Focusing on Picking Winners in the Top Funds

Past Performance Is Everything

There are no hard and fast rules that give you an edge but there is a science in tracking down the absolute top performers.

When choosing a fund, consistency of performance over the three and five years is of absolute paramount importance, ie. Performance Returns - 6 months, 1,2,3,5,7 and 10 years.

Compare Apples with Apples

Different categories of funds (ie. specific sector funds) have different risk profiles, so compare a fund with its peers over one, three and five years. Also, remember that funds with the biggest returns are probably taking on the most risk and will probably be the first to take a hit when the market tumbles. Therefore, to sort out the difference within the Style Managers, we need to measure the past performance on level playing fields such as Standard Deviation, Beta, Tracking Error, Information Ratio and Sharpe Ratio. For example, why do some Fund Managers invest in one set of shares while another prefers completely different companies and why will one fund manager kick all their goals when the share market is booming and another will score when gloom is all around.

Use of Relevant Benchmark

Performance is useless unless it is compared with the relevant benchmark. For example, By improving Risk/Return estimates by using Core Spectrum Quantitative/Qualitative Factor Metric Usability Valuation Models for extracting Alpha. i.e. Efficiency Ratio and Top Quartile which is based on risk, return and time.

Keep Fees Low

Because fees sap returns, they should be kept as low as possible. When analysing Master Funds and Wrap Accounts, keep an eye out for three separate fees: the entry fee, an exit fee and the Management Expense Ratio or MER (the annual charge that covers funds running expenses). Compare MER's between similar funds with the view to choosing a fund with a smaller charge. A higher MER taken out of the total amount invested will have a marked impact on your future wealth.

Rating Agency/Research houses can be fraught with danger

The problem with most Rating Agencies/Research Houses can be fraught with danger because they try to achieve in informed judgment at inappropriate levels of Optimized Asset Class/Asset Allocation that is delivered in the form of core static satellite prior art packages. Simply these portfolio judgments are unattainable because without the systematic building block flexible technique for portfolio construction, improvisation can't possible scenario test with actual Asset Class/Asset Allocation for appropriate combinations of produce output that meets the matching clients risk tolerance. Not surprising therefore they can never achieve the require risk trade off within the realistic economic assumption over the investments Risk/Return horizon that adds values according to the investors realistic estimated for risk tolerance.

Bigger Isn't Better

Generally, the bigger the fund, the more popular it is but don't get caught thinking that popularity means healthier returns. Often a funds large size can harm its future performance, especially if it dabbles in small and mid size caps stocks. Obviously, this doesn't apply to global or international funds where there are unlimited investment opportunities. Most researchers say that a fund should not be more than one or two per cent of the relevant sector in which it invests.

Picking Proven Numbers

The BCM Attribution Symmetry Technique for selection of fund managers and direct shares always offers substantial better opportunities. Unfortunately, preventing bad managers from taking over your fund once you have already invested in it, is out of your control; but you can, at least, ensure that the manager you choose upfront has the experience and expertise to drive the fund towards success. Long tenure in a good performing fund is an indication that the fund manager is a safe bet, while a manager with a cloudy history or a few years experience, is probably worth avoiding.

Don't Get Sucked Into Brands

It's surprising how many people think a big brand means big return. Fund Managers that advertise a lot are not necessarily the highest quality managers. However, spending more on brand building does mean that the manager is spending less on important resources such as staff, technology and research that will help them make better investment decisions with investors money. Don't be afraid to invest in a less known fund manager if it matches your criteria.

Fund Managers Have Their Specialities

Some Fund Managers are terrific at managing Australian equities, while not so good at international or managing fixed interest funds. Therefore, when selecting funds, don't decide on a suitable manager first and then select from a list of funds on offer. Rather the two decisions of manager and fund should go hand in hand.

Using quantitative asset allocation ignores emotion fund manager picking, instead, moving in and out of markets with strict discipline. It's based on computerised number crunching rather than Financial Planners gut feeling of which fund manager will perform best.

Short-Term Ranking

Top fund managers rarely maintain their numbers in ranking for more than two consecutive years. This short-term method of ranking could well see changes at the head of the pack to the "also-rans" as this constant rivalry between "value" and "growth" fund managers performances in the Australian and International markets tend to move in opposite cycles. When the value manager outperforms, the growth manager tends to under perform and visa versa.

There are also more surprises or a "bit of a left field" for Financial Planners as fund managers cycle between top fund manager and wooden spooner due to contrast of style between a mix of growth and value. Some produce remarkable returns for only one year before disappearing into relative obscurity. Growth style fund managers have under performed and are at the bottom of the table, leaving their value manager rivals having delivered better returns simply by hitching themselves to the trend but the beauty with this indicator is, it gives the Financial Planner the ability to show his skills in selecting better class assets by recognising the changes in market sectors by portfolio picking to add value such as the sign of a turn-around in the gap between growth and value stocks in both Australia and International markets in year 2009.

Long-Term Ranking

Tends to take on board with the long term 3 to 5 years mean variances, the inclusion of both growth and value manager in a portfolio that would avoid a style bias that could have ugly consequences of one investment style outperforming the other significantly, whereas it would be more of a bias outcome, solely relying on the results of a short term ranking. Somehow the long-term top ranking fund managers are always on the Financial Planners radar.

The New Paradigm - Absolute Concentrate Risk Adjusted Relative Benchmark Investment Style

With investment styles wrought with huge disparities in performance in recent years, investors have turned to the traditional theme of sustainable earnings growth, value and yield.

As a general rule, Financial Planners don't undertake a rigorous enough risk analysis of a client's portfolio after first determining what risk means to the client and the definition of risk from an investor's point of view is quite different to that of a fund manager. I think what investors really mean in terms of risk, is the risk probability of losing their money against the risk probability of expected return.

Risk, Return and Time are the three key factors at the heart of every successful investment strategy. Although their importance is easily recognised, it is often a difficult task to illustrate the interaction of these variable with each asset class.

Part of the problem of knowing when to buy, sell or hold, is that investors have difficulty accessing and understanding a myriad of information that comes in the form of micro/macro statistical data and other indicators used by professionals to gauge the markets like business sentiment, investment and employment levels and major commodity prices.

Financial Planners, in particular, will need to be aware what the investment styles are, otherwise more of the same de-ja-vu for their clients partly hostages to economic circumstances.

There is a growing consensus that the Industry, FPA and ASIC are hot to come up with a workable risk solution, which can be simply interfaced and understood by the client. BCM undertakes stock picking through a moderate value investment style. Collectively, we have a deep belief in the virtues of value investing according to those investors risk tolerances range, investing in those specific funds with a long-term performance time frame.

When using a ACBARB investment style, two key questions lie at the core of the decision as to whether or not to invest in a fund: -

1. Is it a sustainable track record and
2. Does the income distribution offer good value

Attribution Symmetry Valuation Technique

Investment markets are not fully efficient as asset prices are sometimes driven by irrational influences. These influences often create markets "mispricing" when the market value of a company differs significantly from its true worth.

The overvalued fund managers are ultimately de-rated by the overall market variable multiples or quantitative analysis and industry benchmarks. Over time this mean-revision phenomenon should result in a positive or negative benchmark performance.

To find these underrated, sustainable fund managers, we employ a combination of qualitative and quantitative analysis factors. A mixture of art and science works.

The Screening Process for Sustainability

All funds are screened to eliminate those funds that are below average benchmark in the respective disciplines of Risk and Statistical Analysis. For example, a concept fund or a new fund will be eliminated on the basis that it has no earnings history.

1. Fund Spreadsheet by Sector

Preliminary modelling and analysis is undertaken on the remaining universe of approximately 200+ fund managers.

2. Standard Range of Steps - Risk and Statistical Analysis

Every potential investment opportunity is subject to a standard range of steps in assessing key quantitative criteria.

3. Fund Analysis

Our overall assessment of a fund and inputs into the Absolute Concentrate Value model is a consequence of detail,arithmetic and geometric algorithms information gathering and research. Independent research is the cornerstone of a good investment process and greater emphasis should be placed on Systematic Building Blocks that provides unbiased out performance that can be results influence .

In determining whether a fund process is a sustainable business, it must satisfy most or all of the following characteristics:

1. Continuing strong performance - a preference for superiority in long and short-term income and total return.
2. Demonstrable track record - the longer the track record, the greater the chance of predicting future returns.
3. Good fund management, strong focus on delivering clients returns.

Detail Statistical Modelling is undertaken

Models are based on standardised templates whose purpose it is to present a clear and consistent set of numbers across every fund.

A standard economic framework is applied and the best way to compare apples with apples is to sort the funds into their various sectors.

Having passed the sustainable business test, it must then be determined whether the fund represents good value. We measure this in-house through a sector fund ranking model.

As value investors, we see dividend yields and standard deviation and Sharpe ratio as a critical component of total investment returns.

In a falling and steady market, picking fund managers, which have good fundamentals and pay good dividends to their investors.

Sector Fund Ranking

The screen applies a simple mathematical formula, which assigns a score to each fund. This enables a ranking of stocks from best to worst. It is at this point that portfolio construction considerations kick in. The screen forms the basis of portfolio construction, as it is the better ranking companies, which will proliferate in the portfolio.

Risk Limits - Interface - Asset Allocation

Part of construction of any portfolio is to ensure that you don't take unnecessary risks and that you don't fall in love with your fund selection. This is one of the fundamental reasons why we stress having a process that is repeatable and dispassionate.

Through asset allocation, this allows us to adjust the fund weights in our portfolio when the fund has been reweighted according to a clients risk return, tolerance or where better investment opportunities have been identified.

This is not to suggest that we have got them all right. You must be prepared to make mistakes of judgement but the key is to get more right than wrong and the compounding effect of this would lead to out-performance over time. Experience in the market and having seen it all before, is part of the art of stock picking.

Understanding risk, particularly in the Australian and International Equity markets is crucial to the stability of your portfolio because a 70% exposure to equity markets can have a disastrous capital downsize.

On-Line, Centrally Based, Statistical Landscaping for All Quantitative and Qualitative Research And Portfolio Review Benchmarking

Global equity markets appeared to be highly correlated in this current world of globalisation. Economic trends seemed to be spread throughout the world with devastating effect - look at the 2000 Technology bubble and the crash that followed and the 2008 Global Financial Crisis. It appears as though global equity markets and domestic equity market move in line with each other. With this in mind, how much diversification is there in a portfolio for both Australia and International Equities, Property markets or Australia Fixed Interest and Equity Markets? To achieve a true diversification and lower volatility in your portfolio, you should look for investments, which have a correlation co-efficient of close to zero when measured against each other.

The range of statistical verification systems are designed to take the Financial Planners a step beyond the general trend of the asset class and allow them to gain a more detailed understanding of the inherent risk and return characteristics of each class over both short and longer-term time frames.

Mean Variance - Analysis

After a period of performances, it is always good to know whether a fund manager or a market has under performed or over performed. A Mean Variance - Analysis is a statistic indication of a central tendency giving a value around which the market or fund manager tends to perform in terms of risk/return. The aspect of central tendency is that the mean is always between the extreme values. From the tables below, we can see the importance of this appropriate statistical data. It makes sense to see the impact in the analysis of the samples over long or short-term performance.

• Filtering Down Analysis Take the universe of 1000 Fund Managers and then narrow that down to 20 funds, then for specific fund selection, drill down further to 10 funds for detail, fundamental research on the top Fund Managers who specialise in understanding the market sectors.
• Top Performance Manager A fund performance should be assessed over a longer term. As studies have shown, year after year, to put money on last year's top performing manager will generate bottom quartile performance over the longer term. My suggestion demonstrates choosing those Fund Managers whose track record is based on long-term performance, ie. 3 to 5 years. However, it is also useful to study short term variances of 6 months or 1 year for near standard deviation.
• Volatility or Standard Deviation As with most investments, there can always be long/short-term variances in returns such as the average volatility standard deviation, ie.

  Market Sector	Average Volatility Range %
  International Equities	15 - 18
  Australian Equities	13 - 14
  Balanced Funds	6 - 9
  Fixed Interest Securities	3 - 5
  Property Securities	8 - 10
  Cash	0.2 - 0.4

• Alpha The return of a security or a portfolio would be expected to earn if the market rate of return were zero, ie. the average benchmark. A positive alpha indicates that an investment has earned on average, a premium above that for the expected for the market variability. A negative Alpha would indicate that the investment received on average a premium lower than that expected for the level of variability. Alphas are used as a performance indicator.
• Beta A measure of market sensitivity, ie. the extent to which a Share or Unit Fund fluctuates with the market. This indicator can be used to help identify Fund Managers likely to be aggressive in an active market as well as those that should behave defensively. Beta is a mathematical measure that helps to explain the expected movement in unit price that can be attributed to the broad market movement. In other words, unit funds with a beta of 1.3 carry an expectation of outperforming a rising market by 30% on the way up with a mirror reversal of 30% in a market retreat. Such investments are more volatile than a beta of 1.0 but less volatile should be a unit fund with a beta of 0 6. The expectation here is for 60% of the market's performance on the way up and 60% of any market reversal - a significantly less volatile performance.
• R-Squared The percentage of a portfolio total return which can be explained by market movement. In other words, this is the weight average of the Beta's of the individual Fund Managers of the portfolio.
• Tracking Error A measure of the closeness (standard in returns deviation) with which the portfolio follows a representative market index. For example, if the tracking error (standard deviation) of a fund manager is higher than zero, means the degree of out performance of the index.
• Sharpe Ratio (Risk/Reward) Measures the portfolio efficiency performance of a portfolio's return in risk adjusted terms or simply means the reward receiving for the risk taken. The higher the ratio, it can be considered a very good result while a ratio below 1 0 shows the fund has been ordinarily rewarded.
• Management Expense Ratio (MER) A ratio expressing the management trustee and other expenses of a pooled unit fund as a proportion of the net asset value of the fund. Therefore, the objective is to prefer to spend the risk budget with managers it believes have a competitive edge.
• Information Ratio or Performance Quartiling Graphically, this is a very good indicator of performance reward for risk. In other words, it is a statistical measure dividing a sample into four numerical equal groups. Thus, the "top quartile" means the top 25% of a given sample. In this particular case, the sample indicator, ie. the medium 3 Year moving average of the Australian universe, International Shares and Fixed Interest.
• The range of Risk/Returns Table for Style Investors The Table uses rolling returns ranging in length from 3 years to 5 years to indicate the range of growth/volatility returns.

  Portfolio	Three Years to 30 June 2004		Five Years to 30 June 2004
  	Risk (SD)	Return	Risk (SD)	Return
  Conservative	3.84	4.78	4.31	5.30
  Moderately Conservative	5.46	4.26	6.17	6.13
  Balanced	7.38	4.30	7.86	6.24
  Moderately Aggressive	7.45	3.01	7.90	6.22
  Aggressive	9.60	2.65	10.08	10.41

• Benchmarking for Specific Asset Classes Measuring Asset Class Performances after periodical 6 months, 12 months, 3 years, 5 years and 7 years reviews of the client portfolio by Financial Planners to measure the performance and if necessary, suggested action for strategic recommendation as to whether a restructure of the portfolio is appropriate.

The following range of indices are used to measure the performance of specific asset classes:

Cash

90 Day Bank Bill Rate

Australian Equities

S&P/ASX All Ordinaries Accumulation Index

Overseas Equities

MSCI World ex Australia Net Accumulation Index in $A

Australian Listed Property

S&P/ASX Listed Property Trusts Accumulation Index

Australian Fixed Interest

UBSWA Composite Bond Index

Overseas Fixed Interest

Salomon Brothers World ex Australia Govern Bond Index hedged in $A

Small Companies

S&P/ASX Small Ordinaries Accumulation Index

The Strongest Aggregate Score

The aim of the Strongest Aggregate Score (SAS) is to seek Alpha driven solution was for extensive data processing provisions needed to developed the technique of that underpins this equilibrium investment approach, because according to the attribution pricing model, the only risk that should be rewarded is the market risk.

Exposure to market risk is captured by beta mean variances/fundamentals, which measures the sensitivity of the BCM usability factor metric pricing modelling, to provide statistical returns and all the particular security regarding the portfolio.

While the potential value-add from an investment is more significant, the potential loss from the mis-pricing of risk is also greater. Therefore through the (SAS) technique for protecting capital by choosing a FM/DSO who can control risk on the downside, including the same with Standard Deviation, Beta, Alpha, Tracking Error, Sortino Ratio,Treynor Ratio, Upside Risk, Downside Risk, Skewness and Kurtosio.

Therefore this makes the SAS a superior Alpha driven decision making solution mechanism that are a reasonable proxies for premiums that the FM/DSO are willing to pay for investment risk and it's superiority in analysing the universe for skill driven traditional FM/DSO with the innovated techniques to be able to hack various FM/DSO and components to make up those adjustments where they are needed.

Therefore the SAS tends to make an optimise position, by firstly determined which the products to populate and then populate them to Strategic Portfolio Asset Allocation Structure. The problem with Markowitz's approach is that the strategic asset allocation is based on historical market co-efficient correlation exposures whereas the SAS has now explored how these key variables of Attribution Symmetry Metrics, i.e. the Efficiency Ratio - Ranking Summary together with Top Quartile Strike Rate-Ranking Summary combined with their respective Historical/Forward Summaries, looks behind the FM/DSO as to the way the manage money.

The SAS tends to make an optimise positions thus accordingly one of the finest practice methods for acquiring the best of a breed that decision maker/one could adopt in order to enhance their skills. The SAS is about extracting core spectrum Alpha at the highest usability standard practice i.e. Efficiency Ratio and Top Quartile aimed at superiority selection in analysing the universe for skill driven traditional.

Therefore intrinsic value selection technique is the micro/macro normalised back testing technique for core spectrum that makes up reasonable proxies for premiums, enables FM/DSO to create good opportunities for out-performances/low volatility and because of this factor the strongest aggregate score is regarded as a reasonable proximity that investors are willing to pay a premium. Nevertheless for the SAS to achieve its best results needs a broader micro/ macro core selection process and the knowledge gap system through market/ sector/relative strength/trends that has the statistical/graphic/ textual back-testing ability to research by sectors for valuating efficient Alpha.

Hence SAS appraisal score can be used to select active funds for portfolio construction and to monitor their performance. For investors who wish to combine one or more active funds together with a passively managed core portfolio, the SAS appraisal score should be used.

In order to add value, managers take risks by deviating from the index. They may hold fewer stocks or bonds and weight them differently than their index weights. This SAS appraisal score can also be referred to as the Information ratio because it focuses on the risk and return generated from the fund manager's ability to use information to deviate from the index.

The SAS appraisal score measures how efficient the FM/DSO is in converting securities selection risk into excess return. Reflecting this, a high SAS appraisal score means the FM/DSO are successfully using their securities selection risk to achieve excess returns. A high SAS score means the fund manager would be ideally suited to complementing a passive or indexed fund manager.

Similar to the other reward-to-risk ratios, when selecting funds on the basis of the SAS appraisal score , the higher the value of the score, the better the fund. Theoretically, the SAS score can have a value ranging from zero infinity to positive infinity.

Appraisal Ratio

Description

The Appraisal ratio is the ratio of a risky asset's alpha to its non-market risk, where the alpha of an asset measures the amount of return the asset generates that is uncorrelated with the market return. The non-market risk refers to the variability of the asset's returns that are not affected by the market.

Appraisal ratio  =  Alpha of the asset  /  Non-market risk

When used to evaluate an investment fund, this ratio measures the return from security selection per unit of non-market risk or security specific risk taken by the fund. A fund's security selection return can also be referred to as alpha or the residual return. Put simply, the alpha is just the return a fund would earn if the market rate of return was zero. Hence, this return can be attributed purely to security selection ability.

For example, assume that a fund was able to deliver an alpha of 2.5% with 5% non-market risk. This fund would have an appraisal ratio of 0.5. This means that for every 1% of non-market risk taken, the fund generates 0.5% of return from security selection.

The Appraisal ratio is a measure of an asset or fund's risk-adjusted return and is a type of reward-to-risk ratio. They can be used to gauge the performance of funds in terms of both risk and return.

The Appraisal ratio is calculated using either monthly or quarterly returns but can also be calculated using daily or yearly data. First, the excess return for both the asset and the market need to be calculated. Second, an ordinary least squares regression of the excess returns of the asset or fund against the excess returns on the market portfolio must be run. Then the alpha of the asset or the fund is the intercept of the estimated line of best fit. The non-market risk is equal to the standard error of the regression, which measures the extent to which the actual observation deviates from the line of best fit.

Implications

The Appraisal ratio can be used to select active funds and to monitor their performance. This ratio can also be used for portfolio construction. For investors who wish to combine one or more active funds together with a passively managed core portfolio, the Appraisal ratio should be used.

