Valuing Telstra

Valuing Telstra
Imagine Telstra has caught your eye. Management appears to be addressing its problems but the share price has fallen from $5.14 mid-year to $4 last week. So is it a bargain? Roger Montgomery, of Clime Asset Management, says you can get a rough idea by using a formula he has derived from Warren Buffett for companies that pay most or all of their earnings as dividends. All you need is Telstra's latest annual report, a calculator and some patience.

The formula Return on equity (ROE)/internal rate of return (IRR) x shareholders' equity per share.

Step 1 To calculate ROE, you first need to work out the company's retained earnings. To do this you subtract total dividends from net profit.

Total dividends paid are found in the notes to the balance sheet ($4.1 billion), while net profit is found in the profit and loss statement ($4.4 billion). Hence 4.4 - 4.1 gives you retained earnings of 0.3. Telstra's dividends are fully franked, so to adjust for this divide dividends paid by 0.7 (1-0.3 as the company tax rate is 30 per cent). Hence 4.1/0.7 = 5.8. Add this to retained earnings to give total earnings of 6.1.

Next you need to divide total earnings by shareholders' equity at the start of the year ($15.4 billion), which is found on the balance sheet, and adjust for any additional capital raised or shares bought back. Telstra bought back almost $800 million worth of shares so, assuming capital was reduced in the middle of the year, starting capital is reduced by half $800 million to $15 billion (15.4-0.4). Hence ROE is 6.1/15 = 0.407, or 40.7 per cent.

Step 2 Required return is the return you want from your investment. Buffett requires a return of at least 10 per cent. Montgomery uses a more conservative 15 per cent because this gives him a bigger margin for error. The higher the rate of return you use, the lower the intrinsic value of the company will be, and the less you will be willing to pay for it.

Step 3 To calculate shareholders' equity per share, divide equity at the end of the year ($14.9 billion) by the number of shares on issue (12.4 billion) and you get a figure of 1.2, or $1.20 a share.

Step 4 Putting all this together you get ROE (0.407)/IRR (0.15) x equity per share (1.2) = 3.25, or $3.25 a share. In other words, the value of Telstra for a required return of 15 per cent is $3.25, well short of last week's price of $4!

However, if you use Buffett's minimum return of 10 per cent, intrinsic value increases to $4.88.

To be confident of generating your required return, you would need to buy below intrinsic value.

The drawbacks of dividends
When the sharemarket is volatile or the outlook uncertain, investors flock to companies that pay solid dividends. Yet dividends can hide a multitude of sins.

Roger Montgomery, of Clime Asset Management, says directors use dividends as a selling point but few explain how they arrived at their dividend policy. John Price, of Conscious Investing, believes many investors feel that a known quantity of money in the hand is better than an uncertain capital gain in future.

In an ideal world, companies would pay out all their earnings in dividends and still grow each year. It may amount to sacrilege for some investors, but there is a strong argument that some businesses should not pay dividends.

Montgomery and Price both argue that a company with the power to produce a high return on equity is better off not paying dividends and using retained earnings to continue growing the business.

Warren Buffett's investment company, Berkshire Hathaway, is a good example. It pays no dividends but shareholders have been richly rewarded nonetheless.

Berkshire has produced a steady return on equity of about 25 per cent a year and its shares have grown by an annual average of 22 per cent over the past 40 years.

This is a far better return than most investors could achieve by receiving profits as dividends and investing the money elsewhere.

Price argues that shareholders with a need for short-term cash could sell a few shares and still end up better off in the long run than an investor who buys a mediocre company for regular dividend income.

Do it yourself
John Butler Wood is a retired engineer who has been investing in shares for more than 40 years in a haphazard way, mostly on the recommendations of others.

It wasn't until he retired and had time on his hands that he began to take a systematic approach to investment.

After attending one of Roger Montgomery's ASX seminars three years ago, he began to value companies for himself.

He says his method is simple but thorough.

"First, I look at the financial health of a company, things such as cash flow and various financial ratios. I look for companies with a return on equity of 20 per cent, which culls out a lot of low-profitability companies.

"To limit my search further, I only look at companies [with a market value of] over $100 million," Butler Wood says.

This is a labour-intensive process and Butler Wood admits he spends a lot of time at the State Library of NSW during the September-November reporting season, calling up company balance sheets from the Aspect Huntley database.

Then he puts the numbers through Montgomery's intrinsic valuation formula and homes in on companies with a price that is less than half their intrinsic value.

One of his best purchases was Jubilee Mines, which he bought earlier this year at $4.97 when he estimated its intrinsic value at a minimum of $11.12. It is now trading at $6.50, with an 8 per cent after-tax yield.

Butler Wood describes his investment approach as a work in progress.

"I've never found using stockbrokers successful. I enjoy fiddling with figures and, provided I make gains, it's in my best interests to continue. It keeps me off the street," he says cheerfully.

