Contents

Investment Planning 1. 1

Module 1: Introduction to Investment Markets, Products and Regulation. 14

1.1 The Corporations Act – SG 1.2. 14

1.1.1 The concept of a financial product – SG 1.2. 14

1.1.2 licensing of financial services industry participants – SG 1.4. 15

1.1.3 Disclosure documents – SG 1.5. 15

1.2 Securities – SG 1.7. 16

1.2.1 Equity securities – SG 1.7. 16

1.2.2 debt securities – SG 1.8. 16

1.2.3 Securities market terminology – SG 1.8. 16

1.3 Primary and Secondary Markets – SG 1.8. 16

1.3.1 the Primary Market – SG 1.8. 16

1.3.2 The Secondary Market – SG 1.9. 17

1.3.3 Links between primary & Secondary markets. 17

1.4 The Role of stockbrokers – SG 1.11. 17

1.4.1 What does a stockbroker do – SG 1.11. 17

1.4.2 Stockbroker and client relationship – SG 1.11. 17

1.4.3 Costs of trading – SG 1.13. 18

1.4.4 Equities Trading and the internet – SG 1.14. 18

1.5 the Australian Securities Exchange – SG 1.14. 18

1.5.1 Role and operation of the ASX – SG 1.15. 19

1.5.2 ASX Structure – SG 1.16. 20

1.6 Overview of derivatives – SG 1.17. 20

1.6.1 What is a derivative? – SG 1.17. 20

1.6.2 Exchange traded vs. over-the-counter derivatives – SG 1.18. 20

1.6.3 Australian derivatives markets – SG 1.19. 20

1.6.4 Growth of the global derivatives markets – SG 1.20. 20

1.6.5 Uses of derivatives – SG 1.21. 20

1.7 The Managed Investment Act 1998 – SG 1.22. 20

1.7.1 Definition of a managed investment scheme – SG 1.22. 21

Module 2: the Mathematics of investment. 22

2.1 Definition of Interest – SG 2.2. 22

2.2 simple Interest – SG 2.2. 22

2.2.1 Calculating Simple Interest – SG 2.2. 22

2.3 Multiplication by Powers – SG 2.3. 22

2.4 Compound Interest – SG 2.4. 22

2.4.1 Calculating Compound Interest – SG 2.4. 22

2.4.2 The rule of 72 – SG 2.6. 23

2.5 Future value – SG 2.6. 23

2.5.1 Effective rate. 23

2.6 Present Value – SG 2.8. 23

2.7 Interest rate and investment period – SG 2.9. 24

2.7.1 Calculating the interest rate – SG 2.9. 24

2.7.2 Calculating the investment period – SG 2.9. 24

2.8 Calculating the value of a series of future payments – SG 2.10. 24

2.8.1 Calculating the value of an annuity – SG 2.10. 24

2.8.2 Calculating the value of a deferred annuity – SG 2.12. 24

2.8.3 Calculating the value of a sinking fund – SG 2.12. 24

2.8.4 Calculating the value of a perpetuity. 25

2.9 Discount rate and Discounted cash flows SG 2.13. 25

2.10 Net present value and comparison of investment options – SG 2.16. 25

2.11 Investment yield (internal rate of return) – SG 2.17. 25

2.12 Discounted cash flow valuations applied to tax and inflation – SG 2.18. 25

Module 3. 26

3.1 The equity market. 26

3.1.1 Features of the Australian Equity Market – SG 3.2. 26

3.1.2 The role and history of share ownership in Australia – SG 3.2. 26

3.1.3 Share Market liquidity – SG 3.4. 26

3.1.4 Securities market participants – SG 3.5. 26

3.2 Definition of equity securities. 27

3.3 Types of equity security – SG 3.13. 27

3.3.1 Ordinary shares – SG 3.13. 27

3.3.2 Partly-paid shares – SG 3.13. 28

3.3.3 Installment receipts – SG 3.14. 28

3.3.4 deferred dividend shares – SG 3.14. 28

3.3.5 bonus issues – SG 3.15. 28

3.3.6 rights issue – SG 3.15. 28

3.3.7 Company options – SG 3.16. 28

3.3.8 Stapled securities – SG 3.17. 28

3.3.9 Hybrid securities – SG 3.18. 28

3.4 Listed Managed Investments – SG 3.19. 29

3.4.1 Australian Real Estate Investment Trusts – SG 3.20. 29

3.4.2 Listed investment companies – SG 3.21. 29

3.4.3 Infrastructure funds – SG 3.21. 29

3.4.4 Pooled development funds – SG 3.22. 29

3.4.5 Exchange traded funds – SG 3.22. 29

3.4.6 Hedge funds (absolute return funds). 29

3.5 comparing the features of equity securities and LMIs – SG 3.24. 29

3.6 Share market Sectors – SG 3.25. 29

3.6.1 Industrial shares – SG 3.25. 29

3.6.2 Resource shares – SG 3.25. 29

3.6.3 The Global Industry Classification standard – SG 3.26. 29

3.7 Factors influencing share market performance – SG 3.27. 30

3.7.1 Interest rates – SG 3.28. 30

3.7.2 Exchange rates – SG 3.28. 30

3.7.3 Economic Factors – SG 3.28. 30

3.7.4 Federal Government Economic and Fiscal policies – SG 3.29. 30

3.7.5 Monetary policy – SG 3.29. 30

3.7.6 Other Markets – SG 3.30. 30

3.7.7 Market Sentiment – SG 3.30. 30

3.7.8 Supply and demand – SG 3.30. 30

3.8 Global equities markets – SG 3.31. 30

3.8.1 Accessing better returns – SG 3.31. 30

3.8.2 Diversification – SG 3.31. 30

3.8.3 Why international diversification permits greater returns – SG 3.32. 30

3.9 Risk and return – SG 3.32. 30

3.9.1 Risk-adjusted return SG 3.34. 30

Module 4 Debt Securities. 30

4.1.1 structure of the debt market – SG 4.2. 30

4.1.2 features of the debt market – SG 4.3. 30

4.1.3 Participants in the debt market – SG 4.4. 31

4.1.4 settlement and registration procedures – SG 4.7. 32

4.1.5 The size of the interest rate market – SG 4.8. 32

4.1.6 Primary and secondary debt markets – SG 4.9. 32

4.2 definition and debt securities – SG 4.10. 32

4.3 Interest Rates. 33

4.3.1 What are interest rates? – SG 4.11. 33

4.3.2 Indicator interest rate – SG 4.11. 33

4.3.3 Bank bill swap preference rate – SG 4.12. 33

4.3.4 Wholesale and retail interest rates – SG 4.12. 33

4.3.5 Short-term and long-term interest rates. 33

4.3.6 Creditworthiness of issuers – SG 4.13. 34

4.3.7 The yield curve – SG 4.13. 34

4.3.8 The components of an interest rate – SG 4.14. 34

4.4 short-term interest rate securities – SG 4.16. 34

4.4.1 Cash – SG 4.16. 34

4.4.2 Treasury notes – SG 4.16. 34

4.4.3 Bills of exchange – SG 4.17. 35

4.4.4 Promissory notes – SG 4.20. 35

4.4.5 Negotiable certificates of deposit and certificated of deposit. 36

4.4.6 Repurchase agreements – SG 4.23. 36

4.4.7 Pricing of short-term securities. 36

4.4.8 Key Relationships for price short-term securities – SG 4.24. 37

4.5 Long-term interest rate securities – SG 4.25. 37

4.5.1 Commonwealth Government Securities – SG 4.26. 37

4.5.2 Participants – SG 4.27. 37

4.5.3 The Secondary market in Treasury bonds – SG 4.28. 37

4.5.4 Semi-Government securities – SG 4.28. 37

4.5.5 Features of long-term interest rate securities – SG 4.29. 37

4.5.6 Books close date – SG 4.30. 38

4.5.7 Pricing of long-term interest rate securities – SG 4.30. 38

4.6 The corporate debt market – SG 4.34. 39

4.6.1 Floating rate notes – SG 4.34. 39

4.6.2 Securitised bonds – SG4.35. 39

4.6.3 Subordinated debt – SG 4.36. 39

4.6.4 Corporate Bonds  – SG 4.36. 39

4.6.5 Debentures – SG 4.37. 39

4.6.6 fixed interest managed investments – SG 4.37. 40

4.7 Holding period return – SG 4.37. 40

4.7.1 How to calculate the holding period return – SG 4.37. 40

4.8 Volatility – SG 4.39. 40

4.8.1 How to calculate price volatility – SG 4.40. 40

4.8.2 The affects of yield and term on volatility – SG 4.41. 40

4.9 Other factors affecting the yield of debt securuites – SG 4.42. 40

4.9.1 Credit Risk – SG 4.42. 40

4.9.2 Liquidity and Marketability – SG 4.43. 40

Module 5. 41

5.1 Types of derivatives – SG 5.2. 41

5.1.1 Options – SG 5.2. 41

5.1.2 Futures – SG 5.3. 41

5.1.3 Warrants – SG 5.3. 41

5.1.4 Contracts for Difference – SG 5.3. 41

5.1.5 Forward Rate agreement – SG 5.4. 41

5.1.6 Swaps – SG 5.4. 41

5.2 What participants use derivatives? – SG 5.5. 42

5.2.1 Banks and Large Financial Institutions – SG 5.5. 42

5.2.2 Commodity producers and Merchants – SG 5.5. 42

5.2.3 Debt Issuers – SG 5.6. 42

5.2.4 Corporates – SG 5.6. 42

5.2.5 Managed futures and hedge funds – SG 5.6. 42

5.2.6 Local participants – SG 5.6. 42

5.2.7 Market Makers – SG 5.7. 42

5.2.8 Spread Traders – SG 5.7. 42

5.2.9 Arbitrageurs – SG 5.7. 42

5.3 The concept of short selling – SG 5.8. 42

5.4 what are the risks in the market for derivatives? – SG 5.8. 43

5.5 Options – SG 5.9. 43

5.5.1 The basics of options – SG 5.9. 43

5.5.2 How are options traded ? – SG 5.10. 43

5.5.3 Differences between exchange traded and OTC options. 43

5.5.4 Exercising options – SG 5.11. 43

5.5.5 Key elements of an option – SG 5.11. 43

5.5.6 Why use options? – SG 5.14. 44

5.5.7 Advantages of options – SG 5.14. 44

5.5.8 Risks of using options. 44

5.5.9 Overview of options Pricing – SG 5.16. 44

5.5.10 Expiry profit (pay off) diagrams – SG 5.18. 45

5.6 Warrants – SG 5.21. 45

5.6.1 Overview – SG 5.21. 45

5.6.2 Key features of warrants – SG 5.21. 45

5.6.3 Why investors deal in warrants – SG 5.23. 45

5.6.4 Differences between warrants and ETOs – SG 5.23. 45

5.6.5 Comparing warrants and ETOs with ordinary shares – SG 5.24. 46

5.6.6 Trading warrants – SG 5.24. 46

5.6.7 Investment Warrants. 46

Module 6. 47

6.1 Futures – SG 6.3. 47

6.1.1 What is a futures contract? – SG 6.3. 47

6.1.2 SPI 200 Futures – SG 6.4. 47

6.1.3 Using Equity futures to hedge against market risk and specific risk – SG 6.5. 47

6.2 Short-term interest rate futures – SG 6.6. 47

6.2.1 Characteristics of the interest rate futures market – SG 6.7. 47

6.2.2 90-day bank-accepted bill futures contracts – SG 6.8. 48

6.2.3 Who uses bill futures? – SG 6.8. 48

6.2.4 Hedging using bill futures – SG 6.9. 48

6.3 Long-term interest rate futures (bond futures) – SG 6.10. 48

6.3.1 The underlying instrument – SG 6.10. 48

6.3.2 6.3.2 3-year and 10-year Treasury bonds futures – SG 6.13. 49

6.4 Contracts for difference – SG 6.15. 50

6.4.1 The mechanics of CFDs – SG 6.15. 50

6.4.2 Risks involved in trading CFDs – SG 6.16. 50

6.5 Forward rate agreement – SG 6.17. 50

6.5.1 Risk Exposure – SG 6.17. 50

6.5.2 Advantages – SG 6.18. 50

6.5.3 Disadvantages – SG 6.18. 51

6.5.4 Parties to an FRA – SG 6.18. 51

6.5.5 Calculating the settlement for an FRA – SG 6.18. 51

6.5.6 FRAs and futures – SG 6.19. 51

6.6 Swaps – SG 6.20. 51

6.6.1 Equity Swaps – SG 6.20. 51

6.6.2 Advantages – SG 6.21. 51

6.6.3 Disadvantages – SG 6.21. 51

6.6.4 Uses of equity swaps – SG 6.21. 51

Module 7: Managed Investment Portfolios and structures. 51

7.1 Types of Managed investments – SG 7.2. 51

7.1.1 Managed funds – SG 7.2. 51

7.1.2 Listed managed investments – SG 7.2. 52

7.1.3 Insurance Investment Products – SG 7.2. 52

7.2 Investment platforms – SG 7.3. 52

7.3 Regulated Superannuation Funds – SG 7.3. 52

7.4 Managed Investments in perspective – SG 7.4. 53

7.4.1 Investor Markets: Retail, mezzanine and wholesale managed investments – SG 7.4. 53

7.4.2 History of Managed Investments in Australia – SG 7.5. 53

7.4.3 The managed investment industry today – SG 7.6. 53

7.4.4 Trends in the managed investments industry – SG 7.7. 53

7.5 Participants in the managed investments market – SG 7.9. 54

7.6 Advantages, disadvantages and Risks – SG 7.10. 54

7.6.1 Advantages – SG 7.10. 54

7.6.2 Disadvantages and risks – SG 7.11. 54

7.7 Managed investments vs direct investments – SG 7.12. 54

7.8 Australia: an international perspective – SG 7.12. 54

7.9 Investment options in managed investments – SG 7.13. 54

7.9.1 Single Sector Funds – SG 7.13. 55

7.9.2 Multisector funds – SG 7.21. 56

7.9.3 Hedge funds (absolute return funds) – SG 7.25. 57

7.9.4 Infrastructure funds – SG 7.27. 57

7.9.5 Other asset classes for managed funds Investment – SG 7.28. 58

7.10 Other investment schemes – SG 7.29. 58

7.10.1 Exchange-Traded funds – SG 7.29. 58

7.10.2 Listed investment companies – SG 7.29. 58

7.10.3 Insurance bonds – SG 7.30. 58

7.10.4 Friendly Society bonds – SG 7.31. 58

Module 8: managed Investment Administration Platforms and costs. 58

8.1 Administration Platforms – SG 8.2. 58

8.1.1 Master Trusts – SG 8.2. 58

8.1.2 Wrap and custodial services – SG 8.3. 59

8.1.3 Investor-directed portfolio services – SG 8.3. 59

8.1.4 Individually-managed accounts and separately-managed accounts – SG 8.4. 59

8.1.5 Fund of funds – SG 8.6. 60

8.1.6 Feeder funds – SG 8.6. 60

8.2 Costs of Managed Investments – SG 8.7. 60

8.2.1 Categories of fees – SG 8.7. 60

8.2.2 Indirect Cost Ratio – SG 8.8. 60

8.2.3 Management expense ratio – SG 8.8. 60

8.2.4 Buy/Sell spread – SG 8.8. 60

8.2.5 Performance fees – SG 8.10?. 60

Module 9: Analyzing and Evaluating Investment Products. 61

9.1 Evaluating equity securities – SG 9.3. 61

9.1.1 Pricing a share offer – SG 9.3. 61

9.1.2 Intrinsic value vs Market Price – SG 9.5. 61

9.1.3 Arriving at an appropriate discount rate – SG 9.5. 61

9.1.4 Price/Earnings ratio and earnings per share – SG 9.6. 62

9.1.5 Gearing and the share price – SG 9.8. 62

9.1.6 Value drivers and company specific factors – SG 9.10. 62

9.1.7 The Media and its impact in share offer evaluation – SG 9.12. 62

9.1.8 Advisor Role – SG 9.12. 62

9.2 Case study – SG 9.14. 63

9.3 General Investment Trading rules – SG 9.16. 63

9.3.1 Don’t buy on rumour – SG 9.16. 63

9.3.2 The successful investor – SG 9.16. 63

9.3.3 Diversification – SG 9.17. 63

9.3.4 When to Buy – SG 9.18. 63

9.3.5 timing the transaction – SG 9.19. 63

9.3.6 Stop-losses – SG 9.19. 63

9.3.7 when to sell – SG 9.20. 63

9.3.8 Don’t follow the crowd – SG 9.21. 64

9.3.9 High return probability equals high risk – SG 9.21. 64

9.3.10 Monitoring is a continuous process – SG 9.21. 64

9.4 Market indicies – SG 9.22. 64

9.4.1 S7P/ASX benchmark indicies – SG 9.22. 64

9.4.2 International Indicies – SG 9.23. 64

9.4.3 The role of share market indicies in investment – SG 9.23. 64

9.5 Debt securities: Making the investment decision – SG 9.24. 64

9.5.1 Credit ratings – SG 9.24. 64

9.6 allocating securities in an investment portfolio – SG 9.27. 64

9.6.1 Allocation of securities – SG 9.27. 64

9.7 Analysis of derivatives markets – SG 9.28. 64

9.7.1 why analyse? – SG 9.28. 64

9.7.2 Fundamental or technical analysis? – SG 9.28. 65

9.8 Users of derivatives – SG 9.29. 65

9.9 Speculative Trading – SG 9.30. 65

9.10 Hedging fundamentals – SG 9.31. 65

9.10.1 Purpose of hedging – SG 9.31. 65

9.10.2 Hedging strategies – SG 9.31. 65

9.10.3 How much of the exposure should be hedged? – SG 9.32. 66

9.10.4 Choice of delivery months – SG 9.32. 66

9.10.5 The concept of basis risk – SG 9.32. 66

9.10.6 The amount hedged – SG 9.33. 66

9.10.7 Differences in timing – SG 9.33. 66

9.11 Hedging with equity futures – SG 9.34. 66

9.11.1 Anticipatory hedging with equity futures – SG 9.34. 66

9.11.2 Hedging a current market position – SG 9.35. 66

9.11.3 Using beta factors for a more precise hedge – SG 9.37. 66

9.12 Using bank bill futures to hedge short-term interest rate exposures – SG 9.39. 67

9.12.1 A buying hedge using 90-day bank bill futures – SG 9.39. 67

9.12.2 A selling hedge using 90-day bank bill futures – SG 9.40. 67

9.12.3 Hedging long-term obligations – SG 9.41. 67

9.13 Using derivatives to hedge long-term interest rate exposures – SG 9.43. 67

9.13.1 Types of hedging – SG 9.43. 67

9.13.2 Anticipatory hedging –SG 9.43. 67

9.13.3 Hedging a current market position – SG 9.45. 67

9.14 Key Points to remember when hedging with futures – SG 9.46. 67

9.15 Overview of the managed investment process – SG 9.48. 67

9.16 Defining a managed investment’s objectives – SG 9.49. 67

9.16.1 Risk and Return – SG 9.49. 68

9.16.2 Time horizon – SG 9.50. 68

9.16.3 Example of different investment strategies – SG 9.50. 68

9.17 Formulating the investment strategy – SG 9.51. 68

9.17.1 Investment style – SG 9.52. 68

9.17.2 Active vs Passive investment management – SG 9.53. 68

9.18 Investment Management asset allocation – SG 9.55. 69

9.18.1 Neutral asset allocation – SG 9.55. 69

9.18.2 Strategic Approach – SG 9.56. 69

9.18.3 Rebalancing – SG 9.56. 69

9.18.4 Tactical asset allocation – SG 9.56. 69

9.18.5 Market Timing – SG 9.57. 69

9.18.6 diversified or sector funds? – SG 9.57. 69

9.19 Investment manager selection- SG 9.58. 69

9.19.1 People – SG 9.58. 70

9.19.2 Philosophy and Process – SG 9.58. 70

9.19.3 Performance – SG 9.59. 70

9.20 Asset Allocation and stock selection – SG 9.59. 70

9.20.1 Stock selection considerations – SG 9.59. 70

9.21 Monitoring and Reviewing – SG 9.60. 70

9.22 Selecting managed funds – SG 9.63. 70

9.22.1 Investment Process – SG 9.63. 70

9.22.2 Analysis of managed funds – SG 9.64. 70

9.22.3 Identifying manager skill – SG 9.66. 70

Module 10: Regulation, Documentation and Tax. 71

10.1 Regulation of the securities industry – SG 10.3. 71

10.1.1 ASIC – SG 10.1. 71

10.1.2 ASX group – SG 10.5. 71

10.2 Inside a stockbroker’s office – SG 10.10. 72

10.3 Compliance with stockbroking regulations and standards – SG 10.13. 72

10.3.1 Client profiles and record keeping – SG 10.13. 72

10.3.2 Order taking – SG 10.14. 73

10.3.3 Advice versus no advice – SG 10.15. 73

10.3.4 Corporate actions – SG 10.15. 73

10.3.5 Cash handling and trust account rules – SG 10.15. 73

10.4 Debt securities operations – SG 10.16. 73

10.4.1 short-term debt securities – SG 10.16. 73

10.4.2 long-term securities – SG 10.17. 73

10.5 Securities Documentation. 73

10.5.1 Definition of a prospectus – SG 10.18. 73

10.5.2 When is a prospectus required? – SG 10.18. 74

10.5.3 Lodgment and registration of a prospectus – SG 10.19. 74

10.5.4 Materiality – SG 10.20. 74

10.5.5 Types and contents of prospectuses – SG 10.20. 74

10.5.6 Structure of a share prospectus – SG 10.21. 74

10.5.7 Improving disclosure documents – SG 10.24. 74

10.6 Taxation matter for equity securities – SG 10.25. 75

10.6.1 Dividend imputation – SG 10.25. 75

10.6.2 Capital Gains Tax – SG 10.27. 75

10.6.3 Earnings from fixed interest investments – SG 10.31. 75

10.7 Supervision of derivatives trading – SG 10.31. 76

10.7.1 ASX24 Operating Rules – SG 10.32. 76

10.7.2 contract Specifications and associated rules – SG 10.32. 76

10.7.3 Trading principles – SG 10.32. 76

10.7.4 ASX24 Trading Participants – SG 10.32. 76

10.7.5 Client agreement and trading behavior of participants – SG 10.33. 76

10.7.6 Discipline of participants, penalties and code of behavior – SG 10.34. 76

10.7.7 Trading on ASX24 – SG 10.35. 76

10.7.8 The Role of the clearing house – SG 10.36. 77

10.7.9 ASX Clear (futures) – SG 10.36. 77

10.7.10 Initial Margin – SG 10.37. 77

10.7.11 Variation Margins – SG 10.37. 77

10.7.12 Margin Calls – SG 10.38. 77

10.7.13 Current developments in operating rules and market supervisions – SG 10.38. 77

10.8 Conduct of derivatives business – SG 10.39. 77

10.8.1 Confirmation of trades – SG 10.39. 77

10.8.2 Introducing a client to the market – SG 10.40. 77

10.8.3 Accounts and Audit – SG 10.40. 77

10.8.4 Compensation Arrangements – SG 10.41. 77

10.8.5 Offence Provisions – SG 10.41. 77

10.8.6 Trading Requirements – SG 10.41. 78

10.9 The OTC Market – SG 10.42. 78

10.9.1 OTC documentation – SG 10.42. 78

10.9.2 Processing derivative transactions – SG 10.44. 78

10.9.3 Back Office (operations) – SG 10.45. 78

10.9.4 Middle office – SG 10.46. 79

10.9.5 Self Regulation – SG 10.47. 79

10.10 Taxation issues to consider for derivatives – SG 10.47. 79

10.11 regulation of managed investment schemes – SG 10.48. 79

10.11.1 Duties of an RE. 79

10.11.2 constitution – SG 10.48. 79

10.11.3 Compliance committee – SG 10.48. 79

10.11.4 Compliance Plan – SG 10.49. 79

10.11.5 Custody of Assets – SG 10.49. 79

10.11.6 withdrawing from a fund – SG 10.49. 79

10.11.7 complaints procedures – SG 10.49. 79

10.12 Product Disclosure Statements – SG 10.50. 79

10.12.1 what is a Product Disclosure statement? – SG 10.50. 79

10.2.2 contents of a product disclosure statement – SG 10.51. 79

10.12.3 Master Trusts and Investor directed Portfolio services – SG 10.54. 80

10.12.4 How a product disclosure statement helps clients – SG 10.54. 80

10.13 Taxation treatment of managed funds – SG 10.55. 80

10.13.1 Income and Taxation – SG 10.56. 80

10.13.2 Tax components of income distributions – SG 10.56. 80

10.13.3 Tax-paid managed investments – SG 10.57. 80

10.13.4 taxation issues surrounding property funds – SG 10.60. 80

10.13.5 Other managed Investments – SG 10.60. 80

10.13.6 Individually and separately managed accounts – SG 10.60. 80

Module 1: Introduction to Investment Markets, Products and Regulation.

1.1 The Corporations Act – SG 1.2

Corporations Act 2001 including provisions introduced under the Financial services Reform act 2001 (FSRA) provides a comprehensive regulatory and licensing regime for financial products, investment product providers and investment advisers and their services.

1.1.1 The concept of a financial product – SG 1.2

Corp act act identifies certain products specifically included and excluded

Definition is very borad

Key definitions

Financial product allows:

                A Financial investment

                Manages a financial risk

                Makes a non-cash payment

A facility is defined as including:

                An intangible property

                An arrangement or a term of an arrangement including:

                                One implied by law

                                A combination of the first two points.

A financial investment is where:

                An investor gives money or monies worth to another person

                The other person uses it to generate a financial return or benefit

                The investor has no day-to-day control over use of the contribution

Manages financial risk includes:

                Managing the financial consequences of an event

                Limiting the consequences of fluctuation in receipts or costs

Specific inclusions that are a financial product:

                Deposit-taking facilities by authorized deposit-taking institutions

                Insurance products (unless excluded)

                Securities

                Interest in managed investment schemes

                Derivatives

                Superannuation interests

                Retirement savings accounts

                Government debentures, stocks or bonds

                Foreign exchange transactions (not spot currency exchange) that are not immediately settled

Specific exclusions:

                Health insurance

                State or commonwealth insurance

                Reinsurance

                A credit facility as defined in the regulations

                A physical spot foreign currency exchange subject to immediate settlement

                A payment facility for making non-cash payments to a credit facility

                Insurance provided by an employer to an employee

                Most unregistered managed investment schemes

                State banking

                Funeral benefits

1.1.2 licensing of financial services industry participants – SG 1.4

financial advisers need an AFSL.  Financial advisers much satisfy competency requirements set by ASIC.

Obligations of a financial services licensee under the Corporations act are to:

Do all things necessary to ensure financial services covered by the license are provided efficiently, honestly and fairly.

Comply with license conditions

Take reasonable steps to ensure representative comply with financial services laws.

