, there’s no margin of safety at this price.

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OrotonGroup Apparel, handbags and accessories retailer OrotonGroup has had a chequered history, not that you’d know it from the impressive EBIT margin of 21%. Having hived off the Marcs, Morrisey and Aldo di-worse-ifications, managing director Sally Macdonald has done a great job turning around this once-underperforming retailer. Today, the company has refocused on the Oroton brand, which it owns, and the licensed Polo Ralph Lauren brand in Australia, which it renewed in 2010 for another five years. Today’s price implies that Macdonald can maintain or increase the company’s already high margin. But, given its position in the ‘affordable luxury’ segment, OrotonGroup is at high risk of a profit downgrade. Other risks threaten. The Polo Ralph Lauren brand could Portfolio point suffer from online competition and the company, which previously lost a bundle expanding overseas, is now opening stores in Hong Kong, and . OrotonGroup might be a quality retailer but the stock itself is more ‘luxury’ than ‘affordable’.

The Reject Shop

This discount variety retailer is a former market darling that has run into problems. The company has successfully rolled out stores across Australia but plans to open another 190 stores on top of the existing 211 look ambitious. Management has also changed in recent years and debt levels have increased with the opening of its new distribution centre in Queensland. The company reported a profit downgrade in December, then another in May after floods submerged the new warehouse. Profitability should recover in 2012 but on an EV/EBIT multiple of 11.3, The Reject Shop looks expensive.

Kathmandu Private equity floated two retail businesses in 2009, Myer and adventure clothing and equipment retailer Kathmandu. We weren’t particularly impressed back then—see Kathmandu or Kathmandon’t? from 8 Nov 09 (Avoid—$1.70)—with concerns over same- store sales, valuation, and competition. As with many other retailers, Kathmandu has been rapidly opening stores. Helped by favourable weather, the company is expecting a bumper 2011 (after reporting a downgrade in 2010). But a business model that relies on climatic good fortune and heavily discounted promotions to drive sales has risks, although online sales are unlikely to be much of a threat. What could be a greater menace is Kathmandu’s former owner. Following the expiry of her 5-year non-compete agreement, Jan Cameron is now bankrolling the expansion of New-Zealand-based competitor Macpac. We’d take a closer look at Kathmandu around $1.20.

Fantastic Holdings We ceased coverage on this furniture retailer in Candour can’t save Fantastic Holdings on 28 Feb 11 (Ceased Coverage—$2.32). Yes, furniture is unlikely to be seriously threatened by online sales but, as a largely discretionary category that also relies on a buoyant housing market, it’s certainly at risk from the retail downturn. The share price has fallen since then but Fantastic Holdings is fighting fires on all fronts. The consistently poor business performance means the stock looks inexpensive but, unless management is somehow reinvigorated, this stock isn’t of interest.

Unworthy of attention Retailers are no different to any other stock. They need to demonstrate their worth before you commit to an investment. With strong headwinds, very few small retailers

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deserve your attention at this stage of the cycle. Oroton in particular looks vulnerable to a profit downgrade while Super Retail Group and The Reject Shop carry premium prices reflecting past growth or recovery potential. Kathmandu is in a ‘sweet spot’ this year, although its business model is at risk of longer term competition. Fantastic looks cheap but deserves to be. Only Premier Investments passes most tests—new management, a strong balance sheet and unrealised potential. But the stock falls at the most important hurdle—price. An opportunity may not be far away, though, so put it on your watchlist.

The revolution that has transformed the American energy market has reached AWE. Shale gas is here, AWE has it and no one has noticed. Key Points Shale gas has transformed the American energy There used to be a crisis in American energy. As recently as 2007, North America market fretted about waning energy supplies. Oil production had been declining since the 1970s AWE has changed from the company it was and although gas was an alternative with many qualities, abundance wasn’t one of them. Unfamiliarity with shale gas has resulted in a possible Gas prices approached $15 a gigajoule (gj) in 2007, breaching record highs. Soldiers were mispricing sent to protect foreign oil supplies and billions were spent on alternatives like biofuels. High gas prices, it turned out, offered a solution that soldiers and dollars couldn’t. New technology allowed once dormant supplies of gas trapped within shale formations to be commercialised. Today, gas prices in the US have fallen to less than $5 a gj and gas from unconventional sources accounts for about half of domestic production. If all of America’s energy needs were assigned to gas alone, current reserves would last a century. A crisis has ended in revolution. As with America, AWE has found itself embroiled in crisis, struggling to find resources and suffering from a lack of confidence from investors fretting about production. Shale gas, however, is transforming AWE in much the same way as it has changed American energy supply.