For what it's worth

Most people recognise value for money when they see it, whether it's a Sydney-to-Melbourne flight for $49 or mangos for 50c each. But when faced with Telstra at $4, most investors are unsure if they are looking at a bargain or a basket case.

According to Roger Montgomery, of Clime Asset Management, this is because they have no reference point when they try to put a value on shares. While shoppers can check the price of the same item at rival retail outlets, few investors know what Telstra is worth as a going concern.

Part of the problem is that investors get distracted by the daily ebb and flow of share prices, whereas Montgomery argues that price and value are two different things.

For short-term traders the price of the share is often all that matters, because they buy and sell for a quick capital return. So someone who bought Telstra for $4.02 a month ago could have sold for $4.32 two weeks ago and made a quick buck, but whether Telstra was worth $4.32 is anyone's guess.

Yet for long-term investors the quality of the business is paramount, because that is what will underpin the share price and the total return they receive on their investment.

That's not to say price is unimportant. As billionaire investor Warren Buffett points out, the higher the price you pay, the lower your return.

When share prices fall bargain hunters pile in, because the shares look cheap relative to their recent trading history or to similar companies. Many investors use the price-to-earnings ratio (P/E) to determine whether a share is cheap relative to the market or its peers, but this still ignores "intrinsic value" and is often based on estimates of future earnings.

The dangers of predicting future performance were highlighted in a recent survey by Parson Consulting, which found that only four of the top 100 ASX-listed companies met analyst earnings-per-share forecasts last financial year.

As John Price, the developer of the Conscious Investor share analysis software, says, there is no point buying a bargain that stays a bargain. Or worse, buying a bargain that turns out to be another Enron.

In order to tell the difference, investors need to be able to value the business they are investing in to make sure it can deliver the return they require.

Professionals use different methods to value shares. Most brokers use the discount cash flow method, which tries to estimate future cash flow and discount it back to calculate the current value of the shares.

Fund managers develop their own valuation methods, often using a mix of fundamental analysis and sophisticated computer modelling.

Yet few investment professionals are prepared to reveal their complex formulae.

A cynic might say it is in their interests to let investors believe that valuing shares is too tricky for mere mortals.

Price and Montgomery, who both follow Buffett's investment philosophy, sell investment analysis tools, but they insist people who are prepared to invest a little time and thought can go a long way towards valuing companies themselves and making profitable investments.

"I say the only question an investor needs to ask is what return do you need to get. I don't put a value on shares in terms of dollar value but in terms of returns," Price says.

After all, when you finally sell an investment, the important thing is not what price you paid or whether it was overvalued or undervalued at the time, but the total return of all dividends received plus capital gains.

Controversially, neither Price nor Montgomery put much stress on dividends.

"We talk about total returns, dividend plus capital gains. Money is money," Price says.

Buffett doesn't invest in a company unless he is confident he can make at least a 10 per cent return.

Once you know what return you require and what margin of error you can live with, Price says investors need to sit back and look at the business behind the shares. He says you can go a long way by asking a few questions; the answers can be readily found on free websites.

Price says investors should look for growth in earnings and sales, little or no debt and strong and consistent growth in return on equity (ROE) over the past five to 10 years. "If that hasn't been happening, you have to ask why you think it will in the future," Price says.

ROE is a key measure of profitability, showing the profit made on ordinary share capital expressed as a percentage. Buffett looks for a return of at least 12 or 13 per cent, preferably more. Much less and you could invest for lower risk in other asset classes.

While these questions are numerical, others are more subjective.

Buffett prefers businesses he understands. Most Australians come into daily contact with a range of retailers, goods and services, which gives them an insight into how those businesses are going.

Price says to look at what distinguishes a company from other businesses and whether it has an economic moat to protect its cash flow. For an example of an economic moat, investors need look no further than the Sydney Cross City Tunnel, where the operators negotiated a contract closing off alternative routes.

Also look at a company's competition, brand name, and whether it is a market leader or has a monopoly or patents on key technologies or products. Then you should sit back and see if you can imagine the business continuing successfully in future.

Only then is it time to ask what price you should pay for the company's shares. Using the method in the box below, Montgomery says investors can work out how much they should pay to achieve a specific return with a margin for error, or a level of risk, they can live with.

"This approach allows you to relax. When you invest you can be confident about buying and holding because you know [the shares] are worth more," Montgomery says.

Price's valuation method does take P/E ratios into account when deciding what price to pay. He compares current and past P/E levels, information that is available on some websites.

"If it's been 20 but is now 15, this may be a good time to buy. Don't try to buy on dips in price but on a dip in the P/E ratio," he says.

Even so, the better the business, the less important the share price valuation becomes for long-term investors.

"If you paid too much for Westfield 20 years ago, so what? You would still be a multi-millionaire today," Price says.

Stay cool and learn from your losses

Emotion is the big threat.

We love talking about the wins. They are far better dinner party fodder. But we tend to gloss over the losses, never really wanting to admit our mistakes. Yet often the biggest lessons come from mistakes.

