Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Facebook has been one the most highly anticipated IPOs in years. I'm here today with senior analyst, Rick Summer to see if now is a good time to dive in or if investors should wait for a better opportunity.

Rick, thanks for joining me.

Rick Summer: Sure thing.

Glaser: So let's get your first take on Facebook. When you dive into the company's financials, what do you see? What do you like about this company?

Summer: I think first and foremost, we can't forget how many users it has. There are north of 900 million monthly actives who are going to the site, and more than half of those are actually interacting in some way with Facebook on a daily basis. That level of engagement is absolutely tremendous.

Secondly, you have a wild level of profitability. You have almost 50% operating margins, and a meaningful $3.7 billion in revenue on trailing basis. This is a company certainly to be reckoned with and certainly a future force that already has a business model that's proven today.

Glaser: Let's take a look at the economic moat. It's the cornerstone of lot of Morningstar's equity research. What kind of competitive advantages do you think Facebook has, and will it be able to keep those up over time?

Summer: It's a great point, and this really underlies a lot of what we're doing and talking about with respect to Facebook and with respect to our valuation, as well. Facebook's moat is really built around its user base. So, it's actually 900 million users who are not only just going there, but they are interacting with it. It's part of their identity; it's part of how they communicate with their friends within their Facebook network.

That in and of itself is the most important compelling part of the moat, but it's not just a destination. We have people that are using authentication, meaning the login credentials for Facebook at other third-party websites. We have other third parties that are actually incorporating Facebook data, social plug-ins, comments, and lots of different things. You actually have Facebook spidering out into the fabric of the Web. Those are very difficult connections to be able to dislodge by a competitor.

Secondly, Facebook has actually monetized this and proven that it can generate excess returns on capital even in an environment where ad pricing is pretty weak, because we haven't really figured out yet how to advertise in social networks.

Glaser: So where does the moat come out then?

Summer: Right now, we have a wide moat. The only other wide moat company in the Internet space that we cover is Google, of course. And we're looking in the Internet advertising land of this being a two-headed monster going forward.

Glaser: It doesn't sound like Facebook is going to go the way of MySpace, Friendster, or other social networks that haven't done so well. But what kind of growth is in front of Facebook. It's seem like almost everyone already has a Facebook account. Will the company be able to grow users, or does it need to grow users in order to expand that top line?

Summer: This is an important dynamic. We've told a lot of our clients that this is not Google, and it's really unfair to compare the two. Google was at a very different place in the growth cycle [at the time of its IPO]. It had the advantage of being able to grow users and grow market share over time.

Facebook is different. [It has] nearly a billion users. So in terms of users, sure we can double the users, maybe we can triple users over time, but we're not going to quintuple. And we can't have 10 times the number of users; obviously, that's more people than what we have in the face of the earth.

What we really have are new revenue opportunities, ways to actually increase advertising. We have very small units of advertising. We have north of $7 per user that's being monetized right now. That's not extremely compelling today. So you have to be able to figure out that Facebook can actually monetize this in a much bigger advertising network sort of way.

Two, is we haven't seen an influx of local advertising dollars onto the Web yet. We, obviously talk about Groupon quite frequently. We know that Google's made inroads into the local market. We really believe that Facebook has a lot of very compelling assets to grow the local advertising space in an extremely positive way.

Lastly, we're not as bullish on this as some other research firms are, but we do look at Facebook Credits, which is a payments platform, as being an extremely lucrative way for the firm to offer payments for digital goods. We think physical goods is also an opportunity, but we're still looking at north of $1 billion that Facebook can end up generating from revenue we believe over time.

Glaser: Then what are some of the risks to growth not quite meeting those expectations?

Summer: I think that Facebook needs to make sure that it continues to innovate in ways that don't detract from its user base. The company doesn't want to be the next MySpace; it doesn't want to be the next Friendster. So if Facebook ended up pushing too much advertising, doing things that ended up alienating their users, we will have second thoughts about what the company is doing with respect to its moat.

I think secondly, in the near term there is a tremendous amount of risk. With the advertising that is being placed today, there's not measurable return on investment for a large bulk of these. So we have a lot of funny math that's going on by advertisers and agencies to understand they're getting the proper bang for the buck. Just recently we heard that General Motors is pulling out [its Facebook advertising] campaign because it didn't feel that it was getting the bang for the buck.

We think that Facebook solves his problem over time. We think that network is way too compelling; the data is too compelling for Facebook not to turn into this dominant advertising platform. But today we don't have best practices around that.

Glaser: Facebook a wide-moat business, which sounds great, but you don't want to buy it at any price. Where does your valuation come out? What should investors pay for this growth?

Summer: We're coming out [with a valuation of] $32 a share. Obviously the IPO pricing range is above that, and we expect it to trade even north of that. What we're telling investors is these near-term risks could actually be a very positive thing for investors down the line. Sit on the sidelines today. We're going to see growth slow. We're going to see profitability in terms of margins go down over time, and during this next to 12 to 18 months that could cause some massive pressure on the stock at the same time.

You may get a chance to get this wide-moat business at a substantial discount to the IPO price during the next 12 to 18 months. Right now, when you're looking in the Internet advertising sector, you've got Google, and you've got Facebook. Google is still trading at a pretty substantial discount to our fair value estimate. Why would you pay for premium for Facebook today when we think it's worth $32.

Glaser: Rick, thanks for your thoughts today.

Summer: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.

Christine St Anne: At a recent lunch with the Australian Business Economists, Treasury Secretary Martin Parkinson put his case forward for a budget surplus.  In particular he responded to criticism that the budget surplus was due to a political imperative.

Martin Parkinson: The problem with this argument is that if it's not appropriate to restore the structural budget position when we have low unemployment and the economy is expected to grow at around trend, when will it be appropriate?

In other words, this argument; let’s just wait another year – well, we can always just wait another year and the argument will always be, let’s wait another year.

St Anne: Parkinson said criticisms did not take into account that the return to a fiscal surplus was taking place in a better economy compared with the rest of the world.
 
Parkinson: It is surprisingly under–appreciated in some of the commentary just how Australia’s fiscal consolidation is occurring in a set of circumstances that is dramatically different to that which you can see in almost every other advanced economy.
Many of those economies are stuck between a rock and a hard place. Monetary policy is at or close to the lower bound; fiscal positions, have been allowed to be in deficit for a long time and have been driven by the GFC in some situations to over 100 per cent of GDP. In this environment, traditional monetary policy is not working and opportunities for fiscal policy are limited.
We don’t face the same wrenching predicament. But continued discipline is important to ensure we never get into this situation.

St Anne: Parkinson said that with substantial risks still facing the global economy it was important that Australia maintained its fiscal responsibility. He also issued a warning that while we are in a better shape than other countries, this may not always be the case.

Parkinson: With substantial risks remaining in the global economic environment, in my view it is critical that we move now to recharge the fiscal batteries while circumstances remain favourable. This will give us the capacity to respond to fiscal shocks if they’re required over the period ahead. This just gives you a sense of the advantage we confront.

Across the OECD government debt ratios have been on a steady upward trend since the 1970s. While there have been periods where they have lowered their debt–to–GDP ratios, but basically not by enough in good times, to offset what happens in periods of distress.  The trend is even more concerning when you think about the vast majority of those countries, the big impact of population aging is still to come.
The good news from our perspective is that we are not in that same boat. The challenge for us is to recognise that we cannot assume this will always be the case.

St Anne: Parkinson also dismissed criticisms that some in the Australian community would be irresponsible with some of the spending initiatives.

Parkinson: I think they will do the same if they do if they got a wage increase. Those people who are at the lower end of the income distribution and have higher marginal propensity to consume, will consume it. Those who are receiving it and who are in the upper end of the income distribution will tend to save more of it.  I don’t see anything untoward that.

St Anne: Christine St Anne for Morningstar

Jeffrey Hutton: Contracts For Difference or CFDs have been in the Australian market for about 10 years now, but are they more risk than reward? Joining us to tell us what we've learned since their introduction is Ashley Jessen from Capital CFDs. Ashley, thanks for joining us.

Ashley Jessen: Thanks for having me, Jeff.

Hutton: Ashley, do CFDs stack up as an investment?

Jessen: Yeah, absolutely. It's a good question. I mean CFDs haven't necessarily got the best wrap as far as risk is concerned, I guess. During volatile markets, any trader needs to obviously protect the downside and protect their risk, that's the number one rule of any successful trader. You've always got to protect the downside.

Now with Contracts For Difference, they are a leveraged instrument, so they give you access to greater gains, but they also give you access to greater losses as well. So, when you're trading a product like a Contract For Difference, one of the things to keep in mind is that when the volatility increases, you have opportunity, obviously much more opportunity than you normally would, but when you think about it, you always control the amount of leverage on your account. It's one of the things with CFDs, is the amount of leverage that you get access to.

So, during the times when the market is quite volatile, you can always scale back your leverage, and that's one of the smarter things to do, and always keep your stop-losses nice and tight, and just make sure that you're in control of the amount of risk that you have on your trades.

Hutton: Maybe this is a good time to stop and explain how they work.

Jessen: Yeah. Well, let's start off with CFDs or Contracts For Difference. CFDs enable you to mirror - or they mirror the underlying performance of the stock holding index that you're trading. So, say for example, you wanted to trade BHP. Well, CFDs enable you to trade BHP, but let's say you wanted to buy $10,000 worth, instead of putting 100% of the funds upfront, like you do with say shares, you only need a small amount of money upfront in order to control the full amount.

