The Evidence of Mr Potter
151 Mr Potter prepared two reports for the purposes of these proceedings, namely, his report dated 26 August 2016 and his report dated 7 October 2016. Mr Potter's first report is 125 pages in length (excluding annexures and appendices) and is found in Vol M of Ex A. Mr Potter's second report addresses Dr Coulton's fourth report and is found in Vol T of Ex A.
152 Mr Potter took issue with most of Dr Coulton's evidence and explained his reasons for so doing in his very lengthy report of 26 August 2016.
153 No objections were taken to Mr Potter's report.
154 Mr Potter's report is divided into ten separate sections. I have attached to these Reasons for Judgment as Attachment B the Table of Contents of Mr Potter's report which shows the ten separate sections to which I have referred and the general subject matter of each section. In the succeeding paragraphs, I will endeavour to capture the essence of Mr Potter's reports.
155 At pars 1.2 to 1.4 of his first report, Mr Potter set out his understanding of the substance of the plaintiffs' claims in the present cases. I consider Mr Potter's understanding of those claims to substantially accord with the true position.
156 In section 2 of his first report, Mr Potter set out his opinions in summary form. Each of the opinions expressed in section 2 was supported by detailed reasoning in the balance of his report.
157 In the balance of this section of these Reasons, I set out Mr Potter's conclusions and, to the extent I consider necessary, the reasoning which he provided in support of those conclusions.
158 At par 2.2 of his first report, Mr Potter stated his overall opinion that it is not possible to conclude that the allegedly overstated earnings guidance provided by BBL at various dates throughout 2008 resulted in BBL's shares trading at a higher price than the price at which those shares would have traded in the period from 13 August 2008 to 7 January 2009 had the guidance as to NPAT for the year ended 31 December 2008 been the NPAT that Dr Coulton considers BBL should have announced.
159 Mr Potter disagreed with Dr Coulton's view that the market's expectations of earnings per share (EPS) were "anchored" on the $643 million figure provided in the BBL earnings forecasts which referred to that figure and further disagreed with the manner in which Dr Coulton had applied the PE ratio and the price to book ratio (PB ratio) methodologies which were at the heart of his evidence.
160 Mr Potter did not accept that there was a correlation between the earnings guidance actually announced by BBL prior to the relevant period (ie prior to 13 August 2008) and BBL's share price in that earlier period.
161 At par 2.5 of his first report, Mr Potter expressed the opinion (correctly, I think) that earnings guidance is not the only factor or source of information in the sharemarket. He noted that there had been a significant decline in BBL's share price over the relevant period considered by Dr Coulton. He also observed that that decline occurred in the absence of any change in BBL's earnings guidance. Upon the basis of the analyses carried out by him and set out in his first report, Mr Potter concluded that the decline in BBL's share price over that period was reflective of a market expectation of a significant reduction in BBL's NPAT for the year ended 31 December 2008 and following.
162 At pars 2.6 to 2.8 of his first report, Mr Potter said:
2.6 In section 3 of this report I have identified the following factors that assist in considering whether the claimed reduced earnings guidance proposed by Dr Coulton could have affected BBL's share price:
2.6.1 The circumstances of BBL;
2.6.2 The circumstances of the market;
2.6.3 Analysts' expectations of BBL's future earnings; and
2.6.4 The market's expectations of BBL's future earnings.
2.7 The analyst's and market's expectation of future earnings is referring to the expected earnings in the year ended 31 December 2008 and the expected growth in the years following.
2.8 My review of the factors present both in the market generally and for BBL specifically indicate that BBL's share price was affected both by extraneous events and events specific to BBL. These factors included:
2.8.1 The global financial crisis ("GFC"); and
2.8.2 The deterioration in asset prices in circumstances where BBL was attempting to undertake a restructure that involved the sale of assets.
163 In section 3 of his first report, Mr Potter considered the effect that the claimed reduced earnings guidance on the traded price for BBL shares over the relevant period might have had on the price of those shares. Mr Potter saw his task as endeavouring to assess the impact of the alleged overstatement in forecast earnings being the difference between:
(a) The earnings that were announced from time to time; and
(b) The earnings that should have been announced during the same period
and then quantifying the impact (if any) of this difference on BBL's share price.
164 At 3.4 of his first report, Mr Potter noted (again correctly, I think) that the measurement of the potential effect of the guidance that Dr Coulton considered should have been given is not straightforward. Mr Potter noted that it is a generally accepted proposition that the price of a share is reflective of the market's expectation of future earnings that will be received from ownership of that share. The difficulty for anyone attempting to assess that which he was attempting to assess is that the market's expectations as to earnings in the year for which guidance is being provided and growth in subsequent years are not directly observable but have to be the subject of assessment and judgment. In the next paragraph, Mr Potter expressed the view that he needed to identify and examine factors that would influence the likelihood of whether the claimed reduced earnings guidance would have had a material effect on the share price of BBL during the relevant period.
