The Corporates Get Freaky

Tuesday, 27 November 2012
Melbourne, Australia
By Nick Hubble

Stock market, or freak show?…a silver opportunity to ‘reduce’ your income by 99.1%…what Egypt and Greece have in common…grow up with dividends…low interest rates not helping the mortgage industry

‘Why have a secondary market at all?’ my favourite teacher once asked. At the time, it was so exasperating to hear the question that I couldn’t formulate a coherent answer. But now, I’m asking myself the same question.

First, some background definitions. The primary market is where companies issue shares. They issue them to raise capital (money) for new projects. The secondary market is where investors buy and sell those shares. The company gets nothing out of the secondary market’s buying and selling. So why have it?

Well, if you can’t sell your shares easily, what’s the point of buying them in the first place? And if nobody wants to buy them, it won’t be possible to issue them to raise capital. So the whole primary market wouldn’t work if the secondary one didn’t exist.

The problem is, the secondary market has become a freak show for all that is wrong with modern financial markets. Some of the acts of the show are familiar to you. Gambling instead of investing, too much leverage (use of debt), insider trading, rogue traders…you get the idea. But now it looks like even the people who scoff at this behaviour are caught up in it. The corporates who rely on the financial market to raise capital for their companies have been using the same dodgy number fudging tactics to get ahead.

This chart from Albert Edwards at Societe Generale explains how:

It shows that companies have been going into debt and buying their own shares with the money. It’s just another act in the Freak Show of the stock market. These companies are supposed to borrow money or issue more shares in order to invest in new projects that make money. Instead, they’re manipulating their own shares by buying them on credit, just like they did in the lead up to the credit crisis!

The reason they’re doing this is that buying shares makes the company look better. The share price goes up because there is a buyer, and there are fewer shares left on the market. That raises the amount of profit per share. All this makes the management of the company look good without them actually doing what they’re supposed to be doing – using money to invest in new projects.

Just like the consumers who went into debt to consume, companies have been going into debt to make their performance look good. This partly explains the American share market’s positive performance, and the impressive earnings per share they’ve managed so far. But you can only borrow so much.

***

There’s a new Pharaoh in Egypt. No, it’s not a new Disney movie, it’s reality. Remember that Egyptian revolution? Tahrir Square, Hosni Mubarak and the rest of it? Well, surprise, surprise, the new government is worse than the last. It has replaced ‘military fascism’ with ‘islamofascism’, and the new President has given himself Pharaoh-like powers. There have already been clashes featuring Molotov Cocktails between supporters and opponents of the new president.

Then there’s the financial side of things. According to the Egyptian stock market Director, ‘Egypt announces bankruptcy within 3 months in the case of the continuation of the current situation.’

It’s nice to hear that Egypt is as civilised as Greece these days.

***

Speaking of Greece, here is an amusing collection of recent headlines featuring the negotiations over its debt:

  • 16 [of 17] EURO STATES REJECT GREEK [debt] WRITEDOWN
  • EUROGROUP PAUSES FOR AN HOUR FOR CALCULATIONS, EU OFFICIAL SAYS
  • IMF WANTS EURO ZONE TO CUT GREEK DEBT BY 20 PCT OF GDP UP FRONT, COMMIT TO FURTHER REDUCTION LATER
  • EURO ZONE MINISTERS, IMF REACH DEAL TO CUT GREEK DEBT TO 124 PCT/GDP IN 2020 THROUGH PACKAGE OF EXTRA STEPS TOTALLING 20 PCT/GDP

Hurrah, Greece is fixed! Oh, wait…

  • EUROGROUP DISCUSSIONS OF GREEK AID STILL ONGOING, OFFICIALS SAY
  • EU OFFICIALS SAY UNCLEAR HOW LONG EUROGROUP GREEK TALKS TO LAST

How surprising that an economic problem wasn’t solved by politics.

***

Is this the most famous Australian business leader you’ve never heard of?

He parlayed a gold mining fortune into an oil fortune and changed the course of history. But Australia doesn’t mythologise its business greats the way we do bushrangers and soldiers. Their stories become lost in the pages of history…awaiting historians to bring it back to life.