When investors lose money on the stock exchange it can almost always be traced back to bad decision making, poor discipline and ignoring the fundamentals of share trading.

And the one key factor to these mistakes is letting emotion take over. So let's look at some of the more common emotional mistakes you can learn from.

Trying to recoup losses by taking greater risks is a sure-fire way to lose even more money. While it can be tempting to take bigger risks to win back lost money, this becomes emotional trading and is a classic investment mistake. You need to accept that losses are inevitable and part of the education process.

Likewise, failing to adhere to a stop-loss position can lead to greater losses than necessary.

Everybody, including Warren Buffett, will make an incorrect call at some stage, or the market will move unexpectedly.

That is why you have a stop-loss, or predetermined price point at which a loss is accepted and you close a position, without letting your emotions take control.

Another common investing mistake can be letting profits turn into losses. Many traders will have a story about massive "paper profits" that soon dwindled to become losses. Usually it is because you have been mesmerised by one of the strongest investment emotions greed which has motivated you to hold onto the stock for too long, anticipating even higher gains.

You can avoid this mistake by putting in place a trailing stop loss. This is where a stop loss is raised in line with upward price movements allowing you to avoid the stock slipping back to the entry price or worse.

Another common mistake for investors is overtrading. You may feel miffed because you missed out on an opportunity or it may be that you have been unable to invest all of your capital.

Whatever the reason, you should not try to create an opportunity. Be patient; wait until the right opportunities which adhere to your investment objectives present themselves, and then make your move.

Seven ways to wealth

There are simple formulas to getting rich as long as you are disciplined, but, as warns, there are also wealth hazards.

Forget the seven deadly sins. Oh, you had already? The seven deadly wins might be more your cup of tea then. Especially as you don't have to change your life, apart from getting richer.

Well, not for six of them. But we'll deal with that later.

There's also an eighth one, which is put more in super but that postpones getting rich for a lifetime, so let's skip it. Besides, there's no point putting more in super, despite the tax breaks, if you're just going to run up more on Bankcard to make ends meet.

1 TIME IN, NOT TIMING

To build wealth you have to invest, as distinct from save. Well, both would be good but, notwithstanding rule 5 below, investing is better because it's permanently setting some money aside to build assets.

Saving means you're not buying something now, but you will later. It's delayed spending, a crucial difference and one on which I may ask questions later.

Where was I? Oh yes, the way to get rich is to buy shares, some kind of managed fund or property, preferably at the right time. But the timing isn't as crucial as you think because you need to hang in there for at least seven years so as to go through a whole economic cycle. Plenty of time to forget how you may have paid too much, too.

With shares there's a way of avoiding timing problems anyway. Advisers recommend setting a certain amount aside regularly, say every six months, for buying stock. It's a great trick because you capture price drops (getting more shares cheaply for your outlay) and rises (fewer shares, so you can't pay too much). I have seen shareholders get quite excited by cost price averaging, but then it does take all kinds.

The other thing about timing is that you have to be in it to win it. The sharemarket, strange as it, will every so often put on a few days of staggering growth which, if you miss it, will leave you pretty annoyed, to say the least. A study by Colonial First State found that in the 10 years to June 2003, missing just the 20 best days would have more than halved your return.

That's why you always need to be in the market, even when it seems grim.

Incidentally, the same study showed the market's best and worst days were bunched together, too. Only days apart in fact.

The same is true of property, where sudden movements might not be obvious because there isn't a daily auction, one case where ignorance is bliss.

Among the best share performers over the past 10 years have been the banks. And they pay good dividends, usually fully franked, which gives you a bonus 30 per cent tax break.

2 MIRACLE OF COMPOUNDING

Getting interest on interest, or compounding, is the way to go. If your money earns an annual rate of 10 per cent, and you reinvest the interest, your original investment will double in value in seven years.

Albert Einstein, who should know, once said compound interest was the "eighth wonder of the world".

Miracle will do. Especially since it also works with mortgage repayments, as those calculators of how much interest you save by making just small extra repayments show.

Since you asked, on a $250,000 loan with 25 years on the standard variable rate, a one-off extra payment of $100 saves you five times that over the loan because of the compounding effect. Paying an extra $100 every year, or $2500 over the period of the loan, saves you almost $3800 in interest.

If anything, compounding works even better in the share and property markets.

You can join the company's dividend reinvestment scheme and you automatically get extra shares instead of a cheque. Remember, the following year the dividend will be based on an extra number of shares, too.

If there isn't a dividend reinvestment scheme, use the dividend to buy extra stock yourself either in that company or in something else.

With property, it's a bit pointless buying a few extra bricks with the rent, but all is not lost. You can invest the rent in the mortgage, save it for a deposit to buy another property, or buy some shares with it.

Besides, the property hot spot now isn't residential anyway it's commercial and office blocks.

3 RENT, DON'T BUY

Speaking of property, it's better to be renting than owning. Or to be more accurate, owning a property but renting it to somebody else. That's likely to mean you'll be renting yourself, too.

