Prescott Securities Investor’s Digest The Financial 2 Picking up the world’s Earthquake financial baton. So if the US has dropped the world’s financial baton, who is going to pick it up and when? Darryl Gobbett writes about the whys and wherefores and what next.
Good for the environment and good for investors?
The Carbon Pollution Reduction Scheme. Its impact on the economy and on the success and viability of individual companies.
Stocks to watch.
The marketplace mishaps of 2007/8 were an earthquake waiting to happen; only the timing was unknown. David Middleton discusses the background... and the outlook. The Boxing Day Tsunami of 2004 was caused by the second largest earthquake ever recorded and resulted in death and destruction on an enormous scale. It would be wrong to trivialise the extent of that disaster by comparing the current financial turmoil to it. In some ways, however, there are similarities. The first similarity is the lack of warning. Stresses in the earth’s crust are measurable and there is always the possibility of earthquakes. Some places are more likely to experience them than others and
people who live there do so knowing there is a constant threat. Similarly, there were early warning signs for the melt down of credit markets in the USA. Noted economists had warned of the major overvaluation of residential property in the USA and in other countries – including Australia. Unlike Australia, other countries, especially the USA, had experienced a long period of very cheap money that fuelled property prices and encouraged overbuilding. In the USA credit was extended to many with poor credit ratings on the basis that the loans were supported by property prices. In retrospect, it was an earthquake waiting to happen; only the timing was unknown. What was also unknown was the extent of the disaster. In the United States, property mortgages are non-recourse. If the property value continued on page 7
Market uncertainty and falls in commodity prices are causing negative sentiment in commodity stocks. We examine the possible implications.
s t s
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A way of creating an effective and flexible estate plan by including the option for a Testamentary Trust in your will.
Another Queensland office.
Two months after expanding into Perth, Prescott Securities has opened its second office in Queensland. prescott securities spring 2008 1
Picking up the world’s financial baton
By Darryl Gobbett Adviser, Representative and Chief Economist.
So if the US has dropped the world financial market baton, who is going to pick it up and when? Darryl Gobbett's insight into the whys, wherefores and what next. We believe Governments globally are now putting policies in place that will help ease the crisis in global private investment markets and limit its impact on the major global economies. When will the private sector investors respond positively to these policies and, in the longer term, who will pick up the baton the US has seemingly dropped as the post-WW2 leader of global financial markets? From the seeds of less than 1% of the global debt markets, the problems of the US sub-prime home mortgages have rapidly and unexpectedly bloomed into a global financial crisis. Household names in banking, lending, real estate and insurance have collapsed, been forcibly merged or taken over by others or even by Governments. As major financial institutions choke off the lifeblood of modern economies - the supply of credit - to the real economy of businesses and consumers, we will increasingly face the possibility of severe recession in the US and Europe, unless there is effective and coordinated action by the authorities of the major economies. Actual runs on banks in the US or Europe have been minimal but household savings are being locked up in the financial institutions and not recycled to support the establishment or growth of businesses or the buying or building of homes. As banks have increasingly lost confidence in the credit worthiness and solvency of their industry, regardless of past 2 prescott securities spring 2008
relationships, they do not want to lend to each other, let alone to businesses or households. The impact of this change has been severe even on top rating global banks; last year they were prepared to lend to each other on the “interbank” markets at a margin of about 0.1% over the interest rate at which they would lend $US to the US Government. That margin in early October reached 4.8%. In the US, Residential Mortgage Backed Securities and the Commercial Paper markets in which businesses and home lenders could raise funds by selling securities to banks and other investors have essentially closed. In response, the US authorities have started buying these investments. In Australia, to help non-bank housing finance lenders continue to operate, the Federal Government set up a $4 billion fund (now expanded to $8bn) to buy Australian sourced Residential Mortgage Backed Securities. In the main, this problem is not so much about lowering interest rates, although this would help. It is about reopening access to credit within the private sector. This absence of credit availability in turn is driving down share prices as fears increase about what happens if companies cannot get credit, if the cost of available credit continues to stay so high or if the global economy falls into recession. In such a climate of fear, the current
