Please feel free to move on at once to Chapter 9 on the imputation system and the splitting the atom theory underlying my conviction that its retention is crucial for any hope of continued prosperity in Australia. On a holiday afternoon, I am recording/revealing a side benefit from the privilege of working with one of the world’s most highly regarded economists Trevor Swan (even attested to personally by Milton Friedman).
Part way into Sir Frederick Wheeler’s assignment to help Trevor when he was aiding the Whitlam government, he confessed that he and another famous colleague had stuffed up badly in helping a colleague who received a large (in those days) inheritance. Jointly they had instructed a leading broker to shun investments paying dividends (no franking credits in those days) and go for tax-free capital gains.
Hello. Trevor that’s not what Keynes did or would do. Why don’t we try going for companies with undervalued assets and potentially large income growth. Mentioning a few companies I had modest holdings in (my pre-tax starting salary was $14,000 in those days), he quickly passed over the decisions to me hoping that I could replenish the 50% already lost in we can always hope investments like Mainline and other market favourites. Please understand that period was not especially good for investors anywhere.
My favourites were Santos (then selling at 56 cents later split by the Board on a 27 to 1 basis, ie 2 cents a share for reasons explained later) and Penfolds Wines, a poorly managed excellent wine producing company owning assets worth more than its share price. The big advantage was tax rules which valued inventory at a much lower level than cost price, unbelievably Grange valued in the books at 2 shilling and sixpence a gallon.
We pumped over $100,000 each in to both investments and beautifully for two (short) years there were no dividends or tax bills aside from the continuing PAYE tax on wage income. The investment in Santos completed at the 2-cent level was based on detailed research by my mentor brokers switched on highly paid geologists and my Calgary friends and former colleagues.
Their most favored share at the time was Dome Petroleum which thanks to the huge Devonian reef Rainbow Lake discovery (one quarter mile away from a dry Esso well) went from one-quarter of a dollar to $280 in record time. Asking my most informed colleague whether Santos was good buying at 56 cents, he replied. Our research shows their total acreage is that of Texas and Louisiana combined and the laws of probability here put their value at a minimum of $100 and more likely $200 +.
Anyone investing in or following the history of Santos will know the $200 estimate was on the low side. Thank heavens Calgary advertised its jobs in the weekly Economist in those days. Trevor’s friend ended up as the largest private shareholder in Santos and together with my broker mentor and his clients we spoke for more shares than Alan Bond when he turned up hugely unwelcome to the company and South Australia.
AI has not been very helpful in confirming my recollection of the precise timing of events and the ASX similarly not a source of information about precise dates when income tax became a real problem for the investor we were helping, Whether it was before or after Bond is irrelevant but the first Santos dividend of 150% of our purchase price presented a real problem for me, always believing the best strategy is to choose the best possible investment.
Investor. I do not want large tax bills and the problems they bring. Me. Do you need any more income. Investor No. All I want to do is concentrate on my next book. Me What About Heirs? Investor Only my sister who is very well off. Me. Good. What we will do is give all your investment income away to local charities and you can just keep all the non-taxable capital gains.
By the end of her life, the investor loved the annual gifting process, When Santos paid its first dividend we gifted over $200,000 for the good of the poor in the ACT. Back to asset rich Penfolds. It did not last long; Southcorp acquired it at 8 times our purchase price. They financed it by selling the wine valued at 2 shillings and sixpence a gallon in the books in Queensland bottle shops (and most probably everywhere else) at bargain prices such as Bin 389 for $4.00 a bottle. I bought a bottle of Grange for $10.
Fortunately for the charities, the investment success did not stop. Some one up there was looking down at our help to the various churches and other excellent cause charities. I kid you not. My many successful investments over the years are too often followed by abject failures. Every investment we jointly touched turned into pure gold.
Before concluding this Chapter by returning to the history of Santos, let me give you some idea of how good for investors the late 1970s and early 1980s were. Take our decision to buy high yielding Commercial Banking Company of Sydney Convertible Notes to park a considerable amount of cash (from Penfolds) safely. By good fortune, the NAB needed to buy all the notes to complete its takeover of CBCS. To do so, it bought the notes at the full issue price plus issued 2 free NAB shares per note. What a gift receiving quality share at no cost for owning something useful to park spare cash.
A chance off-market purchase of a considerable number of Sebel Townhouse shares from the owner and manager needing cash to help their family out was similarly unexpectedly well rewarded. Purchased because the real estate value was significantly higher than the share market capitalization (and it was also a well-run high-quality hotel), we should have expected the Mirvac or some other takeover not soon after after at almost three times our purchase price.
