Letting the Bear have his say

The latest lack of updates on this blog is not due to my usual distracted state, but instead due to the lack of an update of material substance from my two key sources Christopher Joye and Steve Keen. So, I was extremely happy to discover yesterday, that both sides have new articles on www.businessspectator.com.au.

As I attempted to disect Christopher's work last time, in this post I will focus on Steve and his article "Wading through the housing furphies". 

There are at least five residential price indexes.  Steve's view is that only the index by the ABS counts, because they are the only group producing an index without any interest in what the index states.  It's a plausible argument, although a somewhat damning inditment on the Real Estate Institute of Victoria, RP Data-Rismark, Australian Property Monitors, and Residex.  

The ABS numbers show a 1.1 per cent fall in the median price for Australia over the March quarter. Steve writes "Australian house prices have now fallen 6.1 per cent from their peak, and have been falling for 21 months, which is the longest downturn in nominal prices ever recorded by the ABS – the previous longest being the 12 months from the beginning of the GFC (which was terminated by my favourite government policy of all time, the First Home Vendors Boost)." In real terms, over the period the drop is not 6.1% but 10%.  

Steve then compares the Australian market to the bubbles in Japan, which peaked in 1991, and in the USA, which peaked in 2006.  The decline in Australian prices is tracking along a similar path to Japan's, while the USA decline was much worse.  The Japanese decline however, has continued for the subsequent 18 years, with prices now less than 40% of what they were at their peak. Before finding a window ledge to jump from however, consider a comment below the article by a fellow called Graham Jacob, who writes that Japan has a falling population with no end in sight to this trend.

Steve's argument is that Japan and the USA are relevant, because in all three cases (Japan, the USA and Australia), prices were driven upwards by accelerating debt (63% correlation in Australia).  Steve doesn't define debt acceleration, but I'm guessing it means the percentage change in the dollar value of mortgage debt from one quarter to another.  (Note, 63% correlation in lay man's terms, mean that 63% of the change in house prices is due to the change in mortgage debt levels, ie I as purchaser can afford to pay more for the house I want because the bank agrees to lend me more money and I agree to borrow more money.)   This raises the question, what is causing the other 37% of the change.  I also have issues with seeing debt acceleration as a root cause.  Debt acceleration doesn't just happen, people decide to borrow more and banks decide to lend more - the question is why?

Steve goes onto explain that at present, the ratio of mortgage debt to GDP in Australia remains higher (or close enough to it) than it has been since 1990, when the graph starts.  So, in essence, [my interpretation] debt accelaration has done all it can do to push prices as high as they can go and a likely fall in debt accelaration will cause prices to fall.  

Steve's view is that the housing market will continue to decline and it will decline faster.  His reasoning for this is that baby boomers have invested in residential property to fund their retirements.  As the market is dropping, they will look to get out, causing further falls.  He references this article "Australia's loss-making landlords" for his evidence of this.  However, I note that "Australia's loss-making landlords" does not mention baby-boomers at all.  Instead is says that 63% of property investors are negatively geared (ie rent is not covering their expenses).  I would have thought that if you are near retirement, you would be in the 37% of investors who are not negatively geared because you have held the property long enough to reduce / repay the mortgage.  If you are instead getting an income from your investment, I doubt you would sell. I would like to know what percentage of properties are held by negatively geared baby-boomer investors before I'll accept this issue will make a significant impact on the housing market.  

This article has not done a lot to improve my understanding of the residential property market or to assist in taking a view on which way prices are going.  I accept that a drop in debt acceleration will reduce prices, but what is causing the drop in debt acceleration?     

New Topic - House Prices

They say necessity is the mother of invention. I find it necessary to find larger accommodation and my preferred form of that accommodation is a house - specifically one with three bedrooms, a laundry, a place to dry clothes undercover, a linen cupboard, a two car garage and lastly, the real icing of the cake, a study.

As such, I am switching the topic of this long neglected blog from the share market to the housing market and the question of whether it is a good time to buy or sell?

My main source of information on this topic will be that venerable institution www.businessspectator.com.au, where in a war seems to be being waged between Christopher Joye (on the buy side) and Steve Keen (on the sell side).


