Intelligent Investor Dec 2012

wEEKLY REViEw | ISSUE 334b | 39 dECEMBER 2011

CONTENTs STOCK REVIEWSsTOCK AsX CODE RECOmmENDATiON PAGE

iN THis issUE...

ASX F&P Healthcare Fosters Group MAp Group Metcash STW Communications

ASX FPH FGL MAP MTS SGN

Hold Long Term Buy Coverage Cease Hold Long Term Buy Long Term Buy

8 7 10 13 5 11

John Addis

In tough conditions, the model portfolios have performed well and members portfolios are prepared to take advantage of a brewing GFC Mk II... (see page 3)

STOCK UPdATESAWE Carnarvon Petroleum Sirtex Medical AWE CVN SRX Speculative Buy Speculative Buy Speculative Buy 14 14 15James Greenhalgh

The past six months were difficult but with Franklins under its umbrella, profit growth is likely to resume... (see page 5)

FEATURESLetter from the Research director Wearing protection Bristlemouth blog | 10 Stockmarket Predictions for 2012 2 3 15Nathan Bell

EXTRASBlog article links Podcast links Twitter links Ask the Experts Q&As Important information 16 16 17 17 20

It was a very respectable interim result but shareholders have little to show for it. Nathan Bell makes the case for hanging on... (see page 7)

James Greenhalgh

RECOMMENdATION CHANGESFosters Group from Hold to Coverage Ceased MAp Group downgraded from Long Term Buy to Hold STW Communications upgraded from Hold to Long Term Buy

Competition and regulatory change make for a tough playground, but ASX remains the biggest kid in the park. If only the share price would slide, reports James Greenhalgh... (see page 8)

PORTFOLIO CHANGESPORTFOLiO sTOCK BUY/ sELL DATE NO. OF sHAREs PRiCE ($) VALUE ($)

Gareth Brown

Income

Fosters Group

Sell

2/12/11

1,250

5.40

6,750

With a more than 30% return since our original recommendation less than two years ago, the acquisition of Fosters delivers a great result. But spend the money wisely... (see page 10)

Jason Prowd

Since the days of John Singleton, STW has become a very differentand overlookedbeast. Jason Prowd makes the case for a cheapish, rather than madly cheap, stock... (see page 11)

intelligent investor

Dear Member, and what to expect from your With the festive season almost upon us, I wanted to let you know when Intelligent Investor subscription over the holiday period. er 2011, and the first newslet ter Your final newslet ter for the year will be published on Friday 9 Decemb 21 January 2012. of the New Year will be published on Friday the formal newslet ter itself. Just It is important to remember, however, that these dates only relate to of days between Christmas and New like rust, our analyst team never sleeps, and apart from the couple the website, and send you interesting Years Day, our intrepid researchers will continue to post articles to Facebook, so there will be plenty of and noteworthy snippets of news on the blog, through Twitter and on this time. new analysis to keep you engaged throughout d, which make for fascinating In addition, you will have the four special reports that have just been publishe g: and in depth study across a number of critical areas of investment includin n John Addis insightful analysis of The coming China crash selects the 10 best Investors n Tips and hints on How to become a better value investor, which perusal College articles for your leisurely top three stocks report and picks n The Top 3 stocks for 3 years, which reviews the results of the 2008 the top 3 stocks for the next 3 year period best resource buys. n And finally Gaurav Sodhi nails his colours to the mast with the Five absorbing reading for you to linger Altogether these reports provide many pages of comprehensive and over throughout the holiday period. who have recently joined us and My thanks to all our renewing members, and a warm welcome to those and advice in 2012. I very much look forward to bringing you all more in depth analysis Happy Christmas

Nathan Bell Research Director

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Weekly Review | Issue 334b

In tough conditions, the model portfolios have performed well and members portfolios are prepared to take advantage of a brewing GFC Mk II.More than the English, the Germans are known for quelling their emotions. The Euro crisis rises at the apex of this national trait. If the Germans really want to save the Euro, theyre doing a bloody good job of hiding it. A few months ago, even the most jaded observer, riled by Eurocracy and its over-reaching instincts, would be hard pressed to imagine a breakup. Now that possibility seems all too real. One senses a dnouement. Last week in Berlin, Polands foreign minister, Radek Sikorski, crashed through the artifice of international diplomacy, saying in a Financial Times editorialnot your typical diplomatic back channelthat, If we are not willing to risk a partial dismantling of the EU, then the choice becomes as stark as can be in the lives of federations; deeper integration or collapse. Indeed. The Germans can either save the Eurozone or, in not saving it, create an apocalyptic crash. Current discussionsand the Europeans do a lot of thatregarding fiscal union among Eurozone countries may (eventually) address the long term issue at the heart of the crisis. Whether the debt is addressed is another matter. Central bankers took matters into their own hands last week, developing a mechanism to help US dollars support the European Central Bank. With Sarkozy and Merkel discussing a renegotiation of the Lisbon Treaty, markets, preternaturally wired to volatility, scorched upwards last week. As of last Friday, the ASX 200 was up 7.6%, the best week in three years. GFC mk 2 If all of this seems a little remote, the comments of recently liberated former CEO of Commonwealth Bank, Ralph Norris, suggest otherwise. In an interview with Business Day, Norris said, This has potential to be significantly worse than the Lehman Brothers collapse and the subprime crisis because now we are talking about nation states. Markets, he said, had effectively frozen and that it doesnt matter how good your name is, you are not going to be able to access markets. Norris looks to have timed his exit to perfection. How do these bankers do it? Two things of note occurred in the banking sector as a result. First, as testament to the extent of the problem, the conservatively financed Commonwealth Bank had to pull a covered bond issue, adequately demonstrating how this seemingly remote crisis has a very considerable local impact. If the crisis deepens, Australia will not escape it. Second, the big four banks slipped close to the prices at which our recommendation guides suggest we would upgrade them. Under these circumstances, though, thats unlikely. The prices in these guides assume a fairly normal international credit market and, at present, its anything but. Dont expect us to upgrade any of the banks any time soon. Meanwhile, James Shugg, Westpacs London-based senior economist, inadvertently challenged one of the shibboleths of his profession: so worried is he about the crisis, hes quite rationally taken up smoking. Things are even worse than you are reading about, said James, reaching for the nicotine patch. Quite. Surely the time is ripe to sell up, pack up and emigrate to, err, Poland, which at least has the advantage of a sensible, plain-speaking foreign minister? Different this time? Not yet. There are a number of reasons whyand one cannot resist the phraseits different this time.

KEY POiNTsPortfolios are well prepared for turmoil with increased cash holdings and a defensive orientation Considering revising our performance report calculation methodology Model portfolio performance has been good and some buy recommendations already performing well

