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The Soapbox

Investing Techniques – Introduction to Fundamental Analysis


There are an endless number of investment strategies, almost all of them involving the use of fundamentals. So what is fundamental analysis? It is a technique that attempts to determine a security’s value by understanding the underlying factors affecting the company’s business and its future prospects. This involves the consideration of both qualitative and quantitative factors. The ultimate aim of conducting fundamental analysis is to determine a security’s ’intrinsic value‘ – that is, the actual value of a company based on all tangible and intangible aspects of the business.

It should be noted, however, that all valuations are subjective in nature and that there is constantly a need to make subjective judgments. The uncertainty underlying fundamental analysis is that the intrinsic value attained is only an estimate, and it is unknown how long it will take (if ever) for the intrinsic value to be reflected in the market price.

By contrast, technical analysis focuses solely on the price and volume movements of securities. The assumption underlying this approach is that all relevant news about a particular company is already priced into its stock, and that its price movements provide more insight than the fundamental factors of the business.

There are also believers in the ‘efficient market hypothesis’ who dismiss both fundamental and technical analysis. The hypothesis contends that it is impossible to beat the market in the long-run as the market is efficient in pricing all stocks on an ongoing basis.

Although there are differing views and methods in identifying mispriced stocks, the importance of fundamental analysis should not be overlooked. Successful investors such as Warren Buffet, Benjamin Graham and Peter Lynch highlight that, although businesses and economic cycles can constantly undergo change, the underlying fundamentals to investing remain unaltered.

Often, the first step of fundamental analysis is to identify potential investment opportunities. This involves identifying both existing price disparities and future opportunities though the thematic research of macroeconomic opportunities, social and consumer behaviors . This funnel approach allows investors to filter and rank the potential opportunities that they wish to pursue.

It is only after opportunities have been identified that investors should proceed onto industry and company analysis. Further research is required to understand by what means the company generates revenue, and how the company is positioning itself to generate profits in the future in response to any changes in its competitive, economic and regulatory environment.

Part II of this series will cover more extensively the use of comparative company analysis as a method of determining whether a company is mispriced in comparison to similar firms.

Investment Strategies – Introduction to Technical Analysis


Within the convoluted practice of modern financial trading, there are two separable schools of thought that have stood the test of time. The first tool in the financier’s predictive arsenal, fundamental analysis, can be described basically as an analysis of balance sheets and cash flow statements. The focus of this article, however, is technical analysis – an observation of the price movements of a security. This tool is used to understand the patterns in the market, and (hopefully) correctly identify any mispriced assets.

Strictly speaking, the investors subscribing to the technical doctrine rely inherently on the assumption that the market has already taken all of the fundamental and broader economic factors into consideration. Hence, technical analysis focuses on using data such as trading volume, historical prices, and open interest to decode the behaviour of the market.

As the market is based on supply and demand – an aggregation of investors buying and selling stocks – technical analysts can exploit opportunities by studying patterns that inevitably filter through.

For example, let’s take a look at a hypothetical world in which Apple stocks do not consistently rise over time. If the share price were to suddenly rise, some investors may be inclined to sell their stake and realise an immediate gain. This would create a structural property – a significant uptick in the stock price, followed by a small downward correction in price. These tendencies create repetitive patterns in price movement that are attributable to general market psychology. Essentially, market participants provide consistent reactions to market stimuli over time. These are the patterns that analysts, armed with their analytical tool bags, aim to exploit.

For a chartist (the classical technician) this would take the form of identifying upward/downward trends and also price levels where the trend is thought to have changed. In more modern terms this is more likely to look like some mathematical engine, able to find and exploit the patterns of the market.

As far as criticism goes, technical analysis bears more than its fair share. The discipline itself has not reached the same level of academic scrutiny or acceptance as the more traditional fundamental analysis has. One of the main issues is that while consistent methods exist to assess the intrinsic value of a company, much of the work in technical analysis is up to the investor – in other words, it is more of a mathematical playground than a concrete, definitive science.

