Fund Manager’s Report - Half Year to 31 December 2011

While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. In addition, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market or downturn, appreciating that things will likely get worse before they get better. However, in time all markets recover including share prices.

Our report, Outlook for 2012 (at the end of this report) covers the likely outcomes for not only the European Debt Crisis but also for the Chinese, Australian and US economies, commodities and corporate earnings.

While markets around the world finished the last week of the year on a slightly more encouraging note, as European legislators made significant inroads to the debt crisis, it wasn’t the whole story.

We saw the US market finish generally flat for the year and down approximately 6% for the half as the best performing major market. However, other major markets that that fund is also exposed (directly and indirectly) suffered much worse treatment by investors over the last half year.

Australia lost 12% (down 15% for the year)

UK lost 7%

France lost 22%

Germany lost 21%

China lost 20%

Japan lost 14%

Hong Kong lost 18%

Above are the national stock indices for the calendar year rounded up or down to a whole number.

No markets were spared the selloff. To further illustrate what a difficult year it was, it is interesting to look at the return of other fund managers who invest in similar equity markets to our own fund. I have selected managers who are widely regarded internationally as the best fund managers in the business, many often referred to as “investing legends” and many who have in recent years been awarded “Investment Manager of the Year” or in the case of Bruce Berkowitz, “Investment Manager of the Decade”. Many you will have heard of, such as Australia’s own investing legend, Kerr Nielsen and perma-bear, Jeremy Grantham, as well as American billionaire, John Paulson – the man credited with picking the GFC and making billions from it.

Investment Manager	Fund	Loss for 2011
Jeremy Grantham	GMO Intrinsic Value Fund	-20%
Ken Heebner	CGM Focus Fund	-21%
Bruce Berkowitz	Fairholme Fund	-29%
Carl Icahn	Icahn Investments	-18%
Martin Whitman	Third Avenue Value Fund	-23%
John Paulson	Advantage Fund	-45%
Bill Nygren	Oak Mark Fund	-8%
Ken Fisher	Fisher Purisima Fund	-14%
Kerr Nielsen	Platinum International Fund	-14%
Mario Gabelli	GAMCO Asset Fund	-11%
Charles Royce	Royce Premier Fund	-18%
Mason Hawkins	Longleaf Partners	-16%
	Average Return	-20%

To round off this list, there is one investing legend missing, Warren Buffett, who is not really a fund manager, but an investment guru who also lost money in 2011, down 5%. On this list, I would have to say having followed all these managers for years, there is not one that over the long-term I wouldn’t trust with my money – 2011 was that kind of year. The managers listed here without exception have enviable records of long-term outperformance and I have no doubt that the last 6 months was simply an aberration soon to be reversed in the short to medium-term.

While the US market may have finished flat for the year, it doesn’t reflect the true picture, as “growth” stocks were sold down and dividend paying “value” stocks were bid up leaving markets looking relatively unchanged but movements in the underlying stocks being, in some cases, quite dramatic.

However, we look forward to 2012 (see our Outlook for 2012 at the end of this report) with a much higher degree of confidence that our holdings will perform as expected. From our forecasts, the holdings of the fund are estimated, on average, to increase sales and earnings by 20% or more in 2012 and all have a history of beating estimates handsomely.

Portfolio Changes in the last 6 months

Over the last half year we have made several changes to the portfolio in accordance with a ‘weighting lower-risk, earnings “certain” stocks higher strategy’ and removing some stocks to be replaced with others that provide greater return potential as per our top down investment theme strategy.

Increased Investment

During the period we added to our investments in Apple, Intuitive Surgical, IBM, MasterCard, Google, Jazz Pharmaceuticals, Qualcomm, 3D Systems, Hexcel, Titan International, Polaris Industries and several others.

Decreased Investment

During the period we took profits or reduced our weightings in major holdings such as Intel, Caterpillar, McMillan Shakespeare and Oracle.

Ceased Investment

During the period we sold our holdings in Altera, BHP Billiton, Parker Hannifin, TRW Automotive, Ezchip Semiconductor, Sun Hydraulics, Arrow Electronics and Teva Pharmaceuticals. In the case of the technology stocks, this was because of the Thailand floods and the reduced medium-term guidance as a result and in the case of the others, due to a fall in our ratings of fundamental value and prospects for the longer-term.

We have reduced our exposure to Australian equities, as our outlook for the Australian economy has diminished due to our concerns over commodity prices, terms of trade, wider corporate earnings and the Carbon Tax.