So, you benefit from all the full movements of the contract for difference, or of the underlying share, but you only need, say 5% of the money upfront. Same with access to indices around the world and foreign exchange, CFDs basically give you a broad market. You can trade anywhere around the world, basically with one piece of software, and you're pretty much ready to go.

Hutton: So you don't have to come up with all the cash upfront?

Jessen: Yeah. So, say for example, BHP is running at just say $40, you wanted to buy 1,000 of those. Well normally, you would have to front up $40,000 cash. When it comes to CFDs, you may only need to put in approximately 5% of the money upfront. So, instead of putting up $40,000, with $2,000 of your own money, you can control $40,000 worth of BHP shares.

So, one of the things that investors need to be really mindful of, and traders in particular, is how much leverage you have, because obviously the more leverage you have, the greater the chance of wins - bigger wins, but the greater the chance of also the downside as well.

So with leverage, comes a bit of a double-edged sword, you need to obviously be mindful of the downside and protect that downside risk, which we were talking about just a second ago with regards to stops. So, you always want to make sure you're running stops with your trading to limit the downside. It's really the only way that you can really look after your portfolio to make sure that downside is covered.

One of the things that we were talking about a little bit earlier was that when you have a loss - and in particular, we have any sort of trading product - if you have a loss, say a 25% loss on your portfolio, it takes 33% just to get back to breakeven. A 50% drop in your portfolio. It will take a 100% just to get back to breakeven.

So, the larger your losses, the higher - that the harder it actually is to get back to just even breakeven, let alone profit. So, smart traders whether they are trading CFDs, futures, foreign exchange, or any of those products, the smart traders will always limit their downside and make sure they keep them nice and small.

Hutton: Just how much in terms of loses should an investor tolerate?

Jessen: Well, very good question, and this is one of the toughest questions, because getting in and buying a position is actually quite easy, but knowing when to get out, whether in profit, or in a loss, is one of the questions that stumps a lot of traders. Usually couple of ways you can determine that: one of them is technical. So, you look for the technical indicators on the chart and you might look for common support areas and a support level is basically where the stock may have come down. It may have hit a certain point, rallied back up, and it might be approaching that level again.

So at some level, the investor is out there and the traders say BHP, or the index or the Aussie dollar represents good value at this price. So, say even the Aussie dollar as an example, when it gets to parity, some people might say that's excellent value and it may have bounced off that level a few times.

So smart traders normally put their stop just below those support levels, just to give themselves a little bit of room just in case it hits it again and then bounces off and rallies again. So say as an example one of the most widely used risk management principles is never risking more than 1% to 2% of your capital in any one trade at any one time.

So, if you're going to take position in BHP, say you've got $20,000 of your money in cash, 1% of that is just $200. So, you take a trade on BHP and then if BHP were to move against you more than $200 or $200, then you would take a loss on that trade and you would move on to the next trade.

So, the number one rule of successful trading is always to your losses small. So, you keep those stops in your - that the overall portfolio, you're never losing too much of that. As I was saying 50% loss takes a 100% to breakeven. If you're sustaining losses of more than 1%, 2% or 5% of your portfolio it just gets so much harder to get back to breakeven.

Hutton: This might be a bit cheeky, but would you sell a CFD to your mother?

Jessen: That's a very good question. CFDs are for a more of an experienced trader. So if my mother was into trading, which she isn't then there would be - it's not a product that is difficult to understand.

Basically it mirrors the underlying and you need to control the amount of leverage that you have on that position, all the positions that you take. So, as long as you understand the leverage aspect to it, and the fact that you the trader - you always control the leverage on those positions.

So it's not the broker that controls the leverage, it's you the trader. So if you use that in a sensible fashion then CFD is an effective tool. So long as you understand the leverage, the more leverage, the bigger the wins, the bigger the losses and the lower the leverage the more you can control it.

Hutton: Ashley Jessen, good luck to you and your mum. Thanks for joining us.

Jessen: Thanks a lot Jeff.

Hutton: It's my pleasure.

Christine St Anne: We are at Wilson Asset Management Investor Forum and today I'm joined by the firm's Geoff Wilson to give us his insight into what sort of companies he looks for in his listed investment vehicles. Geoff, welcome.

Geoff Wilson: Thank you.

St Anne: Geoff, your listed investment vehicle has outperformed the market since inception. What sort of approach do you adopt to find those types of companies?

Wilson: We're very focused on growth companies and when we're looking for growth companies, we're actually looking for growth companies, but we're looking for growth companies that are very cheap, like on low PEs. Ideally, we are looking for a company that's growing at say 15% to 20% per annum and would be on a PE of eight to ten times.

 St Anne: In your presentation, you mentioned some good performing stocks, are you able to talk about them?

Wilson: I mean over the last 12 months, some stocks that have been very good to us are McMillan Shakespeare, that's done well for us, also Breville has done very well, also Ainsworth Gaming, that's - we've made very good money on those type of companies. Now they tend to be smaller companies - smaller industrial companies and that's where we believe we can find those growth companies, the companies that are growing well and truly in excess of the overall market.

 St Anne: And are you able to mention any detractors from the portfolio?

Wilson: There are always detractors in the portfolio. Centrepoint Alliance is a financial services business that we actually thought would do well. What happened is, as they've got new management it's just taken a lot longer than we anticipated. That's been one of bad ones. Another one, another detractor was Symex. We brought that for a trade and unfortunately they raised some capital and they had profit downgrade in the middle of that.

 St Anne: And how do you manage your portfolio along with these underperforming stocks Geoff?

Wilson: An underperforming stock - if there is profit downgrade, then we sell. What we are doing is, we're trying to find those growth companies and once we've found a growth company, we won't buy it unless we can see a catalyst that’s going to change the valuation. So we'll sit in cash, unless we can see that.

Once we've identified the catalyst and that could be an earnings surprise. Anything that we believe will move the share price higher, then we'll buy it. Now, if that company disappoints or if it reaches our target price, then we'll sell it. With profit downgrades - if you have one profit downgrade, then there's a high probability in another one. So, we really want to cut our losses and move on.

St Anne: Geoff, on the point of the good performing stocks, in terms of the small industrials, they have been under pressure of late, how do you see the outlook for that sector?

Wilson: Well, it's interesting you say that. So far this year, the small industrial sector has actually done surprisingly well, even though over the last period, it's been difficult in terms of performance versus the large-caps, but more recently this year, it's actually probably performed -it's probably up double the amount of the overall market. So, going forward, we'll always - we are always focusing on finding opportunities in that sector.

The reason we like it, it tends to be under researched. It's very important to us to meet management. We see probably 800 companies plus each year and it's really to understand how those companies make their money, to understand the management because from our perspective, management is incredibly important particularly in smaller companies.

St Anne: Finally Geoff, can you give us a good outlook for the Australian equity market in general?

Wilson: In terms of the outlook for the market, we are in a deleveraging period and that could take a decade to 15 years, and we say we are four years into it. So the next five to 10 years is going to be difficult. It's going to a real grind from my perspective. In terms of what's happening domestically in Australia, I think it's fantastic that we had the interest rate cut the other week. I'd say there's another 100 basis points on the downside, and then that will have some positive impacts on earnings in Australia.

It will actually be stimulatory to the economy and that's six to nine months down the track, we'll start seeing the benefits of that. It will also move money from term deposits to the equity market. It's also lower interest rates means higher PEs, so you will see some PE expansion. So, we are actually cautiously optimistic, obviously that's domestically. Then when you look at from international perspective, we accept there is incredible uncertainty about Europe and the euro. My view is that the euro won't last, that it will break up and that's going to be very painful. Asia seems to holding it well in terms of growth and America seems to be holding reasonably well as well.

St Anne: Geoff, thanks so much for you insights today.

Wilson: Thank you very much.

Christine St Anne: Morningstar recently completed a report on the small cap sector. To give us an idea about how these managers performed, I'm joined by Tom Whitelaw. Tom welcome.

Tom Whitelaw: Thank you.

St Anne: Tom, how did the small cap managers performed against the broader market?

Whitelaw: Yeah. I mean if you take this over the last five years for example, so when markets fell off a cliff probably in about November 2007, small caps dramatically underperformed in the rest of the market, just given the kind of flight to safety that we saw as people have moved out of small and more risky names and moved up the market cap ladder.

Then when the market bounce from March 2009, small caps dramatically outperformed at this point again as people came back to risk assets, moved back into these stocks, inflated the prices and kind of seeing a little bit of effect at the start of 2012 as well when the market is in a bit of slump in 2010 and 2011 and small caps came back much more strongly than the rest of the market as it rallied in the first quarter of this year.

St Anne: Tom, just how volatile is this sector?

Whitelaw: Yes, it's pretty volatile. I mean the average small cap manager is probably around 40% more volatile we found than the ASX 200 Index, which gives a good proxy for large account managers. Actually, the most volatile strategy that we covered in small caps was actually 80% more volatile than large.

That kind of gives you good idea of just how volatile the whole sector is and it really just shows that investors, when they're investing in this area, need to be cognizant of these risks. Our work around investor returns show that investors often use these highly volatile strategies more poorly, it's often a temptation to buy in after the markets had a good run and then sell out after it's fallen.

St Anne: So, what sort of managers are best positioned to manage this volatility?

Whitelaw: It's very difficult to say which are best position to manage the volatility, because the volatility just exists down at this level of the market, there is not really much you can do to get away from it. We actually found that 90% of the managers that we covered over the last five years have actually shown less volatility than the small ordinaries index itself. So, it just shows that the volatility is there.