In order to add value, managers take risks by deviating from the index. They may hold fewer stocks or bonds and weight them differently than their index weights. This ratio can also be referred to as the Information ratio because it focuses on the risk and return generated from the fund manager's ability to use information to deviate from the index.

The Appraisal ratio measures how efficient the fund manager is in converting securities selection risk into excess return. Reflecting this, a high Appraisal ratio means the fund manger is successfully using their securities selection risk to achieve excess returns. A high Appraisal ratio means the fund manager would be ideally suited to complementing a passive or indexed fund manager.

Similar to the other reward-to-risk ratios, when selecting funds on the basis of the Appraisal ratio, the higher the value of the ratio, the better the fund. Theoretically, the Appraisal ratio can have a value ranging from negative infinity to positive infinity.

Sharpe Ratio

The Sharpe ratio is the ratio of a risky asset's average excess return to the standard deviation of the asset's excess returns, where the excess return is the return of the asset above the risk-free rate. The risk-free rate of return can be provided by the 90-day bank bill rate.

An investor obviously wants to maximise return while at the same time minimising risk. The higher the Sharpe ratio, the more return achieved per unit of risk. Assets that achieve high Sharpe ratios are therefore more efficient in their use of risk than those that achieve low Sharpe ratios.

Implications

The Sharpe ratio can be used to select active funds and to monitor their performance. This ratio is commonly used when examining the ex post performance of hedge funds or alternative investment strategies.

There is an investment axiom, which states that to achieve a higher rate of return, a greater amount of risk must be taken. This implies a trade-off between risk and expected return. For example, investors can attain a greater expected return by taking more risk by increasing their exposure to more risky assets, such as moving from defensive to growth assets, from developed to emerging markets or from Australian to international equities.

Reflecting this, active investment managers attempt to add value by taking structured and informed extra risk(s) in an attempt to produce superior or excess returns above the fair return that should normally be attained as compensation for bearing investment risk. However, active managers should not be rewarded for achieving greater returns simply from just increasing their exposure to market risk, which requires no additional skill above that possessed by most investors.

Consequently, if a fund manager possesses skill and has sound management and processes in place, then the result should be superior measurable returns on a properly risk-adjusted basis. This can be assessed and captured by targeted reward-to-risk ratios.

Generally speaking, a Sharpe ratio greater than one is considered to be very good. A ratio between 0.5 and one is considered to be good. But a ratio below 0.1 is considered to be poor.

There are some potential problems with the use of Sharpe ratios:

• Funds with low risk as measured by variability of returns - such as cash and fixed interest funds - will possibly have very high Sharpe ratios.
• When measured over short periods, the Sharpe ratios can be negative and not very indicative of performance.

Active Alpha Stock Picking Theory

The last few years have been difficult for equity market investors. Many share markets around the world still languish well below the highs posted at the beginning of 2008. But confidence has re-emerged since March 2009 and the markets have risen strongly. Even so, after such prolonged periods of falling market prices, investors begin to ask some interesting and fundamental questions. The role of traditional investment management have been right at the top of the list and out of the dust has encouraged a new breed of active alpha or absolute relative risk/return financial planners.

The difference between these strategies and traditional investment strategies are these active alpha strategies are based on deriving value by sourcing returns generated from taking active risk rather than market risk.

In order to appreciate these strategies, it is necessary to outline the framework underlying the concepts popularised by the rise of absolute returns investment strategies. The BCM has developed a scenario testing modelling system whereby the asset allocation framework and stock selection process based on the equilibrium gap analysis approach. The Capital Asset Pricing Model (CAPM) underpins this equilibrium approach, because according to the CAPM, the only risk that should be rewarded is the market risk. Exposure to market risk is captured by beta, which measures the sensitivity of returns statistical and another nine mean variances on the particular security and the portfolio to market.

According to economic theory, investors should be compensated for bearing risk. This means the return on risky assets can be broken down into two components - a risk free return and a return as compensation for bearing risk. The latter return, which represents an asset return above the "bone" risk free rate is referred to as an excess return. This should not be confused with industry practise of referring to an asset return above the benchmark or market index as excess returns.

Furthermore, there are two types of risks - systematic risk and non-systematic risk. Systematic risk is related to the market and is affected by the economy, while the non-systematic risk on stock specific risk is correlated to the market and is instead specific to a particular company. Modern portfolio theory states that since non-systematic risk can be reduced through diversification, aggregate investors should not be compensated for bearing this risk as they can hold the market portfolio, which in theory is perfectly diversified. By doing this, investors remove all stock specific risk from their portfolios and only face market risk.

However, this assumes that financial markets are efficient and this is a moot point. Obviously active investing assumes markets are not efficient and attempts to exploit any inefficiencies. The two main ways active investment managers can add value is through either stock selection on market timing. Asset consultants have found that an average Australian equity fund managers appear to have stock selection ability but not market timing ability. Stock selection ability is typically measured by alpha.

In order to derive estimates of both alpha and beta, a regression of an asset or portfolio's excess returns can be run against the excess return of the market. A scatter plot of the excess returns (above the risk free rate) of the particular managed fund (referred to as XYZ Fund) against the excess returns of the market (as measured by the S&P/ASX 300 index). The slope of the line of best fit (or regression line) is the estimate of the beta, while the intercept is the estimate of the alpha. Mathematically, alpha represents that part of an asset's (or portfolio's) return that is correlated with the market. In other words, if alpha is positive, regardless of market increments, this positive return should remain.

In this particular case, Fund XYZ has exceptional stock selection ability since its estimated alpha of 0.73% represents the abnormal return of 8.76% per year. Furthermore, the estimated beta of Fund XYZ is 0.69, which means Fund XYZ has a relatively low exposure to the market and as such, is less risky than the market.

The importance of an equilibrium model is to provide a guidepost to the returns investors should expect to achieve in the long run. One of the main advantages of an equilibrium model is its self-adjusting nature. Derivations from equilibrium should not persist over time since investors - upon realising the subsequent mispricing - should properly exploit such derivations. The main implication for investors is that in financial markets that they are mostly efficient, derivations can arise from time to time but should not persist for long. In example, research from the University of Chicago found that high beta stocks had similar returns to low beta stocks.

These perhaps lead to some individual claiming that CAPM is dead; rather than seeing the model is broken, it suggests this is just an anomaly, representing an opportunity to derive excess profits.

The strategy to exploit this anomaly would be to sell high beta stocks as they do not receive adequate compensations for their higher risk (relative to the market) and buy low beta stocks that earn a greater return that should be given to their relatively lower level of risk.

This strategy can be illustrated by considering a hypothetical example. Assume there are two assets A and B where A has a high beta of 1.5 and B has a low beta of 0.5. According to the CAPM, all securities can be compared on the basis of their beta and given a particular beta, there is a corresponding fair return that should be expected. The security market line (SML) depicts this relationship between the expected returns and beta. As in a given example A and B is mispriced according the to relationship given by SML. In the short run, such opportunities may arise but in the long run, equilibrium may arise but in the long run, equilibrium will be established through the actions of investors exploiting this anomaly of alpha arbitrage.

In this particular case, investors should sell A and buy B as their respective expected returns do not reflect the underlying risk. Selling asset A leads to the fall in price and subsequently of its expected future return. The selling should continue until the expected return rises to a level where it hits the SML, at which point equilibrium is achieved.

Quality Income Streaming Needs Of The Client

Income streaming is an important subject and without doubt, Financial Planners greatest challenge, particularly to those living off their investments. Therefore Financial Planners face a more complicated challenge in modelling the needs of clients.

• In accessing the attractiveness of the various income streams - consider initial yields, variability of income and tax efficiency.
• As the income from some asset classes will grow the assets that delivers the highest initial distributions may not produce the most income in the long term.
• "Growth Assets" should also play a strong role in a portfolio irrespective if income is the only objective.
• Fund Managers are generally judged on total returns.
• We need to consider whether the clients income is adequate for their needs and whether the value of their portfolio is rising or falling.

Dividends

1. Notwithstanding fluctuations in the business cycles corporate profits together with the possibility of potential gains and losses but dividends can be expected to grow more rapidly than inflation, ie. from 1980 to 2002, income multiplied 4.87% compared to CPI 2.9%.
2. Income from shares should be produced from a growing capital base.
3. Although the stock market initially produces the lowest level of income over the long term, it is likely to prove the strongest income stream.
4. The tax treatment of Dividends (see Tax Table) is less than the bonds and cash rates; after tax it matches bonds and beats cash for both top and bottom rate taxpayers. This is an interesting phenomenon. There is a cash flow opportunity cost from investing in cash rather than dividends.
5. Although share prices produce high volatility, doesn't necessarily produce high variable income. Share prices fluctuate much more than dividends because of the short-term tendency of the market to be overpriced or under priced; thus an investor can receive a reasonably stable income stream in a period of significant short-term capital volatility.
6. Dividends initially provide only a low level of cash yield but offer tax advantages and a stronger long-term growth.
7. Obviously then, when assessing stock market returns, it is argued that more than half the returns come from dividends. The basis for this claim is that accumulative indices have grown at almost twice the rate of price indices; the phenomenon being the corresponding interest rate of both the growth and dividend components. January 1980 to January 2002, the A.O.I. averaged returns was 7.3 per cent and the Accumulation Index averaged returns was 12.1 per cent pa.

Property

1. Property offers the prospect of delivering income that in the long term matches costs of living expenses because rents will continue to increase while we have inflation.
2. The income from property should be produced from a capital base.
3. Tax treatment of property (see Tax Table) shows that initially property produces by far the highest net return in any tax bracket.
4. Listed Property Trusts offer relative stability of income due to the underlying nature of the lease.
5. Rents are generally reviewed annually and usually only adjusted by a few percentage points.
6. It could be said that property is a very attractive income asset, offering the highest initial yield, both gross and net, with relative low volatility of distribution and the capacity to grow income over time.

Cash And Fixed Interest Rates

1. Interest rates cannot increase in perpetuity so one of the failings of cash and fixed interest as a income source, is its lack of growth
2. Cash provides absolute stability of capital but generates a highly valuable income stream ratchetting up a down every time interest rates are adjusted which in the 1980's was consistently three times rates today.
3. Bond rates have also fluctuated but not as much as cash.
4. A decline in inflation over the last two decades has had a very strong impact on interest rates which have declined markedly. In terms of total returns, bond investors have had compensation of capital gains from falling interest rates whereas cash investors simply earned less income.
5. Bonds and Cash in particular, carry quite high volatility of distributions. They produce a higher initial yield than dividends but not in after-tax terms and have no long term income growth potential.

International Shares

Compared with domestic shares, they would look uncompetitive, offering dividends of around two per cent which are unfranked but far greater opportunities for capital growth simply the prospect for depth for investments on the global markets are fifty times larger.

Tax Treatment

The tax treatment of these income sources varies. Dividends benefit from franking and rent from tax-free or defined components. The Table below shows that initially property produces by far the highest net return in any tax bracket. Although the rate of dividend is less than the bond and cash rates, after tax it matches bonds and beats cash for both top and bottom rate taxpayer.

When To Hedge Global Equities Portfolio

If you've parked money in a global equity portfolio, the chances are you will be wondering or even fretting - here are 13 ways of how much the Australian dollar might affect your returns in the future.

1. A rising A$ reduces the dollar value of an investment in foreign securities, eroding any gains in share prices.
2. The decline of the A$ since late 1995 from around 75c, naturally boosted returns from global stock markets by 3 per cent a year according to Van Dyk Research.
3. In a rising A$ environment, hedging seems to be a prudent decision. Your fund manager will do the hedging for you.
4. Buy and hold investors who are in for a good five to ten years shouldn't be concerned with the daily gyrations of foreign exchange markets.
5. Fund Managers have three options when managing currency exposure -
   1. They can hedge their entire exposure back into A$.
   2. They can leave all of their exposure unhedged.
   3. They can hedge some of their exposure back into A$, depending on their view of the A$.
6. Hedging usually involves taking a position in the options in forward markets to offset the currency exposure implied by holding an underlying asset. In other words, in the A$ may have an impact only on the US investments. Regional funds that invest in locations such as Europe and the Asia-pacific may not suffer significant losses if the A$ rises.
7. The best way to look at it is to hedge the core exposure to A$, ie.
   1. If you take the long-term view on your investments, then its better to leave an international equities portfolio unhedged for the diversification benefits.
   2. In the short-term, with the probability of the A$ moving higher in the next year, you can move some of it into fully hedged.
8. The problem is the switching - you can incur fees.
9. You have to be very confident about the A$ view. If you fully hedge and the A$ falls, you will get burnt.
10. The most sensible advisors would advocate sticking to a long-term view. When it comes to predicting currencies, they are much harder then equities.
11. The best way to look at it is to have a core exposure and hedge the excess. For example, if your minimum exposure to non-A$ currencies approximately 25 percent than anything above that, should be fully hedged.
12. Financial Planners should have information about whether a fund hedges its currency exposure.
13. If you are an investor with a very long term view of say five to ten years, it can be more cost effective not to be hedged at all, as currency effect has tended to be washed out of the equation.

Research Statements

BCM Portfolio Construction Interface - All Profiling System

BCM Portfolio Construction Interface - All Profiling System supporting stand-alone modules for all risk, all performance, all asset class and all investment sector with the most comprehensive range of deep quantitative research tools and relative strength economic indicators, systematically used for determining top quartile performing fund managers in global and domestic markets which presently gives us access to historical data and performances on over 200 Managed Funds and ASX 300 Listed Securities diversified over 24 business sectors.

Therefore, these sophisticated strategically developed analytical tools enables Bus-Tec Pty Ltd to analysis the needs and resource of clients' financial goals and then combine these with the skills and expertise of the organisation to marry these factors into an integrated plan.

Clients therefore can be confident in the knowledge that the investment products recommend to them are extensively researched, thus reducing the risk element associated with investing in Direct Shares.

The Group's services are underpinned by both a comprehensive external research house and in-house research facilities which assess investment opportunities, track and monitor investment products and assess trends on a global basis, updated regularly through its sophisticated software system and research database.

These functions are outsourced by -

Morningstar - Quantitative and Qualitative Research

Through Morningstar's extensive statistical (*mean variances) research database, Financial Management Advisors is able to track and monitor the historical performance, current and historical prices and regular up-to-date product information reports, in excess of 6000 investment trust products.

Aspect Huntley

Aspect Huntley provides one of the most comprehensive, high quality market information and statistical research analysis system on the market, which keeps us informed that helps us make the best investment decision for our clients.

It provides over:

• 70 individual, fundamental tools for research categorised as dividend stability (15), earning stability (25), financial strength (15) and Buy/Sell Opportunity (15);
• 1600 ASX companies;
• daily report summaries of global markets, company research, economic updates<;/li>
• advance trading tools and;
• relevant news articles

BCM Macro Economics - Leading Indices

BCM Macro Economics leading indices are designed to anticipate and identify turning points in the World and Australian economy.

The Leading Index is contained in BCM Macro Economics composite reports produced dialy,weekly ,monthly, quarterly. As well as examining Australia's leading indicators, the report also studies movements co incident and lagging indicators of economic activity in the country, along with comparative data from overseas.

These Leading Indexes, which consist of twenty or more leading indicators, are presented by five typical main Composite Indicators, ie. World Outlook, Australian Outlook, The Growth Sectors, Financial Markets and Domestic Wages and Prices. These include real money supply, stock market price indices, residential building approvals, non-residential building approvals, overtime hours, company profits, real unit labour costs, manufacturing material prices, unemployment rates, Public sector contribution to output growth, terms of trade, net exports, net imports, exchange rates, Balance of Payments, relative strength movement of business sectors, long and short-term interest rates, yield spreads between foreign and domestic interest rates, commodity prices, the lagged impact of output on prices on productivity growth, wages, material, inflation and import prices.

The Importance Of Trust In Financial Planning Relationships Cannot Be Underestimated - A Client Needs To Trust Their Adviser And Dealer

Trust is an important human emotion. In fact, society is built on our yearning to trust each other and our willingness to be trusted.

The major part of the Financial Services Reform Act (FSR) is about stripping away all potential veneers of hidden interests and influences so that clients can feel assured that their trust is well placed.

The role of the adviser is to advise and implicit in the concept of advising is the formation of an opinion - a personal opinion - and a personal approach must be based on an advisers own inquiries.

This concept is an essential part of financial planning, embodied within the "know your client" rule Post FSR, this now sits in the "personal advice" requirements of Section 945A and 945B of the Corporations Act. Section 945A(1) imposes a requirement for the licensee or representative to have a reasonable basis for advice and imposes an obligation that the advice must be "appropriate to the client" which acts as a further enhancement to "knowing your client rule".

All of this leads to the view that advisers must form an opinion and to do that they must make their own enquiries and rely on themselves.

Surely the adviser is not alone? They can't be when you consider that they are only one part of the financial planning process; the client, the dealer and the fund manager all play a role. So trust in the financial planning process must extend to all of them, and between them.

But not according to the Australian Securities and Investment Commission (ASIC) - it appears advisers must trust no one but himself. In other words, after an independent enquiry, this recommendation has to be based on the reasonableness as to suitability for the clients' needs.

There is no defence for a Financial Planner to rely solely upon information imparted to him by a scheme promoter. Also, the planner has a legal duty to make his own enquiries and investigations of investment schemes that was the subject of his recommendations to clients.

Everyday advisers rely upon the assurance of their principal "approved product" list as a source from which an adviser may create an investment strategy for a client. Consequently, there is no loss of consumer protection where the adviser relies on the assurance of their principal, especially under the post FSR regime S917E - The client's remedy is with the dealer as a result of the representative carrying out his duty.

Fund Manager - A Track Record Of Adding Value And Diversifying Risk

Professional investment managers have earned their keep by consistently providing access to diversified equity, bonds and property portfolios in a cost-effective manner.

Managed Funds appeal most strongly to people who do not want to spend their lifetime monitoring their investments. It can be a liberating, safer feeling and rewarding experience for them to entrust their money with professional managers who know how to diversify across the different styles involved with the better asset classes.

But if you are looking for a "do-it-yourself" investment strategy by doing your own research and if you are competent with trading systems software, then the BCM can be a great way to get broad exposure to income and growth assets, like fixed interest, shares and property. Ultimately, you're either reliant on your own leads and research or you're using a full service broker. However, investing through a broker presents its own difficulties. The broking industry right now is facing some hard questions about the integrity of the research produced by analysts.

Transparency Counts

The BCM by comparison, is transparent. At all times, the investor knows exactly how his or her investment is going. The BCM has evolved through the tough industry standards to the point where performance reporting and analysis is highly sophisticated.

BCM knows the way modern fund management and the D.I.Y. investors operate and structured, the entire focus is on making money for the investors.

Professional Fund Managers have to earn their keep today by constantly adding value

It is not just performance bonuses anymore for the Fund Manager - a lot of remuneration systems go beyond whether the team did good or bad. I like to see fund managers have a very good idea of what's added value and what hasn't and the portfolio managers only get paid bonuses on the value they have actually added.

Competition between portfolio managers is also intense and rationalisation in the industry has created a glut of analysts so investors are getting the 'best of best'. Transparency is a double-edged sword of course and with the sharemarket down, the performance of managed funds was one of the hottest topics around.

We think that the BCM can do better than picking the average fund manager - we're about helping Financial Planners to pick better fund managers. The challenge then is picking a manager that can hold his place in the upper quartile over the long-term.

Why You Can't Count On Some Australian Fund Managers

How good are Australian Fund Managers? It's a question that must be asked given the systematic failure of the industry to produce returns to match its lucrative fees over the past decade embarrassing returns. It provides startling evidence that Superannuation returns may continue to disappoint unless drastic steps are taken to erase a culture of mediocrity, which has taken root in Australians biggest financial institutions where the Australian Equity Managers returns didn't even match the local stock market.

According to Mercers, 32 out of 64 fund managers bettered the minus 9% return produced by the benchmark of the ASX 300. However, Fund Managers will tend to explain that any returns as a blip that will pass and not interfere with long-term performance; however, new research shows their success in the 1990's involved what in some instances can be only called pot luck. Research shows a number of one-off factors helped generate impressive performance over the past decade but these factors now no longer exist, exposing incompetent managers that produce double-digit returns simply by riding the market sentiments.

Returns have been on the steady decline since these one-off factors evaporated, ie. the popular "tech-stock" boom grew so big it became part of the benchmark index. Eighteen months ago, the median manager beat the market by 3% pre fees and that's with the "free kick" up as a result of the September 11 recovery.

However, the more insidious reason for the shift in fund managers' future is the exponential growth in retirement savings that has attracted companies the impetus for the banking industry push into funds management that is more interest in profit than generating returns for clients.

Fund managers who have produced double-digit returns in the 90's by riding the bull market will struggle unless they can prove they have the stock-picking skills to deliver market returns in all market conditions.

