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Farrellys Avoiding avoidable mistakes Tim Farrelly August 2010

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farrellys Avoiding avoidable mistakes Tim Farrelly August 2010 Slide 2 farrellys Avoiding avoidable mistakes Bubbles are big and compelling The damage is significant and long term But can they be identified in advance? Can we avoid them? Slide 3 farrellys Bubbles big and compelling AssetYear of peak Gold (US$)Jan 1980 Japanese equities (Yen)Jan 1990 Japanese residential property (Yen) 1991 US equities (US$)Mar 2000 US REITs (US$)Mar 2007 A good idea because The ultimate inflation hedge Japanese companies taking over the world Rising demand, limited supply The internet revolution Stable income, low risk, high returns Slide 4 farrellys but cause significant damage AssetYear of peak Fall from peak to trough Gold (US$)Jan 1980-71% Japanese equities (Yen)Jan 1990-82% Japanese residential property 1 (Yen) 1991-65% US equities (US$)Mar 2000-56% US REITs (US$)Mar 2007-71% Slide 5 farrellys Significant.. and permanent AssetPeak10 years after peak Value of $1000 20 years after peak Value of $1000 Real value of asset Real value of bonds Real value of asset Real value of bonds Gold (US$)Jan 1980 $297$1990$155$3458 Japanese equities (Yen) Jan 1990 Y328Y1977Y496Y2386 Japanese residential property (Yen) 1991Y561Y1962Y689 1 Y2271 1 US equities (US$)Mar 2000 $729$1819na US REITs (US$)Mar 2007 na 1. 19 years after peak Slide 6 farrellys Can your clients afford one or more of these experiences? AssetYear of peak Fall from peak to trough Time till trough Gold (US$)Jan 1980-71%19 yrs Japanese equities (Yen)Jan 1990-82%19 yrs Japanese residential property (Yen) 1991-65%14 yrs US equities (US$)Mar 2000-56%9 yrs US REITs (US$)Mar 2007-71%2 yrs Slide 7 farrellys Avoiding avoidable mistakes Bubbles are big and compelling The damage is significant and long term Can bubbles be identified in advance? How can we avoid them? Slide 8 farrellys The Occams Razor approach tp long term forecasting Income + Growth in income + or - Effect of change of PE Ratio Slide 9 farrellys Long run returns-an example 5%pa EPS PE Price Contribution $1.00 10 $10.00 Income Growth Income PE effect Total 5%pa + + Slide 10 farrellys Long run returns-an example 5%pa EPS PE Price Contribution $1.00 10 $10.00 $2.00 10 $20.00 +7%pa Income Growth Income PE effect Total12%pa + + Slide 11 farrellys Long run returns-an example 5%pa EPS PE Price Contribution $1.00 10 $10.00 $2.00 10 $20.00 $2.00 20 $40.00 +7%pa Income Growth Income PE effect Total19%pa + + Slide 12 farrellys Long run returns-an example 5%pa EPS PE Price Contribution $1.00 10 $10.00 $2.00 10 $20.00 $2.00 5 $10.00 +7%pa -7%pa Income Growth Income PE effect Total 5%pa + + Slide 13 farrellys Forecasting Australian equities returns Return driverEstimateNotes Yield ? Includes imputation credits Growth in EPS ? Change in PEPE now : 14.7 PE 2020 : ? Total Slide 14 farrellys Forecasting Australian equities returns Return driverEstimateNotes Yield5.5%Includes imputation credits Growth in EPS Change in PEPE now : 14.7 PE 2020 : ? Total Slide 15 farrellys How fast can companies grow their earnings? Slide 16 farrellys Capitalism at work Slide 17 farrellys Forecasting Australian equities returns Return driverEstimateNotes Yield5.5Includes imputation credits Growth in EPS3.6 Change in PEPE now : 14.7 PE 2020 : ? Total Slide 18 farrellys Forecasting Australian equities returns Return driverEstimateNotes Yield5.5Includes imputation credits Growth in EPS3.6 Change in PE?PE now : 14.7 PE 2020 : ? Total Slide 19 farrellys Where will PEs be in 2020? Slide 20 farrellys Where will PEs be in 2020? Slide 21 farrellys Forecasting Australian equities returns Return driverEstimateNotes Yield5.5Includes imputation credits Growth in EPS3.6 Change in PE0.8PE now : 14.7 PE 2020 : 16.0 Total Slide 22 farrellys Forecasting Australian equities returns Return driverEstimateNotes Yield5.5Includes imputation credits Growth in EPS3.6 Change in PE0.8PE now : 14.7 PE 2020 : 16.0 Total9.9%pa Slide 23 farrellys Forecasting Australian equities returns & bonds Return driverEstimateNotes Yield5.5Includes imputation credits Growth in EPS3.6 Change in PE0.8PE now : 14.7 PE 2020 : 16.0 Total9.9%pa 10 year Govt bonds 5.2%pa Slide 24 farrellys What did this framework indicate about bubbles? US