165 Mr Potter emphasised that it was important in addressing the alleged impact of the failure to provide further guidance on the share price of BBL to take into account the fact that BBL did not have an entitlement to the entire B&B Group NPAT but rather had an entitlement to portion of that NPAT which in turn reflected BBL's ownership interest in BBIL. At all times, Mr Potter reminded the Court that comparisons of NPAT had to be comparisons between BBL's NPAT at various times and that it was not legitimate to compare BBL's NPAT with B&B Group NPAT, as Dr Coulton had done on occasion.
166 At pars 3.11 to 3.13 of his first report, Mr Potter noted the earnings forecasts that Dr Coulton had set out at pars 24 to 28 of his first report. At par 3.13, Mr Potter set out a table which recorded the differences at relevant times between the NPAT for the B&B Group and BBL's share of B&B Group's NPAT. I set out that table (Table 5) below:
167 Mr Potter then examined the question of whether there was a correlation between past earnings guidance provided to the market by BBL and movements in its share price.
168 At pars 3.19 to 3.24, Mr Potter said:
3.19 Having regard to the above, it is apparent that not only is there not a one-for-one correlation between the variance of forecast NPAT to actual NPAT and share price movements but, in many instances, the 'correlation' is in fact negative, BBL's share price declining following an earnings announcement that exceeded the prior guidance issued by BBL.
3.20 Whilst the past events where the actual NPAT exceeded the forecast NPAT in all instances is of limited application to the claims by the Plaintiffs that negative guidance should have been provided, it does show that the measurement of the potential effect of the guidance that Dr Coulton considers should have been made is not straightforward.
3.21 One such difficulty in measurement of the potential effect is the generally accepted proposition that the price or value of a share is reflective of expected future earnings.
3.22 Expected future earnings is not a single year that is the subject of the earnings guidance but also the years subsequent. The expectations as to earnings in years subsequent will be reflective of expectations as to growth. Not only is the market's expectation as to the earnings in the year for which guidance is being provided not directly observable, market expectations of growth are also not directly observable.
3.23 I consider that one potential explanation or factor that would explain the lack of correlation identified above is that rather than the share price being entirely determined by the NPAT forecasts or guidance provided by the company, the more significant factor would be the market's expectations of earnings. For example, in the table below I have compared the following for both BBL and a number of other larger companies listed on the ASX:
3.23.1 The percentage movement (increase or decrease) between expected earnings (based on 'consensus' analyst forecasts compiled by Bloomberg as a proxy for market expectations) and reported results (normalised to remove the effect of abnormal items); with
3.23.2 The percentage movement in the price at which the shares in the company traded (calculating the movement as being the difference between the closing price on the day prior to the announcement and the closing price on the day the announcement was issued).
3.24 Whilst the analysis may be considered to be relatively simple and not take account of growth expectations and broader financial market conditions as another explanatory variable, it does show that there is a higher degree of correlation (by reference to direction of difference in guidance and share price change, rather than value of change) between the movement in the share price and the difference between consensus analyst forecasts and reported NPAT. In particular, where the variance is positive, the share price has tended to increase and where the variance is negative, the share price has tended to decrease. Overall, the extent of the change in the share price is, however, a fraction of the variance between the analyst expectations and the actual NPAT.
169 Having established that there was no apparent direct correlation between the share price of BBL from time to time and earnings guidance provided by it to the market from time to time, Mr Potter considered that it was necessary to investigate the means by which measurement of the potential effect of the guidance that Dr Coulton considered should have been issued by BBL could be undertaken. He then proceeded to consider such means. He did so under the heading "Events study principles" (at pars 3.28 to 3.56 of his first report).
170 Mr Potter was of the opinion that the circumstances of BBL and of the broader market during the relevant period were such that an events study was not likely to be meaningful. He did, however, draw on events study principles as providing a useful guide in relation to a number of relevant factors to consider in the investigation of the extent (if any) to which Dr Coulton's assessed NPAT guidance could have had on BBL's share price.
171 At pars 3.33 to 3.37 of his first report, Mr Potter explained, in broad terms, the nature of an events study and set out the factors which he considered might be helpful in addressing the task with which he was confronted.
172 At pars 3.40 to 3.46, Mr Potter said:
3.40 The important point from the abovementioned examples of studies that have been undertaken is that they involved a comparison between the earnings guidance and market expectations of earnings. This is because the share price is a reflection of the market's expectations of earnings. Whilst a company's earnings guidance may be a factor in the market arriving at its expectations of earnings, and it may be possible to identify where there has been a change in earnings guidance, the extent to which it is a factor in the price at which shares are traded is not readily apparent or measurable.
