Kreston market update week ending Friday 6th August 2010

Kreston ANZ

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Kreston Dormers

Kreston Dormers Financial Services Pty Ltd

This week's update is early due to the author's Friday commitments.

The ASX 200 had its 5th positive week in a row and has risen 6.7% since early July. Banks went against the rising trend while all other sectors gained by over 1%.

US company results have continued to offset news of slowing US and Chinese economies. European financial markets are stabilising with good profit results from banks and CDS spreads falling. Confidence is returning as markets become more optimistic that US growth will slow but not return to negative territory. As stated previously, we are expecting 5,000 on the ASX 200 by the end of the year although it will not be a smooth run up.

	Index	Change	%
All Ordinaries	4,576	34	0.7
S&P / ASX 200	4,555	24	0.5
Property Index	875	14	1.6
Utilities Index	4,228	57	1.4
Financials Index	4,415	-26	-0.6
Materials Index	12,290	199	1.6
Energy Index	14,964	212	1.4

Bank Term Deposit 12 month rates fell by 0.1% but rose slightly over 3 months.

Term	Rate %	Change in rate
3 months	5.65	0.05
6 months	5.90	-0.10
12 months	6.11	0.00
3 Years	6.80	0.00
5 years	6.95	0.00

Overseas markets continued their upward trends. The US S&P 500 was 1.7% stronger and is up 9.5% over the past 5 weeks. While the UK FTSE had a more sedate 0.9% rise it has rebounded 11.7% in 5 weeks as European sovereign debt issues abated. In Asia, Hong Kong's Hang Seng rose 2.3% and Japan's Nikkei continued its choppy trend down -0.7%.

Australia's Rio Tinto reported a $6.3 billion half year profit and NAB's takeover bid for AXA has been delayed by the regulator.

In this week's Feature Section we review Warren Buffett's biography 'The Snowball'.

Australian News

Rio Tinto announced a $6.3 billion half year profit which was up 125% on the first half of 2009. Strong commodity prices have driven the result and Rio's debt fell by around a third to $US12 billion. A further positive was that the 'troubled' aluminium division turned a profit.

Rio will spend $1.09 billion on iron ore projects over the next 6 years with the majority targeted at the joint venture with BHP in the Pilbara. This follows the announcement last week of a $US4 billion program with Chinese company Chinalco to develop iron ore deposits in Guinea, West Africa.

Company regulator ACCC has required more information from NAB before it will make a decision on NAB's $13 billion bid for wealth management company AXA. AXA is in a trading halt pending the ACCC decision. This process is dragging on.

Australia's trade surplus (exports less imports) almost doubled to $3.5 billion in June. High commodity prices are underpinning the result and will for some months to come.

Residential house building approvals fell 3.3% in June in reaction to the Reserve Bank interest rate rises. That is not necessarily the outcome the RBA was after. They are keen to put a lid on home prices through increases in interest rates but not home building as this will reduce supply at the same time as the population is growing. Contrary to the RBA's goals, home prices rose 3.1% in the June quarter although there are some signs of weakening in cities such as Melbourne.

Overseas News

Overseas news was 'on balance' positive this week.

In the US, 65% of companies have reported and 75% of these have exceeded analyst profit estimates.

The strong company news has been offsetting other data that is showing a slowing US economy. US pending home sales were down -2.6% which was well below expectations. While housing prices have probably bottomed in the US, it will require a rise in employment to make a dent in the large inventory of unsold houses. US factory order was -1.2% softer in June and personal spending was flat.

On the unemployment theme, Treasury Secretary Timothy Giethner, stated that US unemployment may again rise before it falls'. This slackness in employment is not unusual in a recovery and employment data due out Friday is being eagerly anticipated.

We expect further stimulatory measures from the US government to maintain growth and hence promote job numbers.

China has showed some signs of slowing but in the context of their very high growth rates to this point, a slower economy with say an 8% to 9% growth rate would be regarded as a plus. The Chinese Purchasing Managers Index fell to 51.2 in July. Readings above 50 indicate that economic activity is rising so the result is reasonable despite being down on the 52.1 reading in the previous month.

Major UK banks Lloyds, Barclays, HSBC and Standard Chartered all reported markedly higher profits due mainly to lower provisions for bad debts. While we would prefer profits being due to increased revenues, falling provisioning is a good sign that economic conditions are improving. These results reflect a welcome 1.1% rise in UK GDP for the June quarter. In France, Societe Generale and in Germany, Deutsche Postbank each reported large profit increases on the back of much stronger revenues.

Overall, economic conditions in Europe are becoming firmer and the banking system is stabilising. As further evidence of increased confidence, spreads on Credit Default Swaps which insures against default on debt, are in a downward trend. The impact of European Government spending cuts will be the next test for Europe.

Feature Article - Warren Buffet

After having just completed reading a biography on Warren Buffet I thought some of the themes might be interesting if not useful. The book is called 'The Snowball' and the author is an ex investment banker, Alice Schroeder.

Life is like a Snowball

'Snowball' is a reference to Buffett's philosophy that if profits are continuously reinvested over time then the compounding profits on the profits will grow like a snowball rolling down a hill. If the hill is long enough the ability of the snowball to get bigger increases. For example if an investment achieves 7% return per annum, the investment doubles in 10 years and at 15% doubles the money in five years.