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First, you should be far better prepared for a severe downturn, and the opportunities it will bring, than you were in 2007. Much of the past 18 months has been about positioning your portfolio for exactly this scenario. Weve repeatedly made the case for cash, recommended you limit your exposure to the big banks to no more than 10% of your portfolio, steered clear of certain resources stocks, sought international exposure (see our recent series on opening an international trading account, titled Overseas brokerage pt 1 and 2, starting on page 14) and recommended defensive stocks like Woolworths, Metcash and Spark Infrastructure. Thats sound preparation. The year got underway with the two-part series Protecting whats yours: Top risks for 2011 (see issue 311) which underlined these themes. The repetition of them in this very column (see Preparing for uncertainty and Boy scout investing) is surely stretching the patience of Job. We shall assume your preparation all but complete and dwell on it no longer. Second, whilst Sell recommendations get far less attention than Buys, this year theyve been especially notable. For a decadeyes, it really has been that longwe recommended subscribers avoid Bluescope Steel and OneSteel, a view for which weve been regularly criticised. The stupendous share price falls over the past few years demonstrate the benefits of buying good businesses over poor ones. Rio Tinto isnt necessarily a bad business but it is overly exposed, like Fortescue Metals to iron ore. Since the publication on 29 Nov 10 of Why you should sell Rio Tinto (Sell$83.65) it has fallen 21%. The general avoidance of the sector has paid off. With cracks appearing in the supercycle, or at least the economy thats been driving itChinaits a sector to continue to avoid. The recommendation to avoid the rare earths boom proved as timely as the recommendation to avoid uranium stocks Palladin and ERA. Since The end of an ERA (Sell$11.40) published on 10 Feb 11, the share price is down 86% and Palladin, reviewed on 25 Mar 11 (Avoid$3.71) is down 54%. Since 16 Feb 11 in Leighton: Time to buy or exit (Sell$31.69), that companys share price has fallen 33%. Finally, the detailed review of the retail sector bought members attention to the effects of a slowdown in consumer spending but explained the extent of the threat of internet sales to businesses like Myer, david Jones and JB Hi-Fi well before mainstream media grasped the issue (see Ill winds hits JB Hi-Fi, Myer and DJs) from 15 Jul 11. Good opportunities The third factor working in our favour is that, unlike in 2008, the chaos is delivering some great opportunities among blue chip stocks. As research director Nathan Bell says, The difference this time around is that higher quality stocks have suffered as much as everything else. I didnt think Id see the day when Macquarie Group was trading on a yield of 6.7%, Metcash on 6.5% and QBE Insurance on (a slightly misleading) 8.9%. The preparation may have been 18 months in the making, but there were days this year when the need to act came with devastating speed. One such day was 5 Aug 11, when we published Its time to buy: stay tuned and then Blue chips dominate best buys published four days later. Already, and despite the fact that the ASX All Ords Accumulation Index is down 5.9% since the beginning of the year, some of these recommendations are developing nicely. Since the initial upgrade on 6 Jul 10 (Buy$2.59), MAp Group is up 38% (including the 80 cents per security capital payment). News Corp and ARB Corp have also performed well despite the turmoil. Even some of the lesser stocks weve recommended opportunistically have fared well. It took just over a year for Cellestis to return 69% since it featured on 16 Nov 10 (Speculative Buy$2.25). Fosters was another stock lost to a takeover, returning a total of 31% since Put some Fosters in your cellar (Long Term Buy$5.45) on 11 Mar 10. Nor should we forget Centrebet, which, although not formally recommended, featured in an Ideas Lab on 13 May 11 (see Ideas Lab punts on Centrebet), and RHG, recommended repeatedly but most recently on 28 Apr 11 (Speculative Buy$1.05). Since then its up 13% (including the 79 cents per share special dividend). Its also fair to say that our positive recommendations in the funds management sector and with Harvey Norman havent gone as wed hoped. But overall, your analytical team is pleased with how some recommendations are already working out and others are very well position. Buying stocks like Computershare, Challenger Infrastructure Fundboth down in price on our initial upgradeand the host of attractively priced blue chips on our buy list 4


means your portfolio should be well prepared for the current volatility and nicely positioned to take advantage of attractive valuations. The overall quality of the performance shows up in the portfolios. Since the beginning of the year to 5 Dec 11, the Income portfolio is up 6.4% and the Growth portfolio down 2.5%. Both compare favourably with the All Ords Accumulation Index, which is down 5.9%. Portfolio performance Calculating the performance of our two model portfolios is quite straightforward. Doing so for all our recommendations is more problematic. The annual performance report lists every single recommendation on every stock ever made and, through a lengthy process of analysis and calculation, offers annual returns for each type of recommendation. The methodology has its drawbacks; If a stock goes down 50% in one year its treated in the same way as one that goes up 50% each year for five years. Were currently reviewing this methodology and will submit it to members for comment at some stage in January, after which well get the figures professionally audited. Theres no perfect way to calculate performance but the closer the methodology is to reality, the more useful it will be to you. We look forward to your feedback when we announce the proposed changes to you. Lastly, if you havent yet responded to our special Christmas offer, which includes a very interesting book by Satyajit Das called Extreme Money and a special DVD, this is the time to do so. Its been a fascinating, troubled year but weve prepared well; cashed up and with a defensive orientation to our portfolios, we took advantage of the opportunities in July and August, what senior analyst Gareth Brown calls a big swing. Thats a nice allusion to our current stance; poised and prepared to strike at the next opportunity.

The past six months were difficult but with Franklins under its umbrella, profit growth is likely to resume.Profit upgrades are few and far between these days, but Metcash managed one last Wednesday. At its half-yearly results announcement (to 31 October 2011), management stated that the companys 2012 earnings per share would grow by low to mid-single digits (up from a forecast of low single digit growth). In plain Englisha language beyond most corporate executivesearnings are forecast to grow somewhere between 1% and 6%. Its better than flat, but not by much. For the half-year, revenues grew 2% to $6.1bn but profit fell 14% to $94m. Excluding a restructuring charge related to the acquisition of Franklins, underlying earnings rose 1% to $117m (with similar growth in earnings per share to 15.2 cents). As expected, operating cash flow surged, reversing a weak number in the second half of 2011 (due to an inventory build-up for Easter trading). A fully franked interim dividend of 11.5 cents was declared (ex date 9 Dec), up from 11 cents last year. It was a tough period for Metcashs largest division, IGA Distribution. Food price deflation, a more value-conscious consumer and the marketing war between the two supermarket giants conspired to produce a flat result. Under those circumstances, this was a creditable performance.

KEY POiNTsInterim result in line with expectations Franklins acquisition will lift profits Remains a Long Term Buy

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mETCAsH | MTSPRiCE AT REViEw REViEw DATE mARKET CAP. 12 mTH PRiCE RANGE FUNDAmENTAL RisK sHARE PRiCE RisK mAX. PORTFOLiO wEiGHTiNG OUR ViEw

$4.24 5 Dec 2011 $3.3bn $3.70$4.35 LowMed LowMed 5%LONG TERm BUY

An increase in the intensity of the marketing war, perhaps with a price war thrown in, or a decision by either Coles or Woolworths to move into smaller format grocery stores, remains a risk for IGA Distribution. Interestingly, the new head of supermarkets at Woolworths, Tjeerd Jegen, recently expressed surprise at the strong market position of the local independent grocery sector. But chief executive Grant OBrien has been quick to scotch any suggestion of entering this market. Perhaps he thinks Woolies has enough on its plate without taking on IGA. The results from Metcashs much smaller divisions were mixed. Australian Liquor Marketers, under pressure from the supermarkets relentless expansion, produced a surprisingly strong 32% lift in profit. With profit down 35%, the reinvention of Campbells Wholesale appears to be struggling. mighty helpful Over at Mitre 10, where the company enjoyed a 28% increase in earnings in the first half, the turnaround is gaining traction. The company stated that since its acquisition, better management and improved buying had attracted 20 independent hardware stores to the brand. Metcash chief executive Andrew Reitzer explained Mitre 10 was on schedule to generate $1bn in wholesale sales and a 3% operating margin, although it will face challenges as Bunnings and Masters lock horns. A pertinent question remains: If the first half result was flat, how will Metcash produce profit growth during 2012? The answer lies in the tug-of-war that Metcash has had with the ACCC over the acquisition of Franklins. Metcash officially acquired Franklins on 30 September. On 30 November, the ACCC lost its appeal to injunct Metcash from acquiring it (after the fact). While the ACCC can still appeal to the High Courtits determination to unwind the acquisition has been nothing short of dogged, and anchored in economic theory rather than real life according to the judge presiding over the casein the meantime, Metcash is getting on with the job of fixing Franklins. At the results presentation, management admitted the battle had damaged the prize. Franklins sales have dropped 11% since the deal was first announced last year, so Reitzer backed away from his previous claim that the deal would add 1.5-2 cents to earnings per share. Still, the acquisition should end up being pretty profitable once the stores are on-sold to independent owners. Profit boost While Franklins retail business (the stores Metcash will on-sell) is currently losing money, profits from the wholesale business (which it will retain) will boost underlying profit in the second half. On top of that, the companys new distribution centre is expected to begin producing significant productivity benefits. Both of these positive effects were behind the guidance upgrade, and benefits should persist into the 2013 financial year and beyond. The Franklins acquisition has resulted in Metcashs net debt-to-equity ratio hitting 57%, up from 47% in April (see Chart 1). As the stores are on-sold, debt levels should decline slightly, although theyre likely to remain a little less conservative than they should be. While Metcash is a defensive business, its market niche could be threatened if Woolies or Coles launched a concerted attack. High debt levels would make it more vulnerable. In short, the original rationale for the recommendation made on 1 Mar 10 in Metcash: Top quality, budget price (Long Term Buy$4.12) remains on track. Metcash has finally acquired Franklins and, while it is suffering from a difficult market environment and intense competition, the business is sufficiently resilient to withstand the onslaught. The stock is up slightly since 26 Aug 11 (Long Term Buy$4.04) although were hopeful of another opportunity to upgrade a notch (as we managed during a troubled August). On a forecast yield of 6.6% and a PER of 12.5, Metcash remains a solid LONG TERM BUY. The model Growth and Income portfolios own shares in Metcash.