Wealth Management is a Tough Test for Banks

The logic behind the banking industry's move into wealth management is impeccable. In the past 10 years, assets in the Superannuation industry in Australia have grown from $520 billion to $1400 billion. Not only has the Banks' deposit growth rate slowed but total Superannuation assets have exceeded bank deposits with little prospect of recovering to their former glory. Therefore, considering the banks have maintained stewardship of those funds but moreover, the low cost of funding the banks have turned to wealth management as a core strategy.

Banks can't afford to lose revenue from a managed funds arm so they opt for a safe root and are only to match the industry average. It is arguably the biggest gravy train the world has ever seen where business people with no interest in investment management have moved into the industry only interested in making money.

The great irony of this dilemma is that it has been created by Australia's compulsory Superannuation system since the introduction in 1992 - a flow of more than $22 billion pa. No wonder the banks, Westpac,ANZ, NAB and CBA saw a bonanza, controlling over $900 billion or more than 65%.

Banks face a profound challenge in wealth management which boils down to a culture of being forced to go out and sell services. Elsewhere in the world, the very model the banks have adopted for wealth management has failed to perform. This is exactly the model that last year's Sandler Report into British wealth management attacked, citing the particular commission-driven sales, complexity with industry and difficulty consumers faced in making informed decisions.

Naturally these large institutions, who are more focused on distribution than investment management, have realised by mirroring the index, they can reduce costs but charge the same fees despite charging fees for active management. To be fair, Global Fund Managers encounter the same dilemma when facing pressure for benchmarking with their corporate owners.

Investors will be loath to accept the exorbitant $33 million paid to executives such as former Colonial First State chief, Chris Cuffe. This was painful to investors who have suffered more than 12 months of negative returns from managed investments. It provoked calls for greater corporate governance by government consumer advocates and high profile industry figures.

Therefore, from the investors' point of view, the only way to stop this self-gratified image of fund managers is for them to be benchmarked to Cash rather than sector type, because the Cash rate is the only relevant world universal currency.

Market Analysts Would Agree that Equities are a very Risky Asset Class

Traditional managers are generally handcuffed to benchmarks and therefore find it difficult to manage volatility, and as a result, they simply run their portfolios with a similar volatility profile to the index that they are benchmarked against. Unfortunately, it seems to be acceptable for traditional managers to lose money as long as the index they are benchmarked against loses a greater amount than the manager. If they lose slightly less than the index, then the traditional manager feels he has added value. Such an outcome could be a sub-optimal result for the absolute return for the financial planner whose goal is first to preserve capital followed by pursuit of profits.

Traditional Fund Managers generally put too much emphasis on the continually rising market theory and negative returns would be seen as a good result if the manager had out-performed the index they were benchmarked against, whereas Financial Planners consider capital preservation of client portfolios is paramount and any loss is under-performance.

Fund Managers believe that if you just stick with the market then you will be OK in the long run; for example, for the period 1964 to 1981, the Dow Jones Index was without increase with periodical ups and downs, thus remained gainless but to a retiree this meant no capital growth. Risk assessed very differently by Financial Planners will define risk as a deviation from the benchmark as a permanent loss of capital.

What History of the Bear Market teaches us

Following the crash of 1929, the bear market was a slow motion featuring no fewer than six major rallies from 1930 to 1932, each one peaking lower than the previous one but the worst was to come; the Dow Jones Index virtually went sideways for some 20 years before the post war boom kicked in, in 1950 and lasted until the mid 1960's. So bear markets come in two varieties:

• Short - two to three years characterised by sharp rallies and steeper falls, ie. 1973 to 1975
• Long Cycles in market stocks take two steps forward and three steps back for up to 2 decades, ie. 1966 to 1982

A very long bull market can be followed by another market of almost equal duration, ie. 1982-2000 suggesting punishment could go on for 10 years. What is clear is that stock prices have got to go a long way before they met the single digit multiples P/E's of previous bear markets.

Understanding Timing can bring value

Should asset allocation be the same in high and low inflation environments or whether markets are at peaks or troughs. Planners must exercise judgement; it's unavoidable even by those who use diversified funds.

• Rationality believes because we spread a client's money over the typical Balance type mix, we have achieved proper diversification and sit back and waited for the rewards. Equity performances are more than just an average return and standard deviation; they are about people, investors and short-term disappointments.
• Avoid International equities when the value of the Australian dollar is rising and International Securities are falling because:
  • Both in terms of conversion and exchange rate risk, ie. purchase in offshore currency and convert to local currency. In other words, the offshore investment has to risk 3% to 4% just to breakeven.
  • Similarly, their poor relative performance in recent years, making the same mistake made 10 years ago when they decided to enter the foreign markets.
• If growth funds are selected, the Financial Planners have chosen a fundamentally stock market based allocation. As we have found out in the latest global stock market debacle, Fund Managers only play at the edges around their central asset mix mandate.
• As a good example of share prices trading at a higher price relative to R.O.E. to justify it, Japan stock market outperformed the rest of the world pre '89 for a good 15 years which provided a compelling reason not to invest overseas which investors tended to ignore. These out performances left Japan markets trading pretty rich values, leaving Japan shares trading 5 times book values which normally should have been 2 times. The same similarity applies to the US share markets in the '90's but not as badly overpriced like Japan's was.

Investment Style Guide

Investment "Style" has a major impact on how your share funds perform in different conditions. Here we look at some of the different investment styles, how they work and what it means for Financial Planners.

How do fund managers choose which stocks to buy? Why do some fund managers invest in one set of shares while others prefer completely different companies and why will one fund manager kick all the gaols when the share market is booming and another score when gloom is all around?

The answer to these questions lies in the fund managers investment style - the process they use to make investment decisions. At the core of this process in the manager's approach to ranking, buying and selling shares. Some managers want to own companies with a proven ability to grow their business, some seek under priced shares and others focus purely on company fundamentals. A manager's style will be based on the method he believes is most effective but also on the company's history to size and the market it operates in.

Good investment managers have an explicit commitment to their own style. That's important for two reasons. It means a manager can refine their process and build specialist knowledge in their field of expertise. It is unlikely that a manager can be successful without a clean style (one that constantly changes) because they have no structure or consistency to their investment decisions.

Style is important to you as a Financial Planner because it means your manager's action are true to label and therefore more predictable. While using a manager with a particular style won't necessarily improve your performance, it can help protect you from nasty surprises.

Growth Investing - Getting Better All the Time

Simply put - growth managers believe the best way to achieve consistently long-term returns is to buy companies with a history of rapidly growing earnings and the ability to keep doing it. A growth manager's first question is -

1. How quickly has this company increased sales, earning and revenue over the past few years?
2. They also look at a company's financial position - its debt level, how much cash it is generating and how efficiently it deploys its capital.
3. Will the company investment prospect keep growing such as improving market share, proven management and a secure competitive position
4. Growth managers tend to buy stocks in industries that are themselves still developing such as pharmaceuticals and medical technology. Cochlear, the Australian medical implant company is a classic growth stock. Over the past three years it has met its internal targets of averaging 20% annual sales growth. In 2002 financial year, it increased its unit sales by 21% after tax profit by 29% and earning per share by 27%. Cochlear's management is well regarded within its industry and the company is the world leader within its field.

Value Investing - Bargain Hunters

Value managers focus less on a company's earnings and more on its value. They want to own companies with short-term woes that have a battered share price, then buy them cheaply and wait for the price to re-brand. Over time they believe that this approach will generate returns that exceed the overall share markets.

The value manager hunts for bargains, so they spend a lot of time on valuation of a company. By using quantitative measures such as dividend yield and price earnings ratio, they seek to establish the company's true long-term value. Their qualitative effort goes into asking - Can this company recover from its temporary troubles? As a consequence of their style value, managers often end up owning companies that have steady earning streams but may not be favoured by current economic conditions. The also tend to own companies that the market believes are not making best use of their assets.

Sometimes even blue-chip stocks are value stocks. At the height of the technological boom, some major Australian building stocks were under priced as investors chased new economy companies. Investors that bought these stocks during this dip have been rewarded over the past two years.

(I) Note Managers and Mindset

I would like to point out that both growth and value managers use many of the same skills and techniques but have very different mindsets. The key to being a successful growth manger is to find companies that will continue to grow and sell companies that won't. Even the best companies can see their competitive advantage erode over time, such as competitors bring out new products or services or employ better technology. A great growth manager needs to pick his change before the market does and to sell a stock he still feels comfortable to own.

A value manager needs to make a different decision. They earn their money by sniffing our the difference between companies that the market sees as permanently damaged and those with mild cuts and bruises. Value managers must be willing to buy stocks that make them uncomfortable to own.

(II) In and Out of Style

Because the value and growth styles seek to profit from vastly different investment factors, it's no surprise that they perform best in different market conditions. As you would have recalled, growth funds vastly outperformed value funds during the peak of the technology boom in the late 90's. However, since the boom ended, value funds have been a much more rewarding place to be. The different styles don't only thrive at different times - they can also swap places very quickly.

Growth at a Reasonable Price

GARP fund managers favour shares that have strong and growing earnings. At the same time, they also exhibit some value funds tendencies by paying particular attention to the price they pay for those earnings. In essence, they want to buy stocks that should deliver good long-term earnings growth but only selling at prices that are below their long-term value.

Style Neutral or Core Investing

Some fund managers consciously choose to ignore considerations of value or growth. Their "Style Neutral" or Core managers focus instead on deep fundamentals analysis of individual companies in an effort to fund their long-term growth. Their portfolio is likely to contain both growth and value companies. In fact, a "Style Neutral" manager is better described as a "R who attempts to move between value and growth styles as the market dynamics change.

Choosing a Personal Style

Does understanding investment style make investment easier? Perhaps it helps to explain why some fund managers outperform in different market conditions. Over the past two years that is why most managers have been hard hit by the world share market that prised earnings above all else and therefore tended to favour a value investment style. However, the speed with which investment styles can go in and out of fashion highlights why it can be important for both investor and manager to stick with their style.

Whether you consciously or unconsciously shift between styles in time of poor performance exposes you to the very real risk that market conditions change to suit the style you have just abandoned.

Mix and Match Styles

As the investment industry has been aware of the importance of investment style, we have seen an increasing focus on style blending - making sure that investors portfolios contain a mix of values growth, core fixed indexed style enabling Financial Planners to reap the benefits of a combined approach. A multi manager portfolio may deliver the mix of styles that suit the investor.

Style Diversification

Market evidence has demonstrated that Fund Managers have been capable of achieving prolonged period of out-performance that cannot be explained by efficient market theory. Style is given to Fund Managers who continually exploit these fund anomalies (ie. the different risk and return characteristics).

Style Diversification

Appoint managers with complementary investment styles. Essentially diversification style management means that the overall returns will be more insulated when one manager's performance suffers because its out of favour with the market trends as history tells us rarely can a manager perform in positive territory over the course of an economic cycle.

The benefits of style blending won't necessarily increase returns, because over a period of time, you will always be better off investing with the top performing manager; however, it does reduce the risk or volatility for investors; simply its counter-balancing phenomenon major deviations avoids picking winners or realistic timeframe.

1. Value Managers aim to exploit the market conditions by searching for bargain priced securities, buying when they represent good value and selling when they become overpriced.
2. Growth Managers focus on high earning potential or Price Earnings Growth.
3. Growth At a Reasonable Price Manager (GARP) typifies a style where both growth and valuation units are a combined process. A positive correlation to value returns when value is returning well and a positive correlation to growth when growth is returning well. Garp tends to cross over the value growth borders by searching for growth stocks that appear undervalued or unappreciated growth potential, ie. that has the ability of accelerated sales and earnings at a reasonable price.
4. Style Neutral Managers are those with a strong quantified bias who rotate their style depending on market cycle and market inefficiencies.
5. Multi Style are those who use different styles depending on the asset class or mandate given, ie. Active, Passive (Index) Overlay Manager Approach.
6. Hedge Funds - The argument for hedge funds of non-correlation with stock markets and diversification will gain a receptive audience as investors and Financial Planners search for ways to boost returns. Hedge funds act as market neutral strategies, allowing investors to increase their exposure to active management without increasing their exposure to the underlying market risks. No longer do investors have to link the amount of active management in a particular asset class with the level of market exposure they want for that asset class. For example, they can choose to have an underlying exposure to cash or bonds while having all their active management focused on equities or currencies.

Investor Type Benchmarks

This "style box" of investor type asset mix profiles based on anecdotal evidence consistent with the respective investors attitude to market capitalisation and style orientation. The investor profile consists of five diversified funds, ie. Conservative, Moderately Conservative, Balanced, Moderately Aggressive and Aggressive. The client is able to get a picture of how diversified a portfolio is by determining where the funds are located on the grid.

Lifestyle

With some Portfolio Providers providing a generic style-box type or straight through processing (STP), there also seems to be a shift away from risk profile scenario testing based planning and towards a more and hoc life-style focused approach. These systems fail to look at the clients' objectives and work out what rate of return is required to meet those needs.

So-called "lifestyle" approach planning systems should draw on complex calculations to factor in the level of returns required to meet clients' objectives. Reconciliation between ideal outcome and risk tolerance is sometimes a part of lifestyle planning - a client may require annual returns of 12 per cent to meet financial commitments but have a risk profile that results in investment returns closer to the 7 per cent mark.

Tactical Asset Allocation

Without balanced managers responsible for actively managing the mix of asset classes, portfolios can be left to drift away from the desired mix according to the performance of each asset class, or be rebalanced periodically to the desired strategic mix. The alternative is for the dealer group or advisor to actively manage the mix of asset classes or hire a specialist tactical asset allocation (TAA) manager. Increased choice creates the possibility of a more successful outcome but also increases the risk of failure.

By blending a number of actively managed funds each with particular risk/return characteristics - the hope is that they will move in different ways in different stages of the market cycle. That is the theory, but how do you work out specifically which funds are best mixed to achieve the risk/return balance you're looking for.

1. Core Managers are generally combined with managers who display larger style bias and volatilities to further enhance the performance of the portfolio.
2. Market Timing - Timing diversification can introduce enormous amounts of risk into the portfolio, ie. Alan Greenspan speeches, volatility of traders, analysis economic release of economic data.
3. Over Engineered - The more tightly one controls the risks, the more possibility of under performing the market.

Boutique Style Manager

Boutiques are predominately value or style-neutral Fund Managers which have outperformed traditional growth stocks since March 2000 when value stocks took over. Many Boutique managers have a bias towards small companies - a sector of the market that tends to deliver generous gains when it outperforms large stocks. Furthermore, statistical information going back 70 years shows there is a value performance premium of 4 per cent pa. in normal circumstances.

However, not all Boutique managers have a high tracking error or bias towards small companies. In fact, the best-performing Boutique managers who predominately are style- neutral achieve a low tracking error of around 2 per cent per annum. This is because an investment in a style-neutral Boutique could be blended with an investment in a bigger growth manager producing a portfolio that minimises risk but capitalises in market momentum.

In essence, a Boutique manager carrying fewer stocks with a higher tracking error is taking bigger risks than competitors and is likely to outperform significantly if the bits pay off but value stocks won't outperform forever. Growth stocks are showing signs of rebounding after a long period of under-performance and Boutique style would be well informed to shift back to longer stocks.

The Inflection Point In Growth Value Cycles

While some investors are looking for the next free style-based ride, Financial Planners who combine a style neutral approach are more likely to help their clients achieve solid long-term approach results.

What is clearly evident from a MSCI World Index from the last great market downturn starting in 1973, shows that both value and growth styles have suffered long and regular bouts of underperformance, causing investors considerable pain. Therefore, strategies that rely purely on "value" or "growth" trends have given a volatile ride, causing investors to make poor decisions. In addition, the pain can be magnified due to bad decisions such as ill-timed shifts between value and growth styles as evidenced by research in the US which found that "Equity Mutual" funds returned significantly superior returns of 16.29 per cent compared to individual investors of 5.32 per cent over the same period from 1984 to 2000.The reason was that investors chased "hot funds". They switched to high returning funds just before periods of lower performing funds were due to rebound.

The extreme style diversion of recent years has narrowed with growth style managers who look for companies that are working their earnings faster than the average and may pay above average prices for them while the value managers tend to focus more on the value measure such as low P/E and price book value ratio and higher yields. It's not that they are against earning growth per se but generally won't pay so much for it.

Thus neutral managers are skill-blending managers who have numerous variations from Growth on a Reasonable Price (GARP), can provide a more reliable performance and help investors avoid style traps.

While the value/growth divide may currently be at an inflection point, it is the negative correlation that helps investors to achieve more ups and downs that so often cause the abandonment of long-term strategies.

Value vs Growth: The Great Hoax

Fund management 'style' is bunkum and investments should be based on fundamentals, not marketing hype.

When a fund manager defines its investment philosophy as 'growth' or 'value', 'GARP' or 'style neutral', it only perpetuates the myth that such distinctions not only exist, but are also founded on some ancient academic bedrock.

At best, the traditional answers are a marketing message and at worst, show an entrenched lack of understanding of the elements of successful 'investing' (as distinct from speculating or index tracking).

A large proportion of investors mistakenly believe that investing for growth is the antithesis of investing for value and that the factors a typical value investor will look for in an investment may be different from those that a growth investor will look for.

Early empirical studies created the distinction and newer studies simply and erroneously confirm the two schools indeed exist. But like the 'Emperor's new clothes', not everything that can be imagined actually exists.

In an article published in the Australian Financial Review (July 24, 2003) headlined, 'Money flows back into stock funds', the author wrote: "Managers of value funds look for stocks that are considered cheap based on price-to-earnings ration and price-to-book ratio ... Managers of growth funds invest in companies that are experiencing rapid revenue and earnings growth.

First, it is important to note that book value, P/E ratios and the like have little if anything to do with value. If book value was the guide to value, a company would be worth more simply by purchasing more assets regardless of the productivity of those assets. A company might engage in folly and buy a machine that manufactures vinyl records or it might buy a steam engine and thereby increase its book value (and be 'earnings accretive') and according to the above statement, render the company more valuable.

Next, value and growth are not opposite investment styles that real exist.

As Charlie Munger of Berkshire Hathaway once said: "The whole concept of dividing it up into value and growth strikes me as 'twaddle'. It's convenient for a bunch of pension fund consultants to get fees prattling about a way for one adviser to distinguish himself from another. But, to me, all intelligent investing is value investing."

If share market investing is about identifying wonderful businesses and purchasing those businesses at prices likely to produce an above average rate of return, the inputs required include expected future sales growth, profit margins and return on equity. Growth therefore becomes a component of determining value.

The same inputs are required and outputs produced whether the company is accepted as a 'value' stock like West Australian News (WAN) today or a 'growth' stock like Cochlear.

According to the tables on the next page, Company 'A' in Table 1 would be the growth stock. The dividend yield is less than 1 per cent and the price earnings ratio is 42 times earnings. Company 'B', with a dividend yield of 8 per cent and a P/E ratio of 10 would be labelled the 'value' stock.

If we make an assumption that we know exactly what the growth of retained earnings and dividends will be over the next four decades, we discover that purchasing shares in company 'A' will produce the higher return. The higher return indicates the buyer of shares in the 'growth' stock received better 'value'.

Dividend yield and price-earnings ratios therefore have very little if anything to do with determining value. Company 'A' represented better value even though it had a lower dividend yield and higher price earnings ratio. Value is presented by the return that is received by the investor. The higher the return received, the better the 'value' at the time of purchase.

In an attempt to clear up the confusion regarding the growth and value dichotomy, Warren Buffett wrote in the 1992 Berkshire Hathaway Letter to Shareholders: "The two approaches are joined at the hip: growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."

A company can therefore represent good value even if a high price-to-book ratio, high price-earnings ratio, and/or a low dividend yield exist.

Table 2 helps to explain - suppose a company with $5 equity per share is able to generate returns on incremental capital of 20 per cent.

The company's earnings per share would equal $1. If the dollar was retained in the business and the company in the second year was again able to generate a return on equity of 20 per cent, this would equate to 20 per cent growth in earnings, which if multiplied by a constant price-earnings ratio of 10 produces $2 of additional market value. The $1 retained has created $2 of market value.

Table 3, however, reveals the impact on market value for a company generating a low return on equity of 5 per cent.

In this example, the company has again generated $1 of profits that will be retained. Because the return on equity is only 5 per cent, the equity we are required to enter for illustration purposes to generate $1 of earnings is $20. The additional dollar retained, however, has generated only 50 cents of market value. In other words, the 'growth' has had a negative impact to the tune of 50 per cent.

For every dollar retained by the company in Table 3, shareholders will lose 50 cents. Businesses able to generate only low rates of return on equity should not 'grow' but instead return profits to shareholders by way of dividends. Unfortunately, even though many companies are advised by corporate finance departments to do just that, they ignore the advice, instead retaining profits and seeking to inflate their own egos as they inflate the size of the business.

And as Buffett also notes: "Irrespective of whether the business grows or doesn't displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one the investor should purchase."

