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THE DYNAMIC INVESTOR PROGRAM
1. Introduction
Successful investors have a clear understanding of two key elements
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All markets move in cycles that have enormous momentum over time
Many cycles can move far beyond what people think is remotely possible. Consider the following
examples. China in 1820 represented 30% of the global GDP and by 1950 this had declined to only 5%.
Argentina in 1920 had the world’s 4th largest GDP and in 2011 is largely irrelevant on the global stage.
Goldman Sachs forecast the economies of the BRIC countries (Brazil, Russia, China, India) to surpass the
current 6 largest western economies by 2030. There will be setbacks along the way but the trends are
crystal clear and that is where investment fortunes will be made.
The key message here is to toss out all your current reference points and preconceptions about what is
normal or what should be. The next 10 years will see more change and opportunity than you have seen in
your lifetime and almost all of that opportunity to make a fortune will be found in the various resource
sectors. There will be setbacks, but resources move in long cycles and despite strong gains from the start
of 2010, prices remain reasonable. At the current commodity price levels most producers are highly
profitable, so further gains in price are not necessary for the stock prices to rise considerably from here.
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Firstly with existing producers, the current prices are based on analysts’ long term commodity price
estimates which are woefully low in early 2011, so as analysts are forced to upgrade their forecasts as
time goes by, the share prices will respond accordingly.
Secondly most emerging producers that will come into production over the next 1 to 3 years are still
very cheap at current prices. This is a normal part of the price cycle because the risks pre-production
are still rightly being factored in. However as these projects move towards production, we will see
significantly higher stock prices without the need for commodity prices to keep rising.
Further significant commodity price rises (which I believe are highly likely) are not necessary but will
provide some amazing “cream-on-the-cake” for astute investors.
It is my strong conviction that after-tax returns of 25% per annum are available for smart investors who
develop and adhere to a simple disciplined game plan. Consider the impact of that sort of average return
over the next decade because it represents a doubling of your investment funds three times over. Such
performance would set you up for life, so this is a prize worth pursuing diligently. If you then factor in
some steady addition of extra savings along the way, the returns move commensurately higher.
The other equally important consideration is “what will your financial future look like if you just keep
receiving the normal meagre return that most investors get?”
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Every day in the stock market prices rise and fall and there are a multitude of profit opportunities but
these escape most investors who just seem to keep missing them. It is common for investors to buy on
good news only to see the price fall immediately after and so they conclude the market is completely
illogical and is a game that cannot be won. This could not be further from the truth if only they understood
the basics of how markets operate. Most so-called experts that write in the financial press do not
understand how markets operate either so it is no surprise that if you follow them or have been
conditioned to act as they do, you will struggle. Nearly every single commentator is wrong at the turning
points in markets which are the only times when it is important to be on the right side of the market
moves.
Therefore your challenge is to learn to think and act differently from the masses and use a few simple
principles that work amazingly well. To make money in the market you have to have a clear game plan and
the discipline to stay with that plan. The first thing that you need to embrace is to
GIVE UP TRYING TO INVEST BY FOLLOWING THE NEWS
This course is about learning to invest by following the “smart money”.
Have you ever bought a stock that just made a positive announcement, or was written up as a good buy in
the media, and it went down in value? This happens all the time because the good news has already been
priced in and the knowledgeable investor bought in before the news and has already taken the cream.
That is why many good stocks will often top out just when the good news is announced because the smart
money traders have already moved the price higher by buying in early. The news release then just provides
the uneducated buyers for the smart money to sell to. You must learn not to play this game.
The key is to recognise that most major events are preceded by many smaller events with tell-tale signs
that are easy to recognise if you know what to look for. Prices move in trends that can last typically for
many months and sometimes years and whilst these trends can be buffeted around by day to day news
and random price fluctuations, they continue on until some other circumstances end them. Therefore
smart investing is about ignoring the daily movements and focusing on the trends and the patterns that
indicate what is to follow.
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2. Key concepts & big picture perspective
The first key concept relates to trends. You can note on the chart below that prices that form higher highs
and higher lows are tracing out a pattern that takes the price higher over time.
The mirror image of that situation is where a downtrend emerges from a series of lower highs and lower
lows. You can also see on the chart below that after trending lower for 8 months, the price has stopped
making lower highs & lows and in fact has just made a slightly higher high. This is indicating that the selling
pressure is easing and the buying momentum may be increasing. This is the first sign that things may be
turning around for this stock and it is during this transition phase that we need to be alert for entry signals.
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A vital message which I wish to convey is that there are good times for investing in the market as a whole
or in specific stocks and there are bad times. This means that you should be prepared to sometimes sit out
of the market or to drastically reduce your exposure. The stock market rewards diligence and patience
handsomely. The words of Kenny Rogers really ring true – “you have to know when to hold ‘em and know
when to fold ‘em”.
Stock prices over the medium term move according to many influences and tend to trend in sectors. These
sector trends can last for many years and so it is not a matter of just investing across the board in an
attempt to diversify your exposure. This is a common practice but one which just says “I’m too lazy to do
the homework to establish what is good and what is not”. We are in an age now where there is enormous
divergence in performance between differing sectors. For numerous reasons explained in detail below, the
next one to two decades will be hugely positive for most resource sectors. Fortunes will be made during
this period for those who take the time and effort to understand the process and to execute effectively.
Stock prices move ahead of the real economy because markets anticipate future events, so typically we
see prices anticipating what is likely to be occurring at an individual company, sector or economy levels,
roughly 6 to 9 months prior to it happening. It does this based on assumptions which history may or may
not show to be valid. This means that stock prices not only precede economic developments but also
prices can get well ahead of reality or often well behind reality. This is another reason why following the
news is a major problem. Stock prices crashed in 2008 before the mainstream news reflected that
possibility and they started to recover in March 2009 while the economic news was still awful and most
investors were not aware of what was happening.
Those who waited till late 2009 when the news started to improve missed the opportunity of a lifetime
where some of Australia’s best companies doubled in value and hundreds of small resource stocks
increased by 500% to 1000% or more.
