Code Cracking - A breakdown of the ASX (The Intrepid Investor Series Part 4)

Matt Brennan

The world of the Australian share market may seem like hieroglyphics at times; The ASX (Australian Securities Exchange) glossary alone has over 400 items within it which attempt to decode the market place. Besides the individual companies which we encounter in our daily lives (see the table below), the S&P (Standard and Poor’s – rating agency) ASX 200 and the All Ordinaries are the most common links between the share market and the outside world. Whether displayed on the ASX tower in Perth City, or glossed over in a 90 second slot in the evening news just before the weather report, the S&P ASX 200 (arguably the more interesting index) is something that we are all exposed to but yet is not commonly defined. So what does it mean?

“The S&P/ASX 200 is a Capitalisation weighted index measuring the performance of share prices based on the top 200 largest Australian companies.” The index was established by the ASX (Australian Securities Exchange) at 3133.3 points in April 2000 to mirror the All Ordinaries index. When this articles was written there was only .5 points separating the two indices, and the difference is that the All Ordinaries includes all ordinary (there are many types of shares) shares listed in Australia.

In order to translate the above sentiments, it is beneficial to have an understanding of what market capitalisation is. Market capitalisation has two components; the first component can be found in the equity section of a balance sheet for any listed company and that is the shareholders equity, which is calculated by multiplying the share price of a particular company by the number of shares on issue at a given date. For companies that have 100% of their issued capital in the form of ordinary shares market capitalisation is relatively simple to calculate. Take low cost gold producer Medusa Mining Ltd (MML), when this article was written they had 188.9 million ordinary shares on issue and their closing share price was $2.10, as they only had ordinary shares on issue and no debt, this equates to a market cap of $396.69 million.

A company’s total debt is the second component of market capitalisation, and this is calculated by grossing the value of all interest bearing liabilities (loans and other debt instruments) that are used to fund the business. When equity and debt are added together (in Medusa’s case $396.69 million + 0) the number calculated is the company’s market capitalisation at a particular point in time. From this the company can be given a weighting, which is simply the individual company’s market capitalisation divided by the total market capitalisation of the S&P ASX 200 index, and to give perspective on the size of the S&P ASX 200, Medusa Mining represents just 0.03% of the total value within the index. This means that MML’s price movements have almost no impact on the ASX within a trading day. However, contrast this with the share price of BHP Billiton, the largest listed company in Australia, where a 1% movement tomorrow would lead to the S&P ASX 200 moving 0.1% as a

whole (this assumption assumes no other shares are traded on this day.)

Heavyweights: The Top 10 companies in the S&P ASX 200 – source S&P Dow Jones Indices LLC

These 10 companies presented above comprise of over 50% of the total S&P ASX 200 market capitalisation. This top 10 analysis helps explain the way certain industries are structured. Telecommunications was shaped by Telstra being the sole provider in Australia right up until privatisation occurred in three stages beginning in 1997. The movement of the telecommunications index (ASX code: XTJ) is over 95% correlated to Telstra’s share price. It is a similar story in the banking and consumer staples industries. Banks primarily make money through the simple principal of charging more interest than they pay out to customers. It’s a simple business model, where Commonwealth Bank (CBA) CEO Ralph Norris once described it as “there’s nothing worse than a bank that can’t make money.” The larger a bank is in size, the more interest a bank can collect, and this process repeats itself until the big 4 banks now control nearly 80% of the market. CSL Ltd however is an anomaly in the Health Care sector. Innovation within the health care sector is believed to be achieved through hundreds of smaller syndicates trying to achieve the next breakthrough, which is why the healthcare sector is made up of 126 companies whilst the banking sector (excludes diversified financials and property) is made up of just 13 companies.

The Dow Jones (The finance firm which created The Wall Street Journal back in 1889) and the NASDAQ are America’s leading indices. The Dow Jones closed at 15399.65 points when this article was written, does that mean Australia got severely beaten by the Dow as the S&P ASX 200 only closed at 5321.5 points? Not necessarily, the way the markets are scored is in terms of percentage growth. The Dow Jones closed 0.18% higher when this article was written, whereas the S&P ASX 200 grew by 0.7% (up by 39 points.) Due to time zone differences and America’s huge influence in the world economy, Australia will likely post a similar gain to the US on the next trading day. There is a futures market known as the ASX SPI 200 which attempts to guess the change in market movement at the opening of the day’s trade.

The S&P ASX 200 Pie sliced into each sector. S&P Dow Jones Indices LLC

With the above S&P ASX 200 sector weightings, it is now possible to make sector bets against the index. The above implies that for every $100 currently invested in the share market; over $45 is invested in the financial sector (and from the table above – this can be broken down further to over $35 invested amongst the big 4 banks.) Is this how you would structure your portfolio? Where you deviate from the above is reflective upon the individual expectation of certain sectors outperforming others and is one of the main factors which causes the lines to be blurred between trading and gambling.

Fully replicating the S&P ASX 200 would incur brokerage so large the investment will never be viable (plus if this option wasn’t scaled down it would require an initial outlay of over $1 trillion.) An investor has three options if they wish to mimic the above: Option 1: Focus on the top 5-7 sectors apportioning investments with this exact ratio. Option 2: Invest purely in the index (ASX code: XAT) Option 3: Invest in a fund that replicates the index (ASX Code: STW.) An advantage of option 3 is that dividends will be paid twice a year; this may be true for option 1 as well depending on stock selection.

It was Spiderman that once said “with great power comes great responsibility,” however pursuing the share market deeper to its core is more like the Pringles effect, once that lid has been popped it is difficult to stop digging deeper. There is a treasure trove of companies amongst some blatantly obvious shipwrecks, so with preparedness (and let’s face it, a large initial cash balance does help) companies can be explored in the same spirit as Christopher Columbus (after weighing up individual and company specific risk factors) in the padded comfort of a swivel chair.

*Float adjusted market capitalisation refers to the fact that founding members such as Fortescue’s Andrew “Twiggy” Forrest’s initial holdings are not included in the market capitalisation of their companies as there is uncertainty surrounding their initial value and their liquidity (an initial holding would only be sold in the event of a takeover or retirement.) An IWF (Investible Weight Factors) applies to the index if holdings included within the index are not liquid in nature. The IWF requires closer analysis only when the amount is not equal to 1. GICS Refers to Global Industry Classification Standard and from an investing perspective allows benchmarking of the top stocks within a given sector.