ISSUE 5 | 25th February 2009
2008
EDITOR’S MESSAGE
FULLY INSIDE THIS ISSUE
Articles
Warren Buffett: How young investors
can be successful
Richard Kelaher
Weathering the global Recession:
Australia’s Commodities Boom
Balraj Hansra
The Dark side of finance: Derivative
Securities
Louis Yang
Valuations using the PEG ratio
Bobby Lien
Quiz
Fully Challenged:
20 questions to test your knowledge
of the latest market news and WIN!
FULLY UPCOMING EVENTS
Introduction to Stock Picking:
In today’s uncertain climate it pays to
be informed. Let an experienced
Fund Manager inform you about
what are the real picks in today’s
market.
Guest Speaker: Ross McInnes from
Australian
Investment
Research
Services (AIRS).
Date: End of March
Time & Venue: TBA
Cost: Free for anyone to attend
Hello and a warm welcome from the University Network for
Investing and Trading (UNIT). With free membership,
competitions, seminars, and huge social events, UNIT aims to
get students excited and informed about the world of
opportunity that share trading and personal investment brings.
We organise professional traders and experts to give seminars
on how we, as young people, can trade and invest.
With over 2000 members from all faculties across Sydney’s top
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Vice President and Chief Editor
USYD UNIT
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25 February 2008
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ISSUE FIVE
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Warren Buffett: How young investors can be successful
Buffett’s advice to young investors, and how his words are relevant now
Warren Buffett stresses that the keys to success as a young investor are expanding your
knowledge base early, thinking about the underlying business, and gaining real experience.
At the 2007 Berkshire Hathaway shareholder’s meeting, Buffett recounted that he had read
every book on the topic in his local library by the time he was ten. Only with a broad
knowledge base, he says, can one then distinguish between what is useful investing advice
and what is not. A broad knowledge base is the essential lens through which current events,
opportunities and advice are viewed in order to make the best possible decision – and the
key is to develop this early.
Buffett claims reading Benjamin Graham’s Intelligent Investor was a turning point in his life,
which recommended thinking of stocks as businesses rather than pieces of paper that
fluctuate in value. Quantitative methods of trading by nature work on past data, based on
what has already happened, and therefore do not capture marginal opportunities.
An example of how this might be relevant is the current situation surrounding the Australian
banks. Although as of early February the banks had declined in value on the ASX, the banks
seem to be enjoying an unexpected bonanza amidst the financial crisis. Earnings are rising as
alternative sources of funding are drying up, with CBA recently reporting a $2 billion cash
profit for the half year to show for it. CBA are now even advertising a 60 minute home loan
(including paperwork) – an idea that clashes horribly with the notion of a “credit crunch”. A
young investor might think about which business would be well equipped to take advantage
of the situation and make their investment decision accordingly.
Buffett draws parallels between investing and life in general, in that diving into the deep end
by investing real capital is just something that a young investor has to do in order to
understand what investing is all about.
With a broad knowledge base and real experiences in investing, according to Buffett, a
young investor is setting themselves up for success.
Richard Kelaher
USYD UNIT
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ISSUE FIVE
The Dark Side of Finance: Derivative Securities
In recent times, derivatives have been blamed for the destabilisation of financial markets
and, subsequently, the real economy through their riskiness and complexity. Derivatives,
characterised by significant leveraging, can result in gains or losses two or three times the
initial investment. However, implemented well, derivatives can reduce the overall risk carried
by a portfolio. Essentially, derivatives are financial instruments whose value is based on the
price of some underlying asset. These underlying assets can take the form of many diverse
assets, including commodities, stock prices, exchange rates, residential mortgages and even
weather conditions.
Derivatives can be used to transfer risk from one party to another. Often, one party will take a
position in a derivative to insure, or hedge, against a certain event occurring in the future. The
other party will take on the exact opposite risk with the view to profiting from this future event.
This concept will be further illustrated through the discussion of futures, forwards and options.
Derivatives, while being accused of lacking regulation in the wake of the financial meltdown,
offer some very substantial opportunities for discerning investors. This article provides a
background on a few major types of derivatives and the ways they can be used to profit
different types of investors.
Forward contracts are agreements to buy or sell an asset at a specified time, called the
delivery date, at a specified price, called the forward price. The spot price is the current price
of the asset and can be higher or lower than the forward price. They are over-the-counter
derivatives, meaning they are negotiated between private entities without an exchange
intermediary. Futures contracts operate under the same principle as forward contracts, but
are exchange-traded derivatives. They are standardised contracts and are overseen and
assisted in their settlement by a futures exchange. Furthermore, they do not always specify an
exact delivery date and may only specify the delivery month. Aside from such differences,
the basic premise of both forward and future contracts is the transfer of risk from one party to
another. The issuer of the contract can hedge away the risk of a future event, such as a fall in
oil prices, grain prices, currencies and many other events. While such hedging was arguably
the original purpose of forward and futures contracts, they have become very speculative in
nature as speculators can gain significant leverage through the use of such financial
instruments.
