A Carbon-Tax Alternative

I don’t want to, and certainly will never intentionally use my blog to impose my political beliefs on those who visit, interested in my investment views and in our performance.  If a certain philosophical viewpoint shines through, it is unintentional.  Dave and I have historically tended toward opposing ends of the political spectrum, I don’t believe differing political views should stand in the way of friendship.  They definitely need not play a part in your choice of fund manager.  In my view, you should choose someone to steward your money based on your assessment of their historic performance and your view of their likely future performance.

I will do my best to make the assets of our investees perform at their optimum level irrespective of political allegiance.  Whether you voted for an extreme left-wing party such as the Greens or the Communist Party, or an extreme right-wing party such as the Christian-Democrats or Family First, is purely a matter for yourself.  Even if you voted for Rob Oakeshott or Tony Windsor, if you entrust your assets with us, we will do our best to make your assets grow faster than the benchmark.

That said, when a political policy which I believe adversely affects the likely future prosperity of all Australians is proposed, I will feel moral bound to comment, and I will do so regardless of the flavour of the Government that proposes it.

This brings me to the reason for my mid-week post.  I believe the Carbon Tax as it has been proposed is a horrible misstep that not only will not achieve the ends it is purportedly the means to, but will negatively affect this end.

It is my truly held belief that the Australian Carbon Tax in its current form will drive global emissions higher, and that any developed economy adopting a similar policy will do the same.

However, unlike a lot of the carbon-sceptics in the media and within politics, instead of just pooh-poohing an idea, it is my preference to develop and state a viable alternative.

So with no further ado, I provide my Carbon-Tax Alternative.  Feel free to criticise and improve on it, I am sure there is much that could be done to make it better still, but whatever you do, don’t pretend the current proposals are anywhere near as viable. Enjoy your Easter-Break – Tony Hansen 21/04/2011

I am having issues with the link, so here is the text of the Carbon-Tax Alternative:

The Carbon Tax Manifesto, a Carbon-Inefficiency Levy

By Tony Hansen

I am an accountant by profession and a professional investor by choice and as such, the imminent introduction of Carbon Tax measures in my economy (Australia) has suddenly brought the matter, much closer to my heart.  I point this out only to demonstrate I am not an academic, with any particular expertise in carbon emissions or taxation implementation. What I am is a passionate Australian; Australia is, in my view, the best country in the world. When myriad factors that go to quality of life are measured, there would be few who have sampled the lifestyle who wouldn’t acknowledge how very lucky we are to live in Australia.  We are a small (economically), but wealthy country and in my view, can afford to take up a leadership position in reducing global Carbon Emissions.  What we cannot and need not do is handicap our economy to this end.  We must develop a clever mechanism in taking this global leadership position in the reduction/reversal/minimisation of Human impact on the globe, which not only doesn’t handicap our economy relative to our peers, but preferably places our economy at a sustainable competitive advantage.

I have observed the escalating debate over Climate Change over the last 10 or 15 years with only a moderate interest.  I would freely describe my attitude to Climate Change as fairly agnostic.  I do acknowledge that it is almost a certainty that Human existence and most particularly the recent advent of industrialisation have significantly impacted the Earth.  In the same way, I didn’t really need to see the large and growing body of scientific evidence that tobacco smoking is unhealthy, I could arrive at such a conclusion myself.  I would imagine there are very few substances that you could burn and inhale over a long period that will not negatively impact your health.  Still, the majority of people (particularly those whose vested interests were negatively impacted by that reality i.e. smokers/tobacco manufacturers) have required the snowballing evidence pile grow very large before acknowledging that which should have been intuitively obvious, some still won’t.

I would also acknowledge that a peaceful and stable Middle East would be of great benefit to global society generally, but I had frankly thought both these matters too hard to deal with until now, as a consequence, had not given them much thought.  Now that a Carbon Tax is on the cusp of implementation, and the current format will clearly have an enormous negative impact on Australia’s International competitive position, it is now so important to the future prosperity of my country, that I must instead propose a viable alternative.  I will formulate a solution to peaceful Middle Eastern relations at some future point…

It is most important to even the most ardent Climate Change advocate to acknowledge that without an impartially measured and quantifiable scientific measurement of how much Human behaviour adds to the natural movements in Earth’s temperature, it will be hard to convince, particularly citizens of those countries coming lately to the lifestyle improvement inherent in an advanced economy, that they should forego further advancement for ‘the greater good’.  To draw on the ‘tobacco’ analogy above, you should think of the wealthy (economically advanced economies) as big tobacco and those that are less economically advanced, but with burgeoning middle classes as the smokers.  The advanced economies have grown wealthy and powerful through unimpeded carbon emissions and the less advanced economies have become addicted to carbon emissions and are at present unlikely to consider the negative long-term impacts of their addiction.

Absent clear scientifically measured proof presenting some fairly precise measurement of Human impact, more specifically how much changes in Human behaviour (pertaining chiefly to Carbon pollution reduction) can impact the Earth’s temperature downward.  It will be hard to get the required ‘Global’ buy-in to the idea.  With my alternative, you don’t need people to buy in; you make it their economic best interests to do so.

Now, I believe that it can safely be assumed that despite a growing body of evidence, there will, for the foreseeable future be sufficient credible dissenters as to keep the shadows of doubt about Human impact in the mind of the majority.  Faced with this state of doubt, people will understandably not be willing to sacrifice their standard of living to an unproven concept.  We must acknowledge this and understand (rather than disdain) this hesitance.  In designing a system to reduce our carbon emissions, we must consider how this can best be done without impacting the quality of life of the proletariat.

The mechanics of the introduction of a carbon tax in recent years globally has concerned me as being an enormously short-sighted method of dealing with the problem at hand.  Invariably the thinking seems to be ‘put a cost on carbon and people will reduce their consumption of carbon’.  Returning to the tobacco analogy for the final time, and we are globally every bit as dependant on Carbon as a smoker is on tobacco.  Even more-so I would say, I have no intention whatsoever of giving up the comforts that are provided to me by emitting carbon, such as lighting, power, air-travel etcetera. I accept that raising the cost of heavy carbon goods through taxation will have an approximately cause/effect reduction impact in the short term.  Probably something in the quantum of the reduction in smoking that comes when the tobacco tax is raised.  Some people will cut back somewhat, but many, many people will work an overtime shift here or there, or forego some other pleasure in order to feed their carbon habit.  The incentive proposed is poorly structured and in my view will lead to sub-optimum carbon-reduction over the longer term. The only result of a carbon-tax in its current form is that we will all live a little worse as a consequence of its introduction.