3.41 The second factor that the market evaluates quickly, correctly and completely the consequences of the news is, in essence, the efficient market hypothesis that I have explained further in section 7 of this report (refer to paragraph 7.71 to paragraph 7.78). In this case I have seen no information that would suggest the market is not efficient and accordingly believe such a pre condition for an events study would be satisfied.
3.42 Regarding the separation from other news factor, it is important to acknowledge that a change in the value of shares in a company does not typically occur in a vacuum. There are ordinarily confounding events that can be classified into three groups [Annexure 29, Cowan and Seguin paper at Chapter 36, tiled "Event Studies in Securities Litigation", contained in the reference Fannon and Dunitz, Editors for "The Comprehensive Guide to Lost Profits and Other Commercial Damages" Fourth Edition, 2016, Business Valuation Resources LLC, United States (pages 1036-1037)]:
3.42.1 News that potentially affects all equities, including macroeconomic news such as interest rates, employment, GDP growth, consumer confidence etc and non-economic news with economic implications such as political change;
3.42.2 News that potentially affects industry equities, including macroeconomic news specific to the firm's industry and news announcements for firms in the same industry; and
3.42.3 Firm specific news that is simultaneous such as management malfeasance in combination with and [sic] earnings guidance.
3.43 A key assumption underpinning the event study method is that the change in market value of a share (also known as the return, that is the difference between the price of a share at the beginning of the period under examination ("event period") and the price at the end of the period) is that the return on the price at the beginning of the period can be separated into a market wide change in value and a change in value specific to the firm associated with the news event.
3.44 The event study involves comparison of the actual stock price movement over an event window that brackets the news event (often one trading day) to the expected stock price movement if the news event had not taken place to arrive at an abnormal return, which is then tested for statistical significance. The expected stock price movement is meant to take account of the news that has affected all equities, that is, overall stock market movements. A statistically significant abnormal return is the value effect of the specific news event.
3.45 The difficulty with ascertaining the extent to which other market wide news has affected the price of shares on particular trading days is that it is generally accepted that stock returns of some firms move proportionately more or less than the overall market reaction to economy wide news. This requires an adjustment for the relation between the stock returns of the individual firm and the returns of a relevant market index, in this case the ASX.
3.46 The relation between the stock returns of the individual firm and the returns of the market index is typically calculated using a statistical regression model over an appropriate estimation period prior to the relevant event being tested.
173 At pars 3.47 to 3.53, Mr Potter explained the statistical regression model to which he had referred at par 3.46 as follows:
3.47 Mitchell and Netter state that the predicted performance of a stock during an 'event window' is based on the firm's stock price relationship with the market [Annexure 17, Mitchell and Netter, "The Role of Financial Economics in Securities Fraud Cases Applications at the Securities and Exchange Commission", The Business Lawyer, Vol 49, page 567, February 1994]. Mitchell and Netter go on to estimate the market model using the following formula [Annexure 17, Mitchell and Netter, "The Role of Financial Economics in Securities Fraud Cases Applications at the Securities and Exchange Commission", The Business Lawyer, Vol 49, page 567, February 1994]:
3.48 The abnormal return is then [Annexure 17, Mitchell and Netter, "The Role of Financial Economics in Securities Fraud Cases Applications at the Securities and Exchange Commission", The Business Lawyer, Vol 49, page 568, February 1994]:
3.49 In this way, an abnormal return is assessed for a firm following a news event that is specific to the news event. It is the abnormal return that is the effect on the value of the share price of the news event.
3.50 An important variable to arrive at the relation between BBL's share price of BBL and market wide events is the beta factor.
3.51 Betas are calculated from listed companies' historical price data. It is a measure of the sensitivity of a company's returns, relative to changes in the market return as a whole. The Australian Graduate School of Management ("AGSM") is generally accepted as a reliable source for beta factor data for Australian listed companies. It states the following in respect of beta [Annexure 16, AGSM Risk Measurement Service Introductory Notes, page 7]:
"Formally, beta is defined as the covariance of individual returns with those of the index, scaled by the variance of index returns. As a consequence, the beta of the "market" portfolio (containing shares in all companies in market value dollar proportions) will be equal to 1.0. Securities or portfolios with beta higher than 1.0 can be thought of as having higher risk than average, and those with betas less than 1.0 as having lower risk than average. In this context it is useful to remember that the beta of a portfolio is the weighted average of the betas of the individual shares comprising that portfolio, where the dollar weights are given by capital used value.
