Danger ahead

All successful investors have at least one skeleton in the closet - perhaps a punt on One.Tel, Westpoint or a technology fund - that they would rather forget. The trick is to use the experience to help spot investment landmines in the future.

Once you know what to look for, some investments almost scream at you: "Warning, do not enter." In a perfect world, you would simply avoid all hazardous investments, but it's not always so simple.

Sometimes sound companies lose their way, successful managed funds lose their best stock pickers or trusted managers turn out to be frauds.

One of the best protections against a dud is to diversify your investments so you risk only a small percentage of your capital in any one asset.

But everyone would prefer to avoid a loss if at all possible. So if you do come face to face with disaster you may be able to bale out before the crash if you can recognise the warning signs early enough. Here are just a few of the danger signs.

Eye-popping returns
Greg Tanzer, head of consumer protection at the Australian Securities and Investments Commission, says the first thing to look at with fixed interest investments is the return. If it's higher than 8.5 per cent, then take a cold shower.

Tanzer says a reasonable return for any asset class is 1 to 2 percentage point above the average for that asset class. So with the return on low-risk term deposits about 6 to 6.5 per cent, a rate of 8.5 per cent looks good and anything higher involves significantly more risk.

Of course, risk is not necessarily bad as long as you know exactly what risk you are taking and you take a measured approach, not risking all your capital.

Tony Lewis, of fixed interest specialist Lewis Securities, says some high-interest investments can be perfectly safe. High risk can bring high rewards for those with the stomach for it, but Lewis says you should seek professional advice and not risk more than 5 per cent of your capital in any one investment.

Tanzer's second piece of advice is to have a close look at the investment's prospectus or product disclosure statement. This means the investment is registered with the regulator and certain legal safeguards are built in. One of the key things to look for is unreasonably high commissions paid to advisers. This was one of the hallmarks of the failed Westpoint scheme, whereas a great investment doesn't need a hard sell.

Security is also important. You need to know where you stand in the line of creditors if something goes wrong. A first mortgage is preferable and the mortgage should be registered over the property in question.

"If it's not a first mortgage you need to know what the first mortgage is, because you will rank after [the lender] if something goes wrong," Tanzer says.

However, the existence of a product disclosure statement or prospectus should not give investors false comfort, because it can be extremely difficult to detect fraud from public documents.

"You can do all the homework you like and get advice but if management are crooks you will be left holding the baby," Lewis says.

The commission has a risk-and-return calculator on its website (www.fido.asic.gov.au) that allows you to key in the investment you are considering to see how the return stacks up against comparable investments.

Luxury advertisements
Newspapers and radio are brimming with ads that are long on promise and short on detail. Often the ad features little more than an attention-grabbing interest rate.

Kosher borrowers tend to raise money via licensed advisers and their clients. "[Advertising direct] means they haven't got on anyone's approved list so they go to Joe Public who doesn't get professional advice," Lewis says.

Tanzer says investments should not be vague or overly complex. "People think asking questions makes them look stupid but that's not the case. If you can't understand it, don't buy it."

Lewis agrees and urges investors to pick up the phone and challenge them to prove they are safe.

Most of the offending ads are for finance companies or mortgage trusts lending money to high-risk property developers who can't get funds from a bank and may involve a second or third mortgage.

"If everything goes well, you're fine, but if anything goes wrong the financier loses money and so do investors," Lewis says.

Poor cash flow
The first sign of a company in trouble is often an operating loss. This is not necessarily a portent of doom because in an otherwise robust company losses can be temporary. But if the loss is accompanied by falling cash flow then investors should take a long hard look at the numbers.

Greg Hoffman, research director at The Intelligent Investor, says a loss-making company with negative cash flow will quickly become insolvent unless it can raise money from banks and shareholders. Hence, rising debts and deteriorating interest cover (the number of times a company's earnings before interest and tax cover its tax bill) are also reliable warning signs.

If the company continues losing money its bankers and shareholders eventually will say "no more" and the company will go belly up.

To illustrate the point, Hoffman has singled out four companies he believes are treading on too many corporate landmines for comfort.

Winemaker Evans & Tate lost $64 million in 2006 and $73 million the previous year. As at June 30 this year total debts of $169 million exceeded total assets of $140 million.

Evans & Tate's banker has given it some breathing space but Hoffman doesn't hold out much hope for its long-term survival in its current form.

Electronic payments company ERG, Strathfield Group and animal antibiotic group Chemeq are similarly challenged, Hoffman says. All have made losses two years running and all have negative cash flow.

