16/07/2008 - 22:00

Go for value in current environment

16/07/2008 - 22:00

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In times of financial stress, such as those we are currently experiencing, investment patterns and behaviour should be informed and strengthened by lessons passed on from successful investors, such as Warren Buffet and the legendary Sir John Templeton.

Go for value in current environment

In times of financial stress, such as those we are currently experiencing, investment patterns and behaviour should be informed and strengthened by lessons passed on from successful investors, such as Warren Buffet and the legendary Sir John Templeton.

One of the most important lessons to learn, yet one of the hardest to follow, is the edict that you should buy when others are selling and sell when the herd is overwhelmingly buying.

Market manias, such as the late 1990s dot-com boom or the more recent uranium mini-boom, present crazy prices on which sellers are able to capitalise.

Boom conditions are a necessary feature of a market, dragging new equity into risky areas, where usually some winners eventually emerge but many other companies will fail following the boom. Picking the next Google, Yahoo or Paladin Energy is as much a raffle as it is a science, so investors need to be nimble and humble.

There are many legendary stories of buying distressed assets when everyone else is despairing. The clear lesson is that, at all times in an economic cycle, investors need to keep an eye on value and don't get carried away with the mood of the mob who will inevitably be too optimistic or too pessimistic.

Another lesson is to invest and not trade. This is a rich man, poor man thing. The poor man tries to work the market by speculating on market moves, which generally fails, while the rich man is patient and lets the market work for him.

Mr Buffet says that the stock market is a place where money is transferred from impatient to patient hands.

Traders can make money in a bull market but inevitably lose most of it as the cycle turns. Investors judge value and pick stocks for the long term.

An analogous lesson is that timing of purchases and sales in the market is impossible over the long term. No one can do this consistently over the long term and if they say they do, they are lying.

A better investment edict is that time in the market beats timing the market. A well-informed investor may jag a lucky sale at the peak. However, if you can sell anywhere near 20 per cent from the top or buy 20 per cent from the bottom, you can consider yourself a hero!

Gut feel is a strong emotion and it is easy to get carried away with the 'vibe', but is always best backed up by in-depth research. Serious investors always do extensive due diligence of an investment to check out management credentials, cash flow, debt levels and sales outlook.

Panic is a bad investment driver.

At the top of a market, people panic to get onto the latest new hot float while at the bottom of the market, we see people panic to sell perfectly good companies at half their long-term value, for fear that the price will fall further.

Today's market is doubly impacted by over-zealous investors who have geared too highly and are then forced to sell.

Mr Buffet warns against gearing share portfolios, saying that the companies that you invest in are already geared, so gearing purchases quadruples the risk.

The final lesson is to avoid hubris. Excessive pride or an over-inflated belief in one's own investment abilities will ultimately be punished by the market. Let me tell you, it is far better to be humble in the face of the market.

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The Primebroker margin book position has created additional pain in the stock market, following on from the Opes Prime and Tricom debacles. UXC Ltd finds itself with a pile of shares overhanging the market, which were foolishly leveraged by the company's chairman who really should have known better. The company's share price has been telling us that there was a problem with supply and demand on this front for six months; meanwhile the underlying business of UXC has been moving ahead very well. This type of action is typical bottom of the market stuff and will again provide selected buying opportunities for those who have cash.

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While Australia does not have the same sub-prime chaos caused by the irresponsible and fraudulent lending practices seen in the USA, local borrowers are inevitably rolling over from low cost fixed housing loans and must now confront higher rates.

People who took out three year fixed term loans in 2005 at 7 per cent will be rolling over at 9.5 per cent today. This move is likely to result in additional stress on the local housing market and a further reduction in retail spending and consumer confidence.

My digging and delving indicates that this month, about 6,360 loans will face an interest rate reset of 207 basis points.

The number of loans facing reset lifts to 9,985 with a 242 basis point hike by November 2008 and 10,793 loans with a 178 basis point rise by November 2009.

The size of these loans is not known, but if we assume an average mortgage of $400,000 and 50 per cent fixed, we are looking down the barrel of about $1.2 billion of resets in July, lifting interest payments by $25 million a year and about $2 billion worth of resets in November, which would lift payments by a further $48 million pa year.

The situation would remain negative out until mid 2010, when fixed rates may begin to show some decline.

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The demise of US auto-makers and the whole pack of cards, finance/insurance scheme which supports it, will deliver a telling blow to the US economy during the second half of 2008.

Higher petrol prices are lowering US auto sales and will also cause auto leasers to give back vehicles, creating a logjam of new and used cars.

In May, Briefcase outlined an emerging crisis in the US auto industry, resulting from a Ponsi scheme in auto financing. The predicted collapse in this industry will put thousands out of work and have a secondary knock-on effect on US housing and consumer confidence.

While we can sit here in WA rubbing our hands with glee at every dollar rise in the China-driven price of iron ore, we can hardly criticise the Saudis, the Iranians or the Russians for doing likewise as the price of oil rises.

WA producers aren't about to start trying to bring down the price of iron ore to help anyone.

So we certainly can't really expect oil producers to produce more oil in an act of selfless charity to bring down the price to their consumers.

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There has been a deafening silence about the cause of last month's gas explosion at Apache's Varanus Island gas plant.

No doubt the matter is a sensitive insurance issue. In normal circumstances, it is heavily in an operator's interest to keep up with asset maintenance, since the cost of downtime far outweighs the cost of keeping all the gear in good working order.

Costs associated with loss of gas are now estimated to ultimately be over $6 billion, which would pay for 20 new gas plants.

One problem at Varanus, however, may well have been that most of the gas was being sold on a long-term contract for about US$1.20/ Mcf, which may not provide a huge incentive or sufficient operating margin to keep the plant up to scratch.

When that gas was contracted for sale, the Western Australian gas market was very weak. Sale of the gas at such a low price was a good way to get rid of it, so that money could be made from the sale of associated condensate.

Perhaps if the plant was selling gas at the current price of $7-8/Mcf, more care might have been taken to ensure that all pipes were in top order.

The regulator needs to look at such issues to ensure that, as market conditions change (costs and prices), the viability of infrastructure assets, whose operation provides backbone support for the whole economy, is not compromised.

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

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