Wouldn’t it be better if instead of forcing a new tax onto a sceptical public, we developed a system which in conjunction with natural market forces, dramatically forced down the carbon emissions of our economy with only a negligible impact on the prices of the majority of goods and services.

I believe such a concept exists and is remarkably simple, drawing on an important human driver once described by Benjamin Franklin - “If you would persuade, you must appeal to interest rather than intellect”. We could certainly force a tax onto a sceptical populous, by trying to appeal to their intellect, we can ‘persuade’ that carbon emissions are dangerous and the cost of inaction will be borne by not only our generation, but every future generation.  This view will be (and in my view has been) met with the blank stares of a largely disinterested population.  The alternative is a taxation incentive system based on rewarding best practice, or more specifically disincentivising worst practice.  What I like to call a Carbon-Inefficiency Levy.

If we want to reduce Australian carbon emissions, whilst at the same time enhancing Australia’s global competitive position, we must develop a carbon reduction scheme, which instead of taxing all carbon emissions, taxes only those emitters who are excessive or inefficient emissions producers.  Absent this distinction, it is my view that all that is likely to happen is that we export high-emission industries.  In all probability these will go to countries producing the same goods at higher emissions than we were and then exporting them back to us, thereby causing still further damage through the transportation emissions.  That is what’s known as a Lose/Lose/Lose situation, no one wants to get involved in such a situation, let’s not.

I will try to clearly demonstrate this concept.  Assume Australia is a world leader in widget manufacture, in carbon emission terms.  Assume in manufacturing a widget, using the ‘Australian’ manufacturing technique, 1-tonne of Carbon Emissions are produced.  Assume further that there are only 4 other countries in the world that produce widgets, they being Timbucktoo, Podunk, Loamshire & Tipperary.  The 2010 world production of widgets looked something like this:

Country	Total Annual Output	2010 Widget output	CO2 per widget	Total CO2 output
Australia	3.1%	31000	1.0	31000
Timbucktoo	19.9%	199000	1.7	338300
Podunk	11.7%	117000	2.0	234000
Loamshire	24.1%	241000	1.2	289200
Tipperary	41.2%	412000	2.1	865200
Global Totals	100.0%	1000000	1.76	1757700

Global 2010 total widget output was 1 million units. The average CO² produced for each widget was about 1.76 tonnes.    In order to discourage any excessive carbon production in the widget industry, we apply a Carbon-Inefficiency Levy, whereby anyone producing in the top quartile (top-25%) is not levied with any form of excess-carbon levy; Australian operators who are efficient on a global scale are in-fact rewarded (see below) not punished.  Anyone producing in the next quartile is levied with a fairly heavy tax, much higher than the $20 - $50 per tonne I hear bandied about in the press at the moment as a likely carbon price.  For the sake of the example, I will say $250 per tonne.  The 3^rd quartile would be levied with something harsher still, perhaps $500 per tonne and the last quartile with perhaps $1,000 per tonne.  Now ideally, this would be levied on a sliding scale, whereby someone producing at the top of the 2^nd quartile would pay less than someone at the bottom of that same quartile, using the levies above, the scales would look something like this:

25th	$          -
30th	$     76.90
35th	$   153.80
40th	$   230.70
45th	$   307.60
50th	$   384.50
55th	$   461.40
60th	$   538.30
65th	$   615.20
70th	$   692.10
75th	$   769.00
80th	$   845.90
85th	$   922.80
90th	$   999.70
95th	$1,076.60
100th	$1,153.50

In order to have a clearly demonstrated example, we would need to make further assumptions about International widget prices, shipping costs etc. The important thing to remember, the only sphere we are able to control is the Australian economy.  The unique power of the Carbon-Inefficiency Levy, however, you can alter the behaviour of other nations in respect of carbon, you can make them play your game; force them to change their behaviour with your policy.  For example, putting aside widgets, assume that a Podunkian mid-sized 4-door family car can be shipped to Australia for $20,000, and it carries with it 8 Tonnes of carbon-output in the production/shipping process, which is in the 25^th percentile (of global mid-sized car carbon production emissions) ergo it attracts no Carbon-Inefficiency Levy.  Assume further that the Loamshirian mid-sized 4-door family car is exactly equally desirable, can also be shipped to Australia for $20,000, but the production/shipping process generates 12-tonnes of carbon-output, which is in the 70^th percentile (of global mid-sized car carbon production emission).  Now the Loamshirians will find themselves levied with a $2,768.40 Carbon-Inefficiency Levy, and in order to compete with the equally desirable, but now far more reasonably priced.  In this situation, every Loamshirian car not sold in Australia (because a Podunkian one is bought in its stead) has reduced global carbon emissions by 4 tonne (a direct cause and effect relationship).  Now there is an idea the proletariat will buy, no-one is forcing them to buy a Loamshirian 4-door.

The above concept could be easily applied to a meaningful real-world example, such as steel production with a more meaningful pricing system; I only propose it to serve as a simple demonstration of the utility of a Carbon-Inefficiency Levy.  The charge is genuinely optional – you do not have to pay it if you produce efficiently.

The proposal doesn’t end there, because I would demand that such a scheme would be revenue neutral to the end consumer.  The government must make no profit out of such a tax as once they come to rely on it, they would distort its purpose.  To achieve this, 97.5% of the revenues generated by the levy must be returned to the industry from whence they came (To absolutely no other, weak industries will not be supported by strong.  In industries where there is no Australian participant efficient enough to earn the rewards, an application for the revenues would need to be found, perhaps a CSIRO type organisation with a purely scientific focus on carbon-reducing production technologies).  The remaining 2.5% of the revenue represents the annual budget of the tiny but efficient (preferably private) body enacted in order to collect & distribute the levies.  In order to return the revenues, a sliding scale, effectively inverting the above levy would show the manner in which the revenues are returned to.  My sliding scale would look something like this:

1st	20.00%
2nd	16.00%
3rd	12.80%
4th	10.00%
5th	7.87%
6th - 10th	20.00%
11th - 15th	7.50%
16th - 24th	5.83%

So efficient operation would be substantially and handsomely rewarded.  The top vigintile (5%) of Australian operators in any industry would earn 2/3 of all revenues generated by the Carbon-Inefficiency Levy in their industry returned to them.  The smart operators among them will use this funding for R&D to ensure that they continue to lead their industry in low-emission production.

