The Sharemarket - Lisa Baum

How sentiment has changed. Four months ago, government rhetoric and press coverage abounded about how the global economy was at serious risk of descending into a depression-like state and that the era of strong corporate profits and buoyant sharemarkets was over for the foreseeable future.

Fast forward to July and the sharemarket which has posted an impressive rally of around 15% in the last two weeks alone, now trades around 1,100 points or over 30% above the low levels seen in March 2009. The collective sigh of relief from investors is audible, while the stampede to cash has rapidly been replaced by a scrambling to position for recovery.

Following the herd

As more and more investors return to the market, momentum is created. Momentum is an interesting characteristic of share markets and fuels both bull and bear market cycles. It is self fulfilling, underpinned by either fear or exuberance and based on the herd mentality phenomenon.

In this upward phase, investors are cash rich and increasingly afraid of missing the initial stages of recovery. This is not just retail investors. In the cut throat world of funds management underperformance in this market will not be tolerated by investors, so the pressure is on investment managers to also participate.

Fuelling the uptrend further, it would appear that foreign capital is being invested into our domestic market. Capital inflows are reflected in the strengthening AUD which is proving very resilient.

Australia has been spared the worst of the developed world's economic problems and data now points to only a mild downturn. The interest rate easing bias has now pretty much come to an end, barring unforeseen circumstances and the anticipated timing of rate rises is being brought forward. With a stable government, a relatively benign economic environment, a buoyant sharemarket with a yield of about 4.75% and leverage to Chinese growth, international investors must see Australia as a compelling proposition.

So with all this changed sentiment, one has to ask - what is new that justifies the current rush for equity? Certainly the flow of positive news has increased in recent months and this has underpinned buying support. However it is simple weight of money that is driving the market forward. Investors who were previously hoarding cash are gradually trickling it back into the market. Other investors afraid to miss the boat are also jumping in and thus the momentum process begins again, at first tentatively, then picking up speed. Confidence is being rebuilt as part of the process.

A level of caution is warranted

As always though, caution is warranted. Many of the issues that created the global financial and economic crisis remain unresolved. There will be inevitable set backs that shake confidence and with the market rising at a rapid pace we will inevitably run into some periods of profit taking. This is all part of the cycle and is not a problem as it allows the market rises to be consolidated, building a platform from which to move further ahead over time.

Essentially, investors should now be vigilant of any signs of a stalling in global economic recovery by constantly managing their equity exposure, including taking profits on good performers or buying new opportunities as they present. Risk and opportunity are always present in every market phase.

For stock pickers, the trick is being able to identify risk and opportunity and be motivated to act. Portfolios should contain quality companies with premium assets, effective management and strong balance sheets. If a stock has done well and is overweight within your portfolio, then take some profits and rebalance, don't try and wring out every percentage point gain from a rally.

For more passive investors, 'the trend is your friend'. You cannot look beyond a low cost index fund if you are not interested in the day to day ups and downs of the sharemarket. Passive investors however still have to manage their asset allocations and this will involve some pragmatic decision making.

Should investors now be taking profits?

Undoubtedly yes, some portfolio management may be warranted. We have already risen over 30% since mid March and investors who went substantially overweight equities early will be wanting to trim holdings and lock in profits.

Most investors will have had the opportunity to participate in the rush of recent capital raisings. Vast amounts of capital have been raised in recent months from investors as corporates moved to strengthen their balance sheets and position for recovery. This has underpinned the sharemarket's strong performance and proven profitable for investors as well, so some profits could now be banked.

With the market up 1,100 points from its low, where do we now see opportunity?

Predictably the market anticipated the emerging recovery and gained early ground from extremely depressed levels. So while we have undoubtedly ascended out of the bargain basement, opportunity remains.

After having recently witnessed some of the best equity value in a generation, the market now does not look particularly cheap, with average price earnings ratios moving up to around 14x based on earnings per share (EPS) over the last 12 months. However, opportunity remains for long term investors, because companies have recapitalised and earnings per share momentum can be recaptured as the global economy improves. The pick up in earnings momentum may be sluggish in the near term and perhaps throughout 2010, but should pick up pace thereafter.