The very best time to buy a stock for investment is following a major bear market, the subsequent lengthy
consolidation with little investor interest, and just when the price starts to break higher as the smart
money (eager to buy what they know is deep value) forces the price higher through their buying. Whilst
most of the population is fearful that this is just a pause and the market will crash again, this is in fact is
one of the lowest risk times to buy for the long haul and spectacular profits are the usual outcome. Success
in the market is about continually investing when the reward far outweighs the risk. You may experience
the occasional loss but the focus has to be on the bigger picture of how many winners and how much
larger is the average return compared to the impact of the occasional loss.
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2.1 Phase analysis
The key message is that successful investing is basically a very simple process if we can remain detached
from all the conflicting signals. The only thing that makes it more challenging is if we allow the media and
the uneducated masses to influence us into thinking and reacting as they do.
All stocks, sectors and markets progress through cycles which are driven by human psychology and
because that is the case, we can observe the patterns associated with these cycles if we look objectively at
them. The specific nature of the patterns does vary but they are always present. Once you understand how
these cycles play out, then it makes investing with confidence so much easier and productive. Let’s start
with the top of the market which can be identified as phase 3 in a four stage cycle.
At this stage, prices have been moving higher for some time, the sentiment is very bullish with investors
only thinking about how much more money they are about to make, and the media commentary is
overwhelmingly positive. No-one can envisage an end to the party and so investors are happy to keep
buying at any price because they think prices can only be higher next week. Eventually the majority of
investors are fully invested and by any historical comparison, stocks are over-valued and expensive. The
market has now reached a point where the buying depth is thin and prices will have little resilience to
selling. When it all boils down, prices move according to the balance between buyers and sellers. This is a
simple concept but one that gets forgotten when markets are overly exuberant.
The smart money, recognising that prices are over-valued and unlikely to move higher, start selling. This
generally starts with a sudden drop over a short period before a weak recovery and is the first sign that the
character of the market is changing. In phase 3 we start to see wild swings up and down as the uneducated
money keeps buying the dips (as they have become conditioned to do) and the smart money takes every
opportunity to sell into the small rallies. The chart below shows that the price now starts to deviate sharply
below the 150 day moving average which it had not done throughout the bull market rise. The 50 day
moving average also cuts below the 150 day moving average. We often start to see higher volumes on the
down days but definitely the volumes on the rallies become increasingly lower.
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Chart of S&P500 index
Typically in phase 3 we see several peaks and troughs before the selling really gathers momentum into
phase 4. The ultimate confirmation of that transition occurs when the initial lows that formed in phase 3
are broken as below in the example of National Australia Bank which started into a phase 3 top in May
2007 which transitioned into phase 4 in January 2008 when the price took out the phase 3 lows of August /
September. A key aspect to note is that the longer and wilder the phase 3 top, generally the larger the
ensuing decline.
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Chart of National Australia Bank
During the early part of phase 4 many investors are still in denial that the bull market is over and so refuse
to sell the stocks that they paid too much for and are now in a loss situation. The psychology is that they
will sell when the price gets back to what they paid for it because the economic news and the media
coverage is still positive and hope prevails. The only problem is that time is generally several years away
and they will give up and sell for an even bigger loss before that recovery happens. Phase 4 lasts until the
majority of investors have given up and sold out because the economic news has turned negative, and at
that point the decline ends. The chart pattern is now that the price remains consistently underneath the
150 day moving average with rallies back up to it as we can see in the NAB chart above.
We are now in a period where very few investors wish to know about the stock market because the news
continues to be very negative and they are feeling very bruised. As a consequence the trading volumes are
relatively very tiny reflecting the degree of interest. This is phase 1 and whilst prices have stopped
declining they are generally not going to rise just yet either. The price is now quite close to the 50 day
moving average as it all levels out. Depending on the length of the phase 1, the 150 day moving average
may even decline to the price level and flatten out. So the angle of this simple indicator and the price
position relative to the moving average is one the primary tools for the investor.
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Chart of Worley Parsons (WOR)
Many stocks have been sold down much further than their fundamentals would warrant and so during
phase 1 the insiders and the smart knowledgeable money start to build a position because they
understand value and the fact that the business is basically sound. It is almost impossible for the average
investor to buy during this period because the news is still poor and the financial commentators are giving
all the wrong signals. The good news however is that the astute investor does not need to rely on anyone
else. It is just a simple matter of looking at the charts with an open mind and responding to the clear
signals that most people are not seeing because they are not looking for them.
The actions of the smart money puts a floor under the share price by continuing to soak up any shares put
out for sale, so what we have is a transfer of shares from the uneducated money to the smart money at
the worst possible time.
The price is poised to progress into phase 2 which is the bull market phase. As operating conditions
improve, the smart money has to pay a progressively higher price to accumulate the volume of stock they
want and keen sellers by now have largely been fulfilled. The start of phase 2 often sees a sharp spike in
price as smarter traders realise the move is starting and volumes rise. The price moves upwards for a few
days or perhaps a week at most. Some selling then ensues from those who do not quite believe that a new
bull market has started so we see a pause or partial retracement of the recent gains. This is now the safest
and most profitable point for investors to get set for the largest gains. This is where fortunes are made.
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The simplest technique to determine which phase a stock price is in is to use the 50 and 150 day moving
averages of the price. The following provides a guide;
Phase 1 – the moving average has generally stopped falling and may have flattened out and is close to the
actual price
Phase 2 – the price is now above the moving average which is now pointing upwards
Phase 3 – the moving average starts to flatten out with the price fluctuating wildly above and below it
Phase 4 – the moving average is now pointing down and the price is consistently below it with the
occasional rally back up to the moving average line
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So where are we now in March 2011 at the ASX200 index level in Australia? The chart below shows there is
an extended pause within the phase 2 period. It is possible that it is a phase 3 top but the wild swings are
absent. The ultimate test will be whether the index pushes beyond 5000 points or closes below 4200
points.
The real key to making a fortune in the stock market is about having patience to wait for just the best
opportunities and the realisation that it does not take a large amount of activity to produce some stunning
returns over time if you remain disciplined. One of the best ways to do this is to focus on the strongest
sectors during both declines and advances and to invest in the strongest stocks within those sectors. The
very best time to invest is after a major selloff but as that event only comes infrequently (once or twice a
decade) the next best time is after corrections in the market that may last from several weeks to several
months. We will be presented with many such opportunities in coming years. Therefore the simple process
is to identify the strongest stocks which will be the first to advance from the correction and generally move
the farthest over time.
