Anton Tagliaferro, discusses last week’s share market drop and the outlook for the period ahead.

30th July, 2007

The Australian sharemarket dropped by more than 5% last week reflecting large losses on Wall Street, which fell back on concerns about the state of the US mortgage and  housing market and its impact on consumer spending and the economy after continued poor news on the sub prime ( i.e. below investment grade) mortgage market.

IML investment director, Anton Tagliaferro, says: “What is happening today in the US had unfortunately become inevitable and reflects the very loose credit standards used by many lenders there for many years. With defaults now inevitably rising in the once booming sub prime market, credit spreads on corporate debt are blowing out as investors require a higher return for the risk. As a result, global credit markets are in turmoil. As we mentioned at our Adviser Briefings earlier this year in February and March, the amount of  consumer debt taken over the years in the “sub prime “ markets in the US as well as the narrowing of spreads on junk bonds made the current shake out inevitable”.

So what does the current volatility mean for longer term investors?

Tagliaferro said: “We have always been big believers in holding quality stocks in our portfolio.  By quality we mean companies that have a recurring earnings stream, a solid management team and a good balance sheet. While much is written about the fact that our sharemarket is backed by good fundamentals, in our view there are many areas where this is not true at the moment as a result of many investors having lost focus of the risk attached when investing in the sharemarket”.

“For example, today there are currently dozens of mainly speculative mining stocks that make absolutely no money and which are currently being valued by the sharemarket at billions of dollars. Clearly the losses in this area will be significant when sharemarket sentiment is not as bullish as it has been over the last few years and the holders of stocks such as these begin to question the wisdom of continuing to hold these speculative companies. In other areas too, such as the mining contractor area, in our view many stocks are priced at ridiculous levels given the level of risk and volatility of the earnings of most companies in this sector.”

Clearly in weeks like last week where sharemarkets are falling as many geared investors seek liquidity, almost every share fell. It didn’t matter whether you were a hundred year old liquor company like Fosters, or a lower risk toll road operator like Transurban, or a much higher risk company like three year old mining hopeful Fortescue, or contracting company Transfield.”

“The reality though is that those companies that have real assets and real earnings will recover their losses over  time, while many other companies which have zero earnings will inevitably trade at fractions of what they are trading at today at some stage in the future.”

Is this the end of the bull market of the last four years?

“This is always a difficult question to answer. The main problem with bull markets is that eventually they mature and excesses occur as many investors throw common sense to the wind and do not invest in a sensible manner. Inevitably bull market excesses always disappear when investors become more cautious. There is no doubt that valuations in some areas of the sharemarket today are excessive and at some stage these valuations and excesses will unravel.”

Having said this there are many good quality companies like Fosters, Transurban and IAG that our analysis indicates are very attractively priced at the moment for an investor with a three to five year horizon and we are very happy to use our Fund’s cash holdings at times of duress in the sharemarket, such as now, to add to our holdings in these high quality companies”.