In sharp contrast, the table’s fourth column makes explicit the chastened assumption implied by Robert Gottliebsen in The Weekend Australian on 16-17 June 2001. Gottliebsen stated that Telstra’s executives must increase the company’s EBIT (earnings before interest and tax) at a compound rate of 10% during the next several years, and ventured the opinion that there was a strong likelihood that they would do so. (Indeed, reflecting analysts’ and journalists’ perpetually sunny disposition, Gottliebsen stated that “the long outlook for Telstra is now looking better than it has been for some time … [that] the underlying value in the stock has never been better and institutions and individuals that have a long-term view are going to accumulate the stock at around these [$A5.65 per share] levels”). Assuming that Telstra would pay tax during this interval (if it did not it would surely disappoint the Australian Taxation Office) and that it would pay interest on its ca. $A7.0 billion of long-term debt (if it did not it would default on this debt and thereby disappoint its bond-holders), Gottliebsen implied that Telstra’s earnings after interest and tax (and, to be even more generous, ignoring hefty depreciation and amortisation charges) would increase at an annual compound rate of ca. 7.5%.

The contrast between the exuberant and chastened assumptions is stark: the exuberant assumption that raised no eyebrows in 1999 implied that by 2006 Telstra’s coupon would grow to $0.76. Compare this estimate to the chastened one ($0.49): the former is 55% greater than the latter. Similarly, the exuberant assumption implied that Telstra’s coupon would be $0.47 in 2003; under the chastened assumption, however, this level of earnings is not expected until 2006.

It is important – indeed, imperative – to note that nothing in Table 2 suggests that either Telstra or the Australian telecoms market it dominates have fundamentally changed or will change during these years. Rather, credulous brokers, financial advisers, journalists and funds managers were swept away by the euphoria of the late-1990s. Alas, a stubborn and unco-operative reality (column 2) subsequently obliged their bright expectations about Telstra’s coupons (column 3) to yield to comparatively dour expectations (column 4). Only tangentially, in other words, has the hefty fall of Telstra’s market capitalisation since 1999 had anything to do with changes in the Australian telecoms industry, Telstra’s management and operations, its combined state-private ownership, the vigour or otherwise of economic conditions in Australia, etc. This is greatly embarrassing to the army of advisors, analysts, brokers and journalists who, in Australia at least, usually seem to read from the same script. It might thereby explain their strenuous efforts since 1999 to devise Australian “Blue-Chip Cover Stories” to distract attention from their cumulatively-monumental error.

Telstra in 2003

It is useful and revealing to replicate the analyses described in Part IV under contemporary conditions. Accordingly, assume that you can buy either one share of Telstra at $4.20 (its average closing price during the first half of May 2003) or a five-year Commonwealth bond at a price of $4.20 and a yield of 5.1% (the average yield prevailing in May 2003 for Commonwealth bonds maturing in August 2008). Notice, then, that since 1999 the price of the Telstra share has roughly halved and that “risk-free” yields have fallen by 20% (i.e., [.0635 – .051] ÷ .0635 = .20). As before, assume that whichever you chose you are a “long term” investor; that is to say, you will hold your investment for five years. If you purchased the bond then by late 2008 it is virtually certain, given the miniscule possibility of default, that you will earn $1.05 (i.e., $0.21 per year for five years) in coupons and upon redemption will collect total proceeds of $5.25 (i.e., $4.20 of principal plus $1.05 of coupons).

If the Telstra share purchased in 2003 at $4.20 is going to be a better investment than the bond, then it must return to you at least $5.25 by late 2008. Again, however, there is no guarantee that we can redeem our Telstra share for $4.20 in five years’ time; nor can we know the coupons that Telstra will generate on our behalf during these years. Let us therefore adopt a very dour (compared to those made in recent years) assumption regarding Telstra’s future profitability: its coupons will grow without interruption, but at a rate of no more than 2.5% per year – i.e., at one-third that assumed by commentators such as Robert Gottliebsen in 2001 – during the next five years. Under this assumption, in other words, Telstra’s coupons are virtually static and this share closely resembles a bond. Table 3 shows Telstra’s projected coupons for the next five years under this assumption. If so, then at the end of five years a cumulative coupon of $1.86 – 77% more than the bond’s cumulative coupon – would accrue to the Telstra shareholder as dividends, retained earnings or some combination of the two. Note as well, and in sharp contrast to Table 1, from the first year of ownership Telstra’s yield (6.9%) exceeds that of the bond (5.1%).

Table 3: A Simple (2003 Vintage) Evaluation of Telstra

Recall the rule-of-thumb set out in Part III: a share is generally the more sensible investment when its yield is and can reasonably be expected to remain significantly greater than that of a comparable bond; conversely, a bond is more attractive when its yield is equal to or greater than that of a comparable stock.

In sharp contrast to the situation prevailing late in 1999, then, the owner of the Telstra share does not have to wait for the share’s yield to match the bond’s yield. Further, given that its coupon is projected to grow to $0.33 in 2008, in five years the Telstra share can trade at any multiple of its coupon greater than 6.6 (i.e., 6.6/$0.33 = 0.051) in order to match the bond’s yield. Unlike 1999, in other words, Telstra’s fortunes need only meet undemanding (dour) rather than challenging (exuberant) assumptions in order to match the results guaranteed by the bond. The greater the extent to which Telstra is able to exceed these dour assumptions, the more attractive the Telstra share will prove relative to the bond; and the greater the relative attractiveness of the share, the lower its risk vis-à-vis the bond.

Given the circumstances prevailing in 1999, if the result of our investment in Telstra were going to exceed by a significant margin that in the Commonwealth bond, then we had to expect either that our ambitious assumptions would prove to be conservative or that Telstra’s share price would increase faster than the rate of growth of its coupon. In 2003, neither of these demanding conditions applies. In 1999, the results of an investment in Telstra could not reasonably be expected to surpass by a wide margin that available from a “risk free” Commonwealth bond. It therefore made little sense to purchase Telstra shares at prices remotely close to $8.20. To buy at an exuberant price and reflecting exuberant assumptions is not to allocate capital on the basis of the company’s fundamental operations: it is to gamble that the market price of the shares in question 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. To buy under “1999” conditions, in other words, is clearly to speculate rather than invest. But does the purchase of the share under “2003” conditions constitute an investment? Under these conditions Telstra is more attractive than a single given alternative. Is it more attractive in a general sense? This, it seems to me, is a mistake presently being committed by many and perhaps most investors in Australia.

....continued in Part VI

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