Even a 'growth' manager should keep one eye on the price - if he doesn't, then such individuals are merely 'momentum speculators' playing the greater fool principle: buy at any price because a greater fool will pay more for it tomorrow. This, however, would not be called investing but 'gambling' that there is someone else who will, indeed, pay more.

Successful investing requires an understanding that growth contributes to value and recognising that value and growth are two sides of the same coin, will provide a quantum leap in the potential for long-term investing success.

In our ongoing efforts to invest successfully, we only select those opportunities that have both sound prospects for growth and are offered at an attractive price. This is not GARP or style-neutral investing - labels that imply some active thought as to whether a company fits some portfolio-defining criteria.

Remember, all you need is the ability to identify a company's growth potential - it can be strong or flat - and the ability to wait until that company is cheap based on that potential. Fortunately many investors are coming to realise the merit in the above approach but unfortunately the focus now is on the word 'cheap' - trying to determine the exact price that should be paid for a share.

As our example showed earlier, paying a price earnings multiple of 24 times earnings is still value investing if the ultimate rate of return is higher than that available elsewhere. Investing is most intelligent when it is most business-like, not when one doggedly adopts a mantra that is flawed to begin with.

There is no empirical or valuable difference between growth and value. Both are required and so when evaluating companies expected to generate high returns for clients, both should be used.

Fine Tuning The Fund Managers Selection

Share investors in recent years have had to contend with the most challenging period in a quarter of a century. Hence the falling sharemarkets are testing the faith of managed-fund investors who pay professionals to prevent poor returns on their investments. There are going to be subtle changes to the determinants of successful fund performance in the coming five years which will be quite different to what produced the good over the previous five years.

For an average investor, in some ways, it will be easier to choose the better performing manager than it has been recently. You have to go back to the 1970's or even the 1920's to find a harder period for delivering absolute positive returns, yet for the two or three years immediately before, it was hard not to get a decent return of double digit proportions.

The wild times makes it virtually impossible to give reliable advice on past returns. Furthermore, the "boom-to-bust" turnaround was matched by an equally dramatic swing in relative performance of different share-fund-investment styles. Growth fund buying stocks with the promise of high future profits rode high in the later '90's bull run and the valued-orientated funds searching for under-priced companies have done much better in the ensuing bear market. The return differential between average value and growth-stock portfolios has historically been about 5 per cent either way. But between 1998 and 2002, it was 30 per cent. In such conditions, the quality of the fund manager is almost irrelevant.

But it may be time to let go of the obsession the investment world has had with growth and value. In normal conditions, style is not so important and quality growth and quality value managers are more likely to share the spoils.

A more pertinent question may be - "Just how good is their investment process going to be, regardless of their style?" Fund managers have for some time been expecting a return to a closer balance between styles. A look back at the last six months offers some evidence to suggest it's well under way as both the growth and value indices in Australian stocks have converged noticeably recently, ie. over the last 3 months from 31 January 2003 in a falling share market overall, the growth index fell 2.7 per cent while value stocks fell 1.5 per cent - a small variance compared to the past 5 years. One expected a small variance to be the norm in local and international funds.

The top quartile won't be grouped according to style but according to quality managers with well-credentialed investment professionals coupled with a rigorous, robust investment process. In one sense, it should be easier to pick the good managers in these more normal conditions, as they're more likely to rise to the top and deliver consistent returns.

On the other hand, identifying these quality managers in advance will be hard because past returns over the standard five-year time frame will be no guide. So how do investors identify the winning investment process of the future? The longer investors are in the market, the better armed they become with hard questions to ask of advisers, their research providers and fund managers themselves. Here is a guide to the fundamentals:

Step 1 Read the prospectus thoroughly to determine:

• How does the manager construct a well-diversified portfolio?
• What is the investment philosophy?
• How does the manager research stocks?
• How does it select stocks?

Step 2 Query the adviser:

• What do you base your recommendations on?
• Whose research do you use?
• What mix of qualitative and quantitative measures are used in fund selection?

Step 3 Query the adviser on the manager or go direct to the manager:

• How well resourced is the manager for carrying out active investment?
• Is it constrained by size?
• What are the fees?
• How is volatility managed?

To Be Or Not To Be

Fund Managers Fixated To Benchmark Approach Or Pure Targeted Performance Approach (Absolute Return Approach)

Investment managers ought to be given the freedom and responsibility to create real wealth rather than getting paid just for mirroring a benchmark. In fact, a lot of equity managers who operate against a reasonable stock benchmark fund themselves buying stocks they don't like just because they are in the index.

Today's investors are far more aware of their Superannuation returns and unfortunately, the big super funds can't ignore the short-term. There are only two ways the major super funds and smart players can prosper long-term in the stockmarket.

One is to be a genius in calling the switches in the markets or alternatively, investors can take the traditional approach and diversify their risk. Both approaches need a lot of understanding and skill though the diversification approach is a more robust approach and less risky than relying on being able to call the changes in the markets.

This fixation means managers are discouraged from using contrary styles of setting the portfolio for a long term approach or giving the manager an absolute return mandate with a targeted earnings approach of CPI plus 7 per cent.

Active management performances are measured against benchmarks but they end up delivering Indexed Benchmark performances. They are paid active fees for delivering Indexed performances.

Small Companies Fund

Small companies funds rank among the steadiest managed investments in 2003, producing returns that left other stock funds looking sluggish. However, there is no guarantee that this performance will be repeated over the next 12 months.

Figures from research houses show that the best retail small cap investment funds were:

As from a benchmark point of view, the S&P/ASX Small Cap Index in 2003 increased by 32.3% compared to the ASX Top 50 returned 12.5% for the same period.

Small companies rise more than larger caps because they have been out of favour in the bear market. When confidence in global shock somewhat improves last year, many investors opt to buy small companies that were cheaper relative to larger companies. Part of the reason for last year's huge increase was that small companies were resources-focussed.

Thus using A$ will also prove a fillip to small companies. Many small companies are domestically focussed and because the dollar has risen, people are likely to prefer them ahead of bigger companies with offshore exposure.

The Dichotomy Of Small Companies

Nevertheless, it would be unwise to allocate a substantial proportion of an investment portfolio to small companies fund.

1. Small companies funds are volatile investments that do not provide consistent income offered by many blue-chip stocks.
2. Because of the volatile nature of small caps, investors must be prepared to stay in a fund for five to seven years.
3. Investors who want to redeem fund after a shorter period may find the fund in a slump.
4. More than 50% of distributions from small companies tend to be realised capital gains.

How Much Should A Person Allocate To Small Companies

1. The exact amount a person should allocate depends upon the period for which they are prepared to invest, their risk tolerance, and the extent for which they rely on investments for income.
2. A balanced portfolio includes an allocation of about 35% of Australian shares. Only 5% of that figure should go into small funds.
3. The volatility of small cap funds is highlighted in the longer-term performances of funds for example, Macquarie Small Companies Growth just returned 36% in the year but its three-year return was 3.3% and its five-year return was 9.2%.

Many Fallen Heroes Among The Fund Managers

Are the days of all-conquering super hero money managers numbered? While big name managers exit their lucrative jobs, many Financial Planners are left to question the myth and legend surrounding our much-lauded investment heroes.

It seems the fund industry's immortals face the prospect of meeting their most feared enemy - consistently shoddy performance results and banishment from the league tables.

The past 6 to 12 months has seen a mass re-shuffling and exit of former super heroes within funds management such as First State dynamic duo, former chief executive Chris Cuffe and former head of equities, Greg "The Freak" Perry, Perpetual Investments former stalwart and outspoken head of equities - Peter Morgan, BT's former head of equities - Marcus Fanning and his equivalent at Sagitta Wealth Management - Andrew Brown.

1. How Pronounced Is the Hero Worship Phenomenon?

Data compiled by research houses demonstrates the strong correlation between the individuals and the inflow figures for the aforementioned super hero fund managers and their flagship funds over the past decade. The track record of Greg Perry, manager of the Colonial First State Imputation Fund since it was launched in 1988, showed a four-year period of sustained performance from 1996 to 1999 and increased inflows from $94.5 million in 1995 to $512.5 million at the end of December 2000.

However, even in periods of poor performance, due to falling investment markets or out-of-favour investment styles, the super heroes continued to attract funds under management. This can be seen in the case of Peter Morgan's Perpetual Industrial Share Fund where, although the returns have fallen from a peak of 26 per cent a year in 1996, fund inflows jumped from $1.6 million at the end of 1995 to $204 million in 2002.

Van Eyk Research says it is rare to see a fund managers group put up with poor performances year after year without someone's head rolling. This emphasises the role that the combination of brand and hero play in attracting funds under management.

2. But With The Large Fund Management Houses In A State Of Flux, Is The Hero Concept Now Dead?

According to fund of fund managers, Frank Russell, the phenomenon of star fund managers and the ensuing hero worship is not under threat. It gets down to branding and there is a temptation for people to chase past performance, even though there are people out there with good performances. This is one of the major criticisms of the star fund manager phenomenon - that it encourages Financial Planners and investors to look at past performance figures and to make investment decisions based on this.

Ironically however, the one thing that poses the largest threat to the supremacy of the heroes going forward is also the greatest indication of their success volume of funds under management.

3. Over the past 15 years, the creation of the super heroes or star fund managers has been exaggerated

The rewards for simply being in the market have been so enormous. We've had fantastic upward markets with fantastic inflows of funds and they've been paid accordingly because the firms they work for were going to pull in millions of dollars.

Also, during this time, compulsory superannuation was introduced, providing a reliable and significant flow of money into the fund management industry as prevailing bull market conditions meant equity fund managers could deliver an average return of 15 per cent a year to investors. Given this environment, the fund managers that finished on top were rewarded hero status. While they might have a bad year, they would always bounce back.

4. Would a change in the market conditions deflate the image and status of these super hero fund managers

Given the outlook of falling interest rates and inflation coupled with ever increasing productivity, a return of 7 to 8 per cent a year will be considered good. These super heroes are smart guys. They're getting out on top. They are looking forward and saying, "I don't think I can add that amount of value any more. I'll collect the bags full of money and disappear into the sunset".

In return for their services, star fund managers have been well paid. With their remuneration structure tied to a percentage of assets they helped attract, institutions have been increasingly willing to pay the rising fees of the heroes.

Such willingness is exemplified in Colonial First State's $32.75 million payout to Chris Cuffe and the rumoured $20 million payment to Greg Perry. A former super hero of one of the countries top five funds management group says 15 years ago, many people did not know what a fund manager was. Due to the desire by funds management houses to put a persona around the product, this situation has almost been reversed. Research houses, in their research of the processes of the individuals within the fund managers group, have also lifted the profile of individuals fund managers and helped to promote the marketing of the personality manager.

Former star fund managers with high profiles have left the large fund operations because, while in the 1990's it was a great time to be an investment manager, over the past couple of years it has become tough, with the pressure of having to perform month after month in an environment where merger and acquisition activity has shrunk the size of the Australian market even further, means more money is chasing less opportunity.

5. Stars With New Capes

Sagitta Wealth Management's former head of equities, Andrew Brown, while the phenomenon of star fund manager is not dead, the star of the future will not be the same. We have not seen the last of the super heroes but we are going to see them in a different cape.

These star fund managers were good performers but each had a mystery persona that somehow was the allure. For example, Greg Perry did do a lot of presentations which enhanced his allure whereas Peter Morgan was strident in his critiques of companies and Andrew Brown was open and honest about his holdings. Working for a large fund manager for a long time, however, loses its appeal because the fund managers have forced to run a low risk product because of the huge funds under management.

As a result, many former star fund managers are attracted to a smaller boutique model, whose size and experienced investment staff can provide an edge in performance. Further facilitating this shift, is the prevailing tough market conditions and the consolidation of product manufacturers in the industry. Together, these factors have forced institutions to be more open and amicable to the idea of investment with small boutiques. Therefore, given the fact that seven out of ten of the largest fund mangers have left these large institutions to set up their own boutique funds management, boutiques will increasingly likely to be the dominant force in the future.

6. You get this ridiculous situation that the "Marketing Team" wants to take over

What tends to happen when a manager becomes successful is the marketing team takes over and the marketing team runs everything.

Investors Mutual (IML) managing director, Anton Tagliafaro, formerly a fund manager for Perpetual, BNP and County Natwest, broke away to set up his own funds management and realised that if you don't have a good investment team and good processes, it doesn't matter how much advertising and gloss you have around, your value proposition.

Brand Vs Guru Fund Manager Status

The reason that brand has also become an important part of the investment decision, is because in the past, the range of retail products for Financial Planners to choose from has not been great. This has meant that in the eyes of the ultimate client, brand has become an important part of the investment selection process.

If it was a brand your client trusted, it was an easy sale if it performed well and it was one that a researcher signed off on. Yet for some Financial Planners and investors alike, the combination of a hero fund manager and well-known brand name helped to foster a comfort factor with investment decisions. Advisers tend to follow particular people or mega stars because they've got the runs on the board.

Precisely the reason former BT fund manager, Ken Neilson is a star who, after leaving BT to launch his own boutique funds management group, Platinum Asset Management, investors went out of BT and followed him to Platinum.

But it's not enough to just go with someone because you've got a range of quality fund managers out there. Even the best gurus in the world, can make mistakes. Planners are selecting a more balanced view and are a lot more professional in melding together managers for clients' portfolios.

People don't keep dominating. Either the pressure on themselves and the huge funds under management means they can't operate as effectively as they rise to, because being a star manager consistently is the result of a lot of hard work. If it were easy to outperform, everyone would do it. You can't outperform by just doing what everybody else is doing; you've got to come up with contrary ideas.

Seeing The Light

Over the past two years, Financial Planner Geoff Salter has not used big brand name fund managers, preferring to adopt a more intelligent and sensible approach to fund management that does not entail picking yesterday's performers.

Salter says while he was always suspicious of big name fund managers, it wasn't until September 2001, that he had the building blocks or infrastructure available to put an alternative investment model into practice.

The advent of the Business Coach Model (BCM) solved this problem as it allows access to institutional funds with pure exposure to asset classes. This shifted the emphasis away from particular fund managers to an emphasis on managing risk through both asset allocation and asset investment class.

In analysing the style of some managers, Salter found concentration of managers who invested according to Global Industrialised Characteristics Standards (GICS) and close to the S&P/ASX 300 and he also uses the same system for analysis for Direct Share Portfolio. Using this approach, Salter argues he can control up to 95 per cent of -

1. The variation in a portfolio's return through appropriate asset allocation and asset classes if a proper suitable analysis or asset allocation model is done initially, many problems could be avoided.
2. Also increase expected returns is to increase exposure to the better asset classes which is driven by the market trends which is precisely a study of relative strength indexes based on GICS because of its enhanced global predictability qualities.
3. This enables the final process of fund manager picking and market timing through a database deep quantitative analysis.

Salter says many Financial Planners tend to follow star fund managers because both the structure of the industry and education of the Financial Planners are flawed which for the planners end up with higher MERS and unpredictable heroes which leads to client dissatisfaction and unfullfilment.

How To Read The Shares Tables

ASX code

The code allocated to identify securities. The first three characters refer to the underlying equities. In the case of ordinary shares, the last three characters are generally left blank.

Company name or security

Actual name or short name for company.

Shares on issue

The number of shares, convertible notes or options on issue that were active during the past month. Where a traded share, convertible note or option has gone inactive during the month, the number of securities will appear until the next month, to facilitate the reporting of price for the security in the current month. The numbers of shares, convertible notes or options reported in this table (with the exception of those securities delisted during the month) are month-end figures.

Market capitalisation

This is the total market value of the company represented by converting the daily share price over the total number of shares. Since the daily share price fluctuates daily, so will the market capitalisation impact directly on the total value of the company.

Last price

The price of the security at which its last on-market sale took place on the last day of the month.

Monthly high

The highest price traded during the current month.

Monthly low

The lowest price traded during the current month.

Monthly movement in cents

Change in the share price for the month, in cents.

52-week high

The highest price traded in the past 52 weeks. All period high/low prices take into account.

52-week low

The lowest price traded in the past 52 weeks.

$1000 for 1 year

The dollar value of $1000 invested at the current share price relative to the price 52 weeks ago. Dividend payments are reinvested during the period.

$1000 for 3 years

The dollar value of $1000 invested at the current share price relative to the price three years ago. Dividend payments are reinvested during the period.

Net ATP 6 months ($000)

Net after-tax profit for the past six months.

Net ATP 1 year ($000)

Net after-tax profit for the past 12 months.

Net ATP change %

Percentage change from the past financial year.

Earnings per share (EPS)

Measures the earnings attributable to each equivalent ordinary share over a 12-month period. It is calculated by dividing the company's earnings by the number of shares on issue. This represents one of a number of gauges of a company's performance.

Price/Earnings ratio

Shows the number of times the share price covers the company's EPS. It is commonly used to measure how attractive a share is to investors, and to compare shares in one company with another. PE ratio = market price of shares / earnings per share

Price/Earnings growth ratio (PEG)

Ratio of the stock's PE to its prospective earnings per share growth rate. In general, the PE should equal the long-term growth rate in percent. A ratio of one is considered to represent fair value and a ratio greater than one indicates a more "expensive" stock. This ratio is a useful high level check to see whether the PE is justified. This could lead to a PEG ratio greater than one but leave the company fairly valued under the Aspect Value Rank.

PE to sector PE

The price earnings ratio for a stock compared to the average price earnings ratio of the stocks in its relevant GICS sector. A positive number, for example, implies that the stock is trading at a premium to the average stock in its sector. A negative number implies that the stock is trading at a discount to the average stock in its sector. PE ratios are not reported for stocks or securities that have zero or negative earnings per share, nor are ratios to sector and industrial non-bank stocks reported in such cases.

Dividends per share

A rolling 12-month (latest half plus previous half year) dividend rate per share, as declared by the issuer and adjusted by dilution factors resulting from bonus/rights issues or capital reconstruction. Each half-yearly dividend rate per share figure excludes any special cash or scrip dividend declared nearest to that half year. For quarterly dividends, the rolling 12-month figure is calculated on a quarterly basis.

Times cover

The number of times that dividend per share is covered by earnings per share.

Dividend yield

The company's dividend per share divided by the share price and converted to a percentage.

Franking credit

Represents the level of franking attached to the rolling dividend per share. The franking level represents the percentage of the dividend on which tax has already been paid by the company. A fully franked dividend refers to the dividend on which the company issuing it has paid a full rate of tax. Where the dividends are fully franked, it is denoted by 100; where the dividends are partially franked it is denoted by a figure less than 100 (55 refers to a 55% franked dividend).

Earnings yield growth

Calculated by including the effect of imputation credits from franked dividends or, in the case of property trust dividends, by including the effect of tax-free and tax-deferred dividends. For the purposes of the calculation, it is assumed the shareholder is on the top marginal tax rate of 48.5 percent. Shareholders on a lower tax rate will have a higher after-tax dividend yield.

Equity risk premium

The difference between the rate of return available from risk-free assets (such as Government bonds) and that available from assuming the risk inherent in more volatile investment such as shares. Over the very long term in Australia, the equity risk premium is around 6% over cash. Shorter term it is of the order of 3% over long bonds, which are themselves some 2% over cash.

Net tangible assets (NTA)

NTA indicates the net physical assets owned by shareholders of a company at balance date. It is used to calculate the asset value per share by indicating what would happen if all net assets were liquidated, debts repaid and then the remainder divided up among shareholders on a cents per share basis.

Debt to equity ratio

Shows the relationship between funds provided by borrowing and funds provided by shareholders. The debt/equity ratio shows to what extent a company is financed by debt (also called the gearing or leverage ratio).

Debt/Equity ratio = (total debt / shareholder equity) x 100

Revenue

Sales plus other operating revenue. For industrial and service companies, it excludes non-operating revenue such as interest income.

Operating margin

Earnings before depreciation, amortisation, interest and tax, divided by operating revenues. Operating margin is a key statistic for industrial and service companies. It shows the underlying profitability of the business before the effects of financing and from new investments. The trend of operating margin is particularly important and can give a good indication of the long-term viability of a given business.

Net profit margin

Profit after tax before abnormal items, divided by revenues. This profit margin includes all depreciation, amortisation, tax and interest charges which are not included in the operating margin calculation.

Net profit before abnormals

Estimates one-off or non-recurring items and the tax effect of these items. Net profit before abnormals provides a better indication of the long-term earnings trend.

Employees

The number of employees of the company, as reported in the annual report.

Operating sales per share

Calculated by dividing operating revenue by the diluted weighted average number of ordinary shares outstanding. Non-operating revenue, such as interest, is not included.