The charts below of the main sectors of the Australian market demonstrate this point about relative sector
divergence. By far the strongest relative performer since the crash has been the materials index with a
graduation to the worst performers in telecommunications, discretionary retailers and property trusts. The
direction and slope of the 150 day moving average is the key aspect to note.
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Materials Index (XMJ)
Finance Index (XFJ)
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Energy Index (XEJ)
Industrials Index (XIJ)
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Discretionary Retailers
Property Trusts (XPJ)
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Telecommunication Index (XTJ)
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3. Investing methodology
Whilst successful investing is assisted by some knowledge of and analysis of the fundamental financial
factors that impact price in the longer term, the key is being able to buy at the optimal time and in order to
do this an investor needs to be able to understand and read the repeatable patterns that occur before big
moves in the price. There are numerous patterns which are profitable but the two which are by far the
best to identify are;
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When the stock is breaking out of a stage 1 base
When a stock has already broken out but is pausing before moving higher. Whilst we are entering at a
higher price this pattern is more reliable and progresses much further than the initial breakout.
So there is a very clear message here. Do not worry if you have missed the very best entry price, success is
about picking points when the stock is about to embark on a big run with the lowest degree of risk. Also
recognise that as you are positioning for a substantial move higher, the first comparatively small price rise
that you miss is insignificant compared to the potential gains if you get the confirmation that the move is
actually starting.
Ideally we want to see volumes rising as the moves higher commence. This may not be so evident in the
largest stocks as their trading volumes don’t vary too much but it is essential in the small and midcap
stocks to see substantial rises in volume. Generally you want to see volumes at least double the previous
level to support the move.
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Chart of Forge Engineering Group (FGE)
Chart of Matrix Engineering (MCE)
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Chart of Medusa Mining (MML)
Now there are literally hundreds of breakouts every month that are similar to the patterns in the charts
above but many of those stocks are not what I would describe as investment grade. The prices can fire
higher for short periods of time and then collapse back, especially when sentiment turns negative as often
happens with small commodity stocks. These can be great short term trading vehicles but this is not what
we are looking for as investors. We are seeking stocks where the fundamentals surrounding the company
mean that it is just a matter of time before higher prices will occur. So we need to consider the following
key basic factors. Greater detail on how these are calculated is found in appendix 1.
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Return on equity (ROE) – this is the profit that management produces on the shareholder funds they have
at their disposal. When a company is making a profit which is significantly above the cost of capital, then
that increasing value has to find its way out via higher dividends or higher share price. The gains are not
always immediate but they will occur, there is nothing more certain. I look for an ROE of 15% or greater
and preferably on a rising trend
Growth rate of profits – this is the average annual growth with a 3 year rolling average a good period to
use. This is termed earnings per share growth (EPSG) and I like to see 15% per annum or higher
Value – using a ratio of price to net profits (commonly termed earnings) the P/E ratio is a quick means of
determining whether the current price is good value. There are more complex calculations that can be
performed to generate a number called “intrinsic value” but smart investing is not about being a skilled
financial analyst, it is about ensuring that you are choosing stocks whose fundamentals are in the right
ball-park and then using price patterns to time the entry. You can be a wonderful analyst and arrive at a
perfect numerical answer, only to see the price not respond as expected for 6 months or more. I like the
P/E ratio to be below 10 times the forward year earnings but some flexibility is required here as some high
growth sectors traditionally trade on higher multiples because investors are prepared to consistently pay
for that growth.
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Value – combining the P/E ratio and the EPSG provides a more powerful ratio called the “P/E to growth”
ratio or PEG. This ratio divides the P/E by the expected earnings growth rate for the following year or
sometimes the next 3 year average. This is where an understanding of the drivers behind sector
performance is so vital. If we position ourselves only in sectors with high anticipated growth prospects for
the next 2 to 5 years based on solid fundamental grounds, then investing becomes so much more
effective. A PEG ratio of 1.0 means that the current price is consistent with the expected earnings growth
and is fair value. A PEG of 0.5 means that the current price is potentially undervalued and could double in
the next year to return to fair value, all other factors being equal.
Debt level – a simple ratio to use is the debt to shareholder equity ratio which has several variations in
calculation but think of it in terms of your own personal finances. If your home was worth $800,000 dollars
and you owed $400,000 on it then your debt to equity ratio would be 50%. This is a similarly useful
yardstick to ensure that you are not buying companies that may run into difficulties if sales declined or
interest rates rose suddenly. This ratio can also be considered in conjunction with the ROE. If a company
borrows at 8% but is producing profits of 25% on that capital, then they are creating enormous
shareholder value through those borrowings. However if a company is only producing say 5% profits then
they are destroying shareholder value through those borrowings and you need to avoid companies such as
these.
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3.1 Establishing a portfolio & managing risk
It is vital to your success that you adopt a different mindset when investing. What is really at the core here
is that it is not about actual monetary gain or loss but rather relates to your emotions around making
mistakes and taking losses. You must avoid taking any of the following types of actions;
- holding onto losing trades that continue to decline in price
- buying more shares to lower your average entry price, so your risk is now much higher
- getting “married” to an investment idea or specific stock so that you cannot see reality
- feeling like a loser if you do sell and then the share price rises
You must cut your losing positions if you are going to make money consistently in the stock market. If you
lost 30% on two investments but made an average of 50% gain on the other eight investments, then you
would have increased your fund by 34% overall. The key here is to focus on the bigger picture rather than
the outcome of a specific trade. Making an average gain of 50% is quite simple if you invest in just a couple
of stocks that double in value and the other profitable investments just perform satisfactorily. The charts
above of FGE, MCE and MML show those large gains occur regularly if you are focused on what you are
doing. Think about what a before tax return of 34% pa or an after tax return of 25% pa means in terms of
longer term wealth creation as discussed in the introduction.
To achieve great individual profits just requires letting the winners run, which is something that is easier
said than done, but is very possible if you are operating in an environment that helps you to shut out the
“media noise”. The vital aspect of exiting losing positions is to pre-set an exit before you buy that makes
sense based on chart patterns, and is not based on emotion at the time you are thinking of exiting.
