High Yielding Investments WARNING

Beware of advertisements for high yielding investments in the papers. We have received a number of inquiries from clients about such investments offering 9% or 10% per annum or even more.

Usually the offerings are made by smaller finance companies with familiar sounding names. Most of these companies are, no doubt, sound but investors should ask a number of questions before rushing headlong into such investments.

The most important point to remember is the relationship between risk and return. Higher return will nearly always mean higher risk, particularly in the fixed interest market.

One key consideration is whether the companies issuing the debentures are financially strong. Who owns them and who backs them? If you don’t know the name and the company is operating from small premises then chances are they are not financially strong and you should carefully consider this before you invest your money.

With interest rates being so low at this time and with banks willing to lend to just about anyone for any project, you have to ask yourself what type of security underlies a debenture that offers 9% per annum. In many cases the only way that they can offer high yields is because the companies re-lend funds to property developers or to more risky borrowers. High quality borrowers can still borrow at prime mortgage rates from mainstream banks so therefore these finance companies must be lending to less than prime borrowers.

When everything is going well such companies will collect their debts and repay debenture holders. However, when there is a property market slump or a general economic downturn, debenture holders may pay the price for faltering borrowers and could lose some or all of their capital. In such a case, is the finance company strong enough to cover any losses to investors or is the security primarily linked to the assets of the underlying borrowers?

It’s the usual story. If it sounds too good to be true it usually is. Unfortunately, the type of investors attracted to these investments are often those with low risk profiles that avoid shares or other higher risk investments. They are often attracted to the fixed rate return and don’t have a very good understanding of the real risks involved. It is important to beware and remember the return offered is only part of the story.

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What's your Style?

Does your share manager have style? Does it matter?
What style do they have?

Most investors these days understand the need for diversity. Investors can easily access many different investment managers with exposure to shares, property, fixed interest and cash. They also have investments in Australia and in many countries around the world. This kind of diversity is common even with most employees’ super accounts. It’s what a diversified portfolio offers.

Diversity reduces risk; right? But what about style? Should your portfolio have style diversity? What does it mean and how important is it?
There are a number of ways to view style. Three main types of share managers are Value, Growth and GARP.

Value Managers focus on price and are looking for stocks that are underpriced in the market place, due to short term influences. They will analyse a share, and determine what they believe is the right price for the share. They will buy quality underpriced stocks and wait for the price to increase in line with the stock’s true value. The stocks in a value portfolio will have low Price Earnings (P/E) Ratios and they won’t include many IT or start up companies that only show a prospect of future earnings.

Examples of value managers include Maple Brown Abbott, Investors Mutual and Perpetual.

Growth Managers rely less on price and are focused on investments that promise large amounts of capital growth over the longer term. They are not so concerned with the current price. They concentrate on earnings growth believing that this will deliver higher stock prices in the long run. The stocks held by these managers may be more expensive with higher P/E Ratios, high earnings per share growth and high return on equity. Examples of this style of manager include Colonial First State, Credit Suisse and J B Were.

GARP or Growth at a Reasonable Price managers lie somewhere between Value and growth managers. These managers look at the current price of a stock compared to its future earnings potential, rather than current earnings, and value the stock accordingly. Underpriced stocks based of this criteria will be included in the portfolio. ING and AMP are examples of GARP managers.

There are also Style Neutral managers that adopt a combination of all strategies. An example of this style of manager is UBS.

There are other ways to classify investment style. Managers can have a Top Down or Bottom Up style or a combination of both. These descriptions refer to the macro or micro bias that a manager may have in the way they select stocks.

A Bottom Up manager discounts the bigger issues such as economic or market cycles, interest rate movements, country or regional allocation. They look at individual companies and try to find those companies that represent good investments based on the firm’s competitive advantages, quality of management and strength of their balance sheets. For example, they may invest in a quality company making good profits in Japan even if the Japanese economy is widely believed to have major fundamental structural problems.

A Top Down manager would be less likely to buy such a stock because of the state of the Japanese economy. They look at the bigger macro issues first and then make the stock selections.