Assume further, in the widget example given above, that due to a global enacting of a policy similar to this one, Tipperary & Podunk as high-emission, carbon inefficient producers of widgets, are by 2015, no longer able to compete due to the widely adopted policy.  Assume they cut back to producing only their own countries consumption of widgets (112,000 units and 17,000 units respectively), and no longer contribute to global supply (or demand).  We further assume that global demand was flat over the next 5 years, and that the 400,000 units no longer produced by the 2 least carbon-efficient producers are split proportionally among the 3 most carbon-efficient producers (in reality the 2 most efficient, Australia & Loamshire would likely pick up the lions share of the lost global production under such a Carbon-Inefficiency Levy scheme, widely adopted) the result would be:

Country	Total Annual Output	2015 Widget output	CO2 per widget	Total CO2 output
Australia	5.7%	57400	1.0	57400
Timbucktoo	36.8%	367800	1.7	625260
Podunk	1.7%	17000	2.0	34000
Loamshire	44.6%	445800	1.2	534960
Tipperary	11.2%	112000	2.1	235200
Global Totals	100.0%	1000000	1.49	1486820

So, global market forces dictate over time, a more than 15% reduction in global carbon emissions (assuming the industry itself did not improve in that period).  The Carbon-Inefficiency Levy, over time would force improved carbon-efficiency onto any industry it was applied to.  The end result in all likelihood would be minimal change in consumption levels (as I said, we’re addicted to Carbon), but massive reductions in the average carbon produced per unit in any affected industry.

We have no need, nor any right to enforce our policies in any other economy than our own.  To this end, if it happened that there was an Australian manufacturer of widgets who produced their units in a particularly carbon-intensive manner, but could export them to a country with no Carbon-Inefficiency Levy, then that would be their right.  What they could scarce hope to do is compete in Australia.

Now there will be several criticisms of such an example, to save people the effort, let me point out the key ones to begin with, these obviously must be addressed in the incentivisation format.

1. If a Podunkian widget requires (as per the table) twice the carbon emissions to produce, but safely operates for twice as long as an Australian widget, due to its outstanding quality, why should the Podunkian manufacturer be handicapped at the initial sale point, or more to the point, how can the playing field be levelled so as not to disadvantage the higher-quality higher-emission producer.
2. Running costs.  If a Podunkian widget requires (as per the table) twice the carbon emissions to produce, but during operation, produces only half the per annum of CO² of alternatives, we must ensure the Podunkian manufacturer is not handicapped at the initial sale point.  Again the playing field must be levelled so as not to disadvantage such a producer.  In the case of this example, as the annual emissions would fall to the widget owner, they would presumably consider this prospect in their purchase decision, as otherwise the goods produced using the widget would be subject to a Carbon-Inefficiency Levy in their own industry.
3. One industry member being so carbon-efficient that a monopoly is created with price-inefficiency replacing carbon-inefficiency.
4. I am sure there are other potential disadvantages, but nothing in my view that could remotely compare with the ridiculous situation of levying a carbon-tax and then crediting back substantially all of the revenue to those individuals and industries that can least afford to pay the additional cost.  If we only apply a tax to those who can ‘bear’ the cost, how will our behaviour change?

The format could be equally applied to virtually any industry, with only minor adaptations.  Whether the unit of measurement is a mid-sized family sedan, a megawatt hour of black coal generated electricity, a megawatt hour of wind-generated electricity, a tonne of hot-rolled steel, a roll of newspaper or a widget, it should not be too difficult to establish an industry wide benchmark and to enforce the Carbon-Inefficiency Levy.  The fact of the matter is, by focussing on say 10 industries, we could immediately affect substantially all of our carbon emissions in any case.

The key advantages, apart from the already stated avoidance of exporting our emitting industries to potentially less carbon-efficient countries and effectively contributing to a worsening of global carbon emissions problem are these:

1. My very favourite part of the concept is not the optionality of paying the levy, nor its massive and immediate positive effect on carbon emissions.  Best of all is within a few short years, many Australian industries (or any country that was an early-adopter of such a policy) would become world leaders in their field and as low-carbon production becomes more and more important; Australia would develop a massive industry exporting its expertise in low-carbon production to all the laggard countries.
2. As industry becomes more efficient, the standard required to be a non-levied producer would necessarily improve.  This creates a ‘virtuous’ circle of emissions reduction, where the only key downside is the (above-mentioned) potential for monopoly due to one competitor being significantly more carbon-efficient.  Many people don’t realise, how rapidly even our most energy intensive industries have improved in what I consider a short time.  For example, it was only 300 years ago that Abraham Darby developed a process of using coke in place of charcoal to fuel blast furnaces to produce pig-iron.  Absent this fact, there are not enough trees in the world to produce the charcoal required for a single (current) years global steel output.  Improvement didn’t stop with Abraham Darby, between 1975 & 2005, the average energy consumption per tonne of crude steel fell by about 50%.  I would imagine if a thorough investigation were conducted into say the CO² emissions generated in the production of a 1981 Holden Commodore, in comparison to the 2011 model, a similar story would arise.  Given this ‘inbuilt’ self-improvement aspect to the carbon output of industry, applying the proposed Carbon-Inefficiency Levy would have a powerful effect on the speed of this process.  Industries would become more carbon efficient at a more rapid rate.
3. We eliminate a ridiculous (proposed) burden on our economy with no tangible benefit.  If Australian electricity producers (and this may not be the case) are more efficient (i.e. generating more electricity per tonne of coal than their global counterparts), what sensible purpose is there in levying a Carbon-Tax on them, so then Australian production/consumption of electricity goes down and instead we export our coal to another country who will generate less electricity from it than we could have.  The flipside to this is that if Australian producers aren’t at a globally acceptable standard, under my Carbon-Inefficiency Levy, they would soon be as otherwise, the proposed cost to that industry would be much greater than the current carbon-tax.
4. I may be wrong, but I would hazard Australian industries broadly are mostly more efficient than the 50^th percentile of global production.  Although this would be an Australian carbon-initiative, we would be surreptitiously forcing other countries to consider their carbon-emissions at a company level.  This is because in order to export to Australia, they would either need to bear a levy if Carbon-Inefficient, or improve their methods to avoid the levy (as pointed out previously, thusly improving global averages in a virtuous circle)
5. Finally (in my assessment – there may also be further advantages I have not yet considered), can you imagine any business in this increasingly environmentally aware age idly standing by while their customers are choosing between a “Carbon-Inefficient” company and a “Carbon-Efficient” company.  No-one wants to be thought of as inefficient and this whole idea would further augment the competition in the marketplace and accelerate industrial carbon-efficiency improvement.

