March Review Comments
Written by Tony Gray   
Thursday, 10 March 2011 11:27

Portfolio Valuation & Comment

Please find attached a copy of your portfolio as at the 28th of February.

Reporting Season & Australian Shares

Most listed companies during February reported first half results to the end of December 2010, with a minority reporting full year results.  The number of positive surprises was lower than average, although there were also few major negative surprises – this is partly a result of the continuous disclosure regime, where companies provide earlier updates.

Whilst many commentators and fund managers describe the market as historically cheap at 12.5 times earnings, this is in comparison to price earnings multiples over the past 15 years.  During this period sustained falls in inflation and interest resulted in higher than average returns from bonds, property and shares.  As such, investors were prepared to pay a premium share price for the higher growth.  This was a global phenomenon, so international shares also did quite well over this period.

In my opinion this era has passed and we are more likely to see either steady or rising inflation pressures over the longer term.  China is aiming for 13% per annum wage growth for the next 5 years, which means wages will be 80% higher by 2015.  Coupled with a likely increase in their currency, the exported deflation from China is last decade’s story.

During inflationary periods shares provide a good hedge, as earnings tend to rise as prices rise.  The rub is that share prices also tend to be cheaper relative to earnings, so we may go through a period where share prices rise less than earnings. 

Right now I see individual investment opportunities where dividend yields and sustainable earnings growth can reasonably generate low annual double digit returns.  Whether they are achieved in the short-term is another matter.  Whilst some investment is warranted now, I suspect we will see weakness between now and June this year – see my comments on the US and China below.

US Budget Deficit & The Money Lenders

The US Federal Reserve has been buying 70% of new bonds issued by Treasury or more than $1 trillion each year – helping to fund the $1.5 trillion US federal budget deficit (and if we include state deficits gets much worse).  Federal reserve money creation – called quantitative easing to mask the gravity of the situation has boosted US stock prices and transferred wealth from savers to financial institutions.

The music may well stop in June 2011 when the current round of quantitative easing ends and there may well not be approval for a third round following the triumph of republicans over democrats in recent congressional elections.  In order for US insurance companies, mutuals and investors to start buying US government bonds again and fund the deficit, bond interest rates will have to rise.  Bill Gross from Pimco expects a 1.5% rise in the bond interest rate may be necessary.  Apart from the impact on the US budget deficit, higher rates tend to depress the value of growth assets.

I suspect some reversal of the 40% rally by US stocks since June 2010 is underway.

China’s 2011-2015 5 Year Plan

China has set a growth target for their economy of 7% per annum for the next 5 years.  This is dramatically lower than the average growth rate of 11.2% over the past 5 years.  While the plan still involves plenty of capital expenditure, the slower rate of growth represents a moderation in demand against expectations.

Not too long ago Australian commentators were stating that a growth rate below 8% p.a. from China would devastate commodity prices and yet so far the reaction to the 7% target has been minimal!  Looking out to 2014, which seems to be a key date in terms of many new mining projects, then if metal demand rises in line with the Chinese economy, then 31% more iron ore, coal, copper etc will be demanded – a very simplistic analysis I realise.  So far so good – but how to reconcile this with Brazil’s expectation that iron ore production will increase by 100% by 2014!  Brazil is the second largest supplier of iron ore after Australia and there’s no shortage of iron ore expansion in Australia (Fortescue are aiming to triple production), let alone new sources of supply such as Africa.

Mining Boom Boom Boom…

I did some numbers on Sundance Resources earlier this week at the request of one client and the variance in valuation is huge.  The company is running their African iron ore project on the basis that prices will average US$102 per tonne and at this price they will generate a return of more than $40 per tonne over the life of the project.  So far so good – especially with iron ore prices closer to $200 per tonne.  On $200 per tonne Sundance will be trading at only 4 times earnings on full production from 2014 – a bargain surely.  However, last month ANZ forecast a 2013 iron ore price of US$80 per tonne due to increased supply.  At $80 per tonne Sundance is trading at 20 times earnings and hence the stock would be double a ‘reasonable’ price.  This huge variation in valuation is the dilemma faced by every investor or would be investor in mining stocks presently.  Almost all earnings and plenty of shareholders funds and borrowed money are being ploughed into new mines and expansion, with little capacity for dividends to flow.  Should commodity prices remain high, then the returns will be fabulous but when prices eventually fall, the losses will be extreme.


In contrast to the mining boom, energy stocks in Australia have been quite subdued.  This is surprising as the same dynamics driving metal prices (industrialisation of China and India) is resulting in growing demand for oil.  Whilst demand for oil in developed economies is now back to 1998 levels, emerging markets are seeing surging demand and now account for more total demand than the developed world – with no signs of slowing down.  Unlike metals though, there is a shortage of new oil supply projects.  This should see a more sustained rise than the boom bust cycle likely to occur with metals.

Unfortunately the large listed energy stocks in Australia produce much more gas – which does not have quite the same supply/demand dynamic.  They are all also undertaking major projects with additional revenue not properly flowing until 2012 (Woodside) or 2014+ (Origin, Oilsearch and Santos).  As such, they do not appear cheap on current short-term earnings.

All the same, I expect to see Australia will continue to be viewed as a strategically safe source of liquefied natural gas (LNG), especially in comparison to the other major gas province – Qatar in the Middle East.

Holding some energy exposure in portfolios is recommended despite the lower dividend yield, as an inflation hedge and also as a hedge against potentially higher oil prices triggering a fall in other growth assets.

Australian Interest Rates

Demand for credit in Australia has been weaker than expected, with fewer home loans being written, credit card growth the slowest for decades and business lending yet to pick up from depressed levels.  This has meant the banks do not need to raise as much money from depositors and hence term deposit rates have been softening lately.

Outside of the mining sector, the Australian economy is fragile and so any downturn in metal prices and deferral of projects could well see the Reserve Bank of Australia reverse their current ‘mildly restrictive’ interest rate policy.  That is, they may cut interest rates.  In this scenario, holding some longer dated term deposits will lessen the short-term impact on interest income.

For those using term deposits as part of their investment strategy, we are now placing more deposits out to 3, 4 and 5 years – in the knowledge that deposits maturing in the next 6, 12, 18 and 24 months will provide regular access to capital and can be used to take advantage of higher rates if I am wrong.


Reporting season has finished and I am still wading through many company results and comments.  I do work through a review schedule but if you would like to discuss your portfolio and planning position in the short-term, please contact me to arrange an appointment.

We are looking to recruit a trainee adviser – so if you know someone with an analytical mind, who pays attention to detail and has a passion for equities, then let me know.

Best wishes,

A.W. (Tony) Gray BCom, LLB, Dip FP, GDipAppFin, CFP, FFin, MAICD
Principal, TG Financial

Please treat the above comments as General Advice, with no action to occur until we have considered with reference to your financial position, needs and goals.


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