Unquestionably the most intriguing news item of the week was the report from China’s National Bureau of Statistics (NBS) on the Middle Kingdom’s second-quarter gross domestic product (GDP).

China’s economy expanded 7.6 percent on a year-over-year basis during the three months ended Jun. 30, 2012, slowing from 8.1 percent in the first quarter, the NBS reported Friday. Still, this figure bested, if only slightly, official government expectations, and it set off global rallies in equities markets as well as commodities and growth-linked currencies.

The Australian dollar, for example, which has bounced hard off a Jun. 1 low for the year of USD0.97, powered higher on the news to close near USD1.0224, up 0.84 percent on the day and 5.4 percent above its 2012 low. This is despite the fact that the Australian Bureau of Statistics monthly employment report for June showed a loss of 27,000 jobs.

The reaction to the GDP report from China appears to be that 7.6 percent is 7.6 percent, and 7.6 percent is better than most emerging markets and every developed one. But there are “buts,” and they are important. And they are what tell us that all is not clear, that this, like the “success” of the June EU summit, will provide a positive but ephemeral shock to the global system.

The 7.6 percent figure marks the sixth consecutive quarter of decline as well as the slowest growth pace of growth since the first quarter of 2009. And though it “beat” expectations, those expectations were for something “below 8 percent.”

Beyond the headline-grabbing GDP number other Chinese numbers tell a sobering story. First-half industrial value-added output rose 10.5 percent year over year, slowing from an 11.6 percent increase in the first quarter. And retail sales increased 14.4 percent in the first half, slower than the 14.8 percent growth registered in the first quarter.

Fixed-asset investment, one of the principal drivers of China’s economy, grew by 20.4 percent on a year-over-year basis, moderating by half a percentage point from the first quarter and down 5.2 percentage points year-ago levels.

It’s likely, given the stakes this year, that the Chinese government will make a more concerted effort to stabilize the economy and keep growth at least within range of the magic 8 percent mark in the short term.

Spanning the globe to bring you the constant drumbeat of key economic and financial data, if only to provide context for movements in our long-term AE Portfolio Holdings, yields in Spain and Italy have once again backed off from their respective retests of recent highs.

Central banks in Brazil and South Korea both cut target short-term interest rates; both have plenty of room to practice traditional monetary policy by keeping rates above the rate of inflation.

Industrial production in the eurozone in May unexpectedly ticked up by 0.6 percent from April, but it was still down 2.8 percent on a year-over-year basis.

In the US the trade deficit fell by nearly USD2 billion in May, as exports rose to their second-highest level on record. With mortgage rates falling to another record low, applications for new home purchases rose by 3.3 percent.

Meanwhile, the University of Michigan one-year inflation-expectation measure fell to its lowest level since October 2010, likely due to the continuing decline in gasoline prices. And June import prices fell 2.7 percent, mostly led by energy.

Finally, the US government’s auction of 10-year Treasury notes went off with record demand and drove the yield to new lows.

And of course we have the rest of the story, which since the inaugural issue of Australian Edge has involved detailing the negative side of what remains a jagged, lumpy and unsatisfying recovery from the Great Financial Crisis of 2008-09.

Japanese machinery orders fell about 15 percent in May, much more than the consensus estimate for a 2.6 percent decline.

In the US, still the largest economy on the planet and at least the peer of China when it comes to global influence, the National Federal of Independent Business Optimism Index hit an eight-month low, while the University of Michigan confidence survey came in at a seven-month low.

Though mortgage rates have plumbed another low, applications to refinance were at a six-week low. And the producer price index (PPI) unexpectedly rose 0.1 percent month over month, a modest increase, but the core rate was up 2.6 percent year over year.

Of course panic during market downturns, as on the battlefield, is highly contagious. Equally damaging, however, can be succumbing to the euphoria that comes with an upside surprise such as was delivered by China on Friday and chasing stocks not based on value and their ability to build wealth over time but on the faith that this rising tide too shall soon provide an opportunity to foist it off on a greater believer at a still higher price.

The key to successful long-term wealth-building is making investment choices that don’t cost you sleep and that don’t turn on each and every economic indicator, from whatever country. You should focus on high-quality businesses that don’t require you to constantly monitor ups and downs throughout the trading day.