So it was fitting that renowned Historian Geoffrey Blainey spoke about this herculean figure at his induction into the Queensland Business Leaders Hall of Fame this year:


‘William Knox D’arcy is, almost by definition, the most influential Australian who has ever lived. He is a giant figure on the world stage, let alone Queensland stage’

Never heard of him? Don’t worry, you will soon enough. Kris Sayce is on the case. But if you want a quick overview of D’arcy’s achievements now, click on the link above.

***

Gold miners and dividends don’t usually mix. But that’s changing. Apparently, paying dividends are a sign that a gold miner is growing up. Silver Lake Resources Chairman Paul Chapman told investors at the AGM ‘on the dividend front, we have not quite made it yet.’

So can you really own dynamic gold miners and get paid for it?

Dr. Alex Cowie sent around this chart of the Australian gold sector. It comes from Evolution Mining:

How many of the companies pay dividends? Out of the top 20, only 6: NCM, MML, RSG, KCN, TRY, and KRM. As you probably know, a few of these feature in our newsletter portfolios.

***

Slipstream Trader Murray Dawes provided this update on his prediction of a big fall in Australian stocks:


‘The thing I am most excited about at the moment is the set up in the S+P 500. For the last couple of months I have been warning about a potential false break of the May 2012 high of 1422. Well the false break has occurred and we witnessed a steep fall in the stock market over the last few weeks.

‘The S+P 500 fell all the way to the 200 day moving average at 1380 and even busted through it for a couple of nights. But then we have seen a big short squeeze over the last week. The S+P 500 has bounced from 1348 up to 1409 in the last five days. From here it gets interesting.

‘When the market is in intermediate downtrend the short squeezes usually last between 3-6 days. Once the rally has lasted more than six days it is either very long in the tooth or the trend is changing.

‘If we are going to continue trending down then the sell-off that begins from this area should be the big one that surprises market participants. The dominoes are arranged in such a way that another fall could confirm the break of the 200 day moving average and if that happens the S+P 500 could quite literally be 10% lower within a matter of weeks.

‘Of course I could be wrong. Nothing is ever certain in the markets. But my point is that the risk/reward set up at the moment is one of those rare occurrences that only happens a couple of times a year. If I am right I will have a huge win but if I’m wrong I don’t lose that much. That’s a bet I’ll take every day.’

To find out just how far Murray expects the market to fall, click here.

***

Company updates

Remember brewing giant Foster’s Group? It’s the company that for years destroyed shareholder value by diluting a very profitable brewing division with a capital intensive and low return wine division.

After wasting billions, they finally split the two last year and readied the brewing assets for takeover. That duly happened with South Africa’s SAB Miller absorbing Foster’s in December 2011.

But judging by the latest results, Foster’s continues to suffer from the years of underinvestment and poor management prior to SAB’s takeover.

The Australian reported over the weekend that ‘Foster’s sales by volume fell by 13 per cent in the six months to the end of September, when compared with the same period last year.’

SAB Miller Executive chairman Graham Mackay ‘said “adverse trends” were continuing in the Australian beer market and were being made worse by low consumer confidence, but conceded Foster’s performance was worse than the industry as a whole.’

You could argue that low consumer confidence should boost sales of beer. You know…come home from work, low on confidence because the iphone/ipad/ipod you recently ‘consumed’ has only momentarily boosted your mood…so you knock off a six-pack for a momentary buzz.

But the humble six-pack now costs around $16 in Australia.

No wonder consumer confidence is so low.

Meanwhile, Foster’s former wine division, Treasury Wine Estates (ASX:TWE), has gone from strength to strength. Since listing in early 2011, the stock price has increased by around 60%! (See chart below.)

Not that I’d want to invest in a wine business. In fact, we think wine is a horrible business. You have cash tied up in all those barrels waiting to mature. You have cash on the vines that may or may not produce a decent yield, and you have intense competition at the retail level to finally turn the grapes/wine into ‘in the bank’ cash.

This ‘capital intensive’ nature of the business means returns on assets and equity is low. In 2012, TWE generated a return on equity of 5%. For much less risk you can ‘invest’ in a term deposit for that sort of return.