So first I will look at Chris's article "Housing affordability returns, but for how long?" in which he presents his company's approach to measuring house affordability.  The article doesn't draw many conclusions other than to say that the house price to income ratio peaked (bad) at what seems to be about a year ago and has since fallen back (good).

However, when I look at the last graph,  I can't help but think that from March 1993 to about March 2001, a fairly decent period and who knows how long before that, the ratio was between 2.5 times and 3.0 times. I am old enough to remember those years and I know people didn't spend much time worrying about house prices back then.

Then there is a steady rise until about March 2004 (I purchased my apartment in April 2004). During these years I remember people just holding out waiting for prices to drop at any moment, because the prices seemed absurd.  I took the view that house prices don't come down in absolute terms and I needed somewhere to live, hence I dived in. I'm glad I did, because house prices just kept going up.

From about March 2004 until now, the trend in the affordabilty ratio has been fairly flat and people have spent a lot of time complaining about house prices being too high.  I can't help but think that something's got to give and at some point we will see a return back to the 2.5 - 3.0 times band. When and how? Well that's the $64,000 question.

One more time with ... tables!

I learnt a new skill.  It's how to create tables in html. I then learnt an even better skill, how to get Excel to create tables in html, so here is my first table created by Excel:

		2010	2009	2008
	Notes	$'000	$'000	$'000
Premium revenue	5	901,370	829,486	758,238
Claims expense		(635,929)	(599,297)	(553,910)
HBRTF/RETF Levy		(109,898)	(86,978)	(73,128)
State levies		(22,045)	(21,177)	(19,922)
Claims handling expenses	6	(14,407)	(18,384)	(17,683)
Net claims incurred		119,091	103,650	93,595
Acquisition costs	6	(32,512)	(26,642)	(25,625)
Other underwriting expenses - ongoing	6	(39,514)	(36,847)	(34,916)
Other underwriting expenses - demutualisation and listing costs	6	0	0	(10,858)
Underwriting expenses		(72,026)	(63,489)	(71,399)
Underwriting result		47,065	40,161	22,196
Investment income	5	45,794	(1,167)	8,783
Other income	5	1,291	1,183	1,463
Investment expenses	6	(1,344)	(651)	(1,325)
Other expenses - ongoing	6	(5,840)	(7,931)	(3,548)
Other expenses - donation to nib foundation	6	0	0	(25,000)
Other expenses - demutualisation and listing costs		0	0	(7,640)
Profit/(loss) before income tax		86,966	31,595	(5,071)
Income tax expense/(benefit)	7	(25,441)	(7,809)	5,421
Profit/(loss) from continuing operations		61,525	23,786	350
Profit/(Loss) from discontinued operations			0	54
Revaluation of land and buildings			(3,156)
Available for sale financial assets			(88)
Income tax related to components of other comprehensive income			26
Profit/(Loss) for the year attributable to equity holders		61,525	20,568	404

This table sets out the Profit and Loss statements for the years 2008 to 2010 as they appear in the financial statements.  I've added it here because I re-read my last two posts and I couldn't understand them.  I figured if I, being the one who wrote them, couldn't understand them then what hope does anyone else have.  So here is a summary of the two posts with tables, which hopefully will make things much easier to understand.

So, we use the historical P&L to work out the "indicated earning power" or in other words, how much money we think the company can make.

Step One is to remove the non-recurrent items, that means anything that is a one off.  The presence of zeros is a good indicator of this, ie the items "Other underwriting expenses - demutualisation and listing costs", "Other expenses - demutualisation and listing costs" and "Other expenses - donation to nib foundation" only appear in 2008, so we can take them out. There are also a few items listed below the line "Profit/(loss) from continuing operations" which are once-offs, so we can also take them out.  If we do that, we get to here:

		2010	2009	2008
	Notes	$'000	$'000	$'000
Premium revenue	5	901,370	829,486	758,238
Claims expense		-635,929	-599,297	-553,910
HBRTF/RETF Levy		-109,898	-86,978	-73,128
State levies		-22,045	-21,177	-19,922
Claims handling expenses	6	-14,407	-18,384	-17,683
Net claims incurred		119,091	103,650	93,595
Acquisition costs	6	-32,512	-26,642	-25,625
Other underwriting expenses - ongoing	6	-39,514	-36,847	-34,916
Underwriting expenses		-72,026	-63,489	-60,541
Underwriting result		47,065	40,161	33,054
Investment income	5	45,794	-1,167	8,783
Other income	5	1,291	1,183	1,463
Investment expenses	6	-1,344	-651	-1,325
Other expenses - ongoing	6	-5,840	-7,931	-3,548
Profit/(loss) before income tax		86,966	31,595	38,427
Income tax expense/(benefit)	7	-25,441	-7,809	5,421
Profit/(loss) from continuing operations		61,525	23,786	43,848

