Equity Security Analysis

A sign that the market 'works' reasonably well is that it is hard for individual fund managers to consistently outperform the market index. The evidence out there is that this is in fact the case. Here's the latest media report of this. Key graphs:

Consistency - the ability to sustain good returns over time - is an important part of what makes a successful fund; as is persistence, the fund manager's ability to consistently add value and achieve above-benchmark investment returns.

Over any given period there will be some active managers who produce above-benchmark returns, but fund analysis consistently shows that most active Australian equity managers have a tough time producing persistently above-benchmark returns after fees.

It is very rare for a top-performing manager one year to sustain this performance over future years.

A-IFRS / Westpac

Many companies are claiming that the move to A-IFRS accounting standards has made it harder to 'understand' their financial results. In my opinion, it is therefore incumbent upon these companies to explain their results to the market. Westpac has done a good job of this with their Accounting Workshop presentation back in April 2007. It nicely explains how their results are calculated and presented under A-IFRS, and how this has changed from previous standards. It maintains Westpac's good record on disclosure matters. Hopefully we will see more companies doing this sort of thing. Link to pdf file of the presenation here.

Pro-forma earnings

Here's an example of how companies will highlight pro-forma profits when announcing their financial results:

RAMS Home Loans Group today said its 2006/07 pro-forma net profit was $43.5 milllion, up 49 per cent on the previous year.

RAMS said its fiscal 2007 profit was in line with its prospectus forecast and that it was monitoring the likely impact of revent events in global debt markets on its future performance.

Its statutory net profit was $15.11 million, compared to $29.97 million in 2005/06.

Here's the trouble: I don't know what sort of expenses have been excluded in the calculation of pro-forma net profit, so I don't know if it's important for assessing the future profitability (and therefore current value) of RAMS. I don't know if it's calculated consistently from year to year. But I do know that pro-forma profits are almost always higher than statutory profits. Funny, that.

Credit analysis

More discussion about the potential problems with relying on credit ratings agencies. Lawrence Summers argues:

There is room for debate over whether the errors of the ratings agencies stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for ratings and shop for the highest.

But there is no room for doubt that the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings?

Pay for, err, performance?

Concern about Telstra CEO Sol Trujillo pay package. Looks like lots of his so-called 'long-term' incentives vest in about 10 months. That doesn't sound like 'long-term' to me. The SMH article also highlights a problem with executive pay packages; i.e., who designs them. In this case, it looks like remuneration consultants who previously worked for US West, one of Trujillo's former employers. It's hard to determined whether these consultants are working for the shareholders, or the CEO. Nah, that's not true. It's not hard at all. Think about who engages these consultants.

Dividends and future profits

Looks like dividend payout ratios aren't on the increase. If you take dividends as a signal of future profitability, then that's not great news. John Durie (I can't find the article online; page 35 of the 24-25 Aug Weekend Oz) notes that in the current reporting period EPS is up on average 14.6%, sales growth up 9.4%, but payout ratios down to 64.5% (average in the last 8 years at 71%).

Qantas, Private equity and conflicts

Terry McCrann quite rightly takes a stick to Qantas' management over the recent failed private equity bid, highlighting the conflicts that exist when incumbent management (or board members) are part of the bidding team.

It's often the case that management will talk up the prospects of a takeover target so as to extract top dollar for the target shareholders, but in this case folks on the board of Qantas seemingly had a financial incentive to talk down the prospects, so that they could acquire the shares at a lower price. This would explain why Qantas seemed so reluctant to release its earnings forecasts, which showed that things were better than investors had been led to believe. Turns out even those forecasts were pessimistic. I'll have a look at the Qantas results soon - I'll be interested in whether Qantas seems optimistic or pessimistic with respect to its accounting estimates. I'm predicting pessimistic.

Earnings quality - banks

Where are the banks most likely to have issues with their 'quality of earnings'? Provisioning and doubtful debts, that's where. Here's The Australian's Adele Ferguson explaining things.

Takeovers, disclosure, conflicts

Yep, more from Bryan Frith. This time it's PCH, trying to stop a potential buyer talking to the actual shareholders. Oh, and possibly breaching continuous disclosure rules.