In addition, Strathfield and Chemeq have borrowings greater than shareholders' equity (total assets minus liabilities), another bad sign.

ERG and Strathfield have issued hundreds of millions of shares in recent years as they struggle to survive.

According to Hoffman, corporate failures are seldom the result of a sudden misfortune. Instead, they tend to be the gradual and inevitable result of poor underlying economics, giving investors the clues to look for better opportunities elsewhere.

And if the boss has no faith in the business and hardly any stakeholding in it, investors should probably follow suit, he says.

Managers jumping ship
Managed funds tend to be seen as less risky than investing in direct assets such as shares or property, but they are far from failsafe. Not only are managed funds held captive to the performance of the markets they invest in, but they also rely on the skill of the people managing the fund.

Phillip Gray, of research house Morningstar, says one of the first warning signals is often an exodus of the people managing your money. "The fund will say it's the management process that's important, not people, but people are extremely important," he says.

Sometimes key staff jumping ship can be a symptom of ego clashes that could ultimately cost investors money.

Thanks to the amount of superannuation money flowing into managed funds and booming share markets, there has been an unprecedented period of growth for managed funds and a blowout in the salaries and egos of the best-performing analysts.

One example of the perils of ego was the experience of BT Funds Management in the late 1990s. A strong personality overruled the concerns of compliance staff and made large bets on a small number of Australian stocks.

Key staff left but it wasn't until the tech crash and the fall of One.Tel, one of BT's big gambles, that investors began to bale out. Many investors were badly burnt.

BT has since got its house in order and now takes a more conservative approach to stock selection, spreading its money and its risk over a larger number of shareholdings.

Another warning sign is a fund manager who is not able to perform consistently well in a market environment conducive to its investment style.

For example, if a value manager performs poorly in a market crawling with overlooked bargains, or a growth manager limps through a market boom, then something is wrong.

A third sign that it could be time to cut your losses is when a fund's after-tax return lags behind comparable funds for a few years running.

Complex products
An ageing population and a growing demand for income-producing investments has led to an explosion of fixed-interest products with increasingly high returns.

In order to produce these returns products are becoming increasingly complex, with a high degree of financial engineering, often with the inducement of a capital guarantee, low transparency and layers of fees that can be difficult to tease out.

Gray calls this product complexity risk and says that often the seemingly high returns do not adequately reflect the risk involved.

Many fixed-interest funds include high-risk investments - and high-sounding jargon - such as collateralised debt obligations, interdebt funding and mezzanine or subordinated debt. If you're scratching your head wondering what this means, don't fret: you are not alone.

The golden rule is, if you don't understand it, don't buy it. And don't be shamed by aggressive marketing appealing to "sophisticated" investors. Sophistication is no protection if a high-risk investment blows up in your face.

The fact that you've paid through the nose for sophistication will just add insult to injury.

Property frenzy
Safe as houses? Don't believe it. This rule could apply equally to all asset classes but it's particularly pertinent to residential property in a country in love with bricks and mortar.

The West Australian and Darwin property markets are going crazy at the moment, a sure sign that caution is warranted.

Four years ago Neil Jenman, property writer and consumer advocate, was recommending both markets, but no longer. "These are two places to avoid like the plague because people are going crazy," he says.

Three years ago Sydney and Melbourne were booming but the news from those cities today is more likely to be about rising numbers of distressed sales and repossessions. The same is inevitable in Perth for people who buy at the top of the cycle.

A tale of two cities, Sydney and Perth, could not be starker. According to figures from BIS Shrapnel, the median house price in Perth rose 34 per cent in the year to June compared with a fall of 1 per cent in Sydney, three years after the bubble burst.

Gross yields - that is, rental income as a percentage of house prices - on three-bedroom homes in Perth are 3.1 per cent, down from 5 per cent in 2001, a symptom of rising house prices. Jenman says anything below 5 per cent is a danger signal.

Yields in Sydney on three-bedroom homes are 2.7 per cent. Once interest and other costs are taken into account, Sydney property investors are earning a zero return on their investment.

Jenman says the two yardsticks to measure a property investment against are yield and affordability. "Buy when [gross] yields are above 7 per cent and the affordability factor is less than 20 per cent," he says.

Affordability is measured by taking the average mortgage payments as a percentage of the average wage.

National affordability is 33.2 per cent, or pretty unaffordable, compared with a reasonable 17.7 per cent in 1997 before the latest property mania took hold.

According to Jenman, the affordability factor in Sydney today is about 45 per cent, pricing many first home buyers out of the market. If you bought in 1997, take a bow. If you've just bought in Perth, fasten your seatbelts for a crash landing.