So, if you're going to invest down at that level, it's really best just to be prepared to handle it. Actually, the managers that we covered all actually outperformed the small ordinaries index apart from a couple of that time period as well, so it shows you get the low volatility and the performance over the index, which is quite interesting at this level of the market.

St Anne: Tom, your report identified a number of small cap investment managers that were underweight in the resources sector. Do you need to be exposed to this sector in order to outperform the market?

Whitelaw: Not really. No, I mean the managers that we kind of highlight the names like Hyperion, Pengana whose processes do lead them to underweight or not own resources stocks at all, and those managers have consistently manage to outperform and also done so with the similar level of volatility, and also are amongst the highest rated managers.

St Anne: What about fees in this sector?

Whitelaw: Yes, fees are a little higher than they are in large caps. I mean that's again the nature of the beast down here. These managers are picking more stocks normally and have to employee more time visiting companies to really getting an understanding, and that leads to higher fees. So, you're talking 25 basis points higher than the average large cap strategy, which is quite a bit and that’s before you take into account performance fees. So, around half or so - over half the managers that we covered down at this level actually have a performance fee on top.

Performance fees aren't necessarily a bad thing, but we just like to have a fair fee structure. So, if managers are going to have a performance fee, we'd like them to have a smaller base fee alongside that which really compensates the investor for the performance fee with a lower kind of ongoing costs whatever happens. We actually found that wasn't the case in a number of strategies and it actually costs the number of managers that we rated, who would have probably get higher ratings have they had a fairer fee structure.

St Anne: Finally, Tom, how do small cap managers fit in an investment portfolio?

Whitelaw: They're definitely supporting players. So, if you're investing in these kinds of strategies, it's something that's going to be the edge of your portfolio. So, if you have well balanced portfolio of larger Australian managers and some international exposure for example, then these are really the spicy positions that are around the edge that can really add some alpha when the stock market is performing well, but again as we said, you got to be cognizant that these things are likely to fall a lot further than the rest of the market when times are tougher.

St Anne: Tom, thanks for your insights today.

Whitelaw: Thank you very much.

Christine St Anne: Morningstar recently held its investment conference in Sydney. We caught up with Ian Huntley who shared his views on the top stocks in the Australian market.

Ian in your presentation you said that investing in Australian equities was like going into a Woolworths store with lots of choices.  What stocks should investors invest in, given all these choices available to them?

Ian Huntley:  Just like with Woolworths, customers are looking for different things but for a serious person trying to build assets for their retirement, which is a first class income producing assets. They should be looking at stocks relatively low in risk, which are going to give them very good income and growing income over the years.

Don’t worry too much about the price fluctuating, it will.  Just like the prices of everything in Woolworths.  Look at the income and look at the dividends – that’s what you want. You want that income to be stable and growing. Maybe it may comes down a notch or two in harsh times.

Morningstar have a moat rating on companies.  That is really a rating on the stability of income - the closer it is to a royalty stream of income the closer it is to a government bond stream of income. But unlike a government bond, a moat company will adjust for inflation, and can over the years do quite well.

What you are looking for are companies that are paying good dividend yields that are better than bank deposits. The problem with going into bank deposits, are that people have totally forgotten that they [interest rates] can go down. They are going down around the world and they can go down in Australia too.  Your income goes down. Your money’s safe, but your income’s going down.

Meantime a lot of other customers to the stock exchange supermarket are buying income stocks. There has been a bull market of income stocks for quite some time now. For instance the big daddy of them all, Telstra at $2.60 was yielding over 10 per cent fully franked, tax-free. Today it hit $3.60. That’s just in 12 months. The stock exchange is a terrible place, it’s shocking isn’t it? You can make money and get a  good income there!

St Anne: Just with the banks - they are very attractive income-wise but with a low-growth environment and pressures in Europe, do you think they are still in a position to deliver that income?

Huntley: They are delivering good dividends - they are increasing their dividends.  They’re not going to go to the races like they did in the 90s and give a great capital growth but they are giving stable and growing dividend growth of the fully franked kind and the yields are very good. They are pretty close to double bank deposits.

I think you’re much better to invest in the banks than in the deposits, but you don’t want to have more than 30 to 35 per cent of your portfolio of the bank stocks. 

St Anne: With the resources companies Ian, do you think now is the time they should become more income-orientated and start giving dividends back to investors?

Huntley: That’s a big ask. Yes

St Anne: Yes, you do think so? Okay. Finally Ian, do you think now we are on the cusp of perhaps a stronger market. Perhaps even a bull market?

Huntley: I think that will happen.  Theoretically there should be quite a sharp down turn ahead of it, which could happen mid-year.  You are already seeing a bull market in income stocks. Over the next five or seven years I would expect a bull market.  I would think it will be starting later this year or early next year. It will take on a number of different phases over the years - different leadership over that period of time. 

Christine St Anne: We’re at the Morningstar Investment Conference in Sydney today and I am joined by PIMCO’s Peter Dorrian to talk about the role of bonds against falling term deposit rates.

Peter, interest rates are set to fall further now, on the back of that how is that going to be making fixed income more attractive for investors?

Peter Dorrian: It’s an interesting time in the Australian economy. I think the Reserve Bank has finally recognized that the two-speed economy is producing good parts of the nation, but parts of the nation that are doing quite tough, and the 50 basis point cut that we have seen recently is obviously going to have an impact on longer-term rates. Already the 10-year bond rate in Australia is down around 3.5%.

Now, I think the important thing to think about is what that is telling us about the prospects for growth in the economy over the next few years. We still believe strongly that it is telling us prospects for growth in the economy remains subdued and the risk that China’s expansion will slow and thus have an impact on slowing the Australian economy remains pretty high. So we still see good value in Australian bonds at the present time.

St Anne: A lot of investors have been attracted to term deposits on the back of these high interest rates, so do you think now is the time that they should seriously be looking at bonds?

Dorrian: Well, I think it’s really interesting when you look at what’s happened to TD rates in the last few weeks. Lot of investors who might have held a 12 or 24-month term deposit are now facing this very serious reinvestment risk. People who have been earning a 6% or 7% earning rate are now coming out and facing rates in the 2%s and 3%s.

So, a very significant level of reinvestment risk, which is one of those things that we have been talking about, term deposit investors have to think about. So when you are coming out and facing 2% or 3% set return over the next one or two years, again we think a diversified portfolio of bonds looks pretty good compared to that as well.

St Anne: Then finally Peter how have you positioned to your portfolio, are you favoring Australian bonds to overseas or vice versa?

Dorrian: Well, in our diversified fixed income fund, which is the major fund that’s used by investors and advisors in Australia, which generally has a 50-50 mix between Australia and the rest of the world. We still have a favoring towards the rest of the world, because we see higher rates of return coming from some of the emerging markets, better rates of return coming from some of the offshore credit markets and of course we get, by investing offshore, that yields pickup between the Australian cash rate and the countries overseas cash rates. So, global bonds, still in our view, we are overweighed in that portfolio at the present time.

St Anne: Peter, thanks so much for your thoughts.

Dorrian: Christine, it’s my pleasure.

Nicolas Grove: The country's biggest explosives maker and chemicals supplier, Orica, this week announced a half year profit of about $253 million, down around 4% on the same period in the prior year. Here to talk us through the result, I'm joined by Morningstar's Senior Equities Analyst, Peter Rae.

Peter, thanks very much for joining us.

Peter Rae: You're welcome, Nick.

Grove: First of all Peter, what were the main drivers of the result and did it meet your expectations?

Rae: Broadly, it met expectations, maybe it was just a little bit above my forecast. The key issues were much as we thought. Of course this result was hurt significantly by the shutdown of the ammonium nitrate plants up at Kooragang Island near Newcastle so that had a big impact on the result. Reduced EBIT by about round about $90 million, which was what they told the market, so there was nothing surprising about that. So, that's why the result overall was lower by about 4%.

In terms of the key themes, it was pretty good. Demand for mining chemicals and mining explosives was very strong, and they were the key drivers of growth that help to offset that negative impact of the Kooragang Island shutdowns. Demand for ammonium nitrate, which is the key ingredient for explosives, was very strong, particularly in Australia. We saw volumes up 15%. Now part of that was the fact that the first half last year was impacted by severe weather events, so mining activity reduced in the first half last year.

If you look at the underlying growth in demand for explosives here in Australia, it is round about 7%, and that's pretty good and that's a trend that we think will continue. Demand for explosives in the Asian region was good too for mining there, and also Latin America, strong demand for explosives there. So, they were probably the key things that drove the result. So if we didn't have that $90 million negative hit from Kooragang Island, it would have been a very strong result.

If we look at some of the other businesses, the chemicals business; mining chemicals was strong but general industrial chemicals were weak, which is not surprising given the weak environment in industry and manufacturing. The Minova business reported a slight increase in profit, so hopefully that indicates a bottoming out for that business there.

Grove: Peter, was the half-year dividend around about where you thought it would be, and is Orica on track with what you expect it to pay shareholders at the end of the year?

Rae: Despite the slightly lower result, they increased the interim dividend by $0.01 a share. Now that signals to the market, I guess, the Directors are happy that the second half is going to be a good result. I am forecasting a dividend of $0.96 per share for the full year. I don't see any reason to change that. It's a payout ratio of around 51% to 52%, which is consistent with what they have paid out previously.