Options give the holder the right to buy (call option) or sell (put option) an asset at a
specified time, known as the maturity, at a specified price, known as the strike price. The
major difference between options and futures/forwards is that options give the holder the
right to buy/sell, but does not oblige them to do so. American options, allow the holder to
exercise the option (either buy or sell the asset at the strike price) at any time before maturity,
while European options can only be exercised at the maturity date. In the options market, the
long position is taken by the buyer of the option and the short position taken by the seller of
the option. A long call position using share options is taken when call options are bought. A
trader can take a long call position if they believe the share price will rise in the future. In this
scenario, let’s say the current price of the underlying asset, the share itself, is $5. The strike
price of the option is $10 and the option expires in one month. The option gives the investor
the right to buy 100 shares. If, in a month’s time, the price of the stock rose to $15, the holder
of the call option would be wise to exercise the option and purchase the 100 shares at $10
ISSUE FIVE
each. If they sold the shares immediately, they would realise a gain of ($15-$10) x 100 = $500
before premiums are considered. The profit would be reduced by the amount paid for the
option.
In general, when a call option is held, the option should be exercised if the strike price is
below the market price at maturity. If the strike price is above the market price, the holder
would not exercise the option as they could acquire the shares at a lower price on the
market. In this case, the option would simply expire and the holder would incur a loss equal to
the amount paid for the option. The scenario presented above is one of four typical
transactions involving options. A short put (selling a put) can also be used to take advantage
of rising share prices, while a long put (buying a put) or a short call (selling a call) can be used
by traders while the price of the share is falling. Besides these basic positions, traders can
engage in multiple transactions of options and shares to create more complicated positions.
Hedgers use derivatives to insure against a future event occurring. In many ways, it was the
needs of hedgers that prompted financial engineers to create derivatives. These original
hedgers, producers and consumers of commodities in the real economy, needed insurance
against seasonal price changes. For example, a crop farmer could hedge against a fall in
grain prices buy taking out a contract to sell grain at a specified date in the future at a
forward price, say $50. In this manner, the farmer can insure that he will be able to sell grain
at $50, regardless of any future price movements. Of course, grain prices could very well
appreciate to $60, and the farmer would be obliged to sell below market price. If this were to
occur, the speculator on the other end of the contract would buy the grain at the specified
price and make an instant profit by selling the grain at the market price immediately.
In contrast to hedgers, speculators are willing to take on risk by betting on a future event
occurring. By using derivatives, such as futures contracts, speculators can gain leverage by
being exposed to greater risk with very small amounts of capital used initially. A speculator
believing that Australian dollars will appreciate relative to US dollars can maximise his
potential profit (or loss) by taking out a futures contract to buy Australian dollars in the future
rather than buying Australian dollars at present, which requires a far greater initial outlay.
Arbitrageurs attempt to take advantage of price discrepancies of an asset between two or
more markets to profit without being exposed to risk. For example, if an asset is priced higher
in one market than another, the arbitrageur could buy the asset at the lower price in one
market and sell it at the higher price in the other market. However, arbitrage opportunities
are extremely transient as attempts to capitalise on imbalances result in the prices
converging. Thus, the basic example given would be eliminated very quickly in most
circumstances. Consequently, arbitrageurs rely on speed and timing of their transactions to
make a profit.
Louis Yang
USYD UNIT
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ISSUE FIVE
Weathering the Global Recession:
Australia’s Commodities Boom
Australia’s Resources boom in trouble if global rout continues.
Resource stocks have plunged over the past 6 months, commodity currencies like the Aussie
have lost close to 30% and many firms are laying off workers due to massive falls in metals
prices, however it is far from over.
Mining has been the iron horse of Australia’s economy with commodities making up almost
60 percent of Australia’s export earnings. A primary region of growth has been a location in
the North West of Australia called the Pilbara region. The Pilbara is characterised by its
extreme heat; regularly in excess of 45 degrees during the wet season, its large proportion of
fly in – fly out workers (FIFO) and the strong presence of mining heavy weights such as BHP
Billiton, Rio Tinto and a relative newcomer Fortescue Metals. The area is primarily described
as Australia’s saviour in terms of the credit crisis, however with metals correcting severely as a
result of reduced global growth estimates by governments and the IMF alike, they are not
immune to the global slowdown as previously thought before.