A new hope The decision, in AWE: The sequel begins (Speculative Buy—$2.74), to recommend AWE was straightforward enough. Having built a billion dollar business, the company boasted technical success and a fine exploration record. There was $300m cash in the bank and no debt. And the largest exploration effort in the company’s history was about to get under way in a familiar locale, with promising data. AWE | AWE If buying then was the right decision, it produced the wrong result. Drilling one Price at review $1.195 disappointing duster after another, AWE ended the most exciting time in its history with Review date 4 Aug 2011 nothing but an empty wallet. The share price has tumbled and the reputation of this once market cap. $569m virtuous explorer has been crushed. Ambition, once exulted, is now seen as hubris, prior skill dismissed as luck, and the scent of opportunity lost. 12 mth price range $1.18—$1.89 The share price has fallen a hefty 56% since our original recommendation. And yet Fundamental Risk 4 we’re still recommending the stock as a Speculative Buy, although for very different reasons. Share price risk 4 AWE is no longer the company it was two years ago. Instead of betting on conventional Max. portfolio weighting 2% oil and gas, the bulk of its growth will come from shales buried deep beneath the Perth Our View Speculative Buy Basin in Western Australia.

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Gas (dis)charge A series of innovations were needed before liberating gas from tight shales became possible. The two most important were horizontal drilling and hydraulic fracturing, known as ‘fracking’. Horizontal drilling grants access to vast swathes of buried shales, allowing these rocks to be targeted for hydraulic fracturing, where a mixture of sand, water and chemicals are blasted at rocks at high pressure to force them to crack open. This makes previously tight rock formations permeable—perfect for gas to flow through. The infrastructure needed to make this process successful is vast and complex. Whereas conventional drilling requires a simple rig that can be attached to the back of a ute, a fleet of perhaps 20 or more trucks supplying water, sand, propellants and explosives are needed to frack. Price therefore isn’t the only constraint; a sophisticated oil and gas industry able to supply support services is also vital. Little wonder that the US, where both price and infrastructure were favourable, was the birthplace of shale gas extraction. Two additional factors will affect the economics of shale gas extraction. The first is the rate of production, the second the amount of liquids that can be produced alongside gas. Both are vital determinants of economic success. Unlike conventional gas wells, shale gas demands low upfront capital, but the rates of output decline are markedly higher. Producers must keep punching holes and fracking to maintain output, making it a more capital intensive business where production rates are determined by gas prices and how much oil and condensate accompanies gas output. If prices are high, so are margins. Similarly, the higher the liquids content, the higher the margins.

How AWE stacks up The most attractive part of AWE’s shale story is not the size of the resources but its location. In Western Australia, gas prices hover around $8 a gj and threaten to go higher. On the east coast of Australia, they’re half that. AWE, should it achieve technical success, will be selling in the most attractive gas market in the country. Unlike so many other shale gas upstarts, the economics aren’t in question. But two key pieces of information are still missing; the liquids content in AWE’s resource is still unknown but, more importantly, the technical success of fracking in the Perth Basin hasn’t been proven. AWE has run several tests and the results are now being investigated. Early feedback is good but there’s no certainty that large scale production can take place. Beach Energy recently announced successful fracking in the Cooper Basin on Australia’s east coast. Like the Cooper Basin, the Perth Basin is endowed with infrastructure and pricing is far more favourable. The probabilities run in AWE’s favour and the payoff could be huge. A resource of about 4 trillion cubic feet, or about the same size of Woodside’s Pluto field, beckons. Best of all, however, there is zero value imputed in the share price. In fact, AWE’s conventional oil and gas alone is probably worth more than the current market price.

Dramatically mispriced In the rush to punish failure, the market has dramatically mispriced AWE. The raw statistics provide some evidence; EBITDAX (earnings before interest, tax, depreciation, amortisation and exploration) of between $150m-$250m per year are expected until 2020. Yet the company’s enterprise value is just $524m. Most of AWE’s revenue comes from gas rather than volatile oil and, best of all, prospects for sensational resource expansion are high. In most cases, reciting these facts would lead to an investor stampede. But there appears to be little understanding of exactly what AWE is doing in WA. It is a science experiment, one that will take time, but has the potential to reward shareholders. Investing in oil and gas producers, particularly after a string of failures, requires gumption and courage to the point just before foolishness. But the margin of safety here offers justification for it. AWE’s share price is down 11% since 25 Jul 11 (Speculative Buy—$1.345). It remains misunderstood and a SPECULATIVE BUY for 2% of a diversified portfolio. Note: The Growth portfolio owns shares in AWE.

