TELSTRA:
A CONTRARIAN CASE FOR CAUTION

November 1, 1999

That Warm, Glowing Feeling

Telstra is unquestionably a formidable company. It is Australia’s largest listed company and comprises approximately 10% of the All Ordinaries Index. It also holds a pre-eminent position in Australia’s rapidly growing communications industry and has a strong cash flow; and its plans for the Internet, e-commerce and broadcast content have impressed analysts, funds managers and investment advisors. As a result of these and other factors, the owners of Telstra are sitting on very considerable capital gains. The market price of the Telstra 2 installment receipts, for example, has increased by more than 20 per cent in a matter of weeks.

This price windfall has occurred despite the commendable restraint of the second float’s organisers. The Finance Minister, Mr John Fahey, emphasised at its launch that Telstra should be regarded as a long term investment. And most stockbrokers, financial advisors, funds managers and media commentators cautioned that Telstra 2 would be unlikely to repeat the price rise achieved by Telstra 1. Less commendably, however, few have concluded that at current prices Telstra is anything other than a good long-term investment; and, perhaps disturbingly, fewer still have specified exactly what they mean when they utter the phrase “long-term investment.”

When virtually everybody lines up on one side of an argument, it is instructive to think contrarian thoughts and explore contrarian options. Thinking these thoughts leads me to conclude – despite its undoubted status as the pre-eminent company in a rapidly-expanding industry – that at current prices there is a cautious and contrarian case to be put with respect to Telstra. Accordingly, Leithner & Co. will not be investing in Telstra at anything remotely close to current market prices. Unfortunately, however, if this contrarian case holds water then the conventional wisdom has recently encouraged 1.6 million Australians to undertake what will turn out to be a mediocre long-term investment.

Back to Fundamentals

To understand this contrarian case, consider for a moment why people invest. To invest is to forego jam today in order to enjoy at least as much jam tomorrow. If this is to occur, then the annual earnings from one’s investments (or “coupons as I call them) must outpace the effects of inflation and other taxes. Two motivations thus underlie the decision to invest: the necessity of protecting the real value of one’s capital, and the desirability of increasing its value over time.

Another basic point: any coupon which an investment generates must eventually return to its owner. Some coupons (such as stocks’ dividends and bonds’ interest payments) are reimbursed today; others (such as companies’ retained earnings) are returned at some point in the future.

This latter point provides a basis by which investors can compare the relative attractions of major asset classes. A Commonwealth bond, for instance, is a “risk-free” asset in two senses: its interest payments are both fixed and virtually perfectly predictable over time. Real estate is a riskier asset because rental income is more variable and less predictable over time; and stocks and corporate bonds are riskier still because their earnings and ability to make interest payments, respectively, are most variable and least predictable (some studies would say unpredictable).

Calculating Bonds’ and Shares’ Coupons

Calculating a bond’s initial coupon is very easy: it is the dollar amount which its issuer pledges to pay each year to the bondholder. In the case of a 10-year bond with a face value of $1,000 and an initial yield of, say, 6.5%, the issuer pledges to pay the bondholder $65 per year for 10 years; moreover, at the end of the 10 years, the issuer pledges to return the $1,000 to the bondholder. In the meantime, and no matter how many times or at what price the bond changes hands, the $65 annual coupon remains fixed. The price investors will be willing to pay for the bond depends upon three risks: the expected rate of inflation over the bond’s remaining life; the yield on Commonwealth bonds maturing at the same time; and the “risk premium” (i.e., bondholders’ perceptions of the borrower’s ability to pay the coupons and repay the principal on time).

The “coupon” of a company’s shares is merely its earnings per share (E.P.S.); and its earnings yield is E.P.S. divided by its shares’ current market price. As an example, consider a company which earns ten cents per share, has a market price of $2.00 and whose earnings can be expected to grow at a rate of 25% per year.At the end of the first year, the investor receives a coupon of ten cents (either up-front, in the form of a dividend, or as earnings retained and re-invested in the company, or some combination of the two). This represents an earnings yield of 5% on the initial investment of $2. At the end of the second year, the coupon grows to 13 cents (a 25% increase over the previous year), which represents a yield of 6.5% on the $2. Given the growing coupon, the earnings yield increases year by year such that, at the end of the tenth year, it reaches 47.5%. This greatly exceeds any bond’s yield and the rate of inflation which might reasonably be expected to occur over these years, and is especially alluring when compared to bonds’ static return.