There are also Large Cap, Mid Cap and Small Cap funds. These categories relate less to style as to the size of the companies contained within the portfolio. Cap referring to capitalization, meaning the size of a company balance sheet. Smaller companies can be more volatile but can show good growth. The larger companies tend not to able to grow as well and are usually sought after more for stability and steady returns.

Investment Cycles and Investment Styles

Over the last 5 years there have been two distinct periods for share markets. In the late 1990’s and early 2000 Growth managers outperformed and even the quality value managers were in the doldrums. This was a period when growth potential was far more important than earnings. With the technology sector crash followed by September 11 and a continuation of bad news since, investors have taken comfort from the stocks that generate real earnings and nobody is buying optimistic stories about future growth. In this period the value managers have shone and have clearly outperformed.

Similarly, small cap funds tend to do better in times of optimism and the larger funds are favoured during downturns and times of uncertainty.

The graph compares the performance of the Credit Suisse Australian Share Fund (Growth) with the Maple Brown Abbott Australian Share Fund (Value) over 5 years. The line through the middle shows the performance of a portfolio with equal weighting in each fund. This evidences the benefits of diversity. i.e. Less volatility; more stable returns.

It is not always as obvious as it has been over the last 5 years but there is one clear message that does emerge. You can reduce your volatility and minimize the risk of loss substantially by ensuring that you diversify between the different investment styles.

Your financial adviser will usually take these factors into account when making recommendations.

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Market Commentry

The last quarter has finally seen a rebound in share markets across the Globe. This is a welcome relief for investors. The rebound has been quite strong with the S&P 500 Index in the US rising over 20% from its lows in mid March and the Australian All Ords rising over 10% in the same period.

There is emerging evidence that the all important US economy is recovering. Manufacturing has started to expand as has consumer sentiment. There is a wide view that growth rate of the US economy could reach an annualised rate of 3-4% over the second half of the year. However, recent rises in unemployment show how mixed the economic indicators are.

Recent events include the further lowering of interest rates in the US. The historically low rates are a stimulant to the economy together with recent tax cuts and the sharp falls in the US dollar.

In Europe, analysts are less optimistic. Many economies in the European Union are close to recession and the high Euro is exacerbating this problem. A recent lowering of interest rates in June is of assistance but there continues to be more structural work to be done to assist a strong European recovery.

Japan has very recently shown some signs of life with business confidence rising in June. This is evidenced by an increase in machine orders and industrial production which has led to interest rates rises. Investors are positioning themselves for a bounce in growth throughout the Asia region.

In Australia, the Reserve bank failed to lower interest rates citing a pick up in world growth prospects. A further reduction would have fuelled the already overheated property market. Economic growth is expected to be hampered by residual effects from the drought, the high Australian dollar and expected pull back in the property market.
The very recent drop of 3 cents in the Australian dollar against the Greenback is a sign of changing global sentiment and this could see a shift of funds from the Australian safe haven sharemarket to better growth prospects in the US and Asia.

In summary there are cautious signs of a global recovery particularly in the US and Asia. The Australian economy is expected to be subdued. The property sector, including the property trust sector, is expected to turn following a long period of growth. Record low interest rates are set to rise if global and local growth takes off. This makes investment in the bond market very tricky as rising interest rates can lead to capital losses in bond funds.

It is particularly important in times like this to be careful in stock selection as quality will stand out. It is much easier for average stocks or funds to ride a booming market than a cautious one.

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Staff Developments

We are pleased to announce that Jade Khao has taken on the role of Financial Planner having completed her Foundation Diploma of Financial Planning. Jade has a Bachelor of Business majoring in Finance and IT from University of Technology Sydney. Jade recently moved from the role of Paraplanner and is presently studying towards achieving her Certified Financial Planner status.

Our new Paraplanner is Myle Pham. Myle has recently joined Financial Keys. Myle spent two and a half years with Zurich Financial Services and was most recently Technical Support Officer. She has a Bachelor of Commerce majoring in Finance and a Bachelor of Science with a major in Mathematics both from the University of NSW.

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