Market stability

A measure of the stability of the growth of earnings from year to year expressed as a percentage. The maximum figure of 100 percent represents earnings that go up (or down) by the same percentage each year. A low figure means the company's earnings are more volatile and vary significantly from year to year. The stability of earnings growth is based upon fitting an exponential curve to both historical earnings (up to 10 years) and the next two or three years of consensus forecast earnings. More emphasis is placed on the stability of the growth of forecast earnings. Special adjustments are made for negative earnings, for extreme outlines and for earnings near zero. Market stability is calculated with a minimum of four years of data, two of which can be forecasted earnings per share.

Cash flow in cents

Net cash from operating activities divided by the diluted weighted average number of ordinary shares outstanding. Net cash flow represents cash from operating activities. It includes tax, but does not include capital expenditure. Free cash flow can be derived by subtracting capital expenditure per share from cash flow per share.

Capital spending

The amount of cash flow being reinvested in plant and equipment to maintain and grow the company's operations. It excludes investment in acquisitions. It is measured by capital expenditure divided by the diluted weighted average number of shares outstanding during the year.

Payout ratio

The percentage of net profit paid out as dividends. It is calculated by dividing the total dividend payout during the year by net profit before abnormals. Payout ratio is important for a couple of reasons. First, it gives an indication of the sustainability of a company's dividend. A very high payout ratio means the company does not have a large buffer in annual earnings and may need to cut dividends if earnings fall over time. Second, the payout ratio provides a clue to the growth orientation of the company. A low payout ratio means that the company is reinvesting a larger proportion of earnings in future growth. If the investments are successful, it should lead to higher future earnings. If it does not, then the company will be destroying future shareholder wealth.

What To Look For In Filtering Stock Opportunities

1. Concentrate on the fundamentals. Look for a relatively unstretched P/E ratio and one that is not based on a huge ramp-up in forecast earnings.
2. Seek a decent dividend payout and hence a solid franked dividend. Dividends provide a regular tax effective income and a rock-solid footing for your portfolio. A growth-oriented company that pays little or no dividends may give you five years of strong share price performance followed by a slump that sends the share price back to where it started.
3. Back management with a track record for delivery. The chances are that a board that has let investors down once, may do it again. It's much better to stick to those companies that have a fairly lengthy track record of reaching expectation and equally not allowing them to rise unrealistically high in the first place.
4. Avoid dependence on international earnings or foreign exchange risk. Foreign operated businesses do tend to disappoint more frequently than the local operations because Australian executives often misunderstand overseas market structures and also they are less readily monitored by Australian domiciled investors. The currency exchange may clip a few per cent off the translation anyway.
5. Seek business transparency and tangibility. In such a precautionary investment environment, the days of concept stock are well and truly over.
6. Look for good entry levels. Try and make sure you are not buying at the peak of any unprecedented share price rally. Have a look back a year or two and make sure the stock has been notably higher.
7. Look for an element of take-over vulnerability. An open register and a good cash flow multiple are an attractive combination for other reasons but given low interest rates, they lead to take-over appeal.
8. Plan your portfolio with the aim of providing a sectorally balanced group of stocks that conform to these investment principles, particularly those stocks which are influenced by cyclical movements.
9. Don't buy stocks that are loaded up with debt. It's worth running a few quick debt checks to make sure your company balance sheet remains healthy such as the Net Interest Rate Cover, Net Debt/Equity Ratio. Debt is a different beast of interest rates payments to the banks and other creditors can't be reduced or suspended without the risk of bankruptcy.

Tips When Buying Stocks Is To Look At The Way A Company Is Managed

Buy Companies with a Good History

Analysing a company's trading history is essential because it can tell you what the future may hold, such as the conditions in which it does well or poorly, and whether the performance is improving or deteriorating. Important things to look for in a company history include a track record over at least five years of growth in revenue, earning or dividends.

But don't make the mistake that history is everything. Think of it in terms of your private life. When it becomes serious about a potential partner, are you more interested in their past or what they will be in five years time and whether you can grow together.

Remember, every dollar a company ever makes for you as a shareholder will be in the future. Understanding the past gives you a foundation for making better forecasts of what may happen down the track, but its no guarantee. That's why when you study a company track record, the safest approach is to search consciously for parts of the business in which the past may not be a guide to the future.

If a company's past were always an accurate guide to the future, successful companies would remain successful forever and of course that's not always the case. HIH Insurance is an obvious example of a company with a long history of expansion which finally hit the wall. One.Tel had a shorter history but the same result.

The past can only give you a good feel for the type of share price performance you can expect. Shares that have delivered volatile performances in the past, perhaps due to an inherent instability in the business industry such as global commodity price cycle or mineral stocks, will continue to do so in the future.

The first dimension describes a business as it is today, being essentially a matter of results and more importantly, will continue to produce them in the future. The force that causes such things to happen that creates one company in an industry that is an outstanding investment vehicle and another that is mediocre is essentially people.

1. The first dimension of conservative investment consists of outstanding managerial competence in the basic area of production, marketing, research and financial controls.
2. The chief executives should be the cutting edge in their thinking that welcomes dissent and promotes and rewards motivation.
3. The average investor can go about getting a better understanding of both management and inner strengths and weakness of companies in several ways, one successful means by way of "scuttlebutt approach" - going out talking to the company competitors, suppliers and customers to find out how an industry or company really operates.
4. Although examining financial statements is an important part of securities analysis, it's important for the investor that the company has enough momentum to keep going for three to five years.
5. It would be an over simplification to be a buy and hold investor. If a stock hasn't met its required rate of return after three years, the investor should sell.
6. Buy into companies that have discipline management and plans for achieving dramatic long-range growth in profits and that have inherent qualities, making it difficult for newcomers to share in that growth.
7. Don't be afraid to be contrarian; focus on buying companies that are out of favour as a result of general market conditions or because the financial community has misconceptions of its true worth. In other words, the stock is selling at prices well under what its true merit is better understood.
8. Focus on the future, but remember, sometimes forecasts will tell you more about the forecaster than the future. Hold the stock until there has been a fundamental change in its nature such as weakening of management through changed personnel or it has grown to a point where it no longer will be growing faster than the economy. In only the most exceptional circumstances, sell because of forecasts as to what the economy or sharemarkets are going to do because these changes are too difficult to predict. Never sell the most attractive stock you own for short-term reasons. However, as companies grow, remember that many companies are quite efficiently run when they are small; hence fail to change management style to meet the different requirements of skill that big companies need. When management fails to grow as companies grow, shares should be sold.
9. Do not be afraid to look at low yielding stocks because the most attractive opportunities are most likely to occur in the profitable but low no-dividend payouts.
10. Do not be afraid to make mistakes and it is only a mistake if you don't learn from your errors. Making some mistakes is as much an inherent cost of investing for the major gains as making some bad loans is unavoidable in even the best run and most profitable lending institution. The important thing is to recognise them as soon as possible, to understand their causes and to learn to not keep repeating the mistakes. Willingness to take small losses in some stocks and to let profits grow bigger and bigger in the more promising stocks is a sign of good investment management.
11. Diversify your portfolio but don't hold too many stocks. There are a relatively small number of truly outstanding companies. Their shares frequently can't be bought at attractive prices. Therefore, when favourable prices exist, full advantage should be taken of the situation. However, funds should be concentrated in the most desirable opportunities but notwithstanding proper diversification over a variety of industries with different economic characteristics.

    A holding of more than twenty (20) stocks is a sign of financial incompetence although 10 to 12 is a better number as capital gains may justify taking several years to complete towards a more concentrated portfolio.

    Equally, relying on a handful of stocks to achieve your investing goal, despite holding fewer stocks, has a greater opportunity to outperform the broad sharemarket but a greater risk that your portfolio will fall short.

12. Buy companies you can understand with a "two minute drill" is a handy test to help you gauge whether that stock is worth investing in or not. The two-minute monologue can be muttered under your breath or repeated out aloud to colleagues, friends or family so that a child could understand it. Then you know you have a proper grasp of the situation. For example, the type of thing you might say - "I like the Woolworths retail business as a long-term investment because the stores are usually crowded and are always finding better ways to serve customers."

    The company has a track record of growth boosting earnings per share by 16.6 per cent per annum compound over five years and more than doubling its dividend which its dividend yield is still 3 per cent fully franked and its share price has risen threefold over the same period. Woolies continue to expand their supermarkets and six to eight Big W stores each year. Chairman James Strong and CEO Roger Corbett have a history of delivering the goods and company management succession planning over the past decade has been excellent. People need to eat, drink and clean their homes, even if the economy goes through a bad patch; so it can survive a downturn in the economy.

    My main concern is that profit margins in supermarkets could fall as competition intensifies from Coles supermarkets, Foodland and Metcash. If all these companies achieve their growth plans in the next five years, some stores will be unprofitable but that won't necessarily be Woolworths outlets.

    Woolworths shares are no bargain at the current price earning ratio of 19 but the company has a solid core business and history of delivering its expansion plans, making a good long-term portfolio mainstay.

Buy Companies With A Good History

Analysing a company's trading history is essential because it can tell you what the future may hold, such as the conditions in which it does well or poorly, and whether the performance is improving or deteriorating. Important things to look for in a company history include a track record over at least five years of growth in revenue, earning or dividends.

But don't make the mistake that history is everything. Think of it in terms of your private life. When it becomes serious about a potential partner, are you more interested in their past or what they will be in five years time and whether you can grow together.

Remember, every dollar a company ever makes for you as a shareholder will be in the future. Understanding the past gives you a foundation for making better forecasts of what may happen down the track, but its no guarantee. That's why when you study a company track record, the safest approach is to search consciously for parts of the business in which the past may not be a guide to the future.

If a company's past were always an accurate guide to the future, successful companies would remain successful forever and of course that's not always the case. HIH Insurance is an obvious example of a company with a long history of expansion, which finally hit the wall. One.Tel had a shorter history but the same result.

The past can only give you a good feel for the type of share price performance you can expect. Shares that have delivered volatile performances in the past, perhaps due to an inherent instability in the business industry such as global commodity price cycle or mineral stocks, will continue to do so in the future.

Revealing Ratios

Investors employ a wide range of tools to calculate fair value for a company's shares but none is more widely used and abused as the dividend yield and price earnings (P/E) ratio. So what do these ratios reveal and what are the most common mistakes in applying them?

Dividend Yield

Many investors start with the stock assessment of a company's annual dividends per share payment with the current stock price to produce the dividend yield.

DIVIDEND YIELD = ANNUAL DIVIDENDS PER SHARE IN CENTS
                   / CURRENT SHARE PRICE IN CENTS

Some investors feel intuitively that a high yield must be a good yield because the company pays it's shareholders more dividends for every dollar invested in shares, despite the company directors having the discretion to increase or decrease dividend payments depending on the needs of the business.

The yield equation above clearly shows why a high or rising yield may be far from good news. A yield can increase in only three ways -

1. The numerator (dividend per share) increases by
2. The denominator (share price) decreases
3. A bit of both

1. Dividends per share increases (numerator)

When the market valuation price can be driven down through a poor perception of the company's future profitability.

2. The Share Prices increases (denominator)

There are countless examples where the dividend yield has decreased (low yield) due to the stock becoming a high growth stock. These companies are not bought for their dividend yields but for share price growth. These companies prefer to pay pitiful yields rather their profit retention policy ploughs the earnings back into the business to exploit growth opportunities.

Although dividend yields are a useful indicator of the type of stock, it is no arbiter of value and the new way investors try and overcome these limitations, is to treat yield as a comparative tool. Comparing dividends with the market average for other stocks in the same industry or across sectors or individual stocks can yield valuable information.

The Price Earning (P/E) or Please Explain Ratio

Along with the dividend yield, the P/E ratio is by far the most popular shorthand valuation measure. 'Please explain' refers to the notion that the P/E should be employed as a trigger for asking questions about a company's performance - particularly, what factors are driving earnings?

Just as every company that pays dividends has a dividend yield, every company that makes profits has an earning yield. The earning yield expresses the company's earnings per share for the most recent period as a percentage of the share price. If a company earns 50c per share and its share price is $10, therefore its earning yield is about 5 per cent.

Unlike the dividend yield, the earnings yield can be compared to yields on fixed interest investments to get an indication on relative value. This is because it reflects the total return that the company generates, not just dividend payments. Most investors turn the earning yield upside down to reveal a stock's P/E ratio or multiple.

P/E = CURRENT SHARE PRICE / EARNING PER SHARE

Paying for Earnings Per Share

A stock's P/E multiple reveals how much investors have to pay for earnings per share generated by a company or how expensive it is. The traditional formula uses last years earnings per share but since this is like looking in the rear view mirror to drive forward, analysts also calculate forward or prospective P/E's, using earnings forecasts for future years. This provides a true value at which the stock is trading.

Conceptually, if a company's P/E is 20, this represents how many years it would take for the company to "repay" the share price from it's current earnings, assuming that the earnings stands still. If, for instance, James Hardie Industries trades on a P/E of 47, as it did in late 2001, it would theoretically take the company 47 years to repay the share from earnings. This sounds like a long time to wait but it highlights one of the most important points about a P/E. The very fact that James Hardie's P/E reached such high levels in 2001, reflected the expectation among investors that far from standing still, it's earnings would increase as the housing sector boomed, thereby justifying a higher stock price.

Quality Usually Costs More

This explains why many investors still prefer stocks that have historically delivered strong earnings growth such as Cochlear at P/E's of 50 or 60, to others such as Pacific Dunlop and Goodman Fielder, trading at far lower multiples. If earning stream is expected to grow strongly, it's perfectly sensible to pay more upfront for a share of the action and if the growth continues, the value of the underlying earnings should eventually outstrip today's high price.

Many times, low P/E stocks can indeed produce strong returns but the notion that a low P/E is always a good P/E is a flawed as the idea that a high yield is a good yield. Markets look forward, not backwards and how much an investor should pay for a stock depends less on what it is earning now and more on what it will earn tomorrow.

Despite the flaws, the P/E is still the most widely used indicator of value. Like the dividend yield, it is best used as a comparative tool for analysing valuations across market sectors, between stocks and for the overall market at different times in the business cycle. Low P/E or high yield stocks can be good value at any time in the cycle but investors need to make sure the earnings and yield are sufficient to justify the asking price.

Dividend Yield

Dividend yields are also commonly used as a measure or indicator of investment value. Even though the P/E ratio is considered the most important measure of value, the dividend yield is more important to investors that are concerned with yield or income rather than capital gains.

Typically, shares with higher dividend yields also have lower P/E ratios and are hence considered as cheap or value stocks. While a share with a lower dividend yield is accompanied with a higher P/E ratio and is generally considered a growth stock.

Implications

The dividend yield can be used to design portfolios that have certain tilts or style bias. For example, multi-asset income funds will typically tilt their portfolios towards higher dividend stocks, while dividend imputation funds tilt their portfolios toward higher dividend stocks that also have a high level of franking credits.

Countries that have relatively higher dividend yields and lower P/E ratios are considered cheap, while those countries that have relatively lower dividend yields and higher P/E ratios are considered expensive. In determining whether a particular country is over or undervalued, both the dividend yield and P/E ratio are compared to their long run historic average.

Revenue Growth - The Golden Trifector

Revenue takes many different forms but thankfully companies are required to separate the different sources of revenue. Sales revenue, the most important, is the amount earned from selling goods or services to customers and without any non-recurring sales such as interest, dividends and extraordinary revenue from selling off company assets, is the best indication of the operational strength of the company.

If a company can grow sales revenue, then generally the business it runs is getting stronger. However, the challenge for company management is to turn all revenue growth into higher profit which is not always the case. The company may be expanding the markets for its services, or it may be taking business away from its competitors. Either way, the revenue growth is a good sign because it drives earnings, which in turn, drives dividends and subsequently, drives the share price, which in turn, rewards the shareholders as more investors clamber to come on board.

Investors want companies that will give consistently and continuously because that is what creates value and this means their investors are prepared to pay a premium for growth and bid up the price of your share.

How Companies Grow Revenue

Essentially, there are two ways a company can increase revenue - organically or by acquisition. Organic growth is by way of expanding the business through internal awareness of the product or by taking market share away from competitors. In some industries, organic growth is rapid; for example, breakthrough technology or innovative methods of applying old technology may generate demand to keep the business running for many years.

The other way a company can expand sales is through acquisition, and the revenue growth or cash flow is immediately rolled into the bottom line of the acquirer. Small complimentary companies are often called 'bolt on acquisitions'. Acquisitions are a fast way of growing sales, considerably quicker than trying to grow a business organically.

But the speed of acquisitions also brings danger because companies grow as isolated units each with it's own culture, talent pool, computer systems, warehouses and strategic directions. Trying to combine the two sets of these is often difficult, cumbersome or inefficient during the integration period with key personnel leaving. When you buy a company, you don't just buy the competitors, inventory and trucks that are its tangible assets but you buy the nebulous ongoing living entity. This is hard to value and the price to pay is not listed in any catalogue.

Acquiring a company means paying the existing owners a sufficient price to get them to sell, albeit a cheap price if the vendors wish to retire or are forced to sell up by the banks. However, in many instances, paying a high price based on how much they think it will perform over time. In the future, anything can happen, as acquisition doesn't live up to expectation.

Growth through acquisition is a very fast way of growing revenue, but it also carries considerable higher risk than organic growth.

Finding The Balance Between Income And Growth

Australia's top 300 stocks are delivering dividend yields not seen since the early 1990's. This shift coincides with a renewed focus on dividend yields as investors seek secure returns in markets where capital growth is far from guaranteed.

People don't give dividends much thought in bull markets when they reap capital returns but in bear markets, dividends are important. If you are seeking dividend returns but with a lower risk than that required for making capital gains.

Dividends

Thanks to "imputation credits", but the poor shareholders prior to 1987 tax reforms were "doubled taxed" on company dividends. Franked dividends can be one of the most attractive ways to receive a return on investment, particularly for people such as retirees who pay little or no tax. Franking means that shareholders in Australian-resident companies get a credit for tax the company has paid. If their personal tax rate is less than the company rate of 30 per cent, they may end up paying no tax on dividends or even have excess credits which may be used to reduce tax on other income. For the last two years, non-taxpayers have received cheques from the government returning the tax collected by the companies that paid the dividend. For retirees paying no tax, they are basically getting an increased yield. A fully franked dividend is most attractive to people who pay no tax or less than 30 per cent.

Another trend that has encouraged higher dividends has been the increased ownership of Australian companies by superannuating funds which can offset the "franking credits" against their tax liability on other income such as interest.

Dividends vs Growth

Certain stocks have stood out over the years including the Banks, Telstra, TAB, Qantas and Westfield.

1. The average forecasted yield for the top 50 ASX-listed stocks is 4.2%.
2. Property groups' yields are competitive, trading on a forecast yield of 7.1 per cent.
3. While an investment in a 10-year bond will yield about 5.4 per cent, the CBA offers forecasted dividend yields for 2003 of 6.0 per cent.
4. Conventional thinking has it that companies paying high dividends do so because they do not have growth opportunities in which to invest their cash flow.
5. Dividend yields have historically moved in correlation with interest rates such as the bond markets and other debt investments so that companies attempt to attract investors for their investment funds.
6. More conservative investors will look to a yield as a safe alternative to attempting to pick stocks on the basis of value or growth potential.
7. Growth focused Fund Managers on the other hand believe sharemarket investing is ultimately about capital returns.
8. Whether your focus is capital growth or income, keep both sides of the return equation in mind.
9. When reviewing the performance of your sharemarket investments, it is the total return that matters, but many investors focus on just one aspect - the capital returns derived from the movement in share price.
10. It's important to look at the consistency of the dividend yield over time. Investors need to check a company's policy or level of commitment on dividends and its ability to pay them as well as the likely influence on its share price.
11. Over the past decade, dividend yields in Australia have held in a tight range between 2.5 to 4.0 per cent. This reflects three key factors:
    1. In hard times, Australia's economic consistency has not contracted for a record of 11 years, growing at an annual average pace of 3.9 per cent and as the economy has expanded, so profits have grown on an average of 13 per cent a year.
    2. The tight range of dividend yields reflects a similarly tight range for interest rates. Cash rates have held between 4.25 to 7.5 per cent over the decade, reflecting economic expansion combined with stable inflation. With dividend yields lower than cash rates, this reflects the tax advantage of franked dividends and the potential for additional capital returns on shares.
    3. Finally, the returns on Australian shares have held largely in line with the growth of corporate profits. This has meant that the sharemarket has remained fairly valued and as a result, has not dramatically affected dividend yield calculations.
12. From an international perspective, Australia offers relative high dividend yields, ie. seventh out of 23 developed countries. To a large extent, this reflects the relative absence of growth sectors in Australian companies to other major markets and modestly higher domestic interest rates. The decade average returns of 12.5 per cent show little difference from returns made by the domestic sharemarket.

