In This Issue... If Markets Turn Sour Over the Next Year Or So, You May Get A

weekly review | ISSUE 322a | 11–17 june 2011

CONTENTs In this issue... STOCK REVIEWS STOCK ASX CODE Recommendation PAGE Computershare CPU Long Term Buy 5 John Addis stock UPdates If markets turn sour over the next year or so, you may get a chance QBE Insurance Group QBE Buy 9 to buy some of the country’s best businesses at very attractive prices. Westfield Group WDC/WRT Long Term Buy 10 This is where you should look... (see page 2) features A wonderful watch list 2 Investor’s College | Appreciating depreciation 8 Gareth Brown Doddsville blog | Australia’s manufacturing fetish 10 Computershare is a wonderful company trading at a fair price. In extras the first of a two-part series, Gareth Brown examines what makes it tick... (see page 5) Blog article links 11 Podcasts links 11 Twitter links 11 Ask The Experts Q&As 12 Nathan Bell RecomMendation changes Depreciation is meant to help paint a picture of economic reality, Computershare upgraded from Hold to Long Term Buy although sometimes it’s used for the opposite purpose. Here’s how PORTFOLIO CHANGES to tell the difference... (see page 8) There are no recent portfolio transactions

Gaurav Sodhi

The obsession of the media and politicians with manufacturing in Australia has always baffled me. Kim ‘Il’ Carr, the responsible minister, is always quick to demonstrate he is ‘doing something’ to arrest the decline of the holy manufacturing sector... (see page 10) The Intelligent Investor

If markets turn sour over the next year or so, you may get a chance to buy some Key Points of the country’s best businesses at very attractive prices. This is where you Economic danger signs are growing should look. It’s time to prepare for some bargain shopping Call it the socialist hedge. China doesn’t have a free floating currency that the screen Here are 12 stocks, and buy prices, for your watch list jockeys can play with so they make proxies for it instead. Those that believe the Chinese growth story won’t take a nasty turn have made the Australian dollar one of their toys. As James Mackintosh of The Financial Times says, ’The Aussie is the world’s third most overvalued currency in purchasing power parity terms. It is pricing in rising Chinese growth as Beijing tightens. And it has fallen much less than commodities or equities after tracking them all the way up. There is no way around it: the Aussie looks expensive.’ Steven Johnson, chief investment officer of Intelligent Investor Funds wrote recently that, whilst he doesn’t know if the latest data foretells a foot on the brake of the Chinese economy or the first wobbles of a derailment, this is not ’a train I want to be on’. Across the Pacific, the famously prescient Nouriel Roubini (he predicted the US housing market crash in 2005) is warning of a double-dip recession. Bloomberg reports how Roubini ’sees a “perfect storm” of fiscal woe in the U.S., a slowdown in China, European debt restructuring and stagnation in Japan may converge on the global economy’. Roubini predicts a one-in-three chance that those factors will combine to stunt growth from 2013, the other two possibilities being ’anemic but OK’ global growth or an ’optimistic’ scenario. In Europe, where Greek debt is now rated a higher risk than that of Ecuador, the eurozone looks destined for some sort of restructure. One can only kick a can down the road for so long before it starts to fracture. In the world’s financial capitals an aroma of fear drifts across trading floors. Even here in Bondi Junction, where the closest one gets to a financial capital is the street signage of the local Travelex, one can sniff the breeze. TV news bulletins regularly feature the classically cliched image of the broker, head in hands. And the print media now talk of the worries that have preoccupied Krugman and Roubini for years.

Table 1: The watch list Company (Position lAst review Current Current long Term buy buy price in top 10 report) (reco–price) PER yIeld Price target ($) tARGet ($)

1. Monadelphous Sell—$21.31 19.8 4.3% Up to $12.00 Below $10.00

2. Cochlear Hold—$76.18 26.5 2.7% Up to $65.00 Below $55.00 3. Fleetwood Coverage Ceased—$12.80 13.8 6.8% N/A N/A 4. CSL Long Term Buy—$33.97 19.7 4.1% Up to $35.00 Below $28.00

5. Woolworths Long Term Buy—$27.00 16.4 4.3% Up to $29.00 Below $24.00

6. Computershare Long Term Buy—$9.32 16.2 3.0% Up to $9.50 Below $7.00

7. Metcash Long Term Buy—$3.90 13.8 6.3% Up to $4.50 Below $3.60

8. BHP Billiton Hold—$44.71 19.4 2.0% Up to $35.00 Below $30.00

9. David Jones Coverage Ceased—$4.52 11.8 7.5% N/A N/A

10. Leighton HldGs Avoid—$24.78 10.3 7.1% Up to $18.00 Below $15.00

Other quality stocks

ARB Corporation Hold—$7.80 17.6 2.5% Up to $7.00 Below $5.00

Invocare Coverage Ceased—$7.48 27.2 3.9% Up to $6.00 Below $5.00

Woodside Petroleum Hold—$46.94 21.1 2.4% Up to $40.00 Below $34.00

Platinum Asset Mgmt Long Term Buy—$4.74 17.5 5.4% Up to $5.00 Below $3.50

2 Weekly Review | Issue 322a

All up, the Chinese proverb about living in interesting times is taking on an ironic hue. Fear is going mainstream, pulling on its favourite garb and getting ready for an outing. It’s time to prepare to be greedy; there are bargains on the horizon. What follows could be considered as a parachute, a free option on a soft landing and perhaps, if we have prepared well, a strong rebound in the value of your portfolio if that 1-in-3 chance rides home. The report of September 2010 neatly captured what your analytical team determined were Australia’s 10 best businesses. The analysts on each of these featured stocks (except two, for reasons explained later) have assessed the price at which they’d first upgrade to long term buy (4 of these 10 stocks already sport this recommendation) and then (with caution) further upgrade to outright buy. In essence this is a watch list with target buy prices of Australia’s very best businesses. To add a little spice, each analyst has also nominated their preferred high quality stock not in the report, and the price at which they’d like to buy it. Research Director Nathan Bell gets the ball rolling.