share prices for many companies have little or nothing to do with the profitability or inherent value of the businesses. Paradoxically, it is largely the impact of the poor lending and investment practices in relation to US subprime loans that is behind this credit crunch, not any fundamental deterioration in the credit worthiness of the main players in the real economies. This is a time when it is the internally generated actions of the US and European finance sector, and the related knock-on effects, that could cause recession in the US and Europe and, in turn, in the developing economies. This is not a recession caused by an externally generated collapse of consumer or business spending. This risk aversion is also what is behind the 30% or so fall in the value of the $A against the $US and the Yen. Our economy is growing well and the Federal Government has effectively no net debt and is running large Budget surpluses. Australia’s banks are globally recognised
USA drops the baton
as well managed, very profitable, well capitalised and with low bad debts. The big four banks are amongst only 18 banks with credit ratings of AA or better globally. Despite this, if the currency and share markets are any guide, the US is seen as a safer haven than Australia. Getting confidence back in the private investment markets fundamentally needs investors – financial institutions, households and businesses – to feel safe that they will get their money back. Then the normal process of credit creation can be restarted. However, if investors do not feel their money is safe they become less willing to spend and invest and this can start the downward spiral of the real economy as the immediate loss of spending and production is compounded by the next round of job losses and collapsing businesses. This was an important lesson of the Great Depression of the 1930s. So the initial focus of policy makers to these crises has been to ensure that depositors feel protected. This has been achieved either by Governments providing explicit guarantees or by
arranging for financial institutions at risk to be taken over by, or merged with, stronger institutions. The Federal Government announced on 12 October it was giving a three year guarantee on deposits held at Approved Deposit-taking Institutions (ADI) in Australia. This essentially covers the Australian banks, building societies and credit unions. In addition, for a fee, the Government is prepared to provide guarantees on the ADI’s wholesale borrowings here and overseas for up to 5 years. The UK is setting up a £GBP50 billion fund to support its banks and in the US, the Emergency Economic Stabilisation Act gives the US authorities up to $US700 billion to assist financial institutions. It will take some time to see how markets react but the building blocks for recovery seem increasingly in place. Chinese banks have not had the problems of the US and Europeans. The main concern has been whether the strong growth of its economy, a major driving
force of the world economy and commodity prices, could be sustained in the face of possible recession in the US and Europe. China has announced it will aim to keep “sustained and fast” economic growth. As part of this, official interest rates have been cut by 0.27% and bank capital reserve requirements eased. With $US1,200 billion of China’s $US1,800 billion of foreign exchange reserves held in US assets, and half of that reportedly in investments issued by Freddie Mac and Fannie Mae, China has a very keen interest in the performance and stability of US financial markets. This is now possibly as important an issue as continued growth in US demand for Chinese exports. With China now a major source of the growth in both the world’s savings and spending, it seems likely it will play an increasingly active role in world financial markets. The US therefore needs to be careful as it may not be as simple a task as in previous years to recover the dropped baton of world financial leadership.
prescott securities spring 2008 3
Can a company be good for the environment and good for the investor too? By Prescott Securities Adviser & Representative Mark Mackintosh.