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Australand’s security price has fallen 23% since touching $3.20 on 27 April 2011, but Australand Holdings | ALZ the property group’s half-year results (it has a calendar year end) produced no surprises. Underlying profit increased 7% to $65m, and the board declared a 10.5 cent unfranked Price at review $2.48 distribution (ex date 24 June), up from 10 cents. With the company expecting to pay 21.5 Review date 1 Aug 2011 cents for the full year, up 5% on 2010, Australand currently offers a relatively attractive Our View Long Term Buy 8.7% forecast yield. Management cut the residential division’s outlook for the rest of 2011. But as we mentioned on 15 Feb 11 (Hold—$2.98), the fact that this division might continue struggling has already been reflected in the recommendation guide. In contrast, there was standing room only in Australand’s modern office and industrial property portfolio throughout the global financial crisis. Distributions will also increase as $380m of new commerical developments are completed over the next 18 months. Unfortunately Australand has been unable to find long-term lenders despite improved credit conditions, which makes it vulnerable to an economic shock. But given that the value of its land and stock of mostly residential developments would need to drop by more than 50% to justify the current security price, and long leases help protect distributions, there is a decent margin of safety for all but the most conservative investors (who might prefer larger property investments, such as Westfield Group and Westfield Retail Trust). A full review of Australand will be published after reporting season, but at a 30% discount to net tangible assets per security of $3.55, we’re upgrading Australand to LONG TERM BUY. Note: The model Growth and Income portfolios own securities in Australand.

In contrast to the share price fall that followed, this analyst left Macquarie Group’s recent annual general meeting feeling relatively upbeat compared to the analyst presentation back Macquarie Group | MQG in February. At the meeting, the board appeared relaxed as it explained why the ‘annuity Price at review $27.00 style’ businesses were performing well following significant acquisitions. Management Review date 3 Aug 2011 also suggested that improved market sentiment would eventually revive the company’s Our View Buy flagging return on equity. While Macquarie’s financial market divisions are suffering together with overseas rivals, February’s analyst presentation served as a warning that, bereft of material growth options in Australia, it is expanding into riskier and more competitive overseas markets. As we Portfolio point discussed in Banking on Macquarie on 28 Apr 11 (Long Term Buy—$34.87), the group has emerged from the global financial crisis as a more cyclical business. Macquarie expects higher profits in 2012 subject to ‘market conditions’, a large distribution from its interest in MAp Group (discussed in Welcome home MAp Group on 21 Jul 11 (Long Term Buy—$3.44)), and a better second half result (that old chestnut—Ed). The stock currently trades at a 22% discount to book value, a 12% discount to net tangible assets and offers a 6.9% unfranked dividend yield. Conservative investors should steer clear of Macquarie Group due to its leverage to economic shocks, and we’ve increased the business risk rating slightly. But subject to the caveats in the Portfolio point, we’re upgrading to BUY for up to 5% of a well diversified and risk tolerant portfolio. A comparison of Macquarie and its global peers will be published in a fortnight. Note: The model Growth portfolio owns shares in Macquarie Group.

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Rio Tinto’s half year result shows that mining houses will keep spewing cash as long as the Chinese juggernaut marches on. Earnings before interest tax depreciation and Rio tinto | rio amortisation (EBITDA) rose 27% to US$14.2bn, and operating cashflow jumped 31% to Price at review $76.58 a titanic US$12.8bn. Though debt more than doubled to US$8.6bn, due to the acquisition

Review date 4 Aug 2011 of Riversdale Mining and a stake in Ivanhoe Mines. Earnings per share increased 29% to US$3.89, a fully franked interim dividend of US$0.54 was declared (ex-date 10 August), Our View Sell and the company’s share buyback was increased from US$5bn to US$7bn. Despite talk of a diversified business model, Rio’s mighty iron ore division contributed 80% of net profit. Plans are also underway to lift output by 50% to over 330m tonnes per Want to know more? annum by 2015, meaning that a bet on Rio at current prices is a bet on the iron ore price. The interplay of prices and costs, a key industry talking point, is enlightening. Rio produced about US$5bn of additional profit due to higher prices, while about US$2bn was lost in higher costs and unfavourable currency swings. Lower volumes cut profit by

a further US$450m. There is little doubt that Chinese demand (with some help from Mr Bernanke) is sustaining high commodity prices, but a battle is brewing over who should benefit from the windfall profits. Up to now, producers have taken the lions share, but workers, contractors and governments are all demanding a greater slice. Rio doesn’t look expensive based on traditional valuation measures, but the reliance on iron ore remains a key risk (see Want to know more?). The share price has fallen 13% since 11 Feb 11 (Sell—$87.70) and we’re sticking with SELL.