It remains likely that the global economy, including Australia, will still experience a substantial bounce in economic activity (albeit off low levels) and subsequently corporate profits. Strong yields on Australian equities will underpin performance in the interim.

For the major market sectors

The change in fortunes for bank shares, the prices of which are now back to pre Bear Stearns financial crisis levels, has been a highlight of the recent rally, particularly from the perspective of banks as important cornerstone investments in share portfolios.

Some US and UK banks are actually now reporting stunning turnarounds in their profitability. Australian banks were also sold down in line with their global peers, however the Government guarantee, prudent mortgage lending combined with mortgage market consolidation and relatively low exposure to sub prime related securities meant that the banking sector, underpinned by its strong dividend yield, provided one of the great hunting grounds on a risk/reward basis for bargain hunters in the last six months or so.

Bank share purchase plans in recent months have proved a boon for shareholders. The gains in banks have been solid and as valuations are normalising, they may now enter a period of consolidation.

The current strength potentially provides an opportunity to take some profits on positions bought at lower levels and reduce any overweight positions. Longer term however the big banks remain a core holding by way of their dominant market position, their weighting within the Australian sharemarket and for their dividend yield. We currently prefer the Commonwealth and Westpac banks.

The other stalwart of the Australian market - resources, is historically and predictably cyclical, being leveraged to global economic growth. As the cycle continues to move into a more favourable phase, the fortunes of our major resources companies should continue to improve.

We remain at the tip of the global recovery and economic upturn, so one would expect there is still more upside in the resources sector. We feel some poor management decisions have been made at RIO and recent news with regard to spying accusations needs to be played out. For these reasons we prefer BHP and Woodside and we remain bullish on both stocks.

In conclusion

Despite the initial 1,100 point bounce, the Australian share market still remains 37.2% below its November 2007 highs and also remains within Investing Times' Zone 5 buying territory. This underpins our recommendation for investors to remain modestly overweight equities.

Lisa Baum - Regular Contributor - Investing Times

Visit the Investing Times online - www.investingtimes.com.au 
This article is an extract from the August 2009 issue of Investing Times newsletter.

* Zone 5 is defined as a Zone where the value of the All Ordinaries Index is at least 17.23% below the long term trend line of the All Ordinaries Index. The value of the All Ords at 7/8/2009 was 4303 (Zone 5) - 22.54% below the long term trend line. Trend Line value is 5555 at 7/8/2009. You can learn more about the Zone system by subscribing to the Investing Times Newsletter. To order a complimentary copy of the newsletter email susan@investingtimes.com.au or phone 1300 131 526.

What is the value of a listed company?    Andrew Page

Attempting to calculate the 'fair' or 'intrinsic' value of a listed company is no easy task.

Some reasons why Company Valuations vary so widely

For starters, one must be able to first generate accurate estimates for a range of quantitative factors, many of which are sensitive to unpredictable variables and non-specific 'macro' factors. Even if one could reliably calculate accurate forecast values, we must then incorporate them into a theoretical model which attempts to relate these estimates to overall value. This in itself poses its own set of problems as not only are there a wide variety of models, but each particular model can be implemented in various ways.

Given all of this, is it any wonder that we see analyst valuations vary by so much? Moreover, what hope do small retail investors have given they lack access to the same kind of resources? The good news is that you don't need to be able to generate an exact dollar value estimate of fair value in order to gain a sense of whether a security is reasonably valued. As is best said by an old Christian prayer, it's about learning to accept the things we cannot change, having the courage to change the things we can change, and having the wisdom to know the difference between the two. In other words, in the context of fundamental valuations, forget about those things you can't reasonably expect to accurately know, and instead focus on aspects that are more measurable.