Clearly then, when a company is able to increase its coupon, the yield on one’s initial investment also increases. This is a fundamental attribute which distinguishes ownership of a company’s equity (shares) from ownership of its debt (bonds). And it is this compounding which makes the ownership of “growth companies” – if their shares can be bought at a sensible price – so rewarding, since the price of these shares will tend over time to rise roughly in tandem with their growth in earnings. It is this compounding, among other things, which I seek when making Leithner & Co.’s investments.

We can apply this logic to determine whether a “risky” investment, such as a particular company’s shares, offer a better or worse potential return than a comparable “risk free” Commonwealth bond. Generally speaking, shares are more attractive when their earnings yields are significantly greater than that of bonds; conversely, bonds are more attractive when their yields are equal to or greater than that of stocks.

Telstra’s Coupons

Consider Telstra. Assume you have the choice of buying one share at $8.20 (its average closing price over the past several weeks) or a hypothetical five-year $8.20 Commonwealth bond with a yield of 6.35% (the average yield over the past several weeks of Commonwealth bonds maturing in September 2004). Further, assume that whichever you choose you are a “long term” investor and will hold your investment for five years. By late 2004, you will earn $2.57 (51.4 cents per year for five years) in coupons from the bond, and will collect total proceeds of $10.77 ($8.20 + $2.57). If the Telstra share is to be a better investment than the bond, then it must return to you at least $10.77 in five years’ time. At first glance, judging from both recent increases in its market price and statements by analysts and market commentators, this will be a very easy hurdle for Telstra to jump. But when you take another look, it becomes considerably less easy.

A Simple Evaluation of Telstra

The table shows Telstra’s current earnings per share (“coupon”) of 27 cents, together with its projected coupons for the next five years under the rather generous (considering analysts’ statements and reports) assumption that earnings will grow at a compound rate of 17% per year. At the end of five years, cumulative earnings of $2.50 – slightly less than the bond’s cumulative earnings – will accrue to the Telstra shareholder as dividends, retained earnings or some combination of the two. Note, however, that only in the fifth year does Telstra’s earnings yield exceed that of a “risk free” Commonwealth bond (7.2% versus the bond’s 6.35%).

That’s Why Leithner & Co. Is Steering Clear of Telstra

The owner of the Telstra share, in other words, will have to wait five years before the share’s projected earnings yield matches that available today from the bond. Further, given that its E.P.S. is projected to be fifty-nine cents in 2004, Telstra must trade at no less than 18 times ($10.77/$0.59) its projected earnings in 2004 in order to (barely) exceed the bond’s return. Telstra’s fortunes, in other words, must unfold exactly according to these rosy projections for the full five-year period in order in the fifth year to provide a return which only barely exceeds that guaranteed today from a five-year Commonwealth bond.What are the chances that these rosy projections will transpire? Should we accept analysts’ assumption (perhaps faith is a better term) that Telstra’s earnings will grow at 17% per year over the next five years? (Over the past five years, how many Australian companies have been able to increase their earnings per share at this compound rate? Far fewer than you might think.) Can we rely upon other “investors” (speculators is a better term) to keep Telstra’s share price at this level for the next five years? Affirmative answers to these questions provide the rationale for the purchase of Telstra at today’s prices.

For the Telstra share’s return to exceed that of the Commonwealth bond by a significant margin, we must expect either that analysts’ earnings projections turn out to be conservative or that Telstra’s share price will increase faster than its earnings. Over the long term, however, the intrinsic value of an asset cannot grow faster than its earnings.

For this reason, and because its projected return cannot reasonably be expected to surpass by a wide margin the current return of a “risk free” Commonwealth bond, I do not believe that it makes sense to purchase Telstra shares at anything approaching their current market price. To do so is not to invest on the basis of the company’s fundamental operations: it is to gamble that the market price of its shares will continue to increase and become even more detached from the company’s operations, and that it will be possible to sell them at an even more inflated price. Because Leithner & Co.’s investment philosophy precludes speculation, it precludes the purchase of Telstra at current prices.

Others who have purchased Telstra shares or installment receipts recently should ponder very carefully the words of Benjamin Graham and David Dodd: “with encouragement from the past and a rosy prospect for the future, the buyers of ‘growth stocks’ [are] certain to lose their sense of proportion and pay excessive prices.” Warren Buffett described last year what happens when they do so: “investors making purchases in an overheated market need to recognise that it may often take an extended period for the value of even an outstanding company to catch up with what they paid.” Perhaps that is what the Commonwealth Government, together with many stockbrokers, funds managers, financial advisors and media commentators, mean when they say that Telstra is a “long-term investment.”

Designed & maintained by
Artist Web Design
©1999-2008 All Rights Reserved