October 2012 Market Update

Equity markets performed strongly over the quarter, as promises of unlimited bond purchases by the European and US central banks were met with an enthusiastic response. Markets did retreat late in September as the European Central Bank’s (ECB) bold statements collided with European political reality, with the Portuguese government responding to street protests by reversing a recently-announced tax increase, and Germany, Holland, and Finland reneging on a pact announced in June to allow ECB bail-out funds to directly recapitalize Spain’s banks.

European markets led the way with gains of almost 7% in AUD, while Japan retreated 3.4% as companies there struggle to regain competitiveness and relevance, and China fell by 6% as overcapacity is leading to declines in corporate profits.

The start of October we have seen the Reserve Bank of Australian cut interest rates by 0.25% with the official cash rate sitting at 3.25%. This is good news for mortgage holders but not so good for our clients that are self funded retirees as the cash interest rates reduce further. Presently there are also weak retail spending numbers which could add to the case for further rate cuts leading up to the end of the calendar year. These weak retail spending numbers have added to the woes of the already troubled sector. The figures were a marginal increase on last month’s numbers but still managed to disappoint the market and impact the share prices of retail related companies.

As commodity prices decline and slower expansion occurs in China investors are not being compensated for by any fall of the Australian dollar. With the rate reduction from the Reserve Bank this should revive the residential real estate market which has been lower over the past quarter and we should see the Australian Dollar reduce slightly, however it is still above $1.01 US Dollars at the moment.

Gross Domestic Product (GDP) growth is being affected by the shrinking revenue gain from coal and iron ore exports. However, GDP could still rise by some 3% per annum with the recent rate cut. The RBA’s “Financial Stability Review” has reported that households are now more likely to save than before which is good news for the banking and financial sector and bank share holders.

Australia cannot rely solely on China as the importer of its commodities. China is still dependent on demand from external markets such as the US and Europe. Continued weakness in Europe and the US means slower growth in China and, consequently, lower prices for commodities. According to the International Monetary Fund, each one per cent decline in China’s fixed asset investment causes the price of iron ore to fall by 0.8 per cent within a 12 month period. This has resulted in short term reduction in prices of companies such as BHP Billiton (BHP) and RIO Tinto (RIO).

There are few changes to our approach which is to get clients into a portfolio of between 10 – 15 stocks with the following characteristics:

  • Business quality – we look to own businesses whose intrinsic value is rising over time. This is achieved by earning returns on invested capital well above their cost of capital on a sustainable basis.
  • Balance sheet quality – we want to invest in businesses with low levels of financial risk. This is always important, but especially during a period of weaker economic growth and stressed capital markets.
  • Management quality – we look for management to allocate capital for the benefit of shareholders. This means an emphasis on small, accretive acquisitions and share buybacks over large deals where value destruction is common.
  • Attractive valuation – we want to be owners of businesses with the first three criteria only when they are available at value prices. This valuation margin of safety is integral to preserving your capital as well as achieving attractive returns.

If you would like to review your current arrangements please contact our office.