Initiated New Investment

During the period we initiated new investments in the world’s largest electronic medical records company, Cerner; entertainment giant, Walt Disney; fertiliser maker, CF Industries; Australian mining engineer, Worley Parsons; leading mobile communications semiconductor maker and major Apple supplier, Broadcom; marine and general engineer and manufacturer, TwinDisc; online travel company, Priceline; and technology leading oil and gas engineer, Newpark Resources and several other smaller positions.

Fund Portfolio

All up, we have 42 positions made up of 41 long and 1 short position.

10 Largest Holdings	What They Do	Percentage of Fund
Intuitive Surgical	Global Surgical Robot monopoly	7.10%
Oracle	Computers, Software & Cloud computing	6.90%
MasterCard	Global credit card issuer and payments processor	4.40%
Google.	Internet advertiser, world’s largest Internet search engine and diversified online company	4.20%
Jazz Pharmaceuticals	Specialty pharmaceuticals for anxiety and sleep disorders	3.80%
Qualcomm Inc	World’s largest maker of wireless telecommunications products and services	3.80%
IBM	World’s largest global technology company	3.70%
Hexcel	Composite manufacturer to the aerospace industry. Major supplier to Airbus and Boeing	3.50%
VeriFone Systems	Global duopoly providing electronic and POS payment systems	3.50%
Caterpillar	World’s largest maker of mining and construction machinery	3.40%
Top 10 Holdings		44.30%

 

Sector Weightings		Percentage of the Fund
Cash and Cash Equivalent		15%
Basic Materials		4%
Technology		26%
Industrials		17%
Communications		8%
Consumer Cyclicals		6%
Consumer Non-Cyclicals		12%
Financials		2%
Energy and Other		10%

In addition to our equity holdings, we have also invested around 13% of the fund into AUD$ Senior Preferred Floating Rate Securities paying 3% above the cash rate, which is currently yielding the fund 7.25%. These funds remain available to the fund to invest in stocks if we wish to do so.

Understanding Long-term Investing

Most investors would want to be just like Warren Buffett, but few, when given the chance will invest like him. Most invest in exactly the opposite way – they then lose money and constitute the majority of investors who rarely do overly well in stocks. Investing just like Warren Buffett is easy, but very few people can do it. They lack one vital thing – patience.

The average investor is not an investor at all – they are “speculators”. They judge their investments based on daily, weekly or monthly movements. They make decisions to buy or sell based not on the long-term outlook of a business, but what happened yesterday, or become caught up in the fear of what might happen tomorrow – this is speculation, not investing. Most investors are guilty of it and due to the pressure of quick returns, investment professionals (who should know better) also get caught up with it, as they feel that if they don’t follow the bad habits of their customers they will be subject of criticism or redemptions if the results aren’t there in the short-term. This is a major mistake and one that many fund managers make today. It turns most fund managers into “mediocrity-seeking, index-huggers” that would rather be wrong and average, rather than be right and above average because the time frame of the average investor is so short that wrong and average is “safer”.

It’s best to illustrate this by looking at a Warren Buffett favourite – Coca Cola. As we well know, Warren is famous for saying his holding period of a stock is forever and nothing shows and explains his success and the failure of the average investor better than this chart.

Warren and average investors both invested in exactly the same stock and at similar entry points, and even if Warren had bought when everyone else did, he still would be up 34%. The difference was the holding period. The average investor sold a perfectly good company – ignoring all fundamentals, exactly the same fundamentals they relied on so much to buy the stock in the first place – and sold at 19% loss. This is the story of their investment lives. Warren on the other hand is up 54% in exactly the same stock. It’s pointless doing all the research and finding a great investment for the long-term, if at the first sign of trouble, you dump the lot, take a loss and go to cash. It seems to me that most investors forget what they have invested in and have disregarded common sense totally.

Let me give you one more example of less than sensible behaviour. Just say you own a coffee shop, it’s profitable, it has it’s bad days and good days – but over a given period, the business is good. Now, you buy the newspaper and you read that economic conditions could get worse next year, do you immediately put up a for sale sign? Only to take it down a week later when you realise the journalist overstated the issue. No, of course you don’t – so why do it with the other businesses you own - your shares?

Stock in Focus - Qualcomm

Morgan Stanley predicts Smartphones sales will outpace PC and laptop sales in 2012. By 2013, an estimated 650 million Smartphones will be sold. And over 1 billion Smartphones will be sold annually by 2016, according to IMS Research.