The best financial, as distinct from emotional, argument for owning a property is the eventual capital gain it'll give you. That's fine, except that the sharemarket tends to do just as well, and over most periods better, than property. And an investment in shares brings tax breaks from dividend imputation along the way.

True, there's no capital gains tax on owning a home, not to mention the more esoteric point of not being taxed on the benefit of the rent you don't have to pay, but once you take account of the much higher cost of interest which means the less you can put into another investment maintenance and annual expenses, and the inevitable renovation or two, it's not so crash hot.

Leading economist Phil Ruthven of IBISWorld has calculated that the "hidden" costs of owning a home over 30 years add up to a staggering $525,000.

4 RECYCLE DEBTS

Nobody ever got rich by staying out of debt. Not paying it back perhaps, but certainly not avoiding other people's money in the first place.

It's how you use the debt that counts. When used for an investment, so that the interest is tax deductible, it's called leveraging because it magnifies your gains. Or potential losses.

Because ordinary old common debt such as the mortgage or credit card isn't tax deductible, it's expensive and so a potential wealth hazard.

Your mission is to recycle common debt into deductible debt. One way would be paying off the common debt mortgage as quickly as possible, while paying the bare minimum on an interest-only investment loan.

Or taking out a margin loan to buy shares, and using the dividends to pay off the mortgage.

5 PAY YOURSELF

Paying yourself first out of your pay packet might sound self-indulgent, but it's one of the hardest things you can do. The sting comes from the fact that in setting aside part of your income to save, no matter what, necessarily means you're going to have to, I'm sorry, cut back somewhere.

Saving before you've wrestled with the bills sounds like it's back to front, but that's the whole idea. The reason you're not saving more is that you've already spent it. Saving first forces you to stick to a budget.

But the cutbacks don't even have to be all that painful. One tried and tested way is to write down everything you spend over, say, a fortnight. You'll be amazed how much waste there is. Just knowing where your money is going, or not going as the case may be, will just about fix the problem itself.

Cutting back one $4 coffee per workday, and putting it in an online bank account earning 6 per cent, will save you $1018 a year. Think loot instead of latte, if that helps.

Remember, keep your mitts off the savings. So you may as well invest them.

6 TAX

It's a big mistake to let tax considerations influence your investments, since it takes your eye off the main game. Then again, it's a big mistake to ignore tax, too.

Holding an asset for at least 12 months will halve your tax rate when you do sell. Capital losses from a dud stock can help in cutting a capital gains tax bill.

Splitting new assets between family members will also cut tax. But be careful if you already own the asset so as not to get caught up in the general anti-tax avoidance rules.

Salary sacrificing into super lets you cut tax and invest at concessional rates at the same time.

But one of the best tax breaks is dividend franking because it also happens to push you in the right investment direction. A company with a history of increasing fully franked dividends is almost certainly a good long-term investment.

Mind you, there's a danger of overlooking good stocks that have a high proportion of their income from overseas, and so don't carry franking credits on their dividends.

7 DIVERSIFY

As the saying goes, don't put all your eggs in one basket. So how come you've only got eggs?

Don't think that a portfolio of, say, 10 stocks is diversified. It's getting there, but it's not enough. No, that doesn't mean you should have 20 stocks either. In fact, if you had one of all 1300 or so stocks you still wouldn't be properly diversified. You would be carrying an inordinate risk, at least in the short term, over what the sharemarket is going to do.

Rather, you need to have investments spread across different assets. So a diversified portfolio would have a few different stocks but also an investment property or perhaps a listed property trust.

If it gets too hard, managed funds bring instant diversification.

CASE STUDY
Tidy profits for students of the ASX

You can never start investing too young. Just ask Anthony Barhoush, a student who recently finished his finals, and traded shares at school in free periods and lunchtime.

He made his first share trade three years ago when he was just 13.

Over the past year he's invested $5000 and made a 50 per cent return on his $15,000 portfolio.

Because he's under 18 the shares are held in trust in his parents' names, but he can easily trade them online, where brokerage starts about $25.

He said he got a taste for the sharemarket from the ASX game in economics classes at school, encouraged by an uncle, an accountant, who also whet his appetite for investment.

His first trade was in News Corporation "because my dad subscribed to the paper". But since then he's signed up to a share tip sheet, Wise Owl, which has encouraged him to do more research.

Phillip Shamieh of Wise Owl has noticed a growing number of school-age subscribers to the newsletter.

Meanwhile, Anthony has become more sophisticated in his share trading, setting exit and stop loss prices.

"I also like investing in small caps, which is where the greatest investment opportunities can lie and where I have made the majority of my money," he says.

His hot tip?

"Uranium stocks."

Inflation doubts dog the market

Inflation doubts dog the market

The sharemarket hovered around the sticky 4400 mark after a volatile week of trading, as investors remained cautious amid fears of inflation.

The ASX 200 index closed at 4406.10, down 24.9 points on Friday and 34.5 for the week, while the All Ordinaries fell 23.6 points on Friday to 4371.3, sliding 28.8 for the week.

