This is our last market wrap for the year. It’s certainly indicative of the year just gone that our market had yet another up week last week, with the S&P/ASX 200 edging very close to the unprecedented 4000 mark. The index closed the week at 3988, with resource stocks again leading the way. A huge rise in the contract price for coking coal for next year saw coal stocks enjoy a good week, with our own Centennial Coal (CEY) moved from $3.83 early in the week to $4.11 at the end. And with market commentators looking ahead to 2005, the consensus seems to be that whilst the market may cool off a little, resources are well placed to continue their stellar run and commodity prices appear, based on fundamentals, set to move upwards in the New Year.
This week in the US, the Federal Reserve unsurprisingly lifted interest rates for the fifth consecutive time to 2.25%. As is often the case, just when global commentary had unanimously become bearish on the ailing $USD, the tide started to turn. The $USD is off its lows at present, which is great news for our exporters. The $AUD, which reached just short of US80c, is now back around the US75c mark, and the $USD has also strengthened against the yen and the euro. And although President Bush will continue to let the market decide the value of the $USD, he has pledged to attend to the US’s huge trade and budget deficits in an attempt to assist the $USD in strengthening.
In other US news, retail sales have been very robust going into the holiday season. This strong consumer spending, along with solid employment figures, is helping to sustain economic growth despite rising interest rates and high oil prices.
So what then is the outlook for our market looking ahead to 2005? Broadly speaking, we remain bullish. Corporate profits are healthy, global demand for commodities is growing strongly, interest rates are accommodative, the lacklustre property market has pushed more investors towards the equities asset class and the US looks likely to continue setting a rather positive tone for our market to follow.
MACQUARIE INFRASTRUCTURE GROUP (MIG)
ASX code MIG Div yield 1.87% Market Cap 7,767,132,111 Risk med NTA $2.16 Term med 12-month high/low $4.03/$2.71 Closing price $4.01 Forward P/E ratio 21.28 Recommendation Buy around $3.80 / Hold % of holdings 5.00% Original rec 11/10/2004 - Bought around $3.80
With MIG set to go ex a 63.75c distribution on Thursday, Virtually Live listeners tuned into a recommendation last week that we issued on the situation – a recommendation we feel is worth reiterating and explaining here.
The recommendation involved an option strategy. We are aware that options are too complex for many subscribers, and we feel that those subscribers should steer clear of the strategy, but for those who do understand it, we feel this is an interesting little arbitrage. As the stock is likely to lose the 63.75c it is paying on Thursday, we feel the December $3.75 call options (which expire on the ex date) are priced with the expectation that they will be exercised before the stock loses the distribution. The only other liquid option series are the February and May $3.75 call options, and we feel that these two options are over-priced regardless of whether they are exercised before the distribution or not.
With MIG trading at $3.98, the February call options are trading at 28c and the May call options are trading at 38c. Assuming MIG remains unchanged until it goes ex, then the stock is likely to trade around $3.34 on Thursday. That means that for those investors buying these options from us, the options need to be exercised before Thursday or MIG needs to go up 12% within 2 months for the February options or within 5 months for the May options.
Either way, this is a good scenario for subscribers. If the options are exercised by Thursday, we have essentially locked in a sale price of $4.03 (for the February sold call options) or $4.13 (for the May sold call options). We can then, if we choose to, re-enter MIG after it has lost the distribution, and pocket the extra 5c or 15c we have made from selling the call options. And if our sold call options have not been exercised, then we essentially have a further 28c or 38c in our wallets, with further upside up to $3.75.
The major downside in this strategy is if MIG goes down further after it sheds the distribution, but this is a risk whether we implement this strategy or not, and we remain bullish on the stock regardless. The only other downside is that we have essentially limited our upside to $3.75 (by February or May), but even this carries the compensation of the premium available today.
All in all, we feel this is an excellent strategy to take advantage of the current situation, and as such we recommend that subscribers who own MIG should sell either the $3.75 February call options around 28c or the $3.75 May call options around 38c. Subscribers should sell 1 call option contract for every 1000 MIG shares held.
AMCOR LTD (AMC)
ASX code AMC Div yield 4.74% Market Cap 6,307,666,638 Risk med NTA $2.52 Term med/long 12-month high/low $8.34/$6.51 Closing price $7.17 Forward P/E ratio 11.51 Recommendation Hold % of holdings 5.00% Original rec 08/12/2004 - Bought around $6.75
AMC has been looking very strong since its massive slide several weeks ago, despite the continued negative press. The company has said that it has retained the services of an executive recruitment firm to find a replacement for deposed chief executive Russell Jones. As we have said, an appointment should remove a lot of the uncertainty pervading the stock, so we await this eagerly.