Grove: Peter, you have recently expressed some concerns about Orica's Minova underground mining and tunnelling business in the way it has been performing. What do you think will become of this division?

Rae: Look it's difficult to say. The previous management seemed intent on retaining that business, and Ian Smith has not made any comments to the contrary at this stage. They have an efficiency review underway, and particularly in the U.S., which is where business is really underperforming. There is an efficiency review underway, and they are trying to extract some efficiencies to offset some of the competitive pressures that they are experiencing, particularly in the U.S. They are also looking at new products and higher technology offerings as well to try and differentiate themselves from some of their competitors.

But look, the business is returning - or its providing a return on net assets of under 8%, which is less than half the 18% target that they had, when they bought the business. So it's a significant underperformer. For them to keep it, they really need to make some significant improvements to the business, otherwise I think they should be thinking about whether there is parts of that business that they should divest, and in the U.S. in particular, there is some very strong competition and it just does not appear to be abating. So it is a big issue for them to try and get that business to perform, and if they can't, then they have to seriously think about whether they retain or sell parts of that business.

Grove: Finally Peter, what risks should investors bear in mind when it comes to investing in a company such as Orica?

Rae: There is a couple of key risks. One of course is their exposure to the mining sector. The mining sector is going gangbusters at the moment, and as long as that continues, then their volumes of explosives sold to that industry will continue to rise. They made comments yesterday at their briefing that they see volume growth being pretty strong for some time. But if there was a sudden or unexpected downturn in the sector, then that would have an impact on demand for explosives.

One thing that you should bear in mind is that, even if there is a slight downturn, it's not going to have our major impact on them. They are also benefiting from changes in strip ratios, which means that ore grades as they decline then more explosives are required to extract the same amount of ore, so that's something that will benefit them, despite what happens in the resources sector.

One of the other risks that I guess is front of mind after the Kooragang Island incidences - they are chemical company releases of chemicals or chemical spills are always going to cause damage to the company, both reputationally and to earnings. So that's something that they really have to manage carefully, and Ian Smith commented they have put procedures and processes in places, and now they will ensure that the incidence that did happen at Kooragang Island won't happen again. But it's easy to say things like that. But they really do need to have the processes to ensure that they don't have major spills.

Grove: Peter, thanks very much for joining us.

Rae: You're welcome.

Christine St. Anne: We're at the Morningstar investment conference in Sydney today and I'm joined by Ibbotson's Daniel Needham to discuss the case for investing overseas.

Daniel in your presentation, you mentioned possibly a second financial crisis pertaining to the finance sector in Australia, why do you say that?

Daniel Needham: In my mind, it wouldn't be a second financial crisis in Australia, it will be a first, because I think in Australia we didn't really have a financial crisis. Certainly nowhere near as bad as what we've seen in the United States and Europe. I mean there was a huge amount of government intervention in Australia, both directly by the government guarantee on the bonds that banks were issuing in overseas markets, as well as the introduction of the deposit guarantee by the government and the secondary knock-on effects of the huge fiscal stimulus package that was brought into place.

So Australia dodge the bullet in many ways and in using different measures we actually increased our amount of indebtedness post the GFC, as opposed to deleveraging as we've seen in other markets. So when I say - I think the potential for the tailwinds that have supported the Australian economy over the last 20 years. So increasing commodity prices, asset markets moving off very depressed levels to what I consider to be high valuation levels, household balance sheets gearing up significantly and that money being funneled into residential property.

I think the potential, if we had a slowdown in China and a sequential slowdown in the domestic economy, I think the confluence of those two factors could lead us to have a significant potential financial crisis. I'm not saying that's my base case. I think the tail risks in Australia now for the next 10 years are the highest that they have been since the '70s and '80s. I mean, early '90s was obviously one of the worst recessions that we've had. I think it's been a long time since we've had one of those recessions.

The ROE of banks look great, but that ROE is being built off continually increasing debt and increasing asset values and I feel like that's probably run its course. So, the challenge for the Australian investors for the next 10 years and I also think for Australian banks is how they do with a shock from China and effectively a reversal of the virtuous circle of increasing asset prices and leverage.

St. Anne: On that basis, Daniel do you see more attractive valuations overseas compared to Australia?

Needham: I mean, I see markets overseas that are pricing in more potential downside risk. I think Europe whilst it's got some real problems and some of the financial stocks in Europe could face some real challenges, a lot of those are actually in the products. I mean obviously there is a potential that a few banks, effectively the equity gets wiped out. So maybe some of the credit segments for those banks is better to play, but in general I think European companies are trading on significantly higher discounts than Australian companies.

I think Japan also looks fairly promising. I think that we could be saying the exit of 20 years of deleveraging and contracting balance sheets of private companies or private enterprises. So I think that's a positive for the next 10 years.

I also think for an Australian investor being unhedged is critical. I think you can access those foreign markets, some of the high quality U.S. companies are fairly inexpensive, and if you consider the fact that you can buy them in Australian dollar terms they are outright cheap. So, an unhedged portfolio of global equities in the more attractively valued products in the market provide much more - I think much more potential upside over the next five to 10 years than the Australian share market. Within the Australian share market, I think there are still some pockets of opportunity.

St. Anne: What sort of opportunities do you see there?

Needham: I still think Australian REITS are inexpensive, and are giving you a reasonable return. There is some risk around the retail part of the market. I think that you don't get reasonable returns without bearing some risk. But I think that REIT markets are priced for reasonable returns. They are not priced for great returns, but I don't think they are priced for disastrous returns either.

I think outside of the banking sector and outside of the mining sector, there are some parts of the market that have been really suppressed from the tightening interest rate cycle, from the strong Australian dollar. I think that if we see Australia move into a more - a less robust external sector, so weaker export prices, weaker export volumes as well as lower interest rates.

So I think there are parts of the sort of the industrials - Australian industrial companies, they'll actually benefit significantly from that. These companies right now are not priced for a reversal of the Australian dollar or a significant drop in interest rates. They are priced for much of the same as what we’ve experienced and so that creates a medium term valuation opportunity. You want to be looking at what's priced in and you want to be buying inexpensive assets that have got pretty bad outcomes priced in. So, I think there is a subsector of the Australian market that fits our bill.

St. Anne: Daniel you mentioned Europe and Japan was offering opportunities, what about the emerging markets?

Needham: I think emerging markets - it's a very heterogeneous region, and so some regions look more attractive than others. In general, I think profit margins in emerging markets are high, which creates potential downside risk for earnings. I don't think that they are trading on enough of a discount, given the potential for a collapse in earnings in emerging markets.

So, I think emerging markets are probably slightly on the expensive side, but they are nowhere near in our mind those are unattractive as Australia equities or U.S. equities. So I think they probably have a role but they are a risky asset, and I think that their potential to loose - to fall significantly on a recession is pretty high. So, I wouldn’t be going heavily overweight those, or I'll tilting more towards developed cheaper parts of the markets.

Christine St Anne: Hybrids have become increasingly popular with investors, but what are the risks and how do they fit into a debt or equity portion of the portfolio? Today I'm joined by PIMCO's Michael Dale to give us a better insight into these securities.

Michael, welcome.

Michael Dale: Thanks for having me. Appreciate it, Christine.

St Anne: So, Michael, a lot of these hybrids have come into the market, what should investors be mindful of?

Dale: Well, I think, what we try to say at PIMCO is that investors really need to be cautious as classifying hybrids is a fixed interest alternative, because often hybrids will act like bonds in bull markets, but act like equity in bear markets, and the very reason why you invest in fixed interest is to have an asset that's appreciating in value while others are falling.

St Anne: So, can you give us some examples of the risks involved?

Dale: Absolutely. Well, like a fixed interest investment coupons are contractually paid, however hybrids which are being classified as a fixed interest investment will pay you a coupon or income like return, however, these are very much discretionary. In a risk of market, you may find that those discretionary coupon payments may be withheld by the issuer, and so when you need income at the most important times, you may find that the tap is turned off given the optionality that the issuer has with these securities.

Also in terms of capital structure, these securities lie just ahead of equity, and so in the event of a windup of a company, you're actually subordinated to all bond investors, and therefore should be paid for the risk that you're taking. Finally, the issuer has in-built into these contracts over these securities the option of extending the maturing from the call back optionality embedded into the security. So, the investor may find that they're investing for up to around 25 years, so are you being paid the return for that maturity level, I don't think so.

St Anne: Michael, is there ever a good time to invest in hybrids?

Dale: Well, investors really need to take into consideration the risks that are involved with hybrids. First and foremost, are they being paid for the risks that they've taken, the risk that we've already talked about. The fact that their coupon could be turned off in light of a bad run for the company. The fact that you're subordinated versus all issuance of debt, and just above in the capital structure than common equity, and so when they take all that into consideration, the investor that is, they need to then really ask themselves have they got an investment that fits their asset allocation in their portfolio. So, the question is, do you ever really want to invest into hybrids, and I'm not ever saying not to own a hybrid, but I think you need to say to yourself, what is this hybrid doing in my overall asset allocation?

You should look at whether you can purchase an equity, or common equity in the same company, and on a fully franked level is that dividend paying you as much as the hybrid. So, these are the kinds of things you need to ask yourself before investing into a hybrid, but all that we're trying to say is it shouldn't be classified as a fixed interest alternative that pays you income, because obviously, as I've mentioned before hybrids will act like equity in bear markets, and that's not what you invest in fixed interest for.

St Anne: Michael, but in an environment of subdued returns, shouldn't investors look to get that extra return from hybrids?

