Investing

We're under the pump at the moment with reporting season in full swing but I've found a quick way to share some thoughts on ILF's result with you. Apologies for the scribbles but hopefully you find it useful (let me know if not!).

In July 2006, the now bankrupt RiverCity Motorway issued a prospectus promising an initial yield of 6% per annum. They paid it for the first few years but the strange thing was the tunnel wasn’t even built at the time of the float. Not one cent of revenue was going to be generated until 2010 when the road was expected to be opened.

As we pointed out at the time, the yield was nothing but a Clayton’s yield. They raised extra money from investors upfront, just so they could give some of it back while the road was under construction.

Source: RiverCity Prospectus

The rationale was simple. Which of these two options would you find easier to sell: a toll road generating a 6% yield (already you’re thinking safe, predictable asset) or; a patch of dirt where you plan on building a toll road that you have no idea how many people will use? All they did with RiverCity was turn the later into the former by raising extra cash upfront.

Whether it’s dodgy agricultural products, Westpoint’s ‘10% guaranteed’ notes or undeveloped infrastructure projects, people are suckers for the lure of yield.

Which brings us to the current proliferation of ‘income securities’ listing on the ASX.

Here are your three choices:

1)      A Westpac deposit, guaranteed by the Australian government, paying you a margin of 1.15% over the bank bill rate;

2)      equity in Westpac bank, generating an earnings yield of bank bills plus 6.6%, which can be enhanced by franking credits, or;

3)      the new issue of Westpac’s equity-like CPS subordinated notes paying you a yield of bank bills plus 3.25%?

I’ll pay up if you picked the term deposit. It’s a very acceptable margin for a very safe investment. Sure, the government says they’ll only guarantee deposits up to $250k. But if the proverbial hits the fan, they’ll pay up.

I don’t own any myself, but I’ll also pay owning the shares if you have to. You don’t get all of that yield in dividends but any profit the bank hangs onto should translate into future growth. There is plenty of risk, which is why I don’t own them, but there is also plenty of reward on offer.

But the subordinated notes? These things are as far from being equity as Greece is from bankrupt. The regulator, APRA, even classifies them as outright equity, which is why the banks love issuing them. The directors pay distributions at their discretion. APRA can stop the distributions even if the board doesn’t want them to. And, if the bank gets into trouble, the notes convert into equity.

And for taking on all of that you get an extra 2% yield over term deposits?

Unlike RiverCity, it's likely investors will get their money back and earn the promised yield. But if you're happy with the risk, buy the equities. If not, put your cash in a deposit. The middle ground is offering you the worst of both worlds.

If its first deal is anything to go by, South African company Hosken Consolidated Investments (HCI) is going to have a successful time of it in Australia.

Wouldn’t you love to be working in the PR department of one of the big four this week? You already had your work cut out. Not passing on the RBA rate cut was never going to look good and the papers were already salivating at the abuse they were going to hurl at your employer.

Then big Glenn Stevens drops a bomb: the RBA won’t be cutting rates at all. Some say Stevens is actually Jim Grant in disguise. He certainly sings a different tune to 'Zero Percent' Bernanke and the markets, where a rate cut was predicted by every single bank’s economist.

Wishful thinking perhaps. In any case, Stevens has left you with a problem. Your bank now needs to put rates up to recover rising funding costs. That’s a PR disaster of an altogether different magnitude.

The funny thing is that, for once, it’s actually true. NAB Chief Financial Officer Mark Joiner explained yesterday that the bank’s funding cost in the December quarter was 195 basis points (a margin of 1.95%). That’s 70 basis points higher than its current average cost of funding and about the same as they are making on mortgage lending. You don’t need to be a CFO to know that lending money out for the same that it costs you isn’t going to generate much profit.

The winners are depositors. You don’t read much about this rare species in the papers but the combination of Stevens surprise non-move and banks’ funding woes is good news for those with cash in the bank. There’s plenty of competition for cash right now and, alongside mortgage rates, deposit rates should be on the rise. Good luck selling that to the newspapers.

