Why GOOD BUSINESSES can be Cheap

The IOOF Perennial Value Shares Trust has been a consistently well rated, top performing Australian share fund. Average 3 year performance for the fund to September 2004 was 17.37% p.a., outperforming the S & P/ASX 300 Accumulation Index by 6.42% p.a. John Murray, portfolio manager of the trust, gives an insight into how Perennial identifies good businesses at cheap prices.

“Perennial Value’s investment process is about finding cheap stocks that are good businesses. The thinking behind this is that investors are more likely to re-rate a good business and boost its share price. But why would a good business be cheap? The answer traces to the central belief of active share management; that share markets are imperfect. Listed here are seven - sometimes interrelated - reasons why good businesses can be undervalued. In no particular order, they are:

1. Delay in spotting a business has improved
The fortunes of most companies wax and wane. When things get bad enough, steps are often taken to fix the problems. Whatever the remedies, businesses often turn around well before their stock prices do. The fund managers that first pick that a business has improved stand to benefit if, as most likely, its shares subsequently rise. Boral Ltd. is one business that has revamped. New management arrived with the demerger from Origin Energy in 2000 when the shares were around $2. Costs were cut, non-core businesses sold and a culture of rewarding profitable growth installed. The building-materials company was well placed when concrete and other key product prices rose. Boral shares topped $7 in 2004.

2. Effect of big institutions selling
Large institutions can move the share prices of companies when they go overweight or underweight – sometimes so much that the stock price strays from “fair value”. Harvey Norman Holdings Ltd. provides an example. In early March 2003, when doubts existed about the retailer’s exposure to property, a big institution lowered its 20% stake when the shares were just under $2.30. The selling drove down the shares towards $1.90 within weeks. Eight months later, Harvey Norman shares had rebounded to as high as $3.40.

3. Forced sales
Whatever the item, when people must sell they often accept a lower price than otherwise. It happens on share markets all the time. One forced sale was the listing of insurer Promina Group Ltd. in May last year. Its owner, Royal Sun Alliance of the UK, was financially stretched by the woes plaguing British insurers. Promina was listed cheaply at $1.80. The shares had jumped to $4.53 by 30 September this year.

4. Industry out of favour
For various reasons, share markets can turn against industries. Bad news might just mount up. The coal industry was shunned for a long time because coal prices stagnated. Emotional overreactions to a disaster can turn investors off an industry. Airlines were untouchable after September 11 because of concerns about repeat incidents and insurance coverage. Or the share market might get hyped up about one industry and overlook others. Recall the unpopularity of “old-economy” industries such as basic materials during the recent technology bubble.

5. Reliance on earnings revisions
Many share investors run processes where earnings revisions play a major role in buy-and-sell decisions. Accordingly, stock prices tend to overreact to earnings upgrades or downgrades. In 2003, the successful diversified company Wesfarmers Ltd. said the drought would hamper profit growth. Downward earnings revisions saw the stock price fall about 30% within weeks, a rate Perennial Value viewed as too steep for such a good business. It was no surprise that Wesfarmers shares quickly recovered.

6. Role emotion plays
Share prices are set by more than rational analysis. The irrational element of emotion – read fear and greed – plays a big role too. Emotional reactions often explain why markets deviate from “fair value”. Markets often react more emotionally to bad news than they do to good. This asymmetric reaction can leave stocks undervalued.
A case of fear undermining a stock is when Qantas Airways Ltd. shares fell about 25% in 2003 as the SARS virus spread around Asia. Qantas’ earnings were healthy and there was no evidence SARS would be a catastrophe.

