Weekly Review

Number 361, May 11, 2013

The big banks bubble blow-out

If youre a shareholder in one or more of the major banks, or the second-tier banks for that matter, youre probably wondering if there is, indeed, a price bubble thats on the verge of bursting. If you were lucky enough to buy in around last November, or even a little earlier, you would now be counting a capital gain of 30%-50%, depending on where you have stashed some cash. So is it all about to come tumbling down? Thats not likely, and we have three separate articles this week to tell you why. Meanwhile, Robert Gottliebsen and Ian Verrender separately look at two industrial stocks with different earnings outlooks. Oil group Caltex is in a transformation phase, while building materials group Boral having downgraded its earnings forecast is hoping for better times ahead. Elsewhere, Brendon Lau looks at three small cap stocks that Alan Kohler are worth less than their cash value and that could rebound under the right circumstances. Tim Treadgold finds that coal is no longer a dirty word in the energy battle, and John Abernethy hopes Australia will not fall far from the Apple tree. All this and much, much more Your Eureka Report Weekly Review is ready to print. Best wishes,

Inside this issue

Five reasons to hang onto the banks

By Ian Verrender

12 Rebound hopes for three small cash cows By Brendon Lau Three stocks that are trading at or below their cash backing. 14 Cheap coal ignites energy battle By Tim Treadgold Coal is no longer a dirty word for some. Its the low-cost fuel of choice.

26 Balancing out SFGs bid withdrawal By Tom Elliott SFG has taken its bid for WHK off the table ... but it may be worth holding. 28 Ask Max: Your questions answered By Max Newnham Contributions before the budget, corporate trustee costs, franking credits, and more. 30 Collected Wisdom By Cliona ODowd

16 Will Apple spur an Australian train reaction 32 Research Watch 2 Have the big banks had their day? Not likely. By John Abernethy By Luke McKenna Apple has done it ... and Australia should get on 5 Carrs Call: The trouble with the bubble 35 Letters of the Week board the low-cost debt train as well. call By Eureka Report Subscribers By Adam Carr 19 Australian growth a developing story Credit growth is due for a rebound and this By Adam Carr should further fuel the banks. The advanced economies still matter to us but our biggest partners are now developing 7 Banks not cheap, but no hold-up imminent economies. By Roger Montgomery The banks are out of value territory but dont 21 Grim Reaper threat to SMSF property expect a fall. By Bruce Brammall Dont let your partners death destroy your 8 Ready to propser Caltex changes tack SMSF property dreams. By Robert Gottliebsen Operational changes at Caltex should 23 SMSF property the NRAS way eventually flow to earnings, and dividends. By Paul Thewlis and Margaret Hardy A government scheme has potential to add 10 Built up too much? value to the SMSF property equation. By Ian Verrender The building materials group Boral is finding the market conditions tough.

Publisher: Alan Kohler | Managing editor: James Kirby | Editor: Tony Kaye | Investment strategist: Adam Carr | Superannuation editor: Bruce Brammall | Chief reporter: Cliona O'Dowd

Eureka Report is published by Eureka Report Pty Ltd Swann House, Level 7, 22 William Street, Melbourne VIC 3000 Telephone 61 3 8624 3000 Facsimile 61 3 8624 3088 www.eurekareport.com.au

2 Five reasons to hang onto the banks

By Ian Verrender
Summary: Some analysts see the exceptional price growth in the major banks as a bubble waiting to burst. But, when weighing up all of the factors, the banks still have plenty of investment attraction. Key take-out: The banks are trading above the long-term price earnings average, but the ratio is lower than in 2011 and 2012 technically making them cheaper than before. Key beneficiaries: General investors. Category: Growth. It was back in November when they began bandying about the B word. A bubble was forming, according to the bulk of analysts. Banks were overvalued, their payout ratios were unsustainable and earnings growth would be insufficient to support the incredible stock price appreciation that had begun the previous June. Almost six months later, and the warnings have grown louder and increasingly shrill, backed up by ever-more complex calculations and comparisons to support the contention that the bank rally is an accident in waiting and that it is time to abandon the ship before it goes down. Except for one thing. Earnings growth has occurred, and quite spectacular growth at that. Bank shares, meanwhile, continue to forge ahead. The Commonwealth Bank is now the biggest company in the country, toppling BHP Billiton for top spot, while Westpac is hard on its heels as both now have breached the $100 billion capitalisation mark. From 4,433 in early June last year, the ASX 200 banking index had grown to 5,400 by late October before fears of the US fiscal cliff temporarily reversed the trend. It was a spectacular performance that almost universally was considered to have been overdone. Last week it peaked at 6,809. So much for the rear view mirror. The real question is: Where to now? Clearly, this kind of appreciation cant continue indefinitely but it still has a way to go while interest rates are low and falling and credit conditions remain benign. A month ago, I wrote that Australian banks were in a sweet spot and that ANZ and NAB were the best value among the majors (see Why ANZ and NAB are most loved). Last week, both ANZ and Westpac reported half-year results that confirmed that view and sent bank stocks soaring even further. Following are five reasons to hang on to Australian banks, debunking the myths and fears surrounding the banking sector. 1. Australian banks are overvalued

No they arent. They may be more expensive than banks in other developed nations, depending on how you measure expense. But Australian banks didnt follow their global peers into the abyss during the boom years because the Australian market is fundamentally different from those in other developed nations. So why compare them now? On a simple price earnings ratio, Australian banks are trading at 15.1 times this years earnings and 14.5 times next years projected earnings. Thats above the long-term average, the bubble heads claim, even nudging record levels. True. But it conveniently ignores the fact that interest rates not only are well below the longterm average but are sitting at record lows, with every indication they will trend even lower. In addition, Citigroup research indicates that our banks were trading at 16.1 times earnings in 2011 and 15.7 times earnings in 2012. On that measure, theyve actually become cheaper. If you compare the price of our banks to the overall market, again they are cheaper. The banking index is priced below the ASX 200 average of 15.6 times this years earnings and a whisker above next years projected 14.4 times earnings. The banks are much cheaper than industrials, priced at a whopping 16.5 times this years earnings and slightly better value than resources, which traditionally trade at a discount. 2. Credit growth has stalled

You cant argue with that. The latest figures from the Australian Bureau of Statistics and the Australian Prudential Regulatory Authority indicate that business lending has gone backwards and that growth in residential housing is the slowest on record. The only problem with that line of thinking is that it ignores the simple fact that, since the takeovers of BankWest and St George, just four banks dominate the domestic market, making international comparisons redundant. Unlike other jurisdictions, Australian banks are not price takers and have greater pricing power than their American and European counterparts. They hold 83% of all household mortgages. They have the wealth management industry tied up. They have large and increasing market shares in insurance. As a result, margin expansion is far more critical to earnings than volume growth. That explains the endless round of record profits during the past three years from each of the major banks during a period when almost every other industry outside of resources has been in crisis mode. Both ANZ and Westpac improved their margins during the March half and judging from Westpacs Gail Kellys comments last week, they plan to continue that trend. Apart from overall market growth, the stars have aligned for our big banks on almost every other measure. Impairments continue to improve. The domestic real estate market has stabilised and is showing nascent signs of

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recovery. Efficiency and cost cutting continues apace as the expansions of the immediate post-financial crisis era are integrated. While the European debt crisis continues to flare, the acute phase of the crisis has passed and Australian banks have used periods of relative calmness to lock in lower offshore funding costs. 3. Dividends are stretched Which bank?
How They Compare ANZ Price/Earnings 2012 15.1 2013E 14.1 2014E 13.5 Dividend Yield % 2012 4.6 2013E 4.9 2014E 5.2 Source: UBS CBA 17.0 16.0 15.2 4.5 4.9 5.2 NAB 14.2 13.8 13.4 5.3 5.5 5.6 WBC 16.2 15.1 14.5 4.9 5.1 5.4

No they are not. Payout ratios by our big banks have averaged around 75% of earnings. Traditionally, the ANZ has paid the least at around 65% or less but last week indicated it would lift that ratio closer to its upper limit of around 70%, indicating less likelihood of a major acquisition in Asia. Westpacs payout ratio last week lifted to as much as 85% for this year, although that was bumped up by a special dividend. Perversely, the slow credit growth the biggest alarm bell for the bubbleheads has allowed the banks to pay higher dividends. 4. The Australian economy is facing a possible recession

Commonwealth Bank It is difficult to find an analyst recommending CBA as a screaming buy. While most recognise it is well run and well capitalised, its share price performance of late has many thinking it is overvalued. But slow volume growth has paved the way for capital management in the form of a special dividend and it could follow Westpacs lead with the announcement of a special dividend on its full year results. CBA leads its peers on the number of products sold to customers, its cost to income ratio has declined, deposit funding has lifted and it retains the largest market share of home mortgages at more than 25%. Further official rate cuts therefore deliver the opportunity to expand margins which flow directly to the bottom line. As a negative, the Commonwealth is most exposed to share market volatility because of its position in wealth management and funds management operation. Westpac Long criticised for its multi-branding strategy, Westpac surprised investors with its improved earnings and special dividend last week. The analysts mostly rate it a hold. Like CBA, it has worked at cost reduction, margin expansion and balance sheet strengthening through improved deposit funding. While it as reduced its impaired loans to the best since the onset of the financial crisis, they are still well above pre GFC levels delivering the opportunity to further improve earnings. It also has surplus franking credits creating the possibility of further special dividends in the future. ANZ ANZs much vaunted Asian expansion strategy and its proposed transformation into a regional bank has held the promise of fabulous long term rewards while simultaneously restraining its share price growth. While the strategy has been in place for at least four years, a major acquisition has not eventuated and the bank instead has pursued its growth strategy in a far more measured manner. Its improved payout ratio indicates that it intends to continue along this path, thus diminishing the execution risk on a multi-billion dollar takeover. Greater competition in Asian markets, however, would mean that its regional operations may not deliver the type of returns available in Australia.

Global growth is weak and forecasts again have been reduced. Commodity prices are under pressure, problems are emerging in Chinas economy, the resources investment pipeline is about to peak and with the Australian dollar refusing to budge, the nation faces rising unemployment and shrinking corporate earnings. Anything is possible. But that worst-case scenario assumes the domestic currency will never fall, that lower interest rates will have no effect on non-resource industries and that the acute shortage of labour dogging our resources industry which is capital intensive rather than labour intensive suddenly will re-emerge as an oversupply of labour. Even if this scenario eventuated, it is likely the banking sector would ride out the storm better than almost any other. Each of the big four banks are well capitalised and barring a complete collapse of the Australian property market, are well positioned to ride out a recession. 5. Diversify your portfolio, reduce your weighting to banks

Into what precisely? Many industrials are more expensive, with even less reliability in regards to earnings and dividends. Resource giants are looking cheap. But a great deal of uncertainty over the direction of commodity prices has seen stock prices heading south for most of this year. BHP is looking particularly undervalued and the time may be approaching when shifting weightings into the big miners is appropriate but not just yet. Term deposits offer safety. But the yield is lower and there is no opportunity for capital gain. The return on government bonds offers the greatest safety. But the yield is at record lows and the opportunity for capital gains is limited precisely by those record low yields. There is not a great deal of fat left.

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With less reliance on residential mortgages and hence more exposure to business lending, ANZ is expected to benefit from any pick up on corporate lending. National Australia Bank The bank with the most attractive yield, NABs Achilles heel is its UK franchise. With the UK entering a possible triple dip recession, NAB appears stuck with the underperforming assets. But that delivers the possibility of capital growth as the UK eventually improves. In addition, on the domestic front NAB is heavily geared towards business lending and is the bank considered to best benefit from a recovery in this area. It recently, although quietly, abandoned its ambitions to be the lowest cost bank for consumers, indicating it was paying more attention to margin than volume growth. Macquarie The investment bank has shifted ground from entrepreneurial wheeler dealer to yield play. Lifting its payout ratio to 80% last week, the bank enjoyed solid investor support, and has seen a 45% lift in its share price in the past six months. Staff remuneration, however, remains exceptionally high, even for investment banks although Macquarie has reduced this and cut costs through a series of heavy staff layoffs. Its strategy of expanding into traditional investment banking in the US and Europe in the wake of the financial crisis delivers it significant earnings improvement potential in the longer term but has left it overexposed to the worst performing areas of the global economy in the immediate future.