Nathan Bell: CSL, Leighton and ARB Blood products manufacturer CSL, number four on the top 10 list, is one of those stocks everyone should own if they can buy in at a reasonable price. It has a breathtaking 20-year record of high earnings growth, large market shares, an extensive distribution network and a bulletproof balance sheet. Best of all, it’s already priced attractively, partly due to the fact that the strong Aussie dollar is masking the company’s progress. But with a forecast price to earnings ratio (PER) of 18 and paltry 2.5% mostly unfranked dividend yield, it’s only currently suitable for risk-tolerant growth investors. The price would need to fall to below $28 for us to upgrade it to a Buy. And because this is a rapidly changing industry, new discoveries make it unpredictable, which is why the current 4% portfolio limit is unlikely to ever be increased beyond 7%. Wal King’s departure from construction giant Leighton exposed a variety of weaknesses in its business. Construction companies need shrewd management to minimise the risks of all the things that could go wrong. That’s something Leighton used to have, or at least it seemed so, but it’s not so clear now. We would only recommend this stock with a large margin of safety. If the share price fell below $18, putting the company on a 2012 forecast PER of 10 we’d look to upgrade it to Long Term Buy but this isn’t absolute. Leighton would have to be very cheap for us to pull the buy trigger. It’s a very different business from CSL. Back in 2009 four wheel drive accessory maker ARB Corporation traded below $3. It has more than tripled since, excluding dividends. This is a top class business with high returns on capital, ample cashflow and net cash on the balance sheet. The forecast PER of 15.8 doesn’t look expensive but a price below $5, which would require a major cyclical downturn or a significant piece of bad news, is worth waiting for.

Gareth Brown: Computershare and Invocare In Computershare takes the lion’s share—part 1 (see page 5) we recently upgraded this world class company, placed six on the list of top 10 businesses. In the global share registry business it’s much bigger than any other competitor and has great growth potential, impressive margins and high returns on equity. Today’s price doesn’t look obviously cheap but for reasons explained in the recent review, it is reasonable. At a price below $7 we’d upgrade it to an outright Buy. Invocare owns White Lady and Simplicity funerals amongst others and has a dominant position in the ‘death care’ industry. That position is about to be strengthened after the ACCC recently decided not to oppose its acquisition of Bledisloe Group, owner of the Gregory and Carr brands, subject to a few small conditions. The company already generates high margins and return on equity and enjoys a most certain tailwind—the rising annual number of deaths in Australia over the next two decades (see Cashing in on the retirement boom of 3 August 2004). The main issue is price. As the stock trades at more than 20 time 2010 earnings the odds of an outstanding return seem fairly low. But at a price around $6.00 we may well upgrade to Long Term Buy, and below $5.00 take a bigger swing and upgrade to outright Buy.

3 The Intelligent Investor

Gaurav Sodhi: Monadelphous, BHP and Woodside Monadelphous operates in a sector characterised by tough competition and chronic cyclicality, although you’d never know it from the company’s performance. Return on capital employed is more than 50%, incremental return on capital employed is more than 60% and it has consistently lifted dividends. Monadelphous was a worthy winner of the coveted crown of Australia’s Best Business last year. But it’s still a cyclical business and we’d only pay a price that reflects that fact. If the price fell towards $12, Monadelphous would be worth investigating as a Long Term Buy. A dividend yield above 4% is surprisingly high but this isn’t an income stock. Most returns will be delivered from capital gains so this would be one for risk tolerant investors only. At $10 it might well be worth upgrading to Buy. Few have benefited from the industrialisation of Asia as much as BHP. With the highest quality assets spread across a diversified portfolio of resources, BHP will continue to grow as long as China and India do. That makes it difficult to value because so much depends on beliefs about the future. At current prices, BHP sports a PER of 19.4 but this is a highly cyclical business tied to Asian growth. Conservative investors should consider the downside. Although not a firm price, we’d be interested around $35 as a Long Term Buy and think about upgrading further at $30. Woodside Petroleum is my non-top 10 pick. It has grown from hopeful minnow to local giant and early investors have been richly rewarded. But even now Woodside remains rich with opportunity. The Pluto project is a fine example of its technical excellence. No other LNG project has been developed as quickly. And Woodside has plenty of other projects in the pipeline. At prices closer to $40, this would be a fine Long Term Buy and at $34 we’d consider upgrading it again.