3.2 How much to buy
The philosophy and thinking behind effective investing is different from that of trading primarily because
investing is about building substantial capital gains over longer periods of time typically 10 years or longer.
Therefore the effective way to calculate the size of your investments is different. In this program we will be
using a fixed dollar amount which will vary between 3% and 8% of investment capital. I do not believe in
investing more than 10% of my capital in any particular investment because of unforeseen circumstances.
It will be rare for us to get caught out by unforeseen things because the price charts almost always provide
plenty of advance warning, but it is a good sleep-at-night factor if you are not exposed too much to any
single investment just in case. The ongoing information service will also provide guidance on appropriate
levels of overall exposure as market conditions vary. What will be provided is regular guidance on taking
partial profits when prices become extended to the upside and then when to re-load that exposure,
hopefully at a lower price.
3.3 How to enter
The process of exiting an investment that has gone off the rails is described in the next section but we will
know at what price we are going to enter based on the patterns and at what price we will exit for a
controlled loss. This creates what I call a risk gap. Sensible investing should seek to only take investments
where the potential gain is a minimum of 3 times this risk gap. Therefore I look at the fundamentals and
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the patterns to ensure that such a gain (preferably far greater) is possible within a 1 to 2 year time horizon.
The example of FGE would look this way;
- entry price $1.90
- initial exit price $1.30
- risk gap $0.60
- minimum potential profit target $3.70
- last trading price $6.33 = 7.4 times risk
At the time of investment assessment and entry there was no structure to provide a guide to how far the
price might run except that the price was very cheap, the ROE was above 30% and rising, the earnings
growth was very high and the industry prospects solid. This was a powerful combination and therefore we
could conclude that there was considerable upside potential to make the investment worthwhile. You only
need a couple of these types of investments a year to have a great year as long as you quit losing
investments promptly.
The art of entry is about reading the patterns and whilst that skill can be learned it does take a great deal
of repetition over lengthy periods of time to be able to readily identify the best patterns. It is easy to
identify average patterns but as there are a number of factors to consider, it does take a refined skill to
consistently pick the best ones.
3.4 How to exit
The very first thing we need to do before we buy is to know at what price we will concede the investment
is not working and exit. We are buying based on sound fundamentals and a pattern that indicates a very
high probability that prices are starting an upward trend. The level that makes sense to exit therefore is
where the market moves below a strong support level because it should not do that if there is an upward
trend unfolding. Determining the appropriate point to place the exit is a skill which takes time to learn and
that is why this program provides you with that information until such time as you feel confident to make
those judgements yourself.
For those that wish to learn how to do this for themselves we need to separate this process into two
possible scenarios. We will also use two simple tools to help us identify the appropriate exit levels. The
first tool is the 150 day simple moving average of price. Uptrends with strong momentum will tend to stay
above this line until they start to run out of momentum so a close below is an early warning signal that the
uptrend is finishing.
The second tool is to use the pure definition of an uptrend (ie higher highs and higher lows) to provide us
with a guide to where to place our exits. If the price closes below the last significant low then by definition
the uptrend has finished and we should exit. Sometimes the uptrend pauses for an extended period before
moving higher but the overwhelming odds favour exiting.
The first scenario is where, despite our best endeavours at identifying great companies, the share price
falls to our predetermined exit point which is comfortably below a level of major support which is not
consistent with the uptrend continuing. Establishing this level is quite straightforward as the example
below depicts. This was not an investment we would have necessarily made based on the fundamentals
but they serve to illustrate the point. It was actually quite challenging to find examples of investments we
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would have made where the price readily declined to the exit level. If we do our homework properly being
quickly stopped out of an investment should be a rare occurrence. One tends to get caught buying into
stocks that are already over-valued and that is easy to avoid if one is patient and objectively looks at the
opportunity.
Chart of National Australia Bank (NAB)
The second exit scenario is the one that most investors grapple with and that is once the price has started
moving higher but goes into a normal retracement. The decision to be made is whether this is the end of
the run or whether this is just part of the normal uptrend pattern and we should hold for further gains.
This is where the dual use of the two tools outlined above comes into play.
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Chart of Leightons Holdings (LEI)
Chart of BHP
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The other factor that would precipitate an exit would be a significant change in the fundamentals of the
company or the sector that it operates in. However almost invariably, such a change would be clearly
evident in the share price pattern well before that information became public knowledge so it would be a
rare event that you would be required to act on such information.
The key aspect of developing your skills as an investor is to get into a rhythm of only buying strong
companies with the patterns outlined above and to observe the exiting process with discipline and
patience, not being thrown off-line by short term media events. Once you get into this rhythm your
confidence builds and investing becomes stress free and extremely productive. All it takes is to think and
act differently to how you do now and how everybody else does. It removes the “agony” of fretting over
individual losers because you realise that they are necessary to avoid having far bigger losers and they are
far outweighed by all the great investments that you make.
To summarise this vital point about crowd psychology consider the following. Once you start buying stocks
you become bullish on the market and that emotion intensifies as prices go higher until everyone is fully
invested and totally bullish. This is generally the top of the market because there is no more cash to
sustain the momentum. However for most of the trend upwards, investors were on the right side of the
trend and making money on paper. As the downtrend unfolds the opposite happens with sentiment not
turning bearish until near the end of the decline. But at key market tops and bottoms the masses are
always dead wrong and those turning points make or break fortunes, so you must think differently from
the crowd.
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4. Investing where the money is
In order to create significant wealth in the stock market requires you to be aligned with the big picture
trends that are driven by largely unstoppable long term factors. In the coming decade there are a
confluence of factors that are creating the greatest opportunity of our lifetime and one that will probably
never be seen again. The two most populated countries on earth, China & India are moving together
through industrialisation and urbanisation which is placing massive demands on raw materials. At the
same time, Central Bank policies are creating currency devaluations and inflation which is also bullish for
commodities. Thirdly, large companies have never found it more appealing to buy smaller rivals rather
than explore themselves.
There are two key themes to be aware of. The first is that we are still in the early stages of a commodity
super cycle so buying into periods of significant correction will be rewarding. The second is that volatility
will be common and sometimes extreme, so awareness of actively managing your portfolio is vital. A good
overall plan is to have a portion of your portfolio as core holdings to capture long term gains over many
years and the other is for trading purposes to try to maximise gains and make it easier psychologically to
stay focused on your task.