Dale: Well, Christine, no doubt the last three to six months has been a fantastic windfall for risk on investing, and no doubt the investments made into the hybrids of recent months has been a successful transition out of cash and term deposits. But we'd like to say that any bad news that was to come to the market over the next three months would leave these risk assets very, very vulnerable to a sell off, and therefore we don't think that investors should be rushing into risk assets like hybrids by looking for yields. So when you can find comparable yields, much higher up in the capital structure in the same bonds, issued by the same companies, hedged into Australian dollars, we'd say that is a much better alternative for investors given the volatility in markets we're still facing.

St Anne: So, Michael, what kind of assets can investors look for in this low return market?

Dale: Well I think, first and foremost, investors really need to ensure diversification amongst their portfolio. In Australia, we've been heavily skewed towards risk assets for so long now, at the detriment of investment returns. Bonds have been able to produce double digit returns both in global and Australian strategies for a number of years, and whilst may not be able to produce those returns going forward have definitely been seen in a better light from an investor's point of view to the fact that you can appreciate in value, unlock a term deposit for that matter, when other assets, particularly assets are falling in value. So, I think, going forward, the ultimate diversification of one's portfolio is going to be ultimately the most crucial aspect.

St Anne: Michael, thanks so much for your insights today.

Dale: Thanks very much, Christine. Appreciate it.

Nicholas Grove: Well, it's generally accepted that shares can rise more strongly than fixed interest investments over long periods of time, the question still stands: what quality should you look for when it comes to a stock? Here to give us a few ideas, I am joined by Morningstar's Michael Wu.

Michael, thanks very much for joining us.

Michael Wu: It's nice to be here.

Grove: First of all Michael, what are some of the qualities you look for when it comes to a stock and can you also expand upon the Morningstar concept of a moat?

Wu: Well, Nick, let's start with the definition of a moat. A moat is basically the water around a castle. The water basically protects a castle from attackers. So, the same concept can be applied to a business. A very good industry will attract quite - plenty of competition and what economic moat is what kind of competitive advantage a company has in sustaining that return on capital that exceeds the weighted average cost of capital.

We basically assign a moat rating based on how long they can sustain it, a company that can sustain over 10 years will have a narrow moat, and a wide moat for 20 years. Obviously, a company with no competitive advantage will have no moat rating.

Grove: Michael, what kind of criteria are required for a moat rating?

Wu: Nick, there's a number of criterias in Morningstar that we look for. The first one is an intangible asset. What intangible asset is, an asset that's quite unique to the firm and that can come in the form of a patent, a brand or regulatory license. An example could be SP AusNet, where they have a perpetual license in operating a transmission line, an electricity distribution network in Victoria.

Another criteria that we have is cost advantage. A cost advantage is where a player has a sustainable lower cost structure over their competitors, an example - a prime example is Woolworths, where they have a wide economic moat rating. Basically, Woolworths has a significant footprint right across Australia, they’ve got a large efficient supply chain and that allows them to operate at a very low cost and in turn they can pass on those prices, low prices to consumers.

Another criteria we look at is switching cost, where a firm’s product makes it very difficult and costly in the form of time and both time and money for them to switch to another provider. So, a prime example is the banks where the products that's offered by banks are quite common, but it makes it very time consuming for depositors and borrowers to switch between service providers.

The fourth criteria we look at is network effect. Basically, what a network effect is when additional users take up this product or service it enhances the value of that particular product. An example is Trade Me, which is an eBay online auction site in New Zealand, who got a wide moat rating on it. Basically, when more users use that website it enhances the value. It has more people looking at listings and making bids, so it attracts both buyers and sellers on to the site.

The last criteria we look at is efficient scale. Efficient scale is where a market is dominated by two players and this market tends to be quite small. An example is the telecommunication market in New Zealand, where the industry is served by Telecom and Vodafone, they dominate the market and basically they have economies of scale, which limits competitors from entering the market.

Grove: On the flipside Michael, what are some of the warning signs to look for when it comes to evaluating a company?

Wu: It should be constantly looking at companies and industry how that changes the company's competitive advantage. These factors can come from both external and internal. Externally, we look at how new entrants would enter the market, how it would shake up the competitors of the company. An example, if we go back to the early example is Woolworths, obviously, there are new entrants coming in with Aldi and international players like Costco. So that's going to increase the competitiveness of the industry and investors should be mindful of that.

Grove: Finally Michael should an investor only look at buying stocks that pay dividends and if not, why not? We know that diversification across asset classes is important, but is this also important when it comes to the equity market?

Wu: Well Nick, I think an investor should look at diversification in the context of their entire portfolio. Whether a company pays a dividend now or in the future, it really depends on the company itself and the investor individually. So from a company standpoint, it depends on where they are in their business cycle in the industry cycle, what kind of projects they have in hand at the moment. If a company for example, an emerging company in a fast-growing market, perfectly they have quite a number of projects that increases the value of the company.

From a company standpoint, it depends on the capital management strategy where they are in the business cycle and in the industry cycle. A fast-growing firm in an emerging market, there should be quite a number of projects that could increase the shareholder value. From that standpoint we see those companies - it's just better for them to reinvest in the business, instead of paying out dividends. Comparatively, in a company in a very mature market with limited projects, obviously we do want to see the company return dividends to shareholders, as well as maybe perhaps a share buyback program.

From an investor perspective, really it depends on the individual circumstance. This includes the dependence on the cash flow in the form of dividends or for example what the tax status is. For example, a person on a high tax bracket would not prefer dividend being paid out now, which could lift tax payable in this period. To wrap up, it really depends on the investor themselves, so what they should do is, look at the investments - individual investments in the context of the entire portfolio, and remember to consider both risk and return.

Grove: Michael, thanks very much for joining us.

Wu: It's good to be here, Nick.

Grove: To read more on the basics of stock evaluation, please visit the Morningstar.com.au Learn tab and click on the link below.

Nicholas Grove: While there are risks associated with small cap investing and while many of these stocks may not be suitable for all investors, there are opportunities to be found at this end of the market. Here to discuss Morningstar's latest Best Small Cap Businesses Update, I'm joined on the line by Morningstar's Peter Rae.

First of all, Peter, how has the portfolio performed since its last update in February, and what kind of factors are behind this performance?

Peter Rae: Well Nick, the portfolio had performed very well through February and March with 9 stocks in the portfolio delivering an average return of 9.2% for the period. This beat the ASX200 Accumulation Index return of 4.1%. There are a number of factors behind this outperformance.

Firstly, small caps in general performed well through the March quarter, with some reasonable earnings numbers coming through in February. Secondly, a handful of our best small cap business stocks performed exceptionally well. The New Zealand auction website Trade Me raised 25% since we included it in the portfolio in February. It delivered a first half '12 earnings result which was in line with expectations, but more importantly the long-term outlook remains very positive. We're expecting strong growth in earnings over the next five years.

There was another Internet-based business, Carsales.com, which also performed very well. It delivered a return of 20% for the period. This company delivered 20% growth in interim profit, which was on strong revenue growth and also maintenance of high margins. Similar to TradeMe, this business also has a very strong brand, dominant market position. It's outlook is for further strong growth given the continuing trend for classifieds to shift from print to online.

There were also a number of - or couple of other stocks that did very well with IT services company, SMS Management & Technology returning 17%, and the four wheel drive accessories maker ARB Corporation returned 13%.

Grove: Peter, could you briefly take us through Morningstar's selection criteria for the portfolio?

Rae: Yeah, certainly. Look, in selecting stocks we focus on a number of key attributes that set a business apart from its peers. Firstly, we look for businesses that have strong or leading market positions and businesses such as TradeMe and Carsales come to mind there, or we look for businesses with an established niche in a particular market segment, and growing businesses such as ARB Corporation has a particularly strong niche.

Some of the businesses, but not all have been rated with an economic moat, but regardless we still think that the businesses we have in the portfolio have particular business strength, such as strong maintainable brands and that's something that we look for.

We also look for companies with strong management and proven ability to deliver sustainable above average returns on equity and financial strength of course is very important, and we also try to avoid highly cyclical stocks.

Grove: What precautions should investors take and what risks should they be aware of when investing in the small cap space?

Rae: Look, small cap stocks in general are higher risk. Often they lack the product, geographic, and business diversification that a larger stock might have, and therefore they can be more exposed to downturns in the business cycle. Of course, this can also be an advantage if the stock has a particular profitable market niche. Look other risks: often it can be difficult for smaller players to access the necessary capital to finance the growth, and in an economic downturn smaller businesses with excessive debt levels can come under serve financial pressure.

Key-man risk is something to be aware of also. Many small businesses are heavily reliant on one or a handful of managers, particularly where there is a founder who is still a dominant player. Stock liquidity can also be an issue, if the shares are thinly traded, which can often be the case where there is a small free float due to founders holding a major proportion of the stock. Look, given the risks in small caps they may not suite all investors, and for most investors, we think there should be a small part of a well balanced diversified portfolio.

Grove: Peter, just on something that should be front and center in investors' minds at the moment, are any of these companies in the portfolio good dividend payers?

Rae: Yes, Nick. Look, we have a few with fairly good dividend yields. The best dividend yield is from SMS Management & Technology, which offers a forecast 2012 yield of 5.2% fully franked. This company has strong cash flows, no debt, and it maintains a payout ratio of 65% to 70%.