James Greenhalgh: Woolworths, Metcash, Cochlear and Platinum Asset Management Cochlear has helped 200,000 profoundly deaf people hear thanks to its flagship product, the cochlear implant, which has a 70% market share. What’s more, there’s still a worldwide unmet demand for implants. Occasionally, when Mr Market gets a case of nerves, we get a chance to recommend it. Indeed, since 2003 we’ve done so several times and we’re not far away now. At $65 the stock would be trading on a forecast PER of 20—reasonable for a quality business with many years of growth ahead of it—at which point we’d upgrade to Long Term Buy. At $55, it would likely be an outright Buy. Woolworths is Australia’s largest and highest quality retailer. With more than 80% of earnings coming from its supermarket and liquor operations, it’s a resilient and almost recession-proof business. Concerns that the company’s future sales and profit growth are likely to slow, its expansion into the home improvement market, and Coles’s reinvigoration mean the stock is trading on its lowest PER for many years. It’s currently a Long Term Buy, but we hope to get the chance to upgrade it to Buy below $24.00, equivalent to a PER of 13.9, should the business experience a hiccup. Metcash’s place on the top ten business list rests on two things—good management and fortunate timing. Ten years ago, the company’s new management took this struggling wholesaler and slowly transformed it into the ‘third force’ behind Coles and Woolworths. Today, the large majority of independent supermarkets in Australia are supplied by Metcash, whose buying power allows them to compete with the ‘big two’. Like Woolworths, Metcash’s future growth will be lower than before. And its competitive position will always be weaker than Woolworths or Coles (which is why it deserves a lower PER). But a program of store refurbishments and other business improvements, plus early signs the Mitre 10 hardware acquisition is working, show why it would be a mistake to underestimate the company. It’s currently a Long Term Buy, and we’d upgrade to Buy around $3.60 or a forecast PER of 11.5. The thing about the stock that I’d love to own—Platinum Asset Management—is that I already do. At a price below $3.50, which is where I’d upgrade to Buy, I’d like to buy more. Platinum Asset Management is Australia’s best funds management company with a performance in international stocks that is second to none. Platinum has found it tough attracting inflows but at some point that’s likely to reverse thanks to its strong performance. Even the eventual transition away from founder Kerr Neilson to the second generation of management could reinvigorate the investment team and help grow the business. At a price of $3.50, the stock would be trading on a PER of 14 and a fully franked dividend yield above 6%. For such a high quality business, these are attractive numbers.

4 Weekly Review | Issue 322a

12 stocks for your watch list You may have noticed that two stocks from the original special report on Australia’s top 10 business are missing from this discussion; David Jones and Fleetwood. The reasons are easily explained. We’ve been bearish on David Jones for many a year, a view that will be confirmed in the forthcoming research on the retail sector and the impact of online shopping. David Jones is unlikely to emerge unscathed. As for Fleetwood, a manufacturer of mobile accommodation, it’s heavily dependent on the mining boom and is no longer covered, having been culled in Christmas trimmings: Introducing the nifty 50/50. So that’s a lucky 12 top quality businesses for your watch list—5 of which are already on our buy list—and approximate prices at which we’d be likely to upgrade them. Take the time to read the past research on these businesses so that, if the opportunity arises to buy them on the cheap, you’ll be prepared. A portfolio that included these stocks, acquired at attractive prices, would be the best possible foundation for future outperformance, acquired at very low risk. Disclosure: Staff members own shares in Cochlear, CSL, Woolworths, Metcash, ARB Corporation, Invocare and Platinum. First published online 17 Jun 2011.

Computershare is a wonderful company trading at a fair price. In the first of a two-part series, Gareth Brown examines what makes it tick. Key Points Computershare is the industry’s 800-pound gorilla Industries dominated by a single firm are easy to spot. The winner has the highest This dominance is reflected in the company’s high margins, even when charging a similar or lower price; it enjoys a dominant market share, margins and return on equity often over 50%; and it has higher returns on capital. The stock is cheaper than it looks, an issue we’ll That dominance frequently creates a virtuous circle whereby a large market share expand on in part two next week delivers the cash flow that can be used to further strengthen the company’s competitive advantage. The Coca-Cola Company and Gillette are famous US examples, as is Cochlear Computershare | CPU closer to home. Computershare, the world’s largest share registry business, can be added to this Price at review $9.32 illustrious list. But before explaining why, let’s look at the scope of its activities. Review date 16 Jun 2011 Computershare manages the share registers of listed companies across the globe, 12 mth price range $ 8 . 93 — $11. 6 0 managing records, legal titles and dividend payments on behalf of its clients’ shareholders. Fundamental Risk 2.5 It also takes queries and phone calls from shareholders and manages complex employee Share price risk 3.5 equity plans. These activities generate handsome, stable recurring revenues. At key points in the stockmarket cycle, other lucrative but irregular revenue kicks in; Our View Long Term Buy the back end processing of capital raisings, mergers and takeovers, stock splits and other one-offs, for example. Whilst the company is also involved in other businesses, like issuing speeding fines in Victoria and managing tenant security bonds in the UK, we’re recommending you buy Computershare for its share registry activities.

Market dominance For some odd reason, the ASX/S&P Top 100 index currently has 102 stocks in it. Computershare manages the share registry for 60 of them—a 59% market share of the biggest companies in the land. Link Market Services manages 35, Boardroom (formerly