Have adequate financial resources

Maintain the competence of those providing financial services

Ensure representatives are adequately trained and competent to provide financial services

Have adequate dispute resolution system for retail clients

Have adequate risk management systems

Have arrangements to compensate retail clients for loss arising from breaches of the FSRA

Representative

Individual who is a representative of a licensee does not need to obtain a license

Has responsibility to meet RG146

All representatives (other than directors and employees) must be authorized in writing known as “authorized representatives”

Conditions of license

See SG 1.4

1.1.3 Disclosure documents – SG 1.5

Chapter 7 of Corporations act – Retail clients are required to be given 3 main forms of disclosure documents

1. Financial services guide (FSG)
2. Product Disclosure documents (PDS)
3. Statement of advice (SOA)

Criminal and civil liabilities exist for licensees and representatives that:

                Fail to disclose where required

                Provide defective disclosure documentation

**For retail clients only

FSG

See SG 1.5

Product disclosure statement

See sg 1.6

Statement of Advices

See SG 1.6

1.2 Securities – SG 1.7

Security is documentary evidence of the ownership of a financial asset – normally purchased for the purposes of investment

Security – short for marketable security

Can be either:

                Equity securities

                Debt securities

1.2.1 Equity securities – SG 1.7

Equity refers to proportion of any asset owned by an investor

Equity security aka share

1.2.2 debt securities – SG 1.8

Debt security – underlying loan from one party to another

1.2.3 Securities market terminology – SG 1.8

Debt security – underlying loan from one party to another

Terms “stock market” = “Share Market” = “equities market”

Debt Market:

                Money Market – short-term fixed interest security market

                Fixed Interest or bond market – long term interest rate market

                Debt market or money market and bond market – interest rate market, collective term used for both short-term and long-term market.

Instrument – general term refers to a security or derivative product in either short-term or long-term debt market

1.3 Primary and Secondary Markets – SG 1.8

Both equity and debt can be divided into two sub-markets:

1. Primary Market
2. Secondary Market

1.3.1 the Primary Market – SG 1.8

allows a company or government to raise initial capital by selling part-ownership of new investment assets to investors.

Debt Primary Markets

Primary market activity in the debt market is the issuance of treasury bonds by the Australian Government, Australian Office of financial Management (AOFM) – Governments nominated agency.

1.3.2 The Secondary Market – SG 1.9

Facilitates buying and selling of the securities issued in the primary market

Trading via auction style system, where price of a share or debt security determined by supply and demand.

1.3.3 Links between primary & Secondary markets

Investor will generally only participate in the primary market if they can sell on the secondary market

1.4 The Role of stockbrokers – SG 1.11

1.4.1 What does a stockbroker do – SG 1.11

ASX market participants – stockbrokers authorized to trade shares directly on the ASX (own account or clients behalf)

Stockbrokers may:

                Advise clients on possible investments (equities/fixed interest securities)

                Take orders from clients to buy or sell securities

                Execute transactions

                Ensure selling clients or selling brokers deliver valid transfer documents

                Ensure payment is received from buying clients and register the purchases in accordance with the buyer’s instructions or alternatively deliver documents to the buying broker for payment.

                Ensure that when a client buys or sells shares, all appropriate benefits flow (dividends and new issues)

                Research and report on the performance of listed companies and their securities

                Underwrite new issues of securities

                Advise on company takeovers and mergers

                Transact business as a principle and arbitrage between markets

1.4.2 Stockbroker and client relationship – SG 1.11

3 licensed facilities provide access to, and support, trading on the ASX:

1. The licensed market of the ASX operated by ASX Limited
2. The clearing facility operated by ASX clear
3. The settlement facility operated by ASX settlement

To obtain access to these facilities, a broker must be a market participant of the ASX and either contract with or be a clearing participant of ASX clear and a settlement participant of ASX settlement.

Access to these facilities is regulated by the following rules:

-          ASX market operating rules – deal with access to trading facilities on the ASX

-          ASX Clear Operation Rules – Deal with the responsibility for counterparty risk for market transactions, access to clearing facilities and conduct of clearing participants

-          ASX Settlement Operating Rule – deal with access to settlement infrastructure for the purpose of payment, delivery and asset registration

Collectively these rules are referred to as the ASX rules.

Prior to 11^th March 2004 ASX rules were structured around the existence of a ‘broker’, current rules no underpinning presumption that a broker will be the provider of all functions in a transaction

General Law of principle and agent

Client is principle and broker is the agent

Based on Trust, agent always required to deal with a principle in the utmost good faith

Stockbrokers rights

Right to:

Receive commission

Be indemnified

Exercise a lien (i.e. hold assets as security against a debt)

1.4.3 Costs of trading – SG 1.13

Discount Brokerages

                Execution only brokers

Don’t need to comply with the financial advice requirements under the Corporations Act – i.e. advice has a reasonable basis.

1.4.4 Equities Trading and the internet – SG 1.14

Advantages of internet brokerage include:

                Convenience and easy access

                Transactions in all instruments

                Access to information eg market data, company information and research

                Investment tools

                Empowerment of individual investors, due to greater ability to control and track investment

                Lower costs

To date, providers have been fairly evenly distributed between:

                Execution-only traders

                Subscription-based services

1.5 the Australian Securities Exchange – SG 1.14

formed in 2006 by merger of the Australian stock Exchange and Sydney Futures exchange

ASX fulfils 2 basic and complementary needs:

1. the needs of businesses for capital
2. The need for private and institutional investors to invest excess capital efficiently

ASX diverse product base:

                Equities

                Debt

                Hybrid securities

                Listed Managed Investments

                Derivatives

See figure 1.4 – SG 1.15

Other licensed exchanges operation in Australia:

ASX 24 – SFE

Bendigo Stock Exchange

National stock Exchange of Australia

Asia Pacific Exchange

1.5.1 Role and operation of the ASX – SG 1.15

The corporations act requires the ASX to provide markets that are fair, orderly and transparent

In order to achieve this, the ASX has the following objectives:

Promote confidence in its markets and in its clearing and settlement facilities

Achieve appropriate levels of transparency in relation to the activities of its listed entities, and to set standard for their behavior

Promote confidence in the way market participants conduct business on it’s markets and clearing and settlement facilities

Ensure that there is fair and effective interaction with it’s clearing and settlement facilities

Reduce external systemic risk to it’s clearing and settlement facilities

ASX therefore provides facilities to market participants for:

                Trading

                Clearing

                Settlement

ASX’s role is to promote fair trading by:

                Providing efficient trading platforms

                Collecting and supplying statistics and other information concerning the specific matters with which it deals

                Publishing price quotations

A fair market is a market that:

                Is fully and promptly informed of all information necessary to assess the value of a security

                Has adequate liquidity

                Has brokers of the highest standards of ethics and integrity

ASX co-regulates its market with ASIX

Organizations that use the ASX:

                Listed entities

                Stockbrokers

                Institutional and private investors (domestic and international)

                External regulators

                Share Registries

                Custodians

                Other exchanges and their affiliates

1.5.2 ASX Structure – SG 1.16

see fig 1.5

1.6 Overview of derivatives – SG 1.17

1.6.1 What is a derivative? – SG 1.17

Derivative is a date-specific contract to buy or sell an underlying physical asset (wheat or wool) or a financial instrument (bond, bank bill or stock index)

Contract (forward, futures or options) is derived from an underlying asset and cannot exist without it

Delivery obligations are usually ‘closed out’ prior to time of contract expliration

Derivatives can be highly geared (leveraged)

Derivatives can be used to manage risk

1.6.2 Exchange traded vs. over-the-counter derivatives – SG 1.18

Exchange traded – highly standardized, traded on exchange

Over-the-counter (OTC) – market – highly flexible, traded between participants (banks and financial institutions) by phone.

1.6.3 Australian derivatives markets – SG 1.19

2008/9 – derivatives $70,000 billion vs. equity, options and futures $26,500 billion.

1.6.4 Growth of the global derivatives markets – SG 1.20

Used for risk management / currency exposure

1.6.5 Uses of derivatives – SG 1.21

Protect against future adverse interest rate movements

Reduce borrowing costs / increase investment returns

Increase flexibility

Match borrowing structure to company needs

1.7 The Managed Investment Act 1998 – SG 1.22

changed structure of unit trusts

replaced the fund manager and trustee of a unit trust with a single responsible entity (SRE or RE). RE – ultimately accountable for all aspects of the trusts operations (inc performance of the trust and administration).

1.7.1 Definition of a managed investment scheme – SG 1.22

See SG 1.22 for definition

Investors – provide capital and receive a return from the scheme.

Responsible entity – acts as trustee and manager of the scheme

Trust Account – collects and distributes the cashflows for the scheme

Structure of a managed investment

Investments that are not classed as managed investments include:

Regulated superannuation funds

Approved deposit funds (ADFs)

Franchises

Module 2: the Mathematics of investment

2.1 Definition of Interest – SG 2.2

Interest is the cost of borrowed money or the rate of return on money loaned or invested.

2.2 simple Interest – SG 2.2

Calculated on the original principal investment

Amount of interest doesn’t change, no matter how long the funds are invested

2.2.1 Calculating Simple Interest – SG 2.2

SI = P x I x T

Where:

SI = Simple Interest

P = Loan Principle

I = Interest rate (per annum)

T – Period of time (in years)

See example sg 2.2

Part-year simple interest calculation

SI = P x I x D/Y

Where:

D = number of days in the period of investment

Y = number of days in the year

See example SG 2.3

2.3 Multiplication by Powers – SG 2.3

See SG 2.3 + 2.4

2.4 Compound Interest – SG 2.4

Calculated on original principal invested plus any interest.

2.4.1 Calculating Compound Interest – SG 2.4

V = P(1+I)^N

Where:

V = total amount of principal and compound interest at the end of the period

P = the loan principle

I = the interest rate per period

N = the number of periods (e.g. years)

See example – SG 2.5

Compounding periods other than one year – SG 2.5

Usually interest quoted per annum rate, called the nominal interest rate, but this can be converted into the interest rate for the compounding period.

See example – SG 2.5

2.4.2 The rule of 72 – SG 2.6

A return of 7.2% per annum will roughly double in value in 10 years.

Years to double = 72 / annual rate of return

Rate of return required to double in x years = 72/number of years

2.5 Future value – SG 2.6

Future value of investment

FV = PV (1+ I/C)^N

Where:

FV = Future Value of the investment

PV = Present Value of the investment

I = Nominal interest rate (per annum)

C = Number of compounding periods per year

N = Total number of compounding periods

In this formula

I/C = interest rate for each compounding period

See examples – SG 2.6 + 2.7

2.5.1 Effective rate

Effective rate is the annualized interest rate that takes into account the effect of all compounding over a year.

The effective rate reflects the true annual interest rate paid

E = [(1 + I/C)ⁿ]-1

Where:

E = Effective annual rate

I = nominal interest rate (i.e. per annum)

C = number of compounding period per year

N = total number of compounding periods (for a year)

i/c = interest rate for each compounding period

see example – SG 2.7

used to compare mortgages

2.6 Present Value – SG 2.8

How much to invest to get a certain amount after a period of investment

PV = FV / (1+I/C)ⁿ

Where

PV = Present Value

FV = Future Value (the goal)

I = Interest rate

C = compounding period per year

N = total number of compounding periods

See example SG 2.8

2.7 Interest rate and investment period – SG 2.9

2.7.1 Calculating the interest rate – SG 2.9

I = [(FV/PV)^I/N-1] x C

Where:

PV = Present Value

FV = Future Value

I = Interest Rate

C = Compounding period per years

N = Total number of compounding periods

2.7.2 Calculating the investment period – SG 2.9

N = IN(FV/PC) / IN(1+I/C)

Where:

PV = Present Value

FV = Future Value

I = Interest Rate

C = Compounding rate per years

N = Total number of compounding periods

IN = Logarithm function

2.8 Calculating the value of a series of future payments – SG 2.10

2.8.1 Calculating the value of an annuity – SG 2.10

Types of annuity include:

Ordinary annuities – where an initial investment is made and payments are made at the end of each period

Deferred annuities – where an initial investment is made and payments do not start until a set number of compounding periods have elapsed

Perpetuities – payments continue indefinitely

Formula:

Where:

I = the rate of interest for each compounding period

N = the number of periods

PMT = the payment for each period

See examples – SG 2.10 + SG 2.11

2.8.2 Calculating the value of a deferred annuity – SG 2.12

PV = PMT / (1+I)^N

2.8.3 Calculating the value of a sinking fund – SG 2.12

Funds used whenever the investor must “provide” for large future expenses

FV = PMT x (((1+I)^N -1) / I)

Where:

I = the rate of interest for each compounding period

N = the number of periods

PMT – the payment for each periods

See sg 2.12

2.8.4 Calculating the value of a perpetuity

Perpetuity is an annuity where the payments continue indefinitely

Formula

PV = PMT / I

2.9 Discount rate and Discounted cash flows SG 2.13

Discount rate is effectively the minimum return threshold that the investor requires from the investment, should be a rate that effectively compensates the investor for the likely risk associated with the investment

Rate by which future value payments are discounted by

AKA time value of money

Formula

PV = PMT + PMT / (1+I) + PMT / (1+I)²

where

I = the discount rate

PMT = the cash flow payments for each period

See example SG 2.14

The impact of different discount rates

Borrowing costs and DCF valuations

Loan repayment amount should not be included in the DCF cash flow table, unless they form part of the scenario.  i.e. cost of investment 1 (borrowing) versus cost of investment 2 (no borrowing)

2.10 Net present value and comparison of investment options – SG 2.16

This comparison identifies the future cash flows of the investment and uses discount rates to compare the present value of the cash flows achieved from the various investment options, net of the initial investment.

See example SG 2.16

Note: does not consider how to finance the investment

2.11 Investment yield (internal rate of return) – SG 2.17

IRR is the investment return made from an investment

See SG 2.17

2.12 Discounted cash flow valuations applied to tax and inflation – SG 2.18

See example SG 2.18

Module 3

3.1 The equity market

Crucial part of the financial system.  It enables companies to raise funds through the issue of shares and enables investors to receive a capital gain

Also a major investment medium

3.1.1 Features of the Australian Equity Market – SG 3.2

One of the worlds top ten equity markets.

Subject to commodity cycles (approx 39% of market weighting is in resources)

Dominated by institutional investors both local and international (78%) and retail investors (22%)

Highly sensitive to international capital flow, subject to trade and currency cycles

Driven by current situations

3.1.2 The role and history of share ownership in Australia – SG 3.2

Historically predominant investor classes in Australia

        Decline in private investors

        Overseas investors significant purchasers

The post 1987 decline of direct private share investment

        Growth of managed investment funds

        Growth in capital-guaranteed assets of bonds and cash

The return of direct private share investment in the 1990s

        Increased direct share ownership

        Improved investor education

        Major floats

Australian equity market capitialisation today

Market value = 1.4 trillion

Using

Market value capitalization = total shares on issue x share price

The equity market and the free enterprise system

Equity market provides continuous measure of corporate efficiency and profitability

3.1.3 Share Market liquidity – SG 3.4

Liquidity = measure of how much buying and selling can change market price

Market liquidity (%) = turnover /total market capitalization

Turnover = dollar value of shares purchased or sold in a specific market in a given period

3.1.4 Securities market participants – SG 3.5

Market participants can be:

Investors (lenders)

Borrowers (capital raisers)

Intermediaries

See diagram 3.1 – flow of funds – SG 3.5

Investors

Can be either:

Retail (below $500,000)

Wholesale

Retail requires more disclosure

Private investors – see SG 3.6

Retirees – low risk

Speculators – short term price differences

Mums and Dads – conservative retail investors

Discretionary private client management – managed by professionals

Private client investors – has portfolio of investments

Institutional Investors (SG 3.7)

Superannuation and pension funds

Life offices

General insurance officers

Unit trusts and mutual funds

Corporate investors – entrepreneurs, corporations seeking to expand, investment companies

International investors

Business and companies

Capital raising – source money from investor for operations or expansion

Floatation – listing on the ASX

Financial intermediaries

Intermediaries aggregate and package funds

Intemediaries and securities markets – SG 3.11

Share/equity market – stockbrokers & fund managers

Long-term debt market – banks, life companies, superannuation funds

Short-term debt market – futures brokers, fund managers, market makers, option traders

Foreign exchange market – banks, foreign exchange dealers, fund managers

3.2 Definition of equity securities

Ownership of a business

Equity capital called risk capital

See fig 3.2 – list of equity securities – SG 3.12

3.3 Types of equity security – SG 3.13

3.3.1 Ordinary shares – SG 3.13

One share one vote

Exercise control over management

Entitled to dividends

Ranks after debentures and preference shares

3.3.2 Partly-paid shares – SG 3.13

Like ordinary shares

Dividend pro-rataed to fully paid shares

Can be asked to pay balance owing

3.3.3 Installment receipts – SG 3.14

Similar to partly paid

Full dividend

3.3.4 deferred dividend shares – SG 3.14

Dividend paid only after a specified period

3.3.5 bonus issues – SG 3.15

Free shares to existing holders

3.3.6 rights issue – SG 3.15

Entitles investor to take up additional shares at a discount to market price without paying additional brokerage

If renounceable investor can sell otherwise non-renounceable and they cant sell (they expire)

3.3.7 Company options – SG 3.16

See SG 3.16 benefits of company options

3.3.8 Stapled securities – SG 3.17

Ordinary shares in a company that are ‘stapled’ to units in a trust

3.3.9 Hybrid securities – SG 3.18

Characteristics of both debt and equity

Preference shares – SG 3.18

Preferred dividend payments on ordinary shares and on wing-up

Rank behind creditors and debenture holders

Types of issue:

        Convertible preference shares

        Converting preference shares

        Cumulative preference shares

        Participating preference shares

        Redeemable preference shares

        Reset preference shares

Convertible notes – SG 3.19

Fixed interest securities that carry an option to convert to ordinary shares at specific time or redeem for cash.

3.4 Listed Managed Investments – SG 3.19

Managed fund products that give investors access to a bread range of asset classes and investment styles.

3.4.1 Australian Real Estate Investment Trusts – SG 3.20

See SG 3.20

3.4.2 Listed investment companies – SG 3.21

See SG 3.21

3.4.3 Infrastructure funds – SG 3.21

Investment in the substantial capital assets that are required to fulfil major economic and social needs

3.4.4 Pooled development funds – SG 3.22

High risk

3.4.5 Exchange traded funds – SG 3.22

Open-ended funds – market price correlated closely to underlying portfolio

Can be indexed or actively managed

3.4.6 Hedge funds (absolute return funds)

Can invest in many things target a specific return

3.5 comparing the features of equity securities and LMIs – SG 3.24

3.6 Share market Sectors – SG 3.25

1. Industrials
2. Resources

GICS – Global Industry Classification Standard

3.6.1 Industrial shares – SG 3.25

See SG 3.25

3.6.2 Resource shares – SG 3.25

See SG 3.25

3.6.3 The Global Industry Classification standard – SG 3.26

See diagram SG 3.26

3.7 Factors influencing share market performance – SG 3.27

3.7.1 Interest rates – SG 3.28

3.7.2 Exchange rates – SG 3.28

3.7.3 Economic Factors – SG 3.28

3.7.4 Federal Government Economic and Fiscal policies – SG 3.29

3.7.5 Monetary policy – SG 3.29

3.7.6 Other Markets – SG 3.30

3.7.7 Market Sentiment – SG 3.30

3.7.8 Supply and demand – SG 3.30

3.8 Global equities markets – SG 3.31

3.8.1 Accessing better returns – SG 3.31

Investing in faster growing economies outside Australia

3.8.2 Diversification – SG 3.31

Hold international shares

3.8.3 Why international diversification permits greater returns – SG 3.32

Share markets do not move in tandem because:

                Differing composition of stock markets

                Lack of synchronization of national political and economic cycles

                Differing institutional structures

                Different levels of development

3.9 Risk and return – SG 3.32

Greater risk = greater return

3.9.1 Risk-adjusted return SG 3.34

See SG 3.34 for Risk-Adjusted return (RAR)

Module 4 Debt Securities

4.1.1 structure of the debt market – SG 4.2

2 segments:

                Short-term debt market or money market

                                Maturity dates less than 12 months + short term securities

                Long-term debt market (aka fixed interest, fixed income or bond market)

                                Longer than one year – pay coupon

See fig 4.1 – SG 4.3

4.1.2 features of the debt market – SG 4.3

Include:

Wholesale market for large institutions, government or corporate

Deposits accepted for short term and long term

Related to and integrated with other sectors of the financial system

Interest rates in this market are extremely sensitive

Value of the turnover in deposits and financial instruments is high

Market issuers include Commonwealth Government, State governments and corporations

Commonwealth currently uses 3 debt instruments: treasury fixed coupon bonds, treasury indexed bonds and treasury notes

4.1.3 Participants in the debt market – SG 4.4

Borowers – SG 4.4

The Australian government – SG 4.4

State and semi-government authorities – SG 4.5

Major authorities are:

                New South Wales Treasury Corporation

                Treasury Corporation of Victoria

                Western Australia Treasury Corporation

                Queensland Treasury Corporation

                South Australian Government financing authority

                Tasmanian Public finance Corporation

                Northern Territory Treasury Corporation

Local government

Private Sector:

                Banks

                Building societies

                Credit Unions

                Finance companies

                Corporations

Investors:

Major investors in the short term money market include:

                Banks, building societies and credit unions

                Investment banks

                CMTs

                Superannuation Funds

Major investors in the long-term debt market includes:

                Friendly societies

                Fund managers

                Insurance officers

                Superannuation funds

Banks, building societies and credit unions – SG 4.6

Investment banks – SG 4.6

Cash Management Trusts – SG 4.6

Friendly societies – SG 4.6

Fund Managers – SG 4.6

Insurance Offices – SG 4.7

Superannuation Funds – SG 4.7

                3 main types of fund:

1. Market linked (non-fixed interest)
2. Capital guaranteed (combination of fixed interest + non-fixed interest_
3. Capital Stable (fixed interest)

4.1.4 settlement and registration procedures – SG 4.7

Mostly settled electronically

Austraclear – SG 4.7

Computerized settlement systems for all Commonwealth Government and non-Commonwealth Government securities

See SG 4.7 for more details

Reserve Bank Information and Transfer System – SG 4.8

Used for Tender bids for primary issues of new CGSs – see SG 4.8 for more details.

4.1.5 The size of the interest rate market – SG 4.8

Depth and liquidity of the market:

Significant number of buyers + sellers = deep market

Liquidity – turnover

Australia market not as deep or liquid as US and Europe.

Turnover of debt securities – SG 4.8

See SG 4.8

4.1.6 Primary and secondary debt markets – SG 4.9

The primary market

Interest rate securities are issued via the following means:

                Tender/auction

                Private Placement

                Dealer Panels

                Public Loan

The secondary market

Where existing short-term and long-term securities are traded.

4.2 definition and debt securities – SG 4.10

The buyer (borrower) negotiates with a seller of money (the investor) about the price (interest rate)

2 distinct markets

1. Short term debt market
   1. Non-coupon securities: Promissory notes, Bank Bills, Certificates of deposit

1. Long-term debt market
   1. Coupon securities: treasury bonds, Semi-government bonds, Corporate bonds, Asset backed securities

See fig 4.3 – SG 4.10

4.3 Interest Rates

4.3.1 What are interest rates? – SG 4.11

An interest rate is the price of money

Interest rates are affected by many factors including:

Borrower(credit worthiness), economic, market, international and political factors.

Yield

Yield refers to the annual rate of return calculated as a percentage of the market price of the security

4.3.2 Indicator interest rate – SG 4.11

Major indicators all participants consider:

The cash rate

90-day bank bill rate

3 year bond rate

10 year bond rate

Cash

RBA at 9.30am each day sets targeted cash rate

RBA manages liquidity in the market (buys or sells) to achieve cash rate.

90-day bank bill rate

Represents the yield p.a. on bank bills traded in the wholesale market

Major indicator of the ease or tightness of official monetary policy and short-term market sentiment

Three-year bond rate

Dividing line between monetary policy influence and wider macroeconomic influences.

10-year bond rate

Market indicator of the rates at which Governemnt bonds are trading in the market and market’s views of inflation

Relates to longer-term trends in the economy

4.3.3 Bank bill swap preference rate – SG 4.12

Used as an indicator of likely pricing levels of many other short-term instruments

4.3.4 Wholesale and retail interest rates – SG 4.12

Wholesale – large amounts of money

Retail small amounts

4.3.5 Short-term and long-term interest rates

Two most watched interest rates in short-term are:

                Cash rate – determined by official monetary policy

                90-Day bank bill rate

Long term:

                Three-year bonds

                10-year bonds – long bond rate

4.3.6 Creditworthiness of issuers – SG 4.13

Lowest for government, higher for corporate

4.3.7 The yield curve – SG 4.13

Graph that shows the relationship between the yield to maturity and term to maturity

See SG 4.13 – for yield curve types

                Positive (normal)

                Inverse (negative)

                Flat

                Hump-backed

4.3.8 The components of an interest rate – SG 4.14

Interest rates three major components:

1. A real component
2. An inflation compensation component
3. Risk premium component

Real Component

Compensation to the lender for deferring current consumption

Inflation compensation component

Rate of inflation expected in the future

Risk premium component

Several factors:

                Credit Risk

                Liquidity Risk

                Currency Risk

                Political risk factors

Difference between nominal and real interest rates

Observed (actual) interest rates are often called nominal rates, real rate of interest = nominal interest rate – expected inflation.

4.4 short-term interest rate securities – SG 4.16

Less than 365 days

Security issued at discount to face value

4.4.1 Cash – SG 4.16

See SG 4.16

4.4.2 Treasury notes – SG 4.16

Short-term securities issued by RBA

Maturity of 5, 13 or 26 weeks

Pricing of treasury notes

Sold at discount to face value, priced on a yield to maturity basis using bank bill formula (section 4.4.7)

Issuing treasury notes into the market

Rediscounting

RBA can reprice treasury notes up to 90 day in maturity from 8.30am each day

Fixed penalty must be paid if notes become rediscounted

4.4.3 Bills of exchange – SG 4.17

Negotiable instrument sold at a discount to its face value, term can vary from one day to six months

Defined by Bill of Exchange Act 1909 as:

An unconditional order in writing addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum certain in money to the order of a specified person, or to bearer.

Types of Bills

Bank-accepted bills – bill of exchange, accepted by banks

Bank-endorsed bills of exchange – commercial bill, traded by banks but not accepted

Commercial bills – Bills accepted by non-banks, normally trade at yields higher than bank-accepted bills.

3 parties involved in a bank accepted bill of exchange:

1. The drawer
2. The drawee/acceptor
3. The payee/endorser

Subsequent holders “in due course” owners endorse the reverse (see Sg 4.19)

Contingent Liability

Pricing of Bills of exchange

Discount to face value

The Secondary Market

Users of Bills of Exchange

Trade Bills – Finance specific trade transactions

Accommodation Bills – means providing working capital

4.4.4 Promissory notes – SG 4.20

Promissory note is defined under section 89 of the Bills of Exchange Act as:

…an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at a fixed or determinable future time, a sum certain in money to the order of a specified person or to bearer.

3 Important elements:

1. A promissory note is an unconditional promise in writing
2. Amount will be paid either on demand or on a fixed or determinable future date
3. The note does not require a third party to pay the bearer of the note on behalf of the drawer

Who are the parties to a promissory note?

2 parties:

1. The issuer of the note
2. The bearer or specified person

Advantages of promissory notes

Pricing of promissory notes

Similar to Treasury notes and Bills of exchange

Users of promissory notes

Large corporations and semi-government authorities

Issuing promissory notes into the market

1. ‘tap’ issues
2. Formal tender panel procedure

The Secondary Market

Very active market

4.4.5 Negotiable certificates of deposit and certificated of deposit

No secondary market (can’t be traded)

Pricing of negotiable certificated of deposit- SG 4.22

Like Treasury bills, see 4.4.7 SG 4.23

4.4.6 Repurchase agreements – SG 4.23

Security is sold and concurrently an agreement is made to buy back or ‘repurchase’ the security at a later date at an agreed price

Repos

Buying called “reversing into”, selling “reversing out of”

Seller bears market risk.