Although it is a relatively young field, technical analysis provides the freedom for investors to think creatively about investment decisions and truly form strategies that are unique to their style of investing.

The Flying Kangaroo: Turbulence!

Jesse Zhou

To the shock of investors and the Australian public alike, Qantas management announced earlier this year that they would make a loss of approximately 300 million dollars for the 2012 fiscal year, the first loss since Qantas was sold by the government in 1995. Consequently, the Qantas share price (ASX: QAN) dropped below the $1 mark for the first time since the company’s founding, 91 years ago. The actual loss as reported on August 23 in the 2012 financial report was $245 million, which is devastating compared to a $250 million profit a year ago. Qantas is an airline with an iconic brand and a strong reputation, but has been struggling with various structural issues in the past few years.

The long haul international division ‘Qantas International’ is dealing with problems such as rising fuel prices (fuel expense of $4.3 billion in fiscal year 2012), a strong Australian dollar (appreciation of 40% against US dollar over the past few years) and economic uncertainty over European debt despairs. Qantas International does not recover its cost of capital and runs many unprofitable international routes. Since the company is based in the southern hemisphere, it lacks the exposure and geographical advantages that many of its international competitors have. The company has been focused on scaling down international operations and closing unprofitable routes, as the division has contributed a loss of $450 million to the company’s losses last year. Along with the announcements of these distressing financial results, orders of 35 Boeing fuel-efficient jet planes costing up to $8.5 billion were cancelled in August in an attempt to conserve capital.

A credit rating cut has not helped Qantas either, with Standard & Poor’s cutting the rating to BBB-minus. A ratings cut means that Qantas faces higher debt financing costs.

The dominance that Qantas has over the domestic market is not all rosy either with the continuous industrial action causing the grounding of the entire Qantas fleet in October 2011, domestic competitor Virgin garnering an increasing level of market share, and Tiger Airways threatening the duopoly. Singapore Airlines, parent company of Tiger, is prepared to operate at a loss to break the Qantas-Virgin domestic dominance, and has unveiled a new Sydney base that started operations in July. Labour also represents a huge portion of expense for any airline, and with high labour costs this may put Qantas at a disadvantage against competitors.

The airline industry by nature is one that operates on paper thin margins. Averaged over the past 40 years, the net profit margin for the world’s airlines was only 0.1%. It is important for an airline to consider its strategy when implementing the number of flights in a certain region. An excess supply of flights means there may be empty seats, which erodes operating margin. However, running fewer flights means a diminishing presence in the market. This may result in competitors surpassing the airline and capturing more customers. Qantas had been extensively focused on expanding international operations, growing total capacity at 5% annually when demand for its flights was only growing at 2-3%. This expansion has cost the carrier greatly due to escalating fuel prices (from $87 before the global financial crisis, to over $100 a barrel).

Alan Joyce, Qantas’ chief executive, is adamant that the substantial loss will not make a difference to the people who fly with Qantas. With the company holding a cash balance of $3 billion, Qantas is investing in new airport lounges, a new entertainment system and the average fleet age has been reduced to 8.3 years of age, the lowest it’s been in some time. Qantas’s strengths are definitely the market share it has in the lucrative domestic corporate travel market (approx 70% market share) and the growth that the Jetstar division is showing in capacity, passenger and revenue. Qantas services the full-service high-end market, whilst Jetstar dominates the leisure market. Competitors become squeezed in the middle.

For an idea of the size and scale of the domestic airline market, we consider the Sydney-Melbourne route. 7 million people fly between the two cities annually, making the route the 5th busiest route on the planet. Between Qantas, Virgin, Jetstar and Tiger, 200,000 seats are offered every week on the route linking the two corporate hubs. Qantas operates 32 flights a day and Jetstar offers 11. Virgin is throwing everything it has to capture a greater market share of domestic fliers from Qantas, but still has a long way to go as Qantas has a well established premium service for corporate travellers.

