Pew Research Centre has released a report entitled “The New Sick Man of Europe: the European Union”. Its findings add weight to the argument that the current state of the European Union is unsustainable. It states, “the prolonged economic crisis has created centrifugal forces that are pulling European public opinion apart, separating the French from the Germans and the Germans from everyone else”. Favourability for the European Union has fallen from a median of 60% in 2012 to 45% in 2013.

It’s a compelling report that is well worth a read. For today’s blog post, we wanted to share the section that we found most interesting – the opinions that Europeans hold of themselves and each other.

Everyone, except Greece, viewed Germany as the Most Trustworthy country (the Greeks saw themselves as being the Most Trustworthy). Italy acknowledged that they have a lot of trust to rebuild. Interestingly, Poland viewed Germany as both the Most Trustworthy and the Least Trustworthy nation. The French saw themselves as both the Most Arrogant and the Least Arrogant, while Italy, Spain, and Greece all saw Germany as the Least Compassionate nation.

And which country do you think was considered the Most Compassionate? Well, each and every country voted for itself.

The Eurovision Song Contest has been running since 1956. With opinions like those shown in this study do you think that the European Union have such longevity?

Included in the worrying recent signs are reports that suggest amnesia is returning to certain credit markets – in other words, the chase for yield may be causing investors to focus on return, while forgetting to take account of risk.

Most recently, Deutsche Bank and Nomura have drawn attention to a 25% surge in the price of junk-rated commercial mortgage bonds since December, and Bloomberg has reported that the issue of dollar-denominated bonds by Asian Corporates is growing at 10 times the rate of global corporate debt markets, as investors chase the relatively higher yields on offer in the region.

For our part, we will continue to be focused on the long game, and where we feel that the markets are not adequately rewarding investors for the risk they are taking, we will choose not to take it. This may mean holding material cash balances in our funds until the balance of risk and return is more favourable.

Last week’s year-six father and son breakfast was never expected to throw up any investment ideas. Indeed, I was so focused on the kids that I wasn’t even listening out for investment insights when one hit me, or, to be more accurate, brushed gently before me.

It was a friend of mine, a semi-retired fund manager who now spends all his time managing his own portfolio and cattle farm. He made the observation that everyone is sanguine – if not optimistic – about equities.

“Who are you talking about?” – I asked.

“Everyone,” he answered.

Holed up in our converted warehouse in Pyrmont, far from the distracting natter of daily broker lunches and street corner stock tips, we don’t get much of a handle on sentiment. Fortunately we don’t need to. Other than observing which stock presentations at the Macquarie conference only had one or two attendees (gold) and those which only had standing room (commercial leasing), our ‘reading’ of the level of optimism and pessimism is deliberately restricted to our observation of how many stocks are trading well above our estimate of intrinsic value each day.

Either way, my experience is that the market always does what it needs to do to ensure the majority is proven wrong. And based on the sentiment observed by my very experienced and successful friend as well as the number of stocks trading at discount to intrinsic value (none), it looks like the majority appear to be very long indeed. But is the enthusiasm misplaced?

The number of collapsing retailers and fashion houses, as well as the increasing struggle for local tourism operators and food producers to stay profitable under the weight of the high Australian dollar, suggest that there are few reasons to be overly enthusiastic about local economic conditions.

Long term, the issue for our country can be exemplified thus: Australian supermarkets are committed to delivering lower prices to consumers (beating the competition to it) – no matter what the cost. They will import cheaper products from offshore if it means consumers can pay less, and with weaker international currencies making foreign exports more competitive than our own, it seems like a straightforward plan. The problem with this strategy, however, is that local manufacturers go bust and lay off staff, who then in turn have to call for lower prices because they have lost their jobs.

We simply can’t insist that local businesses deliver products and services at lower and lower prices while also demanding that we get paid time-and-a-half, double time and triple time on weekends. Something has to give. Lower prices will only deliver unemployment and serfdom – while we fuel the improvement of overseas businesses and investment conditions.

