Coping with Domestic and Global Bear Markets - Ian Murdoch

It has been a bumpy ride

As we all know the global and domestic sharemarkets are in the middle of a bear market, often described as over a 20% fall and characterised by a number of consistently falling prices lasting quite a few months or even years.

The Australian market is currently 26.5% off its November 2007 high and the All Ordinaries Index continues to hover around the 5000 level, and starting to find support.

Putting it in context

The Australian sharemarket has experienced nine bear markets since the 1960s and the average duration has been about 15 months.  The so called top to bottom average fall has been around 32%.  So we have all seen it before and often forget how it felt or what drove it.  Generally all bear markets are associated with a recession in an economy.

A glimmer of hope is that historically the average increase in shares after reaching their lows has been about 32%.  This in itself cautions selling out of shares in a bear market and making sure you are there to catch the rebound.  It is often quick and strong.

Average

Maintaining the faith that capital markets will grow at rates in the longer term to beat inflation and protect the purchasing power of one's capital, is what investing is all about.

Are we heading for a recession?

The risks are there and the economy's growth is slowing.  It will take time for the full impact to be felt and show up in the numbers.  It is often said that by the time a recession is confirmed by two quarters of negative growth, the central banks have moved and the scene is set for a rebound usually pre-empted by a reduction in interest rates.  It's starting to feel like that a change is about to happen.

The recent slump in the Australian economy and change in the emphasis by the Reserve Bank suggests that interest rates have peaked and will fall in September 2008.  This in itself is also being priced into the market.  Secondly, there has been a change in the outlook for the commodities sector as global economic growth weakens.  The growth outlook for China is still robust albeit a little less bullish.  This could mean further volatility in the resources sector in the coming months.

Has Mr Market factored in all the bad news?

Both in Australia and the US, sharemarkets have fallen over 20%.  We know that the credit crisis goes on and is working its way through the system with ongoing disclosure by major financial institutions.  Spiking of oil prices has been the most recent X factor in 2008 and appears to be subsiding.  Inflation may be starting to peak as well, particularly if the oil price continues to fall.

The sharemarket looks ahead and will be studying this season's corporate reports and projecting out the future earnings.  Any surprises will be dealt with in the usual manner.  We may see increased corporate activity as investment banks do their sums and look for synergies in the market cycle.  So it is not all bad news and it may be all factored in a globalized world of swift information flows and looking to the future.

What to look for

There will be rebounds in sharemarkets if the central banks start to aggressively reduce interest rates in response to ongoing inflation risks and slowing economies.  The keys will be if oil prices continue to fall, commodity prices hold up, the US housing sector slowly improves and market sentiment turns.

We live in interesting times.  It is not very different this time, but different opportunities do arise.  Keep the faith!

Time will tell what the last week in August will bring - Julia Lee

In the week up until 24th August 2008, we've seen some dramatic movements in the market. While the Australian market has only been down 1%, we saw Virgin Blue lose considerably more. Virgin Blue stock lost 58% after its full year results were released in the week.

Virgin Blue's full year profit fell 44% due to record fuel prices last financial year. We also heard from Qantas during the week and while Qantas also faced considerable pressures, the impact of these was far less severe than on Virgin Blue. Virgin Blue scrapped its dividend and saw a barrage of broker downgrades.

This wasn't the only stock to be battered. Babcock and Brown as well as its subsidiaries and funds were sold down heavily. The parent company Babcock and Brown lost 44%. Its shares are now down 92% since the start of the year. Babcock and Brown will be restructuring in order to try and rebuild investor confidence. CEO, Phil Green is gone and now all eyes are on its debt covenants and the ability to meet those agreements. The situation is likely to be followed closely by lenders such as NAB, CBA, WBC and ANZ, all of whom are lenders to the asset company.

Not all the news was bad.

If we look at the top 2 performers in the S&P ASX 200, we saw some impressive performers. Mincor Resources gained 24% for the week and Equinox was up 21%.

Mincor Resources is a nickel miner and announced its full year profit results. Net profit was down 37% due to a fall in nickel prices. Peter Lynch has this to say to investors: "Well, they should think about what's happening. I'm talking about economics as forecasting the future. If you own auto stocks you ought to be very interested in used car prices. If you own aluminium companies you ought to be interested in what's happened to inventories of aluminium. If your stocks are hotels, you ought to be interested in how many people are building hotels. These are facts." The point of the story is that investors should be aware of the underlying drivers which help or hinder a business. The real reason behind the rise in Mincor's share price was the massive rebound that we saw in nickel prices on the London Metals Exchange. Nickel prices rebounded 13.5% during the week.