That brings me to my conclusion.  What possible benefit could there be in introducing a carbon-tax that makes our economy less efficient, and is coupled with a high likelihood of global carbon-emissions rising due to the least efficient producing countries and businesses  being rewarded with extra production due to the short-sightedness of our current proposals.  My alternative proposal above is a very simple idea worked up over a relatively short period, which will no doubt have some flaws, but could not have anywhere near the shortcomings of the horrid proposals floating around at present. Tony Hansen 18/04/2011.

Update No. 3 – 17/04/11

	Inception April 01 2011	Current Price	Performance Since inception
EGP Fund No. 1	1.00000	1.03110	3.11%
EGP20	1000.00	965.65	(-3.44%)
S&PASX200 (TR)	35632.05	35740.79	0.31%

EGP Fund No. 1 Pty Ltd. The benchmark lags us for the first time since launch.  Our inaugural lead is a handsome 2.8%.  Please don’t read too much into these weekly swings, we are bound to have some ups and downs along the way, but beating the market by 1% per week is not sustainable (obviously).  We have had some considerable good fortune in acquiring assets particularly late in the week.  We are now holding just a little over 20% in cash, so the initial allocation is almost done.  With a little luck we’ll be reaping the rewards of the recent asset-allocation for many years to come.

EGP 20.  The EGP20 index has moved by -3.44% since launch. Unfortunately, it has not been nearly as successful as the Fund.  7 out of 20 selections are out-performing the benchmark, but 13 are lagging and some, particularly KCN and ERA are really lagging, which is why the shortfall is so large.  Mining is inherently more ‘white-knuckle’ than most other businesses, so you need to remember that when deciding how to allocate your funds.  Now with the caveat that this is not investment advice, I would say, KCN had a slightly ordinary quarter and as a discounting machine, the market in its infinite wisdom has decided that these results mean that all future cash-flows from the assets KCN own are now reduced in value to a figure 13.7% below that of 11 trading days ago.  It is exactly these opportunities that allow us to beat the market, and it is all at once the problem of passive investing (such as setting an index of 20 stocks with 5% allocated to each) – for if I still believed the KCN story, I can now buy a piece of it for 86.7% of what I could on 1 April (remember, we consider the EGP20 as a poor cousin of EGP Fund No. 1 Pty Ltd, if we considered its constituents as better value than our selections, we would not have them in a sample group, but in our fund). As for ERA, I knew it was a big risk when I put it into the index on April 1.  I knew that there was a reasonable likelihood that the Fukushima Nuclear Plant issues relating to the earthquake and tsunami could combine with the known production issues they were having at Ranger due to the flooding etc.  The question investors need to ask themselves is does this really make them 20.4% less valuable than 11 trading days ago.  I must confess, I am a big fan of uranium as a commodity (long-term), if the world really wants to reduce its carbon output, nuclear is the only viable (read cost-effective) option available, maybe build them in more seismically stable locations though...

S&PASX200TR  The benchmark index is up 0.31% since April 1 launch. It did us the enormous favour of retreating by over 1.8% this week; we have always produced our best out-performance in periods of market declines.  I expect this will continue to be the case.  I must confess I sleep better when the market is in decline, for two reasons, firstly I truly believe the businesses I own are less risky than the broader market and secondly, I go to sleep believing there is a good possibility I will be able to buy more of a good business for less than I did the day before.

The S&P website is a font of interesting & useful information.  Some long-time readers will remember my post on managed fund returns.  Well from the S&P website I found an analysis which quite ably demonstrates the same effect.  For those too lazy to click the link & read, I will summarise – basically 70.57% of the funds measured failed to beat the S&PASX200TR over 5 years.  I came up with over 80%, but you get the idea.  Basically it is not easy to beat the benchmark and for the majority of people who would like an exposure to equities, a low-cost index fund makes most sense.  For those who chase a little extra mustard on their hot-dog; they should look for a fund with the investment manager’s incentives correctly structured, minimal up front-fees and most earnings derived in the event of out-performance.

I will be attending the Blues Festival in Byron Bay over the Easter weekend, but I will do my best to update somehow before I hit the campground - Talk next week (I Hope) – Tony Hansen 17/04/2011

Update No. 2 – 10/04/11

	Inception April 01 2011	Current Price	Performance Since inception
EGP Fund No. 1	1.00000	1.01702	1.70%
EGP20	1000.00	1010.49	1.05%
S&PASX200 (TR)	35632.05	36390.69	2.13%

EGP Fund No. 1 Pty Ltd.  Well, another week has passed (the private investment company has now operated for 6 trading days), and so we update. We have managed to add the full purchase of 2 stocks to our portfolio, and partial purchases of 2 others.  We are still substantially in cash of course 84.15% of our assets as at 5pm Friday.  The benchmark is still leading us, this week the margin has qwidened slightly to 0.43%.  We have tried hard to deploy our cash but without as much success as we had hoped, given our massive cash balance, I am actually very pleased with how narrow our deficit on the benchmark is.  We shall continue to judiciously deploy our cash over the coming weeks, remaining slightly bewildered (I do believe it is generally undervalued however - see below) at the unwavering upward march of the markets, despite several notable headwinds (Oil at US$110, war in Libya and general North African & Middle Eastern unrest, ongoing debt issues with some EU economies, even a fresh Earthquake on Thursday in Japan).

EGP 20.  The EGP20 index has moved up by 1.05% since launch.  There are a couple of stellar performers in the group, but a few laggards are holding the group back, we remain confident that time will see the group catch and eventually pass the benchmark.

S&PASX200TR The benchmark index is up 2.13% since April 1 launch. This is a fairly rapid advance; I always like to bring it back to the context of a business owner.  This means that collectively, the owners of the underlying 200 businesses in this index believe they are $24.45 billion more valuable than they were 6 business days ago.  To put this in further context, holding all things equal (i.e., forgetting about the time value of money and dividend payments etc.), it means that in order for the market to return to its high on November 1st 2007 (ASX200 price index - 6,828.71 points), the market from its Friday close would need to become $448,000,000,000 more valuable in the eyes of the investing public.  Were this to be the case, assuming only Australians owned the ASX200 companies (this is obviously not the case), then on average, every man, woman & child in Australia would become $19,843.68 wealthier.

At the moment, there are 404 stocks we generate quantitative valuations for; this is from a field of over 2200 ASX listed stocks.  We do an in-depth valuation of the market twice a year, just after the release of half-year and full-year earnings.  The valuation process takes Dave and I nearly 2 months to work through and it is from this ‘quantitative analysis’ we derive a list of companies we then do our research on.  When we completed our most recent iteration of the valuation, I found some things of interest I thought I might share with you this week.