In addition, and just as important, the company stated that previous profit guidance was unchanged, and it remains to be seen what kind of fine (if any) the company will receive from the ACCC. Indeed, given the pre-emptive strike made by AMC’s Board, we think the ACCC needs to be careful how it handles this situation. On the one hand, cartel activity needs to be discouraged and a clear signal given that it is not to be tolerated. On the other hand, the ACCC may must also be seen to be recognising how well AMC has handled the situation and so encourage other companies to follow such course of action in such situations. So, certainly at this stage, we continue to feel that the initial sell-off which we took advantage of looks an over-reaction and we expect that as time goes on that the stock will increasingly return to favour. In terms of those subscribers wishing to buy the stock, unfortunately it looks like it may not return to lower levels, and we are not inclined to chase the stock at this price.
STOCKS TO BUY
Coming to the end of the year, we have had numerous subscribers calling to ask which stocks they are able to buy. While the market has remained strong, and many of our recommendations are above our buy limits, there are several stocks we are happy for our subscribers to buy at current levels.
These stocks include Brambles Industries Ltd (BIL) at up to $7.00, Burns, Philp & Co Ltd (BPC) at around 83c, Centennial Coal Company Ltd (CEY) at around $4.10 and Global Mining Investments Ltd (GMI) at around $1.00. However, please remember that there is nothing wrong with holding cash, and the wise investor should wait for opportunities that suit them, not just wait for when they have capital available.
MMC CONTRARIAN LTD (MMA)
ASX code MMA Div yield 0.95% Market Cap 212,626,978 Risk low NTA $1.15 Term med/long 12-month high/low $1.10/91c Closing price $1.05 Forward P/E ratio 77.21 Recommendation Hold % of holdings 10.00% Original rec 11/12/03 - Bought through float
MMA last week released its NTA for the month of November, and the post tax NTA is now 106.7c. Given the expected option exercise next year, we should start diluting NTA for (expected) option exercise, which gives us an NTA of 103.5c. At the current price of $1.06, the small premium to NTA probably reflects many investors positive view of the MMC-HGL investment team.
MMA remains only 45% invested due to the lack of attractive, contrarian style investments in the market. The rest is in cash or cash equivalents. This absolute, capital preservation focus is a potential hindrance to performance in a strongly rising market, but we are very happy with this approach over the long run. This investment team has a very good long-term track record and we see no reason for that to change at the moment.
MMA remains a hold for long-term investors or a buy for those who want a long-term, low-risk investment. Members of the investment team own shares in MMA.
HIGHLANDS PACIFIC LTD (HIG)
ASX code HIG Div yield 0.00% Market Cap 192,991,861 Risk high NTA $0.00 Term med/long 12-month high/low 60c/35c Closing price 46c Forward P/E ratio -66.67 Recommendation Hold % of holdings 3.00% Original rec 03/06/02 - Bought up to 35c
After seeing highs of 50c in the last month and indeed, 60c last year, HIG has been languishing at around the 42c mark. The share price decline hasn’t been due to anything fundamental (in fact, with the gold price as strong as it is, the fundamentals look potentially better than six months ago), but rather a sentiment driven slide based on the absence of anything to get excited about. Stocks like HIG tend to be very announcement-driven and can often drift when there has been little news.
Well, as if to prove this theory yet again, the company announced on Friday that recent drilling at the Kora deposit in PNG (located approximately 1km south of the Kainantu deposit that HIG holders will already be familiar with) has confirmed gold bearing lodes on strike. This means there is an excellent prospect of additional gold discoveries over the untested area between the two deposits. Previous drilling at Kora had inferred a resource containing 310,000 tonnes, but it now appears as though this figure will be significantly boosted! And the share price jumped some 15% on the back of this news in one day!
This is obviously further good news for HIG and for all subscribers who own stock in this company. We have liked this company for some time based on its prospects, but as we have said before, this company is a high-risk investment. It carries sovereign risk (as it is located in PNG) and while it is incredibly asset rich in terms of what is in the ground, that’s a different kettle of fish compared to actually turning those resources into profitable production and sales.
Bearing this in mind, we still like this company and our expectation is for metal prices to remain strong, which will obviously be important given HIG’s gold and nickel mining projects. So, although we reiterate HIG as a hold and welcome this week’s further good news, this company’s share price may go through further sustained periods of little price appreciation and even some downwards drifting. For the patient holder, we do feel there is plenty of upside left in HIG and as it progresses with its projects, the stock will continue to appreciate… but not in a straight line! We want to be sure subscribers holding HIG are fully aware of the style of investment this is – a high-risk, volatile one. We still like it and so we reiterate that this one is worth holding in our view. Stay tuned…
INTERNATIONAL WINE INVESTMENT FUND (IWI)
ASX code IWI Div yield 4.85% Market Cap 131,407,305 Risk med NTA $2.62 Term med 12-month high/low $2.08/$1.80 Closing price $2.06 Forward P/E ratio 26.28 Recommendation Hold % of holdings 5.00% Original rec 20/01/03 - Bought around $3.05 (cum $1.065 return)
Last week was a big one for information flow from the usually quiet IWI. The company announced a six monthly distribution of 4.5c per unit. The stock will go ex this payment on Thursday 23 December but will not actually pay out the distribution until 25 February next year.