Obviously, the big winners are Apple's iPhone and phones running Google's Android platform. Both are major shareholdings of the fund.

In fact, more than 550,000 Android phones are activated every day, earning Google a 48% share of the market. The iPhone has about half that share, but with much higher margins for Apple.

But in the tablet market, Apple sits at the top, with a somewhat similar growth trajectory. In the fourth quarter of 2011, Apple expected to ship 14 million iPad 2 devices, roughly double the 7 to 9 million sold in the second quarter.

Clearly these trends have only just begun. So, our stocks have a long way to run in their growth trajectory. There is one company that will profit form both Apple and Google’s fabulous success.

The company? Qualcomm [Nasdaq: QCOM].

The Android mobile operating system has become the global leader and has helped stabilise average phone selling prices. Of course, there are long-term fears of price battles between Android phone companies; however, this doesn’t matter to Qualcomm, as they supply their chipsets to nearly every maker of Smartphones. Not only do they have supply contracts to supply the chips, but they also own the patents to the technology that make Smartphones work. Without Qualcomm, there are no Smartphones.

Between Android and Apple’s iOS, they command nearly 75% of the global market and Qualcomm’s chipsets are there in almost all of them.

Their new series of Snapdragon System on a Chip (SoC) solutions in mid-2012 will power revenue and earnings growth well beyond 2012. Mobile connectivity and mobile devices will be one of the fastest growing sectors worldwide for the next decade and while Qualcomm has competition, it’s clear that it is by far the industry leader on size and technology and it’s chips are becoming industry standard.

Also, Smartphone shipments will likely grow 35% to 40% growth in 2012 to around 600 million units per year and that by 2015 Smartphone sales will easily be in the neighborhood of 1.1 billion units per year. This represents nearly 300% total growth from 2010. This growth will not only drive up chip sales for Qualcomm, but also substantially increase its lucrative royalty revenue stream.

Even faltering Smartphone companies like Nokia and Research in Motion with their Blackberry range are pinning all their hopes for revival on the Qualcomm Snapdragon chipsets. 

Over the next couple of years the world will adopt 4G baseband technology and these new 4G phones will have to be able to handle 3G and 4G standards which will increase complexity of the chipsets as well as reduce power usage, which is a big plus for Qualcomm as they are the leader in this technology and hold many of the patents necessary that competition will need to license.

The company is in the box seat to gain not only further market share, but also the benefit of a much larger market globally, making it one of our key stock holdings over the next few years.

Outlook in Brief

While we still believe the EU and several European countries have much work to do, we are convinced that progress has been made that will result in investor fear receding over the next two quarters. We feel the ECB, while hamstrung legally from undertaking a US Federal Reserve style Quantitative Easing program, has found some success in providing much needed liquidity to the EU banking system and in effect, provided QE by allowing a carry trade to be undertaken by the banks. The unlimited 1% loans provided to banks for 3 years will allow EU banks to invest that money in sovereign bonds paying higher rates of return. Thus providing the funding and liquidity required. The last part of the framework to reduce risk for the banks will be the broadening of the role and enlarging the capacity of the EU bailout fund, the European Stability Mechanism. Once this is in place we should see sovereign bond yields fall, as is already happening, and in turn should see investors return to riskier assets such as equities, as cash rates and bond yield continue to fall throughout 2012. We do, however, see a possibility of a mild European recession in the first half of the year, but this has been fully priced in to equity prices.

In addition, a continued strengthening of the US economy will also assist equities and we expect the US economy to outperform current estimates and by year’s end be showing 3%+ GDP growth.

Overall, we see some continued volatility in the first quarter of 2012 and then significantly higher prices in the second half of 2012 as certainty returns.

The debt-fuelled boom in economic activity from 2003 to 2007 will probably not be repeated for quite some time as consumers and businesses alike continue their de-leveraging ways. While this is counter-productive to booming stock prices to some extent, it will provide a lower-risk environment for investors moving forward. Government debt, particularly high-leveraged governments such as Greece and Italy, will have years of austerity budgets, as it is no longer possible to continue with extreme levels of debt issuance. While we don’t consider “a crash in sovereign debt or the Euro” as probable, we do regard the most likely outcome as below trend GDP growth, or even recession, for some years, as the balance of debt and income comes back into kilter as debt eroded and depreciated by the long-term effect of inflation and probably weak GDP growth. We don’t regard a second Global Financial Crisis as any real possibility at this stage.

For a complete overview of our take on current world events and how we see 2012 panning out, read our comprehensive Outlook for 2012 Report at the conclusion of this report.

