Another Big Year Ahead

It's been a great year for Australian investors, and clearly the most memorable year of the last decade. Corporate Australia is in unprecedented financial health, and the investing world is finally starting to realise the quality of company, and quality of management, we have down under.

I've tried to spend more time this year getting away from the trading coalface, and meeting the leaders of corporate Australia personally, be they CEOs, chairmen, or company directors.

I'm strongly of the view that record earnings and dividends we are seeing reported in the Australian equity market aren't simply a factor of economic growth, they are a factor of high quality management. I think we sell ourselves short on this management skill topic, and we don't quite realise we are the best corporate managers in the world.

I met several business leaders at a recent charity lunch. They reinforced my view that the custodians of corporate Australia, particularly large-cap corporate Australia, are genuinely decent people. The have humility, humour, substance, and genuine intellect.

We are a nation of doubters and we, unlike Americans, tend to doubt our ability or the sustainability of our efforts. We are always waiting for the bad news, and always looking for the underlying cycle to end. That's why so few investors have actually got the resource cycle right, despite it happening in our own back yard.

Sceptical "guidance counsellors/penguins" have consistently under-estimated earnings growth across a variety of large-cap sectors, and those who were willing to take a non-consensus view have generated strong outperformance. Sceptical "guidance counsellors" also contributed to a wave of merger and acquisition activity, where corporates simply took advantage of the arbitrage between "scepticism" and reality.

The global corporate world is starting to pay more for our assets, earnings, political stability, consistent economic growth, and management. The world is paying a higher multiple for our leverage to the Asian growth engine, and I think this will be a feature of the next decade in Australian equities. I can smell the global merger and acquisition cycle moving right up the Australian market cap food chain, and we will see a top 20 company bid for next year.

A term used in our firm is "shuffling up to the edge". It means, basically, getting as close to the "risk" edge as you can, without falling over it. It involves educated risk taking, and it involves challenging consensus thinking.

I'm sure many of you this year have read some of our ideas and gone "ooh, that's aggressive", but all I'm trying to make you do is consider the share price ramifications if my non-consensus view does eventuate. I'm simply trying to make you think, and most of the best ideas I've had this year were "stomach churning" in terms of consensus risk when I went with them.

When you "shuffle up to the edge" you do occasionally fall over it, but as long as you can pick yourself up, and dust yourself off, you can live to fight another day. This year I've made a few mistakes, but none of them were life-threatening.

Yes, I do regret recommending taking profits in Macquarie Bank (MBL) at $50, and then watching them trade up to $80. However, you will never go broke taking profits, and there's nothing wrong with leaving something on the table for the next bloke. I don't want to leave $30 on the table, but you know what I mean.

Looking to the year ahead it's worth noting that Chinese industrial production rose a cool 16.6% in November, which was the fastest pace in the past five months. This was stronger than economists forecast, and may lead to further price declines for manufactured goods.

You can see why there are allegations the Chinese have been trying to manipulate commodity markets, in an attempt to keep prices low to feed their aggressively expanding manufacturing sector.

Chinese output is rising even as the Government warns of gluts in industries including steel and aluminium. Excess capacity resulting from fixed asset investments, which surged 28% in the first 10 months of this year, are weighing on prices and eroding company earnings.

My best resource contacts are highly suspicious that the Chinese have been active in all hard commodity markets, attempting to keep a lid on prices. This has clearly backfired in the copper market, and they have suspicions that similar situations are brewing in the aluminium, nickel, tin, and manganese markets.

Cleary, the Chinese Government continues to attempt to contain growth, but the fact is the economy continues to exceed the market's growth expectations, which is requiring a larger and larger base load of commodities to fuel it. This clearly means the Chinese have a vested interest in attempting to keep a lid on commodity prices, yet they misjudged demand from the recovering US and Japanese economies.

If we are right and the Chinese have been playing games in the traded commodity markets, and under-stating their actual GDP growth (which is widely believed in Central Banking circles), then we are set for a substantial move higher in commodity prices in the new-year.

At a strategic level, I'm trying to emerge from the season summer trading slowdown in Australian equities, with a portfolio set for the "blow off" stage in commodity prices. As I've written before, nobody believes this can happen; in fact the consensus is for a 30% decline in traded commodity prices in the six months to June 2006.

I want a portfolio full of "pricing power", and conversely, I don't want to be holding any stock where input prices are rising sharply, yet final prices are falling due to excess production in China.

It is particularly important to be holding "industrial" pricing power, or those regaining their pricing power.

Finally, I'd like to wish all readers and their families, a safe and merry Christmas as we look forward to another prosperous new year. When you're serving Christmas lunch, just remember: "You don't win friends with salad."