September 2011 Review Comments
Written by Tony Gray   
Friday, 16 September 2011 16:24

Portfolio Valuation & Comment 

Bond markets are pricing in recession and deflation in the US and Europe, with Greece almost a certainty to default on their sovereign debt.  As widely publicised, the risk is contagion with the market focus likely to shift to Italy, Ireland, Spain and Portugal.  The other risk is a major loss by European banks as so far they have not written down the value of their Greek bonds.  Germany appears ready to recapitalise their banks, but can they cope with write-downs of other sovereign debt?

Perversely, this is seeing a flight to $US as a safe haven, despite the dire financial position of the US Government.  Commodity prices are finally starting to fall, with very sharp falls a possibility, much as occurred in mid 2008 – when commodity market finally accepted the reality of the global financial crisis that credit markets had been factoring.

All very well, but what to do?

Cash & Fixed Interest

A safe haven in the short-term, but with cash rates likely to fall.  For those reliant on income to fund living expenses/pensions, the risk is a protracted fall in at-call and term deposit rates.  For this reason we caution against holding too high a proportion in short-dated term deposits.

Some exposure to longer dated term deposits reduces the risk of significant and protracted interest rate cuts – as has occurred in most other developed economies.  Term deposits have declined sharply in the past 6 weeks, but are still worth considering.

The government has reduced the guarantee on deposits to $250,000 from $1 million, but with no time limit (existing deposits of up to $1 million are guaranteed until the end of 2012).  We take this into account when recommending re-investment terms for deposits.

Whilst we can arrange direct purchases of government bonds, rates are well below those available from term deposits.  We prefer some exposure to inflation linked bonds and remain positive on Aberdeen’s Inflation Linked Bond Fund.

International Shares/Investment

The risk/return from investing funds in this asset class is unclear at present.  On the one hand a fall in the $A is likely to accompany any falls in commodity prices and benefit international shares.  On the other hand, international shares could still fall significantly from current levels.

Emerging markets are highly correlated with Australia (emphasis on banks and materials) and tend to be high beta - meaning they will fall further/recovery further than local shares.

On balance, we are not applying significant new funds to international assets at this time – but will continue to monitor as we also believe the political and economic outlook for Australia makes it prudent to add international assets.


As noted some time ago, we have doubts about the value of residential property in Australia.  It’s interesting to note that non-residential property has performed quite well in the US even while house prices fell sharply.  It appears that the higher income yield made this sector attractive as interest rates fell.  In fact listed property was recently trading at a 20% premium to asset backing – the reverse of the current situation in Australia!

My expectation is that if interest rates fall in Australia and we see a flight to safety out of Europe, then a move into office, industrial and retail property in Australia may well occur.  Ultra low interest rates overseas and the high rental yields on offer in Australia may well see a burst of takeover activity (it has already begun).

We favour the following trusts at current prices (or subject to modest price falls in some cases):

* BWP (Bunnings Warehouse Property Fund) – industrial property
* Commonwealth Property Office Fund – office property
* Dexus Property Group – office property + management and US industrial property
* Westfield Retail Trust – Australian and New Zealand shopping centres
* Australian Education Trust - child care centres (non-core allocation).

The above trusts trade at sizeable discounts to asset backing, have low to moderate level of debt (Australian Education Trust has the highest gearing level at 40%) and distribute high income yields.  Apart from ~17% of the Dexus portfolio, all assets are in Australia or New Zealand.

Australian Shares

We are wary of the risks to the banking sector from European credit markets/sovereign debt issues/bank solvency – despite high income yields.  With other sectors also low, it is reasonable to lighten overweight exposure to the sector or individual holdings.

Mining stocks and mining service companies remain a key risk – being very sensitive to falls in metal prices.  This is a short-term view as I am becoming more comfortable with commodity prices remaining well above historic averages.  This will not necessarily prevent sharp falls – but the lows of 2008 are not sustainable – there is too many higher cost suppliers that will cease production.

The rate of industrialisation in China must slow as that economy transitions away from industrial production – this means a slower increase in demand for minerals, not a decline.  Any sharp falls in mining stocks present an opportunity to add stocks – BHP Billiton and Rio Tinto are predictably our preferred exposure.  Right now though, this sector is a key underweight.

Alumina Corp is a perennial takeover target.  They are a low cost producer of bauxite, the share price is down 40% and debt is low with a gearing level of circa 10%.  A dividend yield of over 5% fully franked is expected for the full year, so the ~7% gross yield exceeds that from term deposits.  At $1.50 we expect a share price of at least $2.50 would be required for Alcoa to successfully buy-out Alumina Corp for the 40% of the AWAC joint venture they don’t already own.  With low US interest rates, a takeover should be strongly earnings accretive for Alcoa.

We prefer companies generating good cash-flow and a healthy return on equity.  Dividend yields generate the largest proportion of long-term returns, so they are a focus also.
A few stocks we are comfortable with in light of results and pricing are as follow:

Core Stock                                               Non-Core Stock

Alumina Corp                                                Metcash Holdings
Telstra Corp                                                 Cabcharge
QBE Insurance                                    
Toll Holdings                                                 Incitec Pivot
Woolworths Limited                                      The Rock (MyState)
Woodside Petroleum                                     ConnectEast (takeover arbitrage)
There are a large number of stocks of interest, where we hope to see the down-trend broken or lower prices to achieve ‘bargain’ levels.  Examples include AMP, Worley Parsons, Monadelphous, Harvey Norman Wesfarmers, Computershare, ASX, Tatts Group, IOOF, ARB Corp, iiNet, M2 Telecommunication, Talent2 International, Resmed and Cochlear.


It appears to me that gold has become too popular and that the bubble has expanded.  It has proven to be a very good hedge against falls in other growth assets.   Whilst I am not yet prepared to recommend a complete exit, I feel it is prudent to sell half of GOLD (exchange traded fund) holdings.

Depending on portfolio holdings, some lightening or exit of junior gold producers may be justified.  At this stage I am content retaining Newcrest Mining in light of the full year result and production profile.


I encourage all investors to contact me with any queries in relation to portfolios.  There were not too many nasty surprises during reporting season, but growth expectations are still being wound back.  Overseas issues are ‘real’ and we are still advocating a cautious stance – but applying some cash reserves to longer dated deposits and select additional share and property exposures.

As always, please contact me if you have any investment or planning queries.

Best wishes,

A.W. (Tony) Gray BCom, LLB, Dip FP, GDipAppFin, CFP, FFin
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.

Last Updated on Friday, 16 September 2011 16:34

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