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5 Carrs Call: The trouble with the bubble call

By Adam Carr
Summary: Forecasts of a decline in bank earnings per share are failing to account for a rebound in credit growth, with interest rates and lending levels at record lows. If anything, bank lending levels are set to grow. Key take-out: In the absence of any clear catalyst for deterioration, bank EPS growth is likely to accelerate from here. Key beneficiaries: General investors. Category: Growth. I realise youve already read a variety of opinions on UBSs bank bubble call last week, including arguments for and against. John Abernethy wrote a great piece as to why banks werent a bubble in his May 3 missive, Bursting the bank price bubble theory. Roger Montgomery continues the theme today with his comment Banks not cheap, but no hold-up imminent, while Ian Verrender wrote a separate article on Monday, Five reasons to hang onto the banks. Im not seeking to replicate what they said, but given the big banks are 27% of the market and a decent proportion of everyones portfolio, I do have something to add to what you have already read. But Ill be brief. The key point Id like to add in support of why banks are not a bubble is that you simply cant call a bubble at the bottom of the credit cycle. Its not credible. Itd be different if credit growth was pumping out double-digit growth rates like in the heyday of the 1980s, at cruising speeds of 25% or so. But were not. You can see from the chart below that total system credit growth is recessionary. Its the lowest since the recession of the 1990s and, at an annual pace of 3.2%, is four-times lower than the average over the last four or so decades (12%). Luckily recessions dont last forever and credit growth, as you can see, is not a constant variable. It would be unreasonable to assume that this low growth will last forever, or even for two more years, for reasons Ill go into below. At this point we just need to know that when an analyst says that the banks are a bubble or even just expensive, they are implicitly assuming an ever-lasting credit recession. Consider that the consensus earnings per share forecast for the big four banks is 5.5% on average over the next two years (this year and next). Thats about the average since 2005 if you include the GFC slump. If, like me, you think the GFC was an outlier, then EPS growth has been closer to 11% since 2005. So a 5.5% growth rate is very low and lower than the 7% average of the last two-years even. I could appreciate that EPS growth might deteriorate if there was some catalyst if there were structural forces or policy influences at play that were dampening credit growth. But there isnt. So the fact that the consensus expects EPS growth to decelerate compared to the last two years, when that period was one of the worst credit recessions this country has seen, isnt something I see as reasonable. Its an explicit forecast that the economy will deteriorate from here, not improve, which flies in the face of what we are seeing here and globally. And it flies in the face of policy settings as well lending rates are at record lows. In the absence of any clear catalyst for deterioration, I think instead that EPS growth will accelerate from here. This is especially if you consider that costs to income for the four major as a whole is still around the average i.e. no evidence of substantial cost cutting. But even if we assume a continuation of the comparatively low EPS growth that weve seen over the last two years, then even on that basis, banks are not rich. Take one of the big banks, Commonwealth Bank for illustrative purposes. Its currently travelling on a forward price-earnings ratio of 14.3 for 2014, with EPS growth of 5.8% for that year. Thats a little above the actual priceearnings recorded over the last decade (13.7), but not onerous. As discussed, 5.8% EPS growth is on the low side. If you take CBAs average EPS growth over the last two years of about 9%, then the forward price-earnings ratio slips to 13.6, which is fair value compared to actual price-earnings over the last decade. At this point, recall John Abernethys piece on why you should actually expect a premium the hunt for yield etc. So 13.6 is too low, its cheap. The prospects for banks really come down to credit growth from here, and there are two reasons why credit growth wont remain in recession. Banks are in no way handicapped in providing more credit should the demand arise. 1. Loans to deposits are low and currently sit around 1.1 times deposits compared to the average of 1.25 and the high in 2007 of 1.4 times deposits. The banks enjoy the best credit ratings of any banks anywhere, have no problem funding on the wholesale markets, and are doing so at ever cheaper rates.

2.

Similarly, there are simply no constraints on the demand side. The myth of heavily indebted Australian households has been well and truly smashed. Two-thirds dont have a

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mortgage or much in the way of meaningful debt, and of the 30% or so who do have a mortgage, the average debt outstanding is $200,000 and RBA estimates suggest 50% are ahead on their repayments 20% by one year or more. More to the point, and after yesterdays decision to cut interest rates to record lows, the capacity to service debt is the best it has been on record.

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7 Banks not cheap, but no hold-up imminent

By Roger Montgomery
Summary: While the intrinsic value of the banks will rise as interest rates fall, and as investors buy into them for higher yields, they are already trading well above their intrinsic values. remains attractive for investors hunting yield. Key take-out: While the banks shares prices and values are rising, their attraction to value investors becomes no greater and may become less. Key beneficiaries: General investors. Category: Growth. Yesterdays rate cut by the Reserve Bank of Australia does a number of things. And while triggering a wave of commentary is one of those things, its not as important as the changes it makes to valuations. The RBAs rate is now lower than at any time since 1960. Targeting the pressure on retail, tourism and manufacturing caused by the strong Australian dollar, the declining rates may go even lower. Many investors understand that as rates decline, the price of a bond goes up. Think about it this way; if you buy a 10-year Treasury fixed coupon bond for $100,000 paying a 5% annual coupon, you will receive two semi-annual payments of $2,500 each. These will continue until the maturity of the bond, at which time the face value will also be returned to you. If interest rates fall during your period of ownership, the market value of the bond could rise above the face value of the bond. This is simply because the government continues to pay $2,500 semi-annually. For the $5,000 annual coupon to be equivalent to a lower than 5% rate, the price of the bond needs to be higher. While many investors understand the inverse relationship between yield and price for bonds, what many dont understand is that exactly the same relationship exists between rates and the value or worth of all assets. The value of property, shares and businesses all rise as interest rates fall. That means that the RBAs rate reductions are fundamentally supporting, if not raising, asset values all else being equal. Lower interest rates, however, also drive investor behaviour something central bankers around the world know only too well. As interest rates decline, investors seek higher yields elsewhere and chase shares higher. This has driven the buying of banks and Telstra for some time, and it could go on for some time yet given the yields on our banks are still not as low as they have been in prior periods. Take the Commonwealth Bank for example, whose yield today is 5.14%. Back in 2006, 2007 and 2010, the yield was even lower than this, and so I think that talk of a bubble could be premature. Keep in mind, of course, credit growth back in 2006 and 2007 was significantly better than it is today. But there is another relationship that doesnt change, one that is as certain as the inverse relationship between yields and bond prices. I am referring to the relationship between price and value. The difference is known as the margin of safety, and over long periods of time the investment strategy that has worked better than all others is the value strategy. Momentum, yield, discount to assets and earnings growth are all strategies that have their day in the sun, but value strategies have persistently outperformed. On top of that, it is simply a logical and rational way for investors to conduct themselves. The lower the price is below the estimated intrinsic value of a company or its shares, the larger the margin of safety and the greater the value. But confusion has emerged among investors. Valuing a company on its yield is not valuing a company at all. Zip up your wallet when an expert tells you the banks are good value because their yields are attractive. Its not the yield that makes them good value. The intrinsic value of our banks rises as interest rates fall. But their share prices were already above my estimate of their value in January and February. Today the value is a fraction higher. The share prices will also rise as investors run away from declining income generated by their term deposits. The only problem is that the share prices are well above the values and, while both are rising, their attraction to value investors becomes no greater and may become less. Now dont get me wrong. I am not saying the banks arent attractive businesses. They are a cosy oligopoly, with high switching costs for customers enabling them to charge pretty much what they like. Nor am I saying that their premium above intrinsic value means they are due for an imminent correction. Valuing a business is not the same as predicting its share price. What I am saying is that they arent cheap, using my measures.

Roger Montgomery is the founder of The Montgomery Fund. To invest, visit www.montinvest.com

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8 Ready to prosper Caltex changes tack

By Robert Gottliebsen
Summary: Oil refiner and distributor Caltex is undertaking a series of transformational changes, including the closure of its Kurnell Refinery in Sydney next year. The company is seeking further growth in its products and margins over time, which should eventually manifest in higher dividend payouts. Key take-out: Once Kurnell is closed, Caltex should earn a lot more than last years $1.70 a share, partly because of the growth rate and partly because of the drag Kurnell had on profits. Key beneficiaries: General investors. Category: Growth. In todays high and rising sharemarket its hard to find stocks that the sharemarket has overlooked. But during the week I had breakfast with the managing director of Caltex, Julian Segal, and his finance director Simon Hepworth. Caltex has always seemed to me to be a company where results have fluctuated wildly on the basis of how global refinery margins moved. It was an oil punting stock. But Segal and Hepworth explained to me that they are in process of transforming the Caltex business so that it becomes a petroleum product distribution operation with an increase in emphasis on high margin products. The transformation will be accelerated by the closure of the Kurnell Refinery in 2014. I have always thought that closing a refinery was a very expensive operation and difficult to do. Caltex has explained to me that if you dig deep, the closure will involve almost no cash outlay at all, although the group is investing $250 million in additional funds to convert the site to a distribution centre. How can you close a refinery and not outlay a lot of money? First of all there is a $309 million after-tax cost in retrenchment and clean-up provisions. The write-down of the asset yields a $120 million tax credit to reduce that $309 million cost. But there is more. To keep Kurnell operating Caltex has to source sweet crude (i.e. low sulphur crude) from Libya and West Africa. Because of the long distances involved, some $200 million in Caltex cash is tied up with working capital. Once the refinery is shut the working capital requirement is slashed because most of the groups petroleum products will be sourced from Asia. And in Asia it is very fashionable for nations to erect an oil refinery, so the capital costs of these refineries is being subsidised by governments in the region, and that means there is a lot of capacity and good deals. One of the reasons why Caltex held onto Kurnell so long was that it needed a deal to gain refined petroleum products at the best possible world price. Segal believes the deal Caltex now has with its 50% shareholder Chevon will deliver excellent petroleum product purchasing prices and protects The latest dividend cut reflects the fact that as well as its normal expansion Caltex is spending $250 million on a massive Sydney distribution centre at Kurnell. But once Kurnell is out of the way this is a stock that is going to earn a lot more than last years $1.70 a share, partly because of the growth rate and partly because of the drag Kurnell had on profits. Moreover the Caltex growth rate will tend to accelerate as the group modernises its service stations so that it is easier to access diesel fuel and there is the ability to pay at the pump rather than getting into long queues. There is absolutely no reason why Caltex cant pay dividends of around 80 cents to $1 a share in, say, two years. I must emphasise that neither the CEO nor the finance director made any forecasts about dividend policy. But in todays yield orientated world, unless there are continuing special reasons, paying 40 cents a share in dividends out of $1.70 a share in profit is not the way to get sharemarket premium. Caltex 2013 Earnings/share $1.6 Dividend/share 36.4c EPS growth -4.9% DPS growth -8.9% Price/Earnings 13.8 Dividend Yield 1.6% Source: Bloomberg. Consensus forecasts. 2014 $1.6 41.6c -0.2% 14% 13.8 1.9% Caltex in the event of shortages. It will enhance Caltex profitability. Caltex will retain its Lytton Refinery in Brisbane, which is a more modern refinery than Kurnell and has been profitable. In the year to December 31 Caltex earned $1.70 a share, so at around $21.40 the stock is priced at about 12.6 times earnings. Given Caltexs history of profit fluctuations, that PE ratio probably sounds reasonable, but without Kurnell suddenly Caltex becomes a growth company. Its marketing and distribution operations have been growing well above 5% a year. Because of the fluctuations in profitability the companys dividend record has been abysmal and the latest years payment of 40 cents a share represents the second year in a row that dividend has been reduced (see graph).