Qantas has also announced a five-year plan to turn around Qantas International. The plan includes the withdrawal from loss making routes, major reductions in capital expenditure, and alliances with other international carriers. A recent tie up with Emirates will provide a boost for Qantas International. The alliance is to involve a code sharing deal where Qantas flights to Europe will go via Dubai rather than Singapore. This deal parallels a relationship that Virgin has with Emirates competitor; Abu-Dhabi based Etihad Airways. Etihad owns a 10% equity stake in Virgin, and operates marketing and loyalty programs together. As a result of entering a global partnership with Emirates, Qantas will see a declining importance in current relationships with British Airways and other members of the Oneworld alliance (of which Qantas is a founding member). Whether this will be beneficial to Qantas or not, it is still too early to say. QAN.AX has been hovering at around $1.25-30 since the tie up with Emirates.

More recently, Qantas has agreed to sell a 50 percent stake of its StarTrack road freight business and is acquiring the air freight business Australian Air Express from Australia Post. This reflects Qantas’ strategy of strengthening core businesses, and deviation away from non-core operations.

Qantas faces tough times ahead. If the company can uphold market expectations and return international operations back into profit whilst defending its domestic and frequent flier operations from industry competitors, then we should see a return to positive financial performance and a promising future.

Disclosure: Author does not have a position in QAN.

The Tech Calamity

NIGEL LAKE, Pottinger

Pottinger is a leading financial and strategic advisory firm, headquartered in Sydney. Pottinger has advised over 200 M&A and financing transactions such as the sale of LJ Hooker in 2009 and a $34b sale of ING Group’s investment arm. In addition, the organisation has won the Australian business award’s “Recommended Employer” award for 6 years in a row.

Nigel Lake, Joint CEO and Founder of Pottinger, sits down with Carmen Lee and Hansaka Pasindu Fernando to talk a bit about himself, and to give Fully Franked an insight into the fluctuations of the technology industry.

P: Firstly, could you tell us a bit about your background and how Pottinger came about?

Lake: Sure. I started out my career in the UK and went through a very typical educational background: school, Cambridge University and the world of accounting. A very common starting point was to do Chartered Accounting. You did that for 3 years and studied part-time whilst you were working for a firm. Once you were qualified and as soon as you can reasonably move on, you move on. I went into what was then called merchant banking (now Investment Banking). There were some slight differences but you can read about those in Wikipedia.

I joined Barings – then the best M&A business in the UK. It was also the longest-established merchant bank, with a very blue chip background but most importantly for me, it was a business that was really going somewhere. I interviewed with a range of big names but this was the organisation that, despite being very old with 10 or 15 years of not really going terribly well, there was a sense that it really had purpose and there were some young amazingly impressive senior people leading this business. So I joined that business and they did tremendously well, top of the league tables in all sorts of industries such as utilities, financial services, pharmaceuticals, media, brewing etc. From a whole series of highlights, the largest deal I worked on was probably the one for Glaxo Welcome Trust (approximately just over £$9bn billion pounds, some A$25bn – still larger than any deal in Australia to date). But Barings went spectacularly bust due to the actions of a trader in Singapore, by the name of Nick Leeson. None of us in M&A even knew that he existed, let alone the bank was doing that kind of thing. It was brought by administrators, then ING. We all stayed. The business continued to do tremendously well but then come 1998 all of us decided that enough was enough and we weren’t going where we wanted to go with ING. ING got frustrated with some other people in the business and literally the whole thing blew up in 6 weeks. Something like 60 out of 100 people left that team in 6 weeks, and we all went different ways. Between us we now work for all the major Investment Banking and advisory businesses around the world, all the big names, some of that diaspora spread through which is an amazingly useful network to this day.