Advantages of using the repo market

For the seller, obtaining short-term liquidity at an advantageous rate

For the buyer, covering short (sold) positions

For the buyer, investment of excess funds

4.4.7 Pricing of short-term securities

Purchase price = maturity proceeds (face value) – interest on purchase price

Formula:

Purchase Price  =             Face Value / (1+[yield x (days to maturity/365)])

Or yield to maturity

Or Bank Bill

4.4.8 Key Relationships for price short-term securities – SG 4.24

Relationship between yield and purchase price

-higher yield lower the purchase price

Relationship between term to maturity and purchase price

-greater term to maturity lower purchase price

4.5 Long-term interest rate securities – SG 4.25

Price more influenced by yield than maturity

If interest rates increase capital price for bond will fall

4.5.1 Commonwealth Government Securities – SG 4.26

Treasury fixed coupon bonds

Pay interest semi-annually in accordance with fixed coupon rate

Sold by tender

Treasury indexed bonds

Issued as capital-indexed bonds where the capital value of the investment on maturity is not fixed when issued but is linked (indexed) to Consumer Price Index (CPI)

Real yield is a better comparison

Coupon-indexed bonds

Principle doesn’t vary, interest payments in dual format, part fixed, part floating (linked to index).

Periodic tenders

Total size of tender announced in Budget Papers reflecting Governments Financial needs

Treasurer determines the maturity, coupon and quantity of each stock to be offered in the tender

4.5.2 Participants – SG 4.27

Most bidders are financial institutions, see SG 4.17 for list

Real investors can deal in smaller amounts

4.5.3 The Secondary market in Treasury bonds – SG 4.28

-has grown rapidly

4.5.4 Semi-Government securities – SG 4.28

See SG 4.28

Turnover and volume

See SG 4.28

4.5.5 Features of long-term interest rate securities – SG 4.29

Par

Purchasing a security at par means that the capital price and purchase price is equal to the face value

Discount

Capital price less than par

Premium

Capital price greater than par

A bond issue

See SG 4.30

4.5.6 Books close date – SG 4.30

Date when issuer (payer of coupon) closes the books and prepares payment

Cum interest

If a security is sold cum interest:

                The previous coupon payment has been made

                The books have not closed for the next coupon payment

                The purchasers will compensate the seller for the interest accrual to date

Ex-Interest

                Books close date has passed

                Coupon payment hasn’t been made

                Purchaser must be compensated for the interest accrual (seller will receive coupon payment)

4.5.7 Pricing of long-term interest rate securities – SG 4.30

-valued based on discounted cash flow method.

PV = F+C / 1+I

Where

PV = Present value price

FV = The future payment on maturity
I = The market interest rate

C = the Coupon payment amount

Half-yearly coupon payments

Effect of changes in interest rates on bonds with one year or more to maturity

-          A fall in interest rates increases the price of a fixed interest security, rising interest rates decrease the price of a fixed interest security

Parcel pricing of coupon securities

-Prices always converted to 3 decimal places

P = C/(1+I)ⁿ

Where:

P = Present Value

C = Future Value (i.e. coupon value)

N = number of coupon periods

I = market yield divided by 200 (eg 6% becomes .3)

RBA bond pricing formula

4.6 The corporate debt market – SG 4.34

4.6.1 Floating rate notes – SG 4.34

Or FRN’s

– long-term interest rate securities which are issued at a margin above the bank bill rate

-Normally reset every 3 months

-coupon is BBSW plus agreed margin

4.6.2 Securitised bonds – SG4.35

-are secured by a pool of assets that are held by a trust and managed by a professional manager

4.6.3 Subordinated debt – SG 4.36

Ranks below holders of secured and unsecured loans but ahead of equity investors (inc preference shareholders)

Also called unsecured bonds

4.6.4 Corporate Bonds  – SG 4.36

Direct debt obligations of corporations in a market tradeable form

Divided into:

1. Financial
2. Non-financial companies

Usually have the following characteristics:

                Fixed or variable interest paid semi-annual in-arrears basis

                Typical term between 2 and 10 years

                Trade at a margin above Commonwealth and semi-government securities

                Brought and sold via stockbrokers

Growth in Corporate bond market due to:

                Cutback in Government Borrowing

                Reduction in number of Commonwealth Government Bonds

                Attractiveness of raising funds domestically relative to offshore markets

4.6.5 Debentures – SG 4.37

Similar to corporate bonds

Fixed interest coupon, secured by fixed or floating charge

Medium (2 years) to long term (10 years)

May be ‘rolled over’

Relatively low risk – secured by assets

Influenced by interest rate movements

4.6.6 fixed interest managed investments – SG 4.37

i.e. Cash management Trusts

4.7 Holding period return – SG 4.37

When a security is sold prior to maturity

4.7.1 How to calculate the holding period return – SG 4.37

Holding Period Return

= (Sale price + Accumulated coupons) – Purchase price)/Purchase Price x 365/no of days held

4.8 Volatility – SG 4.39

Degree to which the purchase price of a security moves with a change in yield

4.8.1 How to calculate price volatility – SG 4.40

See SG 4.40

4.8.2 The affects of yield and term on volatility – SG 4.41

2 rules

1. The longer the term to maturity, the higher the price volatility
2. The higher the yield, the lower the price volatility

Voilatility ‘rules’ for long-term interest rate securities:

                The longer the term to maturity, the higher the price volatility for fixed interest securities with the same coupon rate

                The higher the coupon rate, the lower the price volatility for fixed interest securities with the same maturity date.

4.9 Other factors affecting the yield of debt securuites – SG 4.42

4.9.1 Credit Risk – SG 4.42

Ability to pay and ability to survive

See figure 4.13 SG 4.42

4.9.2 Liquidity and Marketability – SG 4.43

First line liquidity – assets saleable on a day without severe price penalty

Second line liquidity – assets saleable over several days but with potentially high price liquidation penalties

See fig 4.14 – SG 4.43

Marketability

Ability to on-sell a security into the market after it has been purchased.

Module 5

5.1 Types of derivatives – SG 5.2

                Options

                Futures

                Warrants

                Contracts for Difference (CFDs)

                Forward rate agreements (FRAs)

                Swaps

5.1.1 Options – SG 5.2

Standardized contracts that give the buyer the right, but not the obligation to either buy or sell an asset at a specific time at a predetermined price.  Buyer pays money (AKA premium) to seller.

Call options – right to buy

Put options – right to sell

5.1.2 Futures – SG 5.3

Standardised exchange traded contracts to buy or sell securities, commodities or other assets on a specified date in the future at a price agreed upon today.

Futures contract is a legally binding agreement between a buyer and seller (deliver specified quantity and quality of item).

Buyer knows price in advance, seller locks in a fixed price at a given time in the future.

Futures are centrally cleared, settled by exchange clearing house (buyers and sellers must post initial margin around 5%, in addition the post daily settlement or variation margins to cover any losses).

5.1.3 Warrants – SG 5.3

Give the holder the right to buy or sell an underlying security at a given price on or before a predetermined date.

5.1.4 Contracts for Difference – SG 5.3

Equity derivatives that involve trading the difference between the opening and closing price of an underlying asset.

Highly leveraged and very risky

5.1.5 Forward Rate agreement – SG 5.4

Agreement between two parties which sets a fixed interest rate for a period beginning on a future date (start date) and ending on an agreed date (maturity date)

Usually an interest rate hedge.

5.1.6 Swaps – SG 5.4

Interest swap, agreement, two companies borrow equivalent amounts, and then in effect ‘swap’ their borrowing obligations (interest payments) so each will service the other’s loan on term that are mutually beneficial.

5.2 What participants use derivatives? – SG 5.5

Broad Classification:

Trade to manage risk

                Speculators and arbitragers

5.2.1 Banks and Large Financial Institutions – SG 5.5

Common ways:

                Portfolio hedging

                Locking in a future purchase price

                Asset Allocation

5.2.2 Commodity producers and Merchants – SG 5.5

Commodity producers and merchants issue derivatives to manager price risk

5.2.3 Debt Issuers – SG 5.6

Issuers of debt securities (e.g. state government authorities and large corporations actively users of derivatives )

5.2.4 Corporates – SG 5.6

Generally risk management purposes

5.2.5 Managed futures and hedge funds – SG 5.6

Managed futures funds invest soley in derivative markets

Managed futures funds exhibit negative correlation to traditional asset classes (they short the market)

5.2.6 Local participants – SG 5.6

Speculative traders can be:

                Scalpers – frequent and short-term market positions

                Day Traders – execute far fewer trades than scalpers and hold positions for a much longer period

Day traders take position based on their analysis of the market on the day, scalpers have no directional basis.

5.2.7 Market Makers – SG 5.7

Hedge risk make small profit buy and sell (“spread”)

5.2.8 Spread Traders – SG 5.7

movements on the price differential between one security and another

5.2.9 Arbitrageurs – SG 5.7

Attempt to make profit between mispricing of underlying market and derivative contract

5.3 The concept of short selling – SG 5.8

Generally involves the sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value

5.4 what are the risks in the market for derivatives? – SG 5.8

Market Risk – Changes in market

Liquidity Risk – risk may not be able to sell the contract at a fair market price within a reasonable timeframe

Credit Risk – Issuing party my default

Operational Risk – inadequate internal controls or failures of risk management system may lead to unexpected losses

Legal Risk – counterparties performance obligations may not be legally enforceable

5.5 Options – SG 5.9

5.5.1 The basics of options – SG 5.9

Contract between two parties in which one party (the buyer) has the right but not the obligation to buy or sell a specified asset at a fixed price, on or before a set date in the future from the other party (the seller).  Seller gets a premium

5.5.2 How are options traded ? – SG 5.10

Over-the-counter (OTC) options are not traded on a centralized exchange

Exchange traded options (ETOs) are traded on a formal exchange

5.5.3 Differences between exchange traded and OTC options

1. fit with exact client requirements – ETO’s are standardized, OTC can match user requirements

2. Credit dimensions – ETO credit risk clearing house, OTC individual counterparty

3. Pricing factors – ETO’s option price is market-determined, irrespective of the financial strength of buyer and seller.  In OTC market, option premiums not only reflect underlying supply and demand conditions, but also institutions own trading position and creditworthiness of the counterparty (among other things).

4. Valuation – ETO prices are publically available. OTC hard to value.

5.5.4 Exercising options – SG 5.11

ETO – notify broker who notifies clearing house

OTC – buyer notifies option seller

5.5.5 Key elements of an option – SG 5.11

Type of option (put or call)

Underlying asset

Strike price

Expiry date

Premium

Types of options

                Call – buy

                Put – Sell

Underlying asset

Asset option is based on

Strike (or exercise) price

Agreed price at which underlying asset will change.

Call option “out of the money” is price is lower than strike price.

Put option is “out of the money” if price is higher than strike price.

“at the money” is underlying price is same “or close to” strike price.

Expiry date

American style – options can be exercised at any time from date of purchase until (including expiry date)

European style – exercised only on specified expiry Date.

Premium

Cost of option

Break-even point

Price at which the premium is equal to the proceeds after offsetting gains or losses

5.5.6 Why use options? – SG 5.14

Major uses:

To tailor a market participant’s risk-return profile

Liquidity

As insurance over the underlying asset

As a leveraged investment

5.5.7 Advantages of options – SG 5.14

Limited risk characteristics

Flexibility

Premium income for sellers of options

5.5.8 Risks of using options

Risks to buyers of options – option expires (worthless)

Risks to sellers of options:

                “covered” – have underlying asset

                “naked” – don’t have addet

5.5.9 Overview of options Pricing – SG 5.16

Price of option has 2 components:

Intrinsic value – difference in exercise price & current underlying asset price

Extrinsic Value – residual value of the option’s premium above any

Factors influencing the price of an option:

                Price of underlying asset

                Proximity of strike price to the current market price

                Time to expiry

                Market volatility

                Interest rates

                Market expectations

Other factors influencing the price of an option – SG 5.18

5.5.10 Expiry profit (pay off) diagrams – SG 5.18

See SG 5.18 to 5.20

5.6 Warrants – SG 5.21

5.6.1 Overview – SG 5.21

Warrant – structured financial instrument issued by a bank or other financial institution

5.6.2 Key features of warrants – SG 5.21

Underlying instrument

Call or put warrants

Deliverable or cash settled

Expiary date

Exercise style

Exercise (or strike) price

Issue size

Different types of warrants:

                Trading Warrants

                Investment Warrants

5.6.3 Why investors deal in warrants – SG 5.23

Trading for profits

Leverage

Income

Exposure

Limited risk

Hedging

5.6.4 Differences between warrants and ETOs – SG 5.23

Warrants can have non-standard features, options are standardized

ASX guarantees performance in options, warrant issuers secures the warrant

Warrants are generally longer-dated compared to options

Warrants usually issued by a third party

Warrants can be short sold.

Advantages of Warrants over ETOs are:

Warrants tend to be longer-dated to facilitate longer term views

Some warrants pass the entitlement of the income stream to holder

Warrants are issued over broader range of underlying securities

Warrant issuers are obligated by the ASX to maintain a market, while options are priced on a quote request basis

Disadvantages of warrants compared to ETOs are:

Higher risk

Restricted to exercise period

The cannot be short sold

5.6.5 Comparing warrants and ETOs with ordinary shares – SG 5.24

Advantages of Warrants and ETOs over ordinary shares:

Downside risk is limited to value of warrant or ETO rather than full value of the share

Warrants and ETOs allow holders to gain exposure to underlying security at a fraction of the cost of the underlying security

Trading warrants and ETOs have lower brokerage costs

Warrants and ETOs receive a leveraged rate of return

Installment warrants generate a higher dividend yield compared to shares

Disadvantages

A premium is paid above the intrinsic value

No dividends (or franking credits) are received for the holders of trading warrants and ETOs

5.6.6 Trading warrants – SG 5.24

Equity warrants -Warrants over ASX listed securities

Index Warrants – linked to the performance of a share price index

Currency Warrants – exchange an amount of foreign currency for Australian dollars on or before the expiary date

Commodity warrants – linked to the performance of commodity prices or commodity based securities

Knock-out warrants – same as equity warrant, except the exercise price is struck deep in-the-money, contain a “stop-loss” price if underlying asset touches this price warrants automatically expire

5.6.7 Investment Warrants

Investors gain direct exposure to shares, listed property trusts and ETFs by making a part payment upfront and delaying final payment until a later date.

Endowment warrants

Investor pay deposit, interest accrues and dividends decrease final payment (when zero holder gets shares)

Capital-protected warrants

Original Investment is guaranteed.

See Capital Plus – SG 5.29

And caPELs – SG 5.29

Module 6

6.1 Futures – SG 6.3

Launched 1960s for Sydney Greasy Wool Futures

Expanded from then

Sydney Futures Exchange (SFE) become the SFE corporation and merged with the ASX renamed in 2010 as ASX24

6.1.1 What is a futures contract? – SG 6.3

Standardized agreement to buy or sell a financial asset or commodity on a specified date in the future at a price agreed upon today

Centrally cleared

Settlement can be physical or cash

See Table 6.1 – Exchange traded futures contracts by asset class

Equity indicies

Interest rate markets

Environment and energy

Agricultural markets

6.1.2 SPI 200 Futures – SG 6.4

See SG 6.4

Settlement of SPI 200 Futures

Settled in cash

The dollar value of one contract is index value x $25 contracts not closed out are cash settled with reference to the closing price on the last trading day

S&P/ASX 200 Index futures

Mini 200 futures

6.1.3 Using Equity futures to hedge against market risk and specific risk – SG 6.5

Every investor faces “price risk” being either:

Market Risk – risk in adverse price movement across the board market

Specific risk – risk of an adverse price movement in a specific share.

See SG 6.5

6.2 Short-term interest rate futures – SG 6.6

90-day bank-accepted bill futures contracts

6.2.1 Characteristics of the interest rate futures market – SG 6.7

The index system

Are quoted in percentage terms, however ASX 24 uses an index system under which the yield percent per annum is deducted from 100.

This ensures the quoted price on the market moves in the same direction as the value of the security

Basis risk and specification risk of interest rates

Basis risk – the margin between the physical instrument and the futures contract

Specification Risk - The interest rate asset/liability being hedged may differ to some extent from the futures contract e.g. hedging a 9 year bond using 10 year bond futures

6.2.2 90-day bank-accepted bill futures contracts – SG 6.8

90-day bank-accepted bill or bill of exchange futures contract may be used as a hedge for future borrowings using short-term instruments such as bank bills etc.

Settlement

90-day bank bill futures contract unit is $1 Million face value of bank-accepted bills

Contract delivery months are each of the calendar quarters (march, June etc) with settlement taking place on the second Friday of the delivery month

Settlement is in the form of cash or physical bank-accepted bills that have a term of between 85 and 95 days from the date of settlement

Purchase Price = Face Value /1+[yield x (days to maturity/365)]

See SG 6.8 for example

6.2.3 Who uses bill futures? – SG 6.8

Primary purpose of futures is to gain protection (hedge) against unfavourable market movements and so manage risk exposure

3 major categories of potential users of interest rate futures for hedging purposes:

1. Borrowers
2. Lenders
3. Intermediaries

Borrowers use interest rate futures as a hedging tool against adverse interest rate movements

See SG 6.8 for more

Lenders supplier of the funds

Market intermediaries – dealer- type activities

Speculators

6.2.4 Hedging using bill futures – SG 6.9

Bank Bill futures can be used to hedge either a future (anticipatory) or current position i.e. borrow or lend funds at some time in the future and wish to hedge against the risk of fluctuating interest rates.

6.3 Long-term interest rate futures (bond futures) – SG 6.10

Used as a tool for hedging against adverse interest rate risk

6.3.1 The underlying instrument – SG 6.10

Fixed Interest securities

The fundamental characteristics of long-term interest rate (‘fixed interest’) securities are:

They pay a fixed rate of interest (aka coupon)

They mature at a fixed point in time (the maturity date)

Interest (Coupon) is paid at regular intervals (usually six monthly)

The purchaser receives the face value of the investment after a specified period of time call the “term” of the investment

Commonwealth Treasury Bonds – SG 6.10

Bond Pricing Principles

Bonds have two components:

1. Interest (coupon) payments
2. Face value of the bond at expiration of its term

Steps in calculating the present value of a bond

1. Calculate the present value of the interest payments
2. Calculate the present value of the face value
3. Add the two present values calculated above

Application of the RBA bond pricing Formula

See SG 6.11

6.3.2 6.3.2 3-year and 10-year Treasury bonds futures – SG 6.13

Used to hedge against changes in medium and longer term interest rates (traded by ASX24)

Cash Settlement – see SG 6.13

Calculating bond Futures – SG 6.13

Uses of Treasury bond futures

• If anticipating future sales from their portfolios, sell bond futures now to lock in a firm selling price
• Protection from a rise in interest rates, sell bond futures against their portfolios
• If intending to participate in a scheduled future bond tender could buy bond futures to protect themselves against a fall in interest rates between now and when the tender is held
• If fin insto fails at bond tender but expects interest rates to fall, take a position in bonds by buying bond futures now.  Futures then liquidated when interest rates fall or bonds are purchased
• Super fund expecting maturing bonds to yield new investment funds in six months time, could buy bond futures to protect itself against the possibility of interest rates falling
• Corp borrower intending to issue 5-year fixed rate coupon bonds in 2 months time, could sell 3-year bond futures to offset any increases in borrowing costs caused by interest rates rising in the meantime
• Investment banks and short-term money market dealers can use the contracts to facilitate bond switching or trading the yield curve
• Trading opportunities

6.4 Contracts for difference – SG 6.15

A derivative that involves trading the difference between the opening and closing price of the underlying asset

High leverage and high risk

No fixed expiry date, contract size, but have daily financing charge

Contracts settled for the cash differential between the price of opening and closing trades

6.4.1 The mechanics of CFDs – SG 6.15

Investor pays an initial margin

CFD provider is the counter party

Investor holding long position pays interest to the provider, investor holding short position may receive interest from the provider

Benefits of CFDs:

Investors can trade on margin

Easy to use and understand than most derivatives

Offer potentially high returns (at a high risk)

Enable investors to receive dividends paid on the underlying share on long positions and participate on stock splits, no voting and no franking credits

Enable investors to receive interest on short positions

Useful tool for short selling

Enable investors to take long or short positions, thereby benefit from both rising and falling markets

6.4.2 Risks involved in trading CFDs – SG 6.16

High levels of gearing

Margin calls

Counterparty risk

Provider not a market maker

Response timing

Accuracy of pricing

6.5 Forward rate agreement – SG 6.17

Agreement between 2 parties wishing to hedge against future movement in interest rates.  Interest rate cover is for a period beginning on a forward start date and ending on the agreed maturity date

Seller of the FRA is obliged to compensate the buyer of the FRA for a rise in interest rates, buy compensates the seller for a fall in interest rates.

6.5.1 Risk Exposure – SG 6.17

No commitment to principle, only interest rate differtial

6.5.2 Advantages – SG 6.18

No margin calls

Flexibility

Limited credit risks

Off balance sheet

6.5.3 Disadvantages – SG 6.18

Liquidity

Credit risk

6.5.4 Parties to an FRA – SG 6.18

See SG 6.18

6.5.5 Calculating the settlement for an FRA – SG 6.18

See SG 6.18

6.5.6 FRAs and futures – SG 6.19

See SG 6.19

 6.6 Swaps – SG 6.20

Highly traded derivative between large instos

Swaps can be interest rates and currencies

6.6.1 Equity Swaps – SG 6.20

Over the counter exchanges of cash flows in which at least one of the indicies is an equity index

See SG 6.20

6.6.2 Advantages – SG 6.21

6.6.3 Disadvantages – SG 6.21

6.6.4 Uses of equity swaps – SG 6.21

Diversify exposure

Asset allocation

Outperformance tool

Module 7: Managed Investment Portfolios and structures

7.1 Types of Managed investments – SG 7.2

Most common types of Managed Investments are:

Managed funds (unit trusts)

Listed managed investments (A-REITS)

Insurance investment products

7.1.1 Managed funds – SG 7.2

Pooled investments where ownership of the fund is divided into equal units (unitized).  Unit holders have the right to capital and income distributions is proportion to unit holdings.

Unit prices fluctuate based on underlying assets

Managed by the responsible entity (RE)

Advantages of managed funds:

Units can be easily transferred

There is less regulation than a company structure

Units can be re-purchased by the fund

There may be taxation advantages generated from the underlying assets of the fund

7.1.2 Listed managed investments – SG 7.2

Listed managed investments or listed trusts are pooled investments that are listed on the ASX.  Most common type of listed trusts are:

                Australian Real Estate Investment trusts (A-REITS)

                Exchange Traded Funds (ETFs)

                Listed Investment Companies (LICs)

*These investments are closed-ended

7.1.3 Insurance Investment Products – SG 7.2

Insurance bonds (or investment bonds) are basically life insurance policies that operate for a traditional term of 10 years

Investors get associated tax benefits

Friendly society bonds are similar

7.2 Investment platforms – SG 7.3

Types of investment platform includes:

                Investor-directed portfolio services

                Master Trusts

                Wrap Accounts

ASIC considers investor-directed portfolio services (IDPSs) to be managed investment schemes due to the fact that:

“…they involve the expectation of cost savings or access to investments that are not otherwise available:.

IDPSs do not satisfy several of the requirements of a managed investment scheme as defined by the Corporations Act 2001

A client who uses an IDPs has the facility to make all the investment decisions, either directly or by authoring another to act on their behalf

A master trust invests in a range of other managed funds with individual investor selecting either the underlying investment products and fund manager or a select portfolio of managed funds determined by a nominated risk profile

A wrap account is similar to a master trust, but acts as a custodial service, with investments made in an individual investors name

7.3 Regulated Superannuation Funds – SG 7.3

Many Superannuation investors find their funds invested in managed investment schemes

See fig 7.1 – SG 7.4 – types of managed funds in Australia

7.4 Managed Investments in perspective – SG 7.4

Types of Managed Investments:

Unitized managed investment – unit price is value of the total net assets of the managed investment asset pool divided by the number of units on issue.