Buffett being very single minded viewed any consumption of capital (money) as lost future compounded profits. He took this view to an extreme in his early years and consequently the legend (which had some substance at the time) of his frugal lifestyle was born.

Buffett makes mistakes

Like all investors, Buffett has made some very significant investment mistakes. His investment company Berkshire Hathaway was in fact a textile mill acquired by Buffett that never made money. Buffett persevered with the textile operations for years before eventually shutting it down.

Other poor investments include re-insurance company General Re that lost huge amounts just after Buffett acquired the company and investment bank Salomon Brothers that nearly 'went to the wall'.

There is a similar lesson in Kerry Packer's investment 'life'. Despite his reputation as an investor, Packer made many mistakes as well.

Investing when others are fearful and being fearful when other are greedy

Buffett does live this piece of advice. His most notable recent example of this was his investment in Goldman Sachs in late 2008 during the depths of the bear market. In fact, he is unhappy when he has excess cash and asset prices have been pushed up by general market optimism.

Buffett buys companies

This might sound obvious but his philosophy is that he has a deep understanding of the companies he owns including their people and operations. Once he has purchased the company he is more concerned about the company's operations than the prevailing share price.

Risk is a critical

Buffett sees quantifying risk as a tangible and critical part of an investment decision. He will only make an investment where he sees a considerable buffer in the price he pays to be able to absorb negative events if they eventuate. That is, he will only underpay (in his assessment) for an asset. He will weigh up the risk or possibility of unknowns impacting the company and build that into the price he pays.

US Investment Banking Crises Keep Happening

The 2008 bankruptcy of US investment bank Lehman Brothers was a seminal event in the last bear market as it put the financial system at risk and required huge government intervention.

The US has had practice in dealing with these scenarios and you could almost say that investment banking crises are regular occurrences.

In the late 1980's, Buffett bought a large share of Salomon Brothers which at the time was one of the biggest investment banks in the US. In 1991 a Salomon's bond trader circumvented government bond auction rules and the government threatened to exclude Salomon's from future auctions. This would have shut them down. Buffett managed to avert the government penalties at almost literally the last minute on a Sunday night (sound familiar?). A failure of Salomon's would have had a very severe impact on the financial system.

The biography also discusses the Long Term Capital Management ('LTCM') Crises in the late 1990's where LTCM, a relatively small hedge fund, had taken such huge derivative bets that their downfall would have put the financial system at risk (that sounds familiar). At the time, other US investment banks were basically instructed to takeover LTCM positions to 'save the financial system'.

Then in 2008 we had Bear Stearns lose its right to exist and was bailed out by a government organised takeover by Morgan Stanley. Same basic reasons: leverage and derivatives.

Finally, on a Sunday night in September 2008, the government decided not to bail out Lehman Brothers. That was a mistake. Lehman's filed for bankruptcy and put the financial system at risk.

The message is that investment banks will 'blow up' and take others with them unless they are regulated. And it usually comes to a head on a Sunday night.

'Intensity is the price of excellence'

Buffett maintains that excellence can only be achieved through absolute focus or I would say obsession in his case.

From an early age, Buffett's main interest was making money. He became a successful investor and business owner while still at University. All through his life, his number one objective was to make money. Not for what money would buy but as an end in itself.

'Price' in the quote in the previous heading, refers to the costs to his personal life which tended to run second to his business pursuits.

An unconventional personal life

His marriage was not conventional and his late wife lived a parallel life based on social causes and in fact lived in a different state for much of the time. While they stayed married and close until her death, Buffett was living in Omaha with a mutual friend of he and his wife, with everyone's consent.

Buffett has three children that are well looked after but not to the extent you might imagine. His philosophy for his kids was that they receive 'enough money to do anything they want in life but not enough to do nothing'.

Other unusual aspects of Buffet's life:

  • His personality could be described as 'nerdish' due to his consuming focus on business matters, even in social circles.
  • Buffett exists on a diabolical diet of Coke and hamburgers. Whilst he does stray from this menu, he does not stray far.
  • He is intensely loyal to his inner circle and investors and has an obsessive concern of letting people down (financially at least).
  • Oddly he refuses to accept his son's stepchildren as part of the family.
  • His spending habits are quite constrained relative to his wealth. Buffett lives in the same Omaha house he has owned since early in his adult life and he is notoriously unconcerned with his personal appearance. He is not however as frugal as some would suggest as in latter years corporate jets and nice hotels are a feature of his travelling.

The philanthropist Buffett has adopted early 20th century US industrialist Andrew Carnegie's view that, 'he who dies rich dies shamed'. In other words you should give away your wealth before you die.

Buffett has committed to giving away 99% of his wealth through the Bill and Melinda Gates Foundation. Recently he has convinced other multi billionaires to donate large proportions of their wealth.

Buffett's thinking is that it was a fortunate accident that he happened to be born in the US with the abilities he had. He feels that there are others in less fortunate countries with the same abilities that could be successful with the same chance. His philosophy is not that people should necessarily be redeemed from poor choices but that people should be given a chance to realise their potential.