While not as bad as in other nations, the global slowdown has definitely made its presence
known to many involved in the resources sector. Perilya Metals (ASX: PEM), a miner primarily
involved in mining of base metals is one casualty of falling metals prices. Last year, Perilya
laid off half its work force to try to reduce the impact of plunging base metals prices and its
stock is off nearly 95% for the year. Woodside – an Australian oil and gas company have put
a freeze on recruitment, Rio Tinto are drastically selling prized tier one assets such as
Escondida in order to reduce debt. Only in early December did they announce the slashing
of 14 000 jobs and have recently been in talks with Chinalco with a US$19.5b stake from the
Chinese Aluminium company.
ISSUE FIVE
Base metals have been savaged as a direct result of a slowdown in the world’s largest
economy, the US, and slowing growth in China. Base metal prices, especially Copper can be
used to gauge the state of the economy since they are used in manufacturing and home
building. Copper is off close to 40% since June 08. However this is not the main problem the
Aussie miners are facing.
The Pilbara region was first discovered in 1861 and has been mined for metals for over 60
years. It has been the focus of Australia’s economy over the last decade with the massive
amounts of iron ore present. Iron ore is a precursor to steel and iron and is an important
commodity for steel mills and manufacturers. Countries undergoing rapid expansion of
infrastructure such as China and India need iron ore to keep producing the steel required for
infrastructure. Iron ore, a commodity not traded on the exchange like others, is priced
generally by a contract between two parties, the miner and the buyer. These contract prices
are ever escalating and have increased 400% over the last decade due to demand. This has
resulted in massive profits for miners such as BHP and Rio Tinto, however the interesting times
lie ahead.
China hosted and participated in its most successful Olympics ever in 2008 and ever since,
China has been in a post Olympics hangover partly due to the fact that many factories were
shut down over this period in a bid to improve air quality. As a result, China has been able to
start stock piling iron ore and other resources and thus the contract prices are under fire. In
December 2008, Chinese steel production bucked the trend and actually rose month on
month, but this may have only been a clean out of stockpiles with January production down
once again. Many Chinese steel mills are attempting to renegotiate contracts they entered
in, not only because of the global slowdown, but because steel prices are below what it costs
them to produce the steel. The two main elements to produce steel, coking coal and iron
ore, are still extremely expensive due to fact that they are contract prices and are locked in,
unlike spot prices. Shipments of iron ore from Australia to China have been cancelled, some
firms are threatening to cease their business relationships if prices do not reflect the
underlying economic conditions, and others are simply out of business.
This is not the last problem in the book for the miners, as these contract prices expire and will
be renegotiated in April 2009. The exponential growth of the contract price for iron ore is
expected to hit a brick wall when new contracts are entered into, and only then will we see
current economic fundamentals reflected in the price.
Balraj Hansra
USYD UNIT
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ISSUE FIVE
Valuations using the PEG ratio
The PEG ratio is a very useful tool used to value a company relative to its intrinsic value. It is
the ratio of the Price/Earnings to the estimated growth of earnings for the year.
To advance our discussion of the P/E ratio that I wrote in our last issue, the P/E ratio is used as
a proxy among Wall Street analysts for the expected growth in earnings or dividends. In other
words, if a company is valued correctly (at its intrinsic value), the P/E ratio and the growth
rate of earnings (g) should be equal.
Now, taking this idea further, the PEG ratio can therefore help us determine whether a stock is
valued correctly. If the PEG ratio is less than 1, this may indicate that the expected growth
rate of the stock’s earnings is able to beat current market valuation of the stock. That is, the
stock is underpriced. Similarly if the PEG ratio is greater than 1, this may suggest that the stock
is overpriced.
To a further extent, Peter Lynch in his famous book “One Up on Wall Street” suggests that “if
the P/E ratio is less than the growth rate, you may have found yourself a bargain.” To put it
another way, Lynch is advising investors like us to be on the look out for PEG ratios that are
less than 1.
So what are some stocks that have PEG ratios less than 1? As of the beginning of 2009, the
following stocks have PEG ratios less than 1:
CSL Limited (CSL): 0.74
Ansell Limited (ANN): 0.44
Lihir Gold Limited (LGL): 0.58
Brambles Limited (BXB): 0.85
Could these stocks potentially be underpriced? Remember PEG ratios cannot tell us
everything about a stock. You must consider other financial tools such as technical analysis to
help strengthen your investing charisma.