Elsewhere, take a look at the balance of payments’ current account deficit and last week’s budget deficit. Not only do these suggest that the business of Australia is in poor financial shape but that it also has poor managers at the helm. So why the investor enthusiasm?

China. With an increasing influence on Australia from the Chinese stock indices, it is not just the high level of iron ore and coal we export to China that ties us to that country’s fortunes.

But what is going on in China now should serve as a warning to Australian stock market and property speculators. The next five to ten years in China will be nothing like the last decade. That country’s positive influence on Australia’s prospects may become proportionally negative and prove just as cyclical as the commodities we export to them.

China is moving from investment-led growth to consumption, but the transition may not be nearly as easy as that statement is to write. Meanwhile debt growth – the product of China’s own quantitative easing to fund increasingly unsustainable rates of economic growth – may be reaching its own limits, and economic growth must slow if household income is not built up fast enough to replace the contraction in government spending.

I personally think, as do an increasing number of others, that even seven per cent economic growth in China will not be achievable beyond this year, and that the motivation for reaching it this year is merely the pride and reputation of the new leadership. More importantly for Australia, even if seven per cent is achieved, it will not be as capital intensive as previous growth – so we can expect slower increases in demand for our iron ore at best.

On the supply side, RIO, BHP, FMG and Roy Hill will all add to iron ore production in the near term. The result? Falling prices. No wonder George Soros is rumoured to be shorting the Australian dollar. The rumours of me having done the same might also be correct.

If you are trying to pick the bottom in iron ore stocks, or worse, justify their purchase on yield, just remember – you are speculating, not investing. Finally, given we cannot find many, if any, bargains in the stock market currently, buying at today’s prices may also be more speculative than rational.

(…tune back in next Saturday for the second instalment in this series)

You can see the dung that people consume in the picture to the left. Kopi Luwak has been called the most expensive coffee in the world with retail prices reaching €550 / US$700 per kilogram.

Coming back from lunch today, the Montgomery team remembered how expensive Australia is to hire staff, rent commercial space, drive a car and simply live. And having discussed Australia’s prospects with another fund manager at lunch, it occurred to us that the resources industry is the bean, the cat is the economy and the defected remains are what we will all have to swallow shortly.

Today, the Worley Parsons conference call revealed the change in trading conditions in WA (i.e. down) is worse than what they saw during the GFC. In terms of the rate of deterioration, WOR thought they were close to the bottom back in February, but market conditions have deteriorated further since.

Here’s a list of recent statements made by others with exposure to civets:

“Ongoing uncertainty and volatility in commodity markets have driven a continued slowdown of capital investment in the resources and infrastructure sectors with further delays of major projects impacting revenues in the Engineering business. Additionally, the cost management programs of the major miners have led to scope reductions and cancellations across UGL’s operations and maintenance business.” – UGL Managing Director and CEO, Richard Leupen – market update

“Market volatility and weak conditions in the Australian resources sector continue to provide a challenging trading environment. While recent conditional environmental approvals for key projects were positive signs, continuing delays in final environmental and investment approval has resulted in further project slippage with flow-on impacts on anticipated revenues in the second half of FY13.” Sedgman – market update

“Just pulling more tonnes out of the ground is not enough. The mining sector has experienced significant cost increases in recent years, and it continues to do so. In addition, stakeholder expectations of the industry have also grown … We are targeting cumulative cost savings of US$5 billion over the next two years. This will be achieved through a relentless focus on cost reduction and productivity improvement across all areas of our business.” – Sam Walsh, Chief Executive, Rio Tinto – AGM