Firstly, it is my view that the market is trading on the cheap side of historic averages, P/E ratios and forward P/E ratios indicate this, but I believe it can be demonstrated in a number of other ways.  The quantum (of the undervaluation) in my view is somewhere in the range of 10 – 20%; now if the market falls, don’t point the finger at me, it very rarely behaves in a perfectly sensible manner, often over-reacting in the short/medium term to factors which ultimately have only moderate long-term effects.  What I find most interesting is that based on my view of the undervaluation of the market, of the 404 stocks we valued, I find only 160 I expect to outperform the market and 244 that fall below my expectation of the broader markets performance.  Given this statistic, the valuations would seem to contradict my summation the market is undervalued.  This is not the case; the reason in my experience is that slightly more than half of companies usually fall within a price-range where my performance expectation is within about 2.5% of the broader market when followed for a 10 year period, that is to say the market is usually priced approximately right for the majority of stocks.  Now basically, to come up with an assessment of undervaluation, I strip these out (those close to the mean), of the remaining companies, I expect those that outperform will sufficiently outperform that they will cover the underperformance of the others and leave the broader market in an out-performance situation.  As I have stated, something in the order of 1 – 2% p.a. over the next 10 years.  You may remind me in April 10^th 2021 (but not before), and I will review the performance of my forecast. Talk next week – Tony Hansen 10/04/2011

Update No. 1 - 03/04/11

	Inception April 01 2011	Current Price	Performance Since inception
EGP Fund No. 1	1.00000	1.00116	0.12%
EGP20	1000.00	993.15	(0.69%)
S&PASX200 (TR)	35632.05	35808.44	0.50%

EGP Fund No. 1 Pty Ltd.  Well, only 1 trading day, so not much to report yet, as you can see – up only 0.12%, and already trailing the benchmark by 0.38%.  This is the disadvantage of having your assets in cash during a rising market period.  As we will keep our holdings closely guarded, I thought I would instead give you an overview of the positions we intend to take.  As at a few days prior to launch, when Dave and I discussed the initial make-up of the portfolio, we found the following to be the case:

·         We are likely to hold only 8 or 10 stocks initially, as I’ve mentioned, we expect it is unlikely we will ever have cause to hold more than 20

·         Of those selected, only 2 are members of the ASX200

·         The largest stock we will hold has a market capitalisation of over $2b

·         The smallest stock we will hold has a market capitalisation of less than $30m

·         The raw average market capitalisation of the stocks will be about $400m

·         The ‘weighted’ average market capitalisation (as per our intended portfolio construction) will be about $196m

·         The highest P/E stock we will hold has a P/E ratio of about 18.5x

·         The lowest P/E stock we will hold has a P/E ratio of about 4x

·         The weighted average portfolio P/E (as per our intended make-up) will be about 8x, this compares to a current market P/E of nearly 13x (depending on where you source your information)

We expect this group of stocks to grow their earning by something over 20% over the next 2 financial years, and we think it likely the P/E ratios will likely lift also, so barring some unforeseen disaster; we expect the portfolio will grow significantly over the next 2 or 3 years.

EGP 20.  The EGP20 index has declined by 0.69% in the single trading day since launch.  A few of the members had big run ups in the days prior and shed some of those gains.

S&PASX200TR The benchmark index is up exactly 0.5% since launch.

Now that the fund is operating, I will cut back on the weekly rant, we will have plenty to do just monitoring the companies of interest.  I will, however, always use this chance to comment on anything business/market/wealth creation related that is of interest to me, or I believe will be of interest to our investors (and/or the readers and lurkers).

Please do not hesitate to use the comments section to talk among yourselves, now that you’re getting to be a reasonably sizable crowd of monthly followers.  Also feel free to continue sending me e-mails with any topics of interest you would like to see discussed, or hear my views on.  Talk next week – Tony Hansen 03/04/2011

EGP Fund No. 1 Pty Ltd Launches!

Finally, after so many years of planning, we have launched.  Our seed capital has been deposited and we commence from tomorrow in allocating the capital as per our investment principles.  Our Application form and Redemption form are available on request to those who have secured a spot in the initial operating format.

As promised, we launch alongside EGP Fund No. 1 Pty Ltd, the sample index the EGP20.  As mentioned previously, this is a composite of those ASX200 companies we think represent the best of the index we do not own (in EGP).  The constituents (representing 5% each) are:

Disclosure/Caveat - The selections below do not constitute investment advice.  They are simply a view we have taken as to a group of stocks which, based on our quantitative analysis we view as likely being better value than the broader ASX200 over a reasonable term.  Based upon a full and thorough qualitative analysis, there is a high likelihood some of these stocks would be excluded from such a list.  I cannot speak for Dave, but my wife and I own 3 of the stocks listed.

1. RSG
2. OST
3. PBG
4. HIL
5. PPX
6. OMH
7. SIP
8. RIO
9. DOW
10. KCN
11. MCR
12. ALS
13. MCC
14. CAB
15. SHL
16. JBH
17. HVN
18. PRY
19. TEL
20. ERA

The selections above are not advice, if you are at all interested in any of the stocks mentioned above; speak to your financial advisor or accountant.  We will not be held liable for anyone who acts on a list provided chiefly as an entertainment item.

I won’t comment too much on the reasoning behind the make-up of the 20 stocks above, you can see it is fairly heavy with miners, and has a couple of ‘turnaround’ businesses.  There were 7 stocks that also made the above list on a quantitative basis, but were excluded due to certain rules I cannot break (though I have bent them a little with some of the above).  Some of those excluded were for such reasons as insufficient profitable history in the case of some, too much debt or an overly complicated capital structure, the need to see a turnaround gain traction, or just for being an airline in the case of one.

The performance of EGP Fund No. 1 Pty Ltd and the EGP20 will be mentioned each week at the start of any web update we make.

The fund initially houses the seed capital from Eternal Growth Partners Ltd, the asset manager for EGP Fund No. 1, along with investments from our lovely wives and our children.  Our reasoning for starting with our own funds before taking on our other investors is the potentiality for underperformance in the first quarter due to the likelihood of taking some time to allocate all the cash into investments. By this I mean that in the event that the broader market runs upwards strongly whilst we cautiously (it is our default state) deploy our funds, underperformance is more likely. By the time we get to the end of June, it is likely that we will have allocated the majority of our initial capital and any fresh capital we take on will be allocated into an underlying equity base.  Proportionally, this means we will have less of our fund in cash at July 1^st (hopefully only about 10%) than we will at April 1^st (100%).

In respect of the EGP Fund No. 1, though we will post a price update weekly, we will make more thorough quarterly and six monthly updates.  As I have mentioned previously, discussion about particular holdings within EGP Fund No. 1 will be extremely limited and usually restricted to any holdings we have eliminated completely (which is unlikely to be for a couple of years, barring takeover).