We described beta in a previous paragraph as a measure of the average sensitivity of a company's rate of return to that on the market index. Thus a share or a portfolio with a beta of 1.0 will on average move in fine with the market, Similarly a share with a beta of 2.0 will on average move 2.0 percent (up or down) for each 1.0 per cent move (up or down, respectively) by the market index. Such a share will on average perform well in a bull market and perform badly in a bear market. Conversely, a share with a beta of 0.5 will on average move 0.5 percent for each 1.0 percent movement in the market index, and consequently will on average under-perform the index in bull markets but out-perform the index in bear markets. Readers would, however, be well advised to note our inclusion of the words 'on average.' For example, a share with a beta of 1.0 cannot be expected to accurately track the market index. This is because the return on such a share contains specific risk as well as market risk. Only a market index portfolio, containing all shares in value weighted proportions, will track the index exactly since it is constructed to actually represent the index with all specific risk eliminated. All we can say about a share with a beta of 1.0 is that on average it will perform about as well as the market index, but there may be large deviations around this average on a day to day basis. This is still a very powerful statement, however, as the CAPM allows us to rank companies' expected equity returns using beta as a scale as shown in the graph below."
3.52 Changes in economy wide factors such as interest rates, exchange rates and changes in household disposable income or consumer spending will affect projected cash flows of particular companies differently and hence the company has a particular beta. Other market risks that could affect individual company's future returns include government regulation and technological change.
3.53 It is also the case that an equity beta reflects the degree to which a company is leveraged. The higher the debt to equity ratio, the higher the beta factor.
174 At par 3.54 and 3.55, Mr Potter said:
3.54 I have assessed the beta factor of BBL in a range of periods prior to the news event to be as follows [Appendix 4, Potter calculation (Beta)]:
[38 Annexure 32, AGSM Beta (relying on 30 June 2008 for 3 August and 21 August and 30 September 2008 for 8 October, 8 November and 8 December)]
3.55 In my experience, a beta factor in the range of 2 to 3 with a range of in excess of 1 for the high and low ranges, [Appendix 4, Potter calculation (Beta)] suggests that the share price of BBL is relatively highly affected by market wide events. The circumstances in the market over the relevant period of the claimed guidance is therefore an important consideration.
175 At par 3.56, Mr Potter set out his conclusion as to the relevant factors to be considered in making the assessment with which he was tasked. I set out par 3.56 in full:
3.56 The above analysis leads me to believe that:
3.56.1 The circumstances of BBL;
3.56.2 The circumstances of the market; and
3.56.3 Analysts' expectations and the market's expectations of BBL's future earnings (being the NPAT for the year ended 31 December 2008 and the rate of growth in NPAT in the years following)
at the dates at which Dr Coulton considers that BBL's (lower) NPAT guidance ought to have been given are important to ascertaining the likely effect of the claimed guidance on BBL's share price. I have further examined these issues in the following sections of this report.
176 In section 4 of his first report, Mr Potter undertook a very detailed analysis of the background to BBL and the circumstances in which it found itself in the market from about mid 2007 to late 2008/early 2009. The primary material upon which Mr Potter relied for this analysis was in evidence before the Court and was essentially not disputed by the plaintiffs or by Dr Coulton.
177 At par 4.2 of his first report, Mr Potter noted that BBL had a relatively complex structure of investments in listed and unlisted funds and was highly leveraged. He said that, as a consequence, the market considered BBL to be a risky investment. The GFC that began in mid 2007 was occurring throughout the relevant period so that isolation and assessment of the possible effect of the claimed reduced guidance was somewhat confounded. Mr Potter took the view that, from about mid-September 2008, market events were more likely to have been affecting the share price of BBL than was its earnings guidance.
178 At pars 2.12 to 2.19, Mr Potter summarised the important features of the analysis of the background to BBL and the market in 2008 which he undertook. I now set out those paragraphs in full:
2.12 In section 4 of this report I have examined the background of BBL and the circumstances in the market prior to and during the period in which Dr Coulton considers that BBL should have issued a reduced earnings guidance to the market. The available information leads me to believe that there was a close relationship between BBL's share price and events in the global equity markets over this period, in particular the events of the GFC that began in mid 2007. This suggests that a major factor affecting BBL's share price over the relevant period was, to an increasing extent, the events of the GFC rather than investor expectations of BBL's earnings (although I note that these are interrelated issues due to BBL's dependence on the value and performance of listed and unlisted funds in which BBL had an interest in and managed).
2.13 Further to my comments in paragraph 2.5, the closing price of shares in BBL on 21 August 2008 was $2.22 per share, a decline from the prior day closing price of $3.45 per share, representing a decline of approximately 36%. This decline followed an announcement to the market on 21 August 2008 that was consistent with an earlier announcement to the market on 11 August 2008.