The goal of the fund was always to invest for the long-term (3 to 5 years and longer) and the last 6-month period will ultimately be a “glitch” in achieving that goal. During the period’s difficult and challenging market conditions we remained focussed on investing in globally-exposed, high-earnings growth businesses with good fundamentals and business models that were not only operating successfully, but were also scalable. While prices may be well below our fair value for the stocks were are invested in, we believe it’s only a matter of time before the market appreciates the value of these excellent businesses.

It’s important to understand the fundamentals value of the fund’s investments, which we believe based on historical data and economic fundamentals is significantly higher than today’s levels.

Investment success requires remembering that share prices are not blips on a chart, but instead fractional interests in a business. Business fundamentals, not share price quotations, convey useful information. With so many investors fixated on short-term investment performance, successful investing requires a focus not on how one is doing, but on corporate balance sheets and income and cash flow statements.

If the underlying business is executing it’s business model well, innovating and increasing sales, improving margins and posting higher profits each year, it matters little what the share price performance is in the short-term – however, this is rarely the case with investors, who in reality are speculators due to their very short time horizons.

Often, many inexperienced investors see lower prices as an indicator to sell, whereas more-experienced investors who have a somewhat longer time horizon, see an opportunity to buy shares at a discount price is a well-performing business asset. Common sense would dictate that buying good assets when they are cheap is far smarter than selling them at a discount price, yet most retail investors concede to emotion and completely disregard fact and fundamental value at the most critical of times.

Risk is a major factor of investment. However, confusing risk management and emotion is often the undoing of many undisciplined investors.

Our team is looking forward to 2012 and beyond and see an enormous opportunity to take advantage of the strengthening US and global economic recovery, which we are well positioned for.

Lance Spicer

Sydney, Australia

Tuesday 10^th January 2011

“These are days when many are discouraged. In the 93 years of my life, depressions have come and gone. Prosperity has always returned, and will again.” – John D. Rockefeller, July 8, 1

"If a business does well, the stock price eventually follows." – Warren Buffett
 

Outlook for 2012 by Lance Spicer

Well, here we are ready to start a New Year and I hope your holiday season and New Year celebrations were fabulous. Last year in my outlook, I said that I felt the US economy would strengthen and that there would be no double dip recession. I also said that the US market would outperform the Australian market, despite the “mining boom”, and we now know what happened. I just didn’t realise how right I would be, with the ASX having a terrible year, second only to 2008 in recent times. What I didn’t predict was the seriousness of the EU debt crisis and though I did predict an Australian recession, luckily I was wrong and we only had one quarter of negative growth, not the two necessary to be actually called a recession.

Of course, nobody could have predicted the war in Libya that upset oil prices and slowed growth, or the devastating tsunami in Japan and the floods in Thailand that have temporarily made a mess of many of our technology stocks. 2011 is certainly not a year I want to repeat and as most fund managers and investors will tell you, it was more difficult to navigate than 2008 due to its extreme volatility, often in both directions and with counterproductive currency swings. However, we must look ahead and try to get an idea of what 2012 might bring. I have spent much of my break reading the thoughts of analysts, economists, commentators and fund managers and I have to tell you sentiment is mixed, ranging from a replay of 2011, to the start of a multi-year bull market. The sentiment of most retail investors is pretty appalling with the majority feeling that being out of the market is safest. I have never seen so many people negative about the markets – just about everyone I talk to (excluding investment professionals) is gloomy about the stock market – and  justifiably so. But as you well know, the crowd is often wrong and when things are at their gloomiest (sentiment wise) things often turn. However, before that can happen there has to be justifiable reason for it to do so.

So, let’s consider all the risks we may face going into 2012. The number one issue is the European Debt Crisis. Firstly, the debt these countries have accumulated is high. It has taken years to accumulate and it will take years for the debt to reduce to manageable levels, we know that. We also know that for the next 1 or 2 years, European growth will be slower than the long-term average with possibly a shallow recession at the start of 2012. These are known factors. The fears are that it could get worse. That’s what is holding back the markets right now.  It is the same fear that held back markets after the Lehmann Brothers crash in 2008. As we know, Lehmann was it and a few months later the markets recovered.