So can I identify a figure for indicated earnings from this? I might be able to conclude that the underwriting result will increase next year, but the investment result is anyone's guess.

So was there any point in doing this exercise? Yes, because:
1. I now have a better understanding of the risks the business is subjected to - low on the insurance side, high on the investment side.
2. I also have to question the capability of management when they can spend a entire report only talking about one part of the business (insurance) and completing ignorning the other (investment).
2. I have a base for comparision with other companies, which may prove more or less volatile in their earnings.

NIB P&L continued

We saw in my last post that the bottom line is not always the bottom line - by removing just a few no-recurrent items what on the surface looks like a good result can, in reality, be a poor results.

So, after removing costs associated with listing on the ASX, setting up the NIB Foundation and net results from investing, the indicated earning power (IEP) for nib in FY2008 was $36.4m and dropped to $25.6m in FY2009.  I have performed the same exercise on the FY2010 results and again the (NPAT) falls by one-third, down to $17.1m.

So things are not looking so good for nib, but having three years worth of data makes the trends clearer.  In terms of their basic business - selling insurance policies and paying claims - the results are all good. The "underwriting result" has increased from $60.5m in FY2008 to $63.5m in FY2009 to $72.0m in FY2010.  So why is the underwriting result going one way and the IEP going the other way?  There are two aspects to this:

1. tax, and
2. investment result

Tax

In my last post, I did not adjust for tax in my assessment of IEP.  I did this on the basis that tax is an expense that reduces returns to shareholders.  However, looking at it again, the IEP result is being obscured by the fact that the loss due to non-recuring costs FY2008 has provided a tax benefit, the FY2009 tax paid is more typical of a standard year, and the FY2010 tax paid is higher due to the profit made on investments.  So, if I apply the company tax rate of 30% to the before-tax-IEP, I end up with new results as follows:

• FY2008 - $21.7M
• FY2009 - $23.4M and
• FY2010 - $29.8m

In short, a little knowledge is a dangerous thing.


Investment Result

Looking at the P&L, I'm going to use the term "Investment Result" to refer to the sum "Investment Income" minus "Investment Expenses".  I originally excluded Investment Result from my calculation of IEP for the years FY2008 and FY2009 because it represented such a small part of the results.  Obtaining the FY2010 results however, highlights the importance of examining as many years of results as you can when assessing a potential investment.  Here are the Investment Performance results for the last three years:

• FY2008 - $7.5m
• FY2009 - ($1.8m) loss
• FY2010 - $44.5m 

Suddenly, in 2010 the investment result is as important as the underwriting result. You would think that this would make the investment result an important topic of the shareholder review, however, in both the FY2009 and FY2010 shareholder reviews there is only a couple of paragraphs which merely set out a few facts.  Disappointingly, as we have no basis for estimating the investment result for future years, we have no way of assessing a IEP for this side of the business.

This is getting tricky now

I've started reading "Chapter 31: Analysis of the Income Account" of Graham & Dodd's Security Analysis, or rather, I started reading it again.  The date on my last post informs me that it has been six months between drinks (I can't believe its been six months) and I'm not sure how many times I've started Chapter 31. 

As I've discovered with other chapters, Graham & Dodd's relaxed style of writing makes reading the book deceptively easy.  Its when you try to apply the concepts for yourself that you discover how much information the book imparts.  To overcome this, I've decided to "divide and conquer", as they say in the IT world and tackle this chapter over several posts (hopefully in intervals shorter than six months, or I will have died of old age before finishing the book).

The "Income Account", or "Income Statement" or "Profit and Loss" or (as I prefer) "the P&L" is perhaps the most important of the three financial statements provided in a company's annual report.  This is because it is generally accepted that a share's worth is the discounted value of future dividends and the P&L contains the most relevant information to determine this. (Refer to the last couple of paragraphs of my post "What is a share?" for an explanation of discounting.)