The first thing to acknowledge is that calculating estimates for earnings and dividends is notoriously difficult for certain companies, and much easier for others. Established firms with a steady and reliable track record offer greater certainty than start-up companies or those involved in high risk enterprises. For example, supermarket operator Woolworths is able to provide much more accurate guidance than a small minerals exploration company.

Given this, and the fact that advanced valuation modelling is difficult, time consuming and prone to error, we can instead keep things simple and focus on two of the oldest valuation methods available: Price earnings ratios and dividend yields. Of course these models are subject to the same limitations as their more advanced cousins, something that is best expressed by an old industry saying: 'garbage in, garbage out'. In other words, they are only as accurate as the estimates you use in the first place. This is why I suggest focusing on the larger, more established stocks that have a demonstrated consistency in earnings and dividends. It is also why I suggest erring on the side of caution by using figures that are conservative, and even pessimistic.

Fundamental Indicators - PE and Dividend Yield

Both the PE and dividend yield are rather simple calculations and most investors will be familiar with these fundamental indicators. Having said that one must be careful not to mistake their simplicity for ineffectiveness. For our purposes, I believe that a forward looking PE and yield is best. These use expected earnings and dividend values instead of historical data. If the PE is less than the market, and more importantly the industry average, it is a safe bet that it is undervalued. The exact same can be said for the dividend yield. If you are confident that dividends will not be significantly lowered, then it can give you a great idea of value.

The point is best illustrated with an example. Consider the Australian gaming company Tabcorp (TAH.ASX). Being involved in gambling, it is rather defensive in nature, enjoying reasonably reliable earnings and cash flow. Of course, followers of this stock will be quick to point out that 2008 saw a dramatic drop in both earnings and dividends, and that changes to state gaming legislation will negatively impact it in the years ahead, but I believe these can be rationalised. For starters, 2008 was impacted by the horse flu outbreak and this is something that few could have predicted. Besides, an anomalous one off event such as this is unlikely to remain a consistent factor. Indeed, the company has managed a striking return to profitability even over the course of the Global Financial Crisis (GFC).

Figure 1. Earnings History for Tabcorp.

Source: ValueGain

As for the negative impact we will see from the loss of poker machine licenses in Victoria, this is not a problem so long as we account for it in our estimate of earnings. Earnings per share in the year just gone was 93.3c, but it is expected to drop to just 78.1c in 2010.

Table 1. EPS and DPS forecasts for

Source: Aspect Huntley

Currently Tabcorop is trading at $6.70. Therefore we are looking at a forward PE of 8.58 (6.70/0.781). The industry average is currently 11.5, and the long term market average is around 15 - well above what Tabcorp is trading at. So even with the expected drop in earnings, the current price is representing good value. As for the dividend yield, based on expected dividends of 58.8c per share in 2010, we are looking at a yield of about 8.78% (0.588/6.70). The long term average yield of the market is only around 3-4%.

I don't know exactly what Tabcorp's true and accurate fair value is, nor do I need to. Given the expected earnings and dividends, the current share price represents good value. Of course as regular readers would know, I rarely put much faith in forecasts. However if you assume much more pessimistic forecasts, the ratios still appear attractive. Let's say for the sake of argument that the actual EPS and

DPS figures will be 10% lower than what is expected, does this significantly change our perceptions? If you do the maths the PE comes out at 9.5, while the yield works out at 7.9%. These are still attractive numbers and point to great value. In any case, they provide an objective justification for making a medium to longer term investment in this company.

Investing Objectively

It is important to note that these methods will never tell you what a stock is likely to do in a day or week, but over longer timeframes they are extremely powerful. Also remember to apply them to stocks with reasonably reliable earnings and dividends, and if you are like me and suspicious of forecasts, it is best to underestimate the figures.

Nonetheless, these valuation methods are easy to apply and have proven to be very reliable. At the very least they force us as investors to more objective in our appraisals.

Andrew Page -  Media & eLearning Manager - Hubb Financial Group

Download HUBB's free scanning & charting software at www.hubbinvestor.com

All recommendations are provided without consideration of any specific reader's investment objectives, financial situation or particular needs. Those acting upon such recommendations do so entirely at their own risk.