5 The Intelligent Investor

Registries Limited) controls five and Security Transfer Registrars just one. If you’re not familiar with a Zipfian distribution (and how could you not be, there is really no excuse) the Australian share registry market is a good example of it. One company dominates, a second strong player holds about half as much market share, followed by a parade of stragglers. The markets for search engine queries, microprocessors, hearing implants, shavers and soft drinks are other examples with similar industry dynamics. The leading companies in these markets, like Computershare, achieved their dominance through a first mover advantage, substantial economies of scale, high switching costs, a technical and/or execution edge, the importance of reliability and the perceived and actual quality advantages of an industry leader. Computershare enjoys all these traits. And its market share statistics confirm the quality of its business. Over time though, such advantages can be eroded, making room for a strong number two to challenge. To test whether that might happen with Computershare we travelled back to 2005 to see how ‘sticky’ the company’s customers were and whether market shares had changed in the intervening six years. The answer is a resounding ‘no’. From the list of 102 top stocks, 94 were listed in 2005. Computershare managed the share registry of 54 (57% market share) and Link managed 30 (32%). Other registrars managed a combined six registries (6%) and four companies managed their own registries. If anything, the competitive dynamic has shifted in favour of the top two at the expense of the minnows. Link is a strong second player, but it’s not getting the upper hand. Customers also displayed impressive loyalty. Computershare lost only three Chart 1: Geographic split accounts to competitors (just 6% of the customer base over six years) but more than made up for it by poaching other accounts and grabbing the lion’s share of new listings Revenue (six from eight). US 38% This dominance shows up, as one would expect, in the figures. Computershare earns EMEA 22% 20% net profit margins and a 30%-plus return on equity, from an operation that appears AU & NZ 21% to be a commodity-like business but is far from it. Canada 12% Asia 7% Global success This dominance isn’t just a local phenomenon. Since opening its doors in 1978 in EBITDA Melbourne, Computershare now operates in 20 countries, services 30,000 customers US 32% and millions of shareholders. In most major markets, it’s the biggest player. EMEA 26% Whilst the United States is the company’s biggest profit generator (see Chart 1), it’s AU & NZ 14% also the biggest growth opportunity, so it’s worth spending some time here. Canada 18% In many ways, the US equity market is archaic. American brokers tend to hold Asia 10% stocks on behalf of clients—the so-called ‘street name’ system—rather than the Source: CPU shareholder review, Sep 2010 Australian system whereby legal title rests with the shareholder on an electronic register. Although the average investor never sees them, the US system remains one of paper- based certificates. That means brokers rather than registrars (or transfer agent as they’re known in the US) Chart 2: revenues splite by tend to distribute dividends for example. It’s a far more fragmented and less sophisticated service lines system. If it ever were to develop along the lines of Australia’s system, the opportunities for Computershare would be enormous. But that doesn’t have to happen for the company Register maintenance 42% to do well. Corporate actions 13% With more than 100 companies offering differing forms of share registry services, the Business services 17% US market remains fragmented. But Computershare chairman Chris Morris is doing his Stakeholder relationship mgmt 5% best to bring a Zipfian redistribution to the landscape. Employee share plans 9% In an Inside Business interview in 2005, Morris said that subsequent to its acquisition Comm. services 11% of the then number one US player, Equiserve, Computershare had ‘probably 25 to 30% of Tech & other revenue 3% the market there’. He went on to say that ‘there’s really only two other main players now, Source: CPU first half results to 31 Dec 2010 (the registry businesses of) Mellon Bank and Bank of New York. If the opportunity arose then we’d certainly be interested in either of them’. Mellon and The Bank of New York merged in 2007 to become the biggest player in the market. Just seven weeks ago, Computershare announced it was acquiring the shareowner services business of the combined BNY Mellon for US$550m in an all-cash transaction, the largest acquisition in Computershare’s history. The deal is subject to regulatory approval and may yet fall over. But Computershare expects to succeed, having agreed to pay a US$30m break fee if approval isn’t forthcoming.

6 Weekly Review | Issue 322a

If successful, Computershare will be the 800-pound gorilla in the world’s largest stockmarket, doubling its US market share to over 60%, about five times that of the size of the next largest player, Wells Fargo. That’s dominant. We don’t yet know how the acquisition might affect earnings, only that, according to the company, it should be ‘EPS accretive in the first year’. BNY Mellon’s latest annual report doesn’t put much meat on the bone but it’s reasonable to assume that the BNY Mellon division being acquired produced at least US$20m of pre-tax profit from its US$291m of revenue last year. In addition, management expects ‘large, straightforward synergies’ as it drastically cuts BNY Mellon’s technology spending (leveraging Computershare’s existing technology spending of US$162m in 2010), and consolidating premises and staff. In the third year Computershare expects these synergies to amount to more than US$70m a year. Making some adjustments for interest on the money borrowed for the acquisition and taxes, that should add at least seven to 10 US cents to earnings per share by 2015, a 15–20% boost to current EPS. This acquisition isn’t just about saving money though; it’s about making more of it, too. Computershare’s technological and processing edge offers the possibility of selling new and better services to existing BNY Mellon customers much in the same way as the Equiserve acquisition of 2004/05, although it could be much bigger.

Adding it up Want to know more? We estimate earnings per share of US$0.49 for the year ended 30 June 2011. In local currency, that delivers an EPS of A$0.46, a forecast PER of 20 and a historic yield of 3%, 60% franked. No, Computershare isn’t superficially cheap. That forecast is 15% less than 2010 EPS of US$0.578, based on subdued earnings from those irregular add-on services. At some stage, these non-recurring earnings are likely to increase, perhaps markedly. And if the acquisition of BNY Mellon is approved, the share price will quickly appear reasonable, if not cheap. It’s worth noting that if the BNY Mellon deal falls over, the share price might fall in the short term. But the stock is no higher than when the deal was first announced. And if the deal is approved, the price might well shoot up. There’s another important issue—the earnings stream derived from Computershare’s monstrous float of client cash, which averaged US$9.2bn in the first half (if you’re doing your own research, you won’t find this on Computershare’s balance sheet). We expect higher interest rates in several important markets, especially the US, UK and Canada. If that happens, earnings will skyrocket. That’s the basic argument as to why Computershare’s stock is cheaper than it appears. In part two next week we’ll dig deeper into the valuation but with the stock down 3% since 3 May 11 (Hold—$9.60) and our confidence in this great business as high as ever, we’re upgrading to LONG TERM BUY for up to 4% of a well diversified portfolio.