This is a bit technical, so feel free to skip it if technical isn’t your thing. Despite generating a total return of 31% last year, Spark Infrastructure owners could be in for an even better year in 2012.

Whilst Spark owns electricity distribution networks, its financial characteristics are more like a five-year bond than a normal operating business. It owns assets that are monopolies and, to prevent abuse of those monopoly powers, it is regulated by the Australian Energy Regulator (AER).

Every five years, the AER sets the prices that Spark’s businesses are allowed to charge and locks them in for the following five years. It does this by determining an appropriate weighted average cost of capital (WACC) for the business and applying it to the relevant asset base.

The regulator is effectively allowing Spark to earn a fixed rate of return on its assets over the five year period.

The good news for Spark owners is that when the rates were determined about two years ago, the timing couldn’t have been better.

The formula for WACC looks like this:

WACC = w_dk_d + w_ek_e
w_d = debt weighting
k_d = cost of debt
w_e = equity weighting
k_e = cost of equity

If you’re Spark, you want the assumptions used to be as high as possible when the AER is determining your revenue. You want the assumed cost of debt to be high, the assumed cost of equity to be high and the assuming equity weighting to be high (equity always costs more than debt, so the higher the proportion of funding you assume is equity, the higher the overall WACC).

In 2009 and 2010 when the AER was gathering its assumptions, financial markets were in a state of disarray. Implied debt margins were high and finance was hard to come by, which meant the AER assumed a higher proportion of equity than it otherwise would have. All up, Victorian distribution companies CitiPower and Power Corp ended up with a WACC of 9.4% and the South Australian company ETSA was granted 9.76%. I estimate both would have been 1.5% lower in more ‘normal’ financial markets.

You can see the assumptions used by the AER in the table below, complete with an interesting comparison from the prior five year period.

As an example of the benefits Spark is deriving, ETSA obtained real-world 5-year financing last year at a margin of 1.35%. The regulator assumed 2.98% when it determined ETSA's allowable revenue.Of course, once the rate has been set, you want reality over the five year period to be much more benign than the regulator has assumed. That’s exactly what has happened.

Even better, the risk free rate has plummeted. Five-year government bonds were yielding 5.89% when the WACC was determined; today the four year rate is about 3.4% (this regulatory period has four years left to run).

It’s not an exact analogy, but owning Spark is like owning a four-year bond throwing off a 9% interest rate when the market rate is closer to 6%. It should be trading at a hefty premium to its face value, which in Spark’s case is the regulatory asset base used to calculate its returns.

If interest rates continue to fall, expect the Spark stock price to continue rising.

Note: SKI stock price at time of posting was $1.36

Readers of this blog had bit of a chuckle prior to Christmas with our 10 stockmarket predictions for 2012. Nothing is as funny as the real thing though.

Under the heading Global Strategists Are Abandoning Bearish Views, Bloomberg last night documented the year’s first about face:

Strategists at the biggest banks are capitulating on their bearish forecasts after the best start to a year for global stocks since 1994 and gains of more than 7 percent in emerging-market currencies.

Just two weeks after saying that investors should “remain cautious,” Larry Hatheway, the chief economist at UBS AG, raised his recommendations on global shares and high-yield bonds in a Jan. 23 note to customers entitled, “Wrong, but not too late.” Royal Bank of Scotland and Benoit Anne, the global head of emerging-markets strategy at Societe Generale SA, said their estimates for developing nations were proven wrong.

The MSCI All-Country World Index climbed 5.7 percent in January, surprising strategists at Bank of America Corp., Goldman Sachs Inc. and Barclays who had forecast first-half losses because of Europe’s debt crisis. 

The Bank of America analyst explained where everyone went wrong. ‘In hindsight, everybody was so beared up at the end of last year, there was nowhere for the market to go but up’.