I went to HSBC. I wanted to go work at a full service Investment Bank but I didn’t want to go work at an American Investment Bank because the culture was too aggressive. I more importantly wanted the opportunity to build something. The organisation had relationships with about 6800 financial institutions around the world and for the students of financial institutions, that is nearly all of them of any size whatsoever and so there was great potential. I ended up spending 4 years there, partly in London and partly in Asia based in Japan and we were successful in building a really good and quite profitable business in our corner. However most of the rest of HSBC’s investment bank was not operating especially well – unsustainable and not making money. So rather like the Barings example, after 4 years, the time had come so a few other colleagues and I each went different ways to do different things, although interestingly left behind a business that was more sustainable. Most of the significant transactions which HSCB did in financial institutions in the following 3-4 years were all relationships which we had commenced in that period.

The Investment Banking world was looking pretty ordinary post tech wreak (2002) so we thought what better time to sort of hang up our caps for a while. I got married to Cassandra Kelly and we took 6 months off to go travelling (highly recommended at any time in your life). We had the luxury, having worked hard and saved hard, of being able to sit back and not go to work. So we moved here, got ourselves set up and started exploring different things. We tried all sorts of crazy ideas; some of them were just mad, some of them were completely sensible, but we were not the people to do them. In the end we sensibly decided to stick with what we knew, which was advice. That comes to the second half of your question of how Pottinger came about: a belief that there was a better way to do things and a better whole approach. Management consultants think about strategy and investment bankers think about deals. There’s this sort of big gap between the two. Management consultants are remunerated based on having lots and lots of people working for as long as possible. Investment bankers on the other hand, need to get a deal done as fast as possible because if they don’t they will probably be fired (the dog eat dog work of Investment Banking). Neither of those 2 things really give clients what they need: advice which links strategic thinking, financial analysis, commercial common sense which is long-term in nature but done quickly so you’re not there forever without actually choosing where to go.

The person that gets hired by an Investment Bank is a very black and white person with a very particular skill set and particular degree. Through the freedom of our own business, we have chosen different people. People from technology backgrounds, physicists and scientists. We have Commerce-Law people too but we have a much more diverse mix. That has been incredibly helpful. It means we have way more diverse knowledge than is usual for an Investment Banking type business or a consulting type business. This was an amazingly long answer for a short and simple question but is sort of how we got here. The telling detail is: I spent 4 years at KPMG, 4 years at Barings, 4 years at HSBC. [Pottinger] is the only place that I wanted to stay and I’m more excited about where we are now and where we can go than I was at the beginning.

P: From there we’ll go into the meat of the interview. We can see around the world a lot of things are happening in the tech industry. In terms of what’s happening in the world (in regards to social networking and technology) a place to start would be the Facebook IPO. The IPO was very hyped up but it ultimately hasn’t been that successful, do you have an opinion as to what contributed to the Facebook IPO disaster?

Lake: Yes, I think we’ve got pretty clear view around that and there’s been a long history of companies and industry sectors getting incredibly over-valued at different points in time and it goes back to the tulip-bubble, south sea bubble or whatever it was and there are endless examples of bubbles over the years. We have picked up in recent times, as you said, the app-making bubble as a particularly weird addition to the technology era. At the end of the day, whatever anyone says to you about what a company is worth, its value is significantly driven by its ability to make a profit and grow that profit over time. And it is as simple as that. A start-up company like Google started out with cost and no revenues but it grew and it grew and then it started to have some revenues but it still made losses. There came a point in time in which it made a profit. And now Google makes enormous profits and its value is based on a perfectly reasonable forward multiple of those profits. When Facebook came along it’s going to have to go through the same journey. It makes a very small profit at the moment and it will make bigger profit in due cost and perhaps a huge profit in some point in time. But the real question is how quickly does it make a profit big enough so it catches up to Google and can be valuated effectively on a similar model? It may grow quite quickly, that growth will slow. Eventually they may both be very similar companies; certainly Facebook is not going to command a valuation premium over Google for the rest of time. So if you come back to that basic perspective. It was very easy in advance of the Facebook IPO to say: “Ok, how is Google valued?” If you value Facebook at $1bn, how fast does it have to grow profit in the next 6 years until it is in line with Google? And the answer is 52% a year. Now that sounds like a crazy high rate right? But of course in its first 6 years of its IPO Google grew 50% a year. So I think that IPO is valued on the simple assumption that Facebook can do 50% growth per year too. The difference is that when Google first started, internet, search and online revenues were completely new. Google didn’t have any real competitors in that space. Similarly, Google at that point only had 60 million customers which it was already extracting significant profit from. They turned 60 million users into a billion users and grew their revenue.