7 The Intelligent Investor

Depreciation is meant to help paint a picture of economic reality, although Key Points sometimes it’s used for the opposite purpose. Here’s how to tell the difference. Depreciation spreads the cost of an asset over its useful life Imagine you purchase a $10,000 car to use in your small courier business. You expect It can be used to manipulate profits it to last for five years—your drivers will give it a good work out—after which time it’ll be Watch out for companies that capitalise expenses dented, bruised and ready for the crusher. How do you account for the purchase in your books? Well, you could just recognise a $10,000 expense on the day you buy the vehicle. But why would you do that? You’re going to use this car for the next five years so it doesn’t make sense to be slugged with the entire expense in the first year you own it. In year one, this treatment will make your profit look very poor. In the four years that follow, profit will look much better than it really is. For anyone looking at your books, that’s misleading, because accounting aims to provide a clearer picture of economic reality by way of financial information. Instead, you it makes sense to ‘depreciate’ your purchase. On day one, your cash balance will reduce by $10,000. But rather than creating a matching expense, a new asset will be recognised on your balance sheet-your car. In each of the next five years—the ‘useful life’ of your asset—$2,000 of depreciation will be charged against your income statement and the value of your car will be reduced by $2,000 on your balance sheet.

Depreciation at work At the end of the five years, the cumulative result is exactly the same—$10,000 in Measuring depreciation expenses has been incurred relating to the purchase and use of your car. But, by using depreciation, the expenses more closely match its use.

That, by way of example, is depreciation at work. Simple really isn’t it? Er, not necessarily. Sometimes, this process creates a more accurate picture of the economic reality of a business, as it does in our example. At other times it doesn’t. As investors trying to value businesses, we must be able to recognise the distinction. Some

companies use depreciation as intended—as an accurate reflection of economic reality—while others use it to boost profits by capitalising expenses (we’ll get to that in a moment). When depreciation is equal to maintenance capital expenditure—the amount of money a business needs to reinvest each year to maintain its assets and competitive position—cash flow will be equal to accounting profits. When valuing a business, this makes life easy. Let’s say your courier business has five identical $10,000 cars, each with an annual Telstra’s depreciation and depreciation charge of $2,000, with one needing replacement each year. In this case, amortisation schedule maintenance capital expenditure of $10,000 (for one new car every year) would be exactly Asset Expected benefit (years) equal to depreciation ($2,000 multiplied by five cars). Reported profit would thus be equal Buildings 53–55 to your business’s cash flow. Network support infrastructure 4–52

Access mobile 4–16 Capitalising expenses

IT equipment 3–5 But what if you regularly embark on big research and development projects to develop new products? Software assets 7 Because the research and development expenditure (R&D) may not lead to any new Licenses 13 products, it’s best to treat it as an ordinary business expense right? Not necessarily. Some Customer bases 10 companies, such as Cochlear agree: it expenses all its R&D. Software company Integrated Research, on the other hand, claims that a portion of R&D has longer term benefits, and includes this as an asset that should be amortised (see Shoptalk) over its ’useful life’. Telstra is another example, capitalising its software expenses (see above table for

8 Weekly Review | Issue 322a

Telstra’s depreciation and amortisation schedule for selected assets). Such practices have the effect of making profits bigger than they should be (in general, we frown on such ‘aggressive’ accounting practices). Conversely, accounting rules sometimes dictate that a business must recognise costs that it’s not actually incurring. Iress Market Technology is a good example. At the heart of the company’s flagship product is an electronic financial system that was built up over many years. In the past two years, Iress has incurred about $36m of depreciation and amortisation (see Shoptalk) expenses relating to the hardware and software on which its products run. But most of that money won’t need to be spent again; over the same period of time, Iress spent only $8m or so maintaining those assets.

Understates earnings So Iress’s high depreciation and amortisation charges mean its reported profit actually understates its true earning power. In order to estimate Iress’s real profits, we need to adjust its reported earnings, or at least the way we measure them. One method, used on 20 July 10 in Iress’s money making machine (Long Term Buy—$8.40), is to estimate Iress’s ongoing maintenance capital expenditure based on Shoptalk what it has spent in recent years. By using that figure in place of its reported depreciation Amortisation: and amortisation, we can generate a more accurate accounting profit. Depreciation isn’t always adjusted downwards. Capital-intensive businesses such as Onesteel and Amcor often have maintenance capital expenditure far higher than depreciation charges. Here, we need to adjust depreciation upwards to properly estimate earning power. In a perfect world, depreciation would always be equal to maintenance capital expenditure, and a company’s reported earnings would be ‘just right’. We hope this article has explained why it isn’t that simple, how you can spot where depreciation is being misused, and how to account for it.

QBE’s share price fell 4% today following an announcement that claims from the spate of catastrophes in Australia, New Zealand and the US will reduce the company’s full year QBE Insurance Group | QBE insurance margin (the company has a calendar year end). Despite investment income Price at review $16.65 increasing to US$560m for the five months ending May 31 (compared to US$659m for Review date 15 Jun 2011 the 2010 full year), largely due to higher interest rates, the insurance margin is expected Our View Buy to fall toward the lower end of the previous forecast of 15–18%. It is also dependent on claims not breaching existing headroom of US$770m before 31 Dec 11. This isn’t a certainty as net claims over US$2.5m were already US$830m for the first five months of the year, while the crucial US hurricane season is yet to finish. But, unlike some major rivals that have already breached their provision allowances, at least QBE has a degree of protection. Reinsurance rates are also increasing, which will boost QBE’s margins in the short term. Management expects half year profit of between US$660m–704m, up between 50% to 60% compared to the same period last year, and the interim dividend will be maintained at 62 cents. QBE might eventually lower its dividends as it’s currently paying out virtually all of its profits, particularly if it exhausts its provisions. Despite the share price falling 12% since 6 Apr 11 (Buy—$18.97), our opinion of this venerable blue chip hasn’t changed and we’re sticking with BUY. Disclosure: The author, Nathan Bell, owns shares in QBE Insurance, as do other staff members.