Bobby Lien
USYD UNIT
DISCLAIMER
The material in this report is produced as general information only and is not intended to be advice. Readers
should not act on the basis of this information and must seek specific advice from your own professional adviser
before taking any action. No warranty or guarantee is given regarding the accuracy or reliability of this report. The
authors expressly disclaims all and any liability to any person for any loss or damage arising as a result of this
publication, whether whole or part of the contents of this publication. For permission to use this report, you must
accept full responsibility for any action that you take. Note also that past results are not a reliable guide to future
results. Future outcomes are unknown and investing can result in financial loss.
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18-02-2009 11:45:15
ISSUE FIVE
FULLY CHALLENGED
Think you're a market guru? Complete our Fully Challenged Quiz to have a chance at winning
Liar’s Poker, an awesome recount of the investment banking days of the 1980’s by Michael
Lewis.
Answers can be found in the next issue of Fully Franked.
1. Which mining company recently
announced the shutdown of a nickel mine
close to the WA Goldfields?
a.
b.
c.
d.
Rio Tinto
Chinalco
BHP Billiton
Nickel West
3. What does the financial product acronym
CDO stand for?
a.
b.
c.
d.
Corporate Default Obligation
Credit Derivative Organisation
Cash Drop Obligation
Collateralised debt obligation
5. As of January 20th 2009, which is the largest
bank in the world by market cap?
a.
b.
c.
d.
Citigroup
Bank of America
HSBC
UBS
7. What is the value of the recently passed
Australian stimulus package?
a.
b.
c.
d.
US$41 million
US$22 billion
AU$42 billion
AU$390 billion
2. US President Barack Obama recently
implemented a cap for executives taking bail
out money of how much?
a. US$1
b. US$0
c. US$500 000
d. US$100 000
4. Which US investment bank had to recently
cancel a US$50m order for a corporate jet
while taking bail out funds from the US Govt.?
a.
b.
c.
d.
Bank of America
Citigroup
Goldman Sachs
Macquarie Bank
6. Which currency is pegged to the US Dollar?
a.
b.
c.
d.
Hong Kong Dollar
Australian Dollar
Euro
Swedish Krona
8. Which car manufacturer is one of a
handful that has increased registrations this
year?
a.
b.
c.
d.
General Motors
Ford
Toyota
Kia
ISSUE FIVE
9. Which American individual was recently
arrested for allegedly creating a US$50bn
ponzi scheme?
a.
b.
c.
d.
Bill Gates
Bernard Madoff
Timothy Geithner
Vikram Pandit
11. Which investment bank recently
announced that profits would fall 50% year
on year?
a.
b.
c.
d.
Macquarie
JPMorgan
Goldman Sachs JBWere
Merrill Lynch
13. Which Japanese car maker recently
predicted that car sales will fall 54% this
quarter?
a.
b.
c.
d.
Mitsubishi
Toyota
Nissan
Kia
15.The current official interest rate in Australia
is:
a.
b.
c.
d.
6.5%
2.75%
3.25%
7.5%
17. The current official interest rate in Japan
is:
a.
b.
c.
d.
0.25%
0.5%
0.1%
1.00%
10. Who is the current president of the
European Central Bank?
a.
b.
c.
d.
Jean-Claude Trichet
Gordon Brown
Wim Duisenberg
Boris Bartois
12. When is the ASIC ban on covered short
selling of financial securities expected to
end?
a.
b.
c.
d.
Friday 6th March
Monday 9th March
Friday 28th February
Indefinite ban until further
notice
14. As of February 16th 2009, which country
listed has the highest interest rate out of the 4
listed?
a.
b.
c.
d.
Brazil
Turkey
Egypt
South Africa
16. Which mining company is currently
suspended from trading on the ASX and is
facing a possible AU$2.8b write down?
a.
b.
c.
d.
BHP Billiton
Fortescue Metals Group
OzMinerals
Brockman Resources
18. Recently, which Asian economy reported
an annual pace 12.7% drop in GDP in the last
quarter?
a.
b.
c.
d.
Singapore
China
Japan
Thailand
ISSUE FIVE
19. What was the RBA cash rate target as of
the 5th March 2008?
a.
b.
c.
d.
20. Which country is not part of the Group of
Seven (G7)?
3.25%
$1.6 billion
7.25%
$5.1 billion
a.
b.
c.
d.
Australia
Italy
France
Canada
Please submit your answers to competition@unswunit.com along with your name, degree,
student number and contact number by 9pm Friday March 6th. The first entry drawn with the
correct answers and being a member of UNSW UNIT will win a copy of ‘Liar’s Poker’ by
Michael Lewis.
UNIT’s decision is final in determining the winner.
Balraj Hansra
USYD UNIT
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