                Can be either:

                Open ended – new units offered to new shareholders

                Closed Ended – finite number of units over a fixed period, sometimes listed on ASX

Accounts or portfolio (mandate) managed investments are pooled investments where the investor receives either an earning rate or entire reported return

7.4.1 Investor Markets: Retail, mezzanine and wholesale managed investments – SG 7.4

See table 7.1 SG 7.5 (should put in notes)

7.4.2 History of Managed Investments in Australia – SG 7.5

1936 First Fund (Australian Fixed Trusts pty ltd)

1950s First property trust (LJ Hooker)

1974 first mortgage trust

1980 First CMT (Macquarie Bank)

7.4.3 The managed investment industry today – SG 7.6

Australia ranks 4^th in total funds and fastest growing managed fund market in the world

See SG 7.6 for key influences

7.4.4 Trends in the managed investments industry – SG 7.7

Industry becoming more sophisticated from an international perspective

Diversity of managed investment continues to grow

Managed funds becoming more specialized

Public interest in managed funds growth

Growth in index funds

Regulatory changes continue, confusion still abounds

Better training for those distributing investment products

Trend towards fee-based remuneration

Investor interest in alternative investments has grown

Use of technology has increased

Need to educate investors and promote benefits of investing in managed funds has developed

Increased disclosure

Value-Added services provided by Financial Advisers has grown

Increasing media coverage of the industry

New Products

Distribution channels and the availability of investors

The role of fund managers

7.5 Participants in the managed investments market – SG 7.9

Investors – retail or wholesale

Distributors

Promoters

Regulators

Custodians

Research houses

See fig 7.4 Participants and structure of the managed investment market – SG 7.10

7.6 Advantages, disadvantages and Risks – SG 7.10

7.6.1 Advantages – SG 7.10

                See SG 7.10

7.6.2 Disadvantages and risks – SG 7.11

See SG 7.11

7.7 Managed investments vs direct investments – SG 7.12

Managed investments have a limited life

Managed investments have specific buy-back arrangements to accommodate redemptions

Managed Investments not requires to hold AGMs unless change in constitution materially affects the majority of unit holders

RE determines how income is paid to unit holders (must distribute all income received)

Managed investments may issue and redeem units as demand requires

7.8 Australia: an international perspective – SG 7.12

Offers:

                Best practice regulator environment

                A skilled and multilingual workforce

                Robust business infrastructure

7.9 Investment options in managed investments – SG 7.13

Main investment options can be divided into:

                Sector funds or asset class funds -> invest in specific market sectors or asset classes

                Multi-Sector funds that invest in multiple asset classes or market sectors

Australian managed funds use the following markets:

                The Australian Securties exchange

                The international securities markets

                The money Market

                The debt market

                The property market

                Foreign exchange markets

                Derivatives market

Alternative investment vehicle characteristics:

                Relatively limited investment history

                More commonly held by institutional investors than retail investors

                Distinctly different features from more traditional asset classes

                Requires specialist skills to manage

7.9.1 Single Sector Funds – SG 7.13

Single sector funds invest majority of funds in one asset class:

                Cash

                Bonds (fixed interest securities)

                Property

                Equities

Cash funds – AKA CMTs, earn higher interest rates

Bond and Fixed Interest funds

Invest in longer-term fixed interest securities (maturity exceeding 12 months)

Australia fixed interest funds

Returns generated by:

1. Coupon or interest payments
2. Earnings from Trading Securities
3. Credit order of Risk (Commonwealth Government Securities, semi-government securities, corporate securities)

International fixed interest funds – have currency movements as well

Mortgage funds

Invest in debt of mortgage, in default manager sell property

See SG 7.15 for more details

Liquidity issues may occur similar to the GFC

Property funds

Invest in diversified commercial properties

Benefits:

                Liquidity

                Quality of property

                Diversification

                Valuation

                Transaction costs

Property syndicates – long-term property investment strategy

Most are unit trusts (5 to 10 years investment term)

At end of term property is sold, net proceeds to investors

Differ from A-REITs in:

                Sell properties once investment team is complete

                Fewer but larger investors

                Fewer but larger investors

                Have pre-specified investment assets

                Do not offer ready liquidity

Unlisted property trusts

See SG 7.18

Australian Share funds

Large cap – invest in large capitalization stocks

Small cap – invest in small capitalization stocks

Value – invest in low price relative to fundamental value

Growth – invest in fast growing, tend to have high price relative to some fundamental economic variable

Market Neutral – fund has characteristics similar to broad market

Australian funds also have a specialization bias:

                Blue Chip (or large cap) share funds

                Ethical investment funds

                Industrial share funds

                Resource share funds

                Imputation funds – regular dividends

                Index Funds – attempt to match index

International Share funds

                Invest in companies listed outside Australia

                Often called Global funds

                Bring diversification benefits

Specialised international share funds include:

American, European and Asian share funds

Emerging market share funds

Global technology share funds

Global health and biotechnology share funds

Global resources share funds

Global renewable energy share funds

Global small companies funds

Emerging markets (country funds)

South America (brazil, argentina, chile and Colombia)

Eastern Europe (Russia, Poland, Czech republic)

Asia (China, india, Malaysia, Philippines and Taiwan)

Africa (south Africa)

Mediterranean (Greece, Israel, Turkey)

7.9.2 Multisector funds – SG 7.21

Mix of:

                Cash

                Fixed interest

                Property

                Shares

                Alternative investment vehicles

See table 7.3 – Sample diversified funds – SG 7.21

Capital stable funds – SG 7.21

Capital protected funds – SG 7.22

Balanced Funds – SG 7.22

Growth funds – SG 7.23

7.9.3 Hedge funds (absolute return funds) – SG 7.25

Can go long or short

Common features:

                Investments across any asset class or market

                Free choice of trading style

                Free choice of derivative instruments

                Restricted fund transparency

                Ability to leverage the original principal amount

Hedge fund strategies:

                Macro or Global

                Market neutral

                Market timing

                Opportunistic

                Directional

                Short Selling

                Special Situation

Characteristics of hedge funds

See Table 7.6 Traditional funds and hedge funds – SG 7.27

7.9.4 Infrastructure funds – SG 7.27

2 types economic infra structure and social infrastructure

Economic infrastructure:

                Transportation links

                Transportation nodes

                Power

                Water

                Telecommunications infrastructure

Social infrastructure includes:

                Schools and educational facilities

                Hospitals and other health facilities

                Housing

                Correctional facilities

Characteristics of infrastructure funds

                Typically monopoly/oligopoly elements

                High initial capital cost

                Time consuming to build

                Long lifespan

                Exist to support other economic/social activities

                Illiquidity

7.9.5 Other asset classes for managed funds Investment – SG 7.28

Private equity

Commodities

Managed derivatives funds

Endowment funds

Catastrophe bonds

Life settlements

Art/thoroughbreds/ostriches/films

Timber plantations

Distressed debt

Emerging market debt

7.10 Other investment schemes – SG 7.29

7.10.1 Exchange-Traded funds – SG 7.29

7.10.2 Listed investment companies – SG 7.29

See SG 7.29

7.10.3 Insurance bonds – SG 7.30

See SG 7.30

7.10.4 Friendly Society bonds – SG 7.31

Similar to insurance bonds

Module 8: managed Investment Administration Platforms and costs

8.1 Administration Platforms – SG 8.2

8.1.1 Master Trusts – SG 8.2

A managed investment structure that enables an investor to access one or more underlying investments, providing a central administrative hub and single reporting structure

Master trusts can include feeder funds and fund of funds structures within their choice of funds

Master trusts can include feeder funds and fund of funds structures within their choice of funds.

Master Trusts are offered in two investment formats:

1. Discretionary – Investor picks fund and fund manager
2. Non-Discretionary – sponsoring manager selects underlying fund managers and packages them into a single investment

Master trust advantages are: Consolidated reporting and cost-effective fee structures

See fig 8.1 – Structure of a master trust – SG 8.2

8.1.2 Wrap and custodial services – SG 8.3

Virtually identical to discretionary master trusts

Legal structure differs in they don’t have an overlapping trust

Wraps use a custodian to hold and acquire managed funds and other assets

Wraps are just custodial and reporting services, no single responsible entity and no PDS

Lower cost than retail investor, consolidated performance and tax reporting

8.1.3 Investor-directed portfolio services – SG 8.3

Collectively master trusts and wrap services are known as investor-directed portfolio services (IDPSs)

Main features of IDPSs are:

Operators must hold AFSL (specially authorizes them to run an IDPS)

Investors in IDPS receive a FSG

Investors will receive same disclosure documents as individually investing

Investors using IDPS receive quarterly statements

IDPS operates and investors may elect to receive information electronically

Advantages of IDPSs:

Access to wholesale-priced funds

Convenience of delivering consolidated tax and investment reporting

Individual privacy

Ability to create a mixed portfolio of investment assets (all professionally held)

Disadvantages:

Limited extra services or rights that accompany direct share ownership

Ongoing management fees

8.1.4 Individually-managed accounts and separately-managed accounts – SG 8.4

IMAs (individually managed accounts) and SMAs (separately managed accounts) are managed accounts

PDF, FSG both required

(MDAs) – Managed discretionary accounts allow investment decisions to be made at adviser’s discretion, separate legal agreement needs to be signed by client and account manager

Benefits using IMAs / SMAs:

Access to professional investment management

Tax-effective portfolio management

Direct ownership of the underlying securities, which limits the effects of other investor actions on an investors own portfolio

Cost – SMA style similar to wholesale managed funds

Ability to screen individual assets in a portfolio (IMAs only)

Lower turnover portfolios for lower costs and fewer capital gains tax events

Portfolio weighting can follow a broad range of asset allocation

Greater transparency, information and reporting

IMAs and SMAs limitations:

Investment minimums are higher than managed funds

Practical considerations of individual service and increased client contact

May not generate significant after-tax performance above managed fund

Low number of portfolio managers currently offer portfolio management services

Cost especially IMA-style managed accounts

See table 8.1 – SG 8.5

8.1.5 Fund of funds – SG 8.6

Managed fund that invests in other funds

See fig 8.2 – SG 8.6

8.1.6 Feeder funds – SG 8.6

RE sets up a group of funds that feed their investments contributions into other funds operated by that RE.

8.2 Costs of Managed Investments – SG 8.7

8.2.1 Categories of fees – SG 8.7

                1. Entry fees

                2. Exit fees

                3. Ongoing fees

Retail fund fees made up of:

                Management fee for the fund manager

                Custody fees for the custodian

                Other operating expenses

Wholesale fund fees – lower then retail doesn’t pay financial adviser commissions

Mezzanine fund fees – no upfront fees, lower ongoing fees than retail but higher than wholesale funds.  Mezzanine funds need to provide a PDS

8.2.2 Indirect Cost Ratio – SG 8.8

Indirect Cost ratio (ICR) is a measure of the costs incurred by an investor for investing in a managed fund covers all costs

8.2.3 Management expense ratio – SG 8.8

Measurement of fees prior to ICR (in 2006), doesn’t cover all costs

8.2.4 Buy/Sell spread – SG 8.8

See SG 8.8

8.2.5 Performance fees – SG 8.10?

Additional fee over and above basic management fee paid if fund exceeds benchmark

Advantages:

Fees rise and fall with performance

Fees better align investors and fund managers interests

Investors perceive fee as result of fund managers skills

2 Key Disadvantages

1. Performance fee based on index return (not absolute amount)
2. Performance fee may act as call option for the fund manager with all upside but limited downside

Module 9: Analyzing and Evaluating Investment Products

9.1 Evaluating equity securities – SG 9.3

9.1.1 Pricing a share offer – SG 9.3

Analyst needs to assess the future earnings of a company and determine what it is worth in todays dollars

Known as discounting and is key to determining the NPV of a company

Must apply a reasonable discount rate (based on prevailing interest rate and additional risk premium)

Calculation is done many years into the future, divided by number of shares to be issued gives offer price and DCF (an indication of the future performance of the investment)

See example 9.4

Estimated Value of a Company = Future maintainable earnings / discount rate

Issue Price = Estimated Present Value of the Company / Number of shares issued

9.1.2 Intrinsic value vs Market Price – SG 9.5

Intrinsic value = share price valuation based on DCF or relative value i.e. P/E relative to market benchmark

If the intrinsic value is close to, or equal to the current market price of the share, the share is fairly priced.

If intrinsic value is less than the current market price, share may be overpriced by market and investors should consider selling

If intrinsic value is greater than the current market price, share may be underpriced and investor should consider buying

9.1.3 Arriving at an appropriate discount rate – SG 9.5

Normally a risk premium (2% to 4%) is added to the risk-free rate.

Alternatively the average capital yield base (capital gains + dividends) of a particular industry which company trades can be used

9.1.4 Price/Earnings ratio and earnings per share – SG 9.6

Comparison to peers

EPS or P/E ration can be used to compare.

Company management also impacts prices

Earnings Per Share = Net Profit available to ordinary shareholders / Number of Ordinary shares issued

P/E Ratio = Current market Price / Earnings per share

See example SG 9.7

Application of the P/E ratio

P/E Ratio is an effective and easy way of comparing share offerings between companies in a comparable industry or group

P/E ratio disadvantages:

Determining future maintainable earnings is not easy

Industry average earnings multiple (or any other comparison multiple) is appropriate, however it should be blindly accepts

Earnings figure can be influenced by management and accounting methods

9.1.5 Gearing and the share price – SG 9.8

Companies debt figure is another key piece of information in determining correct share price for the issue

WACC

Typical debt level is 30% of the total equity of an industrial company

9.1.6 Value drivers and company specific factors – SG 9.10

Management ability

Core competencies (good financial management, trading operations, successful investment)

Real option values

Ability to take advantage of market opportunities

Quality and stability of earnings

Industry sector prospects

9.1.7 The Media and its impact in share offer evaluation – SG 9.12

Management and Personalities

Growth

Other recent successful listings

Innovations

9.1.8 Advisor Role – SG 9.12

Primary way a financial adviser and investor is made aware of a particular investments risk/return profile, benefits and characteristics is by reviewing the prospectus.

*Important that a financial adviser ensures investors receive and review relevant investment prospectus before investing

9.2 Case study – SG 9.14

9.3 General Investment Trading rules – SG 9.16

9.3.1 Don’t buy on rumour – SG 9.16

9.3.2 The successful investor – SG 9.16

                Is:

                Must do homework

                Open minded listener

                Patient

                Not:

                Guided by emotion

                Impulsive

                Fashion conscious

9.3.3 Diversification – SG 9.17

Key element in successful investing

9.3.4 When to Buy – SG 9.18

Safest to buy on market strength, client may wish to buy in falling market if stock is oversold

9.3.5 timing the transaction – SG 9.19

Timing is key element of strategy design

Critical for short term investor not as relevant for long term investor

May be gradually adding to stock position

Events significantly impacting markets:

Financial crisis

War or acts of terror

Political upheaval

Unexpected company risk

9.3.6 Stop-losses – SG 9.19

Limits losses in a falling market

9.3.7 when to sell – SG 9.20

Exit strategy designed with client’s objectives, characteristics and risk profile in mind

Should consider selling when:

A share is deemed to be overpriced

Outlook for earnings or sector performance deteriorates

When better value in another stock or sector

9.3.8 Don’t follow the crowd – SG 9.21

9.3.9 High return probability equals high risk – SG 9.21

If a return looks to good it usually is

9.3.10 Monitoring is a continuous process – SG 9.21

9.4 Market indicies – SG 9.22

Index is weighted average representation of the price movements of a sample selection of shares

9.4.1 S7P/ASX benchmark indicies – SG 9.22

See SG 9.22

9.4.2 International Indicies – SG 9.23

See SG 9.23

9.4.3 The role of share market indicies in investment – SG 9.23

Barometer for share market performance

Used in passive share market technique

9.5 Debt securities: Making the investment decision – SG 9.24

Fixed interest investments, cheaper brokerage and other fees and charges, purchases of securities below par in order to make gain on maturity or sale and the anticipation of favourable interest rate movements

Steady stream of income

9.5.1 Credit ratings – SG 9.24

Credit rating agencies – see Table 9.7 SG 9.25

Credit analysis – see SG 9.26

9.6 allocating securities in an investment portfolio – SG 9.27

See table 9.8 – model portfolio – SG 9.27

9.6.1 Allocation of securities – SG 9.27

See SG 9.27

9.7 Analysis of derivatives markets – SG 9.28

9.7.1 why analyse? – SG 9.28

Analyse factors affecting prices so informed decisions enable them to profit (or limit loss) in the market concerned

Need to understand factors influencing price

9.7.2 Fundamental or technical analysis? – SG 9.28

Fundamental analysis

Involves examination of all relevant factors affecting the price

Ask questions such as:

What is happening to inflation in major world economies?

Are trends in overseas markets likely to have an impact on Australian interest rates, equities, commodity prices or the value of the Australian dollar?

What effect are these factors likely to have on Australian interest rate, equity, currency and commodity derivative markets?

What is the future international demand likely to be for a commodity and what supply will be available to meet that demand?

Technical analysis

Study of movements in price of the underlying commodity or instrument

Dependant on accurate data

Advocates believe that all market information is expressed in the market price of a commodity

Past patters reliable at predicting future

Combining analysis techniques

Both can be used – see SG 9.29

9.8 Users of derivatives – SG 9.29

Hedger – manage risk

Speculator – purely for profit

9.9 Speculative Trading – SG 9.30

Plays a vital role, provides depth and volume of trading which allows hedgers to enter and exit market easily at fair market prices

9.10 Hedging fundamentals – SG 9.31

9.10.1 Purpose of hedging – SG 9.31

Reducing exposure to financial and commodity price movements, catastrophes, variable operating costs and income

9.10.2 Hedging strategies – SG 9.31

Losses in the physical transaction are offset by profits on futures

Anticipatory hedging – buying derivatives position ahead of or in anticipation of later cash market transaction

Hedging a current market position – take derivative position opposite to position currently held

9.10.3 How much of the exposure should be hedged? – SG 9.32

Suggested coverage of 60-75% of projected sales or purchases (but is dependent on many factors)

9.10.4 Choice of delivery months – SG 9.32

Ideally contract expires at the same time as the cash transaction takes place

9.10.5 The concept of basis risk – SG 9.32

Basis Risk – cash and futures price differ

Other forms of business risk are:

                Delivery basis

                Grade basis

                Location basis

9.10.6 The amount hedged – SG 9.33

Amount hedged may not correspond with physical transaction.

See SG 9.33

9.10.7 Differences in timing – SG 9.33

Differences in time make a difference in price

9.11 Hedging with equity futures – SG 9.34

9.11.1 Anticipatory hedging with equity futures – SG 9.34

Contracts required = $ amount to be hedged / $value of contract

See example SG 9.34

9.11.2 Hedging a current market position – SG 9.35

Sell futures against the portfolio

See example SG 9.36

9.11.3 Using beta factors for a more precise hedge – SG 9.37

Basis risk – impacts the effectiveness of any hedging strategy

Measuring relative volatility

                Beta factor – historical volatility stock movement relative to market

Beta of whole market is 1.0 (greater than 1.0 stock is more volatile, less than 1.0 less volatile)

Weighted beta of a portfolio of shares

See example SG 9.38

9.12 Using bank bill futures to hedge short-term interest rate exposures – SG 9.39

9.12.1 A buying hedge using 90-day bank bill futures – SG 9.39

See SG 9.39 for example

9.12.2 A selling hedge using 90-day bank bill futures – SG 9.40

See example SG 9.40

The relevance of the compound factor – SG 9.41

9.12.3 Hedging long-term obligations – SG 9.41

See example SG 9.42

9.13 Using derivatives to hedge long-term interest rate exposures – SG 9.43

9.13.1 Types of hedging – SG 9.43

1. anticipatory hedging

2. hedging a current market position

9.13.2 Anticipatory hedging –SG 9.43

See example SG 9.43

9.13.3 Hedging a current market position – SG 9.45

See example SG 9.45

9.14 Key Points to remember when hedging with futures – SG 9.46

Money available at maturity

Convergence of futures and physical markets

Amount hedged

Amount hedged vs contract unit

Transaction fees, commission and margins

Changes in futures vs. Changes in cash instrument (basis risk)

Maturity of the instrument being hedged

9.15 Overview of the managed investment process – SG 9.48

Main steps:

Defining the investment objectives

Formulating an investment strategy (inc asset allocation)

Implementing a strategy (inc decisions on asset selection)

Monitoring outcomes against stated objectives

9.16 Defining a managed investment’s objectives – SG 9.49

Considerations for fund managers

                Target market

                Recommended or preferred investment time horizon

                Likely role of the portfolio in the investors total portfolio

                Level of risk acceptable to target investors

9.16.1 Risk and Return – SG 9.49

Returns should be commensurate with the amount of risk taken

9.16.2 Time horizon – SG 9.50

See SG 9.50 table 9.10

9.16.3 Example of different investment strategies – SG 9.50

See SG 9.50

Capital guaranteed

Capital stable or secure

Balanced

Growth

Other terminology

Defensive

Conservative

Moderate

Growth

High growth

9.17 Formulating the investment strategy – SG 9.51

Several decisions must be made:

Which asset classes are appropriate to meet funds strategy

What is expected long-term performance relative to asset classes

Should I be passive or active

Should portfolio be managed internally or outsourced

9.17.1 Investment style – SG 9.52

1. active management

2. passive management

9.17.2 Active vs Passive investment management – SG 9.53

See SG 9.53

Passive:

                Low-cost + low-risk

                Certainty of sector returns

                Not subject to performance volatility

                Not dependent on successful forecasting of future asset price changes

Active:

                Try to outperform market

Terms applied to active equity investment managers:

                Value

                Growth

                Neutral

                GARP (Growth at Reasonable prices)

                Contrarian

                Quantitative

                Technical

                Enhanced index

9.18 Investment Management asset allocation – SG 9.55

1. asset allocation – what to invest in

2. stock selection – how much and when to buy and sell

9.18.1 Neutral asset allocation – SG 9.55

AKA strategic asset allocation (SAA) risk control measure based on expectations about long-term relative performance of each asset call.

See table SG 9.55

9.18.2 Strategic Approach – SG 9.56

See SG 9.56

9.18.3 Rebalancing – SG 9.56

See SG 9.56

9.18.4 Tactical asset allocation – SG 9.56

See SG 9.56

9.18.5 Market Timing – SG 9.57

See SG 9.57

9.18.6 diversified or sector funds? – SG 9.57

The multi-sector approach

The single-sector approach

Asset allocation considerations

9.19 Investment manager selection- SG 9.58

4 P’s:

People

Philosophy

Process

Performance

9.19.1 People – SG 9.58

9.19.2 Philosophy and Process – SG 9.58

9.19.3 Performance – SG 9.59

9.20 Asset Allocation and stock selection – SG 9.59

Separate asset allocation and stock selection functions

9.20.1 Stock selection considerations – SG 9.59

Two principle approaches to security selection:

1. Top down and Bottom up – see SG 9.59
2. Thematic approach

9.21 Monitoring and Reviewing – SG 9.60

Final and crucial step

Benchmarks – SG 9.61

9.22 Selecting managed funds – SG 9.63

9.22.1 Investment Process – SG 9.63

Can be summarized as:

1. Define investment objectives
2. Select the optimal asset class mix to achieve objectives
3. Select Managed funds that will provide desired asset allocation exposure
4. Select managers that will add value above strategic asset allocation

Step 1 – define investment objectives

                Time horizon

                Risk tolerance

                Constraints

                Return expectations

Step 2 – Select optimal asset class mix

Step 3 – Select managed funds

Step 4 – Select managers that add value

9.22.2 Analysis of managed funds – SG 9.64

See SG 9.64 for criteria

9.22.3 Identifying manager skill – SG 9.66

People

Philosophy

Process

Performance

Sources of information: PDS, Half year and fell-year reports to investors, websites

Monitoring investment managers

Performance

Strategy

Purpose of information

Reviewing investment managers

Module 10: Regulation, Documentation and Tax

10.1 Regulation of the securities industry – SG 10.3

10.1.1 ASIC – SG 10.1

ASIC is an independent Commonwealth government authority established by the Australian Securities and Investment Commission Act 1989

ASIC administers the corporations act 2001 and the Australian Securities and Investment Commission Act 2011

ASIC’s key responsibilities include:

Consumer protection in financial products and services

Licensing financial services providers

Regulation of companies and their conduct

The issue and trading of listed and unlisted financial products

Supervision of securities and futures industries and markets (ASX and ASX24)

Registration of auditors and liquidators

Approval for external dispute resolution schemes

Securities market supervisions

Market integrity rules – SG 10.3

Penalty up to $1,000,000

Consumer protection – SG 10.4

Enforcement – SG 10.4

Insider trading

Illegal fund raising

Fraud or theft

Misleading the market

Consumer protection issues

Remedies

Information

10.1.2 ASX group – SG 10.5

No longer co-regulator of it’s securities market

Monitoring of brokers, other market participants and listed entities

ASX has own listing rules

Rules replaced in 1.8.2010 by:

ASX market operating rules

ASX24 Market Operating Rules

Existing rules remain:

ASX clear

ASX clear (futures)

ASX Settlement

Austraclear

ASX objectives – SG 10.6

ASX listing rules – SG 10.7

Supervision and enforcement of the operating rules – SG 10.8

10.2 Inside a stockbroker’s office – SG 10.10

Institutional dealing desk – portfolio management, investment advice and dealing shares on behalf of institutional investors

Private client desk – individual clients, manage share portfolios and may provide financial planning advice

Research department – research reports and analysis of companies

Corporate finance department:

Underwriting new company listings

Arranging share placement

Providing advice on acquisitions

Identifying new companies for stock market listing

See SG 10.12 for more

Money market department – placing clients money into fixed interest investments, CMT’s or on overnight call and operating futures and options markets

Operating and booking department – execute buy and sell orders and book to clients

Administrative department – accounting services, debtor control, reception/typing, legal and compliance, marketing

Settlement department-  processing share transfers and account reconciliations

10.3 Compliance with stockbroking regulations and standards – SG 10.13

10.3.1 Client profiles and record keeping – SG 10.13

‘know your client’ information and client profiling data must be available for inspection by the ASX

Adviser can provide any of the main types of service:

                Order execution only

                General advice and information

                Personal advice

10.3.2 Order taking – SG 10.14

Brokers must ensure that:

                Correct details are received from the client

                Order placed correctly in the market

                Details of orders are maintained by the firm

                Compliance requirements followed and can be substantiated by regulators

                Proof of order instructions have been received from clients

See SG 10.4 for more

10.3.3 Advice versus no advice – SG 10.15

See SG 10.15

10.3.4 Corporate actions – SG 10.15

Important advisers are aware of impending corporate actions 

10.3.5 Cash handling and trust account rules – SG 10.15

See SG 10.15

10.4 Debt securities operations – SG 10.16

10.4.1 short-term debt securities – SG 10.16

Cash – SG 10.16

Treasury notes – SG 10.16

Bills of exchange – SG 10.16

Promissory notes – SG 10.16

Negotiable certificates of deposit – SG 10.17

Repurchase agreements – SG 10.17

10.4.2 long-term securities – SG 10.17

Commonwealth Government securities – SG 10.17

Semi-government securities-  SG 10.17

Corporate debt – SG 10.18

10.5 Securities Documentation

10.5.1 Definition of a prospectus – SG 10.18

Sec 9 of the Corporation Act ‘written notice or other instrument inviting applications or offers to subscribe for securities or offering securities for subscription’

Describe:

Risk and returns of the offering

Financial position of the offering and/or issuer

Rights attached to the offering

Other relevant matters

10.5.2 When is a prospectus required? – SG 10.18

When an issuer who is proposing to issue new securities either equity or debt

Prospectus must be lodged and if possible registered with ASIC prior to accepting applications from potential investors

ASIC has 7 days to review a prospectus for any misleading or deceptive conduct

Exempt offerings – SG 10.19

10.5.3 Lodgment and registration of a prospectus – SG 10.19

Prospectuses must be lodged and registered with ASIC prior to release for subscripts to the market.  Prospectus may not be issued for shares in a company that has not yet been incorporated

See SG 10.19 for more

10.5.4 Materiality – SG 10.20

Section 710 of the corporations act – a prospectus must contain all the information that investors and their financial advisers would reasonably require, and reasonably expect to find in the prospectus.