Also the vitamins and supplements distributor, Blackmores, is currently on a yield of 4.7% fully franked. It also has a relatively strong balance sheet and maintains a high payout ratio. Carsales, iiNet and Reckon, they also offer yields of about 4%, with Carsales and iiNet fully franked, and Reckon 90% franked. Look on average the yield for the portfolio is reasonable at 3.9%, and there is a fairly high level of franking there.

Grove: Peter, thanks very much for joining us.

Rae: Thank you, Nick.

Grove: To read Morningstar’s latest Best Small Cap Businesses Update, Morningstar.com.au, premium subscribers can go to the special reports tab and click on the link below.

Nicholas Grove: Coles supermarkets owned by Australian listed conglomerate Wesfarmers recently unveiled third quarter sales of $6.1 billion. The supermarket giant also revamped its FlyBuys loyalty program in an effort to increase the size of shopper's baskets. Here to give us his thoughts on how the supermarket giant and its parent company are travelling, I'm joined by Morningstar Head of Equities Research, Peter Warnes.

Peter, thanks very much for joining us.

Peter Warnes: Thanks Nick, good to be here.

Grove: First of all, Peter, how did Coles' third quarter sales stack up against those of its arch rival Woolworths and what were the key drivers?

Warnes: Nick, Coles have still got momentum. There is little doubt about that. This is the 15th consecutive quarter that they have achieved positive growth in comparable sales, which is a terrific performance. They have headline growth of 4.1% and comps growth of 2.7% against Woolworths' headline sales growth of 2.9% and flat comps. In addition to that, Woolworths have got the momentum on Coles in liquor and the underperformance of Coles' liquor operations dragged their food operations back by 0.8 of a percent. So their food operations are really firing compared to Woolworths and that momentum is going to be hard to piggyback.

Grove: How did the more discretionary side of things in Wesfarmers retail operations like Target, like Kmart, how did they stack up against their opposite number in Woolies’ Big W?

Warnes: Nick, in that discretionary space, it is very-very difficult. They are still deleveraging by households and very-very frugal and cautious customer. The results from Kmart and Target were if you like it, poles apart. Target is going under a restructuring if you like, with new management and their headline sales were down about 4% and their comps were down about 6%, and that was really due to kind of, trying to restructure and get promotional sales that previously were not profitable at all, so they're cutting out the promotional sales. Their inventory was in good shape, until they didn't have a lot of cheap inventory to get out of the door and so that affected the top line as well, but the margin was better.

Now, in terms of Kmart, there's been a bit of a revival there after a sluggish last quarter of 2011 and they've gone back into the positive territory, with headline up about 1.6% and comps up about 1.9%. I suspect there's a little bit of cannibalization. I think Target loose a bit and Kmart get a bit, but that positive growth there in Kmart is pleasing.

Strangely enough, Big W also pleased, they had headline sales up 1.4% and comps were down about 0.9%, but that was a turnaround; and they indicated that the retail conditions were better in January and better in February and better in March. So as we progress through the quarter, they saw conditions just easing a little bit better. So overall those discretionary performances weren't too bad.

Grove: Just as an aside Peter, in your opinion, does Woolworth's recent foray into hardware retailing pose any kind of threat to Wesfarmers’ Bunnings operation in terms of its market dominance and its earnings?

Warnes: Nick, home improvement hardware is a big market segment in retail. It's probably about $40 billion to $42 billion worth of annual sales. Bunnings is the largest in the space, but it's only got about 17% or 18% of the market. So it's very fragmented and there is a lot of space there for another big player to come in, and that's what Woolworths via the Masters joint venture is endeavouring to do. I mean they have got 10 stores up and running now, and those results for the third quarter up about 29% off a very, very low base is pleasing, but its way-way too early to suggest, one, what the trend is like and two, what the impact on Bunnings is going to be.

Having said that, they have a long-term plan to open and rollout 150 stores. But Bunnings are not letting grass go under their feet either, and they have opened their 200th warehouse in the quarter, and they have 91 more warehouse stores in the pipeline at different varying stages of development to be rolled out over the next couple of years. So it will be competitive, but there is space there for two big players to compete, and I don't think it's going to have a significant effect on Bunnings going forward.

Grove: Finally Peter, do you think the FlyBuys revamp, as a part of Coles longer-term turnaround program is a sensible strategy?

Warnes: Look, supermarket is all about foot traffic and volume, and it doesn't matter how you get them through the door. Once you've got them through the door, then you've got to make sure that they are satisfied in embracing the offer that you're making. That was one of the drivers of the Cole's supermarket performance. What happened is, they are getting increased foot traffic, and in addition to that, the basket size is increasing. So that combination of increased foot traffic and increased basket size is very, very powerful from a volume point of view and that's the goal. So, the FlyBuys program with the Vicar of Dibley running it if you like. I mean it's all about trying to get more new customers through the door, attracting new customers and increasing the loyalty of the existing customers; and if you do that, the volume follows.

Now there is a cost involved, but Coles argue that strange enough, just like Qantas frequent flyers, that Coles FlyBuys will ultimately become profit centre, not a cost centre; and it will take a couple of years to do that. But look, it's a promotional activity. It's designed to attract foot traffic and lift the basket size and that's - if they pull that off, then the momentum will continue to be at Coles and I think it's probably positive.

Grove: Peter, thanks very much for joining us.

Warnes: No trouble Nick.

Nicholas Grove: Australian retail giant, Woolworths last week unveiled its third quarter sales results and here to discuss what they mean for the company and its investors, I'm joined by Morningstar Head of Equity Research, Peter Warnes.

Peter, thanks very much for joining us.

Peter Warnes: Thanks Nick.

Grove: First of all Peter, in your opinion how did the sales stack up overall? In the Australian food and liquor division what you called ‘the engine room’, how did that perform?

Warnes: Yeah Nick, the sales numbers for the third quarter were a little softer than we were looking for, only marginal, but 2.9% increase in Australian food and liquor, which is the engine room, was just off the pace a tad and comparable sales were dead flat. I would have thought that management would have been a little bit disappointed with those.

The top line numbers up 3.7%, when you add in Petrol and all the other operations. Again, probably a little soft than we look for. But look, the engine room is still firing. But look it's very, very difficult. The conditions out there are really very, very tough. Forget about frugalism and then everyone is shopping down. I mean, the weather has been absolutely abysmal, particularly on the east coast and that has really exacerbated the sales performance.

Grove: Were there any areas of the result that caused you any major concern?

Warnes: Again, this niggling thing that's happening in Australian food and liquor. I mean, you could argue that the food operations were a tad softer; in other words, slightly negative growth, because liquor is still driving forward very, very well. I mean, liquor is about 16% of the Australian Food and Liquor sales, and it had another very strong performance.

So, what's happening there - I mean Woolworths are on a very, very aggressive store opening campaign. They'll open 39 supermarkets this year, and there has got to be some cannibalization there. So I think that's what's trimming up, what's happening at the headline number and certainly what's trimming up the comps.

Grove: Peter, while Woolies didn't provide any full year earnings guidance last week, are they on track with your numbers and what kind of other headwinds are they facing in this final quarter?

Warnes: Nick, you're correct. No update on guidance. Guidance is still for NPAT, and this excludes $300 million provision for the consumer electronics, Dick Smith restructure and ultimate divestment. NPAT growth of between 2% and 6%, and our numbers are slightly to the top end of that. It will depend on just what's happening with margins, because margins and efficiency in the supply chain will ultimately determine where the NPAT sits.

Look, yes there are headwinds out there, there is no doubt about that. This is the most competitive environment I have ever seen, with two of the big majors really are - this is a slugfest. This is a heavyweight championship of the world if you like, and people are getting bruised, and I would think that it's going to go on for a little while. But those two retailers will still come out very-very well, they will still be very profitable. There is no signs for concern in either Coles or Woolworths.

Grove: Finally Peter, we're all aware of the shifting sands in the retail market, the migration of the consumer to online, Australians being more frugal and saving more etcetera, etcetera. How well do you think Woolies is adapting to this changing environment?

Warnes: Nick, they've adapted as well as any one, and don't forget this is the biggest retailer in the country about - on a comparable basis, close to $0.30 of every $1 spent goes through Woolworths or Woolworths' owned operation, and that's a hell of a number. The online pressures will obviously affect the discretionary area, but they are not in the big, big tickets items. They are in the more discount department stores and that's not really on where online competition really thrives.

It certainly doesn't thrive in food, and so they have been relatively adaptable. It does affect Dick Smith and consumer electronics and they have decided to belatedly and thank goodness, to pull up stumps; and so if you say are they reacting to it, yes they are and they have packed their bag and going home.

Grove: Peter, thanks very much for joining us.

Warnes: Pleasure, Nick.

Christine St. Anne: Russell Investments recently made changes to its high dividend ETF. Today, I'm joined by Scott Bennett to talk to us about who are the companies that are giving you, the investors the high dividends. Scott, welcome.

Scott Bennett: Hi Christine.

St. Anne: Scott, besides the major banks, who are the companies in your top 10 holdings?

Bennett: Yeah. We've got a really diverse set of holdings in the top 10 for our high dividend index especially. So when we look through the major holdings, in that we have allocations to things such as telecommunication, obviously through Telstra, which is a very high yielding stock. We also have allocations to areas such as media as well, so Seven West Media is a company that has come up and shown fairly good yield over the past 12 months and we expect that to continue, obviously. Then outside of that we've got exposures in gaming, through companies such as Tatts, and then also more the consumer staples through Wesfarmers and also Woolworths, which have very sustainable - what we think a very sustainable dividend yields. On top of that we also ensure that we do have exposure in the resource sector as well, and that exposure is primarily through BHP, which has a very strong history of paying growing dividend.