I will run our first update to EGP Fund No. 1 & the EGP20 index will on Sunday April 3^rd, obviously there will be very little to report. I will try to update virtually every Sunday, and to let you know in advance any time I need to miss an update.  This doesn’t mean you should pay great heed to the weekly movements in either EGP No. 1 price, nor the index, we are targeting long-term out-performance, as such, in the short term, we won’t panic in the event we fall behind, confident in the belief that our views will bear fruit over the longer term.  Our target is benchmark out-performance in at least 75% of 6-month periods totalling 3-5% after performance fees over the medium-term.

For information purposes, the closing prices of the 3 measures we are interested in as at COB March 31 are:

1. EGP Fund No. 1 Pty Ltd          $1.00000 per share
2. EGP20 Index                           1000.00 points and
3. Benchmark                              35,632.05 points

We will be trying hard to effectively deploy our capital over the coming weeks, if you could all pray for declining markets, we would be much obliged – Tony Hansen 31/03/2011

Investment Principles & Shareholder Guidelines (or Dave's Lament)

I had said I wouldn't make a post this Sunday, but I am finally able to submit the Investment Principles & Shareholder Guidelines, those who have secured one of the initial places in the foundation format can contact us to receive the form. The contact details for Dave and I are in the document, please call us before committing cash, because we are limited to 20 shareholders under our foundation (Pty Ltd) structure, and we don't want the cash for the July 1 issue to hit our account until the last part of June.
I have to report Dave and I find ourselves in a slightly upsetting position at the moment, whereby the 2 shares that were going to be two of our heaviest holdings have appreciated substantially of late. In fact since January 1 this year, what was to be our No. 1 holding is up nearly 40% and what was to be our No.2 holding is up nearly 85% since January 1.  These 2 holdings combined were likely to make up over 40% of our asset allocation, and now we have to decide if they still make the grade...
This burns especially, because since January 1, the indices have moved by a much more modest 1.18%, so we have foregone the prospect of substantially augmenting our performance track-record.  I am not completely upset though, these are the 1st & 3rd largest holdings in my family portfolio, and while I've liquidated substantial holdings in order to contribute to the start of the fund this week, I retained all of the No. 1 and 2/3 of the stock that was to be No. 2.  Spare a thought for Dave, though.  About 1/3 of his equity-holdings were in this stock that was to be our No. 1 holding, and in order to have the cash available for the launch of the fund, he had to liquidate this holding, it has subsequently risen over 22% in the 8 days since.  He tries to console himself that he had already booked a 57% profit on a stock he had held barely 18 months, and in a period that the market has traded sideways, but I know his secret pain... We expected that having this cash out of the market for less than a fortnight would not cost us too heavily, well it seems it may have, selling, I maintain is the hardest part of owning stocks.
I will describe the difference these movements have made to my expected return.  On January 1 with stock No. 1, at its then price, it was my favourite stock in the market, now I always view a purchase with at least a 10-year time-frame and at January 1, I expected that every $1 I put into my favourite stock, in 10 years time, I would have about $8.88 to show for it at the end of 10 years (you see why it was my favourite).  With the intervening nearly 40% increase in price, every $1 of this stock, I now view as likely being worth about $6.45 at the end of 10 years.  That is still pretty compelling in my view, but given that this stock was earmarked to make up at least 30% of our portfolio, this basically means if I still proceeded with this 30% allocation, I would expect to make 1.3% less per annum for my investees (over a 10 year measuring period), as I now expect this stock will appreciate by 3.92% less annually.  So that is the bad news, the good news is that I have a few other 'Aces' up my sleeve, and it is my job as the asset allocator to now redesign my portfolio, to snatch back as much of that 'lost' 1.3% per annum as I can.
I will post next on 31 March, the eve of the launch of EGP fund No. 1 Pty Ltd - Tony Hansen 27/03/11

P.S. Dave wanted me to mention that one of the shareholdings I liquidated in the process of compiling my share of the seed funds announced only 58 minutes after I sold the last parcel that they had been subject to a takeover offer they'd declined.  Their share price subsequently & rapidly rose nearly 12% and cost me more than $6,500 in foregone profits.  I had to console myself with the handsome profit I crystallised instead.

The EGP20 index

As I have mentioned previously, the vast majority of our energies in respect of valuations are concentrated outside of the ASX200.  The reason of course being that we seek to look where very few other eyes are going and in this way, hope to find value others have missed.

The results of our investment company EGP Fund No. 1 Pty Ltd will be the thing most people are interested in tracking on the site.  These will be the companies we are actually invested in, and the results of this fund will be the actual returns to our investees.  We will not disclose the stocks we hold, because if we give clear directions on our holdings, our investors could instead hold the stocks directly and would find no use in subscribing for shares in our company.  We are already presenting an investment alternative with no annual management fee.  If we then also disclosed our holdings, we would have nothing to offer prospective investors.  After an investment has been realised, such as by sale, or take-over, only then will we disclose our holding and our thinking behind it.

I have always maintained, that even restricted to investing only in the ASX200, we could outperform the index (S&P/ASX200 TR).  In order to (we expect) demonstrate this, Dave & I have instead proposed that in order to keep our non-investor followers entertained, we will track a selection of 20 businesses from the ASX200, which we do not hold in our fund (because we believe we have superior alternative opportunities), but which we rate as some of the better prospects in the ASX200 (on a margin of safety basis).  We will do this in order to present a pre-determined, trackable index of investments for our followers.

It is my expectation that over time, The EGP20 will do better than the S&P/ASX200 TR, and that our EGP Fund No. 1 Pty Ltd will do better than both, given a reasonable timeframe, say 3-5 years.

The 20 holdings in the EGP20 index will be equally weighted at their announcement (i.e. 5% of the index attributable to each).  The index will be re-balanced twice a year (the first weekend after June 30^th & December 31^st) to include the 20 companies (which we do not hold in EGP Fund No. 1 Pty Ltd) from the ASX200, which we believe, on a chiefly quantitative basis (we will not spend as much time on the qualitative factors as we do with our own investments) represent those with the greatest margin of safety in the ASX200.

