Graeme Samuel's painful lessons

PORTFOLIO POINT: The ACCC chairman's disastrous investment in the troubled DFO chain contains lessons.

This week I didn’t get down to Anglesea but what a week it was to be in the city. There was so much happening.

My old friend Graeme Samuel lost his investment in the DFO chain of property developments and in doing so has alerted every investor of the dangers of not watching your portfolio.

Then BHP threw caution to the wind with a $40 billion bid for the world’s largest fertiliser company Potash Corp of Saskatchewan, sensing the bargain of a lifetime.

After that I sat next to CSL’s Brian McNamee at lunch and received a surprising piece of information about the state of investment markets and where they are going.

It has been an extraordinary week in every sense of the word. And that doesn’t even include what will happen at the polls tomorrow.

I’ve known Graeme Samuel for decades; we first met when he was an up and coming takeover lawyer and we have debated many issues. But no matter who won the debate we always went away smiling because we always uncovered new ways of thinking about a particular subject.

When Graeme became chairman of the Australian Competition & Consumer Commission in 2003 he believed he had more than sufficient money to look after himself, his children and his grandchildren. Many people make similar decisions when they reach a stage in life in which they feel comfortable.

What he should have done was sell most of his assets and put them in a rolling series of term deposits. Instead he choose to get exposure to growth assets but in order to do this he had to follow the letter of the law and set up a blind trust.

Being Graeme Samuel, he followed the rules around blind trusts very carefully. His friends who, on paper, controlled the trust really did control it; Graeme was not quietly telling them behind closed doors what to do with the money.

He must have known that the so-called South Wharf DFO development in Melbourne was an enormous punt because it’s almost impossible to get to. But he thought he his money was safe in the string of successful DFOs established up and down the east coast and had no idea his trustees had allowed these assets to guarantee the highly leveraged white elephant that South Wharf had become.

Had he not been ACCC chairman he would never had to set up a blind trust. He would have been on the board and DFO would never have become so over-extended and I have no doubt his investments would have prospered.

But there are lessons for everyone in the Samuel experience:

• If you don’t have time to monitor your investments, or aren’t able to because of potential conflicts of interest, then you must not be in the high-risk end of the stockmarket. The only reason you might be in this end of the market is because you have great faith in the investment skills of the manager. In most cases this person will not be a friend.

• If you are not able to be actively involved and you don’t have a skilled professional manager then your equity exposure needs to be either very widely spread or confined to leading stocks.

• Taking that further, people aged 64 and over should not have almost all their assets one investment, particularly one that is highly leveraged, no matter how good it looks. If you do your dough you aren’t in a position to earn it back.

• About three-quarters of our crashes arise because bankers have been willing to lend large sums on property and/or infrastructure. Sometimes that property development is linked to retailing and usually the high leverage has attached to it a complex corporate structure. The troubles at DFO are textbook in this regard. Babcock & Brown was the same.

• One of the big lessons we learnt from the financial crisis is that many companies fall over once they are in trouble because they fail to take into account the generous retrenchment benefits that are not in the balance sheet. When a troubled business with long-serving staff tries to downsize, it faces huge retrenchment bills, which it can’t afford. Often that causes the company to delay taking action which can be fatal.

So if you are investing, the danger signs are usually there. High leverage only works when there is an assured source of cash flow and nothing goes wrong.

Some of our most successful entrepreneurs had a brush with troubled times and then recovered to be much stronger. The best example is Rupert Murdoch, but Dick Pratt and Westfield have all encountered their share of difficulties and were better for the experience (for more on Australian companies expanding overseas, click here).

Meanwhile the rescue package means Graeme may recover some of his money but in the meantime it will be very hard going.

BHP Billiton has been extremely cautious throughout the crisis. It is now much less bearish but the Canadian-based PotashCorp is such a wonderful opportunity that it cannot put off making a decision any longer.

Moreover, at BHP it now looks as though the Rio Tinto iron merger will not happen because of European regulatory roadblocks. BHP is now free to undertake another major project and it is looking directly at fertiliser.

PotashCorp is delivering shareholders earnings of about $US6.20 per share and BHP is offering about 21 times earnings for the company. Growing wealth in China and India means that the people who live in these regions are consuming more protein and they need potash to deliver these increases in yield.

While most other companies in the space have held back expansion, PotashCorp is lifting production from nine million tonnes to 17 million over five years.

There is a potash cartel but effectively PotashCorp controls the price and the combination of higher production, a big rise in demand and a long delay before competitors can ramp up production means that for the next decade Potash Corp is going to make a fortune. It looks like iron ore all over again.

The Canadian authorities want BHP to invest their Australian iron ore cash in Canada and are welcoming the big Australian. BHP will have to pay more than the 21 times earnings it has offered but let’s say it pays 22 or 23 times, BHP can see the PotashCorp profits doubled and much more.

Better still, it makes BHP’s own relatively small greenfield Canadian Potash venture much more valuable. BHP wants to end the cartel because it’s holding back price growth. The Canadians don’t understand this but they will, but only after BHP gets control.

PotashCorp’s chief executive, Bill Doyle, knows that if he took the current offer he would be getting ripped off and so he is looking hard for a rival bidder. He may succeed. But if he doesn’t and BHP gets control at a very cheap price, Australians who own BHP shares should know that they are on a winner.

Most Eureka Report subscribers have their own SMSFs or are sizeable private investors. Companies treat them as second-class citizens and direct their communications to institutions. Until very recently institutions were a growing presence on most share registers.

But this week, after CSL announced its results, I sat next to CEO Brian McNamee at a lunch and he told me and others that about four years ago retail Australian investors were down to about 25% of the CSL register.

Since then they have grown to account for about 40%. Conversely, Australian institutions had fallen from 35% 25% of the register. International investors make 35%, so in total institutions are still 60%.

I pointed out to Brian that this trend of a higher retail presence simply reflected what had happened in the savings markets generally. More and more investors on high incomes are abandoning the institutions and their managed funds and the Eureka Report subscribers are at the forefront of this revolution.

For them, CSL is a straightforward way for smaller Australian investors to gain overseas exposure. In the future this divide will become even more pronounced, which means the companies will not be able to ignore the wishes of their retail shareholder base any more

Now I am off to the Keilor pub where for the second time in two years people are spending good money to hear your Eureka Report scribe talk. Mindboggling stuff, I know.

One of the interests I have outside of Eureka Report are the Penleigh and Essendon Grammar School (known as PEGS), where I am the chairman. Two years ago the football club assembled a group of business people who wanted to participate in a $1000 a head lunch fundraiser and today we will do it again.

My reward was a magnificent lunch and wine from Ray Dodd’s kitchen and remarkable cellar. The Keilor hotel is Australia’s oldest family hotel and the Dodd family have held the reigns for 148 years. I will tell you more about what went on next week when we will know who our next PM will be. I am going to have to make a prediction at the Keilor pub. I will very nervously go for Gillard. If I get it wrong that will be the last of the lunches, especially as my Canberra mates tell me Abbott has it won.