TABLE 1: mETCAsH HALF-YEARLY REsULTsHALF-YEAR TO REVENUE ($BN) EBiTA ($m) EBiTA mARGiN (%) NET PROFiT* ($m) EPs* (C) DPs (C) FRANKiNG (%) OCT 11 OCT 10 +/- (%)

6.1 204 3.4 117 15.2 11.5 100

6.0 199 3.4 115 15.0 11.0 100

+2 +2 0 +1 +1 +5

* Underlying numbers

CHART 1: NET DEBT-TO-EqUiTY RATiO (%)60 50 40 30 20 10 0 Oct 08 Oct 09 Oct 10 Oct 11

mTs RECOmmENDATiON GUiDEBUY LONG TERm BUY TAKE PART PROFiTs

Below $3.80 Up to $4.60 Above $6.20

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It was a very respectable interim result but shareholders have little to show for it. Nathan Bell makes the case for hanging on.The only function of economic forecasting, warned US economist Ezra Solomon, is to make astrology look respectable. Following last years profit of NZ$64m, Fisher & Paykel Healthcare originally forecast a 2012 full year profit of between NZ$62m and NZ$76m. That has since proved optimistic. With almost half the companys revenue originating in the US, the rising New Zealand dollar (see Chart 1 over the page) made mincemeat of the prediction. Three months later at the annual meeting, the astrologers cut that forecast to between NZ$60m and NZ$65m. But it wasnt the disaster it appears. In the six months to 30 September (the company has a March year end), sales increased 3% to NZ$252m but unfavourable currency movements kept net profit flat at NZ$28m. Earnings per share stayed at NZ5.2 cents, with the interim unfranked dividend steady at NZ5.4 cents (the ex date has already passed). Non-resident shareholders will also receive a supplementary dividend of almost NZ1 cent. Currency effect The currency effect is a veil thrown over a business performing well. Had the relative currencies remained fixed to the rates of the prior period, the figures would look very different: Revenue up 11% and net profit 34%. What looks like modest growth is actually far more substantial. Even on a divisional basis, things are going well. A 36% increase in sales of lower margin sleep apnoea flow generators was offset by a 4% fall in highly profitable mask sales, although these should improve with the release of new models. F&Ps Respiratory and Acute Care business increased sales by 15%, including a 23% rise in sales of masks and tubes for new, non-invasive applications like oxygen and humidity therapy. Overall volumes may be small but the trend is promising enough. In summary, the case made on 11 May 11 in F&P Healthcare: An awakening (Long Term Buy$2.19), remains intact, a point made most emphatically by comparing the companys current PER under existing exchange rates and historical norms. Assuming the Aussie dollar traded at historically average levels against the New Zealand dollar (see Chart 2 over the page) and that F&P Healthcares original profit forecast of NZ$76m (the high end of the range) was reached, the current forecast price-to-earnings ratio of around 20 falls to 15. Were China to crash, that PER would probably fall further, led by a rising US dollar relative to the local Aussie. But even if exchange rates remain as they are, strong underlying profit growth should be evident in the reported results beyond 2012. Regulation threat There are a couple of minor concerns. The threat from the Patient Protection and Affordable Care Act (PPAAC)part of Obamas plan for universal health coveris a little overstated. The 2.3% tax on medical devices sold in the US from 2013 will probably be offset by increased prices and cost cutting. And the face-to-face encounter requirements for durable medical equipment and home health services will impact healthcare providers more than device manufacturers. The requirement by 2016 for a nationalised competitive bidding process is a minor negative. Its designed to help governments buy more cheaply so one might expect some margin pressure, although F&Ps devices dont enjoy much government financial support anyway.

KEY POiNTsVery respectable underlying interim result Slightly reduced prices in recommendation guide Remains a Long Term Buy

F&P HEALTHCARE | FPHPRiCE AT REViEw REViEw DATE mARKET CAP. 12 mTH PRiCE RANGE BUsiNEss RisK sHARE PRiCE RisK mAX. PORTFOLiO wEiGHTiNG OUR ViEw

$1.77 1 Dec 2011 $920m $1.68$2.50 LowMed MedHigh 3%LONG TERm BUY

FPH RECOmmENDATiON GUiDELONG TERm BUY BUY sELL

Below $1.50 Up to $2.00 above $3.25

CHART 1: UsD Vs NZD0.95 0.85 0.75 0.65 0.55 0.45

Nov 07

Nov 08

Nov 09

Nov 10

Nov 11

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CHART 2: AUD Vs NZD1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 Nov 07 Nov 08 Nov 09 Nov 10 Nov 11

Theres a growing trend for device manufacturers to demonstrate device efficacy to a level not previously required. That means more and expensive work for the company, although it does offer premium manufacturers some advantages: those with the best products, like F&P, will have no trouble while lesser competitors might. minor risks These minor risks have provoked slightly lower prices in our recommendation guide but do not change the fundamental view. Whilst theres a risk that the market for sleep apnoea devices reaches maturity sooner than expected, thats unlikely to be a concern for many years, although it bares watching. Currency impacts are obscuring a company performing very well; F&P Healthcare is fast growing and operates in highly profitable sectors; It offers international and currency diversification; Its profits are largely immune to the economic cycle; Its markets are growing quickly; And a lack of sleep apnoea diagnosis means there are plenty of patients requiring treatment, a fact assisted by the growth in home testing and sleep clinics. Dont let the currency fluctuations mislead you. Despite a lofty forecast price-to-earnings ratio of around 20, with the share price falling 23% since the update on 25 May 11 (Long Term Buy$2.29), this is a company at the top of its game. LONG TERM BUY.

Source: Yahoo finance

KEY POiNTsNew market operator Chi-X has launched Regulatory change may benefit ASX Recommendation guide prices increased

Competition and regulatory change make for a tough playground, but ASX remains the biggest kid in the park. If only the share price would slide, reports James Greenhalgh.If you blinked, you probably missed it: Competition has arrived for ASX. New market operator Chi-X opened for business on 31 October and has since won market share of about 2%. This figure is likely to rise but with equities trading revenue accounting for only about 6% of ASXs total, down from 10% in 2009 (see Chart 1), Chi-X is far from a major threat. The company has also had plenty of time to prepare for the onslaught. While overseas exchanges sat paralysed, ASX lowered execution fees and upgraded its platforms, all of which helped it meet the competition head on. Being a backwater has its advantages. Of course, ASX didnt do itself any favours on 27 October, just two business days before the Chi-X launch. An upgrade to a trading platform caused a four-hour outage on the exchange. Screen jockeys were furious at having to skip a long lunch when trading resumed in the afternoon. In response, new managing director Elmer Funke Kupper, the former boss of gambling group Tabcorp, called the heads of equities at the major broking firms to apologise personally. Thats competition for you. Back in ASX goes dark to avoid doom on 20 Mar 10 (Hold$35.63) and well before Chi-X had even been granted a market operator licence, we advised caution. Now, almost two years later, theres less reason for it. While competition in trading has arrived, ASXs moat is wider elsewhere. The irony for Chi-X is that it has been forced to use ASX for clearing and settlement (see Shoptalk 1) because of the latters monopoly. If ASX loses volume on the trading swings, it could make up for it on the clearing and settlement roundabout. Chi-X isnt exactly thrilled about being forced to buy services from its competitor. Should another clearing house openand European group LCH. Clearnet has confirmed its interest in the local marketChi-X would welcome it.

