19/11/2008 - 22:00

Commentators’ analyses hit and myth

19/11/2008 - 22:00

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BRIEFCASE is amazed at the poor understanding of market dynamics shown by many commentators and self-appointed analysts.

Commentators’ analyses hit and myth

BRIEFCASE is amazed at the poor understanding of market dynamics shown by many commentators and self-appointed analysts.

Some commentators wrongly state that investors cause bear markets by abandoning the stock market, taking their money out of shares to keep in cash or to repay debt. This gives an impression that somehow money is abandoning the share market for other forms of investment. In truth, there are certainly some individuals who have sold shares to retreat to the sidelines, but for each seller there has to be a buyer.

If on a day when there's a $4.5 billion turnover on the market, that means that $4.5 billion worth of shares were sold and the same dollar value of shares were bought by investors who place their savings into the market. The net position on any day is that buyers equal sellers, so let's be clear - there is and cannot be a net withdrawal of funds out of the stock market. (Myth #1)

It is a common belief of many, even quite sophisticated commentators that a company somehow gets richer when its shares trade at a high price. A few folks, who are unskilled in the ways of the market, even believe that when an investor buys shares on the market, somehow the company takes the money. Let's be clear, the only time that a company takes money from shareholders is when it issues new shares, either in an initial public offering or via subsequent placements, exercise of options or rights issues to new and existing shareholders (Myth #2). The whole idea of the stock market is to provide a place where companies can gain access to savings to help them grow their businesses.

When shares move higher, it is the shareholders who benefit. A company can take advantage of a strong market rating for its shares by issuing new shares to existing or new shareholders to raise additional equity in order to fund growth, but the mere trading of shares at a higher or lower level does not impact on a company's cash flow or profits. (Myth #3)

While daily trade on the market is a zero sum game, when we look at the bigger picture of the whole stock market, it is important to understand that it is not a zero sum game (Myth #4). When the value of a share or the whole market falls, wealth is destroyed; it effectively evaporates. Shares in any single company that trade on the market set the price for all of the shares in that company.

Under normal conditions, as a company's business grows and its profits increase, that company's shares will trade at a higher price, reflecting the increased value which investors ascribe to the company. All shareholders benefit as the price of traded shares increase in value, even though they do not trade their shares on the market.

The same is true of today's bear market. With the All Ords Index down more than 45 per cent from a November 2007 high, it is fair to say that the total wealth of investors in listed sharers on our market has decreased by 45 per cent. This wealth has evaporated, gone, disappeared, been destroyed.

Briefcase is sure that some market observers believe that, somehow, one or two investors have gotten away with that money from the market in a big sack and have gleefully gone running down the street with it. Let me tell you, it is not true. Those who sold early may have preserved some cash, taking out some or all of the savings they originally invested, but those who continued to buy, or those who held on to long-term investments have seen their wealth shrink. When the market falls, wealth is destroyed.

Risk levels are so high in today's market that many companies trade with a market capitalisation below that of their cash asset backing. It's like buying a dollar for 80 cents. The CEO of local gold miner Troy Resouces recently made a special stock exchange announcement after he paid out his own 'hard-earned cash' for an additional 60,000 Troy shares on the market, stating that the company was trading at cash asset backing, with no value for its ongoing gold mining and iron ore exploration activities.

In fact, the new game for analysts is to find a company that is growing strongly and thus may have an ongoing need to raise growth equity, and then issue a sell recommendation, purely on the basis that it needs money, which was the reason it listed in the first place.

Market participants, such as conventional and hedge fund managers, are hunting down companies that might want to raise new equity - including Mirvac, Wesfarmers, Asciano and Transfield Services - like packs of wolves. This action is made possible by the tough economic times, but forgets or denies the underlying reason why a company lists in the first place, which is exactly to gain access to capital markets for growth capital, plus provide liquidity to shareholders and ensure that value is always visible.

If, in the long run, value is not reflected in share price, the potential for takeover is always there. The current environment is brutal and the weakest in the herd are being picked off by the jackals circling on the fringes. In any normal market, a bit of equity top-up would be an acceptable event for a growth company whose debt/equity may have strayed over, say, 60 per cent, but in today's market where rolling debt is almost impossible the scent of fresh equity is enough to drive the market into a selling frenzy. Today, any company needing to raise new equity is treated like a leper and its shares are savagely dumped, no matter how strongly its underlying cash flow from operations may be performing.

This type of new equity phobia is difficult for companies to manage, since an absence of access to new equity can put the smooth operation of business at risk. So a company's financial stress can be a case of chicken and the egg. Was the company's cash flow in trouble or did a fall in its equity value cause the cash flow problem, as a result of a breach of some debt covenant? Either way, the issue of new equity phobia is going to become more prominent.

Those companies that have come back to the market early for supporting cash, such as Mirvac and National Australia Bank, are going to be in the best position, while those that don't need new equity are of course in the best possible position.

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Briefcase notices that there has been an increased turnover of directors over recent months, with a constant stream of director resignation notices. Clearly, some directors may have seen the writing on the wall and abandoned ship, while other companies may be slimming down expenses to weather the current times by reducing directors' fees.

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Alcoa Inc's suspension of work on its Wagerup-3 alumina plant expansion will have massive flow-on effects in Western Australia. There are the obvious employment impacts, not only to Alcoa's employees, but also to the many contractors supplying services to the operation.

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GMAC Financial Services said last Wednesday that its third-quarter loss widened to $US2.5 billion, as the ongoing woes of the global credit industry resulted in another quarter of steep losses at its mortgage division. Meanwhile, GMH has warned that it will run out of cash by mid next year, so this once vast industry which underpinned much of the growth in the US economy through the middle of the 20th century, looks to be on its knees, begging for government assistance.

In March or April this year, Briefcase said that if there was to be a follow-up financial meltdown to match the sub-prime house mortgage-lending debacle, it was likely to be a breakdown of the auto finance industry.

Cracks are beginning to appear, with both GMAC and GE Finance withdrawing from Australia and growing disquiet in the US over the state of its automobile industry. A third threat comes in the form of credit card debt on which many users seem to rely. Rising unemployment in both the US and Australia is going to boost the level of personal bankruptcies, leading to further pain in the community and a mountain of losses by the banks.

- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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