For the last two or three years Caltex has been spending retained earnings to send up more and more distribution centres to increase its share of the more lucrative oil supply

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contracts. And that process is going to continue, but it doesnt require virtually anything like $1.30 a share to fund. The best way to show the way Caltex is looking at its future business is to look at a series of charts which highlight just what is ahead of this company.

Look at that growth rate in marketing and distribution in chart 2. That growth is likely to continue.

I must emphasise that in the year ahead there will be big charges as a result of Kurnells closure, and the reduction in stock level is a cash item which does not boost the bottom line. I cant see any great immediate joy in dividends, but the momentum is clearly there and this is a stock that could easily move itself up to 15 times current earnings and pay $1 a share in fully franked dividends. The gross yield would exceed 6% and, as the graph above shows, this is a company that has grown regularly over a long period of time in its marketing and distribution, but this growth rate has been absolutely masked by the fluctuations in the oil refinery business. That is about to stop. There are very few companies in Australia that are growing and that are set to pay much higher dividends, albeit in a few years time. What can go wrong? It is possible that the majors like Shell and BP and Mobil could suddenly start a price war, but I dont think that is likely.

Not many companies have such a strong and consistent growth rate for two of their three main products, and with the third product (gasoline) people are moving to higher-quality higher-margin forms see graph number four .

The price wars are taking place in the gasoline business, but even there the supermarkets are not as aggressive as they were in years gone by. So Caltex is not a stock where somebody wants to make a quick dollar, but it is the sort of stock you can put in a portfolio and know that once the Kurnell turmoil situation is out of the way it will be a stock that will grow profits and grow dividends with not a great deal of risk. It is one for the oak chest.

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10 Built up too much?

By Ian Verrender
Summary: Building materials group Boral has issued a 30% earnings downgrade, citing tough economic and fiscal conditions. The housing recovery remains patchy, and Boral has pointed to weaker construction demand among other factors. Key take-out: Despite this weeks downgrade, three major broking houses continue to rate the stock a buy. Key beneficiaries: General investors. Category: Growth. Boral boss Mike Kane vented this week in a rare display of apparent frustration at the state of the economy and the impotence of monetary policy. Green shoots? He hadnt seen any in housing or construction, he said, and that was after 18 months and 175 basis points of interest rate cuts. Maybe his rant was the tipping point for the Reserve Bank board which, the following day, delivered yet another cut, taking official cash rates to a historic low of 2.75%. But for all the noise surrounding Kanes 30% earnings downgrade his finger pointing at everything from the weather to the economy the massive earnings hit raises more questions than it answers. How much of Borals problems are cyclical, and how much is unique to the company? From an investment perspective, Boral and other building materials supply companies have been bid aggressively higher on the expectation of a housing market recovery 12 to 18 months down the track. The problem is, those expectations have been around for more than three years and, when it finally does arrive, will only serve to justify current earnings multiples. When it comes to housing exposure, there are better investment opportunities among the developers and the REITs, with Lend Lease a clear winner. Prior to the downgrade, Boral was priced at a little over 14 times next years projected earnings, making it one of the more sanely priced stocks in the sector. That blew out to 22 times after the downgrade, but since has dropped to 17 times as the stock price was thumped back to $4.50 levels. As I pointed out last week (The housing stocks on the up and up), clear evidence now is emerging of a recovery in the Australian housing market. But it is patchy and tentative, with Sydney bouncing off a low base and Melbourne labouring under the weight of an oversupplied market while the March figures went backwards. Despite housing affordability at its highest level in years, first home buyers are almost completely absent from the market as governments, both state and federal, have removed incentives. In addition, new construction activity has been concentrated in medium to high density dwellings which, given the extent of common walls, require less material than detached housing. Renovations, meanwhile, are almost non-existent. Kane this week referred to these factors. On top of that, the construction materials division had been hit by persistent wet weather in south-east Queensland along with delays to major projects in Victoria and Queensland that had contributed to a shortfall in third quarter earnings. All these things are cyclical and, clearly, out of the companys control. But the spectre of structural problems continues to dog the company. Kanes predecessor Mark Selway was unceremoniously dumped last year, midway through a radical overhaul of the business. Delivering power to the shop floor and out of senior managements hands apparently put some noses out of joint. But it delivered huge increases in productivity, allowing Selway to shut down large slabs of redundant capacity in masonry, bricks and roofing. While Kane continues to strip costs out of Boral, there are clear signs that the domestic business, particularly for building supplies and especially timber, are suffering from import competition related to the strength of the Australian dollar. Borals gypsum business also is a serious underperformer. Selway bought out French group Lafarge in an Asian joint venture for a whopping $616 million. It seemed like a good deal at the time and probably will be in the longer term. But for now it is a major drag on earnings, although it is performing far better than the Australian arm. On the positive side, Boral has around 11% of its revenue exposed to new housing starts in the US. Unfortunately, the US operation is a drag on earnings at the bottom line and this year is scheduled to lose more than $60 million. But after more than five years in the gutter, the American housing market finally is showing signs of life and the division is expected to move into profit mode by 2015. In terms of Australian housing starts, Boral is estimated to have a 35% revenue exposure to Australian housing starts. After the cuts to official rates this week, the dollar headed lower; well, for a day or so. Kane would be praying for a sustained fall in the currency. It not only makes imports more expensive, but every 1c fall in the Australian dollar adds $2 million to Borals earnings before interest and tax as it repatriates its American income. That does not flow directly to the bottom line, however, as Borals US division has some unhedged US dollar denominated debt.

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Boral Earnings/share Dividend/share EPS growth DPS growth Price/Earnings Dividend Yield Source: Broker consensus 2013 11.4c 9.1c -52.2% -17.6% 39.2 2.0% 2014 26.0 14.3c 129.1% 57.9% 17.1 3.2%

Among the analysts, opinion is deeply divided, although the optimists at this stage hold sway. Despite this weeks downgrade, three major broking houses, Deutsche Bank, UBS and Credit Suisse, continue to rate the stock a buy, with target share prices ranging between $5.10 and $5.38. JP Morgan upgraded its recommendation to hold in the wake of the announcement with a $4.40 price target while BA Merrill Lynch downgraded to a hold. Those in the buy camp firmly believe that recovery in Borals key markets will fuel a sharp rise in earnings which, when coupled with the companys strong focus on costs, will deliver the goods for shareholders. And if this weeks interest rate cut has the desired effect, boosting housing and construction while weakening the dollar and improving Borals foreign earnings position, then the company may see serious benefits. The most bearish is Citigroup. It has long had a sell recommendation on the stock, with a target price of $3.40. While noting the cost savings program is well underway, the broker questions what the position would be like without it. It adds that the key reasons for its negative view of Boral and the sector in general has been not just the weak housing market, but increased competition from existing and new entrants and from imports and the difficulty that will present in terms of future price rises.

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12 Rebound hopes for three small cash cows

By Brendon Lau
Summary: The number of stocks trading at a discount to their cash backing is at the highest level in at least a decade. Many are priced to fail, but some are possibly misunderstood and arguably do not deserve to be trading at or under their cash backing. Key take-out: Junior explorers dominate the list of stocks trading under their cash holdings, with lower commodity prices, rising costs and the lack of access to capital likely to see some go under. Key beneficiaries: General investors. Category: Growth. Dont be fooled into thinking we have returned to some level of normality now that the sharemarket is up at a five-year high. While no one quite knows what normal stands for anymore in the post global financial crisis world, those who doubt the market remains highly disjointed need only look at the explosion in the number of companies you can buy for less than the cash held in their bank account. The number of stocks trading at a discount to their cash backing has surged 144% since the end of the 2012 financial year to 105 the most in at least 10 years. Whats more, the average share price to value of tangible assets (such as property, plant and equipment) has also plunged 37.5% to the lowest level in more than a decade at 3.4 times. This is because companies that are valued at or below their cash backings are essentially priced to fail, in the vast majority of cases. Why else would the market not ascribe any value to the companys assets or operations? This is why junior explorers dominate the list of stocks trading under their cash holdings as the fall in commodity prices, rising costs and the lack of access to capital are likely to see a number of them go under. However, the poor sentiment towards small caps does seem extreme in some cases, particularly since the Reserve Bank of Australia went on the front foot yesterday and joined central banks from other developed nations to stimulate economic growth through record low interest rate settings. Cash to Total Trailing Trailing div Company market cap return 1-yr P/E (x) yield (%) ratio (%) Macmahon 0.95 2.33 13.15 -71.51 Holdings Jetset 0.96 59.70 2.50 7.39 Travelworld Richfield 3.01 11.89 nil 104.00 International Source: Bloomberg, Eureka Report The rate cut and the RBAs willingness to drop the cash rate further to support demand have improved the outlook for cyclical stocks, and there are three small caps that could rebound in the second half as they arguably do not deserve to be trading at or under their cash backing. Macmahon Holdings (MAH) You cant blame investors for shunning the mining contractor. Fear that it will issue another profit downgrade due to project deferrals and the messy divestment of its underperforming construction business has weighed heavily on the stock. Macmahons 72% crash over the past year to its lowest level in a decade gives it a market cap that is only 4% ahead of its $183.5 million cash holdings. The stock typically trades at more than four times its cash, but I am not predicting a near-term re-rating of the stock based on this metric. What I do suspect though is that the stock is close to finding its feet, as Macmahon shouldnt be priced to fall over. If anything, its mining division has a record order book worth $3.6 billion that is made up largely of recurring work, and the company has a healthy balance sheet, particularly following its $80.7 million equity raising. The company is also modestly geared at 9.4%, and while it warned back in February that it would report a net loss of between $10 million and $20 million for the current financial year due to costs associated with the sale of its construction division to Leighton Group, analysts are predicting a sharp rebound in net profit to $54.6 million in 2013-14. All stocks going for less than their cash backing come from the junior end of the market, but small cap bargain hunters should not get too excited as this market anomaly is not usually good news. If anything, a pick-up in such occurrences typically coincides with a period of market stress. The stock closed at 15.5 cents on Tuesday and the average broker 12-month price target is 29 cents.