I expect the write off of Greek debt was the big event and while I still think that maybe another bailout of Greece is possible (probable?) in the near future, I don’t think there will be any contagion to other countries, with the slight chance of Portugal needing some assistance from the IMF and the ESM (the EU bailout fund), but this is only a slight chance.  Greece and Portugal do not worry the markets - they are too small. It’s Spain and Italy that worries the markets and I think, as many do, that this fear is totally overblown. The secondary “concerns” are a slowing of China and the US economy, but these fears are also “overdone”, as there is more evidence supporting improvement than otherwise, particularly in relation to the US economy.

So, let’s get to it and see how I see the year panning out.

·         US Economy

Most people declared the US would fall into recession in 2011, I did not agree with that at all, even though at times I seemed like the only person that had my point of view. I stuck to my guns and at times wondered whether I was reading different data to everyone else. It turned out they had been “bamboozled” by sentiment and emotion and there was no recession – not even close.

In 2012, my prediction is the same - No US recession and growth higher than many expect, edging close to 3% over the year (I expect global growth at an over trend rate of 4%, which is inline with the IMF expectations). Housing will stabilise and start showing signs of growth, but nothing to get excited about - just not worse. Unemployment will continue its current trend and by year-end will be under 8% - possibly well under. US corporate profits will continue to rise to new all-time record highs.

There is some speculation that US corporate profits will be harmed by any EU recession. The fact is US exports to the Europe amount to an estimated $240b for 2012. Of this 40% relates to aerospace and motor vehicles, 25% to chemicals, food additives and fertilisers, 20% to manufactured goods and technology and the other 15% made up of miscellaneous goods and services. A recession in Europe may cut this figure by say, 7% to 8% for around half the year. At which point the other half of the year, would probably show imports over trend, leaving the net exports situation down maybe 6%. On the basis the first two categories are unlikely to feel much reduction due to long order lead times, and the fact that chemicals, food and fertilisers don’t suffer in even bad recessions, there is limited damage that can be felt from Europe in terms of earnings. The GDP of the US is 14 Trillion, which is 14,000 Billion, so this puts the EU exports in perspective keeping mind the net fall may be around $14B, one thousandth of the US economy. However, this does not factor in negative sentiment that any EU recession may cause domestically in the US, which could be more wide-ranging or strains on US banks that provide significant loans to EU business.

IT (Information Technology) spending in the US alone is tipped to rise to $1.8 Trillion (not a typo) according to a survey by Nucleus Research. This is a substantial increase over 2011. They found that over 50% of US companies plan to increase their IT spending to higher levels than 2011. Only 10% said their spend would be lower.

“We are bullish on tech spending based on these survey results. While there is a temptation to cut IT budgets right now, our survey shows that companies view technology investments as a means to drive efficiencies and make existing employees more productive,” said Rebecca Wettemann, VP of research, Nucleus Research.

Another survey determined that over 50% of medium to small companies were planning large scale IT investment in the first half of 2012. These surveys covered thousands of US corporations from huge to small, so it’s not a skewed result at all. It’s also backed up by what I’m hearing from CEOs in IT companies and their growth plans for 2012.  It looks like 2012 could be the biggest IT spending year in history by a long shot. The surveys uncovered that the biggest sectors for investment were mobile communications, data storage and security, social networking, analytics, and corporate efficiency. Every technology company we hold is sitting in the box seat.

There is a mountain of evidence that by the end of 2012, the US economy will again be the leading light in the world economy. I also expect a big “come back” by US financial institutions in the second half of the year as lending frees up further and US home sales increase with higher consumer confidence. Boring old industrials will also start to come back as US manufacturing continues to gain strength. However, it will be the technology companies like Apple, Intel and the like that will be the “stars” of 2012.

·         European Debt Crisis

One trader on the floor of the US stock exchange said just after Christmas that he thought the market would be “out of the gate in 2012” when we all got tired of hearing about Europe. He said it happened in relation to Japan and Libya and it will happen with Europe too. I agree. Once we see that the Euro won’t fall over and no major bailouts are necessary, the whole thing will fade.

The ECB has injected hundreds of billions of Euros (E600B) into the banking system at 1% interest to increase liquidity and give EU banks an opportunity to strengthen their balance sheets and they have taken up the offer with both arms. The first thing they did was use 50% of the money to pay off their short-term debts (3 to 6 months) to the ECB thus turning higher-interest, short-term loans into 1% 3 year loans. This will increase their lending capacity and profits. It’s expected the rest of the money will be put to use being lent out into the retail market and to also (as I predicted last year) buy bonds, such as Italian and Spanish bonds at much higher yields and again make money and repair balance sheets through this “structured and arranged carry trade”. While the ECB couldn’t provide Quantitative Easing, they could arrange for the banks to do it for them.