Based on our current valuations, we believe the EGP20 stocks will outstrip the broader markets performance by about 3 – 5% per annum, this is our expectation, and obviously the market rarely performs exactly in the way that we expect.  We have stated this (3 – 5% out-performance) is our target for EGP Fund No. 1 Pty Ltd, so the fact we will not own these 20 stocks implies we have found something we believe has even greater upside. The EGP20 index will launch alongside the launch of EGP Fund No. 1 Pty Ltd, our fund at the end of the first quarter (31 March 2011).  We will announce the 20 constituents around then.  Bear in mind, the EGP20 index will be completely passively managed.  That is to say, we will nominate the 20 holdings at the start of the period and regardless of any moves in intrinsic value, or reduction in the margin of safety, we will commit to retaining those same 20 stocks in the index until the next adjustment period.  The 20 selections therefore do not represent investment advice and followers are advised to do their own research in respect of the selections if they are interested.

My next post will be on March 31 and will be the launching post for both EGP Fund No. 1 Pty Ltd and for the EGP 20.  Tony Hansen 20/03/2011

Return on Equity

Return on equity (ROE) is usually considered something of a ‘Holy Grail’ for many investors, particularly those, like us with a “Value Investment” disposition.

ROE is the return (by way of profits) on the original capital used in the business (plus retained profits) shown as a percentage.  To demonstrate for those less familiar with the concept, imagine I decide to open a hot-dog stand on a street corner near my home.  Further, imagine that I need to invest $10,000 in the stand/equipment (cooler/cash-register/umbrella/bun-steamer/boiler etc) required to establish the business.  Now after deducting cost of sales (wages/buns/sauce etc) from sales (and depreciating the assets), assume at the end of 12 months I have profits of $2,000, then my ROE for that year was 20%.  Assuming all profits are paid out as dividends, and the business returns $2,000 again the next year, the ROE was stable. Assuming all profits are retained, then in order to maintain a 20% ROE, the business would need to earn $2,400 the following year.

From the above example, assuming 50% of profits are distributed and 50% retained, profit would need to grow at 10% pa in order to maintain the 20% ROE.  Generally speaking, for me, if ROE is likely to decline as a consequence of retaining earnings, then it is preferable to pay the earnings out as dividends.  Provided, however, that a business can maintain or grow their ROE whilst retaining earnings, it is far preferable that it retain the earnings, in fact, this is the sort of business we fervently seek.

What ROE focussed investors often fail to realise, however, is that when you buy shares on market, you are not paying the original equity price.  Assume in the ‘Hot-Dog Stand’ business above could be conservatively assumed to grow EPS at 10% pa (in perpetuity – or something like it) by retaining 50% of profits.  Such a business (provided we can be confident of the growth assumptions) would likely eventually trade at about something like 18x earnings (depending on many factors). On this basis, my $10,000 equity & $2,000 earnings above, the business would likely be valued at $36,000.  So very rapidly, the market would choose to pay $3.60 for every $1 of equity (due to the sound prospects of the business).  Assuming it makes that 10% growth for 10 years, pays out 50% of earnings and still trades at 18x, the investor who paid $3.60 (say per share for one or more of the 10,000 shares) after 10 years would own a stock priced at $8.49 and would have been paid $1.59 in dividends.  In this case, ‘over-paying’ for the equity was quite profitable, a return of about 10.85% pa (despite not having re-invested the dividends).  Depending on inflation levels, this might be a relatively sound result.

Imagine instead a business very much like the above, but it has had disappointing results and recently earned $500 on its $10,000 in equity (an ROE of 5% instead of the 20% above).  Now if due to its disappointing ROE and prospects, the business traded on say 8.5x earnings (Benjamin Graham indicates this is an approximately reasonable price for a business that is likely to neither grow nor shrink earnings), then instead of paying $3.60 per $1 for equity, I would be paying $0.425 for each $1 of equity (granted the original $1 payer has lost – that is not our problem).  Assume in this case, that for 10 years earnings grow at 5% pa and again, 50% of profits are paid out as dividends.  Based on similar factors as used above, a business that consistently grows it profits by 5% pa for 10 years would likely trade at about 11.8x earnings.  On this basis, our 42.5c shares would after 10 years be worth 91.5c and we would have received about 31.5c in dividends.  In such a situation, despite a significantly weaker ROE (in this example, in the 10^th year, the company was still producing an ROE of less than 6.1%) and half the annual earnings growth, we would have earned 11.21% pa (again without re-investing dividends), more than the better ROE and growth business above.

So to put it simply, ROE is a useful metric, but must be used with caution, as like virtually every other financial metric available, we must be mindful of the circumstances around which we use it.  Just because someone, somewhere in the history of the company paid too much for the equity doesn’t mean at its current cost, the equity is overpriced.  Tony Hansen 13/03/2011

What If?

One of the statements I've often heard used by those who try to justify their compulsive ‘undersaving’ or ‘underinvesting’ is “what if I get hit by a bus tomorrow”, or some such morbid, doom-saying prediction.  The inference here is that life is full of uncertainty, so better to enjoy the full measure of your discretionary income in the here and now, than to sock some money away and risk the prospect of leaving behind some inheritance by accident should an unexpected disaster befall you.

I concur with the sentiment of living for now, but my reply to such a statement (“What if I get hit by a bus?”) is “What if you don’t?”. The Australian Bureau of Statistics tells me a baby born in Australia in 2009 had a life expectancy of 79.3 for a male & 83.9 for a female.  Someone turning 40 in 2009 had a life expectancy of 81 for a male and 84.9 for a female.  Furthermore, someone turning 65 in 2009 could expect to live a further 18.7 years (male) and 21.8 years (female).  So my question remains “What if you don’t?”  A fair expectation is that you will quite possibly live until 80, 85 or longer.  In view of that likelihood, I think it is reasonable for someone who has under-saved to this point to find this prospect considerably scarier than being hit by a bus.

For the record, my current life expectancy is 80.6 and I’m quite determined to be ‘above average’.

I really fail to see in a wealthy society why the vast majority of people can’t put away 10% of their after-tax income.  My income was until fairly recently, less than the average Australian weekly wage.  We have 3 children, in their teens and despite this, through the last 10 or 12 years, have managed to accumulate a handsome nest egg, simply through prudent saving and investing.  We are admittedly a 2 income family (some don’t or can’t have this advantage), but we have really wanted for nothing in this period, perhaps holidaying more frugally (and infrequently) than our preference would have been, though in respect of holidays, we have been more generous with ourselves in the last couple of years.  My point is that you don’t have to give up very much in order to establish financial security.  But it is up to you, as Ben Franklin said “He that waits upon a fortune, is never sure of a dinner”.

