Welcome to the October, 2011 edition of Investor Insights.
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Index

1. Investing in the "New Normal"
2. Insurance - Fundamental to Business Success
3. Age and Finances
4. Dispelling the Myths of Short Selling

In previous Investor Insights newsletters, we have referred to the “new normal’. This is a term coined by Bill Gross, Managing Director of PIMCO and refers to the different investment landscape we now face to that of previous decades. It is a world of lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector.

The question investors have been asking is: “What does this mean for my investment portfolio?” We discuss three key implications for investors below.

1. Yield
In recent decades, investor focus has mainly been on capital growth. However, yield is usually the most stable part of an investment return. For example, in the case of Australian shares, dividends have accounted for more than half their total return since 1990. Therefore, when capital growth is constrained and market volatility is high, yields can become even more attractive. Yields are strong in credit (e.g. hybrid securities), A-REITS (listed property trusts) and Australian equities. For equities, focussing on stocks with higher quality dividend yields should have added benefits as these stocks often demonstrate more capital stability and stronger risk-adjusted returns.

2. Active Portfolio Management
In the past the most popular method for investing was to buy-and-hold a diversified portfolio of investments. Buy-and-hold investing works well in secular bull markets. However, we believe that it is now, more than ever, important to actively manage an investment portfolio. A greater focus should be placed on asset allocation strategies that move between asset classes depending on opportunities. Adding value through active management is a strongly diversifying source of return in a portfolio.

3. Patience
The volatility we are currently seeing in markets can result in markets overshooting their fair value both to the upside and the downside. This means that valuations are likely to reach a point where they become so attractive that they become compelling. But this is usually at times of extreme uncertainty. To take advantage of cheap valuations requires a plan, patience and cash on hand - a plan as to where to invest, patience to wait until valuations are compelling and cash to make the desired investments.

Through the death of her business partner and friend, Sue saw first-hand the importance of a risk adviser and adequate, relevant insurance for a business.

Sue knows better than most the value of having the complete range of business insurance in place. As partner in an accounting firm with her long-time mentor and friend, Paul Gillett, Sue was aware of every nuance and consequence of policies – in fact, she spent most days discussing the importance to clients.

But like everybody’s situation, the reality for Sue and Paul was a lot more complex, and just like most people, it came down to “getting around to it” and an aversion to paperwork.

Sue had approached a local risk adviser as a potential referral source for their accounting clients who needed guidance on insurance cover. “He said he wanted to assess our personal situations first,” explains Sue. “He found that what we had was not adequate. So he rewrote all our insurance, taking in to account our new structure, and redid the policies for our partnership and our business insurance.”

Not long after that, Paul was diagnosed with sheath nerve cancer. A biopsy was taken and despite the odds, just 5%, Paul found out it was malignant. During his chemotherapy and a series of operations on scar tissue around the tendons in his wrist, Paul kept up his work with clients. “He was very dedicated,” says Sue. “Paul was conscious of pulling his weight and it was good for him to stay involved.”

Despite treatment, the cancer came back more aggressively. The only option was to remove Paul’s right arm. Sue and the rest of the office staff held the fort while Paul underwent intensive radiotherapy and chemotherapy.

“We were attending an upcoming professional conference, held in Hawaii, where we were being recognised with a distinguished award. Paul was so proud. He wouldn’t be able to go, and I was reluctant to go by myself. He insisted we still go to Hawaii, and in the meantime, unbeknownst to me, Paul was admitted to hospital.”

While Sue and her husband were attending the conference, Paul passed away. They immediately returned. While still in shock, Sue had to gather up the policies, documentation and claims paperwork and as the dust settled, a few home truths emerged.

“The mistake we made,” says Sue, “was not getting ‘key person cover’ on both of us. This would have paid down if either of us was off work, and we needed to employ somebody for that time. It would have taken care of the financial stress.”

“There were so many things we had neglected. We delayed getting around to the appropriate insurance and agreements because we had to tailor them to our specific needs, add our own clauses to the basic documents that were supplied. It was unpleasant to deal with, even though the reality was, Paul was ill.”