Earning Growth

Companies whose earnings will grow are worth more than those that will not grow. Earnings are the key motivation for the existence of public companies and the driving reason for investing in shares. But the significance of real value which can be passed on to the shareholders in the form of future dividends or growth depends on the quality of the earnings summarised in the following ways:

1. Earnings are the driver of shareholders returns
2. Earnings can be measured in different ways, so be careful whether you know $1 million is really $1 million in earnings - ie. Real underlying performance
3. The future outlook for earnings and earning's growth will drive the share price of an investment.

As a shareholder, you are an owner of the business. In your portfolio of investments, the earnings your company makes in one year can be considered your own. The shareholders ownership of the company's earnings is worked out by the net profit divided by the number of shareholders. Most shareholders prefer to think of the returns the operation has generated for the company in a year as the earning yield.

Earning Yield  =  Earnings Per Share     ie.   0.15  OR  7.5% Yield Return
                    / Share Price           / $2.00

However, from an investor's point of view, he is more inclined to value the company on its ability to continue to maintain and improve profit growth in return for the purchase of his investment over a period.

Price Earning Ratio =    Share Price      ie.  2.0   OR 13.3 Times Earning
                     / Earnings Per Share    / 0.15

However, earnings can be confusing because we are really trying to ascertain the real underlying earnings of the company and not the accounting rules manipulations such as accruals, one-off capital gains and capital losses.

EBITDA (Earnings before interest, tax, depreciation and amortisation)

Earnings before interest, tax, depreciation and amortisation represent the non-trading elements of the company. It is useful as a measure of comparing the profitability of various companies, and with a few adjustments, will be a close approximation of the cash flow generated by the business.

EBIT (Earnings before Interest and Tax)

It differs from before in that, the profit is calculated after depreciation expenses and amortisation expenses but before taxes and interest expenses varying greatly between different companies.

Depreciation is an expense incurred in writing down a portion of the tangible assets of a company, having used up some of their value.

Amortisation is the same sort of thing but applied to tangible assets such as goodwill represented by a company acquisition of an asset at a premium over the identifiable net assets that the purchase price contained. It is requested to be written off over twenty years. It is required by accounting standards however, and does determine the reported net profits so a more conservative measure is to include it in the calculations. It really requires a continuing appraisal as to whether the acquisition price has proved prudent and the value is growing - or the reverse.

NPAT (Net Profit After Tax)

At the most basic level, earnings are represented by net profit after tax. NPAT is reached after the vagaries of interest, tax, depreciation and amortisation are all included in the calculation. This does not necessarily make it a poor measure of earnings but as it is the total after expenses are deducted and from which dividends will be paid. NPAT is a more accurate measure at what is left at the end of the day to be distributed to the owners.

All these profit measures should be adjusted for transactions that are out of the ordinary. For example, revenue and profits from the sale of a subsidiary or surplus land should be removed from the earning results. In this way, the core earnings or what the trading asset of the company generates is the best indicator of the future earnings.

Earning Growth

When you buy a share, you are buying on the current earning of the company which is transacted as "yield return" which only the future earnings of the company belongs to you and not the past earnings. Past earnings are the best measure of the future earnings but as we all know, situations change.

Earnings can go up which is great but they can also go down. Companies whose earnings will grow are worth more than those that will not grow.

Consider two companies trading on the same "earning yield" for the next year. Based on forecasts, one is likely to generate the same earnings the following year and for the year to come after that. The other has businesses that are growing and earnings that are likely to grow as well. Therefore, the earning yield of the future earnings would be growing as a percentage if the share price was growing. I would pay more for the business, wouldn't you? The market certainly does. It places a premium price on companies that have recorded growing earnings. The companies, which continue to generate increasing returns to shareholders, are the ideal companies to own.

Everything Comes Back To Price

Smart investors are always mindful that the difference between great companies and great investments is price. For example, a company has a great track record, dominates its markets and it could be years before a genuine competitor emerges - but you still need to check the price tag. On doing so, you may decide your current portfolio is not so bad.

Put simply, you are unlikely to be alone in noticing a company's strong performance and competitiveness. Other investors may well have bid the shares up to a point which the value is no longer there.

The difference between great companies and great investments is price. Take a company like bionic ear maker, Cochlear. Its real compound growth earnings over five years has been exceptional at 31 per cent with compatible growth in dividends. Its growth has been reflected in it's share price until November 2001. Then, over the next year, it's share price fell 40 per cent - from highs around $50 to lows around $29 before moving back up to the $40 mark.

Why? Largely because a great company with excellent growth prospects had become too expensive for the market to bear and if years of expected future earnings has already pushed a company's share price too high, you may have to wait for a dip in price before investing.

Many investors start their assessment of a stock value by comparing its annual dividend payment with today's share price to produce a dividend yield. But dividend yields never give a full story because a rising yield can affect events, both good and bad - raising dividend payments, a falling share price or a bit of both.

Unlike dividend yield, the "Earnings Yield" can be compared with yields on fixed interest investments to get an indication of relative yield. This is because it reflects the total return that a company generates including retained earnings ploughed back to fund the company's growth, not just dividend payments.

Most people turn the earnings yield on its head to reveal a stock's price earnings (P/E) ratio or "multiple" which in simple terms, reveals how much you have to pay for a company's future earnings.

You can compare a stocks P/E ratio to the historical trend in the company's P/E, the market average P/E, the sector average P/E and P/E's for competitors to get a better idea of its relative valuation. The quality companies usually have higher P/E's than others but this does not necessarily mean that they are too expensive, any more than a low P/E means a company is too cheap.

This helps explain why many long-term investors still prefer stocks that house historically strong earnings growth such as Cochlear although its growth style of investing can under perform in some market conditions.

If earnings stream is expected to grow strongly over the long-term, it makes sense within reason to pay more upfront for a share of the action. If growth continues as expected, the value of the underlying earnings should eventually outstrip today's high price.

Don't Buy Stock With Debt

It's worth running a few quick debt checks to make sure your company's balance sheets remain healthy.

"All happy families are alike but unhappy families are unhappy after it's own fashion" wrote Leo Tolstoy in his classic novel Anna Karenina. But the same can't be said of unhappy companies saddled with too much debt. Each company is different but they are all alike in the end and the warning signs may be there if you take the trouble to look.

Corporate collapses like that of HIH Insurance and One.Tel make spectacular headlines but companies usually go broke in the same mundane way as people. If you owe money on your mortgage and don't earn enough to pay it off, your debts pile up until one day the lender pulls the plug.

Fraud sometimes comes into the picture when the writing is on the wall, usually in an attempt to hide a mistake and buy some time. Using debt can be a cheaper way to fund a company's growth than raising fresh equity, so reasonable debt levels can be a sign of efficient capital management. But excess debt rapidly becomes a millstone around the company's neck, reducing earning growth and the ability to realise opportunities and respond to threats.

Dividend payments can be reduced or even suspended if the company needs time to get back on its feet. Although shareholders don't want this to happen, it beats bankruptcy and gives you a chance to get some of your money out or wait for things to improve. Debt is a different beast. Interest payments to banks and other lenders can't be reduced or suspended without the real risk of default and liquidation.

So it's worth running a few quick debt checks to make sure your company's balance sheet remains healthy. One of the easiest things to check is the company's "NET INTEREST RATE COVER" or how many times the company would be paid net interest expenses from profits, ie.

    TIMES  =    EBIT  /  NET INTEREST

Investors usually regard interest cover of five times or more as healthy but leading companies such as Westfield Holding and Brambles often report levels of 8 to 10 times.

Another quick check easy to perform is to compare short-term assets and short-term debts in a company's balance sheet to make sure it has the means to repay short-term debts with liquid assets (Current Ratio = Current Assets/Current Liabilities).

Even a company with a strong long-term asset can have a cash flow problem, just as individuals strike cash flow problems when their wealth is tied up in an investment such as property. Most investors prefer a current ratio of more than two. Some companies manage with a lower ratio but generally speaking, higher is better.

Equity Risk Premium Is Alive And Well

Few things in this bear market have caused more confusion than the equity risk premium. The 'Doubters' argue that shares will do no better than the "risk free" returns on cash or bonds over the long-term. The 'True Believers' counter that shares will continue to outperform at levels of 5 to 7 per cent. Who's right and over what period are the key issues facing portfolio managers and advisers today?

The "Equity Risk Premium" is the long-term difference between the return on shares and the risk-free rate based variously on returns of cash, bank bills or 10-year government bonds. There is a major source of confusion. A high past premium may imply that current share prices are high as a result of price growth whereas a high future premium implies that today's share prices are low enough to leave room for future growth.

To investors enduring the worst bear market in 70 years, the idea that prices were held down to allow future rewards is laughable but despite some woeful periods for shares, the existence for equity risk premium is one of the few enduring trends. Over an investment lifetime, equities have been a resounding winner, producing higher returns than cash in all major markets last century and over all 20-year periods.

There are sound reasons why. The usual rationale is that investors must be compensated for the higher risk of owning shares - particularly given the harsh bear markets that visit every 12 years on average, making the true risk of equity investing far greater than volatility measures allow. But there are even simpler explanations. In a market base, society wealth is generated through the company structure. Apart from building your own business, owning shares is the only meaningful way to participate in long-term growth in companies and the economy.

Where do consumers get their spending money? Mostly from companies they do work for as employees, self-employed. Where do they get the money to fuel the housing booms? Mostly from those same companies. In a market-based society, companies that are expected to produce lower returns than risk-free bank deposits, eventually fail. They are taken over or forced out of business. Only quality companies survive for the very long-term.

Because this creative destruction directs funds to companies that make money, investors can be pretty sure that an equity risk premium will be theirs over the very long-term in a successful market-based society to the extent that investors will accept extra risk without anticipating extra returns.

What's far from clear is how the risk premiums will be delivered to investors in the coming decades. Researchers point out that most estimates of the forward equity risk premium today implicitly assumes no change in the price that investors are willing to pay for future earnings (expressed in the price earning ratio or P/E).

Given that historical P/E's are not cheap, implies investors should not rely on any further multiple expansions in the coming decade to add to the premium. The argument effectively is that today's higher price earnings ratio means investors have already consumed some of the long-term premium, leaving less on the shelf.

What happens, for example, if the P/E of the US S&P 500 index (around 29 on reported historical earnings) and now a reasonable 16 on forward estimates, returns to the long-run norm of 15. First the US high valuation multiples among mega caps (ie. Microsoft, Intel, G.E.) have dragged up the market P/E while some other stocks are cheaper, creating long-term opportunities. Also remembering, that if inflation and interest rates stay low and economic growth is at least moderate, higher valuations than historical norms may be sustainable. Even if de-rating were to occur overnight, investors (through less than expected strong earnings growth or price stagnation) would still be compensated for risk over a period of many years in which stocks still outperform bonds and cash by a decent margin.

A more reasonable conclusion that investors should be ready for a period of lower returns than the 1990's even when this bear market ends, shares could outperform bonds by less than they have done over the long-term period than this new regime but most likely they will still outperform and reward patient investors.

Over the average investors lifetime, the equity risk premium will almost certainly be there and should be generous. Only those who invest in equities consistently, will capture the full rewards with any reliability by using the "equity risk premium" indicator for what it's designed.

The Myth About Shares Being The Best Long-term Investment Proposition

Information like this can be confusing to a generation of Australian shareholders that has grown up reading books, magazines and fund manager brochures that says shares can't be beaten over the long-term.

The Really Critical Thing Is The Time Horizon Used

Over 10 years we are very likely to outperform bonds; over 50 years, shares are fairly well assumed to outperform. But the fact is that investors can't assume that shares will beat bonds over any time period. Also, if the share investment is made at the top of the speculative bubble, it may not outperform over the long-term horizon that the investor has set. Therefore, the rider that really must be attached to the general statement is 'provided that the shares are bought at a reasonable price'.

It's simply false to say that the share market will always outperform over the long-term. If that were true, everyone would be fully invested in shares and there would be no need to diversify a portfolio and that need exists, evidenced by the last century of the S and P 500 Index in the US shares market.

1. You can find six 10-year period that generated a negative return in that index;
2. You can find four 15-year periods; and
3. You can find one 20-year period.
4. There are 11 long-term periods in which a US investor could have beaten the share market's return in a cheque account paying no interest.

So, in the US context, the share market can't always be the best investment over the long-term.

Over 50 years - any 50 years - it is unarguable that any asset class can match the total return from the share market. But realistically, 50 years is not a long-term time horizon of most investors. It's more like 15 to 20 years and it's that long-term experience from the US that shows shares can not only be beaten over the long-term, they can actually send you backwards if you enter the market when they were over-priced.

Data from the Australian share market also confirms that investors over the long-term can expect to be compensated for the extra risk of holding shares with superior performance and in particular, the tax treatment of fully franked dividends has to be taken into account. In fact, franking credits lifted shares into first place on an after-tax comparison of returns for the 10 years to December 2001.

Appraisal Ratio

Description

The Appraisal ratio is the ratio of a risky asset's alpha to its non-market risk, where the alpha of an asset measures the amount of return the asset generates that is uncorrelated with the market return. The non-market risk refers to the variability of the asset's returns that are not affected by the market.

Appraisal ratio  =  Alpha of the asset  /  Non-market risk

When used to evaluate an investment fund, this ratio measures the return from security selection per unit of non-market risk or security specific risk taken by the fund. A fund's security selection return can also be referred to as alpha or the residual return. Put simply, the alpha is just the return a fund would earn if the market rate of return was zero. Hence, this return can be attributed purely to security selection ability.

For example, assume that a fund was able to deliver an alpha of 2.5% with 5% non-market risk. This fund would have an appraisal ratio of 0.5. This means that for every 1% of non-market risk taken, the fund generates 0.5% of return from security selection.

The Appraisal ratio is a measure of an asset or fund's risk-adjusted return and is a type of reward-to-risk ratio. They can be used to gauge the performance of funds in terms of both risk and return.

The Appraisal ratio is calculated using either monthly or quarterly returns but can also be calculated using daily or yearly data. First, the excess return for both the asset and the market need to be calculated. Second, an ordinary least squares regression of the excess returns of the asset or fund against the excess returns on the market portfolio must be run. Then the alpha of the asset or the fund is the intercept of the estimated line of best fit. The non-market risk is equal to the standard error of the regression, which measures the extent to which the actual observation deviates from the line of best fit.

Implications

The Appraisal ratio can be used to select active funds and to monitor their performance. This ratio can also be used for portfolio construction. For investors who wish to combine one or more active funds together with a passively managed core portfolio, the Appraisal ratio should be used.

In order to add value, managers take risks by deviating from the index. They may hold fewer stocks or bonds and weight them differently than their index weights. This ratio can also be referred to as the Information ratio because it focuses on the risk and return generated from the fund manager's ability to use information to deviate from the index.

The Appraisal ratio measures how efficient the fund manager is in converting securities selection risk into excess return. Reflecting this, a high Appraisal ratio means the fund manger is successfully using their securities selection risk to achieve excess returns. A high Appraisal ratio means the fund manager would be ideally suited to complementing a passive or indexed fund manager.

Similar to the other reward-to-risk ratios, when selecting funds on the basis of the Appraisal ratio, the higher the value of the ratio, the better the fund. Theoretically, the Appraisal ratio can have a value ranging from negative infinity to positive infinity.

Sharpe Ratio

The Sharpe ratio is the ratio of a risky asset's average excess return to the standard deviation of the asset's excess returns, where the excess return is the return of the asset above the risk-free rate. The risk-free rate of return can be provided by the 90-day bank bill rate.

An investor obviously wants to maximise return while at the same time minimising risk. The higher the Sharpe ratio, the more return achieved per unit of risk. Assets that achieve high Sharpe ratios are therefore more efficient in their use of risk than those that achieve low Sharpe ratios.

Implications

The Sharpe ratio can be used to select active funds and to monitor their performance. This ratio is commonly used when examining the ex post performance of hedge funds or alternative investment strategies.

There is an investment axiom, which states that to achieve a higher rate of return, a greater amount of risk must be taken. This implies a trade-off between risk and expected return. For example, investors can attain a greater expected return by taking more risk by increasing their exposure to more risky assets, such as moving from defensive to growth assets, from developed to emerging markets or from Australian to international equities.

Reflecting this, active investment managers attempt to add value by taking structured and informed extra risk(s) in an attempt to produce superior or excess returns above the fair return that should normally be attained as compensation for bearing investment risk. However, active managers should not be rewarded for achieving greater returns simply from just increasing their exposure to market risk, which requires no additional skill above that possessed by most investors.

Consequently, if a fund manager possesses skill and has sound management and processes in place, then the result should be superior measurable returns on a properly risk-adjusted basis. This can be assessed and captured by targeted reward-to-risk ratios.

Generally speaking, a Sharpe ratio greater than one is considered to be very good. A ratio between 0.5 and one is considered to be good. But a ratio below 0.1 is considered to be poor.

There are some potential problems with the use of Sharpe ratios:

• Funds with low risk as measured by variability of returns - such as cash and fixed interest funds - will possibly have very high Sharpe ratios.
• When measured over short periods, the Sharpe ratios can be negative and not very indicative of performance.

Company Valuation Techniques

Discount Cash Flow (DCF)

Valuing a company is no easy feat but to do so successfully, can put you right in the money stakes. There is probably no other task performed by analysts and investors that consumes as much brain power and time as trying to value the shares of a company. Anybody amateur or professional who can consistently pinpoint the true worth of the company will have few financial worries.

Warren Buffet has consistently identified and bought undervalued companies for more than three decades. So how do the Buffets of the world calculate the true worth of a company? At the heart of the Buffet approach, is the DCF which involves figuring out what a future series of cash flows are worth today. For example, if a company is expected to generate $100 in free cash flow (FCF = cash received less cash spent) every year for the next 50 years, how much are these cash flows worth today or what would someone pay for them?

To make this calculation, we need to know how risky the $100 net cash flow is. That is, what are the chances that the company won't be able to generate the $100 every year? If the company is certain to generate the $100 every year, the $100 net cash flow is riskless so an investor who buys these future cash flows should earn only a risk free return; for example, the return on a 10-year government bond is, say 6.0 per cent. Therefore, to put a price on these future $100 cash flows, we would discount them at 6 per cent. This would give us a value today of $1576.

Of course, the future cash flows of a company are not certain and therefore investors demand a risk premium. For example, investors may demand a risk premium of 4 per cent above the 10-year government bond rate to buy these risk $100 cash flows. In this case, we would discount the cash flows at 10 per cent (ie. 6 per cent bond rate plus 4 per cent risk premium) to give a value today of $945. It makes sense that an investor will be prepared to pay less for these cash flows than $1576 for the riskless cash flows.

Of course, there is inherent difficulty in trying to forecast an actual valuation report of a company considering the uncertainty as to the knowledge of the company and industry and the economic outlook to forecast future sales. For an analyst who gets these forecasts considerably right, the accurate valuations hopefully produce a good profit for the client. Get them wrong and it might be the time for a different career.

The rest of the calculation is largely mechanical such as multiplying sales by the profit margin gives earning before depreciation, interest and tax which should be close to the operating cash flow generated by the business. However, some of this cash flow will be needed to pay tax and some of it will need to be ploughed back into the company to fund future growth. These non-operating cash flows are deducted from operating cash flows to give the free cash flow.

Free cash flows are essentially what an investor is buying when he or she buys shares in a company and so these are what we have to "discount" to come up with a valuation. If we add up all these values together, we get the total current value but both shareholders and lenders have a claim on this value so the proportion of the company which belongs to the shareholders is less the debt outstanding credits to the company which is equal to the net tangible assets of the company.

Buffett has made massive capital gains out of identifying, buying and holding such stocks, although he only buys when his DCF valuation is significantly more than the prevailing stock price - what he calls the 'safety margin'.

Be Rewarded For Considering The Enterprise Multiples

The price earnings (P/E) ratio is the most widely used measured indicator of stock market cheapness or value. However, the ratio has several shortcomings that may result in investors believing the stock is cheaper or more expensive than it is. One important and generally unappreciated characteristic of a P/E ratio is that it is affected by capital structure. That is, the mix of debt and equity used by a company can have significant impact on the magnitude of the P/E ratio.

The P/E ratio tells investors how many dollars must be paid to purchase $1 of after-tax profits (earnings) in a company. So a company with a P/E of 10, suggests that an investor will need to pay $10 in the market for every $1 of earnings.

While the main detriment of the magnitude of the P/E ratio is expected future growth, capital structure also plays an important role. To see why, assume you are comparing two stocks. Remember, other than the two different companies capital structure, they are identical.

The debt in Company G's capital structure impacts on its after-tax profit in two ways. Firstly, profit is reduced by $500,000 (10%) interest payment on $5 million debt and secondly because the interest payment is tax deductible, Company G pays less tax than Company U. While Company G has half the shareholders equity and market capitalisation of Company U, the after tax profit of Company G is more than half that of Company U, courtesy of lower tax liability. As a result, the P/E ratio of Company G at 7.68 ends up being lower than the P/E ratio of Company U at 10.