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While the company has a fairly clean balance sheet, it has $5.7 million worth of intangibles sitting on its books that is related to goodwill on acquisitions. The intangibles constitute 34% of Richfields total assets. On the upside, Richfield managed to post a 68% increase in net profit to $272,000 in the financial year ended December 2012, even as the shipping industry was hammered by the slowdown in global trade and oversupply of vessels. The turmoil caused Richfields revenue to fall 8% to $6 million, but good cost control enabled the company to bolster margins considerably. That is quite impressive given that 65% of its listed global peers posted a loss for the latest reporting period. Jetset Travelworld (JET) The travel agency is not only trading at a similar level to its cash backing as Macmahon, its also in the midst of a restructure to cope with challenging industry conditions. A drop in the price of airfares, intense online competition, and big cuts in government spending on air travel (government is a large client of Jetset) contributed to an 11% drop in its first half total transaction value (TTV, value of airline tickets, accommodation bookings, etc that is processed through Jetset) to $2.5 billion and a 5% dip in adjusted profit before tax to $18 million. I cant see these pressures abating significantly over the medium term, but unlike media, we know that the traditional travel agency model can work, thanks to Flight Centre. To Jetsets credit, it has achieved cost savings above what most analysts had expected, and this meant its margin between revenue and TTV expanded 0.3 of a percentage point to 5.4% for its retail division and 0.5 of a percentage point to 13.7% for its wholesale business. I dont see a positive re-rating of the stock happening anytime soon given that it will take two years for Jetset to complete its strategic review; but the fact that it has nearly $170 million cash, no net debt, a cache of well-known brands, an expected grossed-up yield of around 9%, and a modest forecast price-earnings multiple of 6.5 times for 2013-14 means it might be worth buying if the share price dipped towards 35 cents. The illiquid stock closed at 40 cents on Tuesday. Jetsets top three shareholders hold around 86% of the stock. Richfield International (RIS) The microcap shipping services company is a more extreme example as it holds three times as much cash as its $3.2 million market cap. One would think debtless Richfield would make a tempting takeover target just for its bank balance alone, if not for its managing direction, Chak Chew Tan, controlling around 37% of the company. Tan and his wife are on the company board and the next three biggest shareholders have another 46% of the stock. But liquidity is not my biggest concern its transparency. Richfield declined an interview request and not much is known about its Singapore-based management team or its other key Asian investors. Richfield is leveraged to any improvement in shipping demand and management is expecting moderate growth in shipping this year. The 26% rebound in the Baltic Dry Index, which reflects the price to ship cargo internationally, seems to support managements outlook. Management better be right. If conditions deteriorate, there is a real risk that Richfield will have to write down a portion of that large intangible that is on its balance sheet. Risk tolerant investors who are unconcerned about potential governance issues might find the stock an attractive addition to their small cap portfolio, but for the rest of us, Richfield should be kept on a watch list for the next six months to see if management has a plan to unlock shareholder value at the next annual general meeting. The stock has doubled in the past 12 months and is trading around 5 cents, but this is still well below the companys net tangible asset value of 12 cents a share.

Brendon Lau is the editor of Uncapped and may have interests in some of the stocks mentioned in the article.

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14 Cheap coal ignites energy battle

By Tim Treadgold
Summary: The global push to reduce carbon emissions, at least in some countries, put coal as an energy source on the backburner. But the implosion of Europes carbon emissions program, and a rise in the gas price, has rekindled demand for coal. Key take-out: Forecasts about future energy supply and demand are proving to be incorrect. With the coal price currently trading below $US90, Australian coal miners can expect a demand rebound. Key beneficiaries: General investors. Category: Commodities. Currencies are not the only asset at war. Energy too is engaged in a race to the bottom, which is producing unexpected results including the restoration of coal as the worlds preferred low-cost fuel for producing electricity. Its too early to tip coal stocks as a buy, mainly because there is the potential for a fresh round of government interference in the market. But demand for coal is rising in Europe and the US, and it remains strong in Asia. Missing, so far, from a complex equation triggered partly by the failure of Europes carbon emissions system, is a meaningful rise in the price of thermal coal, the low-grade material used by power generators. But what the demand picture does show is that some lowcost coal producers have been oversold and that major coal producers, including Rio Tinto, Xstrata and BHP Billiton, should see a profit recovery from their hard-hit energy operations sooner rather than later. Even massively discounted pure coal plays, such as Whitehaven Coal, could rebound once corporate uncertainties are cleared away. While the message for investors is not a clear buy signal, it is a reminder that forecasts about future energy supply and demand are proving to be incorrect. The biggest failure is the Peak Oil theory a popular belief of a few years ago that predicted a time when liquid fuel supplies would dry up. Not only has this not happened, but the supply of liquid fuels (especially natural gas and associated liquids from shale) is rising, especially in the US, with many countries rushing to join the shale revolution. The second major failure has been European attempts to control emissions of carbon dioxide from burning coal. While Australia is determined to try and follow Europe in pricing coal out of its energy equation, the rest of the world is not. Boiled down, the energy war is all about economy vs environment, with regions that once championed anti-coal measures forced to join the move back to coal. This is mainly because its an abundant energy source, and is cheap when compared with environmentally-friendly energy sources such as wind and solar.

The European experience is the best example of whats happening, and a pointer to what might happen in Australia because of plans to link the local carbon emissions price to that of Europe. The coal price has collapsed there, thanks to a combination of recession and an excess supply of carbon emission certificates. Five years ago, a certificate to emit one tonne of carbon dioxide (with coal the major producer of that gas) cost 35 and acted as a major disincentive to investing in coal-fired power stations. Last week, the price of a certificate was around 3, close to a record low and a price which incorporates a 35% fall on a single day, April 16. On that day, the European Parliament voted down a plan to temporarily withdraw 900 million carbon emission certificates, partly because of concern that such a move would force up the price of electricity and prolong the regional recession a prime case of economy vs environment. One result of this botched government policy is that big energy producers were encouraged to invest heavily in environmentally-friendly power sources, only to find that they are now in financial trouble because their wind, solar and gas power cannot compete with coal, because carbon emission permits are cheap. Last month Reuters reported that power generators were losing almost 14 per megawatt hour from electricity produced using gas, but making a profit of 10 per megawatt hour from burning hard coal and 20 per megawatt hour from burning the cheapest and most polluting form of coal, lignite (or brown coal). Germany, the renewable energy leader in Europe, has been forced to turn increasingly to coal to achieve power-system reliability, mining 5% more coal in 2012 than in the 2011. The biggest electricity generator, RWE, has started production from a big new lignite-fuelled power plant near Cologne. Australia's coal outlook Australia is yet to feel the effects of Europes collapsing carbon emissions system because our system is still operating at a fixed price of $23 a tonne, which is set to rise

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over the next two years before becoming a freely-traded system in 2015. But, without more government tinkering with the system, the Australian carbon price could collapse as it has in Europe with one consultancy, RepuTex, forecasting a possible fall to as low as $1.50 a tonne, triggering a recovery in local coalfired power generation. Europe and Australia are not alone in struggling to manage energy policy in a world facing a glut of energy rather than the shortfall predicted by Peak Oil. In the US coal is also making a comeback after last years demand crash caused by a collapse in the price of natural gas. This reflected that countrys shale-gas revolution, which encouraged power generators to switch from coal to gas. Over the past few months, the price of gas has doubled from its low of less than $US2 per million British Thermal Units to more than $US4/mbtu, largely as a result of the recovery underway in that countrys economy with low energy costs a contributing factor. Railway cargoes are a clue to the return of coal in the US, with carloads of coal carried on the seven major rail systems up 22% in mid-April compared to the coal-car count at the end of 2012. Without the same government interference in the power or carbon-emissions market US electricity generators are reacting purely to price signals, and right now coal is a clear winner compared to other fuel sources. For Europe whats happening in the US is compounding an already tricky situation, with major industries such as Dow Chemical shifting production capacity back to the US to capitalise on power prices which are up to 50% less than whats being charged in Europe. It was partly fear of losing more industry to the US that caused members of the European Parliament to vote down the plan to withdraw the 900 million carbon emission permits because it would make European electricity event more expensive as the US drives down its power prices. Champions of renewable energy and opponents of coal are facing stiff headwinds in their crusade against a polluting fuel, and while its too early to say theyre losing the battle there is mounting evidence that industry and households prefer cheaper power (even if coal-fired) to high-cost but ethically-pure renewable power. Asian customers for Australian coal do not appear to be even considering the moral dimension, with demand for steelmaking (metallurgical) and electricity generating (thermal) coal continuing to rise. A healthy appetite Yesterday, the chief executive of the small underground coal gasification developer, Cougar Energy, predicted a healthy appetite for Australian coal in Asia. Rob Neill said he had received a strong response from potential Asian investors in Cougars planned metallurgical coal mine in Queenslands Bowen Basin. That view sits comfortably alongside Whitehaven Coal reporting record monthly rail shipments as it finalises construction of its new underground mine at Narrabri in NSW, despite (or perhaps because of) the thermal coal price sitting at a low $US87 a tonne making it an extremely competitive fuel. Clouded as it is by market and government pressures, the outlook for coal as an investment is not as grim as it might have appeared last year when carbon emission prices appeared to be rising (but are now falling) and Australian exporters were being hit by the low coal price and high Australian dollar. The dollar problem has started to ease thanks to yesterdays interest rate cut, and could ease further if the Reserve Bank becomes fully engaged in the global currency war. Coal demand, if not yet price, is reacting to Europes renewed appetite for coal as a low-cost power source, while the threat of US coal exports hitting world markets is easing as its power utilities switch back from gas to coal. Forecasts for coal prices remain subdued. Commonwealth Bank, in an April 30 research report into Whitehaven Coal (which included a neutral rating) tipped thermal coal to trade around $US89 a tonne this year, rising next year to $US96/t, and $US99/t in 2015. In an earlier report on BHP Billiton, CommBank tipped metallurgical coal to fall from $US183/t this year to $US169/t next year before rising to $US192/t in 2015. Environmentally, coal might be public enemy No.1 but, in the real economy, it is reclaiming its status as the low-cost fuel of choice with government attempts to price it out of the market proving futile, so far.

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16 Will Apple spur an Australian train reaction?

By John Abernethy
Summary: The ability to lock in a 3.85% rate for 30 years was enough to bring technology giant Apple to the capital markets last week. The Australian government has the same opportunity to borrow low-cost funds over a long term to fund strategic investments across rail, roads, port and other national infrastructure. Key take-out: In tapping global markets, Australias economic growth and social policy initiatives could be funded away from simply raising taxes. Key beneficiaries: General investors. Category: Income. The decision by the Reserve Bank to cut cash rates and bring them to historic lows followed some extraordinary policy pronouncements in Europe by the European Central Bank (ECB) in the previous week. These announcements will positively affect the value of the securities in my income portfolios, and this is starkly evidenced by the interest rates that were secured by Apple Inc. in its recent extraordinary bond issue. The RBA decision was belated and forecast by myself a few months ago. I said then, and I reiterate now, that the Australian economy is slowing to a walk under the high $A, which in turn is caused by massive offshore QE programs. Frankly, the 0.25% cash rate adjustment is not nearly enough, and cutting interest rates by themselves is not the answer. Australia needs a co-ordinated policy response that encapsulates both fiscal and monetary settings. I suspect that next week we will see that our government has no stomach for hard strategic policy initiatives, and I do not mean bringing the budget back to surplus. Rather, there needs to be recognition that Australia is a dynamic developing country and not a developed country. The difference is significant because recognition of this simple fact would stimulate our government into a growth expenditure cycle that anticipated compounding population growth of 2% per annum. A debt-funded capital investment cycle would stand Australia aside from the disaster of Europe. Right now it is the ramifications of the disaster in Europe that can be put to our advantage. To understand this we should review the table below to see the extraordinary bond issues undertaken by Apple Inc. in the US capital market last week.

Noteworthy is that Apple was able to set a weighted average bond maturity for $17 billion at a weighted average yield of 1.811%. In this raising people masquerading as capital managers provided Apple with $3 billion for 30 years at 3.85% fixed. The money was not raised by Apple for investment but rather to return capital to shareholders. That alone should have resulted in Apple paying substantially more for this debt then it did. But we live in absolutely crazy times and it suggests an immense opportunity for the Australian government. My point is simple. If world capital managers are so bereft of places to invest, then the Australian government should have the fortitude to access this capital at historically low rates. For instance, imagine if the Australian government borrowed $50 billion of 30-year capital to create a fund for the National Infrastructure and Development. The cost of funds of (say) 3.5% p.a. fixed for 30 years should be well covered by the returns on strategic investments across roads, rail, ports, airports, learning institutions and hospitals. Those strategic investments would propel growth, generate employment and translate into higher tax revenue. The investment returns above cost could be diverted into our National Disability Scheme. Economic growth and a significant social policy initiative could be funded away from simply raising taxes. Sounds logical, but dont expect that to be announced next Tuesday night. The missing link in the worlds QE policy is the direction of the newly created capital into growth projects. Filling the debt holes of governments is not enough. History shows that government debt can only be dealt with in two ways. The preferred route is via growth, and the alternative is default. In 1945 Australian government gross debt stood at over 150% of GDP. That debt did not stall Australias growth and we did not default. Rather, a sustained period of economic growth resulted in the debt being easily managed down.