9 The Intelligent Investor

Westfield Group | WDC

Price at review $8.81 Please click on this link to download the updated Westfield cost base spreadsheet. The

Review date 14 Jun 2011 original version only showed the hard coded numbers from the example discussed in the review. It now contains the formulas for you to calculate your own cost base. If you have Our View Long Term Buy already used the spreadsheet, please download the spreadsheet again to check that your calculations were correct. Note that cell F28 has also been highlighted in yellow as it now Westfield Retail Trust | WRT needs to be updated manually. Please accept our apologies for any inconvenience caused.

Price at review $2.65 Note: The model Growth portfolio owns Westfield Group securities. The model Income portfolio owns both Westfield Group and Westfield Retail securities. Review date 14 Jun 2011

Our View Long Term Buy

The obsession of the media and politicians with manufacturing in Australia has always baffled me. Kim ‘Il’ Carr, the responsible minister, is always quick to demonstrate he is ONLINE COMMENTS ‘doing something’ to arrest the decline of the holy manufacturing sector. The implication Mars is clear: making something is inherently superior to other forms of employment. This is a value judgement based on dubious economics. Jobs in the manufacturing sector, therefore, get far more attention than deserved.

On a prominent business news show this week, for example, manufacturing was quoted as being an ‘endangered species’ and ‘shrinking towards irrelevance’. Australia isn’t alone in such hyperbole. Almost every developed country in the world shares a fetish for manufacturing. And unwarranted concern about its demise.

Manufacturing in Australia is not in perpetual decline. It has in fact grown fourfold since the 1950s and still employs about a million people. It’s just that other sectors of the economy have grown even faster, so in relative terms, manufacturing is a smaller component of the economy today than it was in the past. Gareth Brown (TII) Most assume that cheap imports have killed off the sector, but international competition explains only a small part of this relative decline. More important has been a change in spending habits. As incomes rise, consumer preferences shift and people buy more services than

manufactured goods. They go on holidays, eat out at restaurants and spend time at the gym. Manufactured goods, for example, accounts for about 30% of consumer expenditure today, down from 50% in 1960. So the services sector of the economy has expanded to meet the extra demand, as it has in every other rich country in the world.

Although employment in manufacturing is relatively smaller today than 30 years ago, this has more to do with technology and the growing productivity of the average worker. The sector as a whole is producing more with less. Changes in the structure of the economy and the greater skill of workers mean we are

designing clothes and engineering mines rather than sewing socks. Is this so bad?

10 Weekly Review | Issue 322a

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

Doddsville blog | Charlie Munger to speak his mind Bristlemouth blog | Beginning of the End for China’s Miracle Economy?

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

Boss Talk | Templeton Global Growth Fund Stock Take | The Banks, gold and MAp Group

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

If you have a spare tyre for a building sized truck, now is the time to sell it.

Book excerpt: Fatal Risk: A Cautionary Tale of AIG’s Corporate Suicide By Roddy Boyd.

Fairholme’s Bruce Berkowitz is beating hedge fund managers at their own game.

Transcript of David Einhorn’s Speech at the Ira Sohn Conference.

How Quickly They Forget: Oak Tree Capital’s Howard Marks describes his approach to today’s investment environment.

McKinsey Quarterly: June 2011.

Interesting to see a major shareholder of Tatts Group dump almost half his holding near the all-time low.

Interesting trend. Failed retailers are shutting their doors instead of being sold. First Borders, now Colorado.

Australians paying more than most other countries (this time for roaming). High end property market hit by ‘perfect storm’? Huh? The clouds have barely gathered—what a brainless analogy.