So if you accept that there will be a large and ongoing demand for commodities the question is how best
to gain exposure to these trends. Buying some physical commodities such as precious metals is viable but
buying commodity stocks provides more leverage than buying the underlying commodity itself. Larger
resource companies provide perhaps 2 to 4 times leverage over the underlying commodity whereas small
junior companies can provide very significant leverage of perhaps 10 times and so are hugely volatile.
Buying commodity stocks in 2011 are akin to buying stocks in the early 1990’s. Yes they have already gone
up enough for the uneducated to start thinking they may be in a bubble that is about to burst but in reality
there is many years to go and there are massive gains in front of us. In 1991 the Dow had nearly
quadrupled from the 1987 crash to be at 3000 points and many thought the rally was finished but what
happened of course was that the Dow quadrupled again over the next 9 years before the bull market
finished. Those that exited early before the market action told us to missed out on a veritable fortune.
Make no mistake commodities are in the midst of a bull market which is closer to the start than the finish.
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4.1 The case for precious metals sector as a long term investment
Western society is accustomed to investing in paper assets such as shares, government bonds, or annuity
funds. However the increasingly large investor groups in China and India have always had a preference for
hard tangible assets such as gold and silver. This demand for these metals is set to explode in the next few
years because a confluence of factors, the main one being the insatiable desire for Central Banks to
devalue their currencies to try and make their economies more competitive. The scale and speed with
which this momentum will build will be breathtaking and it will lead to severe shortages and skyrocketing
prices of both gold and silver.
China is the world’s largest producer of gold but they imported 6.7 million ounces in the first 10 months of
2010 which was a five-fold increase over their imports in 2009 so the trend is rising rapidly. The interesting
aspect is that jewellery demand (which has been by far the largest use for gold) only rose 8% whereas total
retail demand rose by 70% according to the Gold Council. Therefore there is a clear trend for Chinese to
own gold as a monetary investment. Furthermore the demand from both China & India in 2010 was about
half of global annual production, a massive proportion.
Gold has always been considered a hedge against inflation and when inflation was low, gold was ignored.
We now have a conundrum around that issue because the price of gold is rising against all currencies, yet
inflation is officially low. However in reality inflation is actually higher than governments are reporting
because they fiddle the numbers for political purposes. The simple fact is that the game has changed
because of all the money printing and gold has now become an alternative to fiat currencies and will do so
eventually on a large scale, not just on the periphery.
There are numerous reasons why gold will continue to rise on a big picture view and investors can rightly
feel very bullish towards the prospects for gold.




Monetary instability – gold will serve to protect assets and to act as insurance against almost all forms of
financial instruments that are being manipulated and are inherently unstable.
Weakness of the US dollar – until the US dollar loses its reserve currency status, the price of gold will move
inversely to the value of the dollar and the Federal Reserve seems intent on devaluing their currency as do
Japan, England, Europe etc in a bid to maintain trade competitiveness.
The actions of Central Banks – political expediency is demanding that weak economies are maintained by
money printing rather than taking the pain of allowing weak institutions to fail so the strong can emerge.
Non-US Central Banks which are large holders of US dollars are diversifying their risk by selling dollars and
buying gold. Recently when the IMF announced it was selling 400 tonnes of gold, there was initially some
fear in the market but India stepped up and bought 200 tonnes in a single transaction worth $6.7 billion.
The amount of reserves for the 8 largest Asian countries plus Brazil range from zero to 5% of total foreign
reserves. Central Banks have gone from being net sellers to net buyers and in particular China and India
which have traditionally held less than 2% of their foreign reserves in gold are seeking to move them up.
Because even small percentage movements on massive numbers equals a great deal of gold to be
purchased, these actions will have a large impact on the demand for gold.
Miners not forward hedging production anymore – the practice of hedging gold production has ceased
over recent years which has removed a massive source of selling from the market.
26


Increased retail demand – the emergence of a more affluent middle class in both India & China is fuelling a
large upswing in demand for gold as an investment. This trend is also being matched by the large increase
in demand from Exchange Traded Funds (ETF’s) specialising in metals.
Gold production is waning in absolute terms with an absence of any really large discoveries. The fall in gold
grades is also not helping production rates and this is all in an environment where the gold price is 500%
higher in a decade so there is no lack of exploration incentive.
There is a definite seasonality to the gold market. On a big picture level gold does well when real interest
rates are low or negative as they are now, or in periods of financial instability. But on a shorter term view,
gold is strong from September to February and then weaker through to August with March, June and July
traditionally being the weakest months. When it comes to gold stocks there is a clear trend for stock prices
to lead the price of gold in both directions. This is a really important dynamic to remember and use to
advantage.
The final consideration, and this is the “icing-on-the-cake”, is the massive trend for larger companies to
takeover smaller gold explorers / developers. Given that finding new large scale gold discoveries in
politically stable regions is getting harder and harder, it is usually cheaper and faster for gold companies to
acquire resources rather than explore themselves. In effect they are letting the junior companies take all
the exploration risks, preferring to pay up for a known resource. This means that there is an enormous
profit potential investing in smaller higher quality gold stocks as long as you follow a process that leads to
higher probability selections.
The case regarding demand for silver is even stronger with a massive swing from China exporting 100
million ounces of silver in 2005 to importing 120 million ounces in 2010. This is a huge demand swing of
220 million oz in a market where only 889 million oz were produced in 2009.
The net result is severe shortages of gold and silver bars and coins through outlets such as the Perth Mint.
These shortages are far beyond the normal demand cycles. One of the key reasons is that the rules for
precious metals ownership in China have changed in the last decade when restrictions were lifted with the
establishment of the Shanghai Gold Exchange in 2002. Investor interest has increased dramatically with
new investment products like the ICBC Gold Accumulation Plan which allows Chinese investors to
accumulate gold through a daily dollar averaging process. One million accounts have been opened
resulting in the purchase of 10 tonnes of gold to-date but forward projections are to 300 tonnes per year
or 10% of current global production.