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Australia was then, and is still now, a developing economy that is hampered by a lack of vision rather than a lack of opportunity. European solution creates a bond asset bubble The low-cost borrowing opportunity above is absolutely caused by QE across the world. Indeed, last week the ECB introduced a new concept that has potential to blow more air into yield markets, and investors need to be aware that interest rates may well go lower. John Abernethy is the chief investment officer at Clime Investment Management. If you are a sophisticated investor, wholesale investor or have $500,000 or more to invest, Clime is offering you a free portfolio assessment or opportunity to discuss your portfolio and investment options with John Abernethy. Click here to register your details.

Source: ECB, Fulcrum Asset Management The above chart shows that the ECB has a number of arms to its policy settings. In particular, it sets the rates it will pay on bank deposits with it (now zero) and the rate it will lend to banks who need liquidity (1.5%). Last week the ECB declared that it will consider dropping deposit rates to a negative rate and said it is prepared to lend unrestricted amounts to banks for as long as the debt crisis is maintained. These are extraordinary statements and it explains why the junk government bonds of Europe are rallying. Italian 10-year bonds are now yielding below 4% despite the massive government debt load and its declining economy. A similar picture is seen in Spain despite its 26% unemployment. In normal circumstances default would be very possible in Italy and very likely in Spain but these are not normal times. The ECB is deliberately driving European banks away from depositing funds with it and pushing them into bonds across Europe. Further, its unlimited lending facility is presenting banks with an interest margin when they buy high-risk bonds. But these high-risk bonds are underwritten by the ECB and so we have a fortuitous circle that has no end in sight. The result is that yields in Europe are tumbling as they are in the US and Japan. Apple cleverly became a beneficiary and so will the owners of the securities held in my income fund. Indeed, after a brief pause I suspect that high-yielding shares will go higher and the perpetual hybrids of Australand (ASX:AAZPB) and Multiplex (MXUPA) will also move much higher in price. Remember, this is not about the rationale pricing of risk but the perverse result of monetary policy that is not supported by fiscal strategy. There will be a time to jettison yield securities for either the safety of cash or better, pure equity opportunities but not just yet.

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19 Australian growth a developing story

By Adam Carr
Summary: Historically, when our major trading partners have experienced strong growth of 4% or so, Australia has had boom times. Our major partners are now predominately developing economies, rather than Europe and the US, and they are forecast to post strong growth of over 4%. Key take-out: The fact our key trading partners are expected to post ongoing strong growth is a good reason not to expect weak growth outcomes. Key beneficiaries: General investors. Category: Economics and strategy. I mentioned in my April 22 piece The slowdown lowdown: No cause for alarm, that the US sequester was unlikely to lead to the jobs destruction that the Congressional Budget Office and other economists thought it would. And last Friday we found out that is indeed the case, so far. The soft number in March that got everyone worried was revised up, and April jobs were strong. The average over the last three months is 212,000, which is extraordinary growth. Still, the debate over US growth prospects is ongoing and, regardless of the US or any individual countrys growth prospects, many people are obsessed with this idea that the global economy is only experiencing tepid growth with little in the way of a meaningful pick-up expected. As a nation, we spend a lot of time talking about it to the point where it seems that we often forget or overlook our own good fortune. Its not without good reason: as a small, open, economy we should be spending a lot for time pondering the globe. In fact, I think it was an ex-RBA governor, perhaps Ian MacFarlane, who said that if economists had only one variable to look at to gauge the prospects for the Australian economy, then it would be global growth. The problem is that the debate in Australia on global growth has become quite confused. For instance, when we read the papers what are they full of? Austerity, and debates over its efficacy. The need for the European Central Bank to print. The US sequester. Japans depression and the need for truly incredible amounts of monetary stimulus. A Chinese hard landing or bubble. Our own Treasurer piping up with his 5 cents of advice, urging the Europeans to abandon austerity and promote growth. The obsession with all of the above has meant that many commentators and economists in Australia have missed the big picture. And this has allowed people to get away with throwing up charts like the one below, to argue their case that global growth is tepid.

You can see from the chart that when the advanced economies go into recession (the shaded columns) we tend to too. Of the five synchronised global recessions since the 1960s, weve shared in three of them. The 2000-01 period and the GFC were the major exceptions, although our economy didnt escape unscathed and slowed sharply. Now, look to the far right of the chart and note the divergence in growth rates. Australia is still experiencing reasonable growth rates while the advanced economies (as a group) struggle. In addition to that, both the International Monetary Fund and OECD dont expect much to change, with growth rates over the next two years averaging 1.7% (1.2% this year and 2.2% next). These are still effectively recessionary growth rates. This bodes ill for us, as historically Australia has only been able to maintain solid growth rates if advanced economies posted growth of 3% or more. Now, of course, many of you will have probably already noted the fatal flaw in the above its outdated and reflects the old world. In the new world, we must include the rise of the developing world China, India, Brazil etc. As we already know, China et al have changed the world enormously over the last decade and the above chart no longer captures the true dynamics. This doesnt stop people trying to dismiss this fact though by noting that China is not immune to economic cycles, or that it is headed for slower growth anyway even a hard landing. Again, comments like these miss the point, as will become clear below. Chart 1 made sense, and our current economic obsessions with austerity and stimulus and the old world (and so tepid global growth) could be justified, when the advanced economies made up the vast bulk of the global economy. Over the decades it has fluctuated between something 7590% of the global economy and about the same again terms of a contribution to growth. The thing is, these days the advanced economies make up only 50% of the global economy, and in recent years have only provided about 15% of its growth.

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of our major trading partners was 4%, we would have all been very excited and we should be as equally excited now.

This suits Australia perfectly, because we need to remind ourselves that the vast bulk of our trade is actually with the developing world now almost two-thirds. Thats a far cry from the previous 50 years or more when at least 50%, sometimes as high as 70% of our exports, went to the UK and US. Even in the 80s the US, Japan and UK accounted for 50% or so of our exports cheque, and two-thirds of our exports went to a US-centred OECD . Thats now something like 40%. That were not reflects in part the fact that weve become conditioned to extraordinarily strong growth outcomes for some of our larger new trading partners in the developing world, and especially China. It also in part reflects our inability to adapt to the new global economic reality. Were used to double-digit growth rates in some cases, and anything below that is disappointing. But this is unreasonable, as it overlooks the extraordinary wealth gains weve seen for those countries over that time. Chinas economy, for instance, is more than twice the size it was in 2005. The developing world has grown so fast that it is now as wealthy in terms of GDP as the developed world and this has all happened in less than a decade . So does it matter that average growth will slow to 4.1% from a pre-GFC average of 5.5% over the next two years, when countries like China are twice the size? No. And, in any case, our major trading partners arent just developing countries. The above growth rate of 4% includes some big advanced economies as well the US, UK and Japan. Even so, were still pumping out 4% growth in aggregate and are hitting that magic 4% line that you see in chart 1. The implications for growth here are fantastic, whichever way you cut it. If you recall last week, in my article Recession calls are ringing hollow, I discussed the idea that a recession in Australia was a low probability, even in the absence or unwinding of the mining boom. Mining investment only accounts for 6% or so of our economy after all, and while we may have had 100% growth per year for nearly 10 years on the way up, you can appreciate were not going to see falls of 100% per year. Thats not mathematically possible. The fact that our trading partners, who provide the vast bulk of global growth, are now expected to post ongoing strong growth is another reason not to expect weak growth outcomes over the forecast horizon.

Thats not to say the advanced countries are unimportant Japan is still our second-largest export partner (22%) and the US and the UK between them take an additional 10%. But the developing world is by far the greatest share of our export wealth, and the US isnt doing badly in any case as we found out on Friday. Now, at this point we need to take another look at chart 1. You can see that when the growth of our major trading partners, or what used to be our major trading partners back then (the advanced economies) experienced growth of around 4%, we typically had strong growth in Australia. Boom times actually. The good news for Australia now is that this is exactly what is forecast not for the advanced economies as a collective, but for our new major trading partners. In the table below Ive shown growth of our major trading partners as forecast by the IMF (reweighted according to their importance to Australia as an export destination) alongside advanced economy growth. As you can see, growth is expected to be around 4% over the next two years. Dont forget, our major trading partners collectively account for over 50% of the global economy and closer to 90% of its growth. They take the vast proportion of our exports. So does it matter that they will grow at 4% over the next few years? You bet. The position is very similar to that of the OECD though the 1960s, 70s and 80s. Back then, if growth

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21 Grim Reaper threat to SMSF property

By Bruce Brammall
3. Summary: Buying a property through a SMSF has many advantages, except when death gets in the way. If a married persons superannuation is held in the form of a property and they die, then in the majority of cases their portion will need to be sold and paid out as a death benefit to their surviving spouse. Key take-out: Simple estate planning to avoid a forced property sale will remove much of the financial pain. Key beneficiaries: SMSF trustees. Category: Superannuation. Death can be rather inconvenient, particularly if poorly timed. And Im not talking about the impact on the deceased. Sure, mostly, they arent going to be thrilled with the event. But it tends to be rather final and today were going to assume that the deceased cant buy their way back to life. When it comes to super, the price of death has gained a whole new value in recent years, particularly as it relates to the purchasing of property inside SMSFs. While SMSFs have always been allowed to buy direct property, the issue of gearing for property inside super has introduced risks that previously didnt really exist. The crux of the problem Lets take a husband and wife (Jim and Jane, both aged 50) and a super fund worth $600,000. Of that, Janes balance is $400,000 and Jims is $200,000. They purchase a property worth $500,000. After stamp duties and other purchase costs, they have $70,000 left in cash (plus any incoming contributions and earnings of the fund). Assume, briefly, that there is no gearing. Not long after the purchase, Jane dies. Her death causes a cashing event for the super fund. Under a wide variety of circumstances, Jim now has a major problem. As two-thirds of the super fund is Janes and were assuming theres no automatic reversionary pension in place because of their ages the super fund will need to pay out Janes portion of the super fund as a death benefit. In the vast majority of cases, in order to meet the death benefit, the property is going to have to be sold. There are many reasons why this could be an awful result for Jim. Predominantly, this is because the super fund doesnt have a big enough cash balance to pay out Janes death benefit, which is likely to be slightly less than $400,000. These other problems include: 1. 2. Costs of selling the property (assume about 3-4% for agents fees and advertising) Being a forced seller. Never great if your property might need some time to attract a buyer at the right price. Selling into a flooded or depressed market.

It wouldnt be in the realms of the ridiculous that Jim could lose the vast majority of his $200,000 in super. Potentially, if gearing was included and the stars werent aligned, he could potentially lose all of it. For example, if, due to a property market downturn, the property had dropped by 20%, then it is now only worth $400,000. There were $15,000 in sales costs (and $30,000 was already blown up in stamp duties on purchase). Jim could suddenly have to pay out nearly $400,000 (probably to himself as dependant), but a good portion of his $200,000 could have been lost in the transaction fees. Imagine then, if the whole thing had have been magnified by gearing. Instead of it being a $600,000 super fund on which $500,000 was spent on a property, take a $300,000 super fund on which $200,000 was spent on the deposit of a super fund that, with a loan, had purchased the $500,000 property. And then, the property market had collapsed and Jane had died. There may be no equity left in the investment property itself. Jim might be paying himself out something, but there would be little to nothing left of his own super. The solution Insurance that is structured and owned correctly. Please note: This is a particularly complex area. And anyone seeing some danger signs in their own circumstances from todays column is advised to seek independent financial advice. A solution is for Jim to own some life insurance on Janes life in the SMSF to ensure liquidity in the event of her death. That is, an insurance contract for $400,000 on Janes life, owned by Jim, would then be payable to the SMSF, specifically to Jims superannuation account. The insurance is then used to, in effect, swap the property ownership that Jane had for the insurance sum. This may allow her super account death benefit to be paid out in the event of her death, without the property being sold. It will come down to the ownership of the insurance policy itself and potentially the flexibility of the rules of the trust deed, in whether it will allow ownership of the insurance premium by another member over another members life. Check your trust deed You will also need to check the rules for your super fund trust deed, as to what they allow for when it comes to insurance, various ownership options and the allowability, potentially, for liquidity reserves. In some cases, for insurance strategies to work properly, the trust deed will need to allow for the segregation of assets between members.

