Newsletter – October 2007

01/10/2007 Level One

BIS SHRAPNEL – are leading Australian economic and industry forecasters.

Recently their Sydney conference outlined some interesting views on the current state of the economy and their thoughts of what is in store in the coming years. Interest Rates – BIS’ official position is that we will see another quarter of one percent rise early next year.

Their unofficial position however was that we could expect more rises thereafter. Interestingly, BIS chief economist Frank Gellor painted the picture of our economy growing at a strong forecast 4.3%.

This growth was primarily a result of the resources boom. However Frank pointed to the fact that generally speaking (except for Western Australian and Queensland) residential property prices have been declining for the past 5 years.

Usually after 5 years of such deterioration, confidence spending and growth rates are down and the Reserve Bank of Australia is cutting interest rates to stimulate the economy and hence residential property prices.

So we now have the resources boom pushing the economy along at a strong 4.3%, unemployment at 30 year lows and the economy being held back by supply constraints.

Net migration was 80,000 – 90,000 per annum when John Howard came to power. Currently net migration stands at 175,000 per annum and is forecast to grow to 185,000 per annum.

Furthermore State Governments are beginning to spend. Recent history has seen state governments run balanced budgets but recent changes have seen large scale infrastructure spending initiatives announced and commensurate budget deficits forecast.

These fundamental changes are designed to improve our productivity and efficiency in an ever competitive world.

They also however fuel a strong and growing economy albeit excluding residential property.

So with the economy strong and the planks in place to have this continue, the real risk to the economy is inflation as oil prices and wage pressures filter into rising business costs.

The extent of this inflationary pressure will ultimately determine the extent of future interest rate rises, as will events unfolding in the U.S.

But make no mistake, these circumstances are unusual indeed. To have the country facing further interest rate rises to curtail inflationary pressures after 5 years of negative growth in residential property prices is not normal.

This obviously will not help residential property prices in the short term, but we must consider that as the new year approaches and we get interest rate rises we are getting further through the current cycle, and the inevitable upturn must come. Whether it be in 2, 3 or 5 years time, time will tell. One thing for certain is that it will come.

People argue about affordability of property prices but we are building a pressure cooker in residential property. While net migration is at historically high levels so too is the natural population increase. When a forecast increase in the natural population to be 130,000 next year we are going to need more accommodation.

With further interest rate rises expected by the Reserve Bank in an attempt to keep a lid on wages and inflation pressures, residential building commencements will continue to plummet. Five years of falling residential prices (except Western Australia and Queensland) has seen builders exit the market on masse already.

It is projected that underlying demand for new residential property is growing at about 49,400 per annum while actual commencements are running at 30,000 per annum. A shortfall of 19,400 is projected for 2007 and a shortfall of 41,400 for 2008.

So you can see interest rates, the commodity boom and residential property construction and prices are all impacting significantly on the Australian economy.

Several things seem certain. All markets work in cycles. The length of those cycles and the extent of the high’s and low’s are uncertain.

The commodities boom will continue for some time, interest rates will rise further, housing shortages will grow, interest rates will fall.

As they say, the more things change the more they stay the same.

Share Market Returns

Have been extraordinary of recent times. For the last 4 financial years the ASX200 has returned the following results:

2003/04  22%

2004/05  26%

2005/06  24%

2006/07  29%

Diversified investors such as Conservative, Balanced, Growth or Assertive investors who have some of their portfolio in cash, fixed interest, property or international shares will not have faired as well, but then they will not have run the risks associated with such high returns either.

Emilio Gonzalez, Chief Investment Officer at Perpetual Funds Management recently spoke of these past 4 years and noted that such a run on the share market has never before been experienced. With a lifetime of experience and $25 Billion to manage at Perpetual, Emilio expressed caution in the current climate and a focus on quality businesses. These returns, while extraordinary have in the most part been supported by strong profit growth and hence justified.

This has primarily been underwritten by the commodities boom and increased flexibility in the labour market. Valuations have however begun to get ahead of earnings and hence we approach more market volatility in the months ahead. Market reactions to unexpected news will be swift and probably overdone.