John Garrett from UBS said 4400 "is seen as a big level of resistance and people watching the market will be pretty happy it held that level."

The market had taken a few weeks to break the 4400 barrier, then skyrocketed, and now had simply returned to its level of six weeks ago, Mr Garrett said.

"The market has certainly moved to being more risk averse. When we had the run-up there was a real desire to be fully invested.

"Certainly now people aren't as reluctant to hold cash in their portfolios."

Investors were cautious ahead of US consumer price index figures that would be announced overnight and what they would mean for levels of inflation, Mr Garrett said.

James Foulsham, senior dealer at CMC Markets, said a negative mood dominated the market on Friday as traders feared a slow-down in the commodity boom and the share price index swung wildly as investors tried to pick the bottom of the market.

"It's been a difficult market for traders this week as we see sentiment shifting almost every day, as evidenced by the markets up one day, down the other," Mr Foulsham said.

Overall the sentiment seemed negative on Friday, with the big miners being hit the hardest, he said.

BHP Billiton had a huge impact on the market index as it swung about over the week.

The big miner slipped below the $20 mark, closing at $19.98 on Friday, down 49c in the day and 49c for the week as oil and commodity prices fell.

Media stocks were also down with Network Ten closing at $3.35, down 5c on Friday and 15c for the week, after concerns about future earnings because of falling advertising revenue.

Publisher John Fairfax closed at $4.23, down 4c on Friday and 21c for the week after announcing its chief operating officer was going to printing company PMP.

Telstra gained, closing at $4.12, up 2c on Friday and 8c for the week.

Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, said the slump in Australian shares this month was a correction rather than the beginning of an extended fall.

"This time of year is normally weak for Australian shares," Dr Oliver said.

"Although the correction may still have a little further to run, we expect the market to be making new highs into next year and as such the setback in share prices should be seen as providing a buying opportunity."

Strong profits and low bond yields had kept Australian shares cheap and profit growth remained reasonable, he said.

"We have not yet seen the sort of investor euphoria that normally characterises major sharemarket tops and the underlying demand for shares is strong at a time when the supply of shares is weak."

Banks a haven in a week of volatility

Banks a haven in a week of volatility

The major banks drove the sharemarket higher yesterday, in what is turning out quite a variable week.

The ASX 200 index jumped 39.4 points to 4468.2 while the All Ordinaries rose 37.1 to 4429.4.

"The ASX 200 fell 40 [on Tuesday]. It rose 28 the day before and fell 6, 96 and 100 in the three days before that. You would be forgiven for getting motion sickness," said Marcus Padley from Tolhurst Noall.

"It just can't make up its mind. The general belief is that we are at the beginning of a correction still, but you should note that volatility means risk and is often a feature of a stalling bull market."

That uncertainty extended to global markets where no dominant theme has emerged, Jamie Spiteri from Shaw Stockbroking said. The Asian markets dropped up to 1 per cent and the Nasdaq index dragged, but the Dow Jones has made gains.

"This is an illustration of volatility," Mr Spiteri said.

It was the four big banks which had the greatest effect on the market yesterday, collectively adding more than 12 points to the index. ANZ was traded most heavily, rising 45c to $23.34.

"There is a lot of research out on the bank sector ahead of the results season," Mr Padley said. "The general comment is that the results will be good. There is also money finding its way into the sector because of its defensive qualities in this yo-yo market and for the forthcoming results and dividends."

Citibank Smith Barney issued fresh research on the banks, recommending the entire sector as a "hold" on the basis it was fully priced and the most expensive it has been in three years. Macquarie Bank analysts preferred ANZ and Westpac and had a "neutral" recommendation on the rest.

Resource stocks surged amid rising oil and gold prices. News that Canadian miner Inco planned to buy rival Falconbridge for $14.4 billion in a deal that would create the world's largest nickel producer, increased confidence among leading mining houses.

BHP Billiton, which would become the world's third largest nickel producer if the merger proceeds, jumped 50c to $20.83. Nickel ore producer Jubilee Mines rose 36c to $7.26, in a day when it announced a successful follow-up drilling program.

Tapping into recent profits made from uranium mining, shares in laser technology group Silex Systems surged 53c, almost 50 per cent, to $1.68 after the US Government gave approval US companies to begin classified due diligence into Silex enrichment technology.

The biggest loser on the ASX 200 index yesterday was Ten Network.

The media company's shares plummeted 18c to $3.31 after it reported a a good profit result but made a disappointing forecast of the year ahead.

Spend it or pass it on

Spend it or pass it on
Is living it up on the kids' inheritance such a bad thing? .

If you are a child of today's retiring baby-boomer generation, it's highly possible that your inherited box of assets will be feather light. It appears that in contrast to their recession-afflicted parents, members of the recent retiring class are setting themselves up to wine and dine their way through their retirement years.