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In any case, the huge surge in interest in property ownership in super is, undoubtedly, a good thing. However, it brings with it many risks. The increased risks associated with gearing is a major new issue. But even if you get all of those things right, with the right intentions, a badly timed call from the heavens could send your best laid plans into a tailspin.

The information contained in this column should be treated as general advice only. It has not taken anyones specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance. Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au

The Institute of Public Accountants (IPA) says Australians need to think about how the compulsory superannuation guarantee charge (SGC) rate, due to increase from 9% to 9.25% on July 1, will be funded when it comes into effect. There are only two possible avenues for funding the increase in the SGC; one, employers will do so, adding to their cost structure or two, employees must sacrifice some of their pay packet, said Andrew Conway, chief executive of the IPA. Self-managed super fund (SMSF) administrator SuperGuardian has launched a second SMSF product in a bid to attract investors looking to take control of their investments. Called Xpress Super, it will provide an SMSF service to rival the top end of the market with fees positioned at the lower end, said chief executive officer Olivia Long. La Trobe Financial has announced the winners of its annual CIO/COO awards, with a presentation at Melbournes Eureka Tower. Chief Investment Officer of the Year went to Gerard Parlevliet, chief investment officer of Commonwealth Bank Group Super, while Graeme Arnott of First State Super took home the award for Chief Operating Officer of the Year.

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23 SMSF property the NRAS way

By Paul Thewlis and Margaret Hardy
Summary: A self-managed super fund with a National Rental Affordability Scheme property has good upsides, but there are also serious potential pitfalls. Key take-out: The leveraged growth of property and the advantageous cash flow and tax benefits of the NRAS inside a SMSF are potentially a strong combination in boosting retirement funds. Key beneficiaries: SMSF trustees. Category: Property. SMSFs and NRAS for the past year theyve been the two biggest acronyms on the lips of property investors. There has been a high level of enthusiasm for buying property in selfmanaged superannuation funds (SMSFs) and buying properties under the National Rental Affordability Scheme (NRAS). This excitement has been counter-balanced by various detractors and doomsayers condemning both. The debate has left a lot of people scratching their heads, trying to figure out how all these opinions fit together. Like many investments, a SMSF with a NRAS property has some great upsides but the setup and maintenance has to be done properly and professionally, otherwise there are serious potential pitfalls. The SMSF story generally starts with a letter opening. The annual superannuation member statement arrives with a feeling of disappointment about how poorly the fund is performing. In discussions with clients, weve found the move to SMSFs appears to be driven at least in part by a perceived lack of performance of institutional superannuation and an associated desire for greater personal control. The appeal of property investment in an SMSF is generally two-fold. Firstly, people who enjoy the control that a SMSF offers are likely to favour bricks and mortar assets. Secondly, property offers the SMSF the ability to leverage its funds by borrowing from the bank to buy the property. This has the potential to magnify the growth of assets. To these advantages you can add the fact that property gives SMSFs a wider investment choice. It lets members take advantage of their experience in investment choice and asset management and of course provides tax benefits. For the analytical ones, SMSFs offer a great tax balancing act opportunity. After allowing for interest on borrowings, holding costs and depreciation, the property makes a tax loss that can be offset against the other taxable income of the SMSF (egg. member contributions or interest on cash assets) to reduce the tax payable. Also the tax on capital gains incurred by SMSFs is different from outside super. An SMSF pays 15% on capital gains for property sold within 12 months, and effectively 10% when the property is held for over 12 months (the SMSF only needs to declare two-third of the capital gain which is taxed at 15%). Most importantly, theres no capital gains tax payable if the property is sold when the SMSF is in pension phase. The downsides of investing in property in a SMSF are the purchase costs and in particular stamp duty. Initially some of your super funds sitting in the SMSF to give you a better tax outcome end up back with the government. But as shown later this is a cost that can be accepted in the context of the overall picture of a leveraged investment. Like other property buyers, SMSFs buying property off the plan can benefit from substantial stamp duty savings in some states. For example, purchasers in Victoria who buy apartments prior to construction only pay stamp duty on the land value apportioned to each individual apartment. Now lets add an NRAS property into the mix. Im not going to go into too much detail about the scheme itself but the main benefit is that the federal and state governments will give the SMSF an estimated $119,833 tax-free income over 10 years. This comes in the form of refundable tax offsets (75%) and tax-free payments (25%) that are paid annually for a decade and indexed. In exchange for the NRAS incentive, the SMSF must rent the property for at least 20% below market rent and incur some additional administrative costs. However, even taking this reduced income and higher cost into account, the overall financial position is a favourable one. There are also some side benefits related to the type of properties purchased under NRAS. As NRAS properties are new, they have greater depreciation allowances than older property. This means greater tax savings potential. A new property will have full depreciation available based on todays construction costs, whereas an older property will only have part or no depreciation allowable (depending on its age). Doing the numbers Lets put this scenario in more concrete terms. To illustrate how NRAS can benefit an SMSF well take an example of an SMSF that has just been set up and has $200,000 in cash that has been rolled over from an institutional super fund. The combined income of the two members of the fund is $120,000 per annum and only their 9% employer contribution is being deposited into the fund. Were going to assume the assets of the SMSF not used for buying property are invested so that they are earning 5% per annum. Well call these assets cash in our examples as if theyre held in a term deposit. At this stage, were just looking at income such as interest and dividends, and not taking into account capital growth. In a benchmark non-property option, well invest all $200,000 in cash assets earning 5% per annum. In year one the SMSF returns $10,000 and the employer contributions add an additional $10,800. Thats a total of $20,800 on which 15% tax is paid ($3120) giving a net after-tax increase in the SMSF assets of $17,680 and a net asset position of $220,800. In the second option, the SMSF invests in a property thats not an NRAS dwelling. Well assume for the sake of

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comparison that the property is a new one purchased off the plan. The purchase price is $300,000 plus there are additional costs of $10,000 (egg. stamp duty and legal costs) and the SMSF borrows at an 80% loan-to-value ratio LVR. Once the purchase is settled, the SMSF is left with a $300,000 property, $130,000 in cash and a $240,000 loan. Thats a net asset position of $190,000 with $10,000 lost in acquisition costs. The income of the SMSF in this second option includes the same employer contribution. Income from the cash is reduced because some of it has been spent on the property but the SMSF is now earning rental income. Gross income of the SMSF has therefore increased from $20,800 to $32,300. However this isnt the full story, as we need to look at expenses and tax. The property and loan incur costs including interest, agent fees, rates and maintenance. In summary the SMSF earns more gross income, has more expenses, pays less tax and earns less after-tax compared to our benchmark option. The after-tax income after buying the property is $11,171, compared to our benchmark that was $17,680. Therefore after the first year the SMSF has a closing balance on its assets thats over $16,000 less than the benchmark option. Finally we have the NRAS option, where the property the SMSF purchases is exactly the same as the previous property but is approved for inclusion in the scheme. The purchase costs are the same but the rent is reduced by 20% and the SMSF receives in return the NRAS incentive (which is $9,981 this year). We see the SMSF earns a lower gross income than the previous property option, has similar expenses and pays the least tax of all three options. The after-tax income of $18,602 is about $1,000 higher than the benchmark option. Therefore, taking into account the purchasing costs of the property, after our first year the SMSF has a closing balance on its assets thats about $9,000 less than the benchmark option. OPENING ASSETS Property Cash TOTAL Employer super Investment income Rent income GROSS INCOME Deductible interest Rental expenses Depreciation TAXABLE INCOME Tax (15%) Add back depreciation NRAS incentive AFTER TAX INCOME CLOSING ASSETS Property Cash Loan TOTAL $217,680 $0 $217,680 $300,000 $141,171 $201,171 $300,000 $148,602 $208,602 $0 $200,000 $200,000 $10,800 $10,000 $0 $20,800 $0 $0 $0 $20,800 -$3,120 $0 $0 $17,680 $300,000 $130,000 $430,000 $10,800 $6,500 $15,000 $32,300 -$17,040 -$3,000 -$5,000 $7,260 -$1,089 $5,000 $0 $11,171 $300,000 $130,000 $430,000 $10,800 $6,500 $12,000 $29,300 -$17,040 -$3,000 -$5,000 $4,260 -$639 $5,000 $9,981 $18,602 No property Non-NRAS NRAS property property

-$240,000 -$240,000

At this stage weve shown that NRAS property is looking better than non-NRAS property, but it still doesnt look too attractive against our benchmark non-property option. But here enters the juiciest part of the SMSF property story leveraged capital growth. Lets take the example weve been using where the SMSF is investing $70,000 in either property or some other asset. For ease of comparison, lets assume both the property and the unleveraged equity grow at 5% per annum. In the graph below youll see the property equity is behind in year two because of purchase costs, but when the SMSF invests in property its benefiting from growth on a larger asset (5% of $300,000) compared to unleveraged equity (5% of $70,000). The property option in this example sees the SMSF over $100,000 ahead at year 10.

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direct property investment as too much work but for those who know and love property investing, the SMSF route could be very advantageous and an NRAS property could be the icing on the cake. Those approaching retirement age in a decade or so are realising their 9% super contributions into retail or industry super funds just wont be sufficient. The leveraged growth of property and the advantageous cash flow and tax benefits of NRAS could combine to give their super a strong push to retirement.

Reproduced with permission from Australian Property Investor magazine. www.apimagazine.com.au. Paul Thewlis and Margaret Hardy are partners at Onyx Wealth. Property and other equities dont grow at the same rate at the same time. So potentially a non-property asset could grow faster than property. How much would the SMSFs unleveraged equity need to grow to match the property? The answer is 13.3% over 10 years, which experience suggests would be an extraordinary performance. Its possible the SMSF would need to invest in high-risk assets to obtain this result. The leaves us with the NRAS story, which says the NRAS property offers the same leveraged growth but with better cash flow potential. One outcome of this better cash flow position is that a SMSF can often borrow at a higher loan to valuation ratio when buying an NRAS property than a nonNRAS property. The Balancing Act To make the NRAS property investment scenario work there are a number of factors to consider when setting it up. 1. 2. 3. A higher loan LVR will give higher leverage. The value of non-property assets needs to be high enough to allow the SMSF to be liquid. Income (egg. member contributions, rent, dividends and interest earned) into the SMSF needs to be high enough to ensure it meets the lenders serviceability requirements. Enough negative gearing to reduce or eliminate the SMSFs tax obligation may be advantageous. Too much negative gearing will mean the SMSF is unable to access tax benefits by having ongoing tax losses. Positive cash flow property is preferable as its adding to your SMSFs assets, not using them up in holding costs. The property sale should be timed to obtain the desired capital gains tax position.

4. 5.

6.

7.