What are the tax implications of turning your home into an investment property and how will it affect your loan repayments? - Julia Hartman

MOST people think about owning a rental once they acquire some equity in their home. Of course, the next step in that line of thinking is why not have a new home for ourselves and rent out the old one?

The renting out of the original family home has many considerations over and above the typical rental property investment decision.

There are savings, such as not having to pay a real estate agent's commission to sell your old home plus stamp duty on the purchase of a new rental property.

These need to be weighed up against the fact there may be less interest and depreciation deductions against this property, as well as considering its potential for capital growth.

LOAN PROBLEMS

Typically you would have made considerable repayments off the original loan to purchase your old home.

Interest on a loan is only deductible if the money borrowed was used to purchase, maintain or improve an income-producing asset.

It doesn't matter where the loan is secured; all that matters is the direct nexus between the borrowed funds and the income-producing use.

In Domjan's tax case 2004, the Australian Tax Office (ATO) was successful in denying a deduction for interest on a loan because the nexus was lost when the borrowed funds went from the loan to a personal cheque account to pay for repairs to the rental property.

In short, if you have a traditional loan on your home there will probably be very little interest you'll be able to deduct against the rent and there's little you can do to change this.

Most people with a mortgage have very little savings because they put everything they have spare into paying off their home loan. If this applies to you it means the deposit for the new home will come from the equity you have in the old home. So the full purchase price of the new house will probably be borrowed. That's a lot of non-deductible interest.

If you've had the foresight to have an interest only loan putting all the principal repayments into an offset account then you're miles in front and in a better position than most to use your old home as a rental property.

You can withdraw the funds from your offset account as a deposit for your new home, hopefully reducing the non-deductible mortgage on that to insignificant proportions and claiming all the interest on the original loan as a tax deduction against the rent.

In an offset arrangement you have two separate accounts: one a loan and the other a savings account.

The bank only charges you interest on the difference between the two accounts, but because they're separate accounts when you withdraw from the offset account it isn't considered borrowing, and with less now offset against the loan you'll be charged more interest on the loan but it's still considered to be the original borrowing to purchase the property, so it's fully deductible when that property is rented out.

If you didn't have the foresight to utilise an offset account then you're only entitled to claim a tax deduction for the interest on any loan where the borrowed funds were used to purchase or improve your original home.

Any borrowings you undertake to buy your new home won't be tax deductible, even if the security is in your old home.

The argument that if I didn't borrow to buy my new home I wouldn't have been able to keep the original home as a rental just doesn't wash with the ATO.

What if you've been fiddling about with the original home loan? For example, borrowing against it for cars and holidays or depositing your wages into the account and drawing back out when your credit card payment is due.

It's quite possible that none of the interest on this loan is tax deductible.

The loan needs to be apportioned between private borrowings and that for the house. Each draw down on the loan for private purposes increases your private borrowings but each repayment you make, even if it has a private source, must be split between the private borrowings and that for the house on a pro rata basis.

For example, a $100,000 line of credit is used to buy the house, then the borrower deposits his or her monthly pay of $2000 into the loan account. The Tax Commissioner now considers there to be $98,000 owing on the rental property.

When the borrower withdraws $1000 to pay off his or her credit card the loan will be for $99,000. However, as the extra $1000 was borrowed to pay a private expense, viz the credit card, now 1/99th or one per cent of the interest is not tax deductible.

The next time the borrower puts his or her $2000 pay packet into the account the Tax Commissioner deems it to be paying only 1/99th off the non-deductible portion (i.e. at this point there's $96,020 owing on the house and $980 owing for non-deductible purposes).

When the borrower takes another $1000 to pay the credit card, there will be $96,020owing on the house and $1980 owing for non-deductible purposes, so now only 98 per cent of the loan is deductible, and so it goes
on. Reference Tax Ruling 2000/2 just in case you thought it couldn't possibly be this bad.