The impact of the Carbon Pollution Reduction Scheme on the economy and on the success and viability of individual companies might surprise you. Much has been written about the Government’s proposed Carbon Pollution Reduction Scheme (Green Paper) and how this may impact on our economy and the future success and viability of individual companies. Already a whole new dictionary of terminology and acronyms has been developed and expectations have built up around the value that could be extracted from such a scheme. But who knows what the real cost or benefit may be? The answer is no-one really knows. But what we do know is that the combination of a growing global population and its associated energy demands, an increasing scarcity of water, food sources and oil and the ever present impact of climate change will have an economic impact. This presents risks to companies at many levels and while some companies are taking these issues seriously there are many companies who still seem to believe that it is someone else’s problem to solve. The development of Responsible or Sustainable investment principles has taken place over the last few years, developing from ethical investment concerns which were driven more by
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personal feelings, into a broader interest in how companies are dealing with the issues of sustainability and their future success. Corporate Social Responsibility (CSR) is a common term used to define the broader issues which can be split into three main areas: Environmental concerns; and how companies deal with the inevitable impact their products and processes have on the environment, use of energy etc, Social issues; such as how the company deals with its employees, outsourced workers overseas, the local community etc, Governance; the Board and management structure, legal compliance and trade practices etc. Companies are now rated on the basis of these issues. And as you might expect, companies which rate well across these areas generally perform better than others. A global study of over 4,000 companies showed that over 5 years, companies which rated in the top 10% on governance issues generated on average almost 4% pa extra return for investors. Put simply, companies which are proactive perform better.
And a broader study which looked at 30 separate pieces of research into the quantitative relationship between CSR issues and investment performance found that only three studies showed a negative correlation. In other words, investing “ethically” does not mean you have to forego some of your return. In 2006 the United Nations developed their Principles for Responsible Investment. These have already been adopted by over 200 investment managers globally, including 40 managers in Australia who control over $360 billion of funds under management – over 27% of all managed assets in Australia. So, whenever (if ever) the Carbon Pollution Reduction Scheme is established in Australia, the issues and how they will impact companies now and in the future are already being considered around Board tables, the investment managers’ committees and the public pension funds – at least by those of them who wish to continue to survive and prosper. Mark Mackintosh is a member of the Responsible Investment Association of Australasia. He is presenting ‘Solutions for Responsible Investors’ at the ‘Non Profit Finance Forum’ in Adelaide at the Holiday Inn on the 28th of October 2008.
Stocks to watch By Travis Adams Direct Equity Analyst.
Recent market uncertainty and falls in commodity prices are causing negative sentiment in world commodity stocks. We examine the possible implications. Over the last year, BHP Billiton (BHP) and Rio Tinto (RIO) have moved from buy to hold due to higher prices in relation to the earnings received. However, recent market uncertainty regarding the level of world growth and falls in commodity prices has caused negative sentiment in world commodity markets. We now take a look at what might happen in these markets and how to get exposure to the resources sector. When it comes to resource stocks we are extremely conservative and there are several reasons for this conservatism. Firstly, mining companies are highly cyclical with very long but steep cycles that are extremely difficult to predict. The last mining boom was in the 1980â€™s and it was a long time between drinks before the next boom period from 2005 to now. Secondly, commodity prices in themselves are extremely difficult to predict and are easily manipulated by the speculative community. For example, the oil price over the past year was pushed close to $US145 per barrel and since has fallen back to below $US92 due to the speculative positions pushing up the price then dumping it on recent fears of a world growth slowdown. Thirdly, mining is a very capital intensive business and the size and scale of building the mines causes risk in the execution of bringing a mining project to production. Compared to other industries mining requires massive capital expenditures that are reliant on commodities prices in order to recoup the investment. The long lead times to production cause the long cycles we see in commodities prices and the sector in general. When prices are low no one wants to build mines that are economically unfeasible
but when prices rise suddenly the rush is on to bring new mines on stream. The catch is that many miners attempt to do the same thing and this in turn pushes up the costs of the resources the miners need to build the mines. When projects finally do get completed there is an increase in supply that inevitably pushes the price down while many projects are still in the long development stage causing those that were late to the development party and not yet producing to lose money. So what to do? You want resources exposure but want to reduce the risk of the investment? Unfortunately any resources investments are inherently risky but there are several things you can do to reduce the risk:
Source: PSL Share Model
To get exposure we prefer investments in the large diversified miners such as BHP and RIO or a diversified exposure through a commodities investment fund such as Global Mining (GMI). Alternatively, to get an indirect exposure to the sector, consider companies like Leighton, United Group, or Worley Parsons, at the right price.