Now Facebook already has the billion users. It started its IPO at the exact same age as Google but hasn’t found a way to monetise that very effectively. It is making much less per user than Google did back then and it has to grow in a much more competitive world. You’re not going to get a Facebook solution for all your searches; it cannot generate the same amount of revenue than Google does because Google has great amount of revenues in this space. It will become more competitive and tougher for Google and the notion that Facebook could grow that rapidly in the absence of a complete shift that is completely new that has nothing to do with their existing business seems very low. So when we looked at Facebook, we said this thing was significantly over-valued. The stock is down 50% and I suspect that if you go through the exact same maths you will still find that it is significantly over-valued.

C: How would you think that Facebook would be able to crystallise their revenues? You said they had to come up with something really different that isn’t already in the market?

Lake: A lot has been written about Facebook and its challenges. One of the easiest ways for Facebook to generate quite substantial revenues is to have some sort of subscription model, but of course they said from the beginning that there will never ever be fees. If it introduces that it will lose a bunch of users. Finding a way to mine the data that people lovingly load up into Facebook and then serve specific ads to people makes theoretical sense but the question is when you go to Facebook have you gone there because you were trying to find something to buy? Not necessarily.  The idea that you can subliminally creep in and get people to buy something is not actually what they’re doing. How many times when you see something on TV do you rip out your laptop or pick up the phone and buy something there and then? Doesn’t happen very often. That’s why the amount you pay for a TV ad per person that watches is massively less for someone looking at an ad online. Now not many people look at the ads online, so the effectiveness of it is not so high. But the revenue per click is 50c-$1 for an individual click-through in some spaces. That’s huge. So think about that when you’re busily searching and clicking on all those ads. You’re actually costing someone, somewhere quite a lot of money.

Coupons on Facebook are a much less direct model then when you sit down and Google blue shoes because you’re trying to buy some blue shoes. The chances are you might actually buy that. If you look at a picture of someone wearing blue shoes are you likely to buy it? I think it is more challenging. Now Facebook is a large company and has been amazingly successful with a huge network of users and is a powerful well-known brand. But joining the dots between a successful revenue and profit model is quite challenging. I think there are things that they can do but it effectively involves taking their existing resources and buying a business that has a much more established monetisation model, and using their reach and resources to leverage that business dramatically. But that is quite a big bet.

P: This is one of the questions which one of our members asked us and that is: How would you value these tech companies? As you said a lot of them have not developed solid revenue streams.

Lake: In principle it is easy because you have to think about at what point in time will this business be profitable, how long will it take to get there, how profitable it will be and how will those profits grow? A piece was written about Zynga when the market price was $10bn. By the time we finished and published it, it was down to $2bn and we still thought it was somewhat over-valued. Zynga makes profit through virtual credits but the proportion of people who use real money in the game is tiny, so the money extracted is incredibly low. And they are not selling many of the games or sell the game for a small amount of money. The games might not last very long as people think they are not as cool as the smartest new game. If you are a traditional game company, you had the right to make a FIFA game. It costs a lot more to make that game but you could make a new edition every year and there will be a huge bunch of people who buys it; a much stronger barrier of entry to your market.