2.14 The 21 August 2008 announcement contained the following items of news relating to BBL:
2.14.1 Group NPAT for the six month period ended 30 June 2008 was approximately 30% less than that achieved in the prior year;
2.14.2 Guidance previously given that Group NPAT for the year ended 31 December 2008 would be no more than that achieved in the year ended 31 December 2007 (that is, "not more than" $643 million) (throughout this report I note that I have assumed that 'not more than' $643 million means $643 million, rather than some lower figure. I make this assumption notwithstanding the risks identified by BBL when it provided this guidance (refer in particular to paragraph 4.77.5).
2.14.3 Additional risks to the result for the year were identified;
2.14.4 A restructuring of the business was re emphasized;and
2.14.5 Shareholders were informed of a decision to cease dividend payments for 2008.
2.15 All things being equal these additional announcements could be expected to reduce investors' expectations of Group NPAT for the year ended 31 December 2008. The reduction in expectations can be seen in analyst reports that I have further addressed below.
2.16 It is not possible to discern the precise reason for the decline in the share price on 21 August 2008 given the broad range of announcements made on that day, although for the reasons explained in section 3 of this report, I consider the extent of the announcements over that period, together with the events of the GFC, to be confounding events that would make it extremely difficult, if not impossible, to quantify the potential impact, if any with a degree of confidence, of the claimed lower guidance assessed by Dr Coulton.
2.17 The effect of the GFC can be seen when BBL's share price suffered a material decline in mid September 2008, being a decline that coincided with the collapse of Lehman Brothers in the United States. It is readily apparent that by this time the market was expecting (due to the previously announced restructure of BBL) material impairment losses to be incurred by BBL upon the sale of assets in a severely depressed global economy (so far as equity prices were concerned). For these reasons, I am of the opinion that following mid September 2008 the market's expectation of BBL's earnings was severely diminished.
2.18 The position of BBL then further deteriorated so that by mid November 2008 BBL:
2.18.1 Announced a larger restructure and asset sale program;
2.18.2 Was in a dispute with a lender(s) regarding release of a EUR 71 million bank deposit (in relation to which, on 20 November 2008, BBL requested a trading halt for its shares on the ASX on account of this dispute);
2.18.3 Had received a further credit downgrade from Standard & Poors ("S&P") to CCC+; and
2.18.4 There was widespread market commentary to the effect that the BBL Group's overall survival and the viability of the planned restructure was subject to the cooperation of a banking syndicate.
2.19 In my opinion these events towards the end of 2008 mean that it was highly unlikely there were any expectations of positive earnings being achieved in the year ended 31 December 2008. As such the share price is most likely a reflection of expectations of significantly depressed trading results and what might occur in a restructuring of the company. In these circumstances, I do not consider the valuation models as applied by Dr Coulton are an appropriate means to assess the effect on BBL's share price had the claimed lower earnings guidance been given.
179 The conclusions which Mr Potter expressed at pars 2.12 to 2.19 of his first report were amply supported by the analysis which he performed in section 4 of that report.
180 Mr Potter noted (at par 4.19 of his first report) that BBL entities had partial ownership of listed and unlisted funds that owned and operated the relevant assets described as "Assets Under Management". In the next paragraph, he said that the exchange traded value of the listed funds in which BBL had an interest had declined materially during the first half of 2008 and that there had been a substantial decline in the traded share price of BBL during the first half of 2008.
181 At pars 4.21 and 4.22, Mr Potter said:
4.21 The decline in values had an impact on the reported NPAT for the six months ended 30 June 2008 by way of recognition of impairment losses. I set out BBL's financial performance by business type / income source for the six months ended 30 June 2008 and the year ended 31 December 2007 as follows [Pages 8 and 9 of BBL Appendix 4D and Management Discussion & Analysis dated 21 August 2008]:
4.22 The losses and impairments have been identified as write down in asset values relating to the following business segments of BBL [Page 9 of BBL Appendix 4D and Management Discussion & Analysis dated 21 August 2008]:
4.22.1 The most significant write down of $198 million was in the Real Estate division, with $134 million attributed to the Co-Investment category, $21 million in Development and $43 million in Principal Investment;
4.22.2 The second largest write down in the Corporate and Structured Finance division, with $48 million attributed to Co-Investment and $92 million to Principal Investment; and
4.22.3 Smaller write downs of $87 million and $15 million in the Infrastructure and Operating Leasing segments respectively.
182 At pars 4.24 to 4.36, Mr Potter set out the summary of activities and relative asset values of each of the primary business segments of BBL.