See SG 10.20

10.5.5 Types and contents of prospectuses – SG 10.20

1. full prospectuses – SG 10.20

2. short-form prospectuses – SG 10.21

3. Supplementary prospectuses – SG 10.21

10.5.6 Structure of a share prospectus – SG 10.21

The summary section – SG 10.21

The company – SG 10.22

Financial information – SG 10.23

Auditor/accountant report – SG 10.23

Company forecast, analysis and risk – SG 10.23

Other information – SG 10.24

Authorisation – SG 10.24

Application form – SG 10.24

Fixed interest prospectus – SG 10.24

10.5.7 Improving disclosure documents – SG 10.24

Prospectuses ASIC in 2006 released guidelines:

Make prospectus as short as possible to assist readability

Leave out extraneous material

Highlight critical information

Organize information in a logical way

Provide clear navigation around the document

Consider incorporating technical and detailed financial information by reference

Use plain direct language

Use a range of communication tools (inc graphics)

Product disclosure documents

ASIC Regulatory Guide 168 Disclosure: Product Disclosure Statements contains PDS policy guidelines

10.6 Taxation matter for equity securities – SG 10.25

10.6.1 Dividend imputation – SG 10.25

prior to dividend imputation profits were taxed twice

Now shareholder is allowed a credit known as imputation or franking credit

Imputation credit = Dividend x (Company Tax Rate / 100 – Company tax rate)

10.6.2 Capital Gains Tax – SG 10.27

Assets acquired before 20 September 1985 – generally exempt

Assets exempt from capital gains tax

1.Assets within a complying pension

2. Taxpayers primary residence

Calculation of Capital Gains tax

Taxable capital gain = net proceeds of sale of asset – cost base of asset

Where:

The proceeds from the sale are net of sale costs

The cost base of the asset includes the purchase price, any capital improvements and purchase costs

If held form more than 12 months discounted by 50%

Capital loss can be used to offset other gains or carried forward can’t be used against other income

Calculating CGT (post 21 sept 1999 asset) – discount method – SG 10.28

1. Calculate the cost base for each part of the asset
2. Calculate the gross capital gain
3. Gross capital gain = net proceeds of sale of asset – cost base
4. For assets held longer than 12 months, multiply result in step 2 by 50%
5. Calculate the assessable capital gain = gross capital gain – CGT discount amount
6. Offset any available capital losses
7. Add the assessable capital gain to other assessable income to determine the overall tax liability

See SG 10.28 for example

Calculating CGT (pre 21 sept 1999 assets) indexation method – SG 10.29

See SG 10.29

10.6.3 Earnings from fixed interest investments – SG 10.31

Dixed interest income is fully assessable in the year it is paid and taxable at the investor’s marginal rate

True return needs to take into account individuals relevant tax rate i.e. interest income x marginal tax rate

See example 10.31

10.7 Supervision of derivatives trading – SG 10.31

ASX supervises market behavior of it’s participants

ASIC regulates Australia’s futures markets

ASX24 has additional rules being:

Conduct markets in fair, orderly and transparent manner to protect interests of participants and general public

Formulate rules and supervision governing the operations of futures markets

Lay code of behavior

Provide necessary organization and support facilities to achieve the above three aims

10.7.1 ASX24 Operating Rules – SG 10.32

See SG 10.32

10.7.2 contract Specifications and associated rules – SG 10.32

See SG 10.32

10.7.3 Trading principles – SG 10.32

See SG 10.32

10.7.4 ASX24 Trading Participants – SG 10.32

2 categories:

                Full participants – Trade themselves and clients

                Full proprietary participants – Trade themselves

Clearing participants – SG 10.32

Admission criteria – SG 10.33

10.7.5 Client agreement and trading behavior of participants – SG 10.33

See SG 10.33

10.7.6 Discipline of participants, penalties and code of behavior – SG 10.34

See SG 10.34

10.7.7 Trading on ASX24 – SG 10.35

See SG 10.35

Execution brokers and clearing brokers – SG 10.35

ASX and ASX24 trading system upgrade – SG 10.35

10.7.8 The Role of the clearing house – SG 10.36

See SG 10.36

10.7.9 ASX Clear (futures) – SG 10.36

ASX clear (futures) has full responsibility for the registration, clearing and processing of all trades executed on ASX24

Functions of ASX clear (futures) – SG 10.36

10.7.10 Initial Margin – SG 10.37

Every trader must pay an initial margin for each contract they trade

10.7.11 Variation Margins – SG 10.37

Any adverse price movements in market must be covered daily with further deposits known as variation margins

Marked to market – SG 10.37

10.7.12 Margin Calls – SG 10.38

Instruction seeking payment of a variation margin is called a Margin Call

10.7.13 Current developments in operating rules and market supervisions – SG 10.38

See SG 10.38

10.8 Conduct of derivatives business – SG 10.39

10.8.1 Confirmation of trades – SG 10.39

Issue of contract notes (containing: date of transaction, description of transaction, amounts paid or payable, taxed) – retail only

Protection of client money – maintains separate accounts for each customer (retail and wholesale)

Other conduct provisions – see SG 10.39

10.8.2 Introducing a client to the market – SG 10.40

See SG 10.40

10.8.3 Accounts and Audit – SG 10.40

Accounts to be kept by a licensee

Appointment of auditor by licensee

Licensee’s Account

Reporting Requirements

10.8.4 Compensation Arrangements – SG 10.41

10.8.5 Offence Provisions – SG 10.41

Offences:

Insider trading

Dishonest conduct

Trading intended to create an artificial price

False and misleading statements likely to induce persons to deal or to affect the price

Fraudulently inducing a person to deal in financial products

Misleading or deceptive conduct

10.8.6 Trading Requirements – SG 10.41

Licensees are required by the Corporations Act to give priority to client orders

See SG 10.41 for more

10.9 The OTC Market – SG 10.42

Derivatives traded OTC include:

Interest rate and currency swaps

Interest rate caps, collars and floors

Forward rate agreements (FRAs)

Swaptions

Currency options

Bond Options

Synthetic agreements for forward exchange

Equity derivatives

Commodity Transactions

Electricity derivatives

10.9.1 OTC documentation – SG 10.42

Use master agreement

International Swaps and Derivatives Association – SG 10.43

Structure of the ISDA Master Agreement – SG 10.43

Other Master Agreements – SG 10.43

*where there are inconsistencies between the master agreement and the schedule, the schedule prevails, where inconsistency between schedule and the confirmation the confirmation prevails

10.9.2 Processing derivative transactions – SG 10.44

See SG 10.44

10.9.3 Back Office (operations) – SG 10.45

Recording

Dealing ticket

Deal-time

Direct feed

Confirmation of transactions

Settlement of transactions

Reconciliation

10.9.4 Middle office – SG 10.46

10.9.5 Self Regulation – SG 10.47

10.10 Taxation issues to consider for derivatives – SG 10.47

See SG 10.47

10.11 regulation of managed investment schemes – SG 10.48

10.11.1 Duties of an RE

Act in best interests of investors

Act honestly

Exercise appropriate skill, care and diligence

Treat all investors fairly

Treat investors of same class equally

10.11.2 constitution – SG 10.48

10.11.3 Compliance committee – SG 10.48

10.11.4 Compliance Plan – SG 10.49

10.11.5 Custody of Assets – SG 10.49

10.11.6 withdrawing from a fund – SG 10.49

10.11.7 complaints procedures – SG 10.49

10.12 Product Disclosure Statements – SG 10.50

10.12.1 what is a Product Disclosure statement? – SG 10.50

A compulsory document that describes how a managed investment is structured and how its investment decisions are made

Mandatory since march 2004

Supplementary product disclosure statements – SG 10.50

Electronic product disclosure statements – SG 10.50

Short form product disclosure statements – SG 10.50

10.2.2 contents of a product disclosure statement – SG 10.51

See SG 10.51

Introduction to the responsible entity – SG 10.51

The investment style, strategy and general notes – SG 10.52

Summary – SG 10.52

Managed Investment details – SG 10.52

Investing in the Managed Investment –SG 10.53

Additional Information – SG 10.53

Application form – SG 10.53

10.12.3 Master Trusts and Investor directed Portfolio services – SG 10.54

See SG 10.54

10.12.4 How a product disclosure statement helps clients – SG 10.54

If investment is appropriate for them

Problems with PDS accessibility – SG 10.55

The importance of adviser compliance – SG 10.55

10.13 Taxation treatment of managed funds – SG 10.55

See SG 10.55

10.13.1 Income and Taxation – SG 10.56

Entitlement calculated either by:

Cents per unit

Cents per unit days

10.13.2 Tax components of income distributions – SG 10.56

Australian income

Imputation credits

Capital Gains

Foreign Income

Foreign Tax credits

10.13.3 Tax-paid managed investments – SG 10.57

Insurance and friendly society bonds

Tax free after 10 years

Withdrawal prior to 10 years – SG 10.58

Additional Contributions (the 125% rule) – SG 10.58

10.13.4 taxation issues surrounding property funds – SG 10.60

Depreciation benefits – SG 10.60

Tax-deferred income – SG 10.60

10.13.5 Other managed Investments – SG 10.60

10.13.6 Individually and separately managed accounts – SG 10.60     

Get back into shape – like everyone else.
See a psychic
Go to the theatre
Launch Equity Owl (http://www.equityowl.com/)
Get Zest KO (http://www.zestko.com) up and running
Do a Calligraphy class
Clean out clothes / junk never worn / used
Go Sailing
Holiday Overseas
See a live band (or two)

Anyone care to offer advice/help on any of the above?

Keep your head down.

This is a nice safe answer, but it doesn’t do much to turn a problem into a possible strength. If you follow these steps hopefully things can improve and quickly:

1. Stay quiet, be calm and controlled – Remember this person can significantly influence your future career in the company.

2. DO NOT argue with the characterisation of the situation – Having tried to use logical arguments in such situations (and confirmed by many others), let me advise you even if your manager is making wild accusations do not argue with them; it will only make things worse.

3. Fix it FAST (if possible) – You can take your destiny in your own hands, get the issue fixed, promptly, completely and fast. Can’t fix it? Get all the facts that led up to how the issue occurred then…. go to Step 4.

4. How can you prevent it next time – Start to see the positive’s admit your mistake and advise your manager what you have done to ensure it doesn’t occur again.

5. Do not share with the team – Don’t talk about the issue with your co-workers, chances are it’s not just your managers view of the world which is wrong…but yours as well. We are all human and our view of the world differs…especially when a mistake has been made. To make things worst imagine what would happen if your manager found out what you said? How much would your career be limited if your manager knew not only you discussed the altercation but you can’t be a trusted confidant.

6. DO NOT SHARE IT WITH HR – Ok things may have gotten heated, your manager may have lost their trolley, said you’re a horrible employee etc…. basically unless your manager has threatened your life (or your family) do not get HR involved, there isn’t much they can do to help the situation (if your life has been threatened then I’d suggest looking for a new role).

Above all else…

If you make a mistake admit it quickly and don’t try to hide it, your credibility is at stake.

Good luck in making mistakes.

The key to understanding why a stock picker like Warren Buffett made his best returns when he was investing in micro caps is understanding that a neglected stock is more likely to offer a mispriced bet.

The idea that there’s a trade-off between risk and return only makes sense if people are paying attention to a stock and correctly pricing it. In other words, the more people are correctly handicapping the situation, the more there is a trade-off between risk and return. The less people are correctly handicapping the situation, the less there is a trade-off between risk and return. This trade-off is not inherent to the situation itself. A fast horse and a slow horse – a good company and a bad company – only become equal in risk adjusted terms when the necessary and correct bets are placed to move the odds to the point that equalizes the expected payoff.

The trade-off between risk and return comes from price. And the price comes from the betting public placing their bets correctly so that favorites pay less and long shots pay more. If the public bets wrong, there is no trade-off between risk and return.

As Ben Graham said:

“…the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.”

In other words, objectively observed prices are the outputs of subjective analysis. Obviously, both the inputs and the black box – the human minds – into which the data is being input will together determine the market price.

People set prices using their minds.

And here’s the thing about minds. They work from experience. And they only experience what they pay attention to.

Here’s William James:

“…one sees how false a notion of experience that is which would make it tantamount to the mere presence to the senses of an outward order. Millions of items of the outward order are present to my senses which never properly enter into my experience. Why? Because they have no interest for me. My experience is what I agree to attend to. Only those items which I notice shape my mind – without selective interest, experience is an utter chaos.”

So prices depend on attention.

The mere presence of data means nothing. People have to read 10-Ks. And they have to care about them. If nobody pays attention to a 10-K, that 10-K doesn’t enter into a stock price. Because the data in a 10-K only moves stock prices through people’s minds.

If you want to think about it like advertising you can. Some stocks are advertised by analysts and newspaper reporters and their own well-known consumer brands and products. Other stocks are unknown because they’re headquartered in the wrong state or wrong country, because they make stuff you’ve never heard of, and because you just aren’t paying attention to them.

Of course, even advertising is useless unless you pay attention to it. A lot of ads are forgotten immediately. And very few ads accomplish anything when shown just once. You might only pay attention to an ad the fifth time it crosses your path. Same thing with stocks. Unless you’re looking for them. Which works for ads too. If you can put an ad in front of someone who’s actively looking for that product, that ad has a good chance of being really effective. Most investors aren’t looking for micro cap stocks. So, it’s really hard to “advertise” micro caps and actually get someone’s attention.

Information about micro cap stocks just doesn’t percolate through the public quite the same way it does in big caps.

The best returns for Warren Buffett, Ben Graham – and yes – even me, come from investments where the public is not paying attention to the stock. It’s neglected. It’s under advertised. Information is being ignored. Maybe the stock is weirdly distributed by happenstance – as in a spin-off or a regionally owned stock.

Who knows?

What I do know is that the amount of attention a stock gets is going to skew who’s handicapping it.

With neglected stocks, most of the people setting the odds – through their bids and asks – are amateurs instead of professionals.

It’s easier to compete against grannies than hedgies.

So, instead of a correct trade-off between risk and return and fairly equal results for buyers and sellers – you end up with professionals, insiders, and people who spend hours hunting for these things winning a lot of money at the expense of amateurs who often know little and care little about the shares they’re selling.

I owned shares in a profitable company that continually bought back stock from its own shareholders at a price less than its net cash per share. There is no equality of risk and return in that situation. There is just the inequality of uninformed and unmotivated amateur investors losing more and more money in round after round of bad bets made against the company, insiders, professionals, and bargain hunters who read SEC reports.

In many cases, the sellers do not actually believe they are selling out at a fair price. They are not rational. They are demoralized.

Since I blog about micro caps, I’ve actually had the pleasure of talking to folks who I realized – after the fact – were on the other side of trades I made. We realized one of us was buying and the other selling during the same week. Essentially, we were sitting around the same poker table, or betting the same race, or whatever gambling analogy you want to use.

Where I was a buyer and they were a seller of a micro cap, I’ve never had the other guy tell me he thought he was getting fair value. I’ve never had someone tell me they thought the rest of the stock market was cheaper than what they sold.

Here’s Warren Buffett:

“In ‘74 you could have bought the Washington Post when the whole company was valued at $80 million. Now at that time the company was debt free, it owned the Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million….That is not a complicated story. We bought in 1974, from not more than 10 sellers, what was then 9% of the Washington Post Company, based on that valuation. And they were people like Scudder Stevens, and bank trust departments. And if you asked any of the people selling us the stock what the business was worth, they would have come up with an answer of $400 million.”

Buffett’s point is that people could appraise the company correctly. They just couldn’t think clearly about the stock. The stock price was set by all these crazy fears swirling around their heads. Intellectually, they knew the collection of properties the Washington Post owned could be sold for close to $400 million. But emotionally they didn’t want to hold the stock when it priced the company at just $80 million.

I see the same thing when people sell micro caps they know are good values. The seller never quite says the stock is overvalued. Or even fairly valued.

What they almost always say is how disgusted they are with the stock. How beaten down and mistreated and just kind of vaguely hopeless they’ve become.

They know the stock is cheap, but they don’t see a way out. They can’t visualize success.

I think this success visualization thing is actually a big part of why some neglected stocks offer such good returns. I don’t want to delve into people’s brains and dredge up some wild theories, but I can’t help but notice that most investors are obsessed with visualizing the exact scenario under which they win.

That’s whacky.

I’ve said before that about 1 in 5 of the stocks I buy ends up getting taken private or bought up by another company. Usually, I don’t plan this outcome ahead of time. I have done it a few times, and my record of buying into situations where a buyout seems likely is pretty mixed. Just buying stocks that are so cheap the buyout would happen at a 50% or 100% premium – that tends to work best whether or not the buyout ever comes.

People really do try to visualize success. They want to know the exact winning scenario.

It doesn’t work that way.

Whenever I’m tempted to visualize my success, I try to snap out of the daydream. I can’t control outcomes. I can only control process.

Visualizing success is a mental crutch. It biases you to seek out situations where the exit is clear instead of situations where the difference between value and price is greatest.

Visualizing owning the stock makes more sense. How will I feel when it’s down 20% next month. Will I buy more? What if they stop buying back stock? What if they suddenly dip into the red for a quarter, a year, or 3 years? What if they go cash flow negative? What if they actually issue more shares?

I visualize the things that I know will scare me the most. I try to avoid stocks where this bad stuff will happen. Not just because I think these are bad, bad things –but because I know I’m a wimp when it comes to these particular reversals.

I want to make sure I’m willing to hold a stock forever if need be.

I’ve tried to condition myself to work in a very specific way. I’ve tried to not focus on visualizing possible outcomes or thinking about catalysts and stuff like that. I have done that at times in stocks like Barnes & Noble (BKS) and look how well that worked out.

Instead I try to only think about owning the stock. I never think about my next move after that. I don’t have a game plan. I don’t have a strategy.

I have a principle. The principle is to always be in the best position. Always own the cheapest, highest quality businesses you can. If you can improve your position by selling one and buying another, do it.

But don’t think you’ve got the future figured out. Because I know I never do.

I’ve taken this approach to an absurd extreme lately.

I now appraise all my stocks apart from their current market value and prepare an actual account summary in non-market terms. Instead of just looking at the daily updated portfolio in terms of the market quote, I also list the net current assets and the 10-year average free cash flow for each stock and then multiply that by the number of shares I own of each stock and total it all up.

Sometimes it helps to see just how much cash, receivables, and inventory I own.

And how big a stream of look through free cash flow my portfolio should produce in a “normal” year.

It sounds silly. And it is. But we have to play these silly head games – or at least I do – or I might end up misthinking a stock in such a way that I do something stupid.

I take thinking about my own thinking very seriously. And I take micro caps very seriously.

Most investors don’t.

It’s understandable that professionals ignore micro caps. They can’t put enough money to work there. But why do individual investors seem to buy and sell micro caps so glibly?

I don’t know.

I know from talking to some folks that the lack of press and analyst coverage is part of it. Often the same negatives like related party transactions, takeover defenses, and cash hoarding that occurs in lots of companies both big and small suddenly makes them very worried when it’s a micro cap. When analysts or the press write about these issues, they become less scary. I guess it’s fear of the unknown.

Actually, I don’t think so.

I’ve come to believe it’s just the lack of confirmation. When I write about a micro cap stock someone owns, they feel differently – better somehow – than when they find the micro cap themselves and never hear its name mentioned by another soul.

None of us like to feel alone. We start to question our sanity.

Personally, I’ve started to lean a bit the other way. When I read another value blogger – even one I respect tremendously – write about a micro cap I own, I start to question whether maybe we’re both fooling ourselves. I know how strong the urge is to welcome a familiar face to our little neglected stock owners support group. You have to find a way to offset that. A stock can’t rationally be any more attractive just because a blogger I like is buying it.

But emotionally it feels that way.

I think that’s the trade-off in neglected stocks. It’s not a trade-off between risk and return. It’s a trade-off between mental comfort and discomfort. Most people don’t feel good owning neglected stocks. They don’t feel comfortable.

When you’re alone in a room trying to think something through there’s often this mental tension, like your brain is going to snap, and the tendency is to quickly choose something – anything – just to make the tension go away.

Experts, analysts, friends, reporters – maybe even a simple product review – give us a convenient excuse to break that tension. We go: “Oh, good, they love the Nook. Now I can buy Barnes & Noble.”

With a neglected stock, there’s nothing outside your own mind that you can use to break the mental tension. You’re the only person reading about it. It’s just you and EDGAR. Your doubts can only be cleared up by your own thinking.

Prices are observed objectively but made subjectively.

Stock prices are determined not by the objective landscape but by the overlapping subjective mindscapes of the buyers and sellers.

People don’t just face a trade-off between risk and reward when they buy a stock. People also face a trade-off between brain pain and brain pleasure when they think about a stock.

There’s even a trade-off between using your scarce mental resources to pay attention to a stock or doing something else.

The best investments Warren Buffett and Ben Graham made were where they turned their attention – and allocated their scarce mental resources – to a stock nobody else was attending to.

Ben Graham’s investment in Northern Pipeline is a great example:

“One day I was looking through an annual report of the Interstate Commerce Commission to obtain certain detailed data regarding railroad companies. At the end of the volume I came across some statistics of the pipeline companies, which the tables said were ‘taken from their annual report to the Commission.’ It occurred to me that such reports might contain information not sent to stockholders…The next day I took the train to Washington…and asked to see the annual report of all eight pipeline companies…To my amazement I discovered that all of the companies owned huge amounts of the finest railroad bonds…Here was Northern Pipeline, selling at only $65 a share, paying a $6 dividend while holding some $95 in cash assets for each share…Talk about a bargain security!”

Nobody is saying neglected stocks are a free lunch.

I’m just saying folks are worried about the wrong trade-off. They’re imaging there’s this especially potent trade-off between risk and return in micro caps. Quite the opposite, the trade-off between risk and return is found most in big caps. The less risky they are, the less reward they offer. It’s amazing how well people handicap some of the blue chips.

The trade-off you need to worry about in neglected stocks like micro caps is different. It’s the trade-off Warren Buffett and Ben Graham made. They applied oodles of brain power to stocks nobody else was looking at. They bought things that didn’t offer any psychological solace in the form of acceptance by their peers or the ability to visualize future success. They turned their attention to things other people ignored.

Simply put, they behaved bizarrely.

They stood out from the crowd and risked looking foolish.

The trade-off these men accepted was that they could get market beating returns by taking on mental burdens. They either had to endure the brain pain or condition themselves not to feel it.

My advice to those who want to follow in the footsteps of Ben Graham and Warren Buffett is to condition yourself to buy the stocks everybody else is neglecting.

Don’t accept the trade-off between risk and return. Instead, choose to make the trade-off between feeling good and investing well.

Ben Graham took a train to Washington. Warren Buffett took out a newspaper ad to buy an illiquid stock.

These guys didn’t just pick different stocks. They thought differently about stocks.

They turned their attention to things nobody else was looking at.

You can to.

Just focus on neglected stocks.

===============================================
PsychoTactics Newsletter: From the Archives
Article: How To Retain 90% Of Everything You Learn
===============================================

Note: If you would prefer this newsletter via RSS please register
at http://www.psychotactics.com/blog. This text-only format is
for those who prefer text and for those who read email on their
smartphones.

If you’d like to unsubscribe from this newsletter, simply scroll
right to the bottom of this email, and unsubscribe.

===============================================

Article: How To Retain 90% Of Everything You Learn

http://www.psychotactics.com/blog/art-retain-learning

===============================================

Imagine if you had a bucket of water. And every time you attempted
to fill the bucket, 90% of the water would leak out instantly.
Every time, all you’d retain was a measly 10%. How many times would
you keep filling the bucket?

===============================================
The answer is simple: just once.
===============================================

The first time you noticed the leak, you’d take action
You’d either fix the bucket or you’d get another bucket, wouldn’t
you?

===============================================
Yet that’s not at all the way we learn.
===============================================
Almost all of us waste 90% of our time, resources and learning
time, because we don’t understand a simple concept called the
Learning Pyramid. The Learning Pyramid was developed way back in
the 1960s by the NTL Institute in Bethel, Maine. And if you look at
the pyramid you’ll see something really weird.

That weird thing is that you’re wasting time. You’re wasting
resources. You’re just doing everything you can to prevent
learning. And here’s why.

===============================================
To summarize the numbers (which sometimes get cited differently)
learners retain approximately:
===============================================
90% of what they learn when they teach someone else/use immediately.
75% of what they learn when they practice what they learned.
50% of what they learn when engaged in a group discussion.
30% of what they learn when they see a demonstration.
20% of what they learn from audio-visual.
10% of what they learn when they’ve learned from reading.
5% of what they learn when they’ve learned from lecture.

===============================================
So why do you retain 90% when you teach someone else or when you
implement it immediately?
===============================================

There’s a good reason why. When you implement or teach, you
instantly make mistakes. Try it for yourself. (In this article for
instance, after I’d read the information, I cited the loss rate as
95% instead of 90% to begin with. I had to go back and correct
myself. Then I found three more errors, which I had to fix. These
were factual errors that required copy and paste, but I still made
the errors).

So as soon as you run into difficulty and start to make mistakes,
you have to learn how to correct the mistake. This forces your
brain to concentrate.

But surely your brain is concentrating in a lecture or while reading
Sure it is, but it’s not making any mistakes. What your brain hears
or sees is simply an abstract concept. And no matter how clearly
the steps are outlined, there is no way you’re going to retain the
information. There are two reasons why.

Reason 1: Your brain gets stuck at the first obstacle.
Reason 2: Your brain needs to make the mistake first hand.

===============================================
Reason 1: Your brain gets stuck at the first obstacle.
===============================================

Yes it does. And the only way to understand this concept is to pick
up a book, watch a video, or listen to audio. Any book, any video,
any audio. And you’ll find you’ve missed out at least two or three
concepts in just the first few minutes. It’s hard to believe at
first, but as you keep reading the same chapter over and over,
you’ll find you’re finding more and more that you’ve missed. This
is because the brain gets stuck at the first new concept/obstacle.

It stops and tries to apply the concept but struggles to do so. But
you continue to read the book, watch the video or listen to the
speaker. The brain got stuck at the first point, but more points
keep coming. And of course, without complete information, you have
‘incomplete information’.

Incomplete information can easily be fixed by making the mistake
first hand.

===============================================
Reason 2: Your brain needs to make the mistake first hand
===============================================

No matter how good the explanation, you will not get it right the
first time. You must make the mistake. And this is because your
interpretation varies from the writer/speaker. You think you’ve
heard or read what you’ve heard/read. But the reality is different.

You’ve only interpreted what they’ve said, and more often than not,
the interpretation is not quite correct. You can only find out how
much off the mark you are by trying to implement or teach the
concept.

===============================================
So how do you avoid losing 90% of what you’ve learned?
===============================================

Well, do what I do. I learn something. I write it down in a
mindmap. I talk to my wife or clients about the concept. I write an
article about it. I do an audio. And so it goes. A simple concept
is never just learned. It needs to be discussed, talked, written,
felt etc. (I wrote this article, ten minutes after reading these
statistics online).

===============================================
The next time you pick up a book or watch a video, remember this.
===============================================

Listening or reading something is just listening or reading.
It’s not real learning.
Real learning comes from making mistakes.
And mistakes come from implementation.
And that’s how you retain 90% of everything you learn.

===============================================
Which is why most of the people you meet are always going around in
circles.
===============================================
They refuse to make mistakes. So they don’t learn.
They’d rather read a book instead. Or watch a video. Or listen to
an audio.

Their bucket is leaking 90% of the time.
But they don’t care.
The question is: Do you?

=======================================
Product Offers: Links you should visit
========================================

1) “Before I purchased the Brain Audit, I thought this is just
crazy, I’ve got so much marketing material that I still haven’t
implemented”.

But right from Sean’s first story and metaphor, I could see this
was different. I was hooked. The Brain Audit challenged virtually
every principle of marketing I’d grown up with. Like selling
benefit or never starting with a negative or problem.

And it’s this refreshing, innovative approach that makes the Brain
Audit a must buy for anyone who is really serious about challenging
the status quo and taking their business to new heights.

Already we’ve applied the principles to one of our workshops and
the response has been fantastic. The Brain Audit and our ongoing
association with Sean has been one of the best business decisions
we’ve every made.

Paul Mitchell, Managing Director, The Human Enterprise, Australia
Judge for yourself at http://www.psychotactics.com/brainaudit

===============================================
2) NEW PRODUCTS: Under $50
===============================================

a) NEW!  Do You Often Hit A Wall Called ‘Writers Block’?
Some days do you feel like you just can’t get started? Learn how the
core elements of outlining can save you from the misery of writing
your next article.
Find out more http://www.psychotactics.com/article-outlining

b) Get ready for 2011!
So year after year you sit down and create a list of things you
want to achieve. Then suddenly it’s March, and you’ve not really
moved ahead as you’d expected.  Find out  Why Most Planning Fails:
The Critical Importance of Chaos in Planning

http://www.psychotactics.com/chaos-planning

b) Nothing bugs you more than a painful client. A client who
hassles you at every step of the way. Learn how to use
the power of the ‘six critical questions’ to get incredible
testimonials–and attract clients that make every day an
absolute joy.

http://www.psychotactics.com/testimonialsecrets

c) Yes, you needs visuals on your sales page, but how do you use
visuals to immediately improve your sales conversion?

http://www.psychotactics.com/visuals-help-conversion

d) Does your websites, brochures, presentations, etc..confuse your
clients? Put sanity into your design with some really simple tweaks.

http://www.psychotactics.com/design-clarity

I hope you find the article useful.
Travis Lepp works for Enunc8 – http://www.enunc8.com a company that provides reporting and analytics to Small to Medium Enterprises.

Despite all the advertising, the QR listing is not attractive for the average retail punter. It’s certainly not cheap and there’s plenty of risk to be overcome in getting performance up to the level that will pay decent dividends.
The QR national float goes down to the (railway) line for retail investors this Friday, the offer closing on the 12th with still no certainty over pricing.

In fact, there’s increased uncertainty given reports that some institutional investors intend bidding less than the proposed minimum price of $2.50 a share. Those reports briefly breathed some life into the QR offer that had been slipping away as the more it was examined, the more expensive it seems to those not being paid to promote it.