On a sunny August day in 1929 failed presidential hopeful Alfred E. Smith gathered the New York press and announced humble plans to build the world’s tallest skyscraper. ONLINE COMMENTS The 102-storey cloud tickler, known as ‘The Empire State Building’, would triumphantly rise Gareth Brown (II) above the Manhattan skyline as a monument to American capitalism. It was a sign of the times. The stock market was reaching new heights following the economic boom of the roaring twenties, and local businessmen (they were all men then)

wanted to leave their mark, developing iconic buildings such as the famous art deco styled Chrysler building, Woolworths and GE Towers. But barely a month after Smith’s announcement the stock market crashed, dropping a spectacular 23% in two days. Egos were crushed, fortunes lost and America entered

the depression. The question then begs itself; does the location of the world’s newest and tallest building projects indicate where the next financial crisis will be?

Manhattan of the Middle East

Visit Dubai and you’ll be struck by the sheer scale and audacity of its rapid development. The city has been transformed since discovering oil around fifty years ago. Dubai is currently home to more of the world’s tallest buildings than any other city, John including the current record holder, Burj Khalifa, which soars almost a kilometre into the sky, with a height of 828 metres. Dubai’s monuments to its vast oil reserves are being cobbled together as quickly as

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its migrant workforce can manage. Ten years ago, most of these developments were just sketches. Now they serve as a powerful visual reminder of Dubai’s wealth, and a boom continued... in oil prices.

Pride comes before the fall

But how does this story end? A property boom starts with a trigger, such as low interest rates and or easy credit. In Dubai’s case, it is an intoxicating mix of easy and cheap credit, and high oil prices. That stimulates investment, and assets values balloon as investment flows increase and lending standards decrease.

Next, the herd, armed with large licks of debt, bids up asset prices significantly beyond their underlying value. Then, when the music stops, property prices collapse, resulting in writeoffs and highly geared developers going bankrupt. Dubai locals, known as Emiratees, are familiar with this sequence of events. Dubai needed a friendly bail out from neighbouring Abu Dhabi during the global financial crisis due to its property bust. So in both modern Dubai and 1920s New York, we have examples where the announcement of a new record-breaking structure being built has preceded a Gareth Brown (II) major economic downturn. Closer to home the Gold Coast suffered a similar fate. The development of the southern hemisphere’s tallest residential building, the Q1 Tower at Surfers’ Paradise, was timed to capitalise on the property boom. More recently, the prices of some properties on the Queensland coast have fallen over 40%. This phenomenon also occurred in other markets, such as Shanghai in China and

Kuala Lumpur in Malaysia, where countless tall buildings including the Oriental Pearl Tower [1994] and Petronas Towers [1998] were built in the lead up to the Asian financial crisis of the late 1990s. The common thread in this cycle of boom and bust is that massive projects such as the Empire State Building or Burj Khalifa are rarely viable from a purely economic point of view (it was decades before the Empire State Building was full with tenants). Rather, they are built as monuments to human achievement when credit is cheap and egos are inflated. Most of the tall buildings currently under construction are either in China or the Middle East. Both economies have experienced mammoth growth over the past decade. Phil O The world’s most audacious project yet is a 1,600-metre tower planned for Jeddah, Saudi Arabia (that’s four Empire State buildings stacked on top of each other). Saudi Arabia is not known for its lack of land, again showing that ego rather than economics is driving development. Keep in mind that tall buildings suffer rapidly diminishing returns once they John reach a certain height due to technology and engineering constraints. Despite the lessons of the past, it seems humans are destined to keep repeating the same mistakes. China’s massive stimulus program during the GFC spared Australia from going into recession. But there are plenty of worrying signs emerging out of China, and perhaps the most obvious red flag is its new skyline. Have you positioned your portfolio to protect against a downturn in China, or are you a China bull? What economic signs do you use to flag possible problems?

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

Doddsville podcast | Flight Centre, value investing lessons and Rupert Murdoch Dumb questions video | Santos

13 Intelligent Investor

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

Jeremy Grantham’s latest quarterly letter on resource limitation.

JG has just finished reading Platinum’s latest quarterly. As usual, it’s a fascinating read.

A fascinating look at how China conducts foreign policy.

Who says buying lottery tickets is a dumb investment? It isn’t always...

It wasn’t the internet that killed Borders, argues Slate.

Find out where you sit on the world’s global rich list.

Aust. capital city house prices down for the sixth straight month. More to come? Video interview with Jeremy Siegel (author of Stocks for the Long Run).