REITs The internet revolution Japanese equities Gold Slide 25 farrellys REITs yields are historically low Source Nareit As at March 2007 Slide 26 farrellys Price/Distribution makes US REITs look extremely overstretched As at March 2007 Slide 27 farrellys What lemmings believe Slide 28 farrellys US Equity REITs forecast Yield3.4% Earnings GrowthInflation + reinvestment- depreciation - leakage 1.9% Valuation EffectYield rises to 5.6% from 3.4%-5.4% CurrencyAussie bonds less US bonds; 5.8%-4.8% 1.0% Total0.9%pa As at March 2007 Slide 29 farrellys 10 Year Forecasts as at October 2000 AssetDividend Yield EPS Growth PE Effect Central Forecast Australian Equities4.5%5.0%-1%8.5% US Equities1.0%6.0%-1%6.0% LPTs8.5%1.0%0%9.5% Bonds6.0%0% 6.0% Slide 30 farrellys Realistic 10 Year Forecasts as at October 2000 AssetDividend Yield EPS Growth PE Effect Central Forecast Australian Equities4.5%5.0%-1%8.5% US Equities1.0%4.0%-3.5%1.5% LPTs8.5%1.0%0%9.5% Bonds6.0%0% 6.0% Based on 2010 PE of 21 Slide 31 farrellys Japanese equity forecast Yield0.8% Earnings GrowthInflation + reinvestment- depreciation - leakage 6.0% Valuation Effect Total (Yen terms) PE falls from 58.4 to 20-10.1% -3.3%pa Japanese Bonds4.5% As at December 1988 Slide 32 farrellys Gold really is an inflation hedge. Slide 33 farrellys Avoiding avoidable mistakes Bubbles are big and compelling The damage is significant and long term But can they be identified in advance? How can we avoid them? Slide 34 farrellys Avoiding bubbles : even smart investors are at risk Newton invests a bit From GMO: Isaac Newtons Nightmare Slide 35 farrellys Avoiding bubbles : even smart investors are at risk Newton invests a bit Newton exits happy From GMO: Isaac Newtons Nightmare Slide 36 farrellys Avoiding bubbles : even smart investors are at risk Newton invests a bit Newtons friends get rich Newton exits happy From GMO: Isaac Newtons Nightmare Slide 37 farrellys Avoiding bubbles : even smart investors are at risk Newton invests a bit Newtons friends get rich Newton exits happy Newton re- enters with a lot From GMO: Isaac Newtons Nightmare Slide 38 farrellys Avoiding bubbles : even smart investors are at risk Newton invests a bit Newtons friends get rich Newton exits happy Newton exits broke Newton re- enters with a lot From GMO: Isaac Newtons Nightmare Slide 39 farrellys Markets can stay irrational longer than you can stay solvent Market first became overvalued in early 1985 Slide 40 farrellys Japan was much worse Market first became overvalued in mid 1983 Slide 41 farrellys Again in the late 90s Slide 42 farrellys US REITS first became expensive in 2004 Slide 43 farrellys Gold a very long time in the expensive range Slide 44 farrellys Dont want to sell too early Date first expensive PeakTime to peak GoldApr 1973Jan 19806 years, 9 months Japanese equitiesSep 1983Jan 19906 years, 4 months Australian equitiesFeb 1985Oct 19872 years, 8 months Japanese residential property198519916 years US equitiesSep 1987Oct 19872 months US equitiesApr 1986Aug 20004 years, 4 months US REITsMar 2005Jan 20071 year, 10 months Chinese EquitiesJan 2007Oct 20079 months Australian equitiesDec 2007Jan 20081 month Slide 45 farrellys Because we dont know how long or how high Just dont buy expensive assets Sellers can take their time Slide 46 farrellys The new imperative in asset allocation Bubbles are a recurring theme The damage caused is significant and permanent No one is immune from their charms They can be clearly identified in advance They are an avoidable mistake Slide 47 farrellys Disclaimer. This presentation has been prepared on the basis that it is only for the exclusive use of the person for whom it was provided. Although information is derived from sources considered and believed to be reliable and accurate, farrellys, its employees, consultants, advisers and officers are not liable for any opinion expressed or for any error or omission that may have occurred in this presentation. Any forecasts included are reasonably believed to be reliable based on current information but due to our inability to predict future events with certainty, they cannot be guaranteed. This presentation is of a general nature only and has been prepared without taking into account any persons particular investment objectives, financial situation or particular needs.

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