As previously written, despite all the advertising, the QR listing is not attractive for the average retail punter. It’s certainly not cheap and there’s plenty of risk to be overcome in getting performance up to the level that will pay decent dividends. As part of a broad portfolio, as punt, well, maybe.

Last minute mission

Yet that Queensland political need remains for this listing not to be a complete dog. It will be a good performance to pull that off.

The QR heavies are on a last minute sales mission overseas, trying to drum up international support for the privatisation as a “safe” way to invest in the China story. With local institutions cool on the pricing, that foreign sales campaign will need to be convincing.

US and Asian investors are more comfortable than Australians with the idea of a company paying little or no dividend. For a start, they don’t have franked dividends – a big incentive for Australian firms to pay them – and there’s a tendency to look for companies that reinvest profits in further growth so that investors are rewarded by way of the shares appreciating for a capital gain.

Old fashioned capitalism

Apple, for example, the world’s second biggest company by market capitalisation and fabulously profitable, doesn’t pay dividends. Bill Gates’ Microsoft is a late comer to the dividend party. Rupert Murdoch’s News Corp is a miserable dividend payer – Rupert and sons don’t need much in the way of dividends anyway as they pay themselves right royally as directors.

And foreign investors are often more comfortable with higher price/earnings ratios than Australians. QR fits that category.

Yet, reviewing the most successful investing style over the past few decades, it’s been very old fashioned capitalism that has done best: a “boring” strategy of buying solid companies that pay good dividends has outperformed the fancier “growth” and “value” schools – although “value” investors often overlap with the dividend buyers.

Sitting on the sidelines

Which brings me back to what it’s like sitting on the sidelines with Friday’s QR deadline approaching. If the possibility of a lower listing price had been encouraged, I might well have been tempted to have a bet – but that has reportedly been scotched. The $2.50 floor price for institutions apparently remains, meaning a $2.40 minimum for retail investors.

At that price, I think I’ll sit it out. QR might well prove to be all right at $2.40 – but it might not. The risk/reward balance doesn’t quite do it for me as a retail investor.

This pretty much echo’s my post on the 13th 2010 (http://travislepp.wordpress.com/2010/10/13/qr-national-be-part-of-something-thats-a-big-disappointment/).

I think the assets are sound but the price is to much, it may stag on listing and I hope it does as this will left the investment bankers hopes in other IPO’s which should lift Maquarie’s price. Apparently the QR in QRNational stands for Questionable Returns

Travis Lepp is an apple fan and managing director for http://www.enunc8.com. Enunc8 specialises in consolidating MYOB, Quicken and disparate Data in addition to web based analytics and reporting.

This valuation is NOT advice and provided as educational only (usually mine), it does not take into account your specific investment objectives, financial situation or financial needs. Before acting on the information you should consider if the analysis is accurate (it probably isn’t) and if the investment is appropriate for your investment needs. You need to also consider your financial situation and you should seek advice from a financial adviser and/or stockbroker.

I can give no guarantee of the accuracy of the information used, omitted, provided or considered in this analysis.

Or to put the information simply:

You should expect my analysis to contain mistakes and omissions, I’m not a professional stock picker nor do I hold an Australian Financial Services License. My work is merely for self education and should not be acted on by any persons (sane or insane) in any location so please don’t sue me.

As your aware I’ve been awaiting the QR National float for quite sometime with the intention to put a maximum of 50% of my portfolio into the stock.  For those that want the short answer, I plan on putting in a big fat $0.

Normally Government floats are a great investment for atleast a few years (think TLS in the early days). They are usually cheap, monopolistic assets, have a virtually guaranteed high dividend yield and provide a great opportunity for capital growth.

After wading through the massive prospectus (mostly a sales presentation) I have the following thoughts:
QRNational’s dividend yield is tiny
It is priced on a PER around 19 – aka not cheap (all ords average is 14).
The business needs massive capital investment in the short term
The forecasts look to high and efficiency gains look optimistic to me (I’m happy to be proven wrong)
It is being pitched as a growth stock and to me it doesn’t appear so.  The main revenue drivers will come from the price of coal, China growth and not QR’s ability to grow organically.

The stock my stag on listing based on the hype but over the long term there could be a different story.  At the time of writing you can buy Woolworths (with reliable income streams at a per of 17).

Regards,

Trav

Travis Lepp is an apple fan and managing director for http://www.enunc8.com. Enunc8 specialises in consolidating MYOB, Quicken and disparate Data in addition to web based analytics and reporting.

It’s a great read on behavioural economics and how a modern country can get things so so wrong….

Onward to Michael Lewis….

As Wall Street hangs on the question “Will Greece default?,” the author heads for riot-stricken Athens, and for the mysterious Vatopaidi monastery, which brought down the last government, laying bare the country’s economic insanity. But beyond a $1.2 trillion debt (roughly a quarter-million dollars for each working adult), there is a more frightening deficit. After systematically looting their own treasury, in a breathtaking binge of tax evasion, bribery, and creative accounting spurred on by Goldman Sachs, Greeks are sure of one thing: they can’t trust their fellow Greeks.
By Michael Lewis•
Photograph by Jonas Fredwall Karlsson
October 1, 2010

VOW OF PROPERTY
Father Arsenios at the Vatopaidi monastery, overlooking the Aegean Sea, in Mount Athos, Greece. He is considered by many to be Vatopaidi’s C.F.O., “the real brains of the operation.”

After an hour on a plane, two in a taxi, three on a decrepit ferry, and then four more on buses driven madly along the tops of sheer cliffs by Greeks on cell phones, I rolled up to the front door of the vast and remote monastery. The spit of land poking into the Aegean Sea felt like the end of the earth, and just as silent. It was late afternoon, and the monks were either praying or napping, but one remained on duty at the guard booth, to greet visitors. He guided me along with seven Greek pilgrims to an ancient dormitory, beautifully restored, where two more solicitous monks offered ouzo, pastries, and keys to cells. I sensed something missing, and then realized: no one had asked for a credit card. The monastery was not merely efficient but free. One of the monks then said the next event would be the church service: Vespers. The next event, it will emerge, will almost always be a church service. There were 37 different chapels inside the monastery’s walls; finding the service is going to be like finding Waldo, I thought.

“Which church?” I asked the monk.

“Just follow the monks after they rise,” he said. Then he looked me up and down more closely. He wore an impossibly long and wild black beard, long black robes, a monk’s cap, and prayer beads. I wore white running shoes, light khakis, a mauve Brooks Brothers shirt, and carried a plastic laundry bag that said eagles palace hotel in giant letters on the side. “Why have you come?” he asked.

How on earth do monks wind up as Greece’s best shot at a Harvard Business School case study? I work up the nerve to ask.

That was a good question. Not for church; I was there for money. The tsunami of cheap credit that rolled across the planet between 2002 and 2007 has just now created a new opportunity for travel: financial-disaster tourism. The credit wasn’t just money, it was temptation. It offered entire societies the chance to reveal aspects of their characters they could not normally afford to indulge. Entire countries were told, “The lights are out, you can do whatever you want to do and no one will ever know.” What they wanted to do with money in the dark varied. Americans wanted to own homes far larger than they could afford, and to allow the strong to exploit the weak. Icelanders wanted to stop fishing and become investment bankers, and to allow their alpha males to reveal a theretofore suppressed megalomania. The Germans wanted to be even more German; the Irish wanted to stop being Irish. All these different societies were touched by the same event, but each responded to it in its own peculiar way. No response was as peculiar as the Greeks’, however: anyone who had spent even a few days talking to people in charge of the place could see that. But to see just how peculiar it was, you had to come to this monastery.

Q&A: Michael Lewis talks about the banks that brought down Greece.

I had my reasons for being here. But I was pretty sure that if I told the monk what they were, he’d throw me out. And so I lied. “They say this is the holiest place on earth,” I said.

I’d arrived in Athens just a few days earlier, exactly one week before the next planned riot, and a few days after German politicians suggested that the Greek government, to pay off its debts, should sell its islands and perhaps throw some ancient ruins into the bargain. Greece’s new socialist prime minister, George Papandreou, had felt compelled to deny that he was actually thinking of selling any islands. Moody’s, the ratings agency, had just lowered Greece’s credit rating to the level that turned all Greek government bonds into junk—and so no longer eligible to be owned by many of the investors who currently owned them. The resulting dumping of Greek bonds onto the market was, in the short term, no big deal, because the International Monetary Fund and the European Central Bank had between them agreed to lend Greece—a nation of about 11 million people, or two million fewer than Greater Los Angeles—up to $145 billion. In the short term Greece had been removed from the free financial markets and become a ward of other states.

That was the good news. The long-term picture was far bleaker. In addition to its roughly $400 billion (and growing) of outstanding government debt, the Greek number crunchers had just figured out that their government owed another $800 billion or more in pensions. Add it all up and you got about $1.2 trillion, or more than a quarter-million dollars for every working Greek. Against $1.2 trillion in debts, a $145 billion bailout was clearly more of a gesture than a solution. And those were just the official numbers; the truth is surely worse. “Our people went in and couldn’t believe what they found,” a senior I.M.F. official told me, not long after he’d returned from the I.M.F.’s first Greek mission. “The way they were keeping track of their finances—they knew how much they had agreed to spend, but no one was keeping track of what he had actually spent. It wasn’t even what you would call an emerging economy. It was a Third World country.”

As it turned out, what the Greeks wanted to do, once the lights went out and they were alone in the dark with a pile of borrowed money, was turn their government into a piñata stuffed with fantastic sums and give as many citizens as possible a whack at it. In just the past decade the wage bill of the Greek public sector has doubled, in real terms—and that number doesn’t take into account the bribes collected by public officials. The average government job pays almost three times the average private-sector job. The national railroad has annual revenues of 100 million euros against an annual wage bill of 400 million, plus 300 million euros in other expenses. The average state railroad employee earns 65,000 euros a year. Twenty years ago a successful businessman turned minister of finance named Stefanos Manos pointed out that it would be cheaper to put all Greece’s rail passengers into taxicabs: it’s still true. “We have a railroad company which is bankrupt beyond comprehension,” Manos put it to me. “And yet there isn’t a single private company in Greece with that kind of average pay.” The Greek public-school system is the site of breathtaking inefficiency: one of the lowest-ranked systems in Europe, it nonetheless employs four times as many teachers per pupil as the highest-ranked, Finland’s. Greeks who send their children to public schools simply assume that they will need to hire private tutors to make sure they actually learn something. There are three government-owned defense companies: together they have billions of euros in debts, and mounting losses. The retirement age for Greek jobs classified as “arduous” is as early as 55 for men and 50 for women. As this is also the moment when the state begins to shovel out generous pensions, more than 600 Greek professions somehow managed to get themselves classified as arduous: hairdressers, radio announcers, waiters, musicians, and on and on and on. The Greek public health-care system spends far more on supplies than the European average—and it is not uncommon, several Greeks tell me, to see nurses and doctors leaving the job with their arms filled with paper towels and diapers and whatever else they can plunder from the supply closets.

“The Greek people never learned to pay their taxes …. because no one is ever punished. It’s like a gentleman not opening a door for a lady.”

Where waste ends and theft begins almost doesn’t matter; the one masks and thus enables the other. It’s simply assumed, for instance, that anyone who is working for the government is meant to be bribed. People who go to public health clinics assume they will need to bribe doctors to actually take care of them. Government ministers who have spent their lives in public service emerge from office able to afford multi-million-dollar mansions and two or three country homes.

Oddly enough, the financiers in Greece remain more or less beyond reproach. They never ceased to be anything but sleepy old commercial bankers. Virtually alone among Europe’s bankers, they did not buy U.S. subprime-backed bonds, or leverage themselves to the hilt, or pay themselves huge sums of money. The biggest problem the banks had was that they had lent roughly 30 billion euros to the Greek government—where it was stolen or squandered. In Greece the banks didn’t sink the country. The country sank the banks.
And They Invented Math!

The morning after I landed I walked over to see the Greek minister of finance, George Papaconstantinou, whose job it is to sort out this fantastic mess. Athens somehow manages to be bright white and grubby at the same time. The most beautiful freshly painted neoclassical homes are defaced with new graffiti. Ancient ruins are everywhere, of course, but seem to have little to do with anything else. It’s Los Angeles with a past.

At the dark and narrow entrance to the Ministry of Finance a small crowd of security guards screen you as you enter—then don’t bother to check and see why you set off the metal detector. In the minister’s antechamber six ladies, all on their feet, arrange his schedule. They seem frantic and harried and overworked … and yet he still runs late. The place generally seems as if even its better days weren’t so great. The furniture is worn, the floor linoleum. The most striking thing about it is how many people it employs. Minister Papaconstantinou (“It’s O.K. to just call me George”) attended N.Y.U. and the London School of Economics in the 1980s, then spent 10 years working in Paris for the O.E.C.D. (Organisation for Economic Co-operation and Development). He’s open, friendly, fresh-faced, and clean-shaven, and like many people at the top of the new Greek government, he comes across less as Greek than as Anglo—indeed, almost American.

When Papaconstantinou arrived here, last October, the Greek government had estimated its 2009 budget deficit at 3.7 percent. Two weeks later that number was revised upward to 12.5 percent and actually turned out to be nearly 14 percent. He was the man whose job it had been to figure out and explain to the world why. “The second day on the job I had to call a meeting to look at the budget,” he says. “I gathered everyone from the general accounting office, and we started this, like, discovery process.” Each day they discovered some incredible omission. A pension debt of a billion dollars every year somehow remained off the government’s books, where everyone pretended it did not exist, even though the government paid it; the hole in the pension plan for the self-employed was not the 300 million they had assumed but 1.1 billion euros; and so on. “At the end of each day I would say, ‘O.K., guys, is this all?’ And they would say ‘Yeah.’ The next morning there would be this little hand rising in the back of the room: ‘Actually, Minister, there’s this other 100-to-200-million-euro gap.’ ”

This went on for a week. Among other things turned up were a great number of off-the-books phony job-creation programs. “The Ministry of Agriculture had created an off-the-books unit employing 270 people to digitize the photographs of Greek public lands,” the finance minister tells me. “The trouble was that none of the 270 people had any experience with digital photography. The actual professions of these people were, like, hairdressers.”

By the final day of discovery, after the last little hand had gone up in the back of the room, a projected deficit of roughly 7 billion euros was actually more than 30 billion. The natural question—How is this possible?—is easily answered: until that moment, no one had bothered to count it all up. “We had no Congressional Budget Office,” explains the finance minister. “There was no independent statistical service.” The party in power simply gins up whatever numbers it likes, for its own purposes.

Once the finance minister had the numbers, he went off to his regularly scheduled monthly meetings with ministers of finance from all the European countries. As the new guy, he was given the floor. “When I told them the number, there were gasps,” he said. “How could this happen? I was like, You guys should have picked up that the numbers weren’t right. But the problem was I sat behind a sign that said GREECE, not a sign that said, THE NEW GREEK GOVERNMENT.” After the meeting the Dutch guy came up to him and said, “George, we know it’s not your fault, but shouldn’t someone go to jail?”

As he finishes his story the finance minister stresses that this isn’t a simple matter of the government lying about its expenditures. “This wasn’t all due to misreporting,” he says. “In 2009, tax collection disintegrated, because it was an election year.”

“What?”

He smiles.

“The first thing a government does in an election year is to pull the tax collectors off the streets.”

“You’re kidding.”

Now he’s laughing at me. I’m clearly naïve.
Fraternal Revenue Service

The costs of running the Greek government are only half the failed equation: there’s also the matter of government revenues. The editor of one of Greece’s big newspapers had mentioned to me in passing that his reporters had cultivated sources inside the country’s revenue service. They’d done this not so much to expose tax fraud—which was so common in Greece that it wasn’t worth writing about—but to find drug lords, human smugglers, and other, darker sorts. A handful of the tax collectors, however, were outraged by the systematic corruption of their business; it further emerged that two of them were willing to meet with me. The problem was that, for reasons neither wished to discuss, they couldn’t stand the sight of each other. This, I’d be told many times by other Greeks, was very Greek.

The evening after I met with the minister of finance, I had coffee with one tax collector at one hotel, then walked down the street and had a beer with another tax collector at another hotel. Both had already suffered demotions, after their attempts to blow the whistle on colleagues who had accepted big bribes to sign off on fraudulent tax returns. Both had been removed from high-status fieldwork to low-status work in the back office, where they could no longer witness tax crimes. Each was a tiny bit uncomfortable; neither wanted anyone to know he had talked to me, as they feared losing their jobs in the tax agency. And so let’s call them Tax Collector No. 1 and Tax Collector No. 2.

Tax Collector No. 1—early 60s, business suit, tightly wound but not obviously nervous—arrived with a notebook filled with ideas for fixing the Greek tax-collection agency. He just took it for granted that I knew that the only Greeks who paid their taxes were the ones who could not avoid doing so—the salaried employees of corporations, who had their taxes withheld from their paychecks. The vast economy of self-employed workers—everyone from doctors to the guys who ran the kiosks that sold the International Herald Tribune—cheated (one big reason why Greece has the highest percentage of self-employed workers of any European country). “It’s become a cultural trait,” he said. “The Greek people never learned to pay their taxes. And they never did because no one is punished. No one has ever been punished. It’s a cavalier offense—like a gentleman not opening a door for a lady.”

The scale of Greek tax cheating was at least as incredible as its scope: an estimated two-thirds of Greek doctors reported incomes under 12,000 euros a year—which meant, because incomes below that amount weren’t taxable, that even plastic surgeons making millions a year paid no tax at all. The problem wasn’t the law—there was a law on the books that made it a jailable offense to cheat the government out of more than 150,000 euros—but its enforcement. “If the law was enforced,” the tax collector said, “every doctor in Greece would be in jail.” I laughed, and he gave me a stare. “I am completely serious.” One reason no one is ever prosecuted—apart from the fact that prosecution would seem arbitrary, as everyone is doing it—is that the Greek courts take up to 15 years to resolve tax cases. “The one who does not want to pay, and who gets caught, just goes to court,” he says. Somewhere between 30 and 40 percent of the activity in the Greek economy that might be subject to the income tax goes officially unrecorded, he says, compared with an average of about 18 percent in the rest of Europe.

The easiest way to cheat on one’s taxes was to insist on being paid in cash, and fail to provide a receipt for services. The easiest way to launder cash was to buy real estate. Conveniently for the black market—and alone among European countries—Greece has no working national land registry. “You have to know where the guy bought the land—the address—to trace it back to him,” says the collector. “And even then it’s all handwritten and hard to decipher.” But, I say, if some plastic surgeon takes a million in cash, buys a plot on a Greek island, and builds himself a villa, there would be other records—say, building permits. “The people who give the building permits don’t inform the Treasury,” says the tax collector. In the apparently not-so-rare cases where the tax cheat gets caught, he can simply bribe the tax collector and be done with it. There are, of course, laws against tax collectors’ accepting bribes, explained the collector, “but if you get caught, it can take seven or eight years to get prosecuted. So in practice no one bothers.”

The systematic lying about one’s income had led the Greek government to rely increasingly on taxes harder to evade: real-estate and sales taxes. Real estate is taxed by formula—to take the tax collectors out of the equation—which generates a so-called “objective value” for each home. The boom in the Greek economy over the last decade caused the actual prices at which property changed hands to far outstrip the computer-driven appraisals. Given higher actual sales prices, the formula is meant to ratchet upward. The typical Greek citizen responded to the problem by not reporting the price at which the sale took place, but instead reporting a phony price—which usually happened to be the same low number at which the dated formula had appraised it. If the buyer took out a loan to buy the house, he took out a loan for the objective value and paid the difference in cash, or with a black-market loan. As a result the “objective values” grotesquely understate the actual land values. Astonishingly, it’s widely believed that all 300 members of the Greek Parliament declare the real value of their houses to be the computer-generated objective value. Or, as both the tax collector and a local real-estate agent put it to me, “every single member of the Greek Parliament is lying to evade taxes.”

On he went, describing a system that was, in its way, a thing of beauty. It mimicked the tax-collecting systems of an advanced economy—and employed a huge number of tax collectors—while it was in fact rigged to enable an entire society to cheat on their taxes. As he rose to leave, he pointed out that the waitress at the swanky tourist hotel failed to provide us with a receipt for our coffees. “There’s a reason for that,” he said. “Even this hotel doesn’t pay the sales tax it owes.”

I walked down the street and found waiting for me, in the bar of another swanky tourist hotel, the second tax collector. Tax Collector No. 2—casual in manner and dress, beer-drinking, but terrified that others might discover he had spoken to me—also arrived with a binder full of papers, only his was stuffed with real-world examples not of Greek people but Greek companies that had cheated on their taxes. He then started to rattle off examples (“only the ones I personally witnessed”). The first was an Athenian construction company that had built seven giant apartment buildings and sold off nearly 1,000 condominiums in the heart of the city. Its corporate tax bill honestly computed came to 15 million euros, but the company had paid nothing at all. Zero. To evade taxes it had done several things. First, it never declared itself a corporation; second, it employed one of the dozens of companies that do nothing but create fraudulent receipts for expenses never incurred and then, when the tax collector stumbled upon the situation, offered him a bribe. The tax collector blew the whistle and referred the case to his bosses—whereupon he found himself being tailed by a private investigator, and his phones tapped. In the end the case was resolved, with the construction company paying 2,000 euros. “After that I was taken off all tax investigations,” said the tax collector, “because I was good at it.”

He returned to his thick binder full of cases. He turned the page. Every page in his binder held a story similar to the one he had just told me, and he intended to tell me all of them. That’s when I stopped him. I realized that if I let him go on we’d be there all night. The extent of the cheating—the amount of energy that went into it—was breathtaking. In Athens, I several times had a feeling new to me as a journalist: a complete lack of interest in what was obviously shocking material. I’d sit down with someone who knew the inner workings of the Greek government: a big-time banker, a tax collector, a deputy finance minister, a former M.P. I’d take out my notepad and start writing down the stories that spilled out of them. Scandal after scandal poured forth. Twenty minutes into it I’d lose interest. There were simply too many: they could fill libraries, never mind a magazine article.

The Greek state was not just corrupt but also corrupting. Once you saw how it worked you could understand a phenomenon which otherwise made no sense at all: the difficulty Greek people have saying a kind word about one another. Individual Greeks are delightful: funny, warm, smart, and good company. I left two dozen interviews saying to myself, “What great people!” They do not share the sentiment about one another: the hardest thing to do in Greece is to get one Greek to compliment another behind his back. No success of any kind is regarded without suspicion. Everyone is pretty sure everyone is cheating on his taxes, or bribing politicians, or taking bribes, or lying about the value of his real estate. And this total absence of faith in one another is self-reinforcing. The epidemic of lying and cheating and stealing makes any sort of civic life impossible; the collapse of civic life only encourages more lying, cheating, and stealing. Lacking faith in one another, they fall back on themselves and their families.

The structure of the Greek economy is collectivist, but the country, in spirit, is the opposite of a collective. Its real structure is every man for himself. Into this system investors had poured hundreds of billions of dollars. And the credit boom had pushed the country over the edge, into total moral collapse.
Road to Perdition

Knowing nothing else about the Vatopaidi monastery except that, in a perfectly corrupt society, it had somehow been identified as the soul of corruption, I made my way up to the north of Greece, in search of a bunch of monks who had found new, improved ways to work the Greek economy. The first stage was fairly easy: the plane to Greece’s second city of Thessaloniki, the car being driven along narrow roads at nerve-racking speeds, and a night with a lot of Bulgarian tourists at a surprisingly delightful hotel in the middle of nowhere, called the Eagles Palace. There the single most helpful hotel employee I have ever met (ask for Olga) handed me a stack of books and said wistfully how lucky I was to be able to visit the place. The Vatopaidi monastery, along with 19 others, was built in the 10th century on a 37-mile-long-by-6-mile-wide peninsula in northeast Greece, called Mount Athos. Mount Athos now is severed from the mainland by a long fence, and so the only way onto it is by boat, which gives the peninsula the flavor of an island. And on this island no women are allowed—no female animals of any kind, in fact, except for cats. The official history ascribes the ban to the desire of the church to honor the Virgin; the unofficial one to the problem of monks hitting on female visitors. The ban has stood for 1,000 years.

This explains the high-pitched shrieks the next morning, as the ancient ferry packed with monks and pilgrims pulls away from the docks. Dozens of women gather there to holler at the tops of their lungs, but with such good cheer that it is unclear whether they are lamenting or celebrating the fact that they cannot accompany their men. Olga has told me that she was pretty sure I was going to need to hike some part of the way to Vatopaidi, and that the people she has seen off to the holy mountain don’t usually carry with them anything so redolent of the modern material world as a wheelie bag. As a result, all I have is an Eagles Palace plastic laundry bag with spare underwear, a toothbrush, and a bottle of Ambien.

The ferry chugs for three hours along a rocky, wooded, but otherwise barren coastline, stopping along the way to drop monks and pilgrims and guest workers at other monasteries. The sight of the first one just takes my breath away. It’s not a building but a spectacle: it’s as if someone had taken Assisi or Todi or one of the other old central-Italian hill towns and plopped it down on the beach, in the middle of nowhere. Unless you know what to expect on Mount Athos—it has been regarded by the Eastern Orthodox Church for more than a millennium as the holiest place on earth, and it enjoyed for much of that time a symbiotic relationship with Byzantine emperors—these places come as a shock. There’s nothing modest about them; they are grand and complicated and ornate and obviously in some sort of competition with one another. In the old days, pirates routinely plundered them, and you can see why: it would be almost shameful not to, for a pirate.

There are many places in the world where you can get away with not speaking Greek. Athens is one of them; the Mount Athos ferryboat is not. I am saved by an English-speaking young man who, to my untrained eye, looks like any other monk: long dark robes, long dark shaggy beard, fog of unfriendliness which, once penetrated, evaporates. He spots me using a map with thumbnail sketches of the monasteries and trying to determine where the hell I am meant to get off the boat: he introduces himself. His name is Cesar; he’s Romanian, the son of a counter-espionage secret-policeman in the nightmarish regime of Nicolae Ceaus,escu. Somehow he has retained his sense of humor, which counts as some kind of miracle. He explains that if I knew anything about anything I would know that he was no monk, merely another Romanian priest on holiday. He’s traveled from Bucharest, with two enormous trunks on wheelies, to spend his summer vacation in one of the monasteries. Three months living on bread and water with no women in sight is his idea of a vacation. The world outside Mount Athos he finds somehow lacking.

“The Greek newspapers, they call us a corporation, but I ask you, Michael, what company has lasted for 1,000 years?” says Father Arsenios.

Cesar draws me a little map to use to get to Vatopaidi and gives me a more general lay of the land. The mere fact that I don’t have a beard will expose me as a not terribly holy man, he explains, if my mauve Brooks Brothers shirt doesn’t do it first. “But they are used to having visitors,” he said, “so it shouldn’t be a problem.” Then he pauses and asks, “But what is your religion?”

“I don’t have one.”

“But you believe in God?”

“No.”

He thinks this over.

“Then I’m pretty sure they can’t let you in.”

He lets the thought sink in, then says. “On the other hand, how much worse could it get for you?” he says, and chuckles.

An hour later I’m walking off the ferry holding nothing but the Eagles Palace hotel laundry bag and Cesar’s little map, and he’s still repeating his own punch line—“How much worse could it get for you?”—and laughing more loudly each time.