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

AET&D sale Hi Gareth Just wondering if II has any addittional information things around. While it might appear statistically cheap, we much on the AET&D sale.I understand that 80% of BEPPA holders prefer the blue chip companies on our current buy list. voted against the proposed sale to ATCO and that a superior offer has now been received. However I note that DUET provided an ASX release on 29 July advising that financial close has been Computershare BNY Mellon acquisition reached in its dealings with ATCO in relation to the matter. Its Hi Guys, Do you know when the anti trust decision is due a bit confusing and I haven’t been able to find any information for CPU’s proposed acquisition of BNY? I cannot seem to find in releases from AET&D Holdings. Ron T any announcements. 0 4/ 0 8 / 2011, Gareth Brown: The sale was voted down by 80% of 0 4/ 0 8 / 2011, Gareth Brown: I would have expected to have voting optionholders. But Brookfield pushed through the sale regardless, heard something by now, but there have been no announcements, claiming the assets would be bankrupted otherwise. I’m angry about and I haven’t come across any loud rumours. This one is with the that, but there’s nothing optionholders can do unless they want to go competition regulators, and they’ll take their time I suppose. to court. We don’t. But it makes the whole point of having a vote a As far as feedback from the company, I guess it doesn’t pay to shambolic waste of money. Anyhow, the maximum proceeds to go shout ‘I expect to win’ or ‘I expect to lose’ before a final decision is to optionholders is about 3 cents, and the final figure is likely to be made by regulators. I’ll write an update as soon as an annoucement lower depending on certain costs and taxes. I’ll write an update when is forthcoming. we hear more. It’s a disappointing financial outcome, unfortunately.

Low ROE businesses A price for Fairfax? I read with interest your recent article “Return on equity: With the significant decline in FXJ share price and the presence Pluses and pitfalls”. It explains quite well why a high ROE does of other value investors jumping on board (I know I know that not necessarily make a good investment. What I am interested in does not mean its good or bad) is there a point at which this however, is the opposite case, i.e. where a company with a low becomes a buy? ROE does make for a good investment. A good example amongst 0 2 / 0 8 / 2011, Nathan Bell, CFA: It’s often said that there is a price your buy recommendations is Spark Infrastructure (SKI). for everything, but Warren Buffett’s advice that ‘you can’t pay a low 0 2 / 0 8 / 2011, Gareth Brown: The other side of the same coin, enough multiple for a business in decline’ sums up our view of Fairax. a good idea for a future feature article perhaps. The answer, once This is a business facing structural decline, without a strategy to turn again, gets down to price. Spark, as explained in Powerplay: Spark vs