7. Market knowledge gaps
Markets sometimes misjudge companies for a variety of reasons, underrating some and overrating others. One that was under-appreciated was Metcash Trading Ltd., a distributor for independent supermarkets in the eastern states. Most fund managers are Sydney-based and many think independent supermarkets are corner stores. Yet in Victoria and South Australia, there are independent supermarkets of the highest standard. Without visiting independent supermarkets outside New South Wales, Sydney-based analysts and fund managers wrongly assumed Metcash would struggle. In conclusion, there are many reasons why good businesses can be cheap and this list doesn’t claim to be exhaustive. Perennial Value believes value managers are often best placed to spot that a good business is undervalued because they are the most focussed on cheap stocks.”
John Murray IOOF/Perennial

John Murray IOOF/Perennial

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Holiday Homes – THE GREAT AUSTRALIAN DREAM

Many Australians aspire to owning a holiday home somewhere up or down the coast or set back in mountain retreats. Investors have been creative in their endeavours to achieve this dream using DIY super fund money and/or borrowed funds claiming interest and costs as deductions against meagre rental incomes.

For many the holiday home is a family tradition spanning generations and the benefits cannot be
measured in financial terms alone. Here are some issues to consider before joining the summer holiday queue at the beachside estate agent’s office.

Lifestyle or Investment Decision – Understand Your Motives
It is important for investors to break down the motives for their decisions and understand what is driving them. Often people buy a holiday home for lifestyle reasons but justify their decision on a belief that they have made a good investment decision.

Those least likely to be disappointed are the ones who purchase the property for personal use and enjoyment. The property will probably not be let, being well furnished and maintained for their own use. They are willing to give up income and some growth to enjoy the personal benefits and they will buy a property in a place where they want to spend time.

Others seeking an investment return can end up disappointed with the outcome. It is important not to get your motives mixed up.

Set Up a DIY Super Fund to Buy a Holiday Home
Despite the many rumours you hear it is illegal to use your super fund to buy a holiday home for your own use. The in-house assets restriction and the sole purpose test specifically exclude this.

Flexibility
Holiday homes can be quite restrictive. If you have hundreds of thousand of dollars invested in a holiday home you may want to think twice about going anywhere else for your holidays. This can potentially limit your holiday choices.

Maintenance
The good thing about going to a resort or someone else’s holiday home is that you don’t have to worry about the ongoing maintenance of the property. For many there’s enough work to be done maintaining one home without going on holidays to maintain another. You can pay for all the ongoing repairs but this further erodes the rental returns.

Rental Yield
The rental yield on holiday homes can be very low.
This is because it is often hard to let a property out of season. In-season holiday lettings are high turnover and high maintenance resulting in high agent’s fees and ongoing maintenance costs. In addition this is the time you probably want to use the property yourself.

Investment Return
Growth rates can be volatile in holiday areas. There have been some spectacular examples of growth such as Byron Bay and Noosa and some very poor examples where prices have hardly moved for years. In other examples prices fluctuate dramatically.

It is important to make comparisons. Where else could you invest your money? How have the Sydney or Melbourne property markets compared with your chosen place? Looking forward, what will property values do with the predicted continued downward trend? Would you get a better return from shares or managed funds?

Liquidity
You can’t sell the lounge room to pay for your children’s school fees. Nor can you sell the house overnight if you need the money urgently. You can however sell some or all of your share portfolio in a matter of days.

Retirement Option
Some people buy a property because they might like to retire there in the future, yet they may receive a far greater return in the interim investing elsewhere. They may also change their mind or circumstances.

The Costs of Getting it Wrong
Transaction costs are high. If you find you’ve made a mistake it can cost a lot of time and money to sell your property. It can be an expensive mistake.

Conclusion
Holiday homes can be a wonderful investment in your lifestyle and your family life but as an investment there are usually better options.

Andrew Condell


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MARKET Commentary

The global expansion continues at a slower rate than many experts were expecting earlier in the year. Increases in oil prices are having a dampening effect on growth. Oil price increases have been attributed to a combination of concerns including Iraq, the recent unrest in Nigeria, problems with Yukos, Russia’s largest oil producer and the recent hurricanes in the Gulf of Mexico.

The US Federal Reserve, has indicated that the “soft patch” the US economy was experiencing, appears to be temporary and that “US expansion was gaining some traction”.