The monk who meets me at Vatopaidi’s front gate glances at the laundry bag and hands me a form to fill in. An hour later, having pretended to settle into my surprisingly comfortable cell, I’m carried by a river of bearded monks through the church door. Fearing that I might be tossed out of the monastery before I got a sense of the place, I do what I can to fit in. I follow the monks into their church; I light candles and jam them into a tiny sandpit; I cross myself incessantly; I air-kiss the icons. No one seems to care one way or the other about the obviously not Greek guy in the mauve Brooks Brothers shirt, though right through the service a fat young monk who looks a bit like Jack Black glares at me, as if I was neglecting some critical piece of instruction.

Otherwise the experience was sensational, to be recommended to anyone looking for a taste of 10th-century life. Beneath titanic polished golden chandeliers, and surrounded by freshly cleaned icons, the monks sang; the monks chanted; the monks vanished behind screens to utter strange incantations; the monks shook what sounded like sleigh bells; the monks floated by waving thuribles, leaving in their wake smoke and the ancient odor of incense. Every word that was said and sung and chanted was Biblical Greek (it seemed to have something to do with Jesus Christ), but I nodded right along anyway. I stood when they stood, and sat when they sat: up and down we went like pogos, for hours. The effect of the whole thing was heightened by the monks’ magnificently wild beards. Even when left to nature, beards do not all grow in the same way. There are types: the hopelessly porous mass of fuzz; the Osama bin Laden/Assyrian-king trowel; the Karl Marx bird’s nest. A surprising number of the monks resembled the Most Interesting Man in the World from the Dos Equis commercial. (“His beard alone has experienced more than a lesser man’s entire body.”)

The Vatopaidi monks have a reputation for knowing a lot more about you than you imagine they do, and for sensing what they do not know. A woman who runs one of the big Greek shipping firms told me over dinner in Athens that she had found herself seated on a flight not long ago beside Father Ephraim, the abbot of Vatopaidi (business class). “It was a very strange experience,” she said. “He knew nothing about me, but he guessed everything. My marriage. How I felt about my work. I felt that he completely knew me.” Inside their church I doubted their powers—in the middle of a great national scandal they have allowed a writer from VANITY FAIR, albeit one who has not formally announced himself, to show up, bunk down, and poke around their monastery without asking the first question.

But coming out of the church I finally get seized: a roundish monk with a salt-and-pepper beard and skin the color of a brown olive corners me. He introduces himself as Father Arsenios.
Grecian Formulas

For most of the 1980s and 1990s, Greek interest rates had run a full 10 percent higher than German ones, as Greeks were regarded as far less likely to repay a loan. There was no consumer credit in Greece: Greeks didn’t have credit cards. Greeks didn’t usually have mortgage loans either. Of course, Greece wanted to be treated, by the financial markets, like a properly functioning Northern European country. In the late 1990s they saw their chance: get rid of their own currency and adopt the euro. To do this they needed to meet certain national targets, to prove that they were capable of good European citizenship—that they would not, in the end, run up debts that other countries in the euro area would be forced to repay. In particular they needed to show budget deficits under 3 percent of their gross domestic product, and inflation running at roughly German levels. In 2000, after a flurry of statistical manipulation, Greece hit the targets. To lower the budget deficit the Greek government moved all sorts of expenses (pensions, defense expenditures) off the books. To lower Greek inflation the government did things like freeze prices for electricity and water and other government-supplied goods, and cut taxes on gas, alcohol, and tobacco. Greek-government statisticians did things like remove (high-priced) tomatoes from the consumer price index on the day inflation was measured. “We went to see the guy who created all these numbers,” a former Wall Street analyst of European economies told me. “We could not stop laughing. He explained how he took out the lemons and put in the oranges. There was a lot of massaging of the index.”

Which is to say that even at the time, some observers noted that Greek numbers never seemed to add up. A former I.M.F. official turned economic adviser to former Greek prime minister Konstantinos Mitsotakis turned Salomon Brothers analyst named Miranda Xafa pointed out in 1998 that if you added up all the Greek budget deficits over the previous 15 years they amounted to only half the Greek debt. That is, the amount of money the Greek government had borrowed to fund its operations was twice its declared shortfalls. “At Salomon we used to call [the head of the Greek National Statistical Service] ‘the Magician,’ ” says Xafa, “because of his ability to magically make inflation, the deficit, and the debt disappear.”

In 2001, Greece entered the European Monetary Union, swapped the drachma for the euro, and acquired for its debt an implicit European (read German) guarantee. Greeks could now borrow long-term funds at roughly the same rate as Germans—not 18 percent but 5 percent. To remain in the euro zone, they were meant, in theory, to maintain budget deficits below 3 percent of G.D.P.; in practice, all they had to do was cook the books to show that they were hitting the targets. Here, in 2001, entered Goldman Sachs, which engaged in a series of apparently legal but nonetheless repellent deals designed to hide the Greek government’s true level of indebtedness. For these trades Goldman Sachs—which, in effect, handed Greece a $1 billion loan—carved out a reported $300 million in fees. The machine that enabled Greece to borrow and spend at will was analogous to the machine created to launder the credit of the American subprime borrower—and the role of the American investment banker in the machine was the same. The investment bankers also taught the Greek-government officials how to securitize future receipts from the national lottery, highway tolls, airport landing fees, and even funds granted to the country by the European Union. Any future stream of income that could be identified was sold for cash up front, and spent. As anyone with a brain must have known, the Greeks would be able to disguise their true financial state for only as long as (a) lenders assumed that a loan to Greece was as good as guaranteed by the European Union (read Germany), and (b) no one outside of Greece paid very much attention. Inside Greece there was no market for whistle-blowing, as basically everyone was in on the racket.

That changed on October 4 of last year, when the Greek government turned over. A scandal felled the last government and sent Prime Minister Kostas Karamanlis packing, which perhaps is not surprising. What’s surprising was the nature of the scandal. In late 2008, news broke that Vatopaidi had somehow acquired a fairly worthless lake and swapped it for far more valuable government-owned land. How the monks did this was unclear—paid some enormous bribe to some government official, it was assumed. No bribe could be found, however. It didn’t matter: the furor that followed drove Greek politics for the next year. The Vatopaidi scandal registered in Greek public opinion like nothing in memory. “We’ve never seen a movement in the polls like we saw after the scandal broke,” the editor of one of Greece’s leading newspapers told me. “Without Vatopaidi, Karamanlis is still the prime minister, and everything is still going on as it was before.” Dimitri Contominas, the billionaire creator of a Greek life-insurance company and, as it happens, owner of the TV station that broke the Vatopaidi scandal, put it to me more bluntly: “The Vatopaidi monks brought George Papandreou to power.”

After the new party (the supposedly socialist Pasok) replaced the old party (the supposedly conservative New Democracy), it found so much less money in the government’s coffers than it had expected that it decided there was no choice but to come clean. The prime minister announced that Greece’s budget deficits had been badly understated—and that it was going to take some time to nail down the numbers. Pension funds and global bond funds and other sorts who buy Greek bonds, having seen several big American and British banks go belly-up, and knowing the fragile state of a lot of European banks, panicked. The new, higher interest rates Greece was forced to pay left the country—which needed to borrow vast sums to fund its operations—more or less bankrupt. In came the I.M.F. to examine the Greek books more closely; out went whatever tiny shred of credibility the Greeks had left. “How in the hell is it possible for a member of the euro area to say the deficit was 3 percent of G.D.P. when it was really 15 percent?” a senior I.M.F. official asks. “How could you possibly do something like that?”

Just now the global financial system is consumed with the question of whether the Greeks will default on their debts. At times it seems as if it is the only question that matters, for if Greece walks away from $400 billion in debt, then the European banks that lent the money will go down, and other countries now flirting with bankruptcy (Spain, Portugal) might easily follow. But this question of whether Greece will repay its debts is really a question of whether Greece will change its culture, and that will happen only if Greeks want to change. I am told 50 times if I am told once that what Greeks care about is “justice” and what really boils the Greek blood is the feeling of unfairness. Obviously this distinguishes them from no human being on the planet, and ignores what’s interesting: exactly what a Greek finds unfair. It’s clearly not the corruption of their political system. It’s not cheating on their taxes, or taking small bribes in their service to the state. No: what bothers them is when some outside party—someone clearly different from themselves, with motives apart from narrow and easily understood self-interest—comes in and exploits the corruption of their system. Enter the monks.

Among the first moves made by the new minister of finance was to file a lawsuit against the Vatopaidi monastery, demanding the return of government property and damages. Among the first acts of the new Parliament was to open a second investigation of the Vatopaidi affair, to finally nail down exactly how the monks got their sweet deal. The one public official who has been strung up—he’s had his passport taken away, and remains free only because he posted a bail of 400,000 euros—is an assistant to the former prime minister, Giannis Angelou, who stands accused of helping these monks.

In a society that has endured something like total moral collapse, its monks had somehow become the single universally acceptable target of moral outrage. Every right-thinking Greek citizen is still furious with them and those who helped them, and yet no one knows exactly what they did, or why.
Monk Business

Father Arsenios looks to be in his late 50s—though who knows, as their beards cause them all to look 20 years older. He’s about as famous as you can get, for a monk: everyone in Athens knows who he is. Mr. Inside, the consummate number two, the C.F.O., the real brains of the operation. “If they put Arsenios in charge of the government real-estate portfolio,” a prominent Greek real-estate agent said to me, “this country would be Dubai. Before the crisis.” If you are kindly disposed to these monks, Father Arsenios is the trusted assistant who makes possible the miraculous abbacy of Father Ephraim. If you are not, he’s Jeff Skilling to Ephraim’s Kenneth Lay.

I tell him who I am and what I do—and also that I have spent the past few days interviewing political types in Athens. He smiles, genuinely: he’s pleased I’ve come! “The politicians all used to come here,” he says, “but because of our scandal they don’t now. They are afraid of being seen with us!”

He escorts me into the dining hall and plants me at what appears to be the pilgrim’s table of honor, right next to the table filled with the top monks. Father Ephraim heads that table, with Arsenios beside him.

Most of what the monks eat they grow themselves within a short walk of the dining hall. Crude silver bowls contain raw, uncut onions, green beans, cucumbers, tomatoes, and beets. Another bowl holds bread baked by the monks, from their own wheat. There’s a pitcher of water and, for dessert, a soupy orange sherbet-like substance and dark honeycomb recently plundered from some beehive. And that’s pretty much it. If it were a restaurant in Berkeley, people would revel in the glorious self-righteousness of eating the locally grown; here the food just seems plain. The monks eat like fashion models before a shoot. Twice a day four days a week, and once a day for three: 11 meals, all of them more or less like this. Which raises an obvious question: Why are some of them fat? Most of them—maybe 100 out of the 110 now in residence—resemble their diet. Beyond thin: narrow. But a handful, including the two bosses, have an ampleness to them that cannot be explained by 11 helpings of raw onion and cucumber, no matter how much honeycomb they chew through.

After dinner the monks return to church, where they will remain chanting and singing and crossing and spraying incense until one in the morning. Arsenios grabs me and takes me for a walk. We pass Byzantine chapels and climb Byzantine stairs until we arrive at a door in a long Byzantine hall freshly painted but otherwise antique: his office. On the desk are two computers; behind it a brand-new fax machine—cum—printer; on top of it a cell phone and a Costco-size tub of vitamin-C pills. The walls and floor gleam like new. The cabinets exhibit row upon row of three-ring binders. The only sign that this isn’t a business office circa 2010 is a single icon over the desk. Apart from that, if you put this office side by side with the office of Greece’s minister of finance and asked which one housed the monk, this wouldn’t be it.

“There is more of a spiritual thirst today,” he says when I ask him why his monastery has attracted so many important business and political people. “Twenty or 30 years ago they taught that science will solve all problems. There are so many material things and they are not satisfying. People have gotten tired of material pleasures. Of material things. And they realize they cannot really find success in these things.” And with that he picks up the phone and orders drinks and dessert. Moments later a silver tray arrives, bearing pastries and glasses of what appears to be crème de menthe.

Thus began what became a three-hour encounter. I’d ask simple questions—Why on earth would anyone become a monk? How do you handle life without women? How do people who spend 10 hours a day in church find time to create real-estate empires? Where did you get the crème de menthe?—and he would answer in 20-minute-long parables in which there would be, somewhere, a simple answer. (For example: “I believe there are many more beautiful things than sex.”) As he told his stories he waved and jumped around and smiled and laughed: if Father Arsenios feels guilty about anything, he has a rare talent for hiding it. Like a lot of people who come to Vatopaidi, I suppose, I was less than perfectly sure what I was after. I wanted to see if it felt like a front for a commercial empire (it doesn’t) and if the monks seemed insincere (hardly). But I also wondered how a bunch of odd-looking guys who had walked away from the material world had such a knack for getting their way in it: how on earth do monks, of all people, wind up as Greece’s best shot at a Harvard Business School case study?

After about two hours I work up the nerve to ask him. To my surprise he takes me seriously. He points to a sign he has tacked up on one of his cabinets, and translates it from the Greek: the smart person accepts. the idiot insists.

He got it, he says, on one of his business trips to the Ministry of Tourism. “This is the secret of success for anywhere in the world, not just the monastery,” he says, and then goes on to describe pretty much word for word the first rule of improvisational comedy, or for that matter any successful collaborative enterprise. Take whatever is thrown at you and build upon it. “Yes … and” rather than “No … but.” “The idiot is bound by his pride,” he says. “It always has to be his way. This is also true of the person who is deceptive or doing things wrong: he always tries to justify himself. A person who is bright in regard to his spiritual life is humble. He accepts what others tell him—criticism, ideas—and he works with them.”

I notice now that his windows open upon a balcony overlooking the Aegean Sea. The monks are not permitted to swim in it; why, I never asked. Just like them, though, to build a beach house and then ban the beach. I notice, also, that I am the only one who has eaten the pastries and drunk the crème de menthe. It occurs to me that I may have just failed some sort of test of my ability to handle temptation.

“The whole government says they are angry at us,” he says, “but we have nothing. We work for others. The Greek newspapers, they call us a corporation. But I ask you, Michael, what company has lasted for 1,000 years?”

At that moment, out of nowhere, Father Ephraim walks in. Round, with rosy cheeks and a white beard, he is more or less the spitting image of Santa Claus. He even has a twinkle in his eye. A few months before, he’d been hauled before the Greek Parliament to testify. One of his interrogators said that the Greek government had acted with incredible efficiency when it swapped Vatopaidi’s lake for the Ministry of Agriculture’s commercial properties. He asked Ephraim how he had done it.

“Don’t you believe in miracles?” Ephraim had said.

“I’m beginning to,” said the Greek M.P.

When we are introduced, Ephraim clasps my hand and holds it for a very long time. It crosses my mind that he is about to ask me what I want for Christmas. Instead he says, “What is your faith?” “Episcopalian,” I cough out. He nods; he calibrates: it could be worse; it probably is worse. “You are married?” he asks. “Yes.” “You have children?” I nod; he calibrates: I can work with this. He asks for their names …
Notes on a Scandal

The second parliamentary inquiry into the Vatopaidi affair is just getting under way, and you never know what it may turn up. But the main facts of the case are actually not in dispute; the main question left to answer is the motives of the monks and the public servants who helped them. In the late 1980s, Vatopaidi was a complete ruin—a rubble of stones overrun with rats. The frescoes were black. The icons went uncared for. The place had a dozen monks roaming around its ancient stones, but they were autonomous and disorganized. In church jargon they worshipped idiorrhythmically—which is another way of saying that in their quest for spiritual satisfaction it was every man for himself. No one was in charge; they had no collective purpose. Their relationship to their monastery, in other words, was a lot like the relationship of the Greek citizen to his state.

That changed in the early 1990s, when a group of energetic young Greek Cypriot monks from another part of Athos, led by Father Ephraim, saw a rebuilding opportunity: a fantastic natural asset that had been terribly mismanaged. Ephraim set about raising the money to restore Vatopaidi to its former glory. He dunned the European Union for cultural funds. He mingled with rich Greek businessmen in need of forgiveness. He cultivated friendships with important Greek politicians. In all of this he exhibited incredible chutzpah. For instance, after a famous Spanish singer visited and took an interest in Vatopaidi, he parlayed the interest into an audience with government officials from Spain. They were told a horrible injustice had occurred: in the 14th century a band of Catalan mercenaries, upset with the Byzantine emperor, had sacked Vatopaidi and caused much damage. The monastery received $240,000 from the government officials.

Clearly one part of Ephraim’s strategy was to return Vatopaidi to what it had been for much of the Byzantine Empire: a monastery with global reach. This, too, distinguished it from the country it happened to be inside. Despite its entry into the European Union, Greece has remained a closed economy; it’s impossible to put one finger on the source of all the country’s troubles, but if you laid a hand on them, one finger would touch its insularity. All sorts of things that might be more efficiently done by other people they do themselves; all sorts of interactions with other countries that they might profitably engage in simply do not occur. In the general picture the Vatopaidi monastery was a stunning exception: it cultivated relations with the outside world. Most famously, until scandal hit, Prince Charles had visited three summers in a row, and stayed for a week each visit.

Relationships with the rich and famous were essential in Vatopaidi’s pursuit of government grants and reparations for sackings, but also for the third prong of its new management’s strategy: real estate. By far the smartest thing Father Ephraim had done was go rummaging around in an old tower where they kept the Byzantine manuscripts, untouched for decades. Over the centuries Byzantine emperors and other rulers had deeded to Vatopaidi various tracts of land, mainly in modern-day Greece and Turkey. In the years before Ephraim arrived, the Greek government had clawed back much of this property, but there remained a title, bestowed in the 14th century by Emperor John V Palaiologos, to a lake in northern Greece.

By the time Ephraim discovered the deed to the lake in Vatopaidi’s vaults, it had been designated a nature preserve by the Greek government. Then, in 1998, suddenly it wasn’t: someone had allowed the designation to lapse. Shortly thereafter, the monks were granted full title to the lake.

Back in Athens, I tracked down Peter Doukas, the official inside the Ministry of Finance first accosted by the Vatopaidi monks. Doukas now finds himself at the center of the two parliamentary investigations, but he had become, oddly, the one person in government willing to speak openly about what had happened. (He was by birth not an Athenian but a Spartan—but perhaps that’s another story.) Unlike most of the people in the Greek government, Doukas wasn’t a lifer but a guy who had made his fortune in the private sector, inside and outside of Greece, and then, in 2004, at the request of the prime minister, had taken a post in the Finance Ministry. He was then 52 years old and had spent most of his career as a banker with Citigroup in New York. He was tall and blond and loud and blunt and funny. It was Doukas who was responsible for the very existence of long-term Greek-government debt. Back when interest rates were low, and no one saw any risk in lending money to the Greek government, he talked his superiors into issuing 40- and 50-year bonds. Afterward the Greek newspapers ran headlines attacking him (DOUKAS MORTGAGES OUR CHILDREN’S FUTURE), but it was a very bright thing to have done. The $18 billion of long-term bonds now trade at 50 cents on the dollar—which is to say that the Greek government could buy them back on the open market. “I created a $9 billion trading profit for them,” says Doukas, laughing. “They should give me a bonus!”

Not long after Doukas began his new job, two monks showed up unannounced in his Finance Ministry office. One was Father Ephraim, of whom Doukas had heard; the other, unknown to Doukas but clearly the sharp end of the operation, a fellow named Father Arsenios. They owned this lake, they said, and they wanted the Ministry of Finance to pay them cash for it. “Someone had given them full title to the lake,” says Doukas. “What they wanted now was to monetize it. They came to me and said, ‘Can you buy us out?’ ” Before the meeting, Doukas sensed, they had done a great deal of homework. “Before they come to you they know a lot about you—your wife, your parents, the extent of your religious beliefs,” he said. “The first thing they asked me was if I wanted them to take my confession.” Doukas decided that it would be unwise to tell the monks his secrets. Instead he told them he would not give them money for their lake—which he still didn’t see how exactly they had come to own. “They seemed to think I had all this money to spend,” says Doukas. “I said, ‘Listen, contrary to popular opinion, there is no money in the Finance Ministry.’ And they said, ‘O.K., if you cannot buy us out, why can’t you give us some of your pieces of land?’ ”

This turned out to be the winning strategy: exchanging the lake, which generated no rents, for government-owned properties that did. Somehow the monks convinced government officials that the land around the lake was worth far more than the 55 million euros an independent appraiser later assessed its value as, and then used that higher valuation to ask for one billion euros’ worth of government property. Doukas declined to give them any of the roughly 250 billion euros’ worth controlled by the Ministry of Finance. (“No fucking way I’m doing that,” he says he told them.) The monks went to the source of the next most valuable land—farmlands and forests controlled by the Ministry of Agriculture. Doukas recalls, “I get a call from the Minister of Agriculture saying, ‘We’re trading them all this land, but it’s not enough. Why don’t you throw in some of your pieces of land, too?’ ” After Doukas declined, he received another call—this one from the prime minister’s office. Still he said no. Next he receives this piece of paper saying he’s giving the monks government land, and all he needs to do is sign it. “I said, ‘Fuck you, I’m not signing it.’ ”

And he didn’t—at least not in its original form. But the prime minister’s office pressed him; the monks, it seemed to Doukas, had some kind of hold on the prime minister’s chief of staff. That fellow, Giannis Angelou, had come to know the monks a few years before, just after he had been diagnosed with a life-threatening illness. The monks prayed for him; he didn’t die, but instead made a miraculous recovery. He had, however, given them his confession.

By now Doukas thought of these monks less as simple con men than the savviest businessmen he had ever dealt with. “I told them they should be running the Ministry of Finance,” he says. “They didn’t disagree.” In the end, under pressure from his boss, Doukas signed two pieces of paper. The first agreed not to challenge the monks’ ownership of the lake; the second made possible the land exchange. It did not give the monks rights to any lands from the Finance Ministry, but, by agreeing to accept their lake into the Ministry of Finance’s real-estate portfolio, Doukas enabled their deal with the minister of agriculture. In exchange for their lake the monks received 73 different government properties, including what had formerly been the gymnastics center for the 2004 Olympics—which, like much of what the Greek government built for the Olympic Games, was now empty and abandoned space. And that, Doukas assumed, was that. “You figure they are holy people,” he says. “Maybe they want to use it to create an orphanage.”

What they wanted to create, as it turned out, was a commercial-real-estate empire. They began by persuading the Greek government to do something it seldom did: to re-zone a lot of uncommercial property for commercial purposes. Above and beyond the lands they received in their swap—which the Greek Parliament subsequently estimated to be worth a billion euros—the monks, all by themselves, were getting 100 percent financing to buy commercial buildings in Athens, and to develop the properties they had acquired. The former Olympics gymnastics center was to become a fancy private hospital—with which the monks obviously enjoyed a certain synergy. Then, with the help of a Greek banker, the monks drew up plans for something to be called the Vatopaidi Real Estate Fund. Investors in the fund would, in effect, buy the monks out of the properties given to them by the government. And the monks would use the money to restore their monastery to its former glory.

From an ancient deed to a worthless lake the two monks had spun what the Greek newspapers were claiming, depending on the newspaper, to be a fortune of anywhere from tens of millions to many billions of dollars. But the truth was that no one knew the full extent of the monks’ financial holdings; indeed, one of the criticisms of the first parliamentary investigation was that it had failed to lay hands on everything the monks owned. On the theory that if you want to know what rich people are really worth you are far better off asking other rich people—as opposed to, say, journalists—I polled a random sample of several rich Greeks who had made their fortune in real estate or finance. They put the monk’s real-estate and financial assets at less than $2 billion but more than $1 billion—up from zero since the new management took over. And the business had started with nothing to sell but forgiveness.

The monks didn’t finish with church until one in the morning. Normally, Father Arsenios explained, they would be up and at it all over again at four. On Sunday they give themselves a break and start at six. Throw in another eight hours a day working the gardens, or washing dishes, or manufacturing crème de menthe, and you can see how one man’s idea of heaven might be another’s of hell. The bosses of the operation, Fathers Ephraim and Arsenios, escape this grueling regime roughly five days a month; otherwise this is the life they lead. “Most people in Greece have this image of the abbot as a hustler,” another monk, named Father Matthew, from Wisconsin, says to me in a moment of what I take to be candor. “Everyone in Greece is convinced that the abbot and Father Arsenios have their secret bank accounts. It’s completely mad if you think about it. What are they going to do with it? They don’t take a week off and go to the Caribbean. The abbot lives in a cell. It’s a nice cell. But he’s still a monk. And he hates leaving the monastery.”

The knowledge that I am meant to be back in the church at six in the morning makes it more, not less, difficult to sleep, and I’m out of bed by five. Perfect silence: it’s so rare to hear nothing that it takes a moment to identify the absence. Cupolas, chimneys, towers, and Greek crosses punctuate the gray sky. Also a pair of idle giant cranes: the freezing of the monks’ assets has halted restoration of the monastery. At 5:15 come the first rumblings from inside the church; it sounds as if someone is moving around the icon screens, the sweaty backstage preparations before the show. At 5:30 a monk grabs a rope and clangs a church bell. Silence again and then, moments later, from the monk’s long dormitory, the beep beep beep of electric alarm clocks. Twenty minutes later monks, alone or in pairs, stumble out of their dorm rooms and roll down the cobblestones to their church. It’s like watching a factory springing to life in a one-industry town. The only thing missing are the lunchpails.

Three hours later, in the car on the way back to Athens, my cell phone rings. It’s Father Matthew. He wants to ask me a favor. Oh no, I think, they’ve figured out what I’m up to and he’s calling to place all sorts of restrictions on what I write. They had, sort of, but he didn’t. The minister of finance insisted on checking his quotes, but the monks just let me run with whatever I had, which is sort of amazing, given the scope of the lawsuits they face. “We have this adviser in the American stock market,” says the monk. “His name is Robert Chapman. [I’d never heard of him. He turned out to be the writer of a newsletter about global finance.] Father Arsenios is wondering what you think of him. Whether he is worth listening to …”
The Bonfire of Civilization

The day before I left Greece the Greek Parliament debated and voted on a bill to raise the retirement age, reduce government pensions, and otherwise reduce the spoils of public-sector life. (“I’m all for reducing the number of public-sector employees,” an I.M.F. investigator had said to me. “But how do you do that if you don’t know how many there are to start with?”) Prime Minister Papandreou presented this bill, as he has presented everything since he discovered the hole in the books, not as his own idea but as a non-negotiable demand of the I.M.F. The general idea seems to be that while the Greek people will never listen to any internal call for sacrifice they might listen to calls from outside. That is, they no longer really even want to govern themselves.

Thousands upon thousands of government employees take to the streets to protest the bill. Here is Greece’s version of the Tea Party: tax collectors on the take, public-school teachers who don’t really teach, well-paid employees of bankrupt state railroads whose trains never run on time, state hospital workers bribed to buy overpriced supplies. Here they are, and here we are: a nation of people looking for anyone to blame but themselves. The Greek public-sector employees assemble themselves into units that resemble army platoons. In the middle of each unit are two or three rows of young men wielding truncheons disguised as flagpoles. Ski masks and gas masks dangle from their belts so that they can still fight after the inevitable tear gas. “The deputy prime minister has told us that they are looking to have at least one death,” a prominent former Greek minister had told me. “They want some blood.” Two months earlier, on May 5, during the first of these protest marches, the mob offered a glimpse of what it was capable of. Seeing people working at a branch of the Marfin Bank, young men hurled Molotov cocktails inside and tossed gasoline on top of the flames, barring the exit. Most of the Marfin Bank’s employees escaped from the roof, but the fire killed three workers, including a young woman four months pregnant. As they died, Greeks in the streets screamed at them that it served them right, for having the audacity to work. The events took place in full view of the Greek police, and yet the police made no arrests.