The lesson? Wine is good for drinking, bad for investing in.

But, evidently it’s been a decent speculation for those who punted on a successful demerger.

The next lesson? Don’t ever, ever expect the stock market to make sense in the short term.

And another thing…lower interest rates are meant to ‘boost’ the economy, right? That’s what the textbooks say, but in reality things are a little different.

Take David Jones (ASX: DJS) for example. For the first quarter of the 2013 financial year it reported 0.3% sales growth, year-on-year. Given the plunge in sales (over 10%) during the first quarter of 2012, the market saw the growth rate as very disappointing.

Not only that, it was bad news for bargain hunters when it flagged that it will be reducing the ‘depth and breadth of discounting promotional events’ to try and lift the profitability of its sales.

The bottom line is that rampant credit growth for much of the past 20 years caused an oversupply of consumption goods. The whole retailing sector is oversupplied. People are still shopping…it has nothing to do with confidence. What you’re seeing is simply a structural change and the painful process of working off excess capacity.

Glenn Stevens’ near-emergency low interest rates aren’t really helping the financial sector either. Here’s a few snippets from small mortgages and financial services firm Firstfolio (ASX: FFF) recent Annual General Meeting:


‘housing credit growth remains subdued compared to the average growth of last twenty years’ and ‘interest rate cuts yet to have a meaningful impact on overall mortgage demand’.

Mind you, these Firstfolio points were under the heading ‘Positioning for Recovery’. We asked Greg Canavan to explain why Firstfolio investors might be positioning for disappointment no matter what their chairman says.


‘There are a lot of comments out there about a ‘recovery’. The more people hear it, the more they believe it, which then impacts their behaviour. To a certain extent it’s self-fulfilling. But only for a very short amount of time.

‘Fundamentally, there is a lack of drivers to support this recovery theory. My analysis suggests that this ‘recovery’ talk is a result of the boost to national income provided by the great boom of China (2009-2011). It takes about a year for the effects of such a boost to flow through the economy.

‘Combined with the interest rates cuts, which has helped with confidence at the margin, this boost to national income gives the impression that we are experiencing a nascent recovery.

‘It is my opinion that those betting on a recovery will be disappointed. The China downturn may have hit the resources sector pretty hard, but it’s yet to impact the rest of the economy. I think you’ll see the hit to national income (which flows from a lower terms of trade) have an effect in 2013.’

***

Do you think gold and silver isn’t relevant in our modern advanced economy? Well, a state politician in Montana wants to be paid in ‘gold before dollars have no value.’ Why would you care? A few months ago I made the same request. But with a twist that you might be able to take advantage of. You see, some gold coins are still legal tender here in Australia. But their real value is worth far more than their nominal, or stated value. Here’s an example. Hidden on the back of this Australian Koala silver coin, which will set you back $110, are the words ‘1 Dollar’.

Why stick ‘1 Dollar’ on the back of a $110 coin? Never mind that, let’s focus on the opportunity all this creates.

My offer to Port Phillip Publishing was to reduce my salary to 1% of its present number, but to pay me in Australian Koala silver coins. Here’s the crucial bit – pay at the nominal value. That’s the ‘1 Dollar’ value, not the $110 retail value.

The result would be that I’m collecting $110 in real value for every dollar on my income tax statement. I’m not sure if this is legal. But in the US, people are using this strategy when they buy and sell things. They just agree to buy/sell at a lower price, knowing the real value of the gold/silver coins they use to pay is far higher. The result is far lower tax. But because the coins are legal tender, they’re not breaking the law.

I’ll dig into the Australian law and let you know what I find.

***

For the Reading Chair

Financial guru Marc Faber’s presentation slides.

‘Financial crises are about bank debt,’ Professor Gary Gorton says in his new book.

I disagree here.

On the awkward effects of an aging population.

China’s ghost cities are only real in reality, not on paper.

While you do the dishes, why not listen and learn how ‘the large pharmaceutical companies produce little or no innovation and use their political power to exploit consumers and taxpayers.’

Regards

Nick Hubble (with Greg Canavan and Callum Newman)
Editor, Scoops Lane