To demonstrate, I have a friend, who recently as he approached his fortieth birthday, had come to the realisation that with continued inaction, his retirement was likely to be a very (financially) tough one.  His earnings are less than the average Australian wage (about 75% thereof), and in-fact by saving 10% of his after-tax income, he would only be putting away $75 per week, or $3,900 per year.  Bearing in mind, this man lives alone (that is to say, bears all marginal living costs) on an income of about $1,000 per week (pre-tax).  As I pointed out to him, by saving this amount, adding to it by 4% per annum (this is the approximate quantum of historic Australian wages growth), and equalling the approximate historic returns of the market (about 12.5% pa over the last 30 years) he would retire at 65 with just short of $1m in his savings account.  Given his current superannuation position (about $150k) and assuming a continued 9% pre-tax contribution (and this is likely to increase through future legislation) and returns of 8.5%, between personal savings and superannuation, my friend will have about $2.8m to sustain him through what is statistically likely to be about 19 years of retirement.  Assuming he moves his whole nest egg to cash that generates only 5% pa thereafter, in order to deplete this $2.8m in his 84^th (and statistically final year), he will need to spend approximately $233,000 per year.  If he wants to leave behind $1m, he need simply cut back to about $200k in annual income.  When considering this, consider the fact that the current aged pension in Australia is $329.20 per week.  Assuming it grows at CPI (about 2.5% pa) the aged pension in 25 years is likely to be in the range of $595 p/w or about $30,950 pa.  Makes $233k look pretty juicy doesn’t it, and besides that, do you really want your retirement income left to the whims of a Government?

Being already in a position where a comfortable retirement is likely, it might be easy to ask “what is the use of generating a good deal more money than you are ever likely to desire to spend?”  To such a question, I am likely to reply as Benjamin Franklin did when questioned at the first manned flight in 1783 (a hot-air balloon) “Sir, frankly, what’s the use of flying in the air?” His reply “Monsieur, à quoi peut bien servir l'enfant qui vient de naître?” or “Sir, what’s the use of a newborn baby?”  Depending on how much we can accumulate will depend on what good we are able to do with it.  With sufficient capital, I may just be able to make a great contribution to the betterment of society.  For now, suffice it to say I thoroughly enjoy the process of accumulation, and with (statistically) 46 and one half years to decide, I don’t need to worry too much about it yet (unless I get hit by a bus…) - Tony Hansen 06/03/2011

Valuing Companies Part 2

You may have noticed I do a lot of 2 part posts.  The reason being is that I start off with a short sharp investing principle I think readers might enjoy, and by the time I’ve typed it out, it runs to 3 pages and is too big for a single post.

So here is part 2 of ‘Valuing Companies’.  The substance of this part is driven by an e-mail I received from one of the readers, who was talking about some of their favourite companies, and asked me what I thought about the value of their current prices.  The three companies are CSL (CSL Limited, the old Commonwealth Serum Laboratories, which is now a broader pharmaceutical company), COH (Cochlear, a manufacturer of hearing implants/medical devices) and CPU (Computershare, a registry manager).  Without valuing these, I know right away, the 3 are outstanding companies, with able, shareholder focussed management and good businesses with fine prospects.  This alone is not a sound basis for an investment decision, to get to that point, we also need to determine that they are selling below their intrinsic value, and is it far enough to justify an investment.

I should point out this, to obtain these valuations, I used a discounted cash flow analysis (DCF), which takes my view of their likely earnings (and exiting share price) forward 10 years, then discounts them back into today’s $ value according to 2 metrics (7% & 12.5% as explained below)

Using a 'risk free' hurdle rate of 7% (this is about what I expect average term-deposit rates over the next 10 years will be), I produce a valuation of $64.80 for CSL, their current price is $36.96 (time-of writing), now this doesn't mean I believe you should rush out and buy them, just that if the only viable alternative 10 year investment (I always use a 10-year view for intrinsic valuations) was a term deposit at 7% p.a, you would choose CSL instead.  Using my preferred 'market' hurdle rate of 12.5% (30 year average ASX return of about 8.1% capital growth & 4.4% dividends), I produce a valuation of $42.41, on this basis, if the valuation is above the current price; it implies my expectation that the valued stock to outperform the indices (in this case by 1.38% annually over 10 years).  To arrive at this, I assume CSL's P/E ratio will compress to about 18x over the next 10 years.  To put this into context, over the last 10 years, CSL’s P/E ratio has averaged 34.8x and over the last 5 years, it has averaged about 22.8x.  Their EPS growth has averaged 25.6% over the last 10 years and 20.86 over the last 5.  The clear demonstration is that the rate of EPS growth is slowing; therefore the P/E ratio should continue to shrink.

On the same basis as above, for COH, I derive $106.34 & $69.77.  Given their current price of $77.14, this means I expect COH to underperform the market by 1% pa over the next 10 years.  I assume a P/E in 10 years of 22x.  Their P/E ratio has averaged about 33 over the last 10 years.  COH trade on a higher P/E than CSL due to the market viewing (with some valid reasons) their immediate future earning prospects as superior.

For CPU, I derive $17.06 & $11.30.  With a current price of $9.80, I rate CPU (only just) as the best of the 3 nominated.  With a probable 1.43% pa outperformance over the next 10 years. I used a P/E of 16x.

As I said, these are superior businesses, but on my assessment, at current prices, they are not particularly cheap.

Basically, in order for me to commit capital, I usually need to be convinced of an intrinsic valuation at least twice the current share price on the 'market' hurdle rate, or closer to 3x on the 'risk free' hurdle rate.  So before I would become interested, CSL would need to hit about $21.20 (a fall of about 42%), COH about $35 and for CPU about $5.65.  Because these are excellent companies, you might allow some leeway on this point, but not even plumbing the depths of the recent downturn, did these companies reach these valuations (though CPU got close).  By contrast, I bought shares in other sound companies at ¼ or less of IV over the same period.  I seek this margin of safety, so wide, that if there are deficiencies in the valuation, the errors have to be very large before I risk significant loss of capital.

Among the other caveats are the usual vagaries of the market, just because I say on my calculations COH will underperform the market over 10 years, doesn't mean they won't beat the market by a handsome margin over the next 12 months and that if some new information comes to light, an acquisition an issue of shares etc, valuations can move considerably based on this new information.  Similarly, despite my rating them 1. CPU, 2. CSL & 3. COH, doesn’t mean that CPU might not perform most weakly of the three over a measured period, in-fact their relative closeness in valuation would leave me relatively agnostic if asked to make a selection.  The important concept here is that despite my assessment that these are excellent businesses, with good prospects, I don’t rate them as sufficiently cheap to reach for my wallet, so the search continues – Tony Hansen 27/02/2011
P.S. Warren Buffett's always outstanding 2010 letter to Berkshire Hathaway shareholders.