Financial policy decisions

Tim Blue in the Weekend Australian writes a nice article about BHP's upcoming decision about financial policies (especially dividends and buybacks - on market vs off market). Whether shareholders will want some of the spoils returned as a fully franked dividend, or as a buyback will depend on their tax preferences.

Markets don't like negative surprises. Especially now.

Another entry for the don't surprise the market readings list. From today's Australian

ANY company delivering profits even slightly under expectations will face severe punishment by the market, analysts warn.

Reporting season moves into full swing today against a background of market volatility and uncertainty.

A stream of major results are scheduled over the coming days, including Leighton, Qantas and Wesfarmers.

"Given the skittishness of the markets, those that only just make earnings estimates consensus or slightly disappoint will probably be penalised and their share price will be sold down," Macquarie Private Wealth division director Martin Lakos said yesterday.

Managers claim that their share prices 'overreact' to missing an earnings target or forecast. Doug Skinner and Richard Sloan show that is especially so for small, growing firms (in a paper published in the Review of Accounting Studies in 2002, Earnings Surprises, Growth Expectations, and Stock Returns or Don't Let an Earnings Torpedo Sink Your Portfolio).

Why I love Telstra

Each semester when we discuss management communication, I keep saying that it would be dumb to announce record profits and at the same time sack thousands of workers. Or lower forecast profits and higher executive pay. Semester after semester, Telstra keeps doing something like that. This time around, it's offering "prudent" guidance about future earnings and at the same time fattening the wallets of the management team.

More (possible) CDR breaches: Cellnet

This time it's Cellnet (ASX: CLT)
Reported by Michael West in The Oz.

This could turn into a long list...

Independent experts

Independent experts reports are often described as neither independent nor expert. A lot of these reports are required by law, and often seem to be a 'cover your a*** document for managers. The valuation methods used in them are often questionable (in terms of valuation methodology, valuation range etc). Paul Kerin makes similar points:

FAIRNESS opinions are primarily arse-coverers for boards. While they can help shareholders, competition helps more. Target boards should focus on maximising competition for their shareholders' shares and forget about fairness opinions -- unless legally required or sufficient competition can't be mustered.

Following a takeover bid, the target's board often commissions a "fairness opinion" from an "independent expert". The expert estimates a valuation range for the target, compares it to the bid and offers one of three opinions. "Fair and reasonable": the bid at least meets the lower valuation bound. "Not fair but reasonable": while the bid is under the lower bound, other factors lead the expert to believe that shareholders should accept. Otherwise, bids are deemed "not fair and reasonable". Half of Australian opinions are fair and reasonable; one-fifth are not fair and reasonable.

Kerin references some research that came out of Martin Bugeja's PhD thesis at Sydney University. Martin has a paper "The 'Independence' of Expert Opinions in Corporate Takeovers: Agreeing With Directors' Recommendations" published in the Journal of Business Finance & Accounting [Volume 32 Issue 9-10 Page 1861-1885, November 2005 if you're looking for it]. His abstract:

The impact of nonaudit services on auditor independence has been the recent focus of regulators worldwide. Using expert reports provided in Australian takeovers, this study investigates a context where the audit independence issue is reversed. As approximately a quarter of expert reports are prepared by the target firm's auditor, concerns have been expressed over the independence of the opinion provided. This paper finds that, relative to other experts, there is no difference in the rate at which experts with other business dealings with the target, including the target's auditor, provide an opinion that agrees with that of directors. However, the capital market reaction around the release of the report indicates that reports produced by auditors are viewed as nonindependent.

Martin finds that 50% of bids increase after a "not fair and reasonable" opinion, but only 14% of bids are increased if there is a "fair and reasonable" opinion issued. That doesn't surprise me.

Continuous Disclosure and Takeovers

There are lots of claims that companies don't comply with their continuous disclosure obligations (<- note: that's a link to a pdf file of ASX listing rules chapter 3), and especially so when takeover negotiations are in place. Here's a recent one that involves Flight Centre and its negotiations with Private Equity Partners.