AsX | ASXPRiCE AT REViEw REViEw DATE mARKET CAP. 12 mTH PRiCE RANGE BUsiNEss RisK sHARE PRiCE RisK mAX. PORTFOLiO wEiGHTiNG OUR ViEw

$31.21 7 Dec 2011 $5.5bn $26.69$39.00 Medium Medium 5%HOLD

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This, however, would require strict regulatory approval and is trickier than approving a new market operator. Clearing requires the careful management of risk; something brought into stark relief by the recent collapse of futures broker MF Global. ASX, as the futures clearing house, had to liquidate MFs positions and even suspend wool and grain trading temporarily due to MFs heavy involvement in those markets. The collapse of a larger brokeror a meltdown of derivatives markets generallycould place significant stress on ASXs various clearing house operations (potentially requiring a capital raising). No wonder the government is keen to ensure this function is properly regulated. Indeed, the systemic importance of the ASXs clearing functions was a reason for the governments decision to block the merger with Singaporean exchange SGX earlier this year. Nevertheless, another clearing house entrant cant be ruled out and, as it generates 8% of ASXs revenue (see Chart 1), competition would erode fees. Regulatory change wont always be to ASXs disadvantage. Theres a global regulatory trend towards central clearing of over-the-counter derivatives. While LCH.Clearnet is no doubt eyeing this opportunity, ASX would be well-placed to provide these services in Australia. So what about ASXs two largest sources of revenue, derivatives and listings and issuer services? While not immune from competition, ASXs derivatives exchange is a natural monopoly. A new entrant would immediately struggle to provide the liquidity traders prefer, while the requirement to put up margin (see Shoptalk 2) acts as a capital constraint for participants. Listings of securities are obviously ASXs bread and butter. Market operators such as Chi-X dont facilitate listings; instead they get a free ride on those provided by the incumbent exchange. ASX shouldnt face significant competition in this space, which is why it hiked listings fees by 34% in 2009. Still, the exchange industry is in a state of flux. Reflecting market concern, the stock has fallen 12% since ASX goes dark to avoid doom, taking the prospective PER from 18.5 to 15.1 with it. How Funke Kupper proceeds will be critical. Former ASX managing director Robert Elstone delivered excellent cost control. Since ASX and SFE Corporation (operator of the Sydney Futures Exchange) merged in 2006, the cost-to-income ratio declined from 37% to 22%. Funke Kupper will find it hard to eke out further savings. Instead, in 2012 a 5% increase in staff costs, rent for the companys new data centre, as well as higher depreciation, will take a toll on profitability. Innovation is one area where Funke Kupper will concentrate efforts. The company has done well to develop a new range of trading platforms but product innovation has lagged. Despite pushing into corporate bonds, exchange traded funds, unlisted funds and international company listings, none have set profitability alight. Lets assume that he fails in that task. What would be left? First, there are monopoly-like positions in divisions such as clearing, settlement and derivatives. Most businesses would love the sort of pricing power this delivers. Then theres the revenue effect of volatility. In August, for example, the number of equity trades jumped 75%. Each and every trade delivered an average of $0.93 in fees to ASX. The appointment of Funke Kupper to the managing directors role sends a signal. Having sorted out his predecessors mess at Tabcorp and, as the former head of risk management for ANZ Bank, hes a steady hand. As long as ASX doesnt do anything stupid, it should be fine. The price, though, isnt attractive enough yet. This is a stock to buy in the doldrums. With significant change afoot, theres a chance it may be at some stage. Weve increased the prices in the recommendation guide slightly to reflect what is likely to be a muted effect from competition in trading but with the share price up 8% since 18 Aug 11 (Hold$29.41), were sticking with HOLd.

sHOPTALK 1 Clearing and settlement

CHART 1: AsX REVENUE (%)30 25 20 15 10 5 0 2008 Trading Derivatives 2009 2010 2011

Clearing Settlement Listings & issuer services

sHOPTALK 2 margin

AsX RECOmmENDATiON GUiDELONG TERm BUY HOLD TAKE PART PROFiTs

Below $28.00 Up to $42.00 Above $42.00

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KEY POiNTsFosters to be sold to SABMiller Proceeds of $5.40 paid by 21 December Numerous similar opportunities for investors

With a more than 30% return since our original recommendation less than two years ago, the acquisition of Fosters delivers a great result. But spend the money wisely.Patriotic drinkers may be sobbing into their beer but sober investors know a good thing when they see it. At yesterdays meeting to approve the acquisition of Fosters Group by SABMiller for $5.40 per share, the yes vote achieved 99.1% support. Presumably, the other 0.9% were still at the bar. The scheme has just been approved by the Supreme Court of Victoria and the stock will cease trading today. The scheme consideration is expected to land in your bank account or mailbox by 21 December. This is an excellent result. Having recommended the stock in Put some Fosters in your cellar on 11 Mar 10 (Long Term Buy$5.45) and collected 40.5 cents in fully franked dividends over the following 21 months, were now selling for $5.40. Add in the one Treasury Wine Estates share granted for every three Fosters shares held at the time of the demerger in May 2011 (current price $3.95), and that adds up to a 31% total return (or 16.5% p.a.) versus 5% for the All Ordinaries Accumulation Index over the same period. Lets drink to that. Whilst an attractive price and Fosters defensive qualities offered an initial margin of safety, it was SABMillers eagerness that ensured such a rapid and happy ending. Shareholders will now receive valuable cash at a time when there are plenty of attractive opportunities elsewhere (see buy list). Raising a Coopers$5.38 2 Dec 2011 $10.5bn $4.23$5.84 Low MediumCOVERAGE CEAsED

FOsTERs GROUP | FGLPRiCE AT REViEw REViEw DATE mARKET CAP. 12 mTH PRiCE RANGE BUsiNEss RisK sHARE PRiCE RisK OUR ViEw

Sturdy blue chip stocks like Woolworths and Metcash are suitable replacements for Fosters, but if you already own them, different and potentially more volatile alternatives include Westfield Group, QBE Insurance, Sonic Healthcare, Spark Infrastructure, MAp Group, Computershare, Brickworks and more. As for our own portfolio, the sale of the 1,250 Fosters shares in our Income portfolio at $5.40 will soon be accounted for but, for the time being, the proceeds will be held in cash. This weekend well raise a glass to the disappearance of this iconic brand from the local index and then raise another to this significant win, perhaps with a Coopers. CEASING COVERAGE. Note: The Income portfolio owned 1,250 Fosters shares, which will now be sold for $5.40 each. Proceeds will remain in cash for now.

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Since the days of John Singleton, STW has become a very differentand overlookedbeast. Jason Prowd makes the case for a cheapish, rather than madly cheap, stock.Recently retired STW Communications chairman Russell Tate was reminiscing on his first days with the predecessor to STW: 90% of the 2030 [staff] were very attractive blondes with not a very high IQ but were running around trying to do stuffit was chaos. Founder John Singleton and pivotal executive Russell Tate sorted the place out but have since departed. Michael Connaghan now fills the executive seat in what is now a very different business. Where once existed a single operation, Connaghan sits atop a 70-agency group. The numbers look impressive. Since listing in 1994 with revenues of $12m, this year STW will book over $300m, a 25-fold increase. Only the recent share price performance strikes a discordant note. In 2007 the companys shares changed hands at over $3. Now they trade at 85 cents, a fall of 75%, following the companys painful capital raising in 2009. The company borrowed too heavily acquiring new businesses. But with many investors left scarred, on a forecast price-to-earnings ratio (PER) of 8.7 STW is a company discarded and ignored. A model acquirer To an outsider, a 70-odd collection of businesses may seem anachronistic and inefficient. But behind the apparent oddness rests a rock-solid rationale. In advertising, clients demand exclusivity. McDonalds, for example, wouldnt want its strategies shared with KFC. Qantas, like Telstra, a client of STWs for over 15 years, wouldnt accept a creative or accounts team working on Virgin Australia. For many agencies this effectively puts a cap on growth. In the ad business, you can have one airline, one car company and one breakfast cereal company but no more. With an array of separate, competing businesses, STW wonderfully circumvents this conflict. Dont like the work of JWT? Fine, try Ogilvy & Mather. Conflict of interest there? No problem, what about junior or human?. Bit edgy for you? How about The Brand Agency or IKON?. Either way, youll end up doing business with STW. Sure, its more expensivealthough back office systems and training are pooledbut its worth it. Clients need the exclusivity and benefit from an ongoing relationship with a particular agencys principals, often the reason why they signed up in the first place. They also get the benefits of a larger group with every possible service available to them. It also thwarts a difficult problem for small agencies, which often lose clients because the overseas head office insists they use the same group worldwide. STW, 20% owned by WPP, one of the worlds big four agency groups, offers that facility. Loss of clients due to international realignments, as theyre called, is much reduced. separate brands Advertising agencies are a bit like investment banks. Each night, the intellectual property of the business goes home in the lift. The separate brands under the STW banner offer staff increased autonomy, help foster unique workplace cultures and offer improved accountability thanks to reduced hierarchies. And healthy competition between agencies (each year STW presents an award to the best performing group) keeps everyone on their toes. The business mix also creates a more interesting and diverse career path for staff. Its a place where you might work in a relatively small business with all the freedom that brings but get the support and opportunities of a far bigger group.