Owning quality businesses with quality management and resisting the herd mentality will place long term investors in good stead.

Like most cycles, all good things come to an end. But with superannuation growing at such an extraordinary pace the “weight–of–money” argument continues to support the market.

In 1992 Australia had $160 billion in superannuation. In 2007 we have just passed the $1 trillion mark and growth is expected to accelerate from here.

CSL – A Great Australian Company

CSL was founded in 1916 as the Commonwealth Serum Laboratories, to meet the demand for locally produced biopharmaceuticals in a country isolated by war. Throughout its history CSL has been a leading national investor in research and development.

CSL was the first to supply Australia’s public with such life-saving products as:

• Insulin

• Penicillin

• Polio Vaccine

In 1994 after a period as a corporatised government company CSL was listed on the Australian Stock Exchange.

We bought CSL in some of our client portfolio’s for between $20 – $30 per share during 2000-2002.

Many clients were unhappy with this selection when in 2003 the stock price fell to a low of $10.70. For some reason the market thought CSL was a marginal biotech company and savaged its share price when that sector was “on-the-nose” with investors.

Despite some clients being unhappy with our stock selection in this case we decided with the research of UBS that we would not sell but hold the stock believing in the company’s products, markets and quality management. Well on October 2, 2007 CSL traded at a high of $109.50. The moral to the story of course is to know what your investing in, understand it and don’t necessarily run with the herd.

Fear panic and greed push markets and stocks excessively high and excessively low, based often on emotion with little regard to fundamentals.

Our job as advisors is to hold the course and keep our eye on the longer term game and not get caught up with short term trends.

Oh and you might be interested to know that CSL recently developed a Cervical Cancer vaccine. A free national immunisation program is now under way, funded by the Commonwealth Government, this vaccine is being widely distributed to young women in Australia and the U.S.

As for the financials to June 30, 2007 CSL reported as follows:

Total Revenue of $3,310million, up 14%.

Net Profit after Tax of $521 million, up 48%.

Research & Development Expenditure of $191 million, up 19%.

Dividends Paid

April 13, 2007         49¢    unfranked

October 12, 2007*  55¢    50% franked

* up from 40¢ the previous year.

Instalment Warrants

are now allowed in Self Managed Superannuation Funds (SMSF’s). From September 24, 2007 SMSF’s can effectively borrow or gear an investment with the use of an instalment warrant.

Essentially an instalment warrant is where a trust buys on your behalf an asset with 2 payments required. One payment upfront and one on completion of the contract, often 1 to 5 years away. If you make the final payment on completion of the contract, you receive the underlying asset.

The warrant provider will charge you interest and fees which are calculated and included in each of the 2 payments but you will receive all dividends, imputation credits and capital growth on the asset from inception.

The use of instalment warrants will greatly enhance SMSF’s ability to gear into the share market and even now into property in some limited circumstances.

Caution and careful planning would however be advised.

Like most gearing strategies, unless you get good capital growth from the underlying asset you could end up worse off.

How Much Superannuation Do I Need to Retire?


Opening BalanceWeekly DrawdownDrawdown Commencement
Age 55Age 60Age 65
Funds Exhaused at Age
$600,000$600Age 100+Age 100+Age 100+
$700,000$800Age 100+Age 100+Age 100+
$800,000$800Age 100+Age 100+Age 100+
$900,000$1,000Age 100+Age 100+Age 100+
$1,000,000$1,000Age 100+Age 100+Age 100+
$1,500,000$1,500Age 100+Age 100+Age 100+
$2,000,000$1,500Age 100+Age 100+Age 100+
$2,000Age 100+Age 100+Age 100+

Assumptions: an annual return net of all fees and charges of 8% p.a compounded monthly. with inflation at 3% p.a. Annual draw downs indexed at 3% The above calculation does not take into account taxation payable (only applicable to persons aged 55 – 60), Centrelink benefits that may be received or income from other investments. This information has been provided as a guide only and should not be relied upon as being specific to your situation.


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