There is ample evidence that money is pouring into silver in all its forms and due to the relatively small size
of the silver market this inflow is having a massive impact on the price. In the 15 week period to December
2010 the price of silver rocketed 50% from $20 to $30 per ounce. The total value of the entire silver
market is estimated to be only US$33 billion (Sprott Asset Management). To put it into perspective, most
of Australia’s top 10 companies by market capitalisation are larger than that and our stock market is only a
tiny player on the global stage. If the demand side of the equation continues as all the signs are indicating,
there are massive rises ahead for silver.
27
The key message here is that as long as Central Banks continue on their current path of currency
devaluation, these new forces have the capacity to overwhelm the current supplies in the gold and silver
markets and force prices far higher.
In addition with silver, there is a growing industrial usage component which adds to the demand and a
significant portion of the silver is destroyed or lost forever, so unlike gold which just changes form, there is
a steady consumption of silver. Of all the silver produced approximately 50% is used for industrial
purposes. The usages are wide and growing rapidly and include medical, electronics, textiles, water
treatment, wood preservation and clothing and in all these new uses very little is recycled. New mine
production only accounts for roughly 75% of demand with the balance coming from scrap and stockpiles
that are dwindling as there are no Central Banks holding vast quantities. There would appear to be only
one longer term direction for the price of silver.
4.2 The case for copper
Copper is the essential base metal as it is used more widely than any other metal in a range of basic
everyday products from telephone lines to car parts, refrigerators, water piping and is a barometer of
economic activity. The GFC caused a large decline in the demand for copper of 4% and the price had
started its decline well before the GFC was acknowledged, so it is a forward predictor of economic activity
and far more reliable than the news. The recovery in price from US$1.30/lb to the current US$4.60/lb was
stunning however because there is little substitution for copper and demand tends to be resilient. The
rapid industrialisation of China virtually ensures continued strong demand growth. It must also be
remembered that the 350% recovery in the copper price has occurred without the big drivers of US
housing and automobiles having started their recovery yet.
History shows that the per capita increases in demand for copper occur as countries grow and China is now
just reaching that threshold where an acceleration occurs. The exciting thing though is that this rapid
increase in per head consumption is occurring with a population of 1.4 billion people and with India close
behind. China’s per capita usage can double and still only reach the lower levels of typical industrialised
usage levels. The potential is extraordinary.
The most telling indicator from my perspective that supply is really struggling to catch up to the demand in
an environment where the copper price is so high that virtually all producers are profitable and the
demand is certainly there and growing. If the massive supply response that some analysts are fearful of
was coming, then why is it not already apparent. There is a deficit of large new mines on the horizon. The
two largest new developments, Oyu Togloi in Mongolia and BHP’s Olympic Dam face some significant
hurdles and without huge new mines the demand side is just rising too quickly for small mines or
expansions to keep up. The only logical conclusion for the longer term is sustained high copper prices.
There are some world scale copper producers such as Freeport McMoran which are good investment
options but there are numerous local targets from BHP to mid-tier companies such as Pan Aust or Equinox
Minerals and down into the ranks of the developers with large deposits like Discovery Metals or Sandfire
Resources.
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4.3 The case for rare earths
Rare earths are the 30 elements that appear at the bottom of the periodic table and possess unique
attributes that make them critical for an expanding array of high tech uses from cars to iPods. Up to 25% of
new technologies rely on rare earths. Lanthanum and praseodymium are essential in the manufacture of
carbon arc lamps, cerium in laser crystals, neodymium in powerful magnets used in wind turbines, and into
uses such as surgical lasers and in the military.
China controls about 95% of the rare earths market which is not a great situation when so many of these
materials have strategic importance. China is also the dominant consumer of rare earths so they are
seeking to lock up and guarantee supply for their own usage. Export quotas have been tightened which has
caused massive price spikes from earlier in 2010.
Given this situation manufacturers in Japan, the US and Europe will increasingly look to foster rare earths
production outside of China. Australia is well placed with a number of deposits in various stages of
development. The big change of course is that now the higher prices makes more deposits economically
viable to mine.
4.4 The case for energy
The energy industry dwarfs all other resource industries and includes coal, oil & gas and uranium. The
same supply and demand distortions that China is causing to every other resource material applies to
energy in all its forms. There are plenty of studies that clearly show the consumption of energy is closely
allied to the size of the global population but we now also have the dynamic that we have seen before
when England, the US and Japan industrialised, that energy consumption reaches an inflexion point and
really takes off. China is at that point now but the scary thing is they are doing it with 1.4 billion people not
100 million as was the case in the past. The bottom line is that the world is already desperately in need of
more energy and have already reached the point where the rate at which oil can be pumped out of the
ground is struggling to match demand and so the longer term price direction is upwards. This is what is
referred to as “Peak Oil” and I believe the signs are that the world is there now or will be in the next 3
years. The misconception is that the planet is running out of oil which is not true, there is plenty of oil left.
The term relates to the fact that we are close to the peak rate at which oil can be produced. There are
perhaps some big discoveries yet to be made but the easy oil has been found and those mega fields are in
serious decline. The new discoveries will be in politically unstable areas and technically challenging
environments such as water depths beyond 2000 metres. There are also the environmental issues which
will hinder or stop some developments.
For the past 20 years there has barely been a discovery larger than 10 billion barrels and yet the world
consumes 1 billion barrels every 12 days. Currently 20% of total world oil production comes from 14 giant
fields that are in excess of 60 years old and so are into the rapid decline phase which is what happens to all
oil wells. One of the largest fields, Cantarell in Mexico which started production in 1979 and peaked at 2
billion barrels per day is now down to just 500 million barrels per day.
This all adds up to the same conclusion – higher prices on a permanent basis and large rewards for the
companies that control the oil.
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It is for these reasons that coal will continue to be a mainstay for global energy as the reserves extend for
centuries. Coal will face increasing environmental obstacles but the reality is that despite the fact that coal
is dirty, it is plentiful and it is cheap. China generates 80% of its electricity from coal, India 70% and the US
50%. This is probably one of the safest commodity areas because the demand is less reliant on economic
activity and far more related to the level of the global population. China is the world’s biggest producer of
coal but their demand has rocketed to such a degree that they are now a net importer of thermal coal.
Australia and Indonesia are the two major coal exporters, so there are numerous investment opportunities
amongst Australian companies.