As on other days, the protesters have effectively shut down the country. The air-traffic controllers have also gone on strike and closed the airport. At the port of Piraeus, the mob prevents cruise-ship passengers from going ashore and shopping. At the height of the tourist season the tourist dollars this place so desperately needs are effectively blocked from getting into the country. Any private-sector employee who does not skip work in sympathy is in danger. All over Athens shops and restaurants close; so, for that matter, does the Acropolis.

The lead group assembles in the middle of a wide boulevard a few yards from the burned and gutted bank branch. That they burned a bank is, under the circumstances, incredible. If there were any justice in the world the Greek bankers would be in the streets marching to protest the morals of the ordinary Greek citizen. The Marfin Bank’s marble stoop has been turned into a sad shrine: a stack of stuffed animals for the unborn child, a few pictures of monks, a sign with a quote from the ancient orator Isocrates: “Democracy destroys itself because it abuses its right to freedom and equality. Because it teaches its citizens to consider audacity as a right, lawlessness as a freedom, abrasive speech as equality, and anarchy as progress.” At the other end of the street a phalanx of riot police stand, shields together, like Spartan warriors. Behind them is the Parliament building; inside, the debate presumably rages, though what is being said and done is a mystery, as the Greek journalists aren’t working, either. The crowd begins to chant and march toward the vastly outnumbered police: the police stiffen. It’s one of those moments when it feels as if anything might happen. Really, it’s just a question of which way people jump.

That’s how it feels in the financial markets too. The question everyone wants an answer to is: Will Greece default? There’s a school of thought that says they have no choice: the very measures the government imposes to cut costs and raise revenues will cause what is left of the productive economy to flee the country. The taxes are lower in Bulgaria, the workers more pliable in Romania. But there’s a second, more interesting question: Even if it is technically possible for these people to repay their debts, live within their means, and return to good standing inside the European Union, do they have the inner resources to do it? Or have they so lost their ability to feel connected to anything outside their small worlds that they would rather just shed themselves of the obligations? On the face of it, defaulting on their debts and walking away would seem a mad act: all Greek banks would instantly go bankrupt, the country would have no ability to pay for the many necessities it imports (oil, for instance), and the country would be punished for many years in the form of much higher interest rates, if and when it was allowed to borrow again. But the place does not behave as a collective; it lacks the monks’ instincts. It behaves as a collection of atomized particles, each of which has grown accustomed to pursuing its own interest at the expense of the common good. There’s no question that the government is resolved to at least try to re-create Greek civic life. The only question is: Can such a thing, once lost, ever be re-created?

Keywords
Business,
Michael Lewis

Yesterday I had a briefing with E.L & C Baillieu, mainly they just talked about the market environment for Australia and the world, key points:

They expect Australian interest rates to rise by 1% – 1.5% by the end of next year.
Continued volatility in Europe with small growth in the US, Australia should grow on the strength of the BRICS.
Australia economy to overheat based on our low unemployment rate, which will cause inflation to increase.

Stocks they like:
CPA
APA group
Adelaide Brighton cement
Brickworks
Dexus
Westfield
And the banks (they didn’t pick a favourite)

Stocks they didn’t like:
Telstra (they have had a sell on them for months) – their Dividend is unlikely to be able to be maintained, a few analysts have this view. The company is struggling to keep it’s existing customers and isn’t competing well with others.

In general they were down on the telco’s but liked some of the engineering companies who will be implementing the NBN.

At present they are expecting short term volatility in the markets, especially if Labour gets in due to the sovereign risk they have brought with the Resources Tax. Labour (under Krudd) scared a significant portion of foreign investment away from Australia for the short term; however with the new Resources Tax deal or the Libs getting in this should return to our market in the medium term.

Cheers,

trav

Travis Lepp is an apple fan and managing director for http://www.enunc8.com. Enunc8 specialises in consolidating MYOB, Quicken and disparate Data in addition to it’s web based analytics and reporting.

Invincible Apple: 10 Lessons From the Coolest Company Anywhere
By Farhad Manjoo (http://www.fastcompany.com/magazine/147/apple-nation.html)

On Wednesday, May 26, 2010, just after 2:30 p.m., the unthinkable happened: Apple became the largest company in the tech universe, and, after ExxonMobil, the second largest in the nation. For months, its market capitalization had hovered just under that of Microsoft — the giant that buried Apple and then saved it from almost certain demise with a $150 million investment in 1997. Now Microsoft gets in line with Google, Amazon, HTC, Nokia, and HP as companies that Apple seems bent on sidelining. The one-time underdog from Cupertino is the biggest music company in the world and soon may rule the market for e-books as well. What’s next? Farming? Toothbrushes? Fixing the airline industry?

Right now, it seems as if Apple could do all that and more. The company’s surge over the past few years has resembled a space-shuttle launch — a series of rapid, tightly choreographed explosions that leave everyone dumbfounded and smiling. The whole thing has happened so quickly, and seemed so natural, that there has been little opportunity to understand what we have been witnessing.

The company, its leader, and its products have become cultural lingua franca. Dell wants to be the Apple for business; Zipcar the Apple for car sharing. Industries such as health care and clean energy search for their own Steve Jobs, while comedian Bill Maher says the government would be better run if the Apple CEO were head of state. (The Justice Department and FTC, which are both investigating Apple’s tactics, might disagree.) A Minnesota Vikings fan dubs his team the “iTunes of quarterbacks,” serially sampling one track from a player’s career, as with Brett Favre, rather than buying the whole album as the Colts have done with Peyton Manning.

This shorthand is useful but tends to encourage a shallow notion of what it takes to emulate Apple. And Apple doesn’t delineate the key factors of its success. Those principles are more closely guarded than its product pipeline. Jobs did not comment for this article. On-the-record comments from the CEO occur in only the most orchestrated environments (at MacWorld, say, or in newsweekly magazine stories timed to new product announcements), or in late-night email messages that defy explication. When it comes to the special sauce that makes his company the paragon of U.S. and global business, the CEO is silent.

How does one become the “Apple of [insert industry here]“? After speaking with former employees, current partners, and others who have watched Apple for many years, it’s clear that the answers center around discipline, focus, long-term thinking, and a willingness to flout the rules that govern everybody else’s business. It’s an approach that’s difficult to discern and tougher to imitate. But everyone wants to give it a try. Here, then, is our report on the Apple playbook. Short of something falling into your hands in a Bay Area bar, this may be as close to the truth about Apple as you’re going to get.

{1} Go Into Your Cave

If Steve Jobs were an architect, he’d work at the futuristic glass-and-steel San Francisco offices of international architecture and design firm Eight Inc. The walls are bathed in white, and the vibe is akin to working behind the Genius Bar. Here, on the second floor, look to the back wall. There you’ll discover a frosted-glass door emblazoned with a white Apple logo. Behind it is Eight’s Apple team — a small group that has worked with the company since the late 1990s to conceive the look and feel of its “branded consumer experiences,” which include its trade shows, high-impact product announcements, and 287 retail stores. The door is locked.

What goes on behind the locked door? “We really can’t say too much,” says Wilhelm Oehl, a principal designer, when I visit him one cloudy spring afternoon. He describes his work with Apple in only the vaguest, most anodyne terms — to “redefine elegance,” to keep an “integrity of design” that “makes the product the hero.” Finally, Oehl mumbles, “We try to capture something that feels like magic.”

These frosted-glass doors, and similar ones all around the world protecting other caves of Apple thinkers, are emblematic of Apple’s fanaticism for secrecy. But those doors are more than mere paranoia. Apple sets its own agenda and tunes out the tech wags — competitors, industry observers, analysts, bloggers, and journalists like myself — who constantly spew torrents of advice, huzzahs, and brickbats in its direction. Behind its doors, Apple can ignore us all.

Jobs has never cared much about what the tech industry has to say. Back in the early 1980s, when he was leading the team building the Mac, Jobs would often give his engineers guidance on what the computer should look like. “Once, he saw a Cuisinart at Macy’s that he thought looked incredibly great,” says Andy Hertzfeld, one of the engineers on the original Mac team and the author of Revolution in the Valley: The Insanely Great Story of How the Mac Was Made. “And he had the designers change the Mac to look like that.” Another time, he wanted it to look like a Porsche.

Get the picture? Computers should be more like sports cars and kitchen appliances. That’s Apple’s audience: high-end mainstream, the folks who buy — or aspire to buy — Porsches. You don’t connect with those consumers by listening to Silicon Valley. Techies, even after all these years of Apple watching, still get bogged down in specs, speeds, and developer contracts. Magic doesn’t happen in an echo chamber.

{2} It’s Okay to Be King

Mike Evangelist (yep, that’s his name) still remembers one of his first meetings with Jobs. It took place in the Apple boardroom in early 2000, just a few months after Apple purchased the American division of Astarte, a German software company where Evangelist was an operations manager. Phil Schiller, Apple’s longtime head of marketing, put Evangelist on a team charged with coming up with ideas for a DVD-burning program that Apple planned to release on high-end Macs — an app that would later become iDVD.

“We had about three weeks to prepare,” Evangelist says. He and another employee went to work creating beautiful mock-ups depicting the perfect interface for the new program. On the appointed day, Evangelist and the rest of the team gathered in the boardroom. They’d brought page after page of prototype screen shots showing the new program’s various windows and menu options, along with paragraphs of documentation describing how the app would work.

“Then Steve comes in,” Evangelist recalls. “He doesn’t look at any of our work. He picks up a marker and goes over to the whiteboard. He draws a rectangle. ‘Here’s the new application,’ he says. ‘It’s got one window. You drag your video into the window. Then you click the button that says burn. That’s it. That’s what we’re going to make.’ “

“We were dumbfounded,” Evangelist says. This wasn’t how product decisions were made at his old company. Indeed, this isn’t how products are planned anywhere else in the industry.

The tech business believes in inclusive, bottom-up, wisdom-of-crowds innovation. The more latitude extended, the greater the next great thing will be. Nowhere is this ethos more celebrated than at Google, where employees are free to spend some of their working hours building anything that strikes their fancy. A few of these so-called 20%-time projects have become hits for Google, including Gmail and Google News.

Apple’s engineers spend 100% of their time making products planned by a small club of senior managers — and sometimes entirely by Jobs himself. The CEO appoints himself the de facto product manager for every important release; Jobs usually meets with the teams working on these new gadgets and apps once a week, and he puts their creations through the paces. “He gets very passionate,” Evangelist says. “He’ll say, ‘This is shit, we can do much better.’ “

How can it be wise for so few people to have the authority — not to mention the time — to make most of the creative decisions at a company as large as Apple? Bottlenecks do result. According to one former Apple engineer, a staff of about 10 “human interface” designers is in charge of the entire Mac operating system. With such a small group making decisions, Apple can put out only one or two new products a year.

But this approach works because Jobs and his team know exactly what they want. A more decentralized company like Google may launch dozens of products a year, but more of them fail. (Have you Waved much lately?) Apple hits for a high average. And Apple’s strong management keeps the troops focused. “Everybody knows what the plan is,” says Glenn Reid, a former Apple engineer who created iMovie and worked on several other iLife apps. “There’s very little infighting.”

“I still have the slides I prepared for that meeting, and they’re ridiculous in their complexity,” Evangelist says, remembering how everyone in the room understood, immediately, that Jobs’s rectangle was right. “All this other stuff was completely in the way.”

{3} Transcend Orthodoxy

A battle rages in the tech industry, fought on the side of “good” by those who believe that software should be “open” — in other words, accessible to developers of all stripes — and on the other by misanthropes who feel that it’s fine to limit development. Techies generally believe that open is not only trendy but virtuous. Google trumpets that its Android phone is more open than the iPhone. Adobe brags that because its software tools help developers create write-once, run-anywhere software, it is the epitome of openness. Apple counters that it wants to replace Adobe’s proprietary Flash with HTML5 and H.264, which are actually open Internet standards. Nonetheless, Apple is perceived as being closed. Cory Doctorow, author and co-editor of the widely noted tech blog Boing Boing, distilled the anti-Apple argument into a single line: “If you want to live in the creative universe where anyone with a cool idea can make it and give it to you to run on your hardware, the iPad isn’t for you.”

This argument may not engage you, and perhaps you even find it boring. That makes you just like Apple. Despite all the noise about Apple’s closed ideology, the company adopts positions based on whether they make for good products and good business: You know, like a results-focused company, not a dogmatic college philosophy major. For example, Apple happily accepted the music industry’s copy-protection requirements because they helped it successfully launch the iTunes store. When they no longer made business sense, it dropped them.

For Apple, the ideas of closed and free aren’t in conflict. “We’re just doing what we can to try and make [and preserve] the user experience we envision,” Jobs emailed Gawker blogger Ryan Tate, who had baited the CEO in the wake of Apple’s decision to ban Flash from the iPhone and iPad. “You can disagree with us, but our motives are pure.” The App Store, Jobs wrote Tate, offers “freedom from programs that steal your private data. Freedom from programs that trash your battery. Freedom from porn. Yep, freedom.”

Developers have griped loudly that the App Store is closed because it dictates how apps get built. But that’s misleading: The problem isn’t that it’s closed, but that its rules are arbitrary, hidden, and frequently changing. If Apple embraced transparency, it could avoid much of this debate. But fundamentally, who really cares about the verbiage? While the bloggers rage on, the App Store is a total success, and even its fiercest foes admit that it offers a dead-easy, totally fun way to find useful things to soup up your phone and tablet. For Apple, that’s the only philosophy that matters.

{4} Just Say No

The new MacBook Touch is bendable. Its single OLED screen features a flexible seam, allowing the machine to function as a laptop, a 13-inch tablet, or even a desktop, depending on how you flex it. The computer has half a dozen peripheral ports, includes a stylus, and comes in two colors. And, I should add, it doesn’t exist. It was designed by Tommaso Gecchelin, a student in Venice, Italy, who is unaffiliated with Apple, but is one of a growing subculture of people around the globe who create and share concept designs of the Apple products they’d like to see.

Although many of these illustrated fantasies are quite beautiful, and some are uncannily realistic, their fatal flaw is often the same. They’re larded with features. Apple is about less (those six ports on the MacBook Touch should have been a dead giveaway that this wasn’t an Apple product). Even Gecchelin concedes, “This is not the Apple philosophy.”

Jobs’s primary role at Apple is to turn things down. “He’s a filter,” says the Mac engineer Hertzfeld. Every day, the CEO is presented with ideas for new products and new features within existing ones. The default answer is no. Every engineer who has gone over a product with him has a story about how quickly Jobs reaches for the delete key. “I’m as proud of the products that we have not done as the ones we have done,” Jobs told an interviewer in 2004.

It’s not just Jobs’s consistent aversion to complexity that prompts him to say no. Apple thrives on high profit margins, and having the willpower to say no keeps production costs down. Eliminating features also helps build buzz. “The great thing about omitting a feature that people want is that then they start clamoring for it,” says Reid, the former Apple engineer. “When you give it to them in the next version, they’re even happier somehow.” Apple has pulled off this trick time and again, most recently with the iPhone OS 4. It includes multitasking, a feature that customers began asking for in 2007, intensifying their pleas after Palm debuted multitasking in its WebOS last year.

How could the iPhone not have something this elemental until its fourth generation? Or take the iPad: Really, no camera? In 2010? Even the iPad-adept 2-and-a-half-year-old girl in the YouTube video complained about it. Come on, Apple, what are you thinking?

Maybe it’s thinking of a reason for you to come back next year.

{5} Serve Your Customer. No, Really

Among the many angry customers whom Jeremy Derr encountered during his time as an Apple Genius, the one he remembers best is the professional photographer with the bad FireWire port. “This guy had been dealing with the issue for weeks, so by the time he came in, he was pretty distraught,” says Derr, who began working as a Genius at Apple’s Houston Galleria store in 2002. Derr determined that the machine would need to go in for service and the repair would take a week. “That’s when he absolutely lost it.”

However great your product, something will invariably go wrong — and as the classic customer-service maxim goes, only then will the customer take the true measure of your firm. In recent years, companies of all kinds — but especially Apple’s competitors in the computer and phone businesses — have adopted strategies that amount to customer avoidance rather than service. They shunt their customers off to outsourced call centers staffed with underpaid agents who read from scripts, or worse, send them to an online FAQ. When Google launched its Nexus One smartphone through its online store in January, it forgot to make any real people available to field support questions. It didn’t take long for the company’s online forums to be flooded with angry customers.

When Apple devised its retail strategy a decade ago, the company had a single overriding goal: to launch stores that were unlike anything that customers associated with the computer industry. Apple hired Ron Johnson from Target and George Blankenship from Gap. (Last year, Blankenship decamped to Microsoft’s new retail-store effort.) Johnson began by asking shoppers to name their best customer-service experience, and he found that most of them agreed on a single setting, the hotel concierge desk. Their effort to re-create the same friendliness you’d find in a Four Seasons Hotel lobby led to the Genius Bar, which Johnson calls the “heart and soul” of every Apple Store.

Geniuses will look at any Apple product for free, regardless of where you bought your item. They’ll take a stab at fixing non-Apple software, and they’ll even help customers with non-tech-support tasks. “I once helped a woman learn iMovie so she could record her wedding reception,” Derr says.

Apple doesn’t charge for any of this. Customers pay only for repairs on out-of-warranty goods, and Derr notes that Geniuses have almost total leeway to waive these fees. How can Apple afford to be so generous? “It’s a loss leader,” says Derr, who left the Apple Store in 2006 to start a software company. “Sometimes someone comes in for help and decides to buy something on the way out.”

That’s exactly what happened with Derr’s angry photographer. As the man ranted about being unable to do without his computer, Derr suggested that perhaps he should invest in another laptop as a backup. “It was like I’d said the magic words,” Derr says. The photographer left the store with a brand-new machine.

{6} Everything Is Marketing

Just as the Genius Bar has proved to be genius, the now-classic Apple slogan “Think Different” also turns out to be more than just words: The brains of Apple fans really are different. When Martin Lindstrom, a brand consultant and author of Buyology: The Truth and Lies About Why We Buy, examined those brains under a functional magnetic-resonance-imaging scanner, he discovered that Apple devotees are indistinguishable from those committed to Jesus. “Apple’s brand is so powerful that for some people it’s just like a true religion,” Lindstrom says.

Apple cultivates religious fervor among its adherents in a number of subtle ways, including its mysteriousness and its suggestion that customers are among the chosen ones. Perhaps most important, though, is Apple’s devotion to symbology. Its most effective marketing efforts, Lindstrom says, are built into the products themselves. Think of the iPod’s white earbuds, the Mac’s startup sound, or the unmistakable shape of the MacBook’s back panel. None of these choices were accidental. Apple understands the lasting power of sensory cues, and it goes out of its way to infuse everything it makes with memorable ideas that scream its brand.

This extends to the fanatic attention to detail that Apple brings to its biggest product launches. These usually commence after months, possibly years, of rumors (we’d been hearing about an Apple tablet since 2002). The actual launch day is choreographed like a dictator’s display of military splendor. One example: Apple buys up all the bus-stop ad space near the Yerba Buena Center for the Arts, the San Francisco venue where it has held its recent events. It then switches its posters while Jobs is speaking. So this past January 27, when I walked into Apple’s iPad debut, the street ads depicted something old; when I left, there’s the iPad everywhere you look. Study the iPad in the poster and its clock says 9:41 a.m. Why? Apple thought of that, too. That’s the exact moment that Jobs revealed the iPad to the world. Somewhere, Kim Jong-il is smiling. Who else but Apple orchestrates its branding to this nth degree?

There may be a limit to the value of Apple’s increasing cultural ubiquity. The company risks a Starbucksian-level backlash. This, Lindstrom says, is Apple’s main branding problem today. Once we’re all members of the church of Apple, will we all keep praying together? Or will the pioneers strike out in search of something less common, the next insanely great thing?

{7} Kill the Past

Don’t be surprised if Apple someday unveils a “desk-free” computer — a machine that lets you slump on the couch with a wireless keyboard while surfing on a giant projected screen. Or a surface that can recognize handwriting gestures, in order to let you sign your name on a touch screen without using a stylus. There may also be a bright future in three-dimensional computing. Instead of fussing with flat windows on your iMac, cubes, prisms, and pyramids would represent apps, and you’d rotate one in 3-D space to interact with different parts of the program.

More fanboy hallucinations? Nope. They’re all mentioned in recent Apple patent filings. We may never see any of these products, but no other company reimagines the fundamental parts of its business as frequently, and with as much gusto, as Apple does. In just the past few years, for instance, we saw the company remake its entire line of notebook computers by instituting a “unibody” production process. Now its computers are laser-cut out of a single slab of aluminum or polycarbonate plastic, a dramatic shift from the way the industry has made portables since their inception.

Apple disregards the entire concept of backward compatibility, which is both a blessing and a curse for rivals such as Microsoft. Over its history, Apple has adopted new operating systems and underlying chip architectures several times — decisions that rendered its installed base instantly obsolete. Jobs killed the floppy disk in the iMac, and he claimed that optical drives were on their way out with the MacBook Air. Now, with the company’s embrace of touch screens, Apple seems to be gunning for the mouse, a technology that it helped bring into wide use in the 1980s. Does this relentless eye toward the future always work? No. Jobs killed the arrow keys on the first Mac; Apple was forced to add them back in a later version, and it has kept them in all its Macs ever since.

More often, though, Apple’s willingness to abandon the past makes for better products. Nothing holds it back, so it can always stay on the edge of what’s technologically possible. Plus, the strategy forces the faithful to keep buying new versions. One Apple customer recently emailed Jobs to ask whether Apple would continue to support the first iPhone, which launched in 2007. Jobs’s response: “Sorry, no.”

{8} Turn Feedback Into Inspiration

Steve Jobs has often cited this quote from Henry Ford: “If I’d have asked customers what they wanted, they would have told me, ‘A faster horse!’ “

This is Jobs’s defense of Apple’s reluctance to listen to even its most passionate customers, and the line is a good one to remember the next time you’re considering a new round of focus groups. “The whole approach of the company is that people can’t really envision what they want,” says Reid. “They’ll tell you a bunch of stuff they want. Then if you build it, it turns out that’s not right. It’s hard to visualize things that don’t exist.”

But Jobs doesn’t exactly ignore customers; he uses their ideas as inspiration, not direction; as a means, not an end. Ever since the netbook boom began, many people have begged Apple to put out its own. These tiny, ultra-portable machines represented the fastest-growing segment of the PC business, and the company seemed to be missing out. Some people (yours truly included) even went so far as to hack PC netbooks in order to run the Mac OS. Jobs could not have been more dismissive. “We don’t know how to make a $500 computer that’s not a piece of junk,” he said of the prospect of an Apple netbook.

Cut to January 2010, and there’s Jobs unveiling a $500 computer that isn’t a piece of junk. But the iPad isn’t a netbook. It’s both more, and less — not just a faster horse.

{9} Don’t Invent, Reinvent

“Revolutionary” is one of Jobs’s favorite words. When he revealed the iPhone, he said, “Today, we are introducing three revolutionary products” (the punch line being that he debuted just one device with the power of three). Three years later, he introduced the iPad by saying, “We want to kick off 2010 by introducing a magical and revolutionary product.” He’s been doing this a long time: In 1989, he introduced the Next computer as the “next computing revolution.”

Revolutionary is a word that drives his critics batty. Jobs touts each creation as unique and original. Detractors insist that they all borrow freely from preexisting technologies. And it’s hard to argue, given that music players existed well before the iPod, and smartphones predate the iPhone. Some of those critics, most recently Nokia and HTC, have taken Apple to court for patent infringement, a charge that Apple is quite familiar with, having settled suits leveled against it relating to the iPod (paying $100 million to portable media maker Creative Technology) and the iPhone (Klausner Technologies, a patent holding firm, had a patent on visual voice mail).

This all depends on what your definition of revolutionary is. Apple’s talent is far more cunning and more profitable than mere infringement. To use a musical analogy, Apple’s specialty is the remix. It curates the best ideas bubbling up around the tech world and makes them its own. It’s also a great fixer, improving on everything that’s wrong with other similar products on the shelves. (One of the underrated joys of a Jobs product demo is the trash talking about what everyone else in the market doesn’t understand.)

The iPad is a perfect example. Much of it has been done before; Bill Gates demonstrated a Windows-based tablet in 2001, and he predicted that it would become the dominant computing format in five years’ time. Windows tablets flopped immediately. Why? First, Microsoft lamely re-created the desktop’s interface, and it required users to deal with a clunky stylus to get anything done. Gates also didn’t encourage developers to create tablet-specific apps. Indeed, as Dick Brass, a former Microsoft executive, wrote in The New York Times last February, Microsoft’s own Office team refused to modify the productivity suite for tablet computing.

Jobs saw that Apple could fix all these issues. The operating system: Apple had solved that problem, to great acclaim, with the iPhone. Interface: The iPhone’s multi-touch did away with the need for a stylus. Apps: The App Store had already proved remarkably capable of encouraging developers to create programs for a new gadget. All that, plus a lot of thinking about design and marketing, and voilà! A tablet that the whole world finally wanted. Was the iPad truly a “new” device? Does it even matter? Apple sold 2 million of them in the first 60 days.

{10} Play by Your Own Clock

A few weeks after the iPad hit the shelves, word leaked that HP had decided to delay and retool the Slate, the tablet PC that it had promised would rival Apple’s “Jesus tablet.” The same day, Gizmodo reported that Microsoft had killed the Courier, another reputed iPad killer. Research in Motion, too, has delayed its planned tablet until 2011.

From what we saw and heard of these devices, they were more complicated than the iPad — full-blown computers in tablet form rather than the streamlined iPad. Caught off guard by the market response, these rivals realized that they’d be releasing their version of a faster horse. They went back to the drawing board. Meanwhile, other Apple rivals, including Google, British Telecom, and Intel, are now scrambling to enter the tablet game.

Apple doesn’t get caught up in this competitive frenzy (perhaps because it’s working behind those locked doors). It plays by its own clock. Apple’s release schedule is designed around its own strategy and its own determination of what products will advance the company’s long-term goals. It can do this, in part, because of Jobs’s exalted position among chief executives. The average American CEO’s tenure is about six years, and it’s steadily declining. Many CEOs are just a couple of consecutive bad quarters away from pink slips. Jobs knows he’s never going to get fired, so he’s liberated to devote years — if that’s what it takes — to attain Apple’s high standards and hit the fat part of the adoption curve. Most CEOs aren’t so lucky.

The company’s long-range focus allows it to do something much more sophisticated as well: build the future into its current products. For the past decade, the company has released a series of platforms — Mac OS X, the iPhone OS, iTunes, its retail stores, the App Store, and recently its own microprocessors and iAd, a mobile-advertising system — that give it a stepping stone to its next products. The iPad is the culmination of all these things. Its glass screen, interface, unibody construction, operating system, and App Store all originated in other Apple products. Within the iPad are clues to Apple’s future gadgets and services, though we’ll only be able to spot them in retrospect.

Of all the points we’ve covered here, Apple’s willingness to go long is perhaps its greatest strength. The company has a plan. It’s on the right path, and that fuels both confidence and grand ambitions. It’s executing, to say the least. Which is why the “Apple of American business” is, well … Apple.

Farhad Manjoo is Fast Company’s technology columnist.

Travis Lepp is an apple fan and managing director for http://www.enunc8.com. Enunc8 specialises in consolidating MYOB, Quicken and disparate Data in addition to it’s web based analytics and reporting.