That’s for speculators. We’re investors. And as investors we’re focusing on the long play. That long play, particularly for Australia, still involves the Middle Kingdom. The stream of statistics will cause bounces and selloffs for markets. But China is still undergoing a process of industrialization, urbanization, marketization and internationalization, and this process will play out over a matter of decades, with substantial investment and consumption potential still to be tapped.

Portfolio Update

Our primary strategy at Australian Edge is to build wealth over time with a combination of rising dividends and capital gains. The key to execution is building a portfolio of companies backed by financially strong and growing underlying businesses. Once we’ve found them, we’re willing to hold on even during times of extreme volatility, provided the underlying business stays on track.

Select technical indicators, however, can tell us a lot about how a stock trades in the near term–particularly how much volatility we can expect to see. This kind of knowledge is invaluable for equanimity when the market is selling off and taking everything down with it. It’s a warning system for when great stocks become temporarily overvalued, and ripe for some profit-taking. And it can help time purchases of selected stocks to maximize returns.

The July Portfolio Update highlights seven pieces of technical data for each of the companies in the Australian Edge Portfolio:

• Market Capitalization: The number of shares outstanding times share price, measures how large the stock is. Larger companies tend to get more attention, but individual trades have less impact.
• Shorted Shares of Stock as Percentage of Daily Float: Short interest is the purest measure of bearish sentiment for a particular stock.
• Percentage of Institutional Ownership: Large institutions, mutual funds and other pools of capital increasingly dominate trading on global markets. The higher the percentage of a company’s stock that’s owned by institutions, the more volatile it’s likely to be in the face of broad market movements.
• Percentage of Insider Ownership: Smaller companies are more likely to have larger percentage holdings by top executives and board members. That’s a vote of confidence in the company, and all else equal it will limit volatility.
• Analysts Buy–Hold–Sell Ratings: These are quite important to institutional buyers and sellers of stocks. A stock covered by many analysts is likely to be more volatile when opinions change. All else equal, a positive outlook by a majority of analysts (more buys than holds and sells) is a stabilizing element. But a company with a lot of negative opinion isn’t likely to be much affected by negative shifts in analyst opinion, which also stabilizes share prices.
• Beta: This measures a stock’s volatility versus the S&P/Australian Securities Exchange 200 Index. Numbers above 1.00 indicate companies have been more volatile than the broad index over the two years ended Jul. 6, 2012. Numbers under 1.00 indicate companies less volatile than the general market.
• 2012 Total Return: Obviously, the higher the better when it comes to total return. But the numbers in the table clearly reflect some stocks’ exposure to volatility in commodity prices.

In Focus

In the introduction to the 2005 Harper Collins revised edition of The Intelligent Investor Jason Zweig, a columnist for The Wall Street Journal, described author Benjamin Graham as “the greatest practical investment thinker of all time.”

At the end of the day, the most important element of a sound investment decision, acknowledged by Mr. Graham, too, is a quality underlying business. It follows from this first principle that you must protect yourself against losses and that you should aim for “adequate” rather than spectacular returns.

Benjamin Graham is also the author of the equally essential Security Analysis, which represents the coming of age of the young graduate who started out of Columbia University–turning down offers to lecture in three departments, English, philosophy and mathematics, at his alma mater–at the Wall Street firm Newburger, Henderson & Loeb and quickly became a one-man statistical department.

Mr. Graham suggested that reasonably priced stocks could be identified by multiplying the price-to-earnings (P/E) ratio by the price-to-book (P/B) ratio. If the resulting number was below 22.5 the stock represented reasonable value. We’ve calculated this number for the entire How They Rate coverage universe (see the “Comment” section under each entry in the How They Rate table) and labeled it the “Graham Factor.”

We’ve focused on, in addition to price, yield, P/B and P/E ratios and the Graham Factor, two other pieces of information. “Beta” is a measure of relative volatility that indicates the price variance of an investment compared to the market as a whole. “Safety Rating” is each company’s score according to the Australian Edge Safety Rating System.

“Beta,” explained Mr. Graham, “is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no.

“Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.”

For risk, we have the AE Safety Rating System.

We’ve narrowed the list down to eight for this month’s In Focus.

Sector Spotlight

Grange Resources Ltd (ASX: GRR, OTC: GRRLF), an aggressive play on China’s long-term urbanization story, is replacing Iluka Resources Ltd (ASX: ILU, OTC: ILKAF, ADR: ILKAY), also an aggressive play on China’s long-term urbanization story, in the AE Portfolio.