4.5 The case for resource service companies
There is an old truism that a safer way to make profits in a mining boom is to be a seller of picks and
shovels rather than the company doing the digging itself. However the stock selection is still critical and if
we look at the performance of service companies across the sector, we can identify a huge variance in
performance in the last year. Stocks such as Forge Group (FGE) and Matrix Composite (MCE) rose by 100%
and 250% respectively in 2010 whilst Leighton Holdings (LEI) actually lost 20%.
The key difference is to have a great management team and to operate in a sector where a strong project
pipeline can harness the massive demand from resources companies and in so doing generate ROE’s well
beyond the cost of capital and generally above 20% per annum. It is also obvious that companies with
Australian focused operations and therefore shielded from currency issues have performed best. The
amazing momentum for these companies shows no sign of waning with Australian Bureau of Agriculture
and Resource Economics (ABARE) projecting $55 billion of capital expenditure in the mining industry.
Naturally there are always higher risks with smaller companies but this sector looks like again being an
absolute standout performer for the next few years.
Let’s look at what has occurred in terms of stock prices over the last 2 years for some financially
conservative and stable companies. The meteoric rises of FGE (1200% gain in 18 months) and MCE (300%
gain in 8 months) appear in earlier charts but here are some more.
30
Chart of Decmil Group (DCG)
Chart of Ausdrill (ASL)
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4.6 How to buy small resource developers
There are price cycles that emerging resource stocks will go through from first discovery to eventual
production if they make it that far. We don’t need to understand or track them in detail because the price
chart tells us everything we need to know well in advance of it becoming public news. However it is useful
to have some understanding of the forces working behind the scenes.
Following initial discovery it is quite normal for the price to double in the next few weeks. At some stage
there is a pullback as early buyers take profits. The next set of investors then starts to build over the next
few months and another doubling of price is quite normal. The stock price can then continue to gain for
perhaps several years as the exploration & evaluation phase continues, it all depends on how large the
discovery is and to what degree the management promotes the stock to the broking community. The next
phase is the feasibility and permitting phase where the stock price will normally decline or just languish as
investors lose interest with the lack of exciting drilling results. In this period a substantial portion of the
early gains can be lost. Once this phase is nearing completion a new set of investors joins and the price
appreciation starts again as the stock moves towards first production.
Of course there is often a takeover offer during this last stage which can typically add 30% to 200%
premium to the share price particularly if there is a bidding war. The majority of exploration companies
never make it to production so great care needs to be taken to isolate the few good companies that have a
high probability from all the others. We have a formula to guide us in our research and this is where we
will be placing considerable emphasis in identifying the best opportunities. One of the core parts of our
approach is to minimise the risk by looking for certain key things that revolve around management and the
size of the resource.
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5. Ongoing information & monitoring
All the information that you require to select great companies and when to enter and exit will be provided
on an ongoing basis through 3 forums.



An investment report published in the first week of each month which will provide an ongoing
analysis of the investment merit but most importantly we will track all announcements that the
company makes and provide to the best of our ability the dates of potential price moving trigger
events. A written component will cover the fundamental aspects while a video component will
cover the charting side of things.
A group webinar for members will be conducted around mid-month to provide a market update on
a timeframe which is appropriate for investors. This is an opportunity to ask questions about your
particular investments.
A forum on our website where questions can be asked at other times and we will also be providing
any guidance from a strategy perspective as market conditions change.
In short you will never be more than 24 hours away from an answer and feedback on your investments.
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6. Appendix 1
6.1 Ratio analysis in general
The fundamental merits of a company tend to be reflected in its share price in the medium term or longer
and not necessarily in the short term. At the end of the day, investors make a comparison between the
returns that are available relative to risk. They seek to achieve a more attractive dividend return on their
money compared to some other asset class, or they are seeking exclusively capital growth or perhaps a
combination of both dividends and capital gain. Whatever they seek it always comes down to an
assessment of return versus risk. Fundamental ratio analysis allows those types of comparisons to be
made.
The flaw in just using fundamentals to select stocks is timing – you may have to wait a long time for the
inherent value to be recognised by the market, but more on that process later.
Whilst consideration of the following ratios allows identification of undervalued and overvalued stocks to
be made, it is not imperative that you conduct this analysis yourself. You may wish to source your watchlist
of stocks from other information sources that are available. It depends on how much time you wish to
devote to this activity. This section is largely presented as background information.
The financial ratios can be categorised into five main areas:
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



Liquidity ratios
Management efficiency ratios
Financial stability ratios
Profitability ratios
Market value ratios
Company managers have some discretion under the accounting standards to choose how the numbers are
presented and this can vary from company to company and from one reporting period to the next.
Therefore it is important to not just look at a single set of ratios. In order to obtain meaningful
information, the trends in ratios need to be taken into account.
6.1.1 Liquidity Ratios:
These are a measure of a company’s ability to pay its debts and creditor obligations in a timely manner by
generating cash. Poor liquidity may be indicative of a problem which is becoming serious, despite
seemingly good profits.
Current ratio = current assets / current liabilities
The higher the ratio, the greater liquidity and the more likely the company will be able to meet its short
term debts on time. A good rule of thumb is for the current ratio to be greater than 2, although service
companies which have little or no inventory can operate successfully at less than 2.
Current assets include cash, receivable, inventory, prepayments, and short term investments
Current liabilities include tax liabilities, payables, and provisions for the future
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6.1.2 Management Efficiency Ratios:
These ratios determine how well a company manages its inventory and debtors by calculating how many
times a year these assets are turned over. The higher the ratio, the more efficient it is using its working
capital.
Debtors turnover = gross credit sales / gross accounts receivables
This shows the number of days the company takes to collect its sales revenue and therefore how
times the accounts receivable turned over in a year.
many
Inventory turnover = cost of goods sold / year-end inventory
This shows the number of times that the company’s stock is turned over in a year and therefore how
efficient management is. The higher the number, the better it is.
Payables turnover = year end payables / year end cost of goods sold
This shows how adept management is at using the terms of their creditors to finance their debtors. The
lower the turnover figure, the better it is. A high rate shows that a company is paying its bills too early.
However it must be realised that financial ratios are calculated using historical data and therefore care
must be taken in using those figures to project forward and to try to predict the future. This is where
looking at trends in these ratios will provide a clearer picture of the consistency of a company’s operations.