Many a retiree has decided to spend it rather than bequeath it and they don't necessarily spend it on the kids. Some retirees are saying, "Well, I've paid for private schooling and HECS debts for the kids, so now it's my time to enjoy myself."

This news, as you can imagine, has driven banks and private lenders into a frenzy of activity. If retirees want to spend money, then financial service providers are only too happy to help them do it, and products such as reverse mortgages have been trotted out at an alarming pace.

Reverse mortgages enable retirees to gradually use up the equity in their property to cover, for example, living expenses, overseas holidays, home renovations or new cars.

Professor of sociology Michael Pusey from the University of NSW argues that kids of rich baby-boomer parents are most likely to benefit from an inheritance, and possibly an early one, in the form of assistance with a deposit on their first home.

But longer life expectancies, the trend towards early retirement and the fact that most retirees' wealth is tied up in super and property means children of the less well-off will fare much worse. Indeed, most will receive an inheritance, if any, at an age when the pressures of family and the difficulties of setting up are all but gone.

If increased costs of living are felt equally by both retirees and their struggling kids, however, should retirees spend it on themselves, give it to their kids early, or bequeath it?

Dangers of giving it away

The spend it or bequeath it debate is hotly contested in senior estate planner Mark Robinson's office at Australian Executor Trustees. In fact, Robinson says: "The thing that I constantly hear from clients is the desire to protect their children's inheritance from the son- or daughter-in-law." Robinson says early inheritance gifts to children will form part of the child's matrimonial assets granting the son- or daughter-in-law claim over it in the event of divorce.

Also, who's to say that the kids won't blow an early inheritance on a shopping spree, invest it unwisely or channel it into a sinking business? And what happens if your circumstances change and you need the money back? "You are relying on the kids to do the right thing, and they may not," Robinson says.

Rising health costs and longer life expectancies may mean retirees will need every last cent in the jar to fund their retirement.

There's also tax to consider when gifting investments such as shares, investment properties or managed funds to children. Although you are giving away the asset to your children, the tax department doesn't see it that way. To them, you have sold the asset, which means they will post you a bill for the capital gains tax you owe.

If you were to bequeath these investments to your children instead, less tax is paid overall. That's because the receiving beneficiaries will pay tax on it only when they sell it, and not when they receive it.

But don't think for a second that gifting assets to your children will increase your entitlement to the age pension.

Unless you gift assets no later than five years before retirement, you can only gift up to $10,000 a year or $30,000 over five years without it impacting on the amount Centrelink pays you.

All factors considered a kid's divorce, bankruptcy, or frivolous spending habits you might decide to bequeath your assets to your children, or beneficiaries, under the will instead. For added protection you could use a testamentary trust that can safeguard your assets from the estranged son- or daughter-in-law, as well as possibly saving your beneficiaries in tax.

Why retirees are spending it

OK, so you've quit the workforce and for the first time in your life you can begin to really live it up. Painting, golf and travelling are all on the agenda. But how will you fund it?

Retirees with large amounts in super or investments don't need to worry too much. But retirees facing a life constrained by the age pension do have a couple of options.

One is the reverse mortgage, which is often termed, "spending the kids' inheritance" because it effectively means releasing equity from the family home over time.

The way it works is that the bank or lender will lend between 10 and 50 per cent of the value of the property (it depends on your age) as either a lump sum or regular income. The interest costs on the loan, which are usually 1 to 2 percentage points higher than ordinary home loan rates, are added on to the debt over time, but you don't have to pay the debt back until the property is sold.

At no time should the debt be greater than the loan and leave your kids with a debt (called a no negative equity guarantee), and at no time should the lender kick you out of your home, since you continue to retain the title to your property. Make sure you check both these points.

Louise Biti, technical services manager at Asteron, says reverse mortgages are sometimes the only option left for age pensioners wanting a higher quality of life. "All it is doing is reducing the kids' inheritance. And does that really matter? Well, I think this generation of retirees actually have to say, 'no it doesn't matter'."

Retirees with an adult child have an extra card up their sleeve that doesn't involve borrowing from the bank. Here the child could take on the role of the reverse mortgage provider and lend the money to the parents. A legal contract could stipulate the yearly interest cost on the loan and the fact that the child takes security of the house at the end of the day. "The benefit for the child is that instead of the bank getting the interest, they get it and the inheritance is not being eaten away," Biti says. "But the child has to weigh it up against what they would have done with the money instead." Charging a parent interest on the loan might seem a bit rough, but it does turn the assistance into a viable investment option for the child.

James Hickey, a partner at Trowbridge Deloitte, says reverse mortgages are not just an option for the struggling age pensioner. His actuarial studies have shown that even retirees with $250,000 in super will have less than what's recommended for a comfortable life in retirement. And rather than selling the family home to downscale, which involves real estate and stamp duty fees, retirees can use a reverse mortgage to turn a lumpy property asset into a way to generate income in retirement.