THE ASX should make inquiries of Flight Centre to determine whether some directors knew several days before their controversial termination of the proposed joint venture with Pacific Equity Partners -- and ahead of receiving a report from the independent expert -- that the transaction was likely to collapse because it no longer had the support of the founding majority shareholders.

If so, that raises the question as to whether the company complied with the ASX continuous disclosure rule, which requires the immediate release of any information known to the company which a reasonable person would expect to have a material effect on the price or value of its securities.

By Bryan Frith in The Australian. I think that the breakdown of takeover negotiations is something that would be of interest to me as an investor. I'm not holding my breath waiting for action from ASIC.

UPDATE: Here's the Sydney Morning Herald's take on the same issue. Similar conclusions drawn.

Industry Analysis: Infrastructure

Here's an example of some industry analysis looking at the infrastructure industry. It makes forecasts about future growth levels, and attempts to relate it to industry competitive conditions.

Fund ratings. Any good?

Ideally fund ratings should give investors a guide as to the likely risk and return of a fund (i.e., investment). However there are plenty of anecdotal examples of where the 'system' doesn't work (err, Enron, Worldcom, HIH etc etc). From (you guessed it) The Australian:

David Gallagher, (a colleague of mine and) Associate Professor of finance at the Australian School of Business at the University of NSW, says the big question is: what does a ratings represent?

"Intuition says a rating should be predictive," he says.

"What is the point of having a rating if it doesn't help make better investment decisions?

"You have to expect that on average a five-star rating would perform in the future, but there is no evidence to suggest it is the case."

Hmm, if you're paying these investment rating agencies, then this is not good news. However it is consistent with the idea that it's difficult for anyone (even the ones you'd expect to) to consistently outperform the market [note: that's difficult, but not impossible. See Warren Buffet and Kerr Nielson]. It also suggests that even small retail investors, if they do a sensible business analysis, may be able to spot some sound investment opportunities.

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Still good buying?

Tim Blue in the Weekend Australian thinks that there are still some good buying opportunities in the Australian share market. Some industry analysis with a focus on Price/Earnings ratios.

Financial information in Australia

I mentioned in class how annoying and inconvenient I find the Australian Financial Review's online strategy - the AFR.com.au site is slow to load, and when it does load, it's full of subscriber only material (which means I by and large won't link to it on this site). The AFR has also removed its material from Factiva, which is one of the UNSW library databases that I regularly use (in my capacity as a researcher) for media searches. In effect, I've argued that the strategy seems to be "let's make The Australian the business newspaper of record)". [Similar to the New York Times "experiment" with TimesSelect].

Looks like Dow Jones agrees. They see a role for a free Australian equivalent of MarketWatch. I think that would be a great development.

Wesfarmers, Coles, strategy & takeovers

Nice little article from Matthew Stevens in the Weekend Australian (Aug 4-5; annoyingly I can't find an online reference) that links business strategy analysis with mergers & acquisitions. He's talking about the (currently) proposed takeover of Coles by Wesfarmers, and focuses on what happens if the bid doesn't go ahead. An interesting time forecast for Coles CEO John Fletcher and Chairman Rick Allert.

SOX 5 years on

The Economist takes a look at the Sarbanes Oxley Act (SOX) 5 years on. A response to corporate collapses (and particularly Enron), it's compliance costs have been accused of driving listing offshore, especially to London. An alternative view is that it is making U.S. investments safer. See an earlier post linking to research that shows that SOX may be resulting in lower cost of capital for US listed firms.

More dumb strategy decisions

Looks like the new owners of the airport rail line want it to go broke again. In the SMH, we get the following lede:

FOUR months after the Airport Rail Link was bought out of receivership by Westpac, fares on the already costly service will rise by as much as $2.

Despite speculation fares would fall after the buyout to entice more passengers, ticket prices will climb next Monday by between 20 cents and $1.30 for tickets from the city to Mascot and Green Square, and by up to $2 to the airport.

As best I can tell, that's a really really dumb strategy. [Mind you, the airport link should have incorporated the SCG, Fox Studios, UNSW, then down to the airport. Or at least have dedicated trains starting at the airport, so that passengers with their luggage can actually get on the train, and put their bags in a dedicated bag 'area'. Sheesh]