KEY POiNTsSTW generates attractive free cash flow and is now more shareholder friendly Concerns remain about debt levels With a cheap price and attractive yield, upgrading to Long Term Buy

sTw COmmUNiCATiONs | SGNPRiCE AT REViEw REViEw DATE mARKET CAP. 12 mTH PRiCE RANGE BUsiNEss RisK sHARE PRiCE RisK mAX. PORTFOLiO wEiGHTiNG OUR ViEw

$0.85 8 Dec 2011 $309m $0.76$1.34 Medium High 3%LONG TERm BUY

11


The strategy appears to be working: STW enjoys above average staff retention rates. Thats important where the business is the staff. Fragmented markets

TABLE 1: FiNANCiAL sUmmARY$m REVENUE EBiTDA EBiTDA mARGiN (%) NET PROFiT FREE CAsH FLOw (FCF) EARNOUT PAYmENTs 2007 2008 2009 2010 2011E RECEssiONUs-sTYLE

215 307 280 313 60 28 43 49 71 23 17 38 68 24 22 79 73 23 39 90

315 66 21 35 40

280 47 17 23 28 5.0 3.5 100 4.1 6.6 17.0

0 37 22 17 33 8.9 8.0 7.3 10.8 3.5 6.5 9.8 6.0

EPs (CENTs) 21.8 DPs (CENTs) 12.0 FRKNG (%) DiViDEND YiELD (%)

Mad Mens Don Draper wouldnt recognise todays fragmented media market. Whereas companies could once choose from three free-to-air commercial TV stations, now theres 11, plus another 90-odd pay TV stations, each targeting an ever narrower demographic. The Internet has played havoc with advertising, too. An estimated 15% of ad spend now occurs on channels that didnt exist 10 years ago, to say nothing of entirely new mediums like Twitter and Facebook (with over 1.2bn users between them) and novel ideas like rainvertising. Media consumption is also changing. The world now has over 60m iPads and over 5% of internet traffic comes from mobile devices. Audiences are fragmenting, niches are becoming narrower and the skills needed to market to them more demanding. Theres now far more to advertising than the big, creative idea, which is why STW owns a stable of research and PR agencies, too. For a big company like Fairfax, adapting to these changes has proved difficult. For STW, its an opportunity. As a new segment develops, it simply makes an appropriate acquisition in the area or expands into it using an existing agency. Ogilvy Earth for example, an extension of the Ogilvy & Mather brand, specialises in green marketing. Last year, Feedback ASAP, which operates in the booming area of customer relationship management, joined the stable. In July 2009, STW took a 20% shareholding in Taguchimail, which offers a customised, real time platform for email marketing optimisation. You can see the approach: As a new area of specialisation develops, STW can very easily enter it. The effects are evident in the companys revenue sources. In 2009, for example, revenues from digital advertising contributed 17% of total revenues. Now they account for 25%. Non-advertising revenue now accounts for nearly half of STWs business.Not without risk Whilst the strategy is sound, it has its temptations. Some members may remember Photon Group, which recently emerged from a near-death experience having overpaid for acquisitions (see Acquisitions: Danger below, see issue 331) . With return on incremental capital employed of around 30% since 2006, STWs acquisitions have added value (in comparison, Photon generated a 6% ROICE over the same period) but it remains a risk. Constantly making acquisitions also requires a constant source of funding. STW, despite producing generous cash follow (more on that later), has tended to fund acquisitions via debt or equity issues. Recently, it has discovered a renewed respect for the companys equity (its even buying back up to 10% of outstanding shares), which has shifted the funding burden to debt. Bank debt is currently $115m, plus $24m of earn-out payments due over the next few years ($38m total). Earn-out payments are contingent liabilities arising from acquisitions, paid only if certain hurdles are met, although theyre often set so low as to guarantee payment. The current debt facilities include $55m in additional available funds and dont require refinancing until 2014. However, this sum will be quickly absorbed by buyback and earnout payments. Debt isnt a concern at the moment but could be if economic conditions deteriorate. More worrying is the fact that STW has quickly regeared after the 2009 capital raising. Wed be more comfortable if the company temporarily cut the dividend to reduce its debt, although with interest cover of seven times its manageable and not enough to deter us. Table 1 summarises the argument in favour. On a forecast PER of less than nine and free cash flow yield of 13%, if the company merely repeats the performance of the past few years, the stock looks cheap. If it can grow earnings at a modest clip, it could well be a bargain. Advertising, though, is notoriously prone to the whims of the economic cycle. Its seductive to think of earnings growth of 8% but less easy to imagine the impact of the contrary. Locally, we havent had a proper recession in 20 years but the global environment is such that that possibility is greater now than at any time since the GFC. If we did enter recession, how would STW fare? The big four overseas-listed global advertising groups (Omnicom, Interpublic, WPP and Publicis) in the United States experienced revenue declines of between 5% -10% and earnings-before-interest-tax-depreciation-and-amortisation (EBITDA) margin compression of between 10% -20% between 2008 and 2009. If that happened here, expect STW to conduct another, perhaps less-dilutive, capital raising.

100 100 100 100 100 14.1 9.4 4.1 7.6 7.1

FCF YiELD (%) 15.9 12.2 25.7 29.1 13.0 PER (X)

7.2 18.1 14.2

8.0

8.7

12


But as Table 1 shows, even in a US-style recession STW would be trading on PER of 17, FCF yield of 6.6% and dividend yield of 4.1%. Thats far from a dire outcome. If earnings remain flat, STW trades on an attractive FCF yield of 13.0%, PER of 8.7 and dividend yield of 7.1%. Should management meet its 5% -10% per year growth targets, the PER drops again to 8.4-8. Not much has to go right for this recommendation to go well. The current price provides an adequate margin of safety and with STWs share price down 5% since 15 Aug 11 (Hold$0.89), its back on buy list. LONG TERM BUY. Note: The model Income portfolio owns shares in STW Communications.

sGN RECOmmENDATiON GUiDEBUY LONG TERm BUY sELL


With the ink barely dry on its corporate simplification, MAp Group announced bold new plans for Sydney Airport.MAp Group securities fell 72 cents, or 20%, overnight. This fall has been well flagged in past reviews and relates to the shedding of entitlement to the special 80 cents per security cash payment. Todays buyer doesnt get that payment. The groups simplification scheme has been approved by security holders and the scheme is due to be implemented on 19 Decemberwith the 80 cent payment mailed or deposited in your bank account on or around the same day. Between now and then, the stock trades on a deferred settlement basis under the code MAPDA. In MAp clears the runway of 15 Nov 11 (Long Term Buy$3.50), we incorrectly stated that the stock will continue to trade under the MAP ASX code. In fact, on 22 December the group changes name to Sydney Airport and ASX code to SYD, a logical change. Be aware that the stock may disappear from your broker statement for a few days before reappearing under the new code. If you wish to trade the security during this period, it might pay to call your broker directly. Airport reorganisation Yesterday, the group announced a bold new plan to do away with domestic and international terminals at Sydney Airport, splitting operations by airline instead. Qantas, Jetstar and other oneworld partners will operate out of Terminals 2 and 3 (the existing domestic facilities) with Virgin, Star Alliance partners and all remaining international carriers operating out of Terminal 1 (todays international terminal). The plan is in its very early days and wont be completed before 2019, but Qantas and Virgin have agreed to work towards the concept. The changes will require significant investment. The benefits will be particularly noteworthy for transferring passengers and confused premiers, and MAps claimed the change will increase overall capacity while reducing peak flows, and reduce airline costs. It is also likely to present new development opportunities in retail and parking for owners of Sydney Airport. As forewarned on 15 Nov 11, were lowering the prices in our recommendation guide to account for the fact that MAp Group now has $1.5bn less in the bank following the special payment. The stock has risen above our adjusted Long Term Buy price of $2.70 and were downgrading to HOLd. Note: Both the Income and Growth portfolios own shares in MAp Group.