11 The Intelligent Investor

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

Recommendation guides Pls do not do away with the recommendation guide. You will but what are your thoughts of overseas focused ETFs compared loose my subscription and many others I am sure. to MFF and TGG which I hold? Other possible overseas ETFs you 17 Jun 2011—Gareth Brown: After a Q&A discussion on would recommend? recommendation guides earlier in the week, we’ve received a few 18 Jun 2011—James Greenhalgh: I’m not sure whether you’ve queries like this. Don’t worry folks, the recommendation guides are seen our article What’s an ETF and why you need to know, but I’ll not going anywhere—we know that they’re valued by many members. point you in that direction. We’re unlikely to recommend specific Have a good weekend everyone. country ETFs because they are index funds. In other words, for us to recommend them, we’d need to be sure that an entire country’s stock market was cheap. This is a different skill to recommending Recommendation guide individual companies. ETFs are really a way of getting exposure to I’m surprised that a member has confused the individual markets (and perhaps currencies), which is a personal Recommendation Guide with ’Price Targets’ which are what portfolio decision based on your own asset allocation. other organizations suggest a price can run to . . .different thing altogether. I think Gareth missed an opportunity to make that distinction a bit clearer in his response. It is unacceptable to not Recommendation guides have the Recommendation Guide and go for up to 6 months I wonder if there is a continuing benefit for the price targets. without much idea of where price sits in relation to value, not Recent examples of issues I have with this is with WDC and knowing whether a stock is closer to an upgrade or downgrade HVN. Surely much off what has been said recently as to reasons which is how it used to be It is totally acceptable to have an for the reduction in the buy price has already been accounted idea of what price we should be paying for a stock in relation for. By continuing to push the price downwards, you may see to its value at any given time, all things being equal of course. members miss out on important opportunities. In the end, even Gareth’s negativity towards the guide actually makes me a bit if only to be used as a guide, I do not see the benefits of the nervous about how much reliance I should place on it if his targets, especially when they are moved when we get too close. heart isn’t in it. Eswaran W 16 Jun 2011—Gareth Brown: Thanks for your feedback, which I’ve 15 Jun 2011—Gareth Brown: It’s a difficult one Eswaran. We call published for the benefit of others. I’d only add that my main concern it a recommendation guide, rather than a price target, because that with the recommendation guide is the potential for misunderstanding. better encapsulates the message we intend to convey. It is our thinking If members all use it the way you’ve explained it here, then I have on valuation at a point in time, not a price guide or an automatic nothing to worry about. Thanks again for your comments. upgrade guide. Sure, we don’t want to respond to unjustified price falls. But sometimes price and value fall at the same time, and we need to respond to valuation falls. Westfield and Harvey Norman are Catalpa update on the way two where the evidence against has been mounting. Catalpa today announced a merger with Conquest Mining Personally, I’d be quite happy to do away with the recommendation and the share price fell 15%. Do you see value in the merger, guide, but many members do find it useful. And some of your concerns and if so, in the absence of a better offer, is it worth buying at wouldn’t necessarily be addressed by doing away with the guide. The these levels, and if so, might it be better to buy into Catalpa, or psychology pitfalls, and the need to constantly assess price versus Conquest, or wait to buy into the capital raising that is proposed value, will be ever present. to take place after the merger? Antony L 16 Jun 2011—Gaurav Sodhi: The deal is surprising and complex. I’m going through the details now and will have an update in the next Aristocrat’s share price few days. I’ve mixed feelings about this at first blush. Buying Cracow Hi guys, are there any reasons for the continuing slide of is something we’ve hinted at and is sensible. Not sure about the rest Aristocrat? While it seems lke now could be a good buying of the deal. We’ll have more to say once I’ve crunched through the opportunity, I thought the same at $2.70 or thereabouts? Any documents. The market appears to think St Barbara’s takeover is now advice/comments would be appreciated. Tim C dead and the stock is trading at pre-takeover levels again. There’s no 18 Jun 2011—James Greenhalgh: Hi Tim. Nothing that we’re aware rush for shareholders (I’m one of them) to act at this stage. of that we haven’t already mentioned. Aristocrat’s competitors in the US are reporting weak outlooks, there remains the risk of regulatory change in Australia to restrict poker machine gambling, the Aussie dollar Overseas ETFs isn’t helping, and there’s concern Aristocrat may have to downgrade Just looked at vanguard ETFs, and the Australian based ones profit expectations again based on these factors. It’s a poor outlook are not of interest because of my heavy weighting to Aussie shares in the short term, but Aristocrat’s history is that the turnaround, when

12 Weekly Review | Issue 322a

it comes, is often surprisingly strong. The longer the turnaround is SOE shareholders. Perhaps they might consider sending an email too. delayed, the less the market tends to believe it will happen, which The case for wind up is strong. may be what is driving the share price.

Great Southern Plantations receivership Lowering the hurdle for Westfield Group Hi. I appreciate II want to spend their time and energy Will there be any elaboration on the decision to lower the researching value stocks, however is it possible to have a high prices in the buying guide for WDC, or is it a simple flow on from level overview of GTP for TRESS2 & TREES3 investors. It has been the general malaise around retailers? Damon B over 2 years since the administration event. It would be nice to 14 Jun 2011—Nathan Bell, CFA: Hi Damon, we’ll be reviewing receive a simple update as information on the web is limited. the two Westfield vehicles as part of a special report on the retailers 15 Jun 2011—Gareth Brown: We do take a look from time to over the next month. The decision to lower the prices in the time and there hasn’t been much in the way of news since a large recommendation guide reflects our view that it is likely to become swathe of land was sold to a Canadian group last year at what looked more difficult to gouge retailers in the years to come. I hope the group’s to be reasonable prices. It increased the chance that there might be performance prompts a reversal of the move in due course, but for a small recovery on funds for investors in TREES2 and TREES3, but now we’re prepared to increase the margin of safety while Westfield we’d suggests it’s still likely to return nothing. The ordinary shares are proves it can adapt to a changing retail environment (as I think it can, even less likely to see a return of any capital. Mentally, we’ve written judging by moves like introducing Costco to some US centres). the three classes of shares off two years ago, and await the day that we can write them off for tax purposes too. Any capital return would be a welcome and most unexpected surprise. We’ll report further as Westfield cost base spreadsheet updated the unwinding process concludes, but there isn’t much to say at this Hi Nathan, Thanks for the article on the WDC/WRT split stage unfortunately. on Friday 10/6—I’ve been waiting for something like this to understand how to treat it. However, there seems to be a problem with the spreadsheet linked in the article. There don’t appear to Metcash’s weak cash flow be any formulas in the spreadsheet cells. It’s not changing the In your update of Metcash you fail to mention the big drop in Table 2 values when entering price and date for example. Also, cash flow which was in my opinion the most noteworthy item. the cell references in the article are different to those in the Does the cash flow drop change the recommendation in any way? spreadsheet—C2, C3 and C4 for example are E7, E8 and E9 in 15 Jun 2011—James Greenhalgh: At the results presentation, the spreadsheet. I’m using Excel 2010 if that makes a difference? there was some attention given to Metcash’s weaker operating cash Thanks Darryl. Darryl W flow by the company and analysts. Management explained that the 14 Jun 2011—Nathan Bell, CFA: Hi Darryl. Thanks for pointing this timing of Easter meant they needed to have more invested in inventory out. The original spreadsheet was uploaded with hard coded figures near year end (and that $97m of this stock had been reduced post instead of the formulas. It has been corrected now and I’ve changed year-end). More importantly, consumers were now buying a lot more the cell references in the review (I forgot that the sexy version of the groceries on promotion, and it was essential that they be in stock spreadsheet adds a couple of columns to improve its appearance). for this. This makes some sense, but it will be worthwhile watching. Thanks again Darryl. Cash flow does tend to swing around a bit for retailers and wholesalers. I remember analysts quizzing Wesfarmers about this regarding Coles a few years back, and management saying that a Dissatisfaction with Souls Private Equity matter of a few days could see it swing by hundreds of millions of In spite of your Sell recommendation on SOE, I can’t bring dollars. Obviously Metcash is smaller, but cash flow can be more myself to pull the trigger given the >50% discount to NTA, of variable than what you might think, especially around certain times which roughly a quarter is in big listed stocks. I have voiced my of the year. dissatisfaction with the manager through the company website, I noted it and will be watching for any reversal in the next set of and have included the text of that message below in case you results, but it doesn’t cause me great concern at the moment. There would be willing to post it here and encourage other ailing is therefore no change to the recommendation. shareholders to do the same. I have held SOE stock since…. Since that time, the investment manager’s performance has been unacceptable, irrespective of the economic conditions. US muni bond market While the manager takes 1.75% of the ever dwindling FUM as I’m hearing increasing amounts of chatter from the US that a reward for this underperformance, shareholders are lumped the bond market is about to go belly up with many towns, with a persistent and widening discount of the stock price to and even whole states, about to declare themselves bankrupt. NTA. Some reparative action is long overdue. At a minimum, the Consequently all their bonds on issue will become worthless. If management fee must be waived. A liquidation of the portfolio this scenario comes to pass what effect will it have both globally would be preferred. Damon B and on the Australian share market? Paul D 15 Jun 2011—Gareth Brown: Having made similar arguments 15 Jun 2011—Gareth Brown: There are smart people on both about MMC Contrarian, Wilson Investment Fund and others, I sides of this debate, and I can’t add anything to that debate. I have understand your frustration Damon, and congratulate you for no idea what the wider consequences a muni bond market blow sharing your concerns with management. Let us know if you get up would be. Theoretically, problems in market A are only likely to back anything of note. I’ve reprinted your email for the benefit of other spread to market B when there’s already an imbalance in B (i.e., the