Once the bailout fund, the ESM, is fully operational and funded to the required level, it will then provide the banking system with the assurance that any further sovereign debt problems will be met by the IMF and the ESM and not be worn by the banks, as they did when Greek debt was cut in half.  While it seem the EU banks are getting profits on a platter, I suspect it was part of the deal when they all agreed to accept the Greek “haircut” and quite frankly, Europe needed QE and this was the only legal way of doing it without the “argy bargy” of getting all EU members to agree to a treaty change in relation to the ECB.

So, I think after the first quarter of 2012, the European Debt Crisis will fade as bond yields slide in the wake of the “EU carry trade”. One problem that still needs to be addressed however is in relation to Italian bonds, in particular 10-year bonds that will mature in the first quarter of 2012. The bond yields as at the end of 2011 were stubbornly stuck around the 7% level, yet shorter-term bonds, up to 3 years were trading at between 3% and 5%. The reason? The 1% ECB loans to banks are 3-year loans and they are being used to purchase similar aged sovereign bonds, bringing down the shorter term yields. If the ECB wants the 10-year Italian bond yields to fall, they need to make some 10-year loans available at favourable rates for this purpose or step in themselves and buy the longer term bonds.

We will still hear of problems in Portugal and Greece and possibly Ireland, but as the problem will be contained to these countries most investors will simply “move on”. These countries, despite having what may be devastating recessions, will have little to no effect on the US corporations. Growth in “Northern Europe” will be surprisingly strong. However, not so strong, that I would be compelled to invest there, just yet.

·         China

China will continue to grow strongly in 2012, but not without a couple of minor scares. The property boom in China is heading for a “hardish” landing but not a crash - the Chinese would never allow a crash of any kind. The banks who had lent so prolifically will pull back their property lending even more than they already have and this will have a negative effect on growth. I expect Chinese growth to pull back to around 7.5% to 8%. This is a drop of around 1% from many forecasts. There will also be some slower growth in manufacturing due to their single biggest market, the EU, slowing. Although many Chinese goods are at the “lower end” of the market and will be less affected than the “mid-range” goods that will be subjected to household budget constraint. The “upper end” won’t be touched at all – it rarely is.

This will have some effect on commodities (and Australia) but not devastatingly so. The Chinese middle class will continue to grow and consumerism will flourish and this will benefit companies like Apple greatly where US branded goods are seen a status symbols. Don’t underestimate the importance of status symbols in Chinese culture and how they perceive the value of things we take for granted.  While our desire for the latest iPhone or iPad is high, theirs is out of control and keep in mind there are more middle class Chinese than there are Americans, Canadians and Australians combined.

·         Gold and Commodities

Gold and commodities won’t collapse in 2012, nor will they boom either. We may have seen the near-term peak in gold. Gold is a hedge for worrying times and also a hedge for inflation. Worries and inflation are dissipating and so is the price of gold. As the market improves throughout 2012, you will see gold soften a little further. The gold price is still being supported by the Indians and Chinese however. They love the stuff and as they become wealthier, their desire to hold gold (as a status symbol) grows. These two countries alone will keep the price of gold above $1200-$1300 for the medium term.

As regards other commodities we have several forces at work here. We have increased production from Australia, Africa, Asia and the Americas keeping a lid on price increases. On the flipside we have continued expansion of emerging nations requiring ever-greater quantities to continue development. On the downside we have the EU being a temporary drag, as well s western governments around the world having to think long and hard about their budgets and which infrastructure projects to commit to. On the upside we have the US economy starting to strengthen and use more commodities. At the end of the day, weighing it all up, don’t expect commodity prices to shoot up in 2012, with the possible exception of copper, which has dropped more than it should have. Commodities will remain pretty much in equilibrium.

Oil will remain elevated due to tensions with Iran. If these tensions ease expect oil at $80-$90, if not they‘ll stay around the $100 mark for most of the year. This level of oil price won’t be too much of a drag on economies, but any move above $110 will cause consumer confidence issues in the US. Let’s hope the Iranians can remain calm (and “sane”)

·         Australian Economy

First the good news, there will be no recession in Australia in 2012 (not a bad one anyway). The mining “boom” will continue to support virtually the whole economy, but things won’t be quite as rosy as we might hope. The lack of rising commodity prices will keep a lid on some projects and investment may fall a little short as “borderline” mining investment may be shelved due to not only flat commodity prices, but also due to government created uncertainty with the Mining Rent Tax, Carbon Tax and perceived anti-business industrial relations policies, as well as hard-line Green anti-mining interjections.