Beyond how you make money and when you make money and how much money you make, think about who can come along and steal that. Who has the ability to take your business away from you? This is why Facebook bought the Instagram business which had gone from 5 million users to 30 million users in a short space of time. People use Facebook to share photos. What if Instagram is a cooler way of sharing photos? It might blow up your $100 million dollar (now $50 million dollar) IPO. So they bought Instagram which now runs as a separate company with 100 million users now. And that’s in about 6 months or 9 months right? An incredibly short space of time. This illustrates how important it was for Facebook to buy that business. Should Instagram have sold? Interesting question. The guy said the business was worth $2bn dollars and maybe he was right. He was persuaded to take a $1bn worth of Facebook stock on the basis that the stock would be worth $2bn dollars but in fact, it is now worth half a billion dollars. Well actually to be fair he (or she) was paid about two-thirds in cash so they kept a big slice of the profit because he got paid in real money and not someone else’s over-valued pre-IPO shares.

P: So from what you are saying, you don’t just look just the quantitative side but also the qualitative side of competitive advantage?

Lake: Absolutely, I mean the quantitative side, which is how much profit a business is making now, is great because numbers are tangible. With technology companies and start-ups and high growth company types you may not have that. You may only have a revenue figure or maybe even just a user figure. People then get drawn into valuing these customers on a dollars per users basis but then that completely ignores the potential of that to ever make profit. So you really need to think far enough into the future to where things do make a profit, how profitable is it, and think about something partly more qualitative: the quality of the business, sustainability of the business and take a view. Now I’m not saying that they are easy to value. But anyone who tells you it’s a different world and it is a paradise for valuation is wrong because it always comes back to how much profit can be made. The Japanese stock market used to value on P/E multiples of 40+ and people say that in Japan it is all different there. When the Japanese market fell 70-80%, it never recovered and valuations in Japan are very normal in line with the rest of the world because it turned out to be just another massive boom.

C: So with the Facebook IPO and how it’s gone. Do you think it’s a sign of another tech bubble coming up or is it just a part of the boom and will keep going?

Lake: It’s interesting and there have been a few (what you might call) pop and flop IPOs when someone’s got a business. Zynga is a good example. It was backed by some VCs on each round of financing, people bought in at a yet higher price because perhaps they thought they could manage to sell out of the IPO at fantastic valuation. Someone was left holding the pieces and the valuation completely collapsed, returning back to more rational levels. Is this a bubble? I think that there is a lot of excitement around certain companies. You have to distinguish excitement which can drive a short term price from long term profitability. This point about short-term attitude is very important because that is where the valuation paradigm is different. If you can build a business which people think is amazing and are prepared to pay an amazing price for, well then great – sell it, take the cash off the table and go do something else because that business may be dramatically over-valued at that point in time.

Apple has been through an amazing period of growth and off the back of some extraordinary products. But go back and watch the launch of the original iPhone in 2007. It was extraordinary what was put into that compared to what people were used to in phones. Then watch the iPhone 4 launch, Steve Job’s last launch. It was quite cool but way less radical. In 2007 they had a phone ‘5 years ahead of its time’ – massively ahead of its time in a fast-booming industry. The iPhone 4 is still ahead of its time and had quite cool stuff, but Samsung and others have been playing catch-up very very fast. Then look at the 4S launch, kind of a bit ahead of its time but looks a whole lot like the [iPhone] 4 launch with the same slides but different numbers. And then if you watch the 5 launch, it is a pretty dram affair. There is nothing in there that is particularly new. That phone is not ahead of its time, it is actually behind its time. The iPhone 5 does not switch off when you go to sleep but Samsung does. When you close your eyes and go to sleep, it switches off. What does that mean for Apple? Growth in China is amazingly important because there are still many hundreds of millions of people in China who want an iPhone. Apple can make huge revenues and their global revenue distribution has dramatically changed in the last 15 months. It is a perfectly reasonable strategy to monetise demand rather than innovate dramatically. But if you get off the innovation bandwagon, it’s so hard to get back on. Apple has been there before. It took quite an amazing personality and force [Steve Jobs] to re-invigorate that business. It is fascinating to watch the world’s largest company with a market cap of over $600bn. Will it grow? Will it shrink? There are very big offsetting dynamics to that. Innovation was not where it was, Chinese growth is hugely significant.