Grange produces magnetite iron ore from its Savage River mine in Tasmania and is in the late-stage development phase of the relatively prodigious Southdown project in Western Australia. It’s the largest producer of magnetite, an oxide of iron and a key input for steelmaking, in the world. Grange’s processed magnetite pellet output commands premium prices because of its higher iron content and lower rate of impurities versus other forms of hematite iron ore such as fines and lumps.

Iluka also occupies a rather unique niche vis-à-vis the Middle Kingdom and the rapid transformation taking shape there, as its mineral sands are in high demand for use in pigments and dyes and particularly as the main input for ceramic tiles. Tile is pervasive in China and throughout Asia, the flooring of choice for literally centuries. Iluka had what it called a transformational year in fiscal 2011, realizing higher prices on larger volumes than it had yet experienced during Emerging Asia’s rapid expansion during the last decade.

We were seduced by an enormous dividend increase as well as management forecasts for similar if not quite as robust results for fiscal 2012 and beyond. Management, however, has now revised downward its guidance for full-year sales for fiscal 2012 twice in a matter of three months and made what appears to us to be a significant error in judgment by opting for short-term pricing schemes rather than long-term contracts for its output.

The former is cause enough to question management’s credibility; the latter, though it may help the company realize outsized returns during boom periods, is no way to establish revenue visibility so crucial to sustaining a consistent dividend.

Grange Resources occupies one Sector Spotlight this month.

When it reported results for the first half of fiscal 2012 in February management of Cardno Ltd (ASX: CDD, OTC: COLDF) didn’t provide numeric guidance for the full fiscal year. The company did note that global market conditions continued to improve, but at a slower pace than anticipated when it reported full results for the prior fiscal year on Aug. 16, 2011.

It did point to a project pipeline of AUD535 million as of Dec. 31, 2011, and forecast “additional growth via organic expansion and acquisitions” that would “further strengthen core competencies.”

Cardno has acquired 30 companies during the past six years, establishing a solid track record of integrating new businesses. This record led to management’s Jun. 27, 2012, announcement that it expects to report net profit after tax (NPAT) of between AUD71 million and AUD74 million for the year ending Jun. 30, 2012, an increase of 21 percent to 26 percent over the AUD58 million the company earned in fiscal 2011.

The stock has been equally impressive generating a total return in US dollar terms of 53.78 percent since we added it to the AE Portfolio Conservative Holdings in November 2011 and 57.51 percent in calendar 2012.

Cardno takes up the other Sector Spotlight in this month’s issue.

News & Notes

RBA Keeps It Steady: The Reserve Bank of Australia held its key rate at 3.5 percent this month, keeping it high relative to the rest of the developed world while balancing a strong domestic story against a questionable global backdrop.

The Word on Safety: Following up on last month’s slight revisions to the interpretation of the AE Safety Rating System, the How They Rate coverage universe, including Portfolio Holdings, which were updated as of the June issue, have now been made current. Here’s a summary of changes.

The Dividend Watch List: The Dividend Watch List includes updates on How They Rate companies that announced reduced earnings guidance during the recent quarterly update period in Australia as well as the usual constituents that reduced dividends during the most recent official reporting period.

The ADR List: Many Australia-based companies that list on the home Australian Securities Exchange (ASX) are also listed on the New York Stock Exchange (NYSE) or over-the-counter markets as “sponsored” or “unsponsored” American Depositary Receipts (ADR).

Here’s a list of those companies, along with an explanation of what these ADRs represent.

How They Rate

How They Rate includes 108 Australian companies–we’ve made no additions to coverage this month–organized according to the following sector/industries:

• Basic Materials
• Consumer Goods
• Consumer Services
• Financials, including A-REITs
• Health Care
• Industrials
• Oil & Gas
• Technology
• Telecommunications
• Utilities

We provide updated commentary with every issue, financial data upon release by the company, and dividend dates of interest on a regular basis. The AE Safety Rating is based on financial criteria that impact the ability to sustain and grow dividends, including the amount of cash payable to shareholders relative to funds set aside to grow the business. We also consider the impact of companies’ debt burdens on their ability to fund dividends. And certain sectors and/or industries are more suited to paying dividends over the long term than others; we acknowledge this in the AE Safety Rating System as well. We update buy-under targets as warranted by operational developments and dividend growth.

In Closing

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David Dittman
Co-Editor, Australian Edge