'You can do all the homework you like ... but if management are crooks you will be left holding the baby.' - Tony Lewis, Lewis Securities

'People think asking questions makes them look stupid. If you can't understand it, don't buy it.' - Greg Tanzer, ASIC

'Buy [property] when [gross] yields are above 7 per cent and the affordability factor is less than 20 per cent.' - Neil Jenman

Telstra sell-off rings true for experts

TELSTRA'S T3 share offer opens tomorrow and, despite widespread misgivings and a listless share price, analysts say it's worth getting on board.

Investors have until November 9 to buy into the Federal Government's $8 billion sell-off of its last third of the telco.

Telstra's share price struggled at $3.63 by Friday's close of trading, and investment analysts were generally lukewarm about the offer. Most said there were better opportunities elsewhere - with the media market in hyperdrive.

However, experts said investors could do well out of T3 over the next few years.

"I invest for my mother-in-law and I am putting her money into T3," said Clime Asset Management chairman Roger Montgomery.

Mr Clime values Telstra at $2.80 to $3 a share based on how the business now stands.

Mr Montgomery said Telstra would be good to own and would do well as media barons battle under the new media ownership laws.

"The Government was never able to put content into Telstra but a media owner could. Telstra has the distribution and will be a great media force in the country in the hands of a media titan," he said.

Mr Montgomery said T3 was a far more attractive buy than the previous share tranche, T2, as there was a 13-month window whereby anybody buying T3 shares at $2 had a gross yield of 27 per cent.

"You would have to be pessimistic to think they won't be above $2 in March 2008 when the final payment is due," Mr Montgomery said.

Greg Canavan, a senior equity analyst at Fat Prophets, said people should do well out of T3 in the short and long term.

"We think Telstra management is doing a pretty good job at the moment, despite all the negative criticism," he said.

"Everyone is rubbishing Telstra so we think there is an opportunity there. The actual business is generating cash and doing well, so it is good for long-term investment."

Mr Canavan said many investors were still smarting after being burnt in 1999 when they bought T2 at $7.40 a share only to lose 50 per cent of its value.

"A lot of people are reacting emotionally after they lost from T2," he said. "But this is a different offer and the share price is half that of T2. I would say T3 is the best of all of the Telstra offers so far."

Sink or float

Sink or float
The Federal Government and its advisers have gone all out to make T3 as attractive as possible.

Hang onto your hats. The great T3 sell-off is under way and promises to be an all-singing, all-dancing act. A $20-million advertising campaign, a sales team of just about every broker in the country, and the combined efforts of the Government and their love-to-hate-them colleagues in Telstra management will ensure no potential investor is left untapped.

But what should investors do? Is it better to learn from past mistakes and adopt a "once bitten, twice shy" attitude to anyone flogging a government stake in Telstra? Or is this the time to be bold and invest in Telstra as a turnaround proposition? Should you be seduced by the razzle-dazzle and prospect of a tasty yield - 14 per cent a year on the first instalment price of $2? Or should you be more concerned about Telstra's weak medium-term growth prospects?

The bottom line is that the Federal Government and its advisers have gone all out to make T3 as attractive as possible.

The offer has sweeteners for retail investors. The yield, at 14 per cent, is well in excess of the 4.3 per cent yield on the sharemarket overall and will doubtless appeal to income-hungry investors. Retail investors are also being offered a 10 cent discount on the $2.10 first instalment paid by institutional investors.

Instead of a discount on the second payment, retail investors are being offered loyalty shares - one Telstra share for every T3 instalment held through the 18-month instalment period.

The Finance Minister, Nick Minchin, says the combination of the first-instalment discount and the loyalty shares represents a 6 to 7 per cent discount for retail investors, who are also being guaranteed the final payment will not exceed Telstra's share price in mid-November.

And then there is the good news delivered by Telstra's management in last Friday's marathon update session. The briefing was a blatant PR exercise to promote T3 (and the skills of Telstra's highly remunerated management team), but gave the market some hope that the Telstra ship is turning.

The headline message of the briefing was actually bad news: a downgrade in expected profits in 2009-10, the last year of the telco's five-year strategy. Telstra's chief financial officer, John Stanhope, revealed higher than expected costs would cut projected earnings growth through to 2010 to 2 to 2.5 per cent a year, rather than the 3 to 5 per cent forecast last November. But the launch of the company's new mobile voice-and-broadband network ahead of schedule and improvements in market share in the broadband market have raised hopes that Telstra is finally getting a handle on replacing its old-technology revenues - most notably those fast-falling revenues from fixed-phone lines - with revenues from newer, high-growth technologies.