We will, however, have further interest rate cuts as consumer spending shrinks further due to lack of business and consumer confidence. This may pick up a little early in the year as the EU debt crisis exits the headlines. However, it will be the introduction of the Carbon Tax that will be on the minds of most Australians and just like when the GST was introduced, we reduced spending for a period, however, it soon returned to normal. Although, I think it will affect household budgets more than the government is letting on and it will have an even worse effect on business, which could see GDP growth in Australia fall to around 2%-3% instead of the expected 4%. The really bad news will come in 2015 when, even the “compensated” will be affected by the removal of Carbon Tax industry subsidies, which will allow the full affect of the tax to flow through to us all, but that is 3 years away and not of immediate concern.

To be honest, outside of mining and mining services, most Australian companies have few earnings growth catalysts. We have very little technology, almost no manufacturing, a handful of companies involved in healthcare and larger number involved in financial services such as insurance and banks.  Take the banks as an example - where are catalysts for earnings growth? Housing is struggling and interest rates are expected to fall, further squeezing margins as they are “pressured” into passing on the full RBA cuts. The banks will struggle to grow earnings in 2012 - passing on the full rate cuts result in margin contraction. Usually, a rate cut means more loans being taken up - meaning they cut margins, but increase loan volume, but that’s just not happening, as Australians are still de-leveraging debt. The banks can only profit by reducing staff, raising fees and utilising ever greater levels of technology – all of which they are doing to keep a degree of earnings momentum going, albeit at a reduced pace. Companies right around the world are using technology to reduce staff. The banks are no different and this remains part of our investment strategy to invest in technology companies, rather than the users of technology - following the “picks and shovels” concept. Elsewhere, I see opportunities within the Australian smaller cap sector, where innovation may drive earnings.

Over the coming year we should see the Australian dollar weaken further, as not only will our terms of trade weaken due to commodity prices weakening, but also the carry trade related to our higher relative interest rates should see investors exit Australian dollars to some extent. I expect to see the Australian dollar finish 2012 at around the US$0.96-US$1.00 range. Although, according to the IMF, the Australian dollar should be around the $0.66-$0.70 range to be correctly valued. The continued strong demand for Australian commodities will keep the AUD$ elevated through the first half of 2012, maintaining some of the current pressure felt by domestic retailers, exporters and tourism and hospitality operators. The second half of 2012 should see weaker commodity prices, a weaker AUD$ to compensate export earnings to a degree, but lower earnings growth overall.  It may be time prepare for the Post-Mining Boom period, when mining no longer provides the growth the Australian economy has become so used to.

However, while I remain a little bearish on the Australian economy, there will still be plenty of opportunities to profit and there is a chance that above expectation growth in the US and China might just save the Australian market from what could be yet another mediocre year.

·         The Markets

The first quarter may feel a little like a continuation of 2011, as the possible solutions to the EU debt crisis are muddled through. However, I think by the end of the first quarter fears of a complete meltdown will have disappeared and concerns over China and the US will be to a great extent placated. This should see steady gains through the second quarter as investors return to equities.

There are a number of factors pointing to 2012 being a stronger year for equities:

1.      US corporate earnings will again further increase the record earnings level. This will further compress PE ratios to historically low levels. Currently, forward PE ratios (for the total US market) are at 12, whereas for several decades the level has been between 15 and 16. This indicates that equities could be 40% undervalued - a statistic that doesn’t remain out of kilter for too long once near-term fears ease.

2.      The S&P 500 valuation is at a current PE ratio of 13.3, this is exactly the same PE and market valuation the market reached in March 2009, before that amazing rally into 2010.

3.      In 2011, S&P 500 profits reached a record $97 per share, which based on the long-term average PE ratio of 15.5 should have seen the S&P 500 achieve a year-end of around 1503 – it finished at 1260, about 20% undervalued. Next year, the estimate for S&P 500 profits is around $105 depending who you listen to. Goldman Sachs are the most bearish and they say $100. So based on the consensus (and they were too low last year) the S&P 500 should finish 2012 around 1650 to be fairly valued. That’s a 31% lift from here – unlikely, yes I know, but what is far more unlikely is a fall from current levels.

4.      Rarely does the dividend yield on the S&P 500 exceed the 10-year US Treasury bond yield as it does now. Whenever this has occurred, there has been a violent snap back by equities in the near-term.