“We must challenge ourselves to increase returns from new investment, in the same way that we need to squeeze returns from our installed instrastructure. IN this regard, capital and exploration expenditure for the 2014 financial year will decline significantly, to approximately US$18 billion, and the rate of spend is expected to decline substantially thereafter. By reducing our annual spend and increasing internal competition for capital, we expect to maximise returns from incremental investment…” – Andrew Mackenzie, Chief Executive Officer, BHP Billiton – 2013 Global Metals, Mining and Steel Conference

“Ausdrill’s core business comprising of mining services in Africa and Australia has largely continued to perform as expected due to the focus on production related services. However, the Group’s profits are expected to be impacted by the general slowdown in activity in the Australian mining sector that has occurred from September 2012 onwards, and which has not recovered as previously expected.” – Ausdrill Limited – market update

Nikki Williams, CEO of the Australian Coal Association, said on SBS in January that the Australian coal sector is at “a terrible junction where not only has the international market come off in terms of prices, but our costs and productivity have gone to a terrible place,” … (Until recently Australia was the cheapest place in the world to produce coal) … “And in just five years, we’re now the highest cost producer in the world at $176 a tonne compared to the rest of the world at $106.”

The head of engineering firm, Coffey International, has warned of a protracted economic downturn far wider than the slowdown in the mining sector, with an ‘increasing cascade’ of project delays and cancellations and little chance of a recovery for some time. “What we have been seeing is significant project delays or cancellations that were broader than simply mining,” Coffey managing director John Douglas told The Australian.

Our friend and fellow portfolio manager has just returned from an whirlwind tour of Chinese steel mills to discover that (unsurprisingly) China believes losing money in this industry is acceptable because of the benefits elsewhere in the economy. Keeping people employed is also a priority. Meanwhile Australia’s largest iron ore producers are committed to producing even more. The price of iron ore is going one way.

If you remember that it was the resources industry that kept Australia out of a recession (sound economic management had little to do with it, Canberra), our question is – what will keep us out of recession now that the resources industry is in one?

We already know Australia is the most expensive place in the world – the legal minimum wage DJs or Myer have to pay an inexperienced uni student as floor staff on a public holiday is $54/hour – but what we may not have known is that this expensive stuff we are all about to be force fed comes from the rear end of the world’s problems.

After noting this historical trend, we followed up with the below table which we have the pleasure of updating following the release of CCP’s 16 May 2013 presentation:

The latest update continues the trend of management upgrading both Purchased Debt Ledgers (PDL) and Earnings guidance throughout the year. As a result of the pattern continuing, our views on the business’ prospects remain unchanged, remembering Montgomery Funds hold the shares.

Indeed the strong and rising levels of purchasing during 2011, 2012, and now a record in 2013, should not only continue to contribute to earnings growth in 2013, but also provide confidence that 2014 will also grow.

The May update only lifted the bottom end of the forecast earnings range, however we believe this is a signal that the result could be at the top end of the range and perhaps exceed it, when announced in August.

This would be a fantastic outcome, as our own estimates for net profit after tax of $30m at the start of the year – were well ahead of the consensus estimates at the time. We now forecast NPAT of $32m or higher being reported in 3-4 months. Keep in mind we could be wrong.

The Montgomery [Private] Fund has held Credit Corp Group Limited, on behalf of its investors and clients, since inception (Dec 2010), and has accumulated a meaningful and material holding since then. Every $100 The Montgomery [Private] Fund invested in CCP has grown to $229. Conversely, an investment in The All Ordinaries Index over the same period has turned the same $100 into $106.

Score a 1 for our investors, and for investing in extraordinary businesses trading at a discount to estimated intrinsic value, and score zero (or 0.06) for the efficient market theory and index tracking.

Excellent returns over such a short time period are encouraging but should never be expected nor projected into the future. Montgomery’s focus continues to be on that future and on finding quality businesses where the market has misjudged their prospects.

Credit Corp Group remains on our quality business list.

Sustaining peak performance over not just years but decades may be the single most difficult challenge for executives.