The US S&P 500 and Dow Jones share indexes have fallen recently as a result of disappointing company earnings reports, and rising oil prices. In Europe, growth remains slow as evidenced in the subdued stock market performances. Highlights were the metals and mining sector listings on the London exchange.

China however continues to grow despite recent policy changes aimed at slowing the rate of growth. The best performing market in the Asia region was India with 16% growth followed by Indonesia which was up 12% following the election of Susilo Bambang Yudhoyono. Japan has had a poor quarter with an 11% drop in the MSCI Japan index, showing Japans susceptibility to negative factors. Thailand and Taiwan remained flat.

The Australian sharemarket continues to reach new records with unemployment and inflation statistics at very respectable levels. The strength of the Australian economy is due to strong exports, consumer and business investment spending, combined with global (particularly regional) economic growth. This is underpinning the local sharemarket.

Australian resource stocks continue to perform well on the back of the continued growth in commodity markets. Overall the Australian sharemarket has outperformed most markets in the world over the past 12 months. For the year to 30 September, the ASX 300 has gained 15%, well in excess of most overseas economies including the majors - the UK, Japan and the US.

Brendan Gallagher and Andrew Condell

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Australians UNDERINSURED

Many Australians are unaware of the consequences or risks of being underinsured. Recent research conducted by DEXX&R research group shows the average level of life cover needed for an Australian is $545,000, while the current average cover is $148,000, only 29% of the level they require. For income protection (or salary continuance) cover the evidence is similarly disturbing with the average cover for an Australian being 23% of that required.

The research, drawn from Reserve Bank and the Australian Bureau of Statistics data, is a call to action for many to review their insurance levels to ensure they or their loved ones do not experience financial hardship if the unexpected occurs.

What to Consider
The adequate level of insurance cover will be dependant on the circumstances and needs of an individual and their family, however as a rule of thumb, life insurance cover should be sufficient to:-

• Pay-out any debt such as mortgages and personal loans
• Provide income replacement
• Cover the additional costs such as child care and/or home duties
• Pay for rehabilitation or home modifications as a result of disabilities

Cover for Your Mortgage
An important and large part of this equation is the outstanding debt component. Due to the incredible housing boom in Australia over the past decade, home mortgages have increased dramatically. It is a common misconception that mortgage insurance covers you in the case of default – this is not true. Mortgage insurance is usually required to be taken out when your mortgage exceeds 80% of the value of your property. Mortgage insurance provides cover for the lender.

Should you die or be disabled and there is no means of repaying the mortgage, the lender can sell your house to repay the outstanding mortgage. If the value of house is insufficient, the mortgage insurance will cover the difference. You do not receive the proceeds for the mortgage insurance.

If you have insufficient life insurance, a forced sale of the family home can be a harsh consequence.

Changing Circumstances
Another aspect that is important when looking at sufficient insurance cover is ensuring it is kept up to date. If you have recently bought a new home; or taken out a loan to renovate your home; been married; or had children, there’s a good chance you will need to increase your cover. Alternatively if your mortgage is paid off and the kids have left the nest you can most likely reduce the level of cover you have.

Your life cover needs to be kept up to date with your changing circumstances and changing needs.

Protecting Your Income
Income protection insurance provides replacement income in the event that you are disabled and unable to work. The rule of thumb for the adequate level of cover is that insurance be provided for 75% of income. This type of cover is sometimes provided by the employer either inside your superannuation fund or outside. Cover within the super environment is usually inadequate as it only provides up to 2 years of income replacement. This type of cover should be supplemented with cover outside super with a 2 year waiting period.

Check Your Cover
So while many of us understand the need for sufficient insurance cover, it is often something we tend to neglect until it’s too late. It’s often just too hard or time consuming.

The best way to ensure you have sufficient cover is to call us and have your insurances reviewed. We will look at the existing cover you have and calculate your needs based on your cost of living, mortgage levels, children and other factors identified above.

If you are underinsured we will prepare quotes, arrange medicals and handle all the paper work. We can take the hassle out of the process so that you can rest easy.

Brendan Gallagher

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