Sue’s advice is simple: “Have your agreements formulated by a competent legal firm with expertise in your field, as well as your insurance completed by a risk adviser. This underpins business success.

“Get your accountants involved for business valuations. Make sure balance sheet items are adequately covered by insurance. When it comes to agreements, make sure each partner can sign for the other in the event of death – a Power of Attorney clause. Keep a copy of signed transfer forms on file. Make sure you have all the details of loans between parties and vendor finance arrangements and how they will be dealt with in the event of the death or total permanent disability of one of the partners.”

“Always ensure the business is adequately covered,” recommends Sue. “For the sake of a couple of hundred dollars a month, you have peace of mind and if you need to claim, half a million dollars.

“If we don’t do it as professionals in the industry, how can we expect our clients, with their own busy lives to prioritise it? We need to be business development advocates as well as focusing on wealth creation, and we need to be proactive and care about our clients’ businesses, and their lives.”

Are you keeping your finances healthy by doing the right thing at the right time? Take a look at these life stage strategies to get you back on track.

Our approach to money is heavily influenced by our life stage. But what are other people our age doing with their money?

Using the right strategies at the best time can be crucial to your financial future.

Accumulators (aged 25-45)

Save while financial obligations are low:-

Control debt
• reduce unnecessary spending.
• pay off the credit card, it's probably costing you more than 15% pa interest.
• consider consolidating credit card debt into a personal loan, and potentially paying less interest. If you do this, resist the temptation to accumulate more debt into your credit card.

Tap into the government for a co-contribution
• if eligible you could get up to $1,000 added to your super for free, every year.

Consider using a mortgage offset account
• this could reduce your loan interest while giving you access to the cash if you need it.

Make sure you have sufficient death, disability and income protection insurance.

Builders/Pre-retirees (aged 45-65)



Stay cash flow positive
• live within your means.
• reduce the mortgage and other non-deductible debt such as credit cards and personal loans. This may free up cash flow for other investment opportunities.
• consider part-time work for a non-working spouse.

Increase contributions to super
• at age 50, the concessional (pre-tax) contribution cap increases from $25,000 to $50,000. (The increased concessional contribution cap applies until 30 June 2012. However the government has indicated that it plans to permanently increase the concessional contribution cap to $50,000 for individuals who have total super balances below $500,000 and are 50 years old or over.)
• consider transferring non-super assets to super. You'll need to take into account any capital gains tax on the transfer and the super rules covering what assets you can transfer.

Split income where possible to save tax
• consider investing money in the name of the spouse who pays the lowest tax.
• consider splitting super contributions between spouses. Up to 85% of concessional contributions within the contribution cap, including Super Guarantee and salary sacrifice contributions can be split.

Look into a pre-retirement pension if you're age 55 or more
• consider salary sacrificing, and drawing down regular income from your super to replace the lost income – saves tax and builds your super without affecting your cash flow.

Make sure you have sufficient death, disability and income protection insurance. Also consider taking out trauma insurance.

Retirees (aged 65+)



Ensure you don't run out of money
• understand your plan for spending in retirement - set a budget for essential expenses and additional lifestyle expenses and how you'll fund each.
• ask yourself if you've invested your assets too conservatively - maintaining and growing your capital today can help you provide the income you'll need in the future.
• consider whether you need to downsize your home

Investigate how your income and assets affect your Centrelink benefits. Simple changes can help ensure that you maximise your total income.

Consider setting up investments to help grandchildren with education costs, a deposit on their first home or an investment nest egg. You'll need to include this in your retirement spending or estate plan.

Think about aged care now. When the time comes, decisions often have to be made very quickly, so plan ahead for which care options you'd like to use and how they'll be paid for.

Review your estate plan
• consider a Non-Lapsing Death Benefit Nomination for your super or a reversionary pension for your pension.
• ensure your Wills and enduring power are in order.

What is shorting?
On those occasions where an investment manager finds a company that they believe will decrease in value, rather than increase, they can take a ‘short’ position in this company.