"[The new network] gives the company another platform for growth," says Michael Heffernan, a senior client adviser and strategist with Austock. "In the future, it could make all the old copper wires redundant and Telstra will be less reliant on that."

Paul Budde, an independent telecommunications analyst, says Telstra desperately needs new growth platforms. He says revenues from fixed lines - a high-margin business for Telstra - are falling by about 10 per cent a year. This revenue needs to be replaced for the company to simply stand still.

In its briefing, Telstra management said while revenue growth would be relatively flat at 2 to 2.5 per cent up to 2010, revenue from new products is already growing and is forecast to comprise more than 30 per cent of sales revenue by 2010. In the year to date, while sales are up only 3.3 per cent, revenue from retail broadband is up 41 per cent, revenue from Sensis is up 10.6 per cent and revenue from mobiles is up by 9 per cent.

Management didn't commit to maintaining Telstra's 28 cent dividend beyond 2007, but in the absence of any real earnings slide, more analysts now believe the company can sustain its dividend.

Peter Hilton, the head of Australian equities with Bridges Financial Services, says while borrowing to pay dividends (as Telstra has been doing) is far from ideal, Telstra has the capacity to do so because of the high amount of cash it generates. Management is forecasting $6 billion to $7 billion of free cashflow by 2010 (compared to $4.55 billion in 2006), which suggests that unless something goes horribly wrong, dividends are unlikely to fall.

"Ultimately, the dividend depends on how profitable the company will be," Heffernan says. "But even if it were to fall to, say, 20 or 22 cents, the yield on Telstra would still be better than that for most other companies."

T3 is by no means a set-and-forget stock. Martin Lakos, a divisional director with Macquarie Financial Services, says Telstra is operating in a very competitive and highly regulated environment. It is significant that the prospectus devotes seven full pages to listing the risks to the business - including regulatory risks, risks with the company's transformation strategy, market and operating risks, and more general risks. Yield-focused investors would do well to heed the warning that reduced dividends are listed as a risk. The forecast 28 cent dividend in 2007 is based on the assumption Telstra will suffer no further adverse regulatory outcomes.

Macquarie is one of the few firms not selling the stock. Lakos says it has a neutral view of Telstra and, while the yield on T3 may be good, he doesn't see it as a growth stock. "We think it will be a non-performer rather than an outperformer," he says. "Earnings growth is likely to be fairly flat, in the order of 2 to 3 per cent, while the major banks, for instance, are looking at growth rates closer to double digits."

Macquarie estimates earnings per share will drop by 8 per cent next year before rising 0.1 per cent in 2008, and accelerating to grow by 10.7 per cent in 2009. Lakos says there is potential upside for Telstra if it is able to achieve greater efficiencies, but he doesn't see that happening at the moment.

Hilton says he believes Telstra's management is on the right track, but just maintaining market share would be a big outcome for the company. He says initiatives such as the new joint venture in China may yield results, but the turnaround will take time.

'The ship is going to turn slowly, if indeed it turns, and you're not likely to see much in the way of fruits of management's strategy by the time the second [T3] payment is due," he says.

While some investors have pointed to the fast recovery of other small-investor stocks - such as AMP - after a big fall, Hilton says you can't assume the same will happen with Telstra. "[A fast turnaround] is a possibility but the challenges for Telstra are greater," he says. "At least AMP had the benefit of the mandated 9 per cent compulsory super contributions to help it. The only mandate for Telstra is increasing competition."

Heffernan has a more optimistic view. "I don't think you should underestimate the benefit of not having the Government looking over its shoulder," he says. "It will finally be able to act for its other shareholders." Heffernan says Telstra is one of the few telcos in the world with a full suite of communications businesses and he believes it is possible ordinary Telstra shares could be worth $7 in three to five years if management's plans play out.

On the regulatory front, Telstra and the ACCC are still at a stalemate on the introduction of Telstra's fibre-to-node network. Budde says Telstra has also stopped progress on regional initiatives, such as expanding broadband access, and he believes its squabbles with the regulator are inhibiting both the development of communications infrastructure in Australia and Telstra's own transformation.

"Telstra has left it very late to do what overseas telcos were doing three to five years ago," he says. "It's now compressed into changing in a situation where revenues are going down, the Government is finally getting serious about competition, and T3 is complicating the whole thing."