183 At pars 4.37 to 4.63, Mr Potter set out relevant market circumstances concerning BBL in the period 2007 to 2008.
184 Having discussed BBL's 2007 financial performance, at pars 4.41 to 4.47, Mr Potter said:
4.41 Following the peak price on 19 June 2007, BBL's share price traded as follows [Appendix 4, Potter calculation (Raw share price date)]:
4.42 In relation to the above I note as follows:
4.42.1 Following the peak of $34.63 on 19 June 2007, BBL's price sharply declined, dropping to $18.80 on 17 August 2007, representing a decline of approximately 46% over the course of two months;
4.42.2 Following this rapid decline, BBL's share price increased to $30 by 8 October 2007 before closing the year at $27.15 on 31 December 2007;
4.42.3 BBL's share price declined sharply in January 2008, dropping to a low of $14.99 on 22 January 2008;
4.42.4 BBL's share price trended lower over the following months, declining by approximately 50% between 10 June 2008 and 13 June 2008, reaching a closing price of $5.25 on 13 June 2008;
4.42.5 BBL's share price then steadily declined over the remainder of 2008, closing at $0.16 per share on 31 December 2008; and
4.42.6 BBL last traded on 7 January 2009 at $0.33 per share.
4.43 Over the course of 2008 the decline in the BBL's market capitalisation, which would normally be considered reflective of lower expectations of earnings and value, resulted in a substantial reduction in BBL's PB ratio. I set out a graph of BBL's PB ratio over the period 2 January 2008 to 31 December 2008 as follows [Appendix 4, Potter calculation (BBL PB ratio)]:
4.44 In relation to the above I note as follows:
4.44.1 Based on BBL's share of Group net assets, BBL's PB ratio declined materially over the course of 2008, from in excess of 4.0 in January 2008 to less than 0.03 by 31 December 2008;
4.44.2 BBL's PB ratio first declined below 1.0 on 13 June 2008 but quickly rallied above 1.0, peaking at 1.37 on 30 June 2008, after which the PB ratio declined steadily until 12 August 2008 at which date it reached 0.97;
4.44.3 After 12 August 2008, BBL's PB ratio never again exceeded 1.0, rapidly declining to 0.56 on 20 August 2008 and further to 0.36 on 21 August 2008; and
4.44.4 Thereafter, BBL's PB ratio continued to steadily decline, reaching 0.03 by 31 December 2008.
4.45 I observe that there was a material disclosure regarding the recorded book value of a significant class of assets described as 'Listed Securities Accounted for as Associates' at 30 June 2008. Page 79 of BBL earnings announcement on 21 August 2008 in relation to the six months ended 30 June 2008 discloses that the recorded book value of the relevant assets in BBL's accounts was $822.6 million but the market price of BB''s interest had declined to $620 million at 30 June 2008 and to $561 million by 18 August 2008, a potential decline in value of $261.6 million that was not reflected in the value of assets as recorded in BBL's financial statements. In relation to this, BBL stated that [BBL ASX Release dated 21 August 2008 (Appendix D, Note 21 - Events Occurring After Reporting Date (page 79))]:
"As at 30 June 2008 and as at the date of this report, Babcock & Brown had no intention or requirement to dispose of any interest in its equity accounted investments. As a consequence, the Directors believe the long term value of those investments remains appropriate and the fall in the market value of those investments subsequent to 30 June 2008 does not materially impact the carrying values of such investments in Babcock & Brown's balance sheet at 30 June 2008. As indicated in Note 1(E) this fall in market value provides evidence of partial impairment of Babcock & Brown's investments in these funds. In accordance with the requirements of AASB 128 "Investment in Associates" Babcock & Brown has completed a review to ensure that the carrying value of its investment in these entities is recoverable. Where appropriate these reviews included an assessment of recovery from Babcock & Brown's share of expected underlying cash flows. These cash flows are predicated on the business plans of associates which typically contemplate the long term use of the underlying assets of those investments"
4.46 The above disclosure highlights the sensitivity of the value of a material class of assets in BBL's financial statements and market events that, all things being equal, could be expected to have had an effect on BBL's PB ratio.
4.47 That BBL's market capitalisation implied a PB ratio of less than 1.0 is, in my opinion, significant in considering the market's expectation of future earnings that would be reflected in the share price and the extent to which the claimed reduced earnings guidance could be expected to affect BBL's share price. This issue is further addressed in section 6 of this report.