P: With all these tech companies coming up (like Facebook, LinkedIn, Groupon) what do you think is responsible for all these companies popping up? Is it a change in consumer preferences or just in the way people are thinking? Or is there some other reason?

Lake: The key point here is that barriers to entry in this space are incredibly low. Anybody can come up with the idea for a cool iPhone app. Anybody can then make one. You put it up on a board somewhere and advertise to people who make iPhone apps. Now if they think its good they will make it for you for free in return for revenues. There is a very efficient market of talent to make these things but you’ve got to still know how to capture someone’s interest and that is not necessarily a scientific process. There are some companies that do well because they are amazingly well promoted and they have big money behind them. There are others which simply draw attention (Pinterest is an example). Why? Because it had been around for a very long time, it is difficult to know. Someone got excited and it went viral. Everybody dreams that something they own goes viral and becomes suddenly very popular but turning that into profit is still a very difficult journey. But the fundamental point is, there is a very open market for these things, it is easy to promote them, you know you can write some software put it in the [App] store and if people start buying it then you’re away. The bloke that wrote Flight Control down at Melbourne is a fantastic example, it became a runaway success and they sold the business for a few tens of millions of dollars. Pretty cool if you can knock that up in your spare time.

P: The main driver for a bubble will be excitement so how would you distinguish a boom from bubble?

Lake: I think the 2 words are used synonymously, I guess for me, I think what people tend to mean about boom is that you have very strong economic growth matched with significant increase in prices, creeping inflation and the sense in the back of your mind, that you may not be admitting to yourself that this is a bubble about to burst and somewhere in there is a gentle transition where it becomes a bubble. The thing about bubbles is that people don’t realise their bubbles, they just think that tulips are the most wonderful things in the world and they should be prepared to pay extraordinary prices for them and this can happen in all sort of places (a complete mismatch between supply and demand). What’s interesting with Facebook is that the investment banks prepare the company for sale, they market the stock, then the price gets ramped up because the original pre-IPO price was talked to be about high $20s to low $30s, nothing as much as from $38, and then the price range was increased and then it was priced at the top of the price range. But who bought those shares? Not many of those shares were bought by institutional investors; many were bought by retail investors whom presumably trusted their retail broker: that this was a great thing to buy. So it is interesting that in some of these scenarios, the smart money doesn’t get caught as much as the dumb money that follows behind because the smart money says you guys should buy this and quietly sells it and walks away. Buyer beware is the moral of that story.

C: So how would you compare what’s happening right now (whether it be a boom or bubble) to what was happening in the early 2000s?

Lake: As far as the world economy goes, the real difference between now, the dot com boom and the bust that followed was the tech wreck caused a collapse in confidence, or perhaps a return to rationalism and how those valuations in those companies were perceived. The broader economy continued to perform quite well and money remained quite cheap. What followed on from that was both equity and debt becoming cheaper and cheaper and cheaper making it easier to finance things on more and more crazy terms which stroked a bubble in asset prices all around the world in all sorts of different ways. This led to what, in Australia, we call the GFC. The rest of the world calls it the Financial Crisis. The Americans will call it the European Crisis and the Europeans call it the American Crisis. Asset values were deflated very rapidly. Since then of course, the US stock market and many stock markets in the world have recovered a long way back to their all-time highs when the Australian economy hasn’t. So in terms of now, there are some specific segments which when you look at valuations and you think they are clearly overinflated, and the Facebook IPO is certainly a case in point. But the malaise is nothing like as wide, valuations are much lower around the world. So whilst there has been this financial crisis and the leveraging of plenty of companies are having a relatively hard time, the drivers which have been principally financial in nature has not really been driven by underlying economic collapse which leads to a recession, a financial slowdown.