St. Anne: Scott, on the point of BHP, a number of investors have been a little bit cranky about the company not giving them the dividends they deserve. So where are they among your top holdings?

Bennett: Yeah. I mean that's quite interesting. I mean BHP generally, the yield on BHP stocks are round about 3% per annum, and that's before including for franking credits. So once you to include franking credits on top of that, you are looking at something around about a 4% yield, which is around about 2% below market, so not the best yielding stock. The reason for that is, I mean, BHP, while it's not necessarily a fantastic growth company, it is very capital intensive in terms of them seeking out acquisitions and the like. But what we’ve seen with BHP, and what might not actually show up on dividend yield. So they have actually been fairly good in terms of managing their capital structure.

Last year, we saw around a significant result of that being, their $2 billion buyback, which many investors were able to participate in and that resulted in substantial amount of yield pickup and income for investors, where that $2 billion effectively treated as a special dividend. BHP, while the yield might not look that attractive in terms of its dividend policy, we think it's been fairly conservative, but definitely progressive in terms of the way it manages dividends over time.

St. Anne: Scott, can you give us a little idea about the processes you have in identifying the sustainable dividends?

Bennett: In terms of the process of using for RDV, what we really want to focus on is not so much what the companies have paid out in the past, but what they are likely to pay out over the next three years. So the reason for that is that dividends, like earnings can be highly sporadic. Those companies are actually likely to pay dividends next year, and for several years after that. So that when we buy a stock, we have a very high likelihood, that it will actually pay dividends over the next three years. So that's where we put the greatest emphasis on the stocks that we are looking at. We obviously do make sure that those companies that we are holding have had a history of paying out a dividend over their history. So we look out over the last five years and look at what their dividend payments have been like over those five years.

The other criteria that we look at, this relates back to the BHP stories, it's really important for investors that their dividends are growing through time. So, if you just save the same amount of dividend each year, over a 10 period, inflation would have eaten away around about a third of the value of that dividend. So you need your dividends to be constantly growing to maintain the purchasing power. So, we explicitly look for dividend growth, and make sure that the companies we are buying have the history of increasing their dividend over time.

Then the final measure we look at is earnings variability. So we want to make sure that the companies that we are investing in are sound, and then they're not highly cyclical.

St. Anne: Investors love the banks when it comes to income stocks. What about the importance of diversification?

Bennett: In the Australian market, we think it's very important to think about diversifying, especially when you are looking at income investing. Because while income investing should be relatively safe way to invest, there are traps obviously associated with very high yield stocks; and while we have confidence in the ability of banks to meet their dividend payments, we think there are lot of a opportunities that investors could forego by just limiting themselves to the banks, and we think there is some very good solid defensive opportunities out there for investors.

ETF include things like SP AusNet, which is an electricity supplier in Victoria. Very stable growing dividend and on a yield of around about 10% fully franked, we think that that offers obviously an attractive opportunity to investors outside of what they might hold within the banks; and we think that level of diversification is important, just so that you’re not overwhelmingly reliant on one source of income.

St. Anne: Scott, banks are also facing a lot of pressures at the moment, so do you think that they are able to sustain the relatively high dividends?

Bennett: Yeah. We think from a capital perspective and from a balance sheet perspective there is not that much pressure to the banks being able to sustain their dividend payouts, and also kind of increase their dividend payouts. What we've seen is the banks have been fairly resilient through time, in terms of supporting their dividend, even though their earnings may have been at risk through some period.

So just as a general policy, the banks don't like to reduce their dividends as a whole. So we think structurally, there isn't really much of a threat to the bank dividend. However, we do kind of realize that from an earnings perspective, the banks can be somewhat at risk. But we think that that risk isn't enough to erode their ability to pay dividends.

St. Anne: Scott, thanks so much for your insights today.

Bennett: Great, thanks Christine.

Nicholas Grove: At a recent investor presentation, Telstra unveiled its capital management strategy and reaffirmed its commitment to paying a $0.28 a share, fully franked dividend in both fiscal 2012 and fiscal 2013, while at the same time effectively ruling out a share buyback for the time being.

Here to give us his thoughts on the outlook for the telco, I’m joined by Morningstar Head of Equities Research, Peter Warnes.

Peter, thanks very much for joining us.

Peter Warnes: Thanks, Nick. Good to be back.

Grove: First of all, Peter, what do you think of Telstra’s capital management strategy, and do you think they're treating shareholders with due respect?

Warnes: Nick, in my expectations and right up my alley, I think they are treating their shareholders with respect. When you have capital allocation or free cash to distribute, they have to look at how they allocate it and there’s three buckets, if you like, and shareholders should get a good part of that.

I think, what they’ve done by saying look, nothing for the next couple of years, we’re going to hold that dividend in place, which is still very attractive, and we’re going to then increase fully franked dividends in the future, and I'll applaud them for that. I was very, very suspect of a share buyback, and I don’t think that’s the way to reward shareholders, unless you’re going to distribute excess franking credits.

Grove: Peter as the NBN is rolled out across the country, you said, Telstra will receive compensation payments that would generate franking credits that can be distributed as fully franked dividends. When do you think shareholders can expect to see an increased payment?

Warnes: Nick, firstly those compensation payments that are going to be paid by NBN Co and the government will be pre-tax in Telstra’s hands. Telstra will then pay tax on those payments, and then create the franking credits that they can then distribute. At this point in time, Telstra has no excess franking credits. They have enough to pay fully franked dividends in 2012 and 2013 at the rate of $0.28 a share, and that is what they will do.

Excess cash will start to accumulate and they’re starting to accumulate right now. In the year to June 2012, they have estimated that excess cash will be somewhere between $0.5 billion and $1 billion and by 2014, it will be somewhere between $2 billion and $3 billion. They will wait until those franking credits are generated, and then in 2014 will lift the dividend, which will be fully franked. Now there is potential to lift it quite substantially, but again I think conservatism will come into play and I am looking for something around $0.34, $0.35 to be paid fully franked in 2014.

Grove: Peter, how is the company faring against its competitors, and do you see any kind of M&A activity happening any time soon?

Warnes: Nick, against competition, look it’s very competitive out there still. We‘re not talking about PSTN, which is the copper network, let’s just ignore that for the moment. Let’s look at, in mobiles, and in network applications and services.  Look competition is still very, very intense in mobiles, but Telstra is still continuing to regain market share that was lost previously, when they didn’t embrace the iPhones early enough.

They’ve spent a fair bit of money on marketing in the last 18 months, but now they’re just kind of easing back on subsidies, on handsets, and so that will be beneficial for both the margin in mobiles, and I would suspect that they are continuing, as I said, to gain market share against - Optus is still trading very, very well and a very, very strong competitor. I still suspect that Vodafone is under the whip.

In terms of M&A, look David Thodey has said that they are interested in consolidated media and why wouldn’t they be.  Foxtel has been a very, very good investment for them. But it will come down to price, and it will come down to see what the regulator has to say, if they put a bid on the table, and had to move then to 75% of Foxtel, which the regulator might have some questions about, given also that Foxtel have just acquired Austar as you are aware.

So M&A is possible. I wouldn’t rule out something in Hong Kong, because as Hong Kong assets are very, very good assets, and they may well find something to bolt onto those. So, nothing in the early stages, but you could see M&A next year.

Grove: Finally, Peter, you’ve written widely of late about the importance of dividends in a post GFC world. Given your views, where do you think Telstra fits in a good solid, well diversified, conservative portfolio?

Warnes: Well Nick, you're right. I mean, post GFC, income from all investments is critical. There has been hundreds of billions of dollars of investors' money lost in the GFC and they’re obviously gun shy and you’ve seen how they are voting; they’re voting with their feet.  Look at the billions of dollars that are in Australian fixed term deposits, and I think that that they are telling you that really we want a return on our assets, no matter what they are and in terms of equities, the same situation.

So, we’ve been driving and looking at companies that have sustainable earnings and sustainable dividends, and it will be the icing on the cake, if in fact you could grow those dividends. So, in terms of Telstra, they are saying, $0.28 a share for next two years and an increase in 2014. Well, on that basis, given that the yield is somewhere north of 8%, and grossed up for franking closer to 12%, look Telstra should be a cornerstone in any investor’s portfolio, particularly income investors.

Grove: Peter, thanks very much for joining us.

Warnes: Pleasure, Nick.

Nicholas Grove: Australian mortgage lending or housing credit has witnessed a structural decline, and joining me to discuss what this means for shareholders in the banks, I'm joined by Morningstar's Senior Equities Analyst, David Walker.

David, thanks very much for joining us.

David Walker: Hi, Nick.

Grove: First of all, David, how the levels of mortgage lending affect the value of bank shares, particularly shares in the big four?

Walker: Well, mortgage lending or housing credit is crucial for big bank shareholder value, but especially for Commonwealth Bank and Westpac, where home loans account for respectively 60% and 58% of total loans on the balance sheet. So, that means that home loans account for a large proportion of net interest income, which is the largest and highest monthly source of bank revenue and banking operating income, and therefore of earnings, and therefore of shareholder value and dividends.

Grove: In your recent special report, you say you don't expect to see a return to pre-GFC levels of housing credit growth over the next five years, what are the factors behind this outlook?