Each SMSF will need to balance these factors to optimise the outcome and an NRAS property will have a different balancing position to non-NRAS property. To make this all work you really need to know what youre doing. You need to work with a professional who has experience in SMSFs and property. The choice of investing in property or any investment does come down to the personal choice of the members of the fund. Some will see

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26 Balancing out SFGs bid withdrawal

By Tom Elliott
Summary: A profit downgrade by accounting services group WHK was enough for SFG Australia to withdraw its takeover offer. WHK said it expects its earnings for the six months to June to come in 20% lower. Key take-out: SFG has said it will look at re-engaging merger discussions at a later date. Key beneficiaries: General investors. Category: Portfolio management. SFG Australia (SFW), WHK Group (WHG) There has been a bit of action in the wealth management space in the past few days. First off, SFG Australia has withdrawn its all-stock offer for WHK Group following WHKs recent earnings downgrade. In a market update at the end of last month, WHK said it expects its earnings for the six months to June to come in 20% lower than the same period last year. Since then, its shares have fallen about 20%. Remember, this was supposed to be a merger of equals when it first came about. I understand a lot of people would have bought into this when the proposed merger was announced back in February, and for those who did, I would be inclined to hold for now. After all, those who bought in at the time werent paying a premium for the shares in the first place. SFG has also said that it will look at re-engaging merger discussions at a later date and I think it makes sense for the two companies to merge, although the reality is it probably wont happen in the near term. The Trust Company (TRU) On a more positive note, Perpetual has put out a takeover bid for The Trust Company. The bid is for 0.1495 Perpetual shares for each Trust Company share, plus a 22 cent dividend. At current prices, its worth around $6.27 per share, plus the 22 cent dividend, so roughly $6.50. If it goes ahead, Trust Company shareholders can choose to receive the consideration in scrip or in cash at an equivalent value, up to a cap of $60 million, or about 30% of the value of the bid. If they opt for more than $60 million in cash, there will be a proportionate scaleback and shareholders will receive the balance in Perpetual shares. The cash alternative will be calculated based on the trading price of Perpetual shares in the 10 trading days before Trust Company shareholders meet to vote on the scheme. My view is that even though Trust Company is not the most liquid of stocks, I think it is probably worth a buy. For a start, its currently trading at about $6.27, so its only trading at what the bid is worth, without even factoring in the dividend. Secondly, Equity Trustees, which has tried to bid for Trust Company in the past, has made it clear that its still interested. So basically, it looks to me like there may be a contested bidding situation here. Equity Trustees can certainly afford to pay more than its previous bid of $5.28, which Trust Company rejected. So there is plenty of potential upside given there are two likely bidders. The only negative is Trust Company is not the most liquid of companies, so it is not the easiest stock to get in and out of. Billabong (BBG) The market is still waiting to hear the verdict on Billabong. All we know is that the talks with Paul Naude and Sycamore Partners are due to end today. No one knows whats going to happen, the bid could be cut, it could be withdrawn, or it might just go ahead. The stock last traded at 45.5 cents, and is now suspended pending an announcement. GrainCorp (GNC) Very briefly with GrainCorp, basically Archer Daniels Midland has completed its due diligence and is proceeding with the bid. However, it is still subject to the various regulatory and shareholder approvals. I think the market is starting to realise that the whole thing could take a while and because of that weve seen the share price starting to drift back a bit. As I said last week, I thought selling at about $12.80 was a good idea, but you know I think that it will go ahead eventually (see: Selling GrainCorp into a sweeter bid).

Tom Elliott, a director of Beulah Capital and MM&E Capital, may have interests in any of the stocks mentioned.

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28 Ask Max: Your questions answered

By Max Newnham
Summary: This article provides answers on maximising contributions before next weeks budget, the costs of corporate trustees, passing super to non-dependents, indexation on benefits, franking credits and overseas income under the proposed super rules, using super to buy a family dwelling, and calculating the 45-day holding period. Key take-out: Income earned from a foreign pension must be included on your personal income tax return, but has no effect on the income earned in a SMSF pension account. Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Superannuation. Should non-contributions be maximised before the budget. Do you think that the $150,000 non-concessional limit could be reduced to something like $50,000? Maybe this financial year is the last year people will have the ability to bring forward the next two years limit and contribute $450,000. So should people act before the Budget in May? Answer: I have not heard of any plans to reduce the current non-concessional contribution limits are scrap the three-year rule. This, of course, does not mean that the government is not considering doing this. If you are at all worried that this could be on the governments agenda, and you have not made any non-concessional contributions in excess of the $150,000 in the previous three years, consider maximising your contributions before next Tuesday, being budget night. What are the costs of setting up a corporate trustee? Can you outline broadly the costs associated with changing an SMSF trust deed from individual trustees to a corporate structure? Is there a minimum amount threshold in the SMSF that you would recommend before making the change? Answer: There are two main costs associated with changing the trustees of an SMSF from individuals to a company. The first relates to the formation of the company, which costs approximately $800. The second is the changes that need to be made to the trust deed, and this will cost approximately $200. If you are doing all of the organising yourself there should be no extra costs, however if your accountant is assisting with this there would be some extra costs related to the work they do. There is no real minimum amount that an SMSF should have in funds before considering changing from individual trustees to a company. The main point to consider is whether it is better to go through the trouble and costs now, or have the worry and administration at the time of one of the members dying. What are the tax treatments for passing super to nondependents? You suggest that there would be 16.5% tax payable on superannuation passing to non-dependents upon the death of a member. I understood there was a different tax treatment for the tax-free (non-concessional) and concessional components of the balance. Is this not the case? If not, what is the benefit of the withdraw/recontribute strategy for increasing the taxfree proportion? Answer: You are right, the persons superannuation can be made up of both taxable and tax-free superannuation benefits. Tax-free superannuation benefits per dollar of income from non-concessional after-tax super contributions. There is no tax payable on tax-free superannuation when it passes to non-dependents. This is why the re-contribution strategy, converting taxable super to tax-free super does work. How can the non-indexation of health care benefits be addressed? I recently sent you an email asking about the fact that the upper limit of allowable income for eligibility for the Health Care /Pharmaceutical card has not been indexed from $50,000 for years. How could this be addressed? Everything else is indexed, including the supposed $100,000 limit for SMSF taxable income. Answer: Unfortunately there are many limits that have been put in place that are fixed and do not increase with indexation. An example of this is the $500,000 small business capital gains tax retirement exemption. Unfortunately the government uses fixed limits that do not increase in line with inflation as a stealthy way to effectively increase taxes and reduce access to benefits. My only suggestion is that you write to local Federal member and voice your concerns. Will franking credits be counted under the proposed super tax changes? My SMSF is in pension mode and I receive a substantial amount of franking credits each year. I have seen a number of references to franking credits in various reports on the superannuation changes but I am still not clear whether they contribute to the $100,000 tax threshold or not. As these credits were introduced to avoid double taxation I would have thought they would not have been considered, but I would appreciate if you could clarify this for me. Answer: When an SMSF burns fully franked income the amount of the cash dividend received plus the franking credit received is shown as income. This means that if the Gillard Governments policy of taxing superannuation fund accounts in pension phase that earns more than $100,000 income in a year becomes legislation that tax would effectively be applied to the franking credits received. Franking credits are included as income because they can result in a tax refund for an SMSF.

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Will overseas income be included under the proposed $100,000 earnings tax change? My husband and I are Australian citizens and residents but receive lifetime annuities from overseas, which are currently fully taxed at our marginal tax rates, apart from a small deduction based on the undeducted purchase price of these annuities. Under the proposed new rules, would the taxation of our overseas annuities remain the same? We have also established a DIY super fund here in Australia. Would the earnings from our overseas funds we do not know what these are as we do not receive them be added to the earnings of our DIY fund in determining our overall earnings above the $100,000 limit? Answer: Under the proposed policy the $100,000 relates to the income earned on an individuals pension superannuation account within an Australian superannuation fund. The income you earn from your foreign pension must be included on your personal income tax return, but has no effect on the income earned by you in your pension account in your SMSF. Can my fund buy my daughters unit? My daughter is in a unit she owns and is in the process of selling it to move to a bigger house due an addition to the family. I would like to buy it outright at market value from my pension fund of the SMSF, which I jointly hold with my wife. The unit will then be part of my portfolio and will be rented properly at market value through an agent to a third party unrelated or known to us. The rent will be credited to our SMSF as an income. Am I doing this within the rules of the SMSF? Answer: There is a specific ban on superannuation funds buying assets and investments from members and related parties. The only exceptions to this rule are publicly listed investments, such as shares, and commercial real estate property. Your daughter would be regarded as a related party of yours, which means that your SMSF could not buy the unit she owns. It would not matter if a market valuation is obtained for the unit and the market rent that needs to be charged, and that the unit will be left through an agent to an independent third party. If your SMSF purchase the unit you would be in breach of the investment rules and would be forced to either dispose of the unit or could be classed as a non-complying fund. When this occurs the income and all of the assets of the fund has tax levied on it at 46.5%. When is the 45-day holding period calculated from? When you purchase shares, is the 45-day holding period calculated from the date the shares were purchased or the settlement date? Answer: According to the ATO, when calculating the 45-day holding period you should not count the day on which the shares are purchased and the day on which they are disposed. This in a practical sense means, taking into account that the shares must be purchased on day one, that to meet the 45-day rule the shares could not be sold until after day 46. Max Newnham is a partner with TaxBiz Australia, a chartered accounting firm specialising in small businesses and SMSFs. Note: We make every attempt to provide answers to readers questions, however, answers are of a general nature only. Subscribers should seek independent professional advice for more in-depth information that is specific to their situation. Do you have a question for Max? Send an email to askmax@eurekareport.com.au

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30 Collected Wisdom
By Cliona ODowd
Summary: Analysts rate Woodside a buy, but recommend selling JB Hi-Fi, while Tabcorp, GPT Group and AGL are holds, the newsletters say. Key take-out: There has been much debate over the big fours rising share prices, but analysts say ANZ still has more to give. Key beneficiaries: General investors. Category: Portfolio management. This is an edited summary of Australias best-known investment newsletters and major daily newspapers. The recommendations offered represent the views published in other publications and may not represent those of Eureka Report. Woodside Petroleum (WPL) Investors on the hunt for yield are viewing Woodside Petroleum in a new light following its decision to increase its target dividend payout ratio from 50% to 80% and its plans to maintain the higher payout ratio for several years. The oil and gas player certainly delivered the goods in its latest trading update, tempting investors further with a oneoff fully franked dividend of $US63 cents per share. The share price surged above $38 as investors rushed to buy in before the ex-date on April 30. But for those who missed out on the special dividend, fear not. The newsletters are convinced Woodside has more to give and say those seeking a balanced portfolio should consider buying in. Forecasts indicate shareholders could see a yield of about 5% to 6% this year. Leaving dividends aside, Woodside saw a solid increase in production in the March quarter. Production rose 55.3% on the previous corresponding period, to 21.9 million barrels of oil equivalent (MMboe). The production results were largely due to its new $US14.9 billion Pluto liquefied natural gas (LNG) project in Western Australia, which is at 90% capacity, and continued strong performance of the North West Shelf business, the oil and gas player said. The investment press has also taken the news on the deferral of projects in a rather positive light, noting that shareholders can reap the benefits of the higher dividends now, and be somewhat assured that Woodside will pursue development opportunities at a time when costs arent so high. Tabcorp (TAH) Tabcorps third quarter trading update broadly met market expectations last week. For now, the newsletters place the gaming business in the hold category due to modest growth and stable revenue. Revenue increased to $480.3 million in the quarter, a 2.6% rise on the previous corresponding period, while year-to-date revenue came in 2.2% higher, at $1.5 billion. The company looks to have largely shrugged off last years loss of the Victorian pokies franchise, with its new gaming services division tracking along at a healthy pace. Tabcorp holds a number of long-term licenses that ensure continued reliable earnings and cash flow. In April, the Queensland government extended Tabcorps license to operate Keno in the state until 2047, while it holds similar licenses in New South Wales and Victoria that expire in 2022. However, the newsletters note the increased competition penetrating the market through the internet as consumers increasingly make use of mobile devices and are concerned over the effect it will have on Tabcorps numbers in the future.