So while the underlying business is the same, the P/E ratio differs, depending on how much debt and equity is used in the capital structure. We need to be aware of this if we use P/E ratio to compare the cheapness of different stocks.

An alternative measure that removes capital structure (and tax) differences and lets us focus on comparing underlying business, is the Enterprise Multiple (EM). This is calculated as enterprise value, ie.

EM  =  MARKET CAPITALISATION PLUS INTEREST BEARING DEBT
         / EARNING BEFORE INTEREST AND TAX (EBIT)

In summary, while the P/E ratio is easily calculated and readily available from many sources, the intelligent investor will be rewarded with greater appreciation of the true value of underlying stock by taking the time to calculate the EM.

Can You Trust A Broker's Research

While research might be well written and offer valuable company insights, it may not be written with you in mind. Rather it may be written to attract business in the merger and acquisitions division, an area that generates a lot more money for the company than you.

In the US, there is a research debacle that is undermining the credibility of research analysts. In May 2002, the investment bank, Merrill Lynch paid $100 million as part of a settlement with the New York State Attorney General over allegations that research analysts were not acting in the best interest of investors.

It was unearthed that some Wall Street analysts published overly optimistic ratings on companies in order to help win investment banking deals. Even some research analysts from Merrill Lynch were openly condemning the same companies that Merrill Lynch were publicly recommending clients to buy, with comments to the effect that "nothing interesting about this company except investment banking fees" and "we see nothing that will turn this around in the near term".

Does this problem also apply to the large Australian Broking Houses who have three key areas of operation - research (where analysts scrutinise company balance sheets and write reports), corporate advisory including mergers and acquisitions, and executions on the dealers' floor where the trading takes place?

In theory, broking houses should have "Chinese walls" that separate the competing interest of these divisions. An analysts research report on company X should not discuss the matter with the investment banking team who are pitching to win corporate business with company X.

Research analysts should have the independence to tell how it is - that the company is a piece of junk. Unfortunately this kind of research reporting can clash with investment bankers who are, at the same time, playing up to management of company X in an attempt to win investment banking business worth millions of dollars.

The potential problem with the major broking houses lies with a conflict of interest because research is often used as a tool to get corporate mandates for advisory deals. Just look at the number of brokers "sell" recommendations - there aren't many because analysts' pay packets are linked to the amount of investment banking business generated, or they will not receive any further information from that company in the future; integrity can be diplomatically swept away.

In Pursuit Of Profit On Shares

When we first start share investing, the object seems simple. Buy the right share at the right price at the right time and catch a good up trend to make a profit.

Some of us start out the correct way of finding the right shares to buy through the fundamental qualitative and quantitative analysis technique. We read articles in the newspapers and newsletters, go to seminars, consult brokers and advisers or even buy expensive computer software that purports to tell us which stock to buy.

However, once we get to the point of being fed up being loosing investors, is the time we have learnt something important. Put simply - knowing when to buy and when to sell is the key to the success of profit making in securities.

Basically, when we look at charts of share prices, there are good up trends consisting of a series of rallies interrupted by corrections or trading ranges (period in which prices track sideways). This essentially means two ways to profit from these trends.

Investment Approach

Identify the trend once it is established. Buy into it and hold the share until the trend has clearly ended. This approach clearly tends to give the best result over time but requires patience and discipline. This is where most investors end up trying to capture the big moves with the minimum transaction costs.

Trading Approach

Jump with the rallies as they start and get out once they are over. Corrections are avoided and funds are switched into some other stock that is rallying. Theoretically, this keeps your money compounding faster than the investment approach. However, it is easier to describe than done and has a handicap in the form of transaction costs.

There are many ways to capture trading profits but whichever way you use, you must be confident in it and have experience in looking at the infinite forms that markets can take.

One of the most common tools of a chartist is the moving average technique -

1. What the moving average does is to smooth out the fluctuations in price day by day, week by week or month by month and thus expose the underlying trend.
2. For example, the average closing price for a given time period is usually plotted on the bar chart as a central line.
3. The moving average is usually plotted on a bar chart as a line.

Relative Strength Index

What we are going to look at is the use of a moving average envelope or commonly known as a 'straddle' which is simply described as a triple moving average meaning two other lines, one a certain percentage above the moving average, one at the same percentage below it. Assume the moving average is 100 today. If we want to construct a 20 per cent envelope, the upper line will be 120 and the lower line will be 80.

The moving average represents a consensus of value as the trend evolves. However, the markets are driven by emotions like fear, greed, hope, ego and regret. This causes the price to swing up above the moving average in an uptrend and down below it in the downtrend. The envelope is used to give us an idea of how far the price gets out of line with consensus of value before it swings up again.

For a fast moving average, 22 days (which is the number of trading days in a month) tends to work well. However, the width of the envelope will vary from stock to stock and has to be set by the eye so that 90 per cent of the time, the price bars are within the envelope. Once we have set the envelope, the trading strategy is to buy near the moving average, that is near fair value and then sell when the price swings up to the envelope.

Research Statements

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Morningstar - Quantitative and Qualitative Research

Through Morningstar's extensive statistical (*mean variances) research database, Financial Management Advisors is able to track and monitor the historical performance, current and historical prices and regular up-to-date product information reports, in excess of 6000 investment trust products.

Aspect Huntley

Aspect Huntley provides one of the most comprehensive, high quality market information and statistical research analysis system on the market, which keeps us informed that helps us make the best investment decision for our clients.

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BCM Macro Economics - Leading Indices

BCM Macro Economics leading indices are designed to anticipate and identify turning points in the World and Australian economy.

The Leading Index is contained in BCM Macro Economics composite reports produced dialy,weekly ,monthly, quarterly. As well as examining Australia's leading indicators, the report also studies movements co incident and lagging indicators of economic activity in the country, along with comparative data from overseas.

These Leading Indexes, which consist of twenty or more leading indicators, are presented by five typical main Composite Indicators, ie. World Outlook, Australian Outlook, The Growth Sectors, Financial Markets and Domestic Wages and Prices. These include real money supply, stock market price indices, residential building approvals, non-residential building approvals, overtime hours, company profits, real unit labour costs, manufacturing material prices, unemployment rates, Public sector contribution to output growth, terms of trade, net exports, net imports, exchange rates, Balance of Payments, relative strength movement of business sectors, long and short-term interest rates, yield spreads between foreign and domestic interest rates, commodity prices, the lagged impact of output on prices on productivity growth, wages, material, inflation and import prices.

Property Myths

Various indexes of affordability has suggested that housing affordability has declined but at the same time, the path of home ownership appears to have fallen only slightly. The most important factor in the rise in housing prices since 1996 is the fall in nominal and real interest rates. This has a significant impact on the distribution of wealth because people who own houses before interest rates fell have made a big one-off capital gain.

To explain the increase in prices is due to the following factors, which may explain the myth that the rise in property prices is all bubble.

These fundamentals include:

1. The availability of cheaper finance
2. Thanks to the return to higher inflation
3. Financial deregulation of housing finance
4. Housing loan securitisation
5. The growth in the average household disposable income
6. The downturn on the sharemarket
7. And the subsidy for first homebuyers

However, the changes generated by shifts in fundamentals are not all permanent. The relative attractiveness of investment in property and equities will swing back again as the share market picks up and the property boom comes to an end.

But it is important to realise that these cycles have always been part of the property market and there is nothing we can or should try to do about them.

Negative gearing and the concessional taxation of capital gains in 1999 have magnified the surge of investment in rental properties and the talk of dropping taxes on land and stamp duty will still be the housing market "second wind".

The taxation system that magnifies asset price booms is a problem particularly in an economic environment in which the frequency and size of asset booms appears to be increasing.

Taxation Implications

Negative gearing is a normal part of commercial life and any attempt to quarantine the property market would create a lot of new inefficiencies.

The changes over capital gains were justified with arguments about the need to encourage surges and investment and to be competitive in global capital markets in the long term.

However, this is one approach to capital gains tax problems that might appeal to traders and that is the reduction in the top marginal income tax rate.

As the top marginal income tax rate falls, the concession in capital gains declines. Of course, there is then a new problem of the fund being more revenue for the government and protecting the progressivity of the overall taxation and workforce system. How the GST and a progressive land tax could come into their own. Perhaps the taxation of trusts also might be revisited.

Many Property Options

Nowadays, property investors are presented with a myriad of investment vehicles that can be used to structure their property portfolios. Some vehicles are more appropriate than others in accommodating the particular needs of the property investor.

In Australia, there are numerous property investment vehicles that may be used to own property. They generally fall into one of two major categories of property investment:

• those where the value of the investment is determined by the realisable value of the properties within the portfolio; and
• those where the value of the investment is directly affected by the broader financial markets, such as the share market and the fixed interest market (see Figure 1)

Examples of the first category of property investment vehicles include:

• Direct property investments - a direct property investment involves the direct purchase and ownership of property assets by the investor. Direct property can be owned either as individual holdings or through pooled vehicles. It is only possible to hold high value properties through pooled vehicles because of the magnitude of the investment required to achieve ownership. Difficulty in achieving the benefits derived from proper diversification discourages individual holdings.
• Unlisted property trusts - an unlisted property trust is a vehicle where the redeemable value of the units in the trust is determined by the value of the property within the trust. The majority of unlisted property vehicles are closed funds. Unlike in the 1980s, when such vehicles were extremely popular, there are not many unlisted property trusts in today's marketplace. Most are held by a small number of superannuation funds. Unlisted property trusts lost attractiveness in the early 1990s due to liquidity constraints.
• Property syndicates - a property syndicate involves a group of investors who pool their funds to purchase one of more properties. Property syndicates typically have a defined life, after which the properties are sold and the capital realised returned to investors. Units in property syndicates cannot generally be redeemed.
• Mortgage Trusts and Commercial Mortgage Backed Securities (CMBS) - a mortgage trust invests in mortgages over residential and commercial properties. CMBS are pooled loans secured by property assets. They only generate income and no capital growth.

In terms of transferring ownership, most of these vehicles have a facility which allows transfer of ownership although turnover in unit holdings is very limited. Pre-emptive rights to existing investors apply in a number of wholesale vehicles. In some, which operate as investment clubs, approval of new investors is required, whether through new application or through acquisition of existing unit holdings.

Investment vehicles that fall into the second category of property investment are typically open-ended vehicles. They include:

• Listed property trusts - listed property trusts are the most common form of property ownership in Australia. The properties within the trusts are owned by unit holders and held in trust on their behalf by the responsible entity of the trust, who has ultimate responsibility for the trust. The properties are managed by a property manager. Listed property trusts are non-tax paying entities. They are classified as "flow through" entities, meaning that they distribute all taxable income to unit holders.
• Property securities funds - property securities funds invest in a portfolio of listed property trusts. This type of investment vehicle suits investors who wish to delegate the task of selecting individual listed property trusts to a professional investment manager.
• Stapled securities - stapled securities combine conventional trusts and shares in a corporation that engages in a range of property services, management, and development or construction activities. Management is internalised, ensuring the interests of the manager and unit holders are better aligned.

A final category is that of property derivatives, which allow investors to gain exposure to the property market without actually owning the physical asset.

A property futures contract provides investors with the opportunity to take derivative positions within their portfolios, as a form of hedge or as a facilitation of transactions. Typically a securities index will underpin a listed property futures contract.

Property investors can comprise of individuals, property investment companies, joint ventures, or even limited partnerships. With a limited partnership, the partners are liable for the debts and obligations of the business only to the extent of their investment.

Foreign investors can invest in various forms of property in Australia. However, certain ownership restrictions apply to such investors. Foreign property investors must seek prior approval from the Government through the Foreign Investment Review board. Foreign investors cannot purchase more than half of an Australian property development.

While there are numerous vehicles that provide ownership of property, particular characteristics such as tax, regulations, liquidity and management will appeal to investors in different ways.

Property Investors, Tax, Tenants And Other Issues

Smart investing in property, particularly commercial property, takes more than checking out real estate advertisements and asking agents for properties offering attractive yields. A good deal of serious thought is advisable before searching out actual investment opportunities.

The process should centre on a number of key issues, starting with whether you have the temperament to be an active property investor, which is what it takes to be successful.

Also, consider whether your motive is speculation, as distinct from investment.

Another matter is whether you can be a realist in terms of your investment objectives and understand the risks as well as potential rewards.

So how might you address some of these issues from a commercial property investing perspective?

1. Know what you want from a property as an investment, in terms of your profile. A retiree, for example, will want an investment that delivers a solid and inflation-matching income stream. A high-taxed investor is likely to prefer an investment offering more in the way of capital growth potential because it will be more tax effective than regular income.
2. Be aware that even if you have done your homework and thoroughly researched an investment, unforeseeable events can still upset things. The future of any property investment can always be influenced by unexpected events.
3. Remember that with property - as with many other investments - there are better times to buy assets, just as there are times to avoid the market. With commercial property, there are different sectors and sub-sectors that can be influenced by different factors. Right now, retail property is much stronger than office suites, with industrial property next in line.
4. Understand the legislative and tax rules. Land tax is a particularly controversial issue for property investors in NSW at present. In Victoria, the Retail Leases Act has made being a landlord more onerous as extra documentation is required to be given to certain tenants. Victoria has its own land tax issue, with the expense no longer allowable as a recoverable outgoing.
5. Put the role of property agents in perspective. While a good property agent can be helpful in identifying opportunities, it is important to remember that they earn most of their money by selling property.
6. Understand the mathematics of commercial property - that it is generally calculated on a per square metre basis, especially office and industrial property. This allows a quick comparison between large and small properties and if you are paying too much for a similar property.
7. Appreciate the difference between real estate speculation and property investment. Many developers engage in property speculation, which is a short-term strategy. They gamble that a property bought today will for one or more reasons (such as renovation or redevelopment) be worth more short term than in the long term it takes for values to appreciate, generally through inflation.
8. A long-term objective is the best approach for an investor. This allows the significant costs of property acquisition - stamp duty, agent fees and legal expenses - to depreciate over time. It also allows an investment to deal with unforeseen events.
9. Recognise that all forms of investment, including property, involve elements of risk. To claim that risk is not an element of property investing is absurd. Commercial property investment risks include a bad tenant, a new shopping centre that takes business away from a suburban shopping strip, or a more modern office building in a better location taking tenants away.
10. Fulfil the hands-on requirements of being a landlord. The role is time-consuming and requires considerable energy. It takes skill to negotiate with tenants so that both parties are happy. It involves knowing that it is in the interest of the landlord if the tenant is successful. If a business improves, any goodwill that accompanies this will, to some extent, flow on to the property. A successful tenant is more likely to want to buy the property from the owner and be willing to pay a premium for this.
11. Be realistic about such issues as the scope to develop a property and be aware of what this entails. Many commercial properties are sold on the basis that they have development potential and can deliver and additional speculative profit for those prepared to pursue this. Development takes considerable skills, such as dealing with local government bureaucracy, contractors, tradesmen and financiers.

Property Investment

The return available on property investment is similar in nature to that available from shares, in that part is received as income and part as capital growth. The income derives from rental receipts less expenses incurred, and capital growth comes from increases in market value. Property is not traded on a stock exchange; it is a matter of private transactions. Market values are therefore subjective estimates made by valuers unless the property is actually sold. Income, however, is generally more predictable than for shares, subject only to tenancy issues. Investment in property can be more involved than other equity investments. The investor can invest in property through property trusts as we well see shortly.

Types Of Property Investment

There are many different types of property investment, each with its own particular characteristics. These include:

• residential houses
• home units
• blocks of flats
• office buildings
• shops
• factories
• warehouses
• vacant land

In assessing the suitability of a particular property, the following factors should be taken into account:

1. Location

   Is the property in a suitable location for its particular type? Consideration should be given to both the immediate and the general locality and any zoning considerations.

2. Supply and demand

   Account should be taken of the current state of supply and demand, together with perceived future trends. Economic and legislative issues are likely to be relevant.

3. Management

   What is involved in the management of a particular property? Leasing and maintenance can produce many problems. These problems can be passed on to an agent, who will manage the property for an appropriate fee.

4. Income

   What is the likely income from the property and how secure it is? How long are the leases and what prospects exist for rental reviews? What is the expenditure likely to be, including maintenance, rates, depreciation and management fees?

Returns Available From Property

The return available from an investment in property includes income (the rental income less expenses) plus capital growth (arising from changes in market value).

The income yield is defined as:

(Income - Expenses) x 100
  / Current Market Value

Income yield varies according to the type of property purchased and its location. Income yields in the range of 4 to 12 percent are most common. The balance of the rate of return, i.e.: the capital appreciation, will depend on the particular property and the issues referred to above.

The capital growth is calculated:

Current Market Value - Beginning Market Value x 100
            / Beginning Market Value

It is generally felt that market values of properties tend to be more stable than ordinary shares, but much depends on the individual property. Generally speaking, an investment in property in a good location will tend to maintain its value in inflationary times and so provide a hedge against inflation. However, the costs involved in a property investment can be very high and can only be effectively amortised over a reasonably long period. The use of property as a short-term investment can only be of a speculative nature.

Comparing Primary Investments

Comparisons can be drawn between the various primary investment vehicles in a number of areas. We summarise some of these below:

Security

Fixed interest investments are considered to be the most secure, with a range of security rankings as described earlier. Top quality property would probably follow, with ordinary shares at the bottom of the list.

Rate of Return

Classical investment theory tells us that rate of return is inversely proportional to security. This is generally true if measured over the long term, but the short-term risk can obscure long-term trends.

Volatility

The term volatility relates to the tendency of values to fluctuate. It can apply to either the market price or the income of a particular investment.

Price Volatility

Fixed interest security prices will vary as prevailing interest rates change. This volatility can be substantial for long-term investments but is almost negligible at the short term.

Property values certainly vary with supply and demand factors, but generally for prime quality investments the volatility is not violent; changes take place gradually.

The volatility of the sharemarket is well known. Market sentiment is a powerful short-term influence, and price variation can take place at an alarming rate.

Income Volatility

There is generally no income volatility in respect of fixed interest investments. However, in cases such as the collapse of Estate Mortgage, income payments from underlying mortgages may cease.

Property income can be highly volatile due to tenancy problems such as vacancies, and the unpredictability of maintenance costs.

Share dividends, being paid from company profits, can also be volatile where profitability changes significantly.

Liquidity

Liquidity relates to the ease with which a particular investment may be sold. An ordinary share may be sold with complete ease on the Stock Exchange except in times of particularly low demand. This situation can apply to an individual share if something goes wrong with the company.

Fixed interest securities can generally be sold, particularly government bonds. Property can be very difficult to dispose of, and in any event the process tends to be drawn out.

Divisibility

This refers to whether part of a particular investment can be disposed of easily.

The disposal of part of a share bundle or fixed interest investment is certainly possible in the open market. However, property investment is generally indivisible.

Management

Investment management of either a share or fixed interest portfolio can be as active as the investor wishes. If the portfolio is passive, then management is restricted to banking the income cheques.

Property needs to be actively managed and often proves very expensive.

Equity investment, i.e. shares and property, can be expected to hold value in real money terms. Fixed interest investments provide no inflation protection on asset values although a degree of expected inflation can be built into interest rates.

Income

Income from a fixed term deposit takes the form of interest earned. Although there may be the risk of variation of interest rates, there is certainty that interest will be paid. The income derived from an investment property depends mainly on occupancy, rent interest rates, expenses, location and economic cycles. Speculative investments such as shares may yield a gain or a loss. Income from shares is in the form of dividends and is subject to investment risk where a company may choose not to pay out dividends for various reasons.

Investment Spread

Both a fixed interest and an ordinary share portfolio can provide a reasonable spread of investments with a relatively small investment. To obtain a satisfactory spread with property requires a very large investment. Even a simple property investment in the commercial sector would be outside the financial range of possibilities for most investors other than institutions.

Taxation

In simple terms, the rules are as follows:

• Fixed interest investments
  Income is subject to normal income tax. If the investment is sold for more than its purchase price, it is taxed as ordinary income. If it is sold for less than its purchase price that loss can be claimed as a deduction against ordinary income.
• Shares
  Income (dividends) is taxable, but tax on dividends may be reduced or negated by imputation credits. Profit on shares may be subject to capital gains tax on sale.
• Property
  Income and capital gains are taxable, but tax deductions are allowed on expenses and certain depreciation items and capital works.

As always, the choice of an investment will depend on the needs of the particular investor.

Foresight Is Key To Building Yields In Property Investments

Because properties are often quoted on our investment yield basis, one of the assumptions made about commercial property with the highest yield are the most popular from an investor's perspective.

It is an assumption that property buyers need to exercise some caution over as it is not necessarily true. In fact, it is often the case that low yields for commercial property reflects popularity instead of the other way around. The popularity could be for a particular type of property or a location.

With commercial property, it is therefore very important to study closely a property capital value and rental growth probability before making a purchase. Investors who can identify various types of property and location when there is rental growth potential will often enjoy greater success.