The graph shows how a 20 per cent loan obtained from a reverse mortgage provider at age 65 will grow over 20 years. Here the retiree pays 8.5 per cent interest on the loan, and the property increases in price by 5 per cent a year. At age 85, the retiree has accumulated over $700,000 in debt, but the property is worth $1.8 million dollars.

The money left over in this example is $1.1 million, which can be bequeathed to children in the estate.

Giving it to the kids early

Estates are notorious for being messy and ugly affairs, and passing on an inheritance in your lifetime at least provides some certainty about the outcome.

As well, as life expectancies continue to rise, most people will receive an inheritance when they are already retired themselves.

With substantial assets already built up, the value of the inheritance is often worth less than assets received by a beneficiary at a younger age.

But as Deborah Wixted, technical services manager at Colonial First State, notes: "Most people are just struggling to fund their own retirement, and their priority must be to themselves."

CASE STUDY

WHEN Roy Cockran called his kids to tell them he'd decided to spend part of the family home on a South Pacific cruise, they replied in no uncertain terms: "Go for it."

Cockran and his wife, who live in a small town on the NSW and Victorian border, are hardly divided when it comes to their inheritance. "When you work all of your life, you get to retirement and you want to enjoy what time you've got left," Roy says.

When the couple retired they still owed money on their mortgage and faced the prospect of living on the age pension for the rest of their lives. This meant few holidays away and limited lifestyle choices.

After reading an article in the newspaper on reverse mortgages, the Cockrans called around for more information. "The first thing that concerned me about a reverse mortgage was that it would affect our pension, but Centrelink gave us the clearance on it and we went ahead."

Reverse mortgage provider Australian Seniors Finance organised a property valuer and lent the couple 10 per cent of the property's value. In February the Cockrans took a South Pacific cruise, drove up to Queensland to visit their daughter and paid off their mortgage.

Since the amount you can withdraw from a reverse mortgage increases by 1 per cent over the age of 60, the Cockrans are already planning their next cruise when they hit the reverse mortgage provider for an additional lump sum in a few years' time. "If we hadn't taken out a reverse mortgage we would still be paying off the balance on the home loan," Roy admits.

All in the family

All in the family

The strategy To structure my children's inheritance so it won't end up with the in-laws.

Do I need to do that? With divorce rates showing no signs of declining, Ross Johnston, the head of dealer services with Australian Unity Financial Planning, says there's a growing interest in ensuring that any assets you leave to family members stay with them and can't be claimed if they get divorced.

Unfortunately, if offspring receive an inheritance in their own name, Johnston says it will generally form part of their assets, which means it's fair game if they subsequently go through a divorce.

It's not just relationship breakdowns that are at issue. Johnston says if a couple are unlucky enough to die at the same time - perhaps in an accident - there are laws that state which one of them is presumed to have died first.

If both bequeath their assets in the same way - usually by leaving them to their children - that's usually not a problem. But some people seek to protect their grandchildren if their son- or daughter-in-law, for example, has children from a previous marriage or has other beneficiaries.

OK, so what can I do? Johnston says trusts are the most effective way of giving your children the benefits of assets, without them actually owning them. They can receive income and other benefits from the trust, but the underlying assets can be protected and - if desired - even preserved for future generations.

You can either use a family trust, which is set up while you're still alive and can be useful in providing your children with benefits while you're still alive, or a testamentary trust which is part of your will.

If you use a testamentary trust, the specified assets are transferred to it when you die and it holds the assets for your beneficiaries.

Are they expensive to set up? It depends on how complex they are. Johnston says a basic testamentary trust can cost about $1000 to set up, but if you need specialist advice - which is advisable when you're dealing with Family Law - it can cost several times that. Whether the cost is justified depends on what the underlying assets are worth and to what extent you feel you need to protect them.

How does the trust work? It's a structure interposed between your children and the assets. It will have a trust deed, which sets out how the trust will be run, and one or more trustees, who administer the trust in line with the deed.

So how does that ensure my children's inheritance can't be claimed by a partner if they divorce? Johnston says there are no bullet-proof solutions, especially when it comes to family law. But there is quite a bit of case law that confirms assets held in trusts may not be deemed to be part of the marital property if the trust is structured properly.

He says you'll probably need advice from a specialist lawyer, but control is a key issue. It may be necessary to appoint an outsider - perhaps a trustee company or a friend or adviser - as trustee or co-trustee to administer the trust.

The terms of the trust deed will also need to be carefully drafted to ensure that, while your children can benefit from your assets, they can't be deemed to be in control or ownership of them.

Johnston says the Family Court has difficulty making orders on third parties which provides trusts with some degree of protection, but there have been cases where it has successfully made such orders in the past.

Another day, another 96 points off market index

Another day, another 96 points off market index

The market has continued its downward spiral as investors react to fears of a US interest rate rise, shaving more than 4 per cent off its value in two days.

The ASX 200 dropped another 96.2 points to close at 4447.3 yesterday while the All Ordinaries fell 95 points to 4401.8.

Despite the massive two-day fall, the largest since the week after September 11, 2001, traders said there was no widespread fear of a crash.