Finally, let's mention Equinox Minerals and Felix Resources. Both these companies performed exceptionally well with Equinox up 21% and Felix up 18% for the week. Both of these companies mine uranium and the outlook for uranium prices have shifted. Prices are expected to gain due to flooding at a key uranium mine at Cigar Lake. This has boosted the forecasts for uranium prices and hence uranium companies.

Only time will tell what the last week of August will bring but with around 60 companies expected to report this week and 80 the week after, the next two fortnight will be anything but boring.

Happy Investing!

Julia Lee - Equities Analyst - Bell Direct

To buy or sell shares visit - www.belldirect.com.au  

Bell Direct does not provide investment advice. This information is general information only. You should consider your own financial situation, particular needs and investment objectives before acting.

What's the difference between being negatively geared and having positive cash flow? And how will it affect your bottom line? - Julia Hartman

NEGATIVE gearing is running a property at a loss so that the overall effect of the property on your tax return is a tax deduction. The tax saving can then be used to support the property. If the tax saving is good enough it may even result in the property having a positive cash flow.

For example:

Notice how the property is only cash flow positive if the owner is in the 46.5 per cent tax bracket which, from July 1, 2008, means he or she would have to earn more than $180,000 a year.

The more likely tax bracket would be 31.5 per cent. To be in this bracket from July 1, 2008 you would have to earn less than $80,000 a year and more than $34,000. Note, this lower threshold increases over the next few years but the upper threshold is expected to stay the same until 2014.

Buying a property and having $45 a year extra as a result sounds good, doesn't it? Even if you're only in the 31.5 per cent bracket and only have to top the property up to the tune of $1905 per year it's not bad.

So now all you need to do is rush out, buy this property, sit back and wait for it to pay itself off. But let's look at what sort of property would fit the above example.

The special building write-off is quite high. This could be because it was built between July 18, 1985 and September 16, 1987 so it qualifies for a depreciation rate of 4 per cent. But even at this rate it would have to have cost $150,000 to build way back then.

Also, if this is the case the property is only entitled to depreciation over 25 years so this claim is about to expire. It's more likely that the 2.5 per cent rate applied, which means the building write-off will last for 40 years after it was constructed (100/2.5).

To qualify for $6000 in building depreciation a year at the 2.5 per cent rate the building must have cost $240,000 to build. Yet the interest of $22,000 in the example could only cover borrowings of $258,823, assuming an 8.5 per cent interest rate.

A substantial deposit would have been necessary to have such a low interest expense and still receive such a high rate of rental return.

Even if you find a property that has a positive cash flow you still want to achieve some capital gains to offset the CGT.

You see, at a standard rent return on investment of 5 per cent the property would have to be worth $400,000 to receive $20,000 in rent.

Maybe this could have been achieved by buying well and some clever renovations, but if it was achieved because of a large deposit then the $45 per year return is a poor yield on those funds unless there's capital growth.

The key factors to look for in a positive cash flow property are a strong rental return compared with purchase price and a low land value, as land isn't included in the special building depreciation amount.

Generally these qualities are found in remote areas where capital growth isn't as good. A more likely profile is a $300,000 property where $310,000 is borrowed to cover the purchase and associated costs.

For example:

If the above is typical of properties that are available then it's going to take some real bargain hunting to find a positive cash flow property.

Higher cash flow costs won't improve your cash flow. In fact, if they're not deductible, such as initial repairs, they work against your cash flow.

The two factors that increase your cash flow are higher depreciation (including special building write-off) and a high tax bracket.

Higher depreciation as a percentage of the purchase price is achieved by buying a newish property with a low land value, such as a unit or in a remote area, because the special building write-off is based on the original cost to build the property.

Even if you find a property that has a positive cash flow you still want to achieve some capital gains to offset the CGT.

CGT will be payable even if you sell for only enough to cover the original purchase price plus buying and selling costs. This is because you're required to reduce your cost base by the amount of building write-off you've claimed.

If you can't find a positive cash flow property you need to make sufficient capital gains to cover the tax on the reduction in your cost base, the cash shortfall each year you own it and the CGT.

The mystery of how this is calculated is detailed in the box above.

The first example in this article would require capital growth of 1 per cent per annum (assuming a $400,000 purchase price and large deposit) to break even, but that doesn't take into account the loss of opportunity with the money used for the deposit.