KEY POiNTsMAp trades ex-capital payment today ASX code changes to MAPDA, then SYD Major airport reorganisation planned

mAP GROUP | MAPPRiCE AT REViEw REViEw DATE mARKET CAP. 12 mTH PRiCE RANGE BUsiNEss RisK sHARE PRiCE RisK mAX. PORTFOLiO wEiGHTiNG OUR ViEw

$2.83 6 Dec 2011 $5.3bn $2.89$3.59 Medium MedHigh 5%HOLD

mAP RECOmmENDATiON GUiDELONG TERm BUY HOLD sELL


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AwE | AWEPRiCE AT REViEw REViEw DATE mAX. PORTFOLiO wEiGHTiNG OUR ViEw

$1.375 7 Dec 2011 2%sPECULATiVE BUY

AwE RECOmmENDATiON GUiDEsPECULATiVE BUY HOLD sELL


For the second consecutive year, AWEs annual meeting was marked by penitent management and pensive shareholders. Despite an operating performance that met expectations, the share price remains stubbornly slothful. Two important projects seek to change this; redevelopment at BassGas and testing of shale prospects in Western Australia. The mid life enhancement at BassGas will consume $500m and shut down production for five months next year. But the new equipment and wells bolted to the lonely, unmanned production platform will boost subsequent output by 30%. This should arrest the decline in AWEs output over the past two years. In AWEs shale transformation on 04 Aug 11 (Speculative Buy$1.20), we detailed the science experiment that the company was orchestrating among the shales beneath the Perth Basin. New drilling, expected to be conducted next year, awaits final approvals. It cant come soon enough. Appraisal of the shales here will be vital in determining whether gas production is possible. Development will take time, but the quantities of gas available are potentially massive; early work suggests accessible gas of around 4 trillion cubic feet (Tcf), about the same size as Woodsides Pluto field. The exploration write-offs, asset write-downs and falling production of the past few years have been frustrating for shareholders (including your analyst). However, with production restored and the drilling of shale prospects imminent, theres a good chance well see less mourning and more merriment come next years annual meeting. AWEs share price is up 11% since 31 Aug 11 (Speculative Buy$1.24) and it remains a SPECULATIVE BUY. Note: The Growth portfolio owns shares in AWE.

CARNARVON PETROLEUm | CVNPRiCE AT REViEw REViEw DATE mAX. PORTFOLiO wEiGHTiNG OUR ViEw


CVN RECOmmENDATiON GUiDEsPECULATiVE BUY HOLD sELL


Our initial production estimates for Carnarvon Petroleum were wrong. Relying on historical data and results from several production tests, we estimated production would be more than twice what it is today. That failure meant we paid too much in Carnarvon Petroleum: a potential Thai coup on 11 Oct 10 (Speculative Buy$0.47). Its not easy after a large unrealised loss, but we need to ignore the initial buy price and concentrate on the price and value today. The company still holds 20m barrels of high margin oil. Despite oil prices of more than $100 a barrel, the market attributes less than $3 a barrel for the reserves at the current share price. The business generates real cash, so even at todays depressed production rates, between $20-30m in net operating cash should continue to flow for another two decades. Production costs are low and there is no debt. With an enterprise value of just $58m, a lot of pessimism is already priced in. The market has already made its judgement but the range of possible outcomes remains wide. About a dozen new wells will be drilled next year in conventional sandstone reservoirs, while new technology aims to reduce variability in the more difficult volcanic reservoirs. If this lifts production rates then the share price will climb. But if those measures fail, the markets verdict is justified and the share price will languish. One small comfort is that, with no debt and continuing strong cash generation, theres little risk of insolvency. With lower production estimates, the prices in our recommendation guide have been lowered. The share price is down 30% since Carnarvon Petroleum changes course from 06 Sep 11 (Speculative Buy$0.15) and we recommend the stock as a SPECULATIVE BUY for 2% of a risk tolerant portfolio.

14


Sirtex Medical |

James Greenhalgh

The share price of liver cancer treatment provider Sirtex Medical is down 13% since our update of the companys profit result on 29 Aug 11 (Speculative Buy$4.95). Theres been no negative news of note; on the contrary, the company reported total dose sales rose 11% in the first quarter this financial year. Strong growth of 19% was reported for each of the US and Asia-Pacific regions, although dose sales fell 7% in Europe due to the summer holiday period. Dose sales wont rise in a consistent fashion each quarter, but management expects a recovery in Europe in any case. Perhaps investors are focusing on the clinical trial investment program, where Sirtex expects to spend $60m over the next five years. Patient recruitment for these studies has commenced, with the aim of establishing the SIR-Spheres technology as a first-line treatment for various tumours. While this investment is necessary for longterm growth, it does reduce cash flow in the short term. In 2011, free cash flow fell from $19m to $5m. While setbacks are common in the biotech sector, Sirtexs technology is strong and the business has a lot of momentum. Expect the stock to be volatile, but it remains a SPECULATIVE BUY.

siRTEX mEDiCAL | SRXPRiCE AT REViEw REViEw DATE mAX. PORTFOLiO wEiGHTiNG OUR ViEw


sRX RECOmmENDATiON GUiDEsPECULATiVE BUY HOLD sELL

Below $6.00 Up to $12.00 Above $12.00

Like religion, financial forecasting meets a very human desire to know the unknowable. It doesnt matter whether the forecasts are accurate or not, people sleep better at night under the assumption that theres a predictable future laid out ahead of them. So, in the name of community service, Im going out on a limb and laying down my predictions for 2012: 1. A lot of things will happen that no forecaster thought to include in their predictions for 2012. These events will be the obvious consequences of the current economic and political environment. So obvious, in fact, that they werent included in the predictions. 2. Many things wont happen that forecasters did include in their predictions for 2012. This will be a result of unforeseen circumstances and six sigma events, annual anomalies that crop up one in a million years. 3. A small number of the vast number of predictions about 2012 will randomly come true and the predictors will be proclaimed gurus. This will be despite the fact that it was their 1000th prediction and the first one they got right. 4. All predictions will be adjusted throughout the year so that the forecasters final prognostications, announced on Christmas Eve, will be very close to accurate. 5. Those fund managers that outperform for the year will cite their skills, systems, intelligence and uncanny ability to time the market as the reasons for their outperformance. While acknowledging that past returns are no guarantee of future returns, the past returns will be included in advertising materials in very large font. 6. Those that underperform will cite the randomness of markets and that any one bad year will obviously be followed by a good one, because underlying it all they have

ONLiNE COmmENTs J mako s Hall

Trav

nugget

Alistair

simon Hicks 15


CONTiNUED...

Rob & Julie

Dave sinclair

superior skills, systems, intelligence and uncanny ability to time the market. Marketing materials will include performance statistics over a more appropriate time frame. 7. Dividends will be more important than capital gains. Unless the market goes up a lot. If the market goes up a lot, capital gains will be more important than dividends. 8. Every single CEO in the country will be in the top quartile of CEOs in the country. They will get paid accordingly. 9. They and People familiar with the matter will continue their crucial role in the worlds affairs. That is because they know everything. 10. Finally, perhaps most importantly, markets will fluctuate. We expect the All Ordinaries to go up, down or sideways in both the first and second halves of the year. Keep this list by your side and you cant go wrong. If you have your own predictions for 2012, add them via the comments box below.

Bruce Bargon

Below is a list of doddsville and Bristlemouth blog articles published by our analysts this week.Doddsville blog | The limits of monetary incentives Bristlemouth blog | Healthzone Horribly Out of Shape

Below is a list of podcasts published to the website during the past weekDoddsville podcast | The banks special edition and 2011 in retrospect Special podcast | The coming China crashPart 1 Special podcast | The coming China crashPart 2

16


Below is a list of this weeks article links posted by our analyst team to our Twitter page.December edition of the McKinsey Quarterly. 3Q letter from Jeremy Grantham, titled The Shortest Quarterly Letter Ever (registration required). This research suggest pay-as-you-want pricing prompts generosity. I dont believe the results. Despite the recession more American are eating out than ever before. This article explains why. German engineering group Siemens plans to set up own bank. Daniel Kahneman talks intuition and optimism with Sam Harris. Whos afraid of behavioural economics? The negative house price data is starting to stack up... Cross shareholdings already entrench Soul Patts management, ignoring minority protest votes seems unnecessary. eBay takes the retail fight offline with pop-up store in London.

Please note that the member questions below have undergone minimal or no editing and appear essentially as they do online.