The other consideration for potential T3 investors is how the market will view both T3 and ordinary Telstra stock during the instalment period. While Hilton says there is a risk that institutions will push the price up in the coming weeks, the Government has done its best to structure the offer to avoid a repeat of T2.

The threat of an overhang of the shares being transferred to the Future Fund has been pushed into - well - the future, thanks to a two-year escrow period. This means these shares won't come onto the market until after the T3 period. The loyalty shares should also discourage investors from selling T3 after they have collected their dividends.

Ultimately, you're buying shares in Telstra. If you wouldn't consider Telstra shares, you probably shouldn't consider a leveraged investment in the telco, which is effectively what T3 offers. Any bad news for Telstra will be even worse news for T3 investors.

While T3 offers a high yield, Hilton says it is not like buying a bond, and investors shouldn't just be thinking about cash flow. He says the one certainty is that Telstra's share price will move one way or the other in the next 18 months. "There will be a lot of water under the bridge before the second instalment is due," he says. And while that tasty yield will cushion some of the pain of any fall in T3's price, there is no guarantee its price won't fall. Thanks to the inherent gearing in the instalments, a slump in Telstra's share price could result in an even larger percentage loss for T3 holders.

If you want exposure to Telstra in the next 18 months, however, Hilton says it makes more sense to hold T3 than the ordinary shares. For this reason, he expects some investors to sell Telstra shares to buy T3 instalments in the coming weeks.

An investor with $5000 of Telstra stock, for example, could sell that to buy $5000 of T3, giving them a greater exposure to any Telstra turnaround - or they could free up some cash by reinvesting in the same number of T3 instalments and keeping the difference between the value of the shares and the value of the instalments. Depending on the investor's tax situation, selling Telstra shares could also generate a capital loss to offset gains on other investments.

Heffernan says he expects T3 to be especially attractive to superannuation funds as, on their 15 per cent tax rate, the yield on T3 will actually be closer to 20 per cent after taking into account the franking credits on the dividends. "As long as the share price doesn't fall by 20 per cent, that's very good," he says.

The author owns Telstra shares.

T3 - KEY DATES

October 9 Prospectuses launched
October 13 Record date for determining Telstra shareholders eligible for a T3 entitlement
October 23 Retail offer opens
November 9 Retail offer closes
November 15 Institutional offer opens
November 17 Institutional offer closes
November 20 Final instalment price announced
November 20 T3 instalments list on ASX
May 15, 2008 Record date for final payment
May 29 Final instalment due

Your key questions answered
What will T3 instalments cost?

The first instalment - to be paid when you apply for the securities - is $2. That's a 10-cent discount on what the institutions will pay. The second payment won't be determined until November 20, well after the retail offer has closed. It will be determined by an institutional bookbuild (in which institutions will bid for shares). As a protection, retail investors won't pay more (in total) than the average Telstra share price in the three trading days leading up to the final price being determined. So it will depend on Telstra's share price over the next six weeks and the level of institutional demand.

When do I have to apply for my T3 instalments?

The public offer will open on October 23 and close on November 9. In the unlikely event T3 is oversubscribed, it may close earlier.

How many shares is the Government selling?

It is selling $8 billion worth, or 2.15 billion shares - a third of its remaining 51 per cent stake. The rest will be placed in the Future Fund. If there's a lot of demand, the Government has reserved the right to increase the offer by 15 per cent.

Do I get a discount on my final payment, as I did with T2?

There is no cash discount, but if you hold your shares for the full T3 period, retail investors will get one bonus Telstra share for every 25 T3 instalments they own. So if you bought the guaranteed general allocation of 2000 T3 instalments, you could convert them to 2080 shares in May 2008.

What is the minimum investment?

The minimum application is 500 T3 securities ($1000) and there is a maximum retail limit of 200,000 instalments - if you're really keen.

Am I guaranteed a shareholding?

There is a general guaranteed allocation of 2000 T3 securities. If you own Telstra shares on October 13, you'll be guaranteed at least 3000 shares or one T3 instalment for every two Telstra shares you own - whichever is greater. Brokers' clients may also receive a firm allocation.

Will I get a dividend?

You'll get three in the instalment period ­- in April and October next year, and again in April 2008. The combined value is estimated to be 42c, giving you a yield on your initial investment of about 14 per cent a year. However, Telstra has not given any guidance on whether it can sustain its dividends past 2007. The dividends will be fully franked.

How will the T3 instalments be listed on the sharemarket?

They will be listed separately to Telstra shares until the final payment is made. But you can still buy and sell them, as with ordinary shares.