It is a very different set of dynamics which some of the recessions have come before. The challenge is that confidence is quite low but the availability of credit to support growth in effect will be very high now. The US has just started down the path of QE3 and the challenge is you get caught in the so called Keynesian liquidity trap where it doesn’t seem to matter how much credit is available, it is not enough to stimulate people to start behaviour differently. That is much more sinister than the tech wreck which was quite isolated. Are we in a space where there will be very low growth for a quite a long period of time? And the answer is quite likely yes. We have already seen in Japan 20 years of more or less no growth. You don’t want to think about that. The Australian economy is very different, we obviously have the benefits of a huge explosion in the construction of resource projects and that of course will pass quite quickly. There is a few more years left to go but there is not decades of construction left. What follows is a very long tail of 20-30 years of productions of those facilities. But the value of that production remains quite in the air which a few people have commented on quite rightly. The value of that production is likely to fall as more facilities come online and the Australian dollar has a very good track record of off-setting that. The Australian dollars you get may not fall as much as the price of the US dollar does but you are also (from the Australian economy point of view) producing quite a lot more, so net revenues from the country is probably positive. But there are some big ups and downs in that there are some segments, such as the liquid gas exports, which create uncertainty as to how that sector will perform. A number of the mines have been slowed down or put on hold because the world gas prices massively collapsed as suddenly the spark of new gas finds in US is now exporting massive finds off the north coast of Africa, and the UK’s North Sea Oil has run out almost completely but has now got a whole bunch of shoal gas or coliseum gas that can be mined. We’ve got huge amounts here as well but it has now been shipped around the world so has become a global market. Previously if you produced gas locally you could sell it in your local market and that might be a good thing or a bad thing. Now people put it on ships and ship it around the world so the dynamics of that market have changed completely.

P: What companies do you think will likely be very successful in the years to come, or even long term?

Lake: That is a great question. We were running a trading session for our team this morning all around valuation, talking in particular about how you go about producing long term financial models. You can obviously use those as the base of discounting cash flow valuations but there are obviously many weaknesses with discounted cash flow valuations. There is not necessarily a lot that is particularly right about them but they are at least a useful tool. One of the things we talked about was that for many modern companies, you are confident that it will be here tomorrow and you are confident that it will be here in a year’s time. How confident are you that it is going to be here in 5 or 10 years’ time? That depends slightly on what it is and one of the fascinating things are, if you go back and look at company growth and performance in the databases that we all have access to, those databases don’t include all the companies that went bust. You get a view of history that is inflated by the fact of self-selections because databases only contain the winners. Once companies go bust, people don’t leave them in the database anymore so you miss that.

There are also clearly organisations where if you take a 5 or 10 year view, they can just disappear. Consider the late 1990s and how Apple or Nokia was valued. In round numbers, one of those companies was a $100bn company and one of them was a $10bn company, and the $100bn company came from Finland. Wind the clock forward 10 years, one of the companies is worth $630bn and the other is a $10bn company. And the $10bn company (or indeed even less) comes from Finland. That’s because one played the change from 2G phones to 3G phones (particularly smartphones). One played and won and the other one didn’t even really play at all…until recently. If Nokia delivers what they have suggested with this round of phones produced in conjunction with Microsoft, then they will have their first proper smartphone.

C: So to end the interview, we have an informal question. If you could go back to university and give yourself some advice, along what lines would that be?

Lake: I think it’s very difficult to know. It’s difficult to think back to what advice you can give that you would have listened to [chuckle], because you’re in that stage of your life where you sort of think that you know quite a lot and then as the years go by, you discover you know less and less (you all have this to look forward to). I think that most important thing is around what is possible. For pretty much anybody, way more is possible than you typically imagine. Most people have an experience of the working world which is driven by their parents and what they do, possibly what their friends do. They might get the odd summer job and see some little bit in the world. Even with what I’ve done, given the opportunity to have a window into many different things, most of that window is only in the corporate world, parts in government world and little bits in not-for-profit organisations. When you think about the many jobs that people do, I only understand a small percentage of them. I also think that being open to opportunities, being prepared to enjoy the experiences that come along and recognising possibilities is where the best things can happen and it is easy to close your mind to that. So it’s all about having a flexible mind.

P & C: Thank you so much for your time.

Lake: That’s ok. My pleasure.


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