ASIC To Replace ASX As Supervisor of Australian Financial Markets

Someone asked me what I thought about the government’s decision to give our official corporate regulator, the Australian Securities and Investments Commission (ASIC), responsibility for supervising real-time trading on Australian markets, as announced by Treasurer Wayne Swan.

That means that ASIC would be responsible for investigating and uncovering insider trading, market manipulation and other fraudulent practices that occur on financial markets.

This responsibility was previously assigned to the market operator, the Australian Securities Exchange (ASX). Since the ASX demutualised and became a publicly listed company in 1998, it has been argued that there is now a conflict of interest between its duty to supervise the markets and its duty to maximise profits for its shareholders. That was the government’s reasoning for ordering the transfer of powers.

My answer is that I agree that there is a conflict of interest, but I do not believe ASIC is competent enough to carry out its new duty. ASIC is under resourced, inefficient and has a culture of apathy and incompetence. In addition, they lack the ASX’s technological know-how. The government did not mention how much extra funding they were going to allocate, if any.

I want to hear more about plans for extra funding and a cultural purge before I would have any degree of confidence in the new arrangements.

Bank Shares

Earlier today, I was asked whether I thought Australian Bank shares are a good investment in current market conditions.

For the sector as a whole, I expect Capital Gains to be subdued for the next few years as our economy is slowing, interest rates are high and people are borrowing less (or paying back debts). Profit growth will be very small, however I do not expect any cuts in dividends.

For individual banks, the situation is not so clear. ANZ has been in the news due to having increased its provisions for bad debts, as well as the OPES Prime fiasco. NAB has also copped some flack due to exposure to the US mortgage crisis. SGB and WBC have done better, both reporting strong single digit earnings increases.

I am not going to make a call, but I can tell you how I would start my analysis – I would examine each bank to determine the proportion of income from each of the bank’s activities, e.g. Retail banking, business lending, wealth management/financial advice and others. Also, I would look at the proportion of income earned in Australia and the proportion earned overseas. I can then make my own judgement on the future prospects of each activity.

Commonwealth Securities provides research from Aspect Huntley on its website. The above information can be found under the ‘Analysis’ tab.

Be cautious about PEG estimates provided online. These are purely guesses made by the research company’s analysts. It is better to read each bank’s earnings guidance in their annual report and use your own critical thinking skills to see what assumptions lie behind them.

For me, banks are now an income investment, as they pay large, stable, fully-franked dividends. I have been holding ANZ and NAB since last year. Do not consider this a recommendation.

‘Undervalued’ Capital Notes

Someone I know recently went to an investment course conducted at an evening college.

The presenter pointed out a number of ASX-listed debt securities (often called Capital Notes) that are trading below their Net Present Value (NPV), by between 5-12%. I was asked for my opinion.

For those that don’t know what these are, these are much like bonds – they are normally issued by public companies, e.g. banks/insurance companies to the public in order to borrow large amounts of money, e.g. to facilitate expansion.

Each bond/note that is issued has a given face value, e.g. $100. They pay a certain interest rate periodically for the duration of their lifetime, i.e. 8% per annum for 10 years,  after which the bond matures and the face value is paid back.

The underlying value of a bond at a given point in time is the Net Present Value (NPV) of its future cashflows. We take each pending payment (interest income and the face value paid upon maturity), discount them back to today’s dollars using current market interest rates and then sum them together to produce the NPV.

This is why when the RBA raises interest rates, the value of bonds falls, and if interest rates fall, the bonds rise.

OK, here’s a far better written explanation from Investopedia:

http://www.investopedia.com/university/advancedbond/advancedbond2.asp

OK, so does this mean that if a bond/note is currently being traded below its NPV, that it is a risk-free investment? The answer, as always, is in the fine print.

I checked out a couple of product disclosure statements. I noted the following:

  • One product gave the company the right to indefinitely delay maturity of the bond.
  • One product stated that in the event of the company getting into financial trouble, note holders would rank above shareholders, but below other debtors.
  • Some have other conditions that make returns dependent on the movements of the company’s normal shares.

Such conditions may potentially pose risks and should be factored into your investment decision.

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