The NTA as at the end of November was $2.62. No reference was made to “post tax”, so we must assume this is a pre tax figure. We are not comfortable with the release of this figure like this. Other LICs provide both a pre and post tax figure.
The stock remains at a substantial discount to NTA, reflecting the market’s general discomfort with management and perhaps the sector. Finally, IWI also announced its expected and overdue proposed restructuring. There are several strategies being pursued: 1) The management company (Berren) of the trust is being bought by the trust and will be stapled to the trust units (this is consistent with the current market trend). 2) The trust is also buying a small US based, corporate advisory company that is supposed to provide corporate services to players in the wine sector. This company has been closely associated with IWI for some time. We find it hard to see how this adds any value. 3) A new CEO, Mr Ian Macoun, has been appointed. He has been in the funds management industry for many years. 4) The company wants to remove the limitations that stop it investing more than 20% of its capital overseas. Its current shareholding (25% of total assets) in Constellation is exempt. This will free the company up to have an even greater global focus. 5) Management has also proposed an off market buy back at a small premium to a share price that has not as yet been set. It is unlikely to be significantly above the current price.
Overall, some of the restructuring proposal makes sense. However, this investment has not done well for subscribers, so we are sceptical about things changing dramatically. We remain of the view that unitholders’ interests would be best served by a wind up, but we are not particularly confident that this will happen, despite it being the goal of some shareholders.
We will have a closer look at the information memorandum when it is released in a few weeks time and update you, but for the moment, the stock remains a hold (at $2.07) but not a buy for non-holders.
There has been an additional announcement post the information above. The company has requested a trading halt due to a large stake in the stock being put up for sale. We will just have to wait and see exactly what is happening here, but we doubt that this stake being sold will have a material impact on the value of the IWI units and therefore the market price.
BURNS, PHILP & CO LTD (BPC)
ASX code BPC Div yield .00% Market Cap 1,706,744,544 Risk med NTA N/A Term med/long 12-month high/low 90c/51c Closing price 84c Forward P/E ratio 13.44 Recommendation Hold % of holdings 3.00% Original rec 03/05/04 - Bought up to 62c
BPC has drifted off its recent highs and is currently trading at around 83c. For new subscribers, BPC owns the old Goodman Fielder (GF) businesses and has recently sold its US assets. It has sound management and is still in the process of improving efficiencies and structure at GF. The company is controlled by Graeme Hart and run by Tom Degnan. They have proved to be very good at running this company and making solid acquisitions. They have huge exposure to the share price and although they are focused on operational and strategic issues (rather than share price), their interests are aligned with those of shareholders.
BPC remains a medium risk buy at 82c for the medium to long-term. In a market in which we are having difficulty in finding value, BPC remains attractive, perhaps because it seems to be well off the radar of much of the market. Patience may be required, but we have always said, patience is a critical component to successful investing. Members of the investment team own shares in BPC.
GLOBAL MINING INVESTMENTS LTD (GMI)
ASX code GMI Div yield 0.00% Market Cap 77,170,698 Risk med NTA $0.00 Term long 12-month high/low $1.06/83c Closing price 99c Forward P/E ratio 0.00 Recommendation Buy around 99c / Hold % of holdings 3.00% Original rec 08/04/04 - Bought through float
GMI released its NTA as at the end of November. It came in at $1.08 (post tax), up from $1.03 at the end of October. GMI remains a conservative way to play the resource stocks and as our view on resources remains positive going forward, subscribers can still buy GMI at around 99c as a medium to long-term, medium to high-risk investment.
MINARA RESOURCES LTD (MRE)
ASX code MRE Div yield .00% Market Cap 787,919,451 Risk high NTA $0.00 Term med/long 12-month high/low $3.65/$1.53 Closing price $1.70 Forward P/E ratio 6.06 Recommendation Hold % of holdings 3.00% Original rec 04/03/04 - Bought up to $2.95
As we mentioned in last week’s report, we do not feel that MRE is a sell at any price, and we feel that the market had over-reacted to last week’s announcement. Accordingly, we counselled subscribers that in our view, it would be wise to wait for some strength in the stock before exiting.
Fortunately, the stock has rebounded somewhat and is currently trading at $1.70 after seeing lows of $1.53. At this stage, we are continuing to advise subscribers to keep holding MRE. Several brokers have issued buy recommendations over the past week, which is reassuring, and although this may not carry a lot of weight with investors, the company has also reassured the market that the sell down was an overreaction. Subscribers are advised to hold until further notice.