This involves them borrowing the share that they believe will fall in price from a broker and selling it at the current price.If the share price decreases as expected, the investment manager buys back the share at the lower price and returns it to the broker, keeping the difference as profit. This is shorting; the practice of benefiting from an anticipated decline in the value of a share.

While shorting strategies have the potential to generate returns in both up and down markets, there are a number of myths about shorting that have stopped many investors from using these strategies within their portfolios.

Here we tackle seven common misconceptions about shorting:

1. Shorting can make a company go bankrupt
Shorting a share is no more sinister than selling a share for less than you paid for it. Assuming a company has a reasonably strong balance sheet, even if its share price fell to zero, it would still be worth the value of its balance sheet. All shorting does is expose weak companies.

2. Shorting played a part in the GFC
Prior to the GFC, there were a lot of companies with over-stretched balance sheets and these were exposed during the GFC. Shorting did not create the downward pressure on these shares during the GFC. However during the extraordinary circumstances of the GFC, it can be argued that it compounded the pressures already at play.

3. Shorting = positive returns
While shorting provides the opportunity to profit in both rising and falling markets, not all short positions generate a positive return. In fact, shorting is a specialist skill, as picking companies that will decline in value can often be much harder than picking companies that will rise in value.

4. Shorting is not transparent
All short selling transactions and positions are declared to the Australian Securities Exchange at the end of each trading day and are available to all market participants.

5. Shorting is not ethical
Some view shorting a company as tantamount to wanting it to fail. This is not the case.
In fact, shorting can be a benefit to the overall market because it adds liquidity, improves trading efficiency and helps to highlight where poor company management is not delivering on its promise to shareholders.

6. Shorting involves unlimited downside risk
It is true that, when opening a short position, the theoretical risk is limitless because the value of the share could increase forever. However, a ‘stop loss’ (described below) can be used to ensure a share is sold when it hits a predetermined price, which limits the amount of risk involved.

7. Shorting doesn’t work
The positive long-term performance of market indices leads many to believe that shorting does not work. The aim of short selling is to profit from shorter-term factors, such as negative news or earnings downgrades, and can be used as a complement to a long portfolio that benefits from share price gains over the long term.

What are the benefits of shorting?
Shorting allows investors to profit from declining share prices. Not only can this boost portfolio returns, it can also provide diversification from the traditional ‘long only’ portfolio.

If a ‘long’ investor finds a share to be unattractive, their only options are to sell the share, or not buy the share. If a ‘short’ investor finds a share to be unattractive, they can short the share. If the investor’s assumptions are correct and the share falls in value, the short investor can actively generate a return from a share that is set to decline in price.

What are the unique benefits of a long-short fund?
When fund managers use a ‘short’ portfolio in conjunction with a traditional ‘long’ portfolio (a long-short fund), the role of the short portfolio is to boost returns from tactical short positions.

These two styles of investing complement each other. Short positions take advantage of shorter-term factors such as negative news or earnings downgrades, while the long positions focus on the longer-term principles of sound investing. Any profits from the short positions may be used to increase existing long holdings, buy into new long holdings or, if there are no high conviction opportunities on offer, the profits can be held as cash, accruing interest. A long-short fund can deliver additional returns for investors in volatile or sideways markets.

Risk management is so important
While well-chosen short positions can generate returns, especially during periods of market uncertainty, taking short positions does involve higher levels of risk than taking long positions only. Having a rigorous risk management process in place is a key part for any successful shorting strategy.

The process we use for all our long-short strategies is:
• Stop losses at 10%. If any share that we short increases by 10%, the position must be immediately closed, thus limiting the loss to a maximum of 10%.
• Maximum position of 2.5%. No individual short position can exceed 2.5% of the portfolio.

Together, these risk controls mean that the worst possible portfolio impact of a single poor short position is a negative 0.25% return for the portfolio.

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This newsletter contains general information only and does not take into account the investment objectives, personal circumstances or financial needs of any particular investor. You should therefore obtain professional financial advice before making any investment decision based on the information provided in this document. In the event that this newsletter contains information about a particular financial product, you should also obtain a Product Disclosure Statement in respect of that product prior to making any decision to acquire that product.