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SP Ausnet, was—until recently—available on a free cash flow yield of the experience is like the US, where early falls in some of the more 15%. One needs to make downward adjustments for tax to make buoyant markets, like Las Vegas, Miami and Phoenix, in 2006/07 the comparison fair (infrastructure owners such as Spark generally merely hinted at what was to come everywhere else in the country, don’t pay corporate tax, with distributions taxed at the shareholder or whether it is truly isolated to coastal south east Queensland. Gold level). Let’s make an adjustment (not perfect but useful) for 30% Coast and Sunshine Coast have moved from very overpriced to, let’s tax and call it a 10.5% free cash flow yield. The equivalent free cash say, more fairly priced in a blisteringly short period of time. flow yield for high-ROE Wotif is around 4%, and it’s 6% or so for We wrote that report in 2008 because we thought it needed Platinum Asset Management. And we’d also argue that Spark is a more saying. For the most part, most of our analysts are still fairly bearish defensive business. So, in response to your question of what could on most property in Australia, for reasons we’ve highlighted numerous make a low ROE stock a good investment, the most common answer times on the Doddsville blog more recently. But we need to be is ‘a low enough price’. Othertimes, ROE can be misleading because careful on the topic because our licence is only for covering listed of specific accounting issues—see Reassessing Coca-Cola Amatil for Australian stocks—although we’d argue if you know how to value a one of many other reasons why reported ROE mightn’t explain the bond or share then you have 90% of the knowledge for valuing most true economics of a business. property. And we’d also argue you can’t understand Australian bank stocks without understanding Australian property. Perhaps it’s time for another property-focused blog piece in order to gauge views among White Energy - no thanks! Doddsville readers. Do you have any opinion on WEC? John Kinghorn seems to have put a LOT of his RHG money into it, but now it can be bought more cheaply than he managed. Thoughts on DRP participation 0 2 / 0 8 / 2011, Gareth Brown: Kinghorn doesn’t have a great track What are your thoughts on Dividend Reinvestment Plans as record of growing wealth for external shareholders, in fact it’s poor against receiving the dividend? indeed. We profited from RHG by buying at the right time, but 2007 02 Aug 2011—Gareth Brown: It all depends on your personal float investors did poorly. situation, such as whether you’re in saving mode or need income to Given the shenigans at RHG, and how it took a shareholder revolt live off. But our key thoughts were highlighted in this Investor’s College to stop him taking the company from external shareholders way too article. Essentially, it depends on whether the stock is underpriced, cheaply, we’d be very hesitant to get into business with him again. fairly priced or overpriced. Feel free to use our recommendations Any Kinghorn-led stock would need to be absurdly cheap to attract as a guide—ie, if a stock is cheap enough to garner a positive our interest. We haven’t looked very closely at White Energy, but don’t recommendation from us, then participation in its DRP can be a think it’s likely it would fit that requirement. useful and cheap way to increase your investment in an underpriced stock. We certainly wouldn’t recommend participating in the DRP of a stock that we believe is overpriced. A wonderful watch list Hi Guys, Not so long ago you published a ‘wish list’ of Bluechips with a pricelist should markets go through a correction. XRF Scientific Any chance of republishing it or letting me know. Looks as though Hi team, I was just wondering if Gaurav had any opinion on it may come in handy soon. Stephen M XRF Scientific (XRF) ? I understand its too small for you to cover 04/08/2011, James Greenhalgh: Hi Stephen. The article is A but interested in whether you think it is worth a look? It has wonderful watch list—thanks for the suggestion, as it’s something many passed my relatively basic filters... members might be interested in revisiting. We’re certainly not that far 04 Aug 2011—Gaurav Sodhi: These little niches are potentially away from upgrading a couple of stocks on the list, such as Cochlear, good hunting ground, but in XRF’s case, the story is perhaps too well CSL and ARB Corporation. And Computershare and Woolworths are known; the stock has enjoyed quite a run. XRF machines are famously within 10% or so as well. It’s certainly nice to see buy opportunities inaccurate and I’m not sure how large the market will ultimately be approaching in some high quality stocks. for something like this. The stock is richly priced too, so you would have to be very confident about the implied growth actually occurring. Good area to be investigating and it’s probably worth more research Gold Coast property walloped time if you are so inclined. Hi guys. Ive been on the Gold Coast for a few weeks and am amazed at the price reduction from a year or two back on some properties eg some properties are selling for less than half their Drawbacks of ROE purchase price from 2 years ago. You wrote a really good report on Gareth Brown’s piece on ROE is useful, However, while it property a few years back which I think was right on the money. may well be the truth, I don’t think it’s the whole truth. A couple I would be interested in yours and other member views on the of examples come to mind: many stocks rely on gearing to get gross rental return on different types of property required before their ROE up from pretty ordinary ROA—such as infrastructure property represents good value. Gross returns in the 10% range stocks. Providing their gearing is well managed and is on steady are starting to emerge again for the first time in ages. I think this businesses, that’s OK. I think banks should probably be assessed would make a really interesting forum debate. Philip O on an on ROE basis. Thee areas were not mentioned in Gareth’s 0 2 / 0 8 / 2011, Gareth Brown: It’s been an impressive fall, hasn’t report. Comments please. it? And especially so in light of the fact that some other parts of the 02 Aug 2011—Gareth Brown: I think this is a good point, and it’s country are barely down at all. It’ll be interesting to see whether great you’re thinking about these matters. But the article was intended to