In the second example you'd need capital growth of 4.4 per cent per annum just to break even. This is based on holding the property for five years and assuming you're in the maximum tax bracket both during the time you owned it and when you sell it.

See box above for these calculations.

Assume nothing and always crunch the numbers so you know exactly what you're asking the property to achieve.

If all else remains the same but you're only in the 31.5 per cent tax bracket during the period of ownership and when you sell then the first example requires capital growth of 1.4 per cent per annum to break even. The second example requires 5.2 per cent per annum.

Don't miss that final point. If you're only in the 31.5 per cent tax bracket and buy a typical rental property as per the second example, the capital growth must be greater than 5.2 per cent on average each year to make any profit at all out of the investment.

As discussed, properties that lend themselves to positive cash flow tend to be in areas of low capital growth.

Assume nothing and always crunch the numbers so you know exactly what you're asking the property to achieve.

For more on how to crunch the numbers and determine whether or not you should invest in a particular property, see our two-part report in the January and February 2007 editions of API or order your back copy online at www.apimagazine.com.au.

© Australian Property Investor magazine - www.apimagazine.com.au. Reproduced with permission.

This information is of a general nature only and does not constitute professional advice. You must seek professional advice in relation to your particular circumstances before acting. Please read our warning and disclaimer.

SMSF Questions & Answers - Laura Menschik

In response to questions from Money.com.au newsletter readers I have selected a few questions to address that illustrate important aspects of electing to manage and operate a Self-Managed Super Fund - SMSF.

Question 1: I have a SMSF with the current Trustees for the fund being myself and my adult son. My son has recently taken up an overseas appointment and it is now not as convenient for him to perform some of the duties of a trustee. My other children are either overseas or not always readily accessible.

I have been told I must have two trustees. Are there any other options since the assets of the fund are entirely mine at this stage?

BT - Sydney, NSW

Answer: Central management and control must be based in Australia - as a SMSF is run by a Trustee. Although this means the Trustee must be in Australia the control must be at least 50%, which is currently your situation. The market value of the assets of resident active members must be more than 50% of the assets of all active members in a super fund, which is also being met. This means that although your son is overseas, you are here and he may be able to sign off at various intervals throughout the year as required, which shouldn't present a problem.

If you and your son are individual Trustees, and he has no balance in a member account, you may want to consider using a Corporate Trustee instead, with yourself as the sole Director.

Other solutions may be to change to an APRA based Trustee (which may add an extra layer of fees, etc.) or bring another one of your children into the fund even though they may not be very accessible, but maybe more accessible than the son mentioned.

Question 2: Recently like many other investors I have seen the SMSF's performance turn quite a bit negative. I'm intending to retire in the next five years and start drawing on our SMSF. We are keen to acquire some land that would suit us as a retirement building plot and would like to do so in our SMSF, but it may not make any profit for the fund. I can't take out enough money yet to buy it outright but the land is capable of producing a bit of income that should cover some of the gearing costs. I can only fund 60% of the purchase price from the fund to make sure I leave enough to provide an income and therefore need to borrow the rest.

Can I gear it, even if it makes a net loss for the next few years, there's the potential to appreciate but it may not? Will we be able to own the land later in our own right when I retire without getting in a big tangle?

RD - Gold Coast, QLD

Answer: With the recent changes to enable SMSF's to borrow to purchase residential property, banks/lenders will lend for investment purposes only. They will not lend for vacant land, construction or property development, as well as other restrictions. Also, assets of the fund need to be at arms length and not (intended) for personal use.

If your circumstances allow, you may consider personal borrowing to acquire the land and, once you are able to meet a condition of release, withdraw funds from your SMSF to repay the loan and develop the property accordingly. Your accountant should be able to calculate whether or not this option is appropriate.

Also, you should review your investment strategy to ensure that your SMSF's investment objectives are on track to meet your financial requirements.

The answers to the questions above are general in nature and readers should always seek further advice before making any financial decisions.

If you have an SMSF question that you would like addressed in a future edition, please feel free to email me at lm@wlm.com.au with the reference: "Q&A for Money.com.au".

As with all aspects of your financial affairs, and especially in regards to SMSF's, ensure that you are not beaching any rules, plan accordingly and appropriately and always seek professional advice in areas for which you are uncertain or have less expertise.

Laura Menschik
Director and Authorised Representative
WLM Financial Services Pty Ltd.
CERTIFIED FINANCIAL PLANNER TM - SMSF SPECIALIST ADVISER TM
Visit WLM Financial Services online wlm.com.au

Borrowing to Invest - Simply Unthinkable? - Andrew Page

For many retail investors the idea of borrowing money to invest in shares is simply unthinkable.  Generally speaking people consider it to be too risky and financially irresponsible.  But why is it that this view prevails?