One of the questions to be asked when examining a P&L is "What are the true earnings for the period studied?".  In a simple world, one would be able to look at the bottom line of a P&L and if it showed a profit of $23.8m, we could say that the true earnings for the period studied were $23.8m.  Unfortunately, we live in a very complex world with very complex accounting standards developed to deal with very complex things that people do with money, hence, we need to do a bit more work that this.

There are three elements of a P&L that "require critical interpretation and adjustment":

1. Nonrecurrent items (ie things that are one-off's and won't happen again)
2. Operations of subsidiaries or affiliates - particularly tricky as you may not be given any details about them other than their profit or loss
3. Reserves

Non-Recurrent Items

Graham and Dodd list nine types of non-recurrent items and point out that they need to be taken out to determine the "ordinary operating results". By doing this, we can get a better idea of the "indicated earning power", which is what you would expect the company to earn each year if business conditions remained the same.

To apply this concept I am going to examine NIB Health Fund's financial result for the year ending 30 June 2009 [specifically the pdf file titled Appendix_4E_Preliminary_Final_Report_30_June_2009.pdf, which I downloaded from NIB's website]. For the time being I'm going to only look at the Consolidated results and ignore the Parent Entity results. I have chosen NIB because I have had a health insurance policy with them for several years and, as a result, when they listed on the ASX they gave me some shares.

NIB's Income Statement is on page 41 of the annual report. NIB's profit for the previous year FY2008 was only $404,000, but increased to $23.8m for FY2009. Coincidentally, a large part of the difference is due to non-recurrent items and so proves a useful example when considering this chapter.
In looking for non-recurrent items the first thing I do is run down the list of figures and compare last year and this year.  Any items which differ significantly are likely due to non-recurrent items.

The most obvious thing that first stands out are the two items:

• Other underwriting expenses - demutualisation and listing costs: which was $10.8m in 2008 and $0 in 2009; and
• Other expenses - demutualisation and listing costs: which was $7.6m in 2008 and $0 in 2009.

These costs resulted from the demutualisation of NIB Health Fund and its listing on the Australia Securities Exchange in November 2007.  Obviously, this is an event that will likely only happen once in a company's existence, so we should exclude them entirely as they only serve to obscure NIB's "indicated earning power".  In doing so, the profit for FY2008 lifts from $404k to $18.9m.

The third expense that occurs in FY2008 and disappears in FY2009 is a $25m payment to the NIB Foundation. There is no discussion of the Foundation in the FY2009 financial statements, however, the media releases on the NIB Foundation website state that this donation established the Foundation using funds raised for the purpose as part of the ASX listing. The NIB Foundation aims to distribute $2m in grants each year, so presumably they are using the $25m as capital to raise the $2m each year. There is no mention made regarding whether NIB will provide ongoing monetary support to the Foundation, so I’m going to assume that we can exclude it for the purposes of determining NIB's "indicated earning power". As a result, the FY2008 profit lifts to $43.9m and suddenly what on the surface seemed an extraordinary improvement in performance from FY2008 to FY2009 is looking like a dramatic decline.


The next items to look at are Investment Income and Investment Expenses. If we add these two items together they represented on 1% of costs in FY2008 and 0.2% of costs in FY2009, so the temptation is to just ignore them all together. But as this is a learning exercise, we are going to delve in and see what we can find out about them. This will involve reading the dreaded Note 1. Every set of financial statements has a Note 1 - Summary of Significant Accounting Policies. Note 1's set out how the financial statements are put together. Note 1's always consist of several pages of single spaced type in a small font that contains a lot of accounting jargon. This is why I have never before read a Note 1, but I suppose there is a first time for everything.

So, on the third page of NIB's 14-page Note 1, we learn:

• changes in the value of financial assets are put on the profit and loss statement.
• dividends from subsidiaries are put on the profit and loss when the right to receive the dividend has been established - so even though they might not yet have recieved the cash, NIB will report the income as earned on the P&L.
• rent from building they own and lease out is put on the P&L for the period when it should have been received.

All these items are annoyances when it comes to determining a company's "indicated earning power".