6.1.3 Financial Stability Ratios:
These ratios help analyse the ability of a company to withstand financial shocks such as rising interest rates
or economic downturn.
Debt ratio = total liabilities / total asset
This ratio is a guide to how much protection creditors would have in the event of a liquidation of a
company. Most analysts would wish to see this ratio below 50%
Debt to Equity Ratio = total liabilities / shareholders funds
This shows the extent to which debt providers have financed a company compared to shareholders. The
difference here is that debt providers require regular repayment of interest, which creates an immediacy
of cashflow necessary to meet those payments, whereas shareholders do not have to be paid on certain
defined dates.
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6.1.4 Profitability Ratios:
Return on equity (ROE) is a basic profitability test and is an indication of the skill of the management to
extract a profit from the equity used in the business. It measures the rate of return earned on
shareholders’ investment and includes any debt used in the business. Therefore one can determine
whether benefit is being gained from the debt being used, as well as the assets.
ROE = OPAT / total equity
OPAT – operating profit after tax from profit & loss statement
Total equity – from balance sheet
6.1.5 Market Value Ratios:
Earnings per share (EPS) = OPAT / number of shares on issue
Any non-recurring items such as an asset sale which is a one-off boost to profit in that financial year must
be removed from the profit before calculating the EPS. We are looking for a consistent improvement in the
EPS numbers over time and ideally the forward forecasts are also showing growth.
Price / earnings ratio (PE) = share price / EPS
This demonstrates how many times current year earnings that investors are prepared to pay for future
earnings. This value allows comparison between different companies in seeking good value. An overall
Australian market PE is generally around 15 times when values are considered to be “normal”. Thus values
lower than 15 may indicate a company is undervalued and values higher than 15 may indicate an
overvalued situation. However this needs to be considered relative to the industry sector as stated earlier.
Price earnings growth (PEG) = PE / EPS growth
This ratio compares the current PE with the rate of growth in earnings and allows an assessment to be
made as to whether the PE is fair or not. Companies with a high PE are not necessarily overvalued if their
earnings growth is substantial over the medium to long term. Analysts look for PEG to be less than one to
indicate potential good value
Dividend yield = dividend (cents) / share price (cents)
Dividend yield shows the rate earned by shareholders from dividends relative to the current price of the
stock. There are many factors influencing how investors perceive the level of dividends, but it is considered
relative to other investment return alternatives, such as effectively risk free bank term deposits.
There are numerous other ratios which can be considered but your focus should not be on becoming a
highly skilful analyst, but rather just getting the basic fundamentals right and then using the price charts to
tell you how the market is perceiving all the known data at any point in time. At the end of the day, it is not
the fundamentals which will determine a share price, but the markets perception of the fundamentals, and
that can be quite different. Keep it simple with an objective of just getting in the right ball-park.
The following formula is presented as a framework for selecting companies in strong financial health, with
outstanding management and which are not overvalued.
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6.2 The Key Ratios
6.2.1 Quality management
ROE > 15%
The easiest way to determine whether a company has outstanding management is to look at their track
record in producing profits from the resources they have at their disposal and in particular at the trends of
these ratios.
ROE – should be greater than 15% per annum and showing a rising trend over at least the last 3 reporting
periods.
Some discretion may be exercised here because some highly leveraged companies (eg banks) operate in a
way where the return on assets will be very low but return on equity (accounting for the borrowings or
level of gearing) is significantly higher.
6.2.2 Earnings growth
EPS growth > 10%
Good companies grow their earnings consistently year after year and 10% growth is considered to be a
sound benchmark. Occasionally a lower or negative figure may be acceptable as a one-off if there is a
particularly good reason for it, so again some discretion is possible.
6.2.3 Don’t pay too much
PE < 15
PEG < 1.0
The PE multiple will to a degree need to be viewed in the context of the sector as a whole. Sectors that
have very favourable future growth prospects will often be given high PE ratios by the market. If the PE is
above 15, then the PEG must be less than 1.0 indicating that the earnings growth more than justifies the
higher price multiple
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6.2.4 Industry prospects
It is absolutely critical that the company you are considering investing in has profit growth prospects in the
next 2 years as a minimum if it is going to give you an edge on the market. Many investors run into trouble
because they keep investing in the traditional ideas. The economy runs in cycles and therefore the
companies that will benefit from the current conditions will vary over time. You must ensure that the
stocks on your watchlist will give you a large edge on the rest of the market by operating in sectors that
will be very supportive of strong earnings growth. At present the sectors that do have favourable outlooks
for the longer term future are:
o
o
o
o
o
o
o
o
diversified resources
engineering for resources
engineering for infrastructure development
gold producers
energy producers
agriculture
fertilizers
healthcare
The companies that will encounter severe headwinds and should be viewed with great caution include;
o
o
o
o
o
o
o
banks
leveraged infrastructure funds
property trusts
transport
retail
media
leveraged industrials
6.2.5 Low debt levels
The debt to equity ratio measures how much money a company should safely be able to borrow over long
periods of time. It does this by calculating the company’s total net debt (short and long term debt minus
cash) and dividing it by the amount of shareholder equity.
Debt to equity ratio = net total debt / shareholder equity
Debt ratio < 0.50
The days of the highly leveraged business model are over. Companies carrying excessive debt will struggle
with the higher cost of money and the problem of obtaining it when needed. Their share prices will be
dealt with accordingly by the market.
The other ratio to consider as a guide, is the level of interest cover. This reflects how many times the
earnings before tax can cover the interest expense. It shows how much of a safety margin exists if the
company’s earnings were to temporarily turn down.
Interest cover = EBIT / interest expense.
A ratio above 2 is considered to be satisfactory.
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6.2.6 Summary of the fundamental rules
Return on Equity (ROE)
Greater than 15% and a rising trend
Earnings per share growth (EPS – 3 yr av)
Greater than 10%
Price earnings ratio (P/E)
Less than 15 times current year earnings
PEG
Less than 1.0 if current P/E is less than 15
Less than 0.8 if current P/E is above 15
Industry prospects for growth in next 2
years
Strong
Debt / equity ratio
Less than 0.5
Interest cover
Greater than 2 times annual interest
expense
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