1. Invest in large miners: Size enables the company to supply when demand arises and have the capacity to increase production. 2. Invest in diversified miners: Companies such as BHP and RIO have diversified exposures that are not reliant on any one commodity. Prices for individual commodities can be highly volatile, for example the recent moves in oil which has fallen nearly 40% since July 2008. 3. Invest in low cost miners: Low cost means that the company is able to restrict cost growth when times are tough and able to profit when commodity prices fall. The marginal producer is the one that will incur the first losses should the commodity price fall.
Source: PSL Share Model
These companies support the mining projects across Australia with revenues that are diversified with infrastructure development. As with any purchase the price you pay is important. BHP and RIO have traded at high prices recently and recent share market turmoil has seen them fall away. We have rated them â€œAccumulateâ€? for investors and think the resources stocks are starting to represent good long term value. These will remain volatile in both directions so investors need to realise this before they commit to a purchase. prescott securities spring 2008 5
By Prescott Securities Adviser and Representative Peter Hickey, Robina Qld.
One way of creating an effective and flexible estate plan is to include the option for a Testamentary Trust in your will.
Tax minimisation A TT allows for tax effective income distribution. Through flexibility of distribution of income the TT effectively lowers the rate of tax paid on Estate income. The diagrams below illustrates the potential tax benefits of using a TT.
With a Testamentary Trust
Testamentary Trust is created
Assume $100,000 in taxable income and Beneficiaries have no other income.
(Discretionary or Fixed) Trustees selected, trustees run the trust
Testamentary Trust Partner Children Grandchildren
A Testamentary Trust (TT) is a trust created from a will. Instead of all of the assets of a deceased estate being distributed to the beneficiaries, some or all are retained in a trust for the benefit of beneficiaries. It provides the option of either a discretionary or fixed trust with each providing different benefits. The persons nominated as trustees of a TT have the ability to determine which beneficiaries receive distributions and the timing and amount of distributions. Alternatively, the Trust may provide for fixed entitlements for beneficiaries, although flexibility is recommended to retain the advantage of any tax planning opportunities. It is important to consider carefully who are to be the trustees of the TT. They should be persons who you know have some financial management skills and can be trusted to act in the best interests of the beneficiaries.
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However, you must be careful as any income not distributed to beneficiaries each year is taxed at 46.5% in the hands of the trustee. Asset protection A well drafted TT may also assist to protect the assets of beneficiaries of the estate. As the TT is not owned directly by the beneficiaries it can offer a level of protection from creditors. It can also provide protection of your estate for subsequent generations as the assets will never be directly available in property settlement disputes, be available for spendthrift children, or in the event of matrimonial breakdown. The family court may, however, have some regard to assets in a TT and could adjust the assets outside of a TT in determining the asset split between a husband and wife.
If a beneficiary is not capable of handling their own financial affairs or have special needs, you could leave part of your estate for that personâ€™s benefit PARTNER CHILD 1 CHILD 2 CHILD 3 by naming them as the primary beneficiary (but not a trustee) of a TT. $25,000 $25,000 $25,000 $25,000 It prevents abuse of the trust assets by Total tax payable for partner and 3 children will be unscrupulous people or irresponsible $12,900 or effective tax rate 12.9% individuals.
With no Testamentary Trust A TT within a will allows beneficiaries Assume $100,000 in taxable income and Beneficiaries have no other income.