In a recent case study entitled Sir Alex Ferguson: Managing Manchester United, Harvard Business School Professor Anita Elberse said of Ferguson, “He seemingly knows what to say when and understands what different players need . . . He holds everyone to the same high standards but will tailor his approach to different personalities”.

He is commanding when the situation requires. As Ferguson himself said, “You can’t ever lose control – not when you are dealing with 30 top professionals who are all (multi) millionaires. And if anyone steps out of my control, that’s them dead”.

Getting the best out of the team is every leader’s challenge and Australian business is no different. We believe that the business boat a manager gets into is arguably more important than how good a rower the manager is, but when a great business boat meets a great manager, the ride for investors can be as long and as enjoyable as it was for Sir Alex and Man U.

Ben’s blog today is a story about diversity and community, about profits versus people and whether the desire for ever-lower prices can live in harmony with the desire for ever increasing wages and living standards.

Here’s Ben’s blog:

This month I went down to the local hardware store in search of a new mower. Unfortunately, the shopkeeper only had two in stock, both of which were not suitable to manage the small patch of grass masquerading as my backyard. It was recommended that I should visit the nearest Bunnings to see what they had in stock.

I found it interesting that the local hardware store felt comfortable to suggest this. Sure, the nearest Bunnings is a few suburbs over, so it doesn’t compete directly in the local area. What’s more, mowers are bulky, and expensive-to-store products that would not be as profitable to stock in a small metro store. As long as the local shopkeeper is able to earn a decent margin on smaller items like taps and sandpaper, it wouldn’t really hurt their bottom line if their customers make the trek to Bunnings for their larger hardware purchases. Or would it?
At a recent conference, Terry Bowen, the Finance Director for Wesfarmers, noted that management is focused on expanding the Bunnings chain into urban centres. When you consider that Woolworths is also looking to open 150 Masters stores in order to compete in the home improvement sector, it will only be a matter of time before the suburban and industrial areas reach critical mass.

The boom in Do-It-Yourself and Do-It-For-Me renovations should support the urban expansion. Dulux Paints released their half-year results this week and reported that over 60 per cent of their business is related to existing homes. So while housing with large backyards is less common in the inner city, it may prove to be a profitable market for the home improvement retailers.

And before you think that Bunnings is constrained to the outer suburbs with their “big box” warehouses, management is now rolling out multi-level warehouses with underground carparks that are more economical for smaller, premium real-estate.

So it seems that the constant pursuit for growth will drive management to open sites in more and smaller or more densely-populated areas – indeed, competition may become so intense that there may be a time when my local hardware store will shy away from making the same recommendation, lest he disappear altogether. But the romantic in me would like to think that Bunnings’ bulk-purchasing business model might aspire to allow community and diversity to prosper also.

Here’s an excerpt:

“Dating back perhaps as far as the early Nineties, traders and others inside these banks were sometimes calling up the company geeks responsible for submitting the daily Libor numbers (the “Libor submitters”) and asking them to fudge the numbers. Usually, the gimmick was the trader had made a bet on something – a swap, currencies, something – and he wanted the Libor submitter to make the numbers look lower (or, occasionally, higher) to help his bet pay off.

Famously, one Barclays trader monkeyed with Libor submissions in exchange for a bottle of Bollinger champagne, but in some cases, it was even lamer than that. This is from an exchange between a trader and a Libor submitter at the Royal Bank of Scotland:

SWISS FRANC TRADER: can u put 6m swiss libor in low pls?…
PRIMARY SUBMITTER: Whats it worth
SWSISS FRANC TRADER: ive got some sushi rolls from yesterday?…
PRIMARY SUBMITTER: ok low 6m, just for u
SWISS FRANC TRADER: wooooooohooooooo. . . thatd be awesome

Screwing around with world interest rates that affect billions of people in exchange for day-old sushi – it’s hard to imagine an image that better captures the moral insanity of the modern financial-services sector.”

And here’s the link to the complete story.