Of course! Our obsession with predicting the future is farcical. It can also be very detrimental. A very wealthy close friend of mine called me in a small panic prior to Christmas. He’s a Eureka Report subscriber and Alan Kohler’s final Weekend Briefing for last year told him that the ‘risk of another major panic sell-off on the market’ was so high that my friend ‘must take action’. Kohler himself was planning on significantly reducing his ‘already reduced exposure to equities, possibly to zero’.

I told my friend that I had no idea whether there was going to be another panic sell-off or not, but that the risks Kohler was so worried about (Europe, US, China etc) were consensus views and all over the front pages of the paper. Generally, that means they are already factored into share prices.

Yesterday I tweeted a link to great Time article on the importance of deliberate practice. Practice itself is not enough, the article says, you need to practice the right things. For us, that means reading and learning the things that are going to make us better investors, not wasting our time on futile market forecasts.

There could be another panic sell-off tomorrow, next week or the week after. No one knows. If they did, it would already have happened today.

There is a grey line when it comes to insider trading. Much of what I do as a job is trying to collate information that other investors don’t yet have. If you sit on the side of a newly opened toll road and count the cars going past, you might be able to collect information that the owner of the toll road hasn’t yet released. Is that insider trading? We haven't done it, but if you were to spend the time and money to fly to New York, drive to Long Island and investigate which of RNY’s previously unoccupied commercial properties now have tenants, would that be insider trading?

Not in my books. The information is publicly available, it’s just that most investors couldn’t be bothered looking for it.

Then there’s the ‘mosaic theory’, a CFA guideline which stipulates that you aren’t (obviously) allowed to trade on any material information that hasn’t been made public, but you are allowed to use lots of individually immaterial pieces of non-public information to make a case. For example, you might ring ING Real Estate Community Living Group (ILF) to speak to the CEO, Simon Owen, and the secretary tells you he’s in New York. You’ve already noted that the board had written up the value of the New York assets in its 31 December accounts. You also remember your meeting with the asset managers of these particular retirement homes on a recent trip and finding out that they are logical buyers and owners of the assets. There’s nothing wrong, according to the CFA at least, with concluding that a sale of ILF’s New York assets is imminent and that the price will likely be at or close to the 31 December book values (I have actually reached such a conclusion, by the way).

In that particular case, I agree. It’s a grey area, though, and there is enough leeway under this mosaic approach to allow Martha Stewart to justify her actions (Stewart was indicted for insider trading following revelations her broker’s assistant to her the CEO of ImClone has been dumping his stock ahead of an adverse FDA ruling).

Some things, though, seem fairly clear cut to me. Last week, David Einhorn, US hedge fund manager, high profile value investor and friend of Whitney Tilson, was fined £7.2m for market abuse.

Einhorn admits he sold millions of shares in Punch Taverns after learning in a management and broker meeting that the company was about to launch a discounted capital raising. The information wasn’t public but Einhorn specifically told the broker, Merrill Lynch, that he didn’t want to be told any information that would prevent him from trading (‘wall crossed’, in the lingo).

So that makes it ok then?

‘This is as much like insider trading as football is like soccer’ Einhorn told the press after agreeing to pay the fine. Perhaps an apt cultural slip up, David? It does seem about as similar as football and soccer. The English version.

Earlier in the week I asked Bristlemouth readers a couple of unrelated questions:

1.      What are the last two numbers of your mobile phone number?

2.      What percentage of countries in the United Nations are African?

We received 218 responses to our little poll and we split the responses up into those with a phone number than ends between 50 and 99 and those with a phone number between 00 and 49. The results look like this:

Hi Bristlemouthers,

I'm interviewing Dan Ariely for an Intelligent Investor podcast on Wednesday. We want to do a small experiment before the podcast, though, and need your help.

Could you please answer the two questions below? Please don't look at Google and don't worry, you'll understand when you listen to the podcast.