PARTNER CHILD 1 CHILD 2 CHILD 3 $91,999 $2,667 $2,667 $2,667 Total tax payable for partner (no tax payable by children as $2,667 is the current tax free threshold applying from 1 July 2008 for minors after allowing for the low income rebate) will be $24,179 or effective tax rate of 24.17%
the flexibility and choice that a normal or standard will simply cannot match and is not just for the wealthy. A wellplanned TT can last for up to 80 years after the death of the will maker, and can provide ongoing asset protection with significant tax savings for spouse, children, grandchildren and greatgrandchildren. You should consult your accountant, solicitor and financial adviser to ensure that you are aware of all the advantages, disadvantages, costs and responsibilities before you make the decision to include this in your will. The above comments provide only a general overview of the concept of a TT. Specific advice should be sought in relation to your personal estate planning needs.
continued from page 1
Prescott Securities opens second Queensland office
drops below the loan value the owner can simply hand in the keys and walk away. The large fall in property prices put many in this situation just at the time the interest rate on their loans was starting to rise. Merchant banks on Wall Street had turned these poor loans into financial products and sold them around the world. The financial risks had been taken on by insurance companies for substantial fees and the protected products were rated as investment grade by respected ratings houses. The collapse, when it occurred, was so substantial the insurance companies went broke and the investment capital was completely lost. Wall Street merchant banks had their balance sheets destroyed, some went broke and some changed hands at ‘fire sale’ prices. Banks with histories spanning more than a century went out of business.
From left to right - Peter Hickey, Joyce Ellingham, Natalie Goodall, Kellie Sloan.
Just two months after expanding into Perth, Prescott Securities has opened its second office in Queensland. The new office is located in the central Gold Coast commercial hub of Robina and will complement the firm’s other Gold Coast office at Sanctuary Cove. Prescott Securities Chief Executive Officer, Mr David White, said the current expansion in Queensland is in line with the ongoing national growth of the firm, which has also seen the establishment of new offices in New South Wales and Western Australia over the past three years.
The decision to open an office in Robina was due to the appointment to Prescott Securities of WHK Cressey Lynch principal, Peter Hickey. Peter has vast experience in this region and has taken an experienced team with him to service an already established and new client base. Prescott Securities has many long standing relationships with clients that have been built on our focus for patient, longer-term investing with an emphasis on meeting clients’ cash flow requirements. The clients of the Robina office will continue to benefit from this philosophy.
The financial tidal wave has swept over share and property markets around the world. Some companies and investments found themselves, fortuitously, on higher ground but many have experienced damage and many have been destroyed. The value of investment markets has fallen to a level you would normally only see in the worst of recessions and the key question on everyone’s mind is whether or not we are going to have one. There are as many different views as there are commentators. AMP’s respected economist Dr Shane Oliver believes the financial system will continue to be well managed by central banks and governments who are acting very differently to the financial threats than governments did at the time of the Depression. He points to falling oil prices and likely falling interest rates and the early recognition and writing off of losses. Respected columnist Robert Gottliebson does not believe we are in for a repeat of the Great Depression. He also noted that even if we go into a recession the world will not end. We have had recessions before. A recovery of markets will occur and a recession will simply make the recovery longer, years rather than months. prescott securities spring 2008 7
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Prescott Securities Limited | ABN 12 096 919 603 | ASX Market Participant | Australian Financial Services Licence No. 228894 | www.prescottsecurities.com.au | firstname.lastname@example.org Disclaimer: The information contained within this document was compiled by Prescott Securities Limited (PSL) based on materials from other sources and PSL provides no warranty regarding the accuracy or completeness of the information. All opinions, conclusions, forecasts or recommendations are reasonably held at the time of compilation but are subject to change without notice by PSL. PSL assumes no obligation to update this document after it has been issued. Except for any liability which by law cannot be excluded, PSL, its Directors, employees and agents disclaim all liability (whether in negligence or otherwise) for any error, inaccuracy in, or omission from the information contained in this document or any loss or damage suffered by the recipient or any other person directly or indirectly through relying upon the information. This publication is intended to provide background information only and does not purport to make any recommendation upon which you may reasonably rely without taking further advice. This publication does not take into account any person's investment objectives, financial situation and particular needs. If advice is sought, specialists in Tax, Legal & Financial Planning, where applicable, are consulted. Prescott Securities Limited (PSL) holds an Australian Financial Services Licence No: 228894. PSL is a WHK Group firm. © Prescott Securities Limited October 2008. All rights reserved.
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