15 Intelligent Investor

highlight some specific drawbacks with ROE, rather than all drawbacks. gross rental return on different types of property required before We can’t fit the ‘whole truth’ in every 1,200 word article. We’ve explained property represents good value. Gross returns in the 10% range other ROE drawbacks, including the debt issue, in Weighing up ROA, ROE are starting to emerge again for the first time in ages. I think this and ROCE part two. We agree that ROE can be misleading/dangerous would make a really interesting forum debate. Philip O for companies that use more than a small amount of debt. It’s why 02 Aug 2011—Gareth Brown: It’s been an impressive fall, hasn’t we tend to use and discuss ROCE more than ROE—ROCE is a more it? And especially so in light of the fact that some other parts of the robust assessor of business quality because it isn’t mislead by how country are barely down at all. It’ll be interesting to see whether the company is funded (debt vs equity).On that note, I wouldn’t be the experience is like the US, where early falls in some of the more paying too much attention to the ROE of a bank, too highly geared in buoyant markets, like Las Vegas, Miami and Phoenix, in 2006/07 my opinion. Given their use of leverage (debt and depositors’ funds), merely hinted at what was to come everywhere else in the country, bank ROE should be very high, and it’s still only a small part of the or whether it is truly isolated to coastal south east Queensland. Gold picture for assessing a bank investment. One can see that by looking at Coast and Sunshine Coast have moved from very overpriced to, let’s the number of US financial businesses that reported high ROE results say, more fairly priced in a blisteringly short period of time. in 2007 and were out of business by 2008/09. Personally, I think ROE We wrote that report in 2008 because we thought it needed saying. is only of particular use in assessing lowly-geared industrials. ROCE is For the most part, most of our analysts are still fairly bearish on most generally a more useful guide, although far from infallible. property in Australia, for reasons we’ve highlighted numerous times on the Doddsville blog more recently. But we need to be careful on the topic because our licence is only for covering listed Australian stocks—although News Corp: Buy American or buy Australian? we’d argue if you know how to value a bond or share then you have I’m looking to follow your recommendation and add News 90% of the knowledge for valuing most property. And we’d also argue Corp to my portfolio. I see that News Corp is listed both in you can’t understand Australian bank stocks without understanding Australia and in the USA. Does it matter which one I choose? Are Australian property. Perhaps it’s time for another property-focused blog there advantages in buying in the USA vs Australia considering piece in order to gauge views among Doddsville readers. that I’m not a tax resident in Australia. 02 Aug 2011—Gareth Brown: Because of the potential for arbitrage, price tends to be ‘fair’ compared with the Low ROE businesses US price. For example, the voting B shares closed at A$14.94 on the I read with interest your recent article “Return on equity: ASX on Friday 26 July 2011. The US price opened at US$16.38 just Pluses and pitfalls”. It explains quite well why a high ROE does after the Australian market closed. Given the current exchange rate not necessarily make a good investment. What I am interested in of A$1=US$1.10, it’s almost exactly the same price in one market however, is the opposite case, i.e. where a company with a low as the other. It’ll tend to trade at a fair price, because otherwise ROE does make for a good investment. A good example amongst arbitrageurs will step in and profit from the difference, correcting any your buy recommendations is Spark Infrastructure (SKI). gaps in the process. 02 Aug 2011—Gareth Brown: The other side of the same coin, a So your decision should be based on what’s easier and more tax good idea for a future feature article perhaps. The answer, once again, friendly for you as an investor from a third jurisdiction. I can’t know how gets down to price. Spark, as explained in Powerplay: Spark vs SP Ausnet, that works for you but, if there are no tax differences between holding was—until recently—available on a free cash flow yield of 15%. One US or Australian shares in your country of domicile, there should be needs to make downward adjustments for tax to make the comparison little overall difference whether you buy the US or Australian shares. fair (infrastructure owners such as Spark generally don’t pay corporate tax, with distributions taxed at the shareholder level). Let’s make an adjustment (not perfect but useful) for 30% tax and call it a 10.5% free A price for Fairfax? cash flow yield. The equivalent free cash flow yield for high-ROE Wotif is With the significant decline in FXJ share price and the presence around 4%, and it’s 6% or so for Platinum Asset Management. And we’d of other value investors jumping on board (I know I know that also argue that Spark is a more defensive business. So, in response to does not mean its good or bad) is there a point at which this your question of what could make a low ROE stock a good investment, becomes a buy? the most common answer is ‘a low enough price’. Othertimes, ROE can 02 Aug 2011—Nathan Bell, CFA: It’s often said that there is a be misleading because of specific accounting issues—see Reassessing price for everything, but Warren Buffett’s advice that ’you can’t pay a Coca-Cola Amatil for one of many other reasons why reported ROE low enough multiple for a business in decline’ sums up our view of mightn’t explain the true economics of a business. Fairax. This is a business facing structural decline, without a strategy to turn things around. While it might appear statistically cheap, we much prefer the blue chip companies on our current buy list. Global investment ideas I’m really enjoying the current Doddsville series on the Italian value investment seminar. Would you consider producing a report Gold Coast property walloped of the “top 100” (or appropriate number) value investors globally Hi guys. Ive been on the Gold Coast for a few weeks and am with a small summary on each of them? I think that would offer amazed at the price reduction from a year or two back on some a great insight to members on sources of offshore ideas and properties eg some properties are selling for less than half their philosophy. purchase price from 2 years ago. You wrote a really good report on 29 Jul 2011—Gareth Brown: Glad you’re enjoying the blog posts, it property a few years back which I think was right on the money. was certainly fun and worthwhile attending the seminars. We’re trying I would be interested in yours and other member views on the to do more interviews with Australian fund managers, such as this