With commercial property rental growth potential can be inhibited by our existing rent review arrangement. If the returns from the rental income are static, the property will often show a low yield, especially if prices are rising and if prices are experiencing a spurt, the investment yields may look even worst. This shows that properties with a high yield, especially during a robust market, may actually be relatively poor investment in terms of either their capital potential or scopes to negotiate a more favourable lease arrangement.

One area of Melbourne commercial property market which has been experiencing success is the strip suburban shopping centres of Kensington, Yarraville, Elwood, Gardenvale, Port Melbourne, North Fitzroy, Northcote, and Black Rock, which have emerged as vibrant cafe and restaurant precincts, in response to the demographic changes and increased commercial activity in the surrounding area.

The more active investors with a developers' bent, there is scope to take advantage of the so-called government current 2030 strategy that allows certain strip shop areas to be developed into higher-density activity centres where two-storey suburban shops with land can be redeveloped into shops plus with two to four residential apartments depending on the are of the land. This represents a value-adding opportunity for more entrepreneurial investors to convert a shop with 4 percent investment yield based in the rental income into something bigger worth some more profit.

A selection of the highest-yielding commercial property sales over the last six months:

Housing Borrowers Staying On Course

More than 80 per cent of the household debt has gone into the housing market, where prices are now starting to fall and about a third of borrowing for housing has been poured into the rental property bubble.

But households in general are less exposed than we might have feared. Basically, the households bearing the largest part of the debt are those most able to afford it. Household debt (most of which is connected to property) rises with the net wealth of incomes.

Higher incomes and higher net wealth means households can survive higher debt levels and are less vulnerable to changes in property values and interest rates. The most vulnerable to changes in the property market are the highly geared investor in rental property, where excess supply has pushed rental yields below dividend yields and earnings on fixed interest.

More than 10 per cent of households report having an investment property and 55 per cent of those investment properties have debt on them although the Reserve Bank points out that this is likely to be understated.

However, about 70 per cent of investment property is owned by households in the top 40 per cent of the income distribution and about half of all investors household are in the top 20 per cent of wealth distribution. Generally, investor households are older and higher incomes (across all age groups) than non-investor households, although the younger investors are more likely to be negatively geared.

The distribution of debt and rental property investment is a stabilising factor in the market. That is the likelihood of forced sales and a consequence of collapsed property prices is less than it would be if large number of low income, low wealth households had been sucked into the market.

Older and higher income investors are less likely to have to sell in the face of higher interest rates or lower rental yields or capital losses.

The property investment market remains overwhelmingly an activity for those with above average incomes. Also there is no evidence that there is a higher proportion of less sophisticated lower-income earners has entered the property market in recent years.

The number of property investors has risen by one third in recent years and one of the most important factors during that growth has been rising incomes. Ironically, we are seeing the flip side of bracket creep, with taxpayers moving into rental property investment as their income and marginal tax rises.

Whilst housing prices have overshot the market fundamentals and a greater number of negatively geared investors are a force for increase price volatility, however the market adjustment is likely to be more in the nature of an extended period of stagnating prices rather than a price collapse. This is partly because homeowners and investors historically have preferred to hold on to properties until inflation has wiped out normal capital losses.

Also, there are still a number of other powerful factors working in favour of price stability;

• That 70 per cent of Australians are owner-occupiers and are unlikely to sell if property prices fall.
• Australians lending for property is typically on the basis of full-recourse mortgages. That reduces the attraction to borrowers of defaulting.
• A further issue is the likely direction of interest rates in any severe downturn.

While interest rates have a powerful effect on housing prices, a bigger threat on the property market is rising unemployment. Heavily geared property buyers, first homebuyers, ambitious house upgrades and negative geared investors are most likely to default if they lose their jobs. The RBA will almost certainly be culling interest rates if unemployment rises. There have been occasions where unemployment and interest rates have risen at the same time, but they are rare - and they have been made less likely by increases in household debt.

The RBA will cut interest rates aggressively if property prices bubble (likely to go into a free fall) threatens economic activity from the property bubble causing a major correction with its negative consequences on consumers and business confidence.

How To Find The Best Values In Commercial Property

Property investors need to broaden their view. The boom in residential property has drawn prices to levels where mean investment yields are down to 2 to 3 percent par in Sydney and Melbourne and 3 to 4 percent in other cities.

For property investors as distinct from home buyers, rather than buy residential property at these low investment yields, why not consider commercial property where yields are 2 to 3 times these levels depending on when you buy.

While the main commercial alternatives - retail, office and industrial - are often viewed as sectors for more professional investors, they also offer opportunities for private investors. In essence, the weight of money that has gone into residential market alone in 2003 has been irrational.

In fact, on our investment basis, the income returns in the non-residential markets have been far more attractive. Income returns offered from the commercial property are often superior to residential returns. But people who understand how residential property investing are in a minority compared with those who reckon they understand residential property.

While there are more private investors in residential than commercial property and that the commercial market also attracts many professional investors and property developers, from an investment perspective, there is no real reason why private investors shouldn't be involved with commercial sector.

The attraction of commercial properties bought as an investment includes the fact that properties are generally leased for three and five year terms, and three and five year renewal periods. This contrasts with one year terms and six monthly renewals that are the norm for residential leases.

From these leases, a commercial investor can earn net income returns of between 5 and 10 percent in the property that's actually a lot more affordable than many people think. It is possible for instance, to buy a suburban office suite or a small factory unit as an investment for the same price as a suburban home unit.

For the price of a reasonable quality freestanding home, an investor can buy a well-treated shorter-title shop in a shopping strip.

The main reason there are more private investors in residential than commercial property is familiarity. It's probably a big leap from being a residential property investor for which they feel more comfortable with than buying a shop or office unit. The principle reason more individuals focus on residential is the lack of knowledge about commercial property.

A significant market of commercial properties owners are immigrants who bought a shop or warehouse from which they run a business to support their families. This is often the case with immigrants that their children are encouraged with higher education and they are not interested in taking over the family business. As a result, the owners often end up selling the business and renting the property, which proves to be a good source of retirement income.

While this is one important category of investors, a new and growing group are trustees of self-managed super funds. Superannuation rules allow DIY funds to take investments in business real property from which a business is being run. This includes business properties owned by the fund members or their relatives. As long as the property is encumbered by a mortgage or used as security in any form for other investments, and is a good investment proposition, a self-managed super fund can be a sole or part owner.

The growing numbers of self-managed super funds are being targeted by commercial property developers particularly of office suites and factory units. The attraction being these self-managed funds are looking for property investments that are small offices or factories that can be cheaper than home units. There has been a growing appeal for commercial properties with a three year lease with a three year option are within the attractiveness ball park, small office suites have been particularly attractive amongst the professionals.

A number of developers have bought deeded offices and refurbished them to a high-standard small office building (50 squares). The facilities can include a gym boardroom, separate and shared amenities, and a reception area.

The buildings tend to attract professionals as tenants or owner-occupiers and have been popular with investors. New strata office suites of about 200 squares with amenities and parking could be bought for around $2,500 to $3,500 per square metre whilst boutique-style suites with shared facilities of up to 70 square feet range from $5,500 to $6,500 per square metre.

Infrastructure As Property

Where land and improvements form the basis of infrastructure assets, and the operation of the underlying business is contracted to a third party, infrastructure may be classified as property.

Infrastructure Definition

Infrastructure is a general term for facilities and services required by the community and for production. Around 70 percent of Australia's stock of infrastructure is commonly referred to as "economic" infrastructure. It comprises road, rail, air transport and communication facilities, and the production and transmission utilities for electricity, water and gas. Government business enterprises (state owned) have provided the majority of utilities infrastructure.

The remaining 30 percent of infrastructure assets are categorised as "social" infrastructure, usually provided by governments for communities. It includes hospitals, prisons, schools, police stations and day-care centres.

Infrastructure As A Property Style Investment

Classification of infrastructure as property requires examination of the key attributes. Return expectations, return structure from income and capital gains, the security of the income stream and investment timeframe may be common characteristics.

Broadly defined, property assets are undeveloped and developed land and any buildings or developments on the land. A key characteristic is the security of rental income.

Infrastructure might be considered as property. Specific screens, which assess projects in terms of classification as property, equity or debt are required. Project level analysis is required in terms of the definition of property and whether returns is principally driven from property assets, or from business activity, or from a loan.

A key first examination is in terms of the definition of property. Does it represent land, which then generates rental returns? If this test is passed, does it generate return principally from property or is property peripheral to the business activity? Each infrastructure investment needs to be examined in this framework.

Business risks, as distinct from financing or management risks, which arise in property investment relate largely to the structure of the rental arrangements. Generally, rental is subject to the credit risk or covenant of tenants. Rental, which is related to business turnover - common in investment property - is also a reflection of credit risk. The risk shifts to an equity risk when rental is dependent upon the profitability of the business. One example is toll roads, where the owners choose to rent the road to a toll operator, which then bears the associated business risk, being the number of cars using the toll road. In this case, the owners of the road retain the property investment characteristics - rental stream and capital growth - and the toll operator bears the equity risk.

Infrastructure Finance Providers

Traditionally, infrastructure projects have been government-owned, funded by the issuing of debt. In the last decade there has been a shift towards privatisation of infrastructure assets, including utilities.

The use of private sector debt, equity or property finance for projects that would otherwise be directly funded by government provides potential advantages. It contributes to retaining the AAA credit ratings applied to the Commonwealth and most state governments, and frees up government revenue for other priorities.

In Australia, this relationship between public and private sectors is referred to as Public - Private Partnership (PPP).

In Victoria alone, there are currently almost $10 billion of major projects being delivered across the state, including Australia's biggest current Public Private Partnership - the Spencer Street station redevelopment.

Investment In Infrastructure

There are several listed infrastructure companies that allow investors to buy into infrastructure assets, including Macquarie Infrastructure Group, Transurban, Hills Motorway and Australian Infrastructure Fund. There are also unlisted specialist funds offered by companies such as AMP, Colonial First State and Hastings.

What Asset Class?

Debt funding for infrastructure will be judged on the merits of the loan security and the issue terms. Inflation-linked interest rates are commonly used in preference to nominal interest rates.

Ownership of the business integral to the infrastructure project, such as the toll operator or a hospital manager, is an equity investment.

Where the freehold or leasehold land and improvements are owned and the business of operating the facility is contracted to another company, it ranks as property.

Where the land and business are integrated, such as an electricity distributor and there is some public control over pricing, this would rank as a utility equity investment.

Share And Share Alike - An Insight Into Property Syndication

Property syndicates allow investors to own property, generating secure, high-yielding and tax-effective direct property returns. However, they are not risk-free investments.

While still in its early stages, the property syndication market is rapidly growing in Australia, expanding from a zero base in 1994 to more than $8 billion today. Research house Property Investment Research (PIR) reported that at June 30 2003, there were 303 syndicates, with an average asset size of $26 million.

Property syndication involves a group of investors who pool their funds to purchase a property. It enables investors to target a specific property, which you cannot do to the same extent in a managed investment. The investor group can comprise a few investors pooling millions of dollars each to purchase a property, or hundreds or thousands of investors each contributing a few thousand dollars. The properties purchased are typically large-scale commercial office, retail or industrial properties.

Unlike The Others

Property syndicates have certain characteristics that make them different to other types of property investments. These include;

• Fixed term - syndicates typically have a fixed life of between five and twelve years, after which the property is sold and the capital proceeds returned to investors.
• High yields - yields generally range from between 8% and 12% per annum. These high yields are achieved through gearing enhancing the rental yields.
• Gearing - levels of gearing range between 40% and 65% and are generally higher compared to listed property trusts, which average around 54%. The debt comprises a non-recourse loan, thereby limiting the investor's liability to the amount of their initial investment outlay.
• Liquidity - while certain syndicates do facilitate transactions, most syndicates are illiquid investments.
• Fee structures - most property syndicates have performance-based fee structures. Significant up-front acquisition fees are charged.
• Attractive tax benefits - the structure of property syndicates enables some or all of the income earned to be tax advantaged via depreciation allowances.

Room For Risk

Despite their attractions, property syndicates are not risk-free investments. They possess distinctive risks.

Given that the quality of the property is the key to a successful property syndicate, investors should ensure the property is low risk in terms of location, age, tenant quality and lease expiry. Syndicates comprising older properties and properties in secondary locations may offer higher yields, but with greater risks attached, such as capital expenditure required to maintain the condition of the property during the investment term.

Investors should closely analyse the market research and financial analysis contained within the syndicate prospectus, to ensure the property is reasonably priced for the risks involved such as gearing levels or over-renting.

Over-renting refers to the situation where the rent payable by the existing tenants is significantly greater than the market rent, making future releasing at the same rent unlikely.

Given that the dynamics of the property market can rapidly change from undersupply to oversupply, or through interest rate changes, investors should consider risks associated with realising the value of the property at the end of its fixed term. A clearly defined exit strategy is crucial for successful syndicates.

Investors should seek syndicates managed by an experienced licensed manager. The syndication market is extremely fragmented, including many small and inexperienced players.

Prospective investors should consider that a diversified approach by including a number of syndicates and listed property securities in a portfolio to ensure a more attractive risk-return outcome.

Property Syndicates Built On Shaky Foundations

No doubt some property syndicates are well managed and will produce sound returns for investors. However, certain features, which are quite widespread in syndicates, could be considered entirely unacceptable in any other form of managed investment. (I acknowledge up front that there are individual variations that this article cannot take into account.)

A fundamental problem faced by all managed property investments is the challenge of liquidity in a pooled investment structure, which holds illiquid assets.

Unlisted property trusts floundered at the start of the 1990s. Sentiment turned against property and they suffered substantial net withdrawals. They found themselves with a queue of redemptions when the funds were tied up in buildings, which required considerable time to sell in an extremely weak market.

Listed trusts solve the problem by trading units on a stock exchange but with the consequence of increased volatility. It is sometimes argued that these provide inadequate portfolio diversification, as they tend to move in line with equities. There have been times when this was so, but certainly not in recent years. The returns from the All Ordinaries Accumulation Index and the Listed Property Trust Accumulation Index have diverged materially. In fact, listed trusts have been an excellent diversifier while stock markets have been weak.

The structure of property syndicates varies, but generally, they address the liquidity problem with a fixed term with no redemption rights in the meantime. This does prevent withdrawals from causing the structure to collapse, as occurred with unlisted trusts. However, saying to investors who wish to withdraw that they can't does not solve a liquidity problem - it is a liquidity problem.

Having to irrevocably commit capital to an investment for a period of, say, a decade, irrespective of changes in personal circumstances or investment markets, is inherently undesirable. Investors would surely require the prospect of a much higher return than from an alternative investment to reward this increased risk.

In any case, investing with a sale date determined years in advance, irrespective of whether it is an attractive time to do so, is an unusual concept.

However, there is often the possibility of extending or shortening the term by a vote of investors. The idea that one's right to sell an asset or not is out of one's own control, and is subject to a vote of strangers who don't understand or care about one's personal financial situation is, to me, abhorrent. Imagine the sense of loss of control if you vote for termination and the majority do not.

There is also substantial evidence that inflow into market sectors is greatest when they are at a peak and outflow is greatest at a low point. Thus, one could find that the majority votes to wind up the fund at the very worst time.

The lower perceived volatility of syndicates arises from the fact that the properties are only valued periodically, say annually. Valuation is a very inexact science as anyone who has ever received an estimate of his or her property value before putting it to market knows.

Valuers must base their appraisals on evidence, usually recent comparable sales. In the 1990 unlisted trust debacle, everyone knew that the market was collapsing but the latest transactions of landmark properties had been at the peak. Thus, the prices ultimately realised for prime properties were far from net tangible assets.

Similarly, syndicate investors do not have a precise idea of such basic information as what their investment is worth at any point in time.

Syndicates usually incur exceptional costs. The transaction costs of managed funds, including listed vehicles, are only those you incur to buy/sell the units. You do not have to pay for the entire costs of establishing, and later terminating the trust; nor those of buying and later liquidating the entire portfolio. The fund and the portfolio precede and endure beyond your tenure as an investor.

In a syndicate, the investors have to pay for the creation and termination of the fund and the acquisition and disposal of the properties. As real estate carries much higher buy/sell costs than any other asset, these must have a material impact on return. I have seen syndicates where these were likely to exceed 15 percent of investors' initial capital (due to gearing).

In addition, some syndicates carry much higher managed expanse ratios than are generally acceptable for listed trusts. There are also examples where initial fees are described in ways that can mislead the unwary. For example, I have seen entry fees described as being five percent of the 'value of the properties'. This was in a fund which geared 1:1 so it represented 10 percent of investors' capital.

However, fee structures vary widely so it would be unfair to generalise. Sharp practices with fees are not exclusive to any one-investment type.

Many syndicates have very high gearing. By definition, gearing increases risk.

In principle, I believe it is better to have investors gear to the extent that they wish and buy ungeared assets, rather than invest in funds with internal gearing. This allows for separate decisions to be made about decreasing gearing or selling the asset. For example, if it was believed property was in a period of flat growth, it might be appropriate to invest in it, but not to gear into it.

While the portfolios of syndicates will vary widely, it is common for them to offer a very high-income yield. Double-digit income is not unknown. It is a tautology to say that a high yield property is one which commands a low price for the rent it produces.

The naïve might hope that if, say, a 10 percent yield is added to growth in line with inflation, say three percent, there is the prospect of a spectacular return. Indeed, this would be spectacular - but highly unlikely. No one would buy a property yielding five percent if there were properties yielding 10 percent with equal security and growth prospects. A property selling cheaply (ie: a high yield) is doing so because of risks either to the future income stream or capital value.

Today, gearing increases cash flow as rental yields exceed the rate on borrowing. However, if it is acknowledged that high yield properties are trading at lower prices because they have the prospect of lower growth, this is an unusual asset for gearing.

The strangeness of the syndicate structure may simply be illustrated by the analogy with a hypothetical investment offered by the "You Can't Be Serious Asset Management Company". This will be an equity trust with some unusual features.

The fund will have a 10-year life and can't be redeemed in the meantime, no matter how much your personal circumstances or market conditions change.

However, the majority of investors can out-vote you on whether you can access your money at the end of the term or at other times.

It will have much higher costs than a typical managed fund, particularly in regard to buy/sell expenses.

It will involve a high degree of gearing, fixed years in advance of knowing market conditions.

You will not have a very precise idea of the investment's value at any time over the next 10 years. Once a year, there will be an approximate estimate made. This may have a benefit in that you will experience nil volatility during each 12-month period.

If a fund manager approached financial planners with such a proposal the reaction is likely to be: "You can't be serious!"

Not all syndicates are structured this way, but a significant proportion is. These funds differ from this analogy mainly in that they invest in property rather than shares.

Is the fact that you actually know what a listed trust is worth at any point in time, and therefore recognise its volatility, so undesirable as to make the syndicate structure more attractive?

The Risk And Realities Of Real Estate

For those interested in residential property investing as distinct from buying a home, a less frenzied market is often a better time to assess opportunities and have a realistic look at what properties offer.

There are many investors who like property but have been holding off investing during the boom times and some may be eager to get in because they believe they missed out on the latest price increases. But it is important that before they buy property, no matter how comfortable they may feel with it, that they consider such issues as risk of having their portfolio dominated by a sizeable property asset. The classic asset allocation models suggest a 10% portfolio allocation to real property which is one reason why financial planners suggest property as an investment for their highest net worth clients.

Investors need to understand the property cycle

• Investors need to be aware of property's cyclical behaviour and that three or four years of impressive growth can be flowed by up to seven years of little price movement.
• To be safe, this suggests a 10 year outlook for property investment because it helps to spread the high entry and exit costs of going into property such as stamp duty when you buy and the agents commission when you sell.
• Investing in property requires an appreciation of interest rates, how rate rises can affect costs.
• It is important to be able to afford periods when property might be vacant.
• Investors need to keep a tax side of the property investing in perspective, particularly with depreciation deductions. Two types of depreciation allowances may be available to investors - a 2.5% or 4.0% building allowance against the cost of the building. The rate depends upon the age of the building.
• But the major depreciation deduction promoted by project developers, is for plant and equipment such as carpets, a hot water system and window furnishings. For new projects, these deductions can look impressive but it should be noted that they only last four or five years, depending on the depreciating method chosen. There are faster ways of depreciating these assets (the diminishing value method) that will enhance tax deductions against rental income for a few years.
• But investors will often then face the cost of replacing many of these items for which they have been allowed deductions. This means that they are not in the same league as such concessions as the evergreen tax credits for share investors under dividend imputation rules.
• Once the depreciation allowance runs out, investors face the prospect of paying income tax on their higher net rental income at their personal tax rate.
• The tax advantages associated with real estate are often misunderstood and their value overstated. New investors may overlook such extra costs as land tax.
• The principal tax advantage of property is the capital gains tax concession which is also available on other investments.