Firstly, an increase in value of some shares you own (financial assets), doesn't put money in your pocket - at least, until the time you sell them, when the value would have changed again. So on the one hand, this should be excluded from assessment of indicated earning power (I'm going to go ahead and start calling this "IEP") on the other hand, over the long term, this will come into play.

Secondly, we do not have the financial statements of the subsidiaries so we have no way of assessing their IEP's and therefore no way of assessing likely future dividends and their contribution to NIB's IEP.

Thirdly, we have no details on the rental properties so cannot assess whether the rent is representative of a typical year or whether, for example, a significant tenant is about to vacate and leave 60% of the buildings empty for an indefinite period.

Fourthly, there is no breakdown of the investment income and given it has gone from a positive $8.8m in one year to a negative $1.2m the next, it could do anything in the third year. It may well be that when we examine the balance sheet we will get a better handle on this, but in the mean time, I'm going to fall back on my earlier comment and say that this is such a small part of NIB's IEP and exclude it.

With all these non-recurrent items excluded FY2008 profit becomes $36.4m and FY2009 profit becomes $25.6m and what looked like a good year has turned into a bad year with a 30% drop in profit from FY2008 to FY2009.

For the next post I will read through NIB's annual report and see what they have to say about their results. I will also run this exercise on the FY2010 results and see how the next year has been.

Dividends are good

The next section of chapter 29 examines the practice of retaining profits to build up the business.  The issue here is that if you owned the business you could take 100% of the profit because the profit is what is left over after everyone else has been paid.  However, most companies will retain part of the profit on the basis that it will enable management to build up the business and maintain the dividend rate in future.

I briefly discussed dividends when establishing my stock screening criteria (See "Selecting Stocks - Take Two" from January 2009).  Based on the premise that the value of the unpaid amount is added to the company value (because a share is a portion of the company), I said I preferred companies that don’t pay dividends because individuals receive a 50% deduction on tax due on capital gains (ie the change in the share price) and it is paid only when you sell (if you are not classified as a day trader by the ATO and hold the shares for over a year) but pay full tax on income (ie the dividend) and pay it annually.  (At least that is my understanding, tax law is always changing and I could simply have it wrong).  Also, there are no brokerage charges associated with reinvesting your dividends if they are just retained by the company (although this is not an issue if the company offers a dividend reinvestment plan).

Graham and Dodd question the practice of retaining earnings (ie withholding dividends) on the basis that:

1. if two companies are similar in all respects except the size of the dividend paid, the one with the higher dividend will have the higher share price.
2. withholding profits lowers the return.
3. it rarely succeeds in maintaining the dividend rate in terms of $ per share.
4. any increase in share price generated by withholding dividends will not necessarily compensate the shareholders for the dividends withheld – particularly if you take into account the interest that would have otherwise been earned on the funds.  I had a go at trying to test this using the data I’ve complied for the NAB, but given the volatility of the share market, seven years is too short a period.
5. they believe a study would show that the earning power of a corporation does not expand in proportion with the dividends withheld, although they are assuming the company is retaining the majority of the earnings, say 70% to 90%.
6. individuals in charge of companies have a vested interest in withholding dividends – they will want to retain the cash in the company where they have control over it and they will want to increase the size of the company for self aggrandizement and to generate a higher salary.  They may also withhold dividends to depress the share price so they can purchase more shares or to minimise their tax bill.

In relation to point 3, I have replicated an exercise Graham and Dodd performed on United States Steel, in my case using figures for National Australia Bank over the period 2003 to 2008:

Sum of earnings per share for the period:    $14.455

Dividends paid to shareholders                   $10.380

Dividends withheld:                                  $  4.075

In 2009, after earnings fell to $1.975 per share from $2.373 per share the year before, NAB reduced its dividend to $1.46 per share from $1.94 per share the year before.  With over $4 per share “saved up” in the previous six years (and more if I went back further), there seems little justification for reducing the dividend. I scanned through the annual report to find any discussion on how NAB determines the amount of the dividend and found nothing.

Graham and Dodd’s conclusions are:

• Any dividend not paid out loses value for the investor.
• The major proportion of earnings should be distributed and any earnings withheld should be justified by management.
• You should look for both an adequate return and an adequate dividend when investing.

Diversion: A Wordle

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