185 At pars 4.48 to 4.50, Mr Potter examined the trailing PE ratio of BBL in the following terms:
4.48 In addition to BBL's PB ratio. I set out below a graph of BBL's trailing PE ratio. This graph represents, on a daily basis, BBL's market capitalisation divided by the prior year's earnings. I set this out as follows [Appendix 4, Potter calculation (Raw share price data); I have prepared this analysis based on the prior full year NPAT and have not sought to update it for half year results as they were announced part way through FY08]:
4.49 In relation to the above I note as follows:
4.49.1 BBL's trailing PE ratio declined materially from 2007, where BBL was valued at up to approximately 27 times the prior full year earnings, to a multiple of approximately 15 times prior year earnings by 2 January 2008;
4.49.2 BBL's trailing PE ratio continued to dramatically decline, dropping below 10 times prior year earnings on 22 January 2008 and below 8.0 times on 7 March 2008;
4.49.3 BBL's trailing PE ratio continued to decline thereafter, dropping to below 5 on 12 June 2008 and to 3 by 13 August 2008; and
4.49.4 BBL's trailing PE ratio thereafter continued to decline, first dropping to below 1 times prior year earnings on 15 September 2008.
4.50 The above graph shows that whereas the market had historically valued BBL at high multiple of historical earnings, the material ongoing decline in BBL's PE trailing ratio indicates that, in my opinion, the market no longer expected BBL to generate the returns (earnings) that had historically been achieved.
186 At pars 4.52 to 4.61 of his first report, Mr Potter discussed the impact of the GFC on BBL's business and share price. I set out those paragraphs in full:
4.52 The events of the GFC are relatively recent and well documented. A useful summary appears at pages 380 to 384 of the valuation text by Koller, Goedhart and Wessels of McKinsey & Company [Annexure 19, Koller, Goedhart and Wessels of McKinsey & Company titled "Valuation: Measuring and Managing the Value of Companies", Fifth Edition, 2010, Wiley]. This reference outlines the following events:
4.52.1 In the years following 2001 and up to 2007 the financial, energy, utilities and materials sectors had experienced sharp increases in profits and values. The accelerated trends were a consequence of growth in Asian economies, particularly China, rises in housing prices, particularly the United States and Europe and expansion of credit markets including innovative financial instruments such as securitised finance instruments that provided lenders the opportunity to repackage and redistribute individual loans across many investors, the result of which was sharp increases in private sector debt. The combination of the rising house prices and innovative finance instruments allowed the transfer of mortgage default risk across banks globally. This led to the emergence of increasingly risky borrower segments known as sub prime loans;
4.52.2 A peak value of the S&P 500 Index was reached in mid 2007;
4.52.3 The financial crisis began to unfold in mid 2007 that drove the world's economy into its steepest downturn since the 1930s. Corporate profits dived and stock markets across the world lost more than half of their value from the peak levels in 2007 over the next year and a half;
4.52.4 A significant factor that emerged at the beginning of the crisis appears to have been the fall in United States housing prices and a resulting increase in mortgage default rates;
4.52.5 As a result of the high mortgage default rates finance institutions globally began to unwind their mortgage exposures. Values of underlying security plummeted bringing an increasing number of financial institutions into financial distress;
4.52.6 One of the most significant events was the collapse of the United States investment bank, Lehman Brothers in mid September 2008;
4.52.7 Other global financial institutions had to be rescued by governments including American International Group and Citigroup of the United States, Royal Bank of Scotland in the United Kingdom and Fortis and ING in the Netherlands;
4.52.8 The GFC resulted in the largest asset write-offs in history of around $2 trillion to $3 trillion for lenders in the United States and Europe; and
4.52.9 The economies in United States and Europe entered a deep recession, the lowest point of the S&P 500 occurring in March 2009.
4.53 I set out a graph of the S&P 500 index over the period 1 January 2007 to 30 June 2009 as follows [Appendix 4, Potter calculation (Graphs)]:
4.54 The events of the GFC and the effect on global economies has also been well documented in papers and presentations contained in bulletins issued by the Reserve Bank of Australia. For example, the RBA Bulletin for August 2008 documents the conditions prevailing globally and in Australia [Annexure 31, RBA Bulletin August 2008, pages 1 to 96], consistent with the outline set out in paragraph 4.52.
4.55 These events are particularly relevant to BBL because of the global nature of its assets and operations. The Real Estate division of BBL and its joint venture with GPT include a material investment in United States properties. The sharp decline in United States property values was one of the factors identified as driving the GFC. The decline in BBL's share price is consistent with the decline in global markets and companies that were comparable to BBL over the period.