5.      Since the 1960’s the Dow Jones Industrial Average has reacted inversely to the Initial Jobless claims issued by the US Department of Labor weekly. The steady trend downwards in jobless claims would indicate that a significant rally on the Dow was overdue.

6.      Economic fundamentals in the US continue to improve monthly. In addition, consumer and business confidence is approaching pre-GFC levels.

7.      US home sales and housing starts have shown signs of recovery and many US homebuilders expect to increase employment in 2012, thus further reducing unemployment concerns.

8.      The US are reducing their involvement in foreign wars with the withdrawal from Iraq. This will be beneficial to the US economy, as they have already spent over $1 Trillion dollars on Iraq. History has shown, since the First World War that the US stock market goes sideways during times of large-scale war and then heads steadily up in times of peace. The current sideways movement began with the War on Terror. The last time the US market had such a long-term “sideways” movement was during the Vietnam War (1965 to 1975).

9.      Periods of low interest rates are normally associated with bull markets due lower returns being offered by non-equity investments. With lower interest rates around the world being with us for at least another 18 months to 2 years, we can expect once fears ease that equities will offer the best returns.

10.  As pointed out earlier, technology spending in 2012 is set to be the highest in history.

11.  I would like to add to the list the predictions of hedge fund legend Doug Kass, who last year picked the market almost precisely, as he often does (although, he did get the price of gold wrong and he missed on Microsoft taking over Yahoo), but everything else was very close. Whilst I completed my analysis and had written this report before his ideas were available, I thought you might like to see what his major predictions for 2012 are:

·         For the US market to hit an all-time high August or September.

·         Growth in the US economy to accelerate

·         Mitt Romney to defeat Barack Obama in the presidential elections

·         There to be a brief scare over the EU debt crisis in early 2012 due to Greece running off the rails with riots and the Greek PM weakening on austerity. He is quickly brought back into line.

·         The EU suffers a very mild recession and the ECB continues to flood the market with cheap money. The EU recovers rapidly.

·         German and French stock markets rally strongly.

·         Apple’s share price to hit $550 and introduces a dividend. iPads and iPhones completely dominate their rivals.

·         We’ll see merger mania fuelling markets

·         Financial stocks to make a big comeback

·         Retail investors’ flock back to the market – Mutual funds have the best year since 2007.

·         China has a soft landing

·         Israel attacks Iran – The US stays out of it and tries to broker peace.

Now, these are the predictions of Doug Kass, who has a very good record at being very close to the mark every year. However, I must say I agree with much of what he’s predicted.

So, what could undo a rally in 2012?

Simply something not on the current horizon – known as a black swan event e.g. a war with North Korea or Iran for example or possibly an earthquake in a major city in Asia or the US – something along those lines.  A black swan event could happen at any time and you shouldn’t base your investment strategy on something that may or may not happen.

The only known concern that could cause trouble would be an unwinding of the EU and a breakdown of the Euro.

However, if that was going to happen, it would have happened by now, as many steps have already been taken that have eased that possibility, such as: Strengthening the banking system with injections of cheap money by the ECB; Strengthening the fiscal responsibility and accountability of member countries for future budgets unanimously; Also strengthening and increasing the size of emergency bailout funds and instigating a process whereby central banks around the world co-operate in providing liquidity, such as the process of reducing the margins charged on US$ loans. Lastly, it’s in Germany’s (and Frances’s) best interest to keep the Euro and all the countries (except maybe Greece) in the Eurozone, and quite frankly they have enough economic might and reserves to ensure that it remains workable.

Potential sovereign downgrades by ratings agencies will have a very short-term effect on markets, as we saw when the US was downgraded, but then recovered in literally weeks. I expect any EU downgrades to have an equal or lesser effect.

Conclusion

The weight of economic evidence points towards much higher equity markets in 2012, in particular the US and Germany. Australia will rise to a lesser degree on the back of the US market.

The only major risks seem to relate almost exclusively to a very unlikely unravelling of Europe, which as each day passes looks less likely. It seems we are in a fortunate position right now, fear and concern is still very high keeping markets low, yet fundamentals are telling a very different story. Often opportunity comes wrapped in a problem, 2012 could be a year to start unwrapping.

Lance Spicer is a director and shareholder of the Trident Investment Management Pty Ltd the Investment Manger of the Trident Global Growth Fund Australian Registered Scheme Number (ARSN) 120 329 026. Comments and Opinions expressed are that of the Investment Manager. Before investing in the Trident Global Growth Fund please read the Product Disclosure Statement in the first instance available from here or www.amhonline.com.au/trident