13 The Intelligent Investor

sub prime meltdown exposed problems in the wider debt markets, the subject of the AFL, people overseas can pay US$86/year to rather than caused them). We’re focused on the imbalances in the see every AFL game through liveafl.tv, live or on demand replay, Australian economy, which make us exposed to external shocks, rather a way better deal than having to get Fox Footy! than trying to forecast which shock might cause troubles. 15 Jun 2011—Gareth Brown: Good feedback. There are certainly changes in this space, and the distributors (pay tv companies) face some big hurdles. It’s why I’m much more comfortable with the New CEO of Treasury Group content providers (the biggest part of News Corp’s business) than the A quick comment on Andrew McGill becoming CEO of Treasury distributors. But Murdoch obviously holds a different opinion, by bidding Group would be good please. I’ve googled etc but can’t find out for the remainder of BSkyB and now being a part of the Austar bid. too much about him but the announcement seems to read quite aggressive and not much else I just wonder if it may be time to go with TRG. Ray and Jane F DUET 15 Jun 2011—James Greenhalgh: Hi Ray and Jane. I’ve no Should I hold duet as I only invest for income because of particular comments on Treasury Group’s new CEO at this stage I’m my age? Ken J afraid. With new CEOs it is usually a case of waiting and seeing what 15 Jun 2011—Gareth Brown: Ultimately the decision rests with you their strategy is, which usually involves seeing them in action several Ken. But we’re not recommending members own Duet, as highlighted times at results presentations and the like. in this review last year. We prefer other infrastructure stocks, such as I presume you’re referring to the ’mergers and acquisitions’ Spark Infrastructure and, a little further up the risk scale, MAp Group. experience and, while that doesn’t inspire us either, clearly the board wants Treasury to diversify further. So far, the track record here has been reasonable, in spite of our concerns. In the end, though, it is the ups and downs of sharemarkets that Gold One not on the shortlist will drive Treasury’s valuation (and how well existing managers attract Question for Gaurav—I understand you were planning to funds under management). If you’re pessimistic about this, then that discuss some gold stocks in the forthcoming weeks. Wondering should be what drives your decision rather than a change of CEO in whether Gold One International (ASX code GDO) was on your my opinion. radar. There is currently an arbitrage opportunity that you may find interesting. A Chinese consortium has made an offer of 55 cents per share which is currently a 10% premium to the current Alternatives to pay TV share price of 50 cents. Peter J Hey guys, just listening to your podcast now regarding Austar 14 Jun 2011—Gaurav Sodhi: Hi Peter. I haven’t followed the and Foxtel, and you brought up the trend of watching more takeover, but I have taken a look at Gold One. South Africa is what streaming video instead of pay TV. I live in the US and have cut worries me. Cost inflation is rampant across the SA gold industry and cable and now stream all my TV. It’s much cheaper than cable, labour laws are particularly unfavourable. Gold One’s strategy is a good and with Netflix, iTunes and Amazon Video-on-Demand I can get one and they have done a reasonable job, but the risks are too high anything I want legally and cheaper than paying for cable, and to justify more interest. Unless there is an exceptional opportunity, it’s getting easier for the non-tech savvy consumer every year. On South Africa is an unattractive place to be mining.

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, ALL, ALZ, ARP, AVO, AWC, AWE, BBG, BER, CAH, CBA, 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, RNY, ROC, SDG, SDI, SFC, SGN, SGT, SHL, SKI, SRV, STW, TAP, TGP, TIM, TIMG, TRG, TRU, TWE, TWO, VMS, WBC, WDC, WHG and WRT. his is not a recommendation.