Investors are advised to hold Tabcorp at current levels

GPT Group (GPT) In its first quarter trading update, GPT Group reiterated its target of full-year earnings-per-share (EPS) growth of at least 5%. The group confirmed the distribution payout ratio will remain at 80% of realised operating income (ROI) ie profit less non-recurring items. The group has suspended its dividend reinvestment plan for now, and distribution for the quarter was 5.1 cents per share, a rise of 10.9% on the corresponding period in 2012. GPT also announced a move to half-yearly distributions from July 1, which it said would deliver cost savings. The newsletters broadly view GPT as a hold for the time being. The groups total portfolio performed well in the quarter, with the retail property portfolio recording continued high occupancy of 99.7%. The logistics portfolio occupancy came in at 98.5%, while occupancy for the office portfolio was slightly lower at 95.7%. Investors and newsletters keen for any further comment on the status of its takeover bid for Australand got some insight from chief executive Michael Cameron. He said GPT is committed to advancing a proposal, but it is important to remind you that we don't have to actually do the deal to achieve our strategic goals, he said.

Investors are advised to hold GPT at current levels

AGL Energy (AGK) AGL Energys share price took a hit last week after the company lowered its profit guidance for full-year 2013 on the back of increased retail competition and soft wholesale market conditions. The newsletters still see potential, and rate AGL a hold. Underlying profit for the full year is now expected to be in the lower half of the guidance range of $590 million to $640 million. AGL said in the update that it had seen unprecedented customer churn volumes in Victoria and New South Wales due to intense competition and has started to place more emphasis on retention to counter heavy

Investors are advised to buy Woodside Petroleum at current levels

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competitor discounting. There are reports that Origin is offering discounts of up to 25%. Separately, the energy retailer noted increased solar penetration and declining manufacturing as reasons behind the softer wholesale prices. Still, the newsletters say there are a number of reasons to remain positive on AGL. These include the recently purchased Loy Yang generator, which has provided benefits of scale and improved coverage of retail load with owned and controlled, South Australias recent deregulation of electricity pricing, and its position as one of the countrys biggest renewable energy generators.

Investors are advised to hold AGL at current levels

JB Hi-Fi (JBH) JB Hi-Fis update to its full-year guidance came on the back of stronger-than-expected sales in the half year to date. Its share price rose sharply on the news, but the newsletters are less than convinced and rate it a sell. The retailer said that sales in fiscal 2013 are now expected to be around $3.3 billion and net profit after tax (NPAT) is forecast to be between $112 million and $116 million. This represents a 7% to 11% increase in NPAT on the previous year. Although the retailer recorded a lift in sales in the first four months of the second half, year-to-date sales are down 1.3% due to a 3.4% decline in like-for-like sales in the first six months. Despite its low-cost business model delivering a competitive advantage over its peers, the newsletters believe increased competition and price deflation remain long-term risks. Online competition is seen as a big threat, as consumers increasingly take advantage of the cheaper products on offer, while plans by retail giants Costco and Woolworths to compete aggressively in the sector are viewed as a further negative. The newsletters are also unsure of what growth opportunities lie ahead for the retailer apart from the rollout of new stores, and rate the investment risk as high.

Investors are advised to sell JB Hi-Fi at current levels

Watching the Directors Caltex Australia managing director and chief executive Julian Segal was a big seller last week, offloading 325,412 shares at $20.90 apiece, bagging himself a healthy $6,833,066. Elsewhere, M2 Telecommunications founder Vaughan Bowen sold 1,000,000 shares, collecting $5,445,377 in the process, while chairman Craig Farrow offloaded 95,000 shares for $527,250. Bowen still holds over $28 million worth of stock, while Farrow holds about $3 millions worth. Finally, Atlas Iron managing director, Kenneth Brinsden, bought 212,000 shares for $183,486 in on-market trades during the week.

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32 Research Watch
By Luke McKenna
Summary: This weeks Research Watch covers a range of investment snippets, including the top dividend destinations, banks vs resources, small caps, the Nikkei and short skirts, Dow 15,000, Dr Copper, and Buffetts market forecasts. Key take-out: Credit Suisse analysis shows the Australian market offers the fourth highest dividend yield and the highest payout ratio within the G20 markets. Key beneficiaries: General investors. Category: Portfolio management. Despite all this talk about the hunt for yield, it turns out you dont need to venture too far at all. Credit Suisse has just named Australia among the top dividend destinations in the developed world, and lists the individual stocks that will help you capitalise. There arent any banks on that list, which could give weight to Goldman Sachs call to make the switch from hell out of our big four, and into mining shares although others suggest you should be thinking much smaller. Meanwhile, what Dow 15,000 means for you, and what Nikkei 13,000 means for a pop group that uses the index as a wardrobe cue. Dr copper looks ill and margin debt is hitting new highs, leading hedge fund manager Leon Black to sell everything thats not nailed down. But on video, fresh from Berkshire Hathaways annual meeting, Warren Buffett makes a case for stocks at record levels (he remembers Dow 100). The best dividend stocks in one of the best-yielding markets... Companies present in both the capex and upside screens: Adelaide Brighton (ABC), AGL Energy (AGK), Brambles Limited (BXB), Fantastic Holdings (FAN), OrotonGroup (ORL), Pacific Brands (PBG), Premier Investments Ltd (PMV), Qantas Airways Ltd (QAN), Rio Tinto (RIO). (Credit Suisse, May 7) Avoid the bank bubble with the switch from hell...

The banks will go higher if the US keeps running, but their long period of outperformance for the banks Id say its over or very near an end. Banks have outperformed resources by +97% in the last 28 months and its time to chase these (very) cheap resources. For me its time to begin the switch from hell time to go back into those beaten up resources do you seriously see this going too much further!!!! (Richard Coppleson of Goldman Sachs, May 6) But dont neglect the small caps...

The Australian market offers the fourth highest dividend yield and the highest payout ratio within the G20 markets. We have screened Credit Suisse coverage according to whether they offer high and sustainable dividend yields. Predictably, Banks, A-REITs, Healthcare and defensive exposures screen well on this basis. In addition, we have asked Credit Suisse stock analysts which of these stocks could deliver an upside dividend surprise in the short term.

Since 1972, the S&P 500 increased nearly 5,000%. Yet, owning the top stock in the S&P 500 by market capitalisation increased in value approximately 400%. (John Del Vecchio of The Active Bear ETF, May 1)

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Long bets, short skirts Perhaps its not such an impressive record after all...

Kanon Mori, Yuki Sakura, Hinako Kuroki and Jun Amaki have been following the Nikkei 225 stock average obsessively since Prime Minister Shinzo Abe took office in December. The oldest of the foursome is Mori, but she is still only 23. The youngest is Kuroki, 16 and still in high school. None of them are studying for a degree in economics, let alone playing the stock market. Instead, the four are members of a new idol group, Machikado Keiki Japan, and stocks play an important part in their performances. We base our costumes on the price of the Nikkei average of the day. For example, when the index falls below 10,000 points, we go on stage with really long skirts, Mori explained. The higher stocks rise, the shorter their dresses get. With the Nikkei index ending above 13,000, the four went without skirts altogether on the day of their interview with The Japan Times, instead wearing only lacy shorts. (The Japan Times, May 2) What does Dow 15,000 mean?... Technically: Technically, theres isnt much to the mark. These big, round numbers dont mean anything technically, as Tomi Kilgore pointed out. The Dow is already above its 50-, 100- and 200-day moving averages, three closely watched technical markers. Psychologically: The effect of something like Dow 15000 usually is more psychological. Big, round numbers always attract interest. The difference is that during the past few decades, it was an article of faith that the market represented the economy, or even that the market was the economy. The aftermath of the Crash of 2008 has severely disabused most everybody of that notion, one reason why interest in the market, and trading volumes, remain so lacklustre even as the indexes hit fresh records. Its hard for most people to get excited about new highs in the stock market when theyre still trying to rebuild the wealth they lost from the 2000 and 2007 stock crashes... Valuation: Weve become so bubble battered over the past 13 years, that its natural to think any rising asset must be in a bubble, but its relatively easy to make a case that stocks are fairly valued. The simple forward-year PE ratio on the S&P 500 is a hair under 15, roughly in line with the long-term average. (Wall Street Journal Money Beat, May 7)

(Dave Rosenberg of Gluskin Sheff, May 5) As Dr Copper falls ill...

Edwards central argument is that just as both the US and Europe are slipping towards outright deflation, investors have convinced themselves they just have to participate in the liquidity fuelled frenzy offered by unlimited QE. But the copper price is saying something different and it offers a solid reminder that liquidity itself can disappear very quickly indeed, as it did when Edwards last drew our attention to Dr Copper back in January, 2007. (Albert Edwards of Societe Generale via FT Alphaville, May 2) And with leverage running hot...

Its rather alarming to see NYSE margin debt just shy of its all-time high as of the March reading. My guess is weve actually already surpassed the all-time high though we wont officially know until April data is released. Fun times knowing

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we live in a world that is built on such a fragile foundation. (Pragmatic Capitalism, May 5) It might be time to sell everything thats not nailed down... Its almost biblical. There is a time to reap and theres a time to sow, Leon Black, chairman and chief executive of Apollo Global Management declared to the Milken Institutes global conference in Los Angeles, alluding to that same Scriptural passage. We are harvesting, he added pointedly. That is, the private-equity giant is a net seller because things simply cant get much better. We think its a fabulous environment to be selling, he says, noting Apollo has sold about $13 billion in assets in the past 15 months. Were selling everything thats not nailed down. And if were not selling, were refinancing. Thats because there has never been such a good time to borrow -- which is raising warning flags for Black. The financing market is as good as we have ever seen it. Its back to 2007 levels. There is no institutional memory, he observed, referring to the peak of the last credit bubble. That was when then-Citigroup CEO Chuck Prince famously said that as long as the music was playing, bankers had to keep dancing -- which they did, with disastrous consequences when the band stopped. (Barrons, May 4) Video of the Week: Although Buffett says markets will go a lot higher... Youll see numbers a lot higher in your lifetime, says Buffett, joking about watching the Dow cross 100.

(Click here to watch the video: CNBC, May 6)

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35 Letters of the Week

By Eureka Report subscribers
ResMeds dividend drought Why would I buy, on a PE of 22.3, shares in a company which has $1,000,000 in cash but doesn't pay a dividend? (How ResMed is still hitting sixes, May 1). Brian Bartley Rogers response: My column was more a suggestion for members to conduct some research rather than buy shares in the company as such. You might like to think about Berkshire Hathaway, which hasn't paid a dividend since 1967 yet its shares have risen from $US18 to $US160,000 since then because it has retained all of its earnings and compounded those retained earnings at a high rate of return on equity. Despite generating $24 billion in cash annually today, it pays not a cent in dividends. If you need an income you could sell a Berkshire share and if you wanted to have a good year, you could sell two! Be sure to seek and take personal professional advice before trading any securities. Leveraging a lower dollar I was interested to read Robert Gottliebsens article, The big risks markets are ignoring, and his comments on the Australian dollar. What investments can we invest in to take advantage of a falling Australian dollar? Name withheld Editors response: You may find Ian Verrenders article, Winners from a dollar demotion, of interest. Collecting the wisdom I enjoy the Collected Wisdom column, and would be very interested to know the number and identity of 'Australia's best-known investment newsletters' referred to throughout. JC Editors response: Thanks for your comment. Collected Wisdom looks at a combination of analyst reports, broker calls and business news sites each week to determine suitable stocks to analyse and the appropriate call for each one. Positive thinking Adam Carr is a breath of fresh air. His positive attitude combined with his knowledge is something that the other doom and gloom "experts" should look at. Well done Adam. Name withheld Downside to low interest rates? I would be interested to see an article in Eureka Report on the economic downsides of lower interest rates in the longer term. The mantra today in low confidence is lower interest rates but how low can they go and at what cost? Name withheld We welcome your letters Eureka Report is always seeking insightful comments to publish on our letters page. If you have a letter to send, please click here.

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