"Nothing fundamental has changed in the outlook in Australia, so it is either overseas forces or people taking profits from what has been a very strong run," said Hans Kunnen, head of investment markets research at Colonial First State.

The market made more than 8 per cent last quarter and has risen 60 per cent since March 2003. Yesterday's fall returned the market to its level of six weeks ago; it closed on August 31 at 4446.8.

"The general feeling … is that it is a correction, not a crash," said Marcus Padley from Tolhurst Noall. "At the moment it is just lemmings collecting on the cliff and deciding to jump. We'd need to see some indicators to change for this to turn into something worse."

A few big stocks that had stretched the whole market index did not reflect how the market had gone as a whole, Mr Padley said. These are "the stocks that everyone has made easy gains in".

Mr Padley cited financiers Macquarie Bank - which fell $3.19 to $69.00, down 8.5 per cent in two days - and Babcock & Brown, which has lost more than 16 per cent of its value to close at $16.51, down $1.05 on the day.

The resource sector was hit hardest. Among the big losers were BHP Billiton, which lost 69c to $20.76, a 6.5 per cent drop in two days. Australia's largest oil and gas producer, Woodside Petroleum, dropped $1.51 to $32.00, down almost 10 per cent since Tuesday.

Building stocks with exposure to the US were among the big losers too. "Rinker and James Hardie were sold off aggressively again on fears of interest rate hikes in the US," said James Murch, a portfolio manager at Opis Capital.

Rinker Group fell 84c to $15.10, dropping more than 10 per cent in two days, and James Hardie lost 31c to close at $8.27, reversing the strong gains these stocks made in the aftermath of the US hurricanes.

Local building material stocks, such as Boral, which dropped 47c to $7.43, were also dealt a blow following very soft August building approval numbers on Wednesday, Mr Murch said.

"The banks have outperformed this week. You've been seeing a little bit of rotation out of resources and into banks," he said.

Stockmarket plunges 100 points

Stockmarket plunges 100 points
More than $21 billion was wiped off the Australian stockmarket yesterday in its biggest single-day loss since the week after the September 11 terrorist attacks.

Local traders were anxious after a plunge on Wall Street, which was sparked by a US Federal Reserve warning that interest rates were likely to rise and energy prices were driving inflation higher.

Investor panic gathered momentum around lunchtime with aggressive sell-offs throughout the afternoon.

The ASX 200 benchmark lost 100.1 points to close at 4543.5, its largest single-day drop since September 17, 2001, when it lost 145.5. Yesterday's losses took 2.16 per cent off the market value.

The All Ordinaries closed at 4496.8, down 94.7 points.

Every sector of the market was down with the biggest losses on the bourse being among resource and financial stocks, the two sectors which have benefited most from recent market gains.

"There really wasn't a sector that stood out as a strong performer which suggests people think the market is well overdue for a bit of a pull-back," said Justin Gallagher, head of Sydney sales trading at ABN Amro. "We had a very strong week last week. The market just kept on kicking and people were surprised the market held on as well as it did."

But yesterday saw a complete reversal in sentiment.

"People started to think this market is not going to recover. It didn't look like bouncing at any stage during the day," Mr Gallagher said.

The big mining groups had an abrupt end to their dream run. BHP Billiton contributed to a significant chunk of yesterday's losses, taking 14.6 points off the ASX 200 as it fell 75c to $21.45 in heavy trading. Rio Tinto lost $1.51 to $57.10.

Another 17 points knocked off the ASX 200 came from the four major banks. ANZ lost 65c to $23.45, the Commonwealth dropped 38c to $38.32, Westpac came off 43c to $20.87 and the National Australia Bank came off 43c to $32.76.

The head of institutional sales at Goldman Sachs JBWere, Patrick Crabb, said the pull-back was a readjustment after rapid market gains.

"You've got to keep in mind we've gone up 8 per cent over the quarter and 60 per cent in the last 10 quarters." Yesterday's losses only took the market back to where it was eight days ago.

"The market has got a little ahead of itself and had a bit of a reality check," Mr Crabb said.

The high price-to-earning ratio stocks, such as Macquarie Bank, were especially vulnerable after the recent market bull run, he said. Macquarie Bank lost $3.08 to close at $72.19.

Financier Babcock & Brown lost almost 11 per cent, after a 7 per cent fall the previous day, and closed down $2.12 at $17.56, making it the worst performer on the ASX 200 for the second consecutive day.

The heavy losses in the fading market darling have been attributed partly to a broker report by Capital Partners valuing the stock at $7.60. It might also be explained by the capital gains tax discount kicking for in those investors who have held the stock since its listing 12 months ago.

Mr Gallagher said if the sharemarket drops away further today, there will start to be real jitters about whether gains over recent months are sustainable. He said there had been several smaller single-day drops over recent months which people have used as an opportunity to buy back into the market.

"[But] after a couple of down days you may see the psychology of the market change. People will be reluctant to buy the dips."