Tin in the Dragons Den Gaurav, What is your outlook for tin and do you see value in companies that are established tin miners such as Metals X or prospective tin miners such as Venture Minerals? Antony L 07 Dec 2011Gaurav Sodhi: Every buy recommendation we make goes through an internal vetting process that we call the Dragons Den. The analyst responsible for an idea must present it to the team and be prepared for a bombardment of questions and doubts that are inevitably raised. Only after this arduous process can the idea migrate to being a recommendation. Venture Minerals was taken to the Dragons Den earlier in the year but we decided it was too far from production, and hence too speculative, to be considered. Important changes in the market make tin exposure worth considering. We identified Venture, Metals X and Kasbah Resources for research but knocked out Metals X and Kasbah quickly; the formers exposure to tin is diluted by other ventures and Kasbah is exposed to too much political risk. Venture is still interesting (I own shares in the company) and remains on my watchlist. It may get another go in the Dragons Den depending on how production plans go. Thoughts on agriculture Hello to you all Looking forward to the next two years at the different industry to be invested in. I believe that a soft commodities/ agriculture has got a lot of reasons to be explored more. With china getting more wealthier and changing there diet to a more protein, a growing population, the current Australian harvest looks to be above average, water storage around Australia looks to at higher levels. All these indicators look favourable for agriculture. My questions are: What are your thoughts on Australia Agriculture over the next two years? What is your preferred agriculture based stock pick? Peter H 05 Dec 2011Gareth Brown: My thoughts are in contrast. I understand the bull case for agricultural commodities and I have some sympathy for it. But agriculture has historically been a tough way to make money, and backing corporate farmers a particularly efficient way to lose it. While commodities like wheat and cotton have traded at or near record prices earlier this year, listed opportunities like Prime Agriculture and Tandou have undertaken shareholder-wealth destroying capital raisings, and their shares have been rightfully punished. Calling for higher agricultural prices is one thing, finding companies that can use those higher prices to generate real wealth for shareholders, rather than expanding their corporate domain, is another matter. Few agricultural companies have great management, and fewer still a genuine moat. Its a very tough business and weve generally shied away from it. There are no agricultural companies were particularly interested in at the moment. The risk of Elders going broke In case Elders goes into administration, will there be any money left for ELdPA holders? Karol M 07 Dec 2011Nathan Bell, CFA: Hi Karol. Thats the $64m 17


question. If Elders goes bust as the sharemarket is perhaps suggesting, then its likely that there will be nothing leftover for Elders Hybrids securityholders. Thats why the portfolio limit is set low at 2%. In a firesale Elders assets are unlikely to cover its debt obligations that rank ahead of the hybrid securities. It could also be years before the receivers sort out the mess and allow hybrid owners to claim a capital loss. Anyone that owns the hybrid securities needs to be prepared for the event of a permanent capital loss, which is why both the prices of the ordinary shares and the hybrids are trading at such low levels. For the moment were holding the securities in the model Growth portfolio as the position size is only 1% and the potential upside is relatively large. But, unlike members portfolios, there are no tax consequences to the model portfolio that members need to take into consideration, which makes our decision easier. For example, some people might be better off selling now and using any losses to offset their capital gains. spotless Group takeover Spotless GroupWhile you dont cover this stock do you have any thoughts regarding any value here given the current discussions with PEP? 06 Dec 2011James Greenhalgh: This Doddsville piece, titled Resistance is futile for Spotless Group, provides some thoughts that might be of interest. If youre asking whether its worth speculating on the takeover, thats hard to determine. My personal view is that a takeover is quite likely at some point over the next year, but Im generally uncomfortable with takeover speculation. As the bid has not been sanctioned by directors, its not yet a takeover arbitrage situation in my view (see the questions in Takeover arbitrage profits ease, in issue 301). spark infrastructures payout ratio Spark Infrastructure seem to be paying out more in distributions per unit than they are earning is this correct? If so how are they funding the distributions? Richard I 08 Dec 2011Gareth Brown: I suspect youre looking at distribution compared with reported profits, or perhaps DPS vs EPS on the financial pages of our website. For a variety of complex reasons, reported profits for infrastructure assets can be very misleading and not indicative of genuine economic gains. We believe that the right way to think about it is to compare distributions to cash flow, rather than reported profit. SKI generates more than enough cash to cover its distributions. See Powerplay: Spark versus SP AusNet (see issue 320) for a more detail explanation. Origins PE ratio I am looking at the new financial data for ORG available in this site and notice that the PER for 2011 is 73.12 much higher than previous years. As a sanity check I divided the Market Cap (13600) and EBIT (1157) for 2011 which produces a value of 11.75. I know that my sanity check would not be the way the PER in the site is calculated, but can you please explain firstly how the PER is calculated in your site and why the PER for 2011 is so high? 07 Dec 2011Gaurav Sodhi: Youve stumbled across one of the dangers of relying on quantitative analysis. The PER is usually calculated using the share 18

price and earnings per share. In the latest results, Origin reported an EPS of around 20c which is why the PER appears to be over 70. But that number was affected by several one-off items which we explained in more detail in our review in issue 327. The underlying profit number, which excludes these one-offs, was much higher. Automated data services (we source our numbers from Capital IQ) will never be able to detect these subtleties and this is a good example of why investing by numbers alone is a dangerous idea. Thanks for raising the issue. Paying up for souls Private Equitywhy? Several times over the last week or so SOE has been traded at 16.5 cents...is there any rational reason behind this? 08 Dec 2011Gareth Brown: I dont think the volume at that price has been particularly high, so I wouldnt be reading too much into what might be just one or two investors decisions. The only logical reason I can see for paying more than 16.3 cents is for the option valuesee previous response outlining the matter. In short, you dont need to decide whether to take cash or Soul Pattinson shares for some days, creating a free option. I wouldnt be paying for it but perhaps someone else disagrees. PaperlinX sPs securities Hi guys, Is there any potential upside in PXUPA now that they are down around the $18 mark? did you look at these pref shares at any time during your sweep of income securities? If so, any chance of pointing me to that research or if PXUPA was reviewed but not published could you possibly highlight any key risks you identified with these securities for members to look into further if they wish? Alex H 05 Dec 2011Gareth Brown: These securities have a $100 face value but are trading today at $19clearly, the market has grave concerns about PaperlinXs solvency, and we share that concern. Obviously, the potential upside is substantial. The running yield alone is in excess of 30% per annum. But this is a highly risky security. PaperlinX has bled cash for years, despite selling a lot of its asset base. If I was a bank lender to PaperlinX, Id be nervous. Its hard for me to point you in the direction of things to analyse to get comfortable with the risks involved, because I myself cannot get comfortable with the risks involved in this one. Well be giving it a wide berth. Interested parties should focus on PaperlinXs solvency, as that will directly determine whether this speculation succeeds or fails. And even if it passes your tests there, get to know the terms of the instrument. Im uncomfortable with the fine printthe idea of a perpetual security with discretionary, non-cumulative distributions jars with every conservative bone in my body. The potential rewards from this security are undoubtedly high, but the risk is also huge and, in my opinion, overshadowing. more fracking CsG With respect to the coal seam gas debate, I wanted to point out that fraccing is only required for very deep deposits (i.e. tight gas or shale) and therefore doesnt apply to coal seam gas, which is extracted from very shallow deposits. So, the issue that gets the most attention is really only related to a very small number of companies. Regulators are moving quickly to regulate fraccing, mainly because it doesnt affect that many players at


the moment. Also, the lifecycle greenhouse emissions of coal seam gas are freely available from any environmental impact assessment for these projects as well as relatively credible sources like the department of Climate Change and Energy Efficiency. The numbers that come out of these studies are however highly dependent on where the boundaries of the assessment are (e.g. where/how is the gas transported/processed/consumed) and the assumptions around fugitive emissions (which apply equally to coal mines where the gas isnt extracted process), so one cant really make a blanket statement about lifecycle impacts of the product. I can guarantee however that the coal seam gas companies are considering very carefully how much of their product is being released as fugitive emissions, given that its not only lost product, but now taxable as well. Love your work on the podcasts Gaurav. Chaim K 05 Dec 2011Gaurav Sodhi: You raise a good point, Chaim. Where mining starts and finishes will also influence the level of carbon emitted. CSG extraction mostly takes place by de-watering coal beds, but some fracking does occur. The nature of the coal bedsthickness, porosity etcis vital in assessing how damaging this shallow fracking is, which is why CSG is one of the most heavily regulated mining activities on the planet. Each coal bed needs to be treated differently. I still feel that the hydrology issuethat is, the impact of large scale water extraction from coal beds and how to dispose of itis the great unknown. Smarter folks than me have already approved the process but it is a risk to be aware of. investment Growth Bonds What do you think of Investment Growth Bonds? I understand they used to be called Insurance Bonds They seem to be a bit like superannuation for people who are too old to put money into super. 05 Dec 2011Gareth Brown: I dont know much about them, sorry. We only cover listed investment opportunities, and such bonds are unlisted and illiquid. Theyre often sold on the basis of their tax advantages (if youre prepared to hold for the long term), but Id recommend reading and understanding all the fine print in the offer document before getting involved. It might be a matter to run past your financial planner or an accountant who specialises in such matters. How to treat mAp Group special payment Hi, Sorry if this is a dumb question but I am still a newbie to investing. I was wondering how we handle the 80c payment from MAP with regards to our portfolio? If I remember correctly it was described as a return of capital?? Putting it simply, if I paid $100 for a TV and got $50 cash back I have only really paid $50 for that TV. Should I change the purchase price of that TV to $50? If I leave it as $100, together with the price drop it looks like a massive loss for the portfolio, or am I missing something here? Luke B 08 Dec 2011Gareth Brown: Not dumb at all. Im not completely sure whether youre referring to the tax effect or the effect on calculating portfolio returns, though. Regarding taxation, Ive answered a similar query here. In short, Im not completely sure of the consequences but it looks like there might be some capital gains tax to pay on the cash componentthe tax payable is likely to depend on your initial cost price. I expect more detail from MAp, if not sooner then with the tax guide it publishes each August. The payment wasnt technically a