Enough of the share market action, much more important for Australia is our contribution to Santos in its early days. Enter Alan Bond who caused major concern buying a large holding in a tricky way, avoiding the need to make a matching offer to other shareholders wanting to get out at the same share price. Mr. Bond skirted ASX listing rules by buying the company Burmah Oil Australia that owned the Santos shares and not the Santos shares themselves.
The CEO John Zehnder contacted me to seek the reaction of the large shareholder, telling me that the first decision of Mr. Bond on the Board was to replace the modest Beer Fridge by an expensive Cocktail Cabinet. Based on my experience and knowledge of gas companies SAGASCO and AGL, we suggested State government intervention to set a limit on the largest individual shareholding in the Company.
In AGL it was for many years a 2% limit (more about that later) but to neuter Mr. Bond, South Australia quickly introduced a 15% limit. We also used our influence to suggest that the new Board give more attention to drilling and exploration than cautiously spending their funds. Helped by my Calgary contacts, we convinced the Board to focus on the higher return, lower risk prospects early drilling and seismic data revealed.
Even though not as big as Rainbow Lake, the oil and gas discoveries started flowing and the Board focused more on supporting the from day 1 high quality exploration staff. Visiting Moomba and shouting the bar on a thank you trip brought back fond memories of my earlier time in longer established real oil country. How fortunate Professor Swan’s friend was in backing the early days of our oil exploration history.
To conclude this Chapter, there is one further point of interest truly relevant to the imputation system. Always interested in arbitrage and seizing opportunities, Santos offered a fantastic opportunity. At any earlier time needing more cash (as exploration companies always do), Santos issued Class C shares at a higher price than the existing ordinary shares.
Even though they ranked parri passu (equally) with the ordinary shares, the ASX listed them separately to the ordinary shares. Given the volume of short-term trading in resource sector shares, market demand focused on the highly liquid ordinary term shares, creating a wide disparity in the price of the two categories of shares. Aware of the opportunity for long-term holders, happy to pay full brokerage, we instructed our brokers to switch the holding from ordinary to C class shares when the divergence in price was more than forty cents.
The brokers loved the business, the maximum differential we achieved was seventy-eight cents, and over a lengthy period we expended the total holding by around 30% at no additional cost, The directors finally decided to end this distortion seeking our advice as the largest C class holders on the strategy. Our suggestion to follow long standing U.S. practice was to split the shares initially on a three for one basis, at once reducing the percentage of C Class in the total structure.
The favourable market reaction plus exploration success boosted the share price and encouraged two further three for one split. We still had the same number of C Class shares after the ultimate twenty-seven for one share split, but there were heaps more ordinary shares. The C Class market distortion was now only a minor blip.
As was inevitable, through our broker several market participants expressed interest in acquiring our holding. At least two thought we were a charity not understanding the value of our assets, then two of the finest corporate executives turned up: Morry Williams and Norm Connellan from AGL.
They were of course major current and future users of Cooper Basin resources but subject to strict NSW Government regulation of their operations. My advice to the investor was what a wonderful opportunity to help both Santos and AGL, the major problem being what to do with all the money from the off-market huge transfer.
Before considering the offer, I insisted on a thorough briefing on what sort of company AGL was. What I discovered delighted me and I am sure Keynes would have loved it too. Undervalued property everywhere, Haymarket, North Sydney Office Block. huge harborside and other gas equipment land holdings but better still an efficiently managed and run headquarters. Particularly impressive was the extensive use of the old 360s even in the early days of computing.
Decision made easy. Take the cash and at once have our broker switch all the cash into AGL shares. Capital gains tax-free and we give away all the income from AGL in the same way as we shed Santos and other income to charities. Now finally, a clear and convincing reason the continuation of the imputation system (next Chapter) is so essential to ensuring the future strength of our economy.
We were purchasing AGL shares when all dividends were double taxed, once via company tax and then by personal income tax when receiving dividends. Frankly buying a large holding of AGL shares presented no problems back then. Investors shunned them because they paid a high dividend, around 6% at our purchase prices, fully taxable for many at high marginal tax rates.
We started buying at $1.35 (my rough assessment assets per share of at least five times that) and had to stop at $1.85 when Mr. Williams called me one afternoon. What was the name of the investor who sold us the Santos shares? Someone has just exceeded the 2% statutory limit on individual share holdings. Me. Oops Morry. Sorry. By how much. Morry Number of Shares. Me. That holding will meet the limit tomorrow. If not, call me back.
Look at the meteoric rise in the AGL share price since that time. With the introduction of imputation credits, the whole scenario changed dramatically, and investors no longer misled by unjustifiable double taxation piled in.
Our share market adjusted valuations very slowly after the 1987 introduction of the new system, largely because of the original stuff-up of denying its benefits to the largest category of domestic share investors, superannuation funds. The real as it turned out major adjustments in market valuations could only start when the government made imputation credits available to all domestic taxpayers one year later. Onwards to the next Chapter.