Posted by Debbie on Oct 24th, 2008

There’s a phrase going around at the moment. Something about a pig wearing lipstick. The gist of it – quite cruelly – is that pigs are still ugly even if a Revlon “Super Lustrous” lipstick is applied to the kisser.

We think we can safely say that the ANZ Bank [ASX: ANZ] profit results this morning fall into the ‘pig in lipstick’ class.

The notes to the results try and tell us that it was a “solid underlying result” in a “difficult environment.” Operating income was up 4%. OK, maybe that is solid. But operating expenses were up 10% which wiped out the income gain. Not so solid…

Even worse than that, thanks to ANZ’s flirtation with CDOs and CDSs the bank is taking a $1.9 billion impairment charge – in other words writing it off – which helped to cut profits by 23% compared to last year.

Earnings per share are down by 26% to $1.55 per share. One fortunate piece of good news is that ANZ is maintaining its dividend payout. It has to really. Although the payout ratio has increased from 65% to 90%, chances are that it would have maintained the dividend even if it had to dig into cash reserves.

If the dividend had been cut to maintain the 65% payout ratio we could have seen about $5 wiped off the share price. It still isn’t all over for ANZ though. It has taken these write downs after pricing the derivatives on a mark-to-market basis. In other words, the price if they were to close them out in the market today.

Because the bank doesn’t have to do that yet it is making assumptions that the price of the CDOs and CDSs will revert to the norm over the next few months and that there will not be any further defaults. It’s a pretty big assumption to make based on what has happened so far.

When Will the Market Regain Some Confidence?

“It’s all about confidence.” We heard someone say that yesterday. Or maybe we just read it. We don’t remember exactly. The point they we’re making is that all this stuff going on in the financial markets is due to a lack of confidence. Once that returns then the markets will be fine.

We wouldn’t disagree with that entirely. But we won’t agree with it completely either. After all, it is still possible to be confident and wrong at the same time.

Your Dollar Devalued

There is confidence somewhere though. The policy makers seem to be extremely confident that they have got inflation licked. Don’t worry about it being over 5% at the moment because by 2010 it will be back to the 2-3% target band.

Thanks for the pep talk but it still doesn’t get around the fact that our money will be worth 10% less by then. “Oh, but you can put it in a savings account and earn at least 6% on it” we’ll be told. The money you have today you can, but what about the money that hasn’t been earned and received yet?

The $1 you get paid next October will have the same face value as today, yet it will be worth 5% less to you by the time you are paid it. And the following year it will be worth another 5% less if inflation doesn’t fall back to the target band. And you can’t earn interest on something you haven’t received yet.

Unless Macquarie develops a leveraged savings account we speculated on yesterday.

But at least the policy makers are confident about being able to rein in inflation.

Where Should I Invest?

Based on the above you would think that we are still bearish on the stock market. But we aren’t. And we’ve been happy to say so for a few weeks now.

We are sure that there are a lot of people that have increased their cash holdings recently. Especially now that the government is implementing a guarantee for all cash deposits. The danger is that investors become complacent and dare we say it, over-confident about remaining in cash.

The reality is that cash in the bank will probably be a lousy investment over the next twelve months. Especially if inflation remains high and interest rates fall.

Now is the time to be scouting for good opportunities in the stock market across a range of strategies. Our personal preference is to look for the big risk, big return small cap stocks that will lead the markets on the way up.

But you don’t want to put your whole portfolio in small caps because it is a riskier end of the market. So even looking for undervalued, cash rich companies – such as those Digger & Driller Al Robinson has been looking at – or those companies that are able to maintain a healthy dividend payout despite an economic downturn are probably going to produce a better return in the next 12-24 months than holding cash.

This article is written by Kris Sayce from Money Morning. Money morning is a website that aims to give you intelligent and enjoyable commentary on the most important financial stories of the day, and tell you how to profit from them.