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video with Wayne Jones, or recent podcasts with Peter Wilmshurst although for different and more complicated reasons. Reported net (Templeton), Matthew Kidman (Wilson) and Wayne Peter (Peters profit, for a variety of reasons explained below, is a next-to-useless McGregor). We may very occasionally do something with an offshore guide for understanding MAp’s real economic profits. Proportionate manager (look at for a quick podcast interview with young hedge earnings is, we believe, a very good guide. It’s management’s attempt fund manager Sahm Adrangi in the near future). And there’s always to adjust for those areas where accounting and economic reality differ. room to expand the Masterclass series (of which we’ve so far done Last year, proportionate earnings was $444.2m (page 9 of MIR), or Warren Buffett, Peter Lynch, Ben Graham and Phil Fisher), although 23.9 cents per security (page 12). We think you can use that as a top 20 might be a more realistic aim than top 100. good guide to the economic profit of the entity. If you’re after a more global perspective, we’d recommend Value It’s very difficult to do a reconciliation between reported earnings Investor Insight, it’s great value. We don’t have the international from the annual report and the ‘proportionate earnings’ from the contacts or resources to put together as good a product as this, management information report. Firstly, a big chunk of what should so for those wanting more on international money managers, we’d be considered shareholder’s equity is actually set up as a shareholder recommend Value Investor Insight. loan (don’t let the word loan put you off, it acts like equity. It’s been done for tax reasons). Secondly, the reported accounts are jumbled by the fact that the European airports are equity accounted and Understanding MAp Group’s profit Sydney is fully consolidated into the accounts (it should become a Dear Gareth, RE: MAP’s net profit after interest expense? Just little easier once MAp is total focused on Sydney Airport). Thirdly, wanted to thank you in advance for being patient with investors for now, foreign exchange gains and losses are flowing through the and members who are a bit slow at grasping your concepts. reported accounts (the debt associated with the European airports are I read your reviews on MAP but I can’t get my head around in Euros and DKK. This is naturally quite hedged but knocks reported understanding it’s net profit after interest expense. Also, I can’t profits around from year to year). Fourthly, reported depreciation is understand the “Proportionate EPS” concept. Is there another way substantially higher than actual maintenance capital expenditure. So to explain MAP’s net profits (after interest expense—excluding balancing what’s in the annual report with what’s in the management depreciation and amortisation etc. as this confuses me) for information report is tough, and difficult to explain in a reconciliation us dummies? Would I be extremely incorrect to view things that actually balances. from the following angle (using figures from pg 58 MAP annual But we think that owners can ignore reported net profit and look report): Net Profit (approximate) = Cashflow from operating at the proportionate earnings in the management information report. activities—investing activities—borrowing costs / interest expense We believe this number offers a good estimate of the actual economic = $864 Million—$89 Million—$391 Million = $384 Million Market profits coming from the airport to MAp. Steve Johnson (Intelligent cap = 1,861,211 shares x $3.25 = $6.048 Billion I seem to only Investor Funds) worked on the original Macquarie Bank bid for Sydney understand things, or compare businesses, based on it’s price vs Airport, so he (and we by extension) understands a fair bit about the net earnings (after interest expense—exclude depreciation and assumptions involved and are comfortable with those assumptions. amortisation etc). For simplicity, would I be extremely wrong to Alternatively, as you’ve done, one can look at free cash flow. It’ll conclude MAP’s P/E (using 2010 annual report) = $6,048 M / tend to be lumpier than management earnings. It will also fully deduct $384 M = 15.75 times I glanced over MAP’s annual report (page growth capital expenditure, and so will be somewhat understated on 58) and wish to clarify some points: 1. average, and especially in the big years when a new car park or retail 03 Aug 2011—Gareth Brown: Firstly, just to clear any confusion arm is built. But over time, on average, it’ll make a pretty good guide. for anyone else reading this, when you talk about net profit I assume Note the cash flow number you’ve calculated isn’t all that different you mean reported (headline) net profit from the annual report. from the proportionate earnings calculated by management. Neither Proportionate earnings that I’m often referring to is a number are anywhere near reported net profit. that comes not from the annual report but something called the We don’t tend to think about this asset in terms of PER, although Management Information Report. you can certainly calculate one from proportionate earnings if you Sometimes, reported net profit isn’t a useful guide to the real wish. It’s probably more revealing to look at the high (and, over time, economic progress of a company, trust or asset. We’ve argued, growing) yield. But I’d be careful about any PER or yield calculation for example, that reported profits are useless for assessing listed today, because the Sydney Airport swap will move those numbers investment companies. It’s a somewhat similar situation for MAp, around (and generally for the better).

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