QANTAS AIRWAYS LTD (QAN)
ASX code QAN Div yield 4.90% Market Cap 6,854,791,865 Risk high NTA $3.07 Term med 12-month high/low $3.81/$3.13 Closing price $3.67 Forward P/E ratio 10.55 Recommendation Sell around $3.68 % of holdings 3.00% Original rec 15/12/03 - Bought around $3.38
It appears we have broken our hoodoo and exorcised our QAN demons! Maybe someone finally heard our pleas from last week’s report, as lo and behold, the stock moved up to, and beyond, our $3.68 sell price!!
The stock is currently trading at $3.66 after having traded as high as $3.72 and hence, all subscribers have been able to exit this one for a nice, albeit not quick, 13.9% profit. We can now put this one to bed and we will cease coverage of QAN, unless of course further opportunities present themselves in the future.
AINSWORTH GAME TECHNOLOGY LTD (AGI)
ASX code AGI Div yield .00% Market Cap 159,494,603 Risk high NTA $0.26 Term long 12-month high/low $1.41/38c Closing price $1.07 Forward P/E ratio 63.80 Recommendation Hold % of holdings 3.00% Original rec 24/12/01 - Bought around $1.05
Just a short note to let subscribers know that the new AGI convertible notes begin trading tomorrow, albeit on a deferred basis. It is likely the notes will not be liquid enough to switch into until they begin trading on a normal basis, so we will issue advice on purchasing these once we feel the liquidity will permit us to buy it.
RULE OF THE WEEK - VALUATION FORMULAE
At our Buffett seminar in Queensland recently, Bob Miles spoke about Benjamin Graham’s simple formulae for assessing intrinsic value based on a small number of very simple variables. While even Graham said it was simplistic and left a bit to be desired, it was and remains a great guide to intrinsic value (IV) and we thought it was an interesting point to share with readers.
The formulae is: value = current normal earnings x {8.5 +(2 x earnings growth/10)}.
If we consider an example: a company which earns $5m (current) and is growing at 15% per annum. IV = $5m x {8.5 + (2x15/10)}. Therefore IV = $57.5m. This provides an indicative current year P/E of 11.5.
But in his book “The Intelligent Investor”, Benjamin Graham uses a discount element to bring the valuation into line with current interest rates. He does the above calculation and then adds the following to the formulae: IV x risk free rate / bond rate.
Now this provides an indication of a stock’s value. What Warren Buffett then decides is what sort of discount he would require to buy this stock and this is when his assessment becomes more qualitative. If it is an excellent company, with sound management, barriers to competition etc, then he may feel that buying at a 10% discount to IV is acceptable. He will then buy at that discount. If the stock falls further, he will usually buy more and allocate a higher portfolio share to the investment as it gets cheaper and therefore, lower risk with greater upside.
It is important to note that Warren would probably not buy a stock at IV because above average returns cannot be generated by buying things at fair value, and obviously, if a stock trades well above fair value, it makes sense to sell it because from that point, above average returns cannot be generated.
One of the world’s great investors, Peter Lynch, had a slightly different formula that he used. He and others reckon that when the price/earnings ratio is approximately equal to the rate of growth in the earnings per share (EPS), a growth stock is fairly priced. A common way of showing this is with a "PEG" (price to earnings to growth ratio):
Prospective PER PEG = --------------- EPS growth
When the PEG is 1, the stock is fairly priced. Value and GARP investors look for stocks with a PEG below 1, and preferably below 0.5.
Another great fund manager had a slightly different take on things again. John Neff used something he called the "total returns ratio". He divided "total returns" (growth + dividend yield) by the price/earnings ratio:
EPS growth + dividend yield TRR = --------------------------- PER
Neff liked to buy stocks with a total returns ratio at least twice that of the market average. He would dig up the figures for forecast earnings growth for the Standard and Poor’s 500 companies and add the average dividend yield and divide by the average PER. He had no fixed preference for a total returns ratio, but clearly using this ratio and comparing it among many stocks, it would provide a comparative measure that favoured stocks with relatively low P/Es, high growth and high payout ratios. For stocks without dividends, the reasons for this need to be considered and perhaps some flexibility may need to be employed.
We have tried to make this basic introduction to valuing stocks as simple as possible. This is by no means a complete explanation of stock valuation. This subject remains one that is constantly debated between professional investors and to some degree, is as much art as science, but we all need to start somewhere and some simple valuation formulae are a good start.
For those who are interested in learning more, we suggest you read The Intelligent Investor by Benjamin Graham. He was Warren Buffett’s mentor, so why not make him yours? John Neff on Investing by John Neff is also very good.