Using your loan this way will, on average, lead to a loan becoming 100 per cent for private borrowings within five years. A possible strategy to create more deductible debt on your old home is for one spouse to buy the other spouse out.

IF YOU HAVE A TRADITIONAL LOAN ON YOUR HOME THERE WILL PROBABLY BE VERY LITTLE INTEREST YOU'LL BE ABLE TO DEDUCT AGAINST THE RENT AND THERE'S LITTLE YOU CAN DO TO CHANGE THIS.

There may be stamp duty costs, though it's worth asking the stamp duty office in your state if it would tax a transfer between spouses.

It may be necessary for the transferring spouse to still retain one per cent ownership. The spouse who sells his or her share of the property could use the proceeds (after paying off their share of the loan) to reduce the mortgage on the new home.

There's still a question as to whether the purchasing spouse can claim the interest on the loan, to pay out the selling spouse, as a tax deduction.

There needs to be some other reason for entering into the arrangement than the tax benefit. For example, the arrangement may be entered into to settle a disagreement on whether to keep the house or not.

Interpretative Decision (ID) 2001/79 is a private ruling on this topic, where the ATO accepted the tax benefit wasn't the dominant purpose. IDs are only binding on the ATO by the taxpayer who made the application so you'll need to apply for your own and it's worth quoting ID 2001/79.

Be careful to consider the tax bracket of who ends up owning the property because it will now only go in their tax return.

Next month: A look at the depreciation, repairs and capital gains tax ramifications of making your home a rental.

© 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.

Reviewing past sharemarket performance with an eye to the future - Julia Lee

The path of recovery is not always clear-cut, however if you find a way to review past performance in the sharemarket and then see how it might be applied to the future, you may well be rewarded.

Let's take a look at how you can plot your way to benefit in this recovery by looking at the past, present and future.

Looking back at the Sharemarket

Let's start by looking at past recoveries.

Graph 1 below is the Australian All Ordinaries index after the 1987 stockmarket crash. It took around 10 years for the market to surpass the peak reached just before the crash of 1987.

Graph 2 is also the Australian sharemarket and the All Ords, this time in 1980. The pullback in the Australian sharemarket was much more gradual in 1980 and it took until 1984 until the market surpassed the previous peak.

Recovery Path for the Australian All Ordinaries index after the 1987 Stockmarket Crash

Recovery Path for the Australian All Ordinaries index in the early 1980s

What these two graphs show is that the path of recovery is not always clear-cut.

The first thing you can see is that both recoveries followed a bumpy ride. The ride up isn't without its pullbacks and corrections but these pullbacks in a rising market can provide you with an opportunity to add to your portfolio.

The second thing you can see is that, in retrospect, the rise was inevitable. The winners invested in the sharemarket at the lower levels in order to profit when the market recovered.

For example, from the low in 1982 to the high in 1986 the market rose 150%. From the low in 1988 to the high in 1994 the market rose 90%.

Looking at the Current State of the Sharemarket

The road to recovery is hard navigate, particularly if you've been 'long' and held onto stocks throughout the fall. But if you have the ability to review the past and focus on the future, you can be rewarded.

Here is a chart showing the path of recovery so far for the Australian sharemarket, starting from the peak in 2007.

It might seem hard to invest in the sharemarket now, especially since it is up around 36% from the low in March.

However, if you can learn anything from the past, it is that the ride up should be bumpy but also hugely rewarding. This really is all about how you view the market.

Future movements of the Sharemarket

Do you view the market from the viewpoint of the past and look through that to the future? Do you look at the sharemarket and see the huge loss of 54% or do you look to recovery and the gain of 120%? This is what the gain would be if you had taken a chance and invested near the lows and stayed strong when the market recovered to its previous high.

Some people look at the market now and see opportunity. Others only see the risk. All I know is, I'm much more comfortable buying on the pullbacks now compared with how I felt two years ago. Where do you stand?

Happy trading!

Julia Lee - Equities Analyst - Bell Direct

To buy or sell shares from as little as $15 per trade, go to 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.

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