Walker: There has been a structural decline in home lending or housing credit growth from the double digit rates of growth that we saw before the GFC, Global Financial Crisis, to the mid-single digit rates that we're currently seeing. Now, before the crisis the double-digit growth rates were part of a very long-term trend towards higher household debt, leveraging and borrowing, which began with financial deregulation in the 1980s.

Now, financial deregulation freed households from the restrictive lending laws and bank credit practices of the 1970s and the early 1980s, and it started a long term uptrend in household borrowing and debt and leverage, which fed on - which both fed on and engendered higher housing prices. People had to buy more to buy houses, and that in turn bid up the price of houses thus requiring more borrowing. Now this continued largely unchecked with some volatility until the global financial crisis, when the scale of the crisis, the extent of the alarming headlines led to a very sudden and profound change in the attitudes of Australian households to debt, credit and saving.

In the last quarter of 2008, the household saving rate went from about 4% to over 11% in just one quarter, so there was a sudden and dramatic large shift in household attitudes to debt and saving. No doubt, caused by the scary headlines, and the thoughts of what might happen to households, so obviously they became more aware of their vulnerability with their high rates of leverage and levels of debt especially due to fears of higher unemployment, even though the Australian economy came through the crisis very well, the unemployment didn't rise very much. So, the increase - that structural increase in household leverage can't be repeated because it was a product of financial deregulation, which won't happen again.

For double digit growth rates to return, we need to see the kind of very favorable investing in household environment that we saw in the 1990s, and most of the '20s. We have to see expectations of large increases to housing prices, and that's not about to happen. Investors would have to be a lot more confident - none of these things are about to happen, we’re in for a prolonged period of flat, maybe slightly rising, slightly falling housing prices, and the risks are mainly on the downside.

The Australian economy doesn't recover soon, if growth doesn’t start to become more evenly distributed, then housing prices are likely to trend lower. We could be in for a period of flat house prices and high yields like we had before World War II for example. So, all of this is going to affect the desire and ability of households to borrow against houses, and that's why the country and the banks are in for a long period of single digit growth in housing credit, a very different outlook from what many of us lived with for 25 years.

Grove: David, given your outlook, which banks will be most adversely affected, and on the flipside, which banks will be least affected?

Walker: Okay, so the banks with the highest proportions of home loans on their balance sheet, total loans in descending order - Bank of Queensland, Suncorp, Bendigo & Adelaide, Commonwealth Bank, and Westpac. ANZ and NAB, of course, also have huge values of housing loans on their balance sheet, but the ratios are relatively smaller because the proportions of business loans are so much higher, and it's partly due to these banks' overseas exposures, which in the case of ANZ and in the case of NAB as well, remembering NAB also has many U.K. home loans on its balance sheet, and they don't account for our analysis which is about Australian home loans.

Grove: David, in your report, you talk about rate cuts late last year doing little to spark demand for loans, and expectations for high house prices, high utility prices, higher fuel prices, et cetera, also dampening borrowing, what do you believe has to happen to get borrowers back borrowing?

Walker: The February out of cycle rate rises by the banks led to an unexpected and large effect on household borrowing confidence. We heard the likes of Stockland's CEO, Matthew Quinn say that, the February out of cycle rate rises triggered such a decline, he's saying, he's never seen such a sudden decline before. So, from here probably 50 basis points of Reserve Bank official interest rate reductions fully passed on, mind you, which is not going to happen, also without the anxiety of further out of cycle increases, which is also not going away.

Realistically, it would be necessary to stimulate a recovery of confidence in the housing market. Now that's going to happen realistically, so the most likely outcome is continuing improvements in affordability. Affordability is recovering. Reserve Bank Financial Stability Report has confirmed that. Yields are improving as well, so at some point affordability will improve to the point that that should stimulate a bit of a recovery in housing credit.

We're forecasting a modest recovery from around 5% to around 7% over the next two years, not very much, but something. Now investors will probably get a bit more interest again now that yields are rising as well.

Grove: David, thanks very much for joining us.

Walker: My pleasure, Nick. Thank you.

Grove: To read David Walker's special report on housing credit Morningstar.com.au premium subscribers can go to the special reports tab and click on the link below.

Rachel Haig: I'm Rachel Haig from Morningstar.com. A big question for a lot of investors is what is the best way to use their money? If they don't have enough to do both, does it make more sense to invest or to pay off debt? Here with me to address some of these issues is Morningstar's director of personal finance, Christine Benz. Thanks for joining me, Christine.

Christine Benz: Rachel, nice to be here.

Haig: So, where should someone start if they're grappling with this decision?

Benz: One obvious starting point is if you have high-interest credit card debt. In that case, it's very unlikely that you'll earn 18% or 20% by investing in the market, so paying off that credit card debt is going to be, by far, the best return on your capital.

One other area would be setting up an emergency fund, because the worst thing would be to find yourself digging an even bigger hole by layering on more credit card debt while you're paying off additional credit card debt. So you want to carve out that emergency fund, usually three to six months worth of living expenses.

And finally, if you're earning a 401(k) match, not investing in the 401K plan is the equivalent of turning away free money.

So those should be three starting points for anyone who's wrestling with the question of whether to pay off debt or invest.

Haig: When you're looking at which type of debt you should pay off first, obviously high-interest credit card debt, where you're paying a lot and not getting anything for that, is one of the first things you should eliminate. But how should you calculate it, generally? Which sort of debt is worth carrying?

Benz: Other types of debt, like mortgage debt and student loans, sometimes are characterized as good debt. But realistically, I think you have to think about whether you could earn the rate of return by investing in the market that you're paying to service your mortgage loan, or even your student loan. So even though those rates might seem nice and low on paper, paying them off or prepaying them is a sure return on your money.

Another consideration to bear in mind is whether you're earning any sort of tax deduction on your interest. If you are earning a tax reduction on your mortgage interest or on your student loan interest, that may push them down a little further on the priority scale versus investing.

Haig: OK. And what impact would it have if someone's carrying private mortgage insurance? Does that play into this at all?

Benz: It's definitely a consideration. Typically, you have to pay private mortgage insurance if you have less than 20% equity in your property. So if you are someone who's on the hook for PMI, that would encourage you to prepay the mortgage on a more aggressive schedule than perhaps your mortgage lender requires you to do. That would be another argument for definitely paying an extra $100, $200 a month to get rid of that PMI as soon as you possibly can.

Haig: All right. And what about for people who are younger or people who are further along in their investing careers? How does that factor into their decision?

Benz: Your portfolio's stock-bond mix should definitely figure into the decision. One way to think about it is, what return am I likely to earn on this portfolio? If I'm someone who's later in life and my portfolio is consisting mainly of bonds and cash, realistically, my return on that portfolio may not be that high, and I may well be better off paying down my mortgage or paying whatever debt I have off versus investing additionally in that investment portfolio.

So asset allocation is definitely a consideration. Someone who is earlier in life, and maybe their portfolio is predominantly stocks, that's a greater argument for investing in the portfolio versus paying down, say, mortgage debt.

Haig: Well, those sound like great guidelines. Thanks for joining us today.

Benz: Thanks, Rachel.

Haig: For Morningstar.com, I'm Rachel Haig.

Christine St Anne: Russell's Fund Manager Survey looks at a view that a number of investment managers have across a range of asset classes. To discuss the outlook, I'm joined by Russell's Greg Liddell.

Greg, welcome.

Greg Liddell: Thank you.

St Anne: Greg, in the survey fund managers are bullish on equities, why is that?

Liddell: The main feature there is valuations. I think, for the second quarter in a row, no manager in the survey said that Australian shares were overvalued, and 64% of managers said that Australian shares were undervalued. So combined with, I think, a little bit of a settling down of the global environment, certainly some pause in the sovereign debt crisis in Europe allowed more positive sentiment to come through and that's reflected in the survey results.

St Anne: So, within Australian equities what sectors were they most bullish about?

Liddell: Yeah, there's been a rotation out of the more defensive sectors like consumer staples into more cyclical sectors, so energy, industrials, telecommunications were the preferred sectors over the quarter. The other sector that was of note was that AREITs, after having been out of favor now for a very long time increased their - the bullishness on that sector increased from 21% to 47% which is quite substantial increase.

St Anne: What about the sectors that they were most bearish on?

Liddell: Again, looking - starting to look at some of those defensive sectors like - that have had a very good run last year, over the last - over the course of 2011, such as consumer staples.

St Anne: Greg, what about the fund managers views on the small cap sector, does that have a brighter outlook?

Liddell: Yes. Small cap managers are quite bullish on the small cap sector. I think about 67% of managers stated that they were bullish on small caps, and that comes back to the fact that managers believe that the Australian market should do well over 2012 and they're prepared to back higher beta positions.

St Anne: Greg, finally what about the fund managers views on China?

Liddell: Yeah, we asked managers this quarter what factor most influenced their portfolio construction decisions. Pretty much across the board they said that the China and Chinese growth was the most important factor that they took into account. It outranked even the Australian dollar, which has obviously been - the high Australian dollar has been a big issue for managers for some time now, and the issue with China is over the uncertainty of the growth outlook and whether or not there's going to be a hard or soft landing over there.

Manager opinions remain pretty divided on that. The housing situation over there is another point of contention, whether or not Chinese housing is in a bubble. Certainly, some sectors are, but we don't feel that there is risk of a collapse in the market over there in any sort of general sense, but that's what's giving managers most cause for concern.

St Anne: Greg, thanks so much for your thoughts today.

Liddell: You're welcome.