Part of the reason is that when markets fall, the financial press is filled with horror tales of lending gone wrong.  In the past year we have seen just how wrong it can go, with high profile examples such as Opes Prime, Lift Capital and Tricom, all of which racked up millions of dollars worth losses due to irresponsible lending and investment practices.

But perhaps a more dominant factor is that in our culture, debt is traditionally considered to be a bad thing.  And certainly this is true for the most part, but it really depends on what you use the borrowed funds to purchase.  I would argue that using borrowed money to buy anything that depreciates or does not itself generate an income stream is a questionable strategy.

Due to the effects of interest, we end up paying much more than would otherwise be the case, and the reason we do this is that it allows us to bring forward our purchase.  We can buy what we want NOW, without having to save up for it.  The availability of easy credit, and ever increasing material aspirations have transformed us from a society of savers to a society of borrowers.  But I digress.

Using a debt facility to buy an asset is an entirely different proposition.  When I speak of assets, I am referring to anything that holds value and increases in value over time.  The best assets also generate an income stream, and when we apply this definition, we strip out things such as antiques, art and cars and are essentially left with things like shares and property.

Borrowing to invest in these kinds of assets means that although interest costs will increase our total spend, we will often still be in a better position at the end of the day.  It all depends how the interest charge stacks up against our total return.  However in terms of both property and shares, history has repeatedly demonstrated that over the long term the rate of return for these investments is well above the cost of credit.  As such, the eventual return not only covers your lending costs, but usually exceeds it to the point that you end up making a greater return than you would have if you only used your own funds.  In essence, using borrowed funds gives you greater purchasing power, and that means that you gain leverage.  

And this is where we come across a great irony.  Australians are as pleased as punch to borrow hundreds of thousands of dollars to buy property, because they know that they will generally make a great return even after their interest expense has been factored in.  However for the most part Australians are reluctant to consider borrowing even a few thousand for an investment in shares - even though we know from history that shares perform very well in the long term (in fact, they have performed better than property!)

Perhaps the main reason for this is that people think that property never losses value.  This misinterpretation largely stems from the fact that property is valued very rarely.  Strictly speaking, we only know the value of our property twice; once when we first purchase it, and again when we finally sell it.   Because there are usually many years between these two events, we usually only ever notice an increase in value.

Contrast this with shares.  They are valued every second of every business day, so we know exactly what they are worth at every point in time.  Because of their liquidity (the fact that they can be bought and sold very quickly and easily) we see share values being quite volatile.  And this is the main reason why people consider shares to be risky - because they see share prices rising and falling in short spaces of time.  But to be fair, if we were to make an effective comparison between the volatility of property and shares, we should compare how the share market performs over longer time frames.

Below we can see how the market has performed on an annual and daily basis over the past 25 years.  Remember that these charts show the same market over the same time frame - all we have done is to focus on the annual change rather than the daily change, and as soon as we do that we see the volatility disappear!

To further highlight the point, imagine how you property price would change if you put your house to auction every weekend.  I guarantee that you would see just how volatile property prices can be!

Another thing to note is that there is a very wide spectrum of listed companies.  At one end of the scale we have solid, "blue-chip" companies that have a proven track record of solid and increasing assets and earnings and usually pay a dividend.  At the lower end of the spectrum, we have small start-up companies that are all promise.  Of course every company starts out small, and there are amazing examples of shares that have gone from 1c to $50, but these are generally the exception. 

So when I talk of borrowing to invest in shares, I'm not talking about these "penny dreadful" stocks.  The established, proven businesses are the ones to invest in because not only are they less risky, but they also tend to be much less volatile.

So if we accept that over the long term blue-chip shares have always performed well, that volatility is less of a concern, and that borrowed funds give us leverage, why wouldn't we use a credit facility to invest in shares?  One of the most popular facilities to do this is with a margin loan, and without getting into the specifics, they are simply a loan that is secured by the shares you purchase - much in the same way as your home loan is secured by your house. 

Like any debt instrument they represent a degree of risk, as leverage can work to multiply your losses just as it can multiply gains.  Also, you can be forced into selling your shares in a falling market when you are issued with a dreaded "margin call".  I feel that these are risks that can be effectively and easily managed, and next time we will go into the specifics of margin lending and show you how you can safely and effectively gain leverage in the market.

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