capital return but a payment of consideration in exchange for giving up your ownership in the Bermudian entity. As for the effect on measured portfolio performance, then it all depends on how you measure performance. How do you treat an ordinary dividend? Id argue that ordinary dividends need to somehow be incorporated into your measurements of portfolio returns, and large special payments should be treated no differently. Portfolio management software (we make no recommendations) might be useful if you need help with the calculations. If youre just looking to roughly measure capital gains, though, you can either adjust the cost price downwards (less conservative, will result in higher reported returns) or adjusted the end price upwards (more conservative, will result in lower reported returns). Of course, all this is theoretical and it depends what youre trying to measure. Its more important to focus on what counts (making good, low risk profits) than how it is counted. In that regard, were happy with how our investment has played out so far. increasing font size Hi Guys, to help the user finding it hard to read the website, use Ctrl + +i.e. CTRL PLUS SIGN to increase the font of any website at any time (and CTRL MINUS SIGN to reduce. Steven J 06 Dec 2011James Greenhalgh: Thanks for the tip Steven. Ive published it for the benefit of other members. How much cash to hold? I concur ver y much with John Addiss comments in the directors Cut regarding the state of preparation that Portfolios ought to be in for a potential market swoon (or GFC MkII). However, I have to ask the question as to why your recommendations in respect of hold cash are so vague, while your equities recommendations are clear and definitive. Ive looked at your articles and the video (The Case for Cash) and cant find any quantification of recommended cash levels. The Growth and Income Portfolios both hold cash, but at a very low levelI suspect this is not the level you have in mind as appropriate for the times. I understand that all investors have different risk tolerances which impacts on their desire to hold cash, or to buy into one stock (or sector) versus another. But I dont think that needs to prevent you from plotting a course for portfolio cash holding that balances risk/reward as you see it. After all, thats what youre doing in constructing the Portfolios now, though the cash levels shown are (I assume) incidental, rather than by design. My suggestion is that you set the cash level in the Investment Portfolios at the level you believe is optimum for that portfolio given its performance objectives. By all means assign appropriate rates of return to the cash holdings so that the total return is factored into the Portfolio performance assessment. Many thanks 07 Dec 2011James Greenhalgh: I suppose the reason were not definitive about how much cash you should hold is because its impossible for us to advise on. How much cash you hold is dependent on your risk profile and objectives, as you acknowledge. We have covered this topic in the Building and Managing your Portfolio special report (see page 9) although weve been just as vague there. Some people should hold 10% cash, some should hold 50% how much you do is a personal decision. Our advice is probably best couched in terms of more cash than you usually would at the moment. 19


Youre right that theres some inconsistency with the model portfolios, which typically dont hold much cash. Long ago we took the decision to be mainly fully invested to prevent us from being too pessimistic. That is, we took Peter Lynchs view that we wanted to be caught with our pants up given the then view that the market tends to rise over time. Most fund managers, for example, are forced to be more or less fully invested because thats what people are paying them for (i.e. for stockmarket exposure rather than cash). Our position on that is changing, and we are considering holding more cash in the portfolios given the current situation. Bear in mind that we have considered the Fosters takeover proceeds and MAP capital return to be effectively cash for some months now. So the portfolios hold more cash than it appears at first glance. Thanks for keeping us on our toes on this issue! Computershare debt concerns dear Intelligent Investor, My question is regarding computershare. looking at the balance sheet of the company, I am very concerned about the amount of debt it now carries, particularly with $550m bridge facility for the recent Bank of Melon acquisition. It is my understanding that the 2011 annual report balance sheet debt does not include this figure as it is a post balance event and only mentions them in the notes. Net debt to equity ratio is almost a 100% when the bridge facility is included where I think a comfortable figure should be below 50% for a cyclical company like CPU. I would appreciate your thoughts on this. don W 08 Dec 2011Gareth Brown: Great question Don. Perhaps this is worthy of an Investors College article at some stage. I think of ratios as useful but often misleading guides to underlying reality. So using multiple metrics is often a better way to think about thingsit helps highlight where any one ratio might mislead. At 30 June 2011, net debt was about US$670m (debt of about US$1bn partly offset by company cash of US$350m). Compared with shareholders equity of $1.245bn, its a net debt to equity ratio of roughly 55%. When the group takes on US$550m debt for BNY Mellon, debt will rise (yes youre right, this comes on after the last balance date). The net debt to equity ratio will rise closer to 100%* or so by my reckoning. But Id argue net debt to equity isnt the best way to think about Computershares solvency. The company generates substantial profits and cash flows (a significant part of of which is highly resilient) on a small equity base. The business isnt capital intensive. Such asset-light,

wide moat businesses often look scary on a debt-to-equity basis, despite fairly conservative financing. Interest coverage, a more telling ratio for Computershare if you ask me, as measured by profit was more than 10 times in 2011 (pre-tax profit covered interest payments more than 10 times). On a cash flow basis the coverage was even higher. Of course, that was based on quite low interest rates that may one day rise. But then so would the interest received on the companys huge float, so Computershare is more than hedged naturally against higher interest rates. Shareholders should actually be hoping for higher interest rates. This coverage will fall somewhat after the acquisition, but dont forget the new BNY Mellon assets will start generating extra cash flow for Computershare pretty quickly. We think the financing is fairly conservative and expect the debt figure will fall reasonably rapidly over the following year or two anyway. *Adjusted 9 December, because of an error in my original calculations. F&P Healthcare Hi Nathan, read your latest review on FPH and found your point on currency effects well made, however the performance of FPH does not overly excite me as it appears to be quite erratic. Also the dividend payout is unusually high and I would not count on FPH being able to maintain paying out all its net profit. Robert J 05 Dec 2011Nathan Bell, CFA: Hi Robert and thanks for the kind words. If you analyse the revenue excluding currency hedging over the past ten years it has been increasing relatively consistently. The major problem has been with the gross margin (and therefore net profit) which has been falling with the weak USD, particularly after 2006 when some profitable hedges rolled off. In part, I think fears that the suffering will never end is creating the opportunity. Though currency relief or not, this company still has to grow fast for a while yet to justify its premium price tag. Management has stated that it will hold the dividend steady until earnings increase to the point where retained profits have reduced the current debt to total capital ratio to between 5% and 15%. The company expects this to take four years. If that happens, it would be a great result. If earnings hit a speed bump, though, youre absolutely right, it would be sensible to cut the dividend to keep debt at manageable levels. Its not my major concern, though. Im very focused on analysing whether the company is defending its position against its larger rivals. Thats what will determine returns from here over the long run.

imPORTANT iNFORmATiONIntelligent Investor PO Box 1158 | Bondi Junction NSW 1355 T 1800 620 414 | F (02) 9387 8674 [email protected] www.intelligentinvestor.com.auWARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Intelligent Investor and associated websites are published by The Intelligent Investor Publishing Pty Ltd (Australian Financial Services Licence no. 282288). dISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation. COPYRIGHT The Intelligent Investor Publishing Pty Ltd 2011. No part of this publication, or its content, may be reproduced in any form without our prior written consent. This publication is for subscribers only. dISCLOSURE In-house staff currently hold the following securities or managed investment schemes: ABP, ALL, ALZ, ARP, AWC, AWE, AZZ, BBG, BCC, BER, CBA, CIF, CMIPC, CND, COH, CPU, CRC, CSL, CUE, EBT, ELDPA, HVN, IAG, IDT, IFL, IFM, IVC, KRM, KRS, MAP, MAU, MCE, MFF, MLB, MQG, MTS, NABHA, NBL, NWS, PGA, PTM, QBE, QTI, RCU, RNY, ROC, SDI, SFC, SGN, SGT, SHL, SKI, SRV, TAP, TGP, TLS, TRG, TRU, TWE, TWO, UXC, VMS, WBC, WDC, WES, WHG and WRT. This is not a recommendation.

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Intelligent Investor Dec 2012