4.56 In that regard I set out a graph of BBLs share price as compared to the prices of Macquarie, Allco Finance Group Limited ("Allco") [Macquarie Bank and Allco Finance Group have been included on the basis that they were the most comparable ASX-listed companies to BBL, both operating a similar business model (sourcing investments and deriving income from principal investment, advisory fees and asset management fees) and operating within the same industry segments (notably the infrastructure, leasing and property sectors)], the ASX 200 and the S&P 500 over the period 1 January 2008 to 31 December 2008 [Appendix 4, Potter calculation (Graphs) (Prices have been rebased to a starting value of 100 for comparability)]:
4.57 As illustrated, the decline in BBL's share price followed a similar trajectory to that of Allco's, albeit that BBL's share price fell over a longer period of time, and followed the same downward trajectory as that of Macquarie and the indices as a whole (albeit the decline in BBL (and Allco) was far more pronounced than for either Macquarie or the indices as represented by the ASX 200 and the S&P 500).
4.58 The effect of the decline in global market equity prices was reflected in the traded prices for shares in the listed funds in which BBL had an interest. The trends in the share prices are set out in the following graph [Appendix 4, Potter calculation (BBL managed funds - graphs) (Prices have been rebased to a starting value of 100 for comparability.).]:
4.59 The above chart illustrates that the traded prices for shares in the Babcock & Brown Infrastructure and Babcock & Brown Power experienced sharper declines in the first half of 2008, following which all four funds declined dramatically.
4.60 In particular I note that, in addition to the substantial declines in share price that occurred over the course of May 2008 where the share price declined by approximately 40%, Babcock & Brown Power's share price declined substantially during the week commencing 11 August 2008, declining by approximately 72% between 11 August 2008 and 20 August 2008.
4.61 In light of these substantial declines, I have reviewed the ASX announcements issued by Babcock & Brown Power with a view to explaining the cause of the decline.
187 At pars 4.62 and 4.63 of his first report, Mr Potter looked at the position of Babcock & Brown Power in a little more detail and concluded that the market expected that the business of that entity would not perform in accordance with management's expectations.
188 At par 4.67 of his first report, Mr Potter noted that, at BBL's Annual General Meeting held on 30 May 2008, shareholders were given some indication of a planned restructure. He then noted that, in mid-June 2008, an apparent debt issue had arisen that caused BBL to make a number of ASX announcements and a more formalised effort at a restructure. He noted the detail of these announcements at par 4.68 of his report.
189 Mr Potter then proceeded to look at events which affected BBL in August 2008. He considered those events in detail.
190 At pars 4.70 to 4.72, Mr Potter said:
4.70 The graph below shows BBL's closing share price during the month of August 2008 [Appendix 4, Potter calculation (Raw share price date)]:
4.71 In relation to the above I note as follows:
4.71.1 On 1 August 2008 BBL closed at $6.55, rising to a high during the month of August of $6.80 on 6 August 2008 and 8 August 2008;
4.71.2 On 11 August 2008 BBL declined to $6.00, a decline of $0.80 (11.8%);
4.71.3 On the subsequent two trading days, BBL continued to decline, closing at $5.43 on 13 August 2008, taking the decline to $1.37 (20%) from the high on 8 August 2008;
4.71.4 On 14 August 2008 BBL declined a further $0.43 (8.6%);
4.71.5. On 15 August 2008 BBL declined a further $0.55 (11%);
4.71.6 On 19 August 2008 BBL declined a further $1.06 (24%);
4.71.7 On 21 August 2008 BBL declined from $3.45 to $2.22, representing a decline of $1.23 (36%); and
4.71.8 Therefore, between 1 August 2008 and 21 August 2008, BBL's shares declined from $6.80 to $2.22, a decline of $4.58 or 67%.
4.72 Over the month of August 2008 BBL issued the following announcements to the ASX:
191 At pars 4.74 to 4.77, Mr Potter considered in detail the announcements made by BBL to the ASX during August 2008.
192 At par 4.78 of his first report, Mr Potter noted that the closing price of BBL shares on 21 August 2008 was $2.22 per share, a decline from the prior day's closing price of $3.45 per share, representing a decline of approximately 36%.
193 At par 4.79, Mr Potter said:
It is not possible to discern the precise reason for the decline in the share price on 21 August 2008 given the broad range of announcements made on that day. I note that the guidance as to Group NPAT for the year ended 31 December 2008 remained the same, however a number of additional risks to the result for the year were identified. Further, the restructuring of the business was re-emphasized and shareholders were informed of a decision to cease dividend payments for 2008. All things being equal, these additional announcements could be expected to reduce investors' expectations of future earnings.
194 Mr Potter then looked at relevant events affecting BBL in October 2008. At pars 4.80 and 4.81, Mr Potter said:
4.80 I set out a graph of BBL's share price as compared to the prices of Macquarie, Allco, the ASX 200 and the S&P 500 over the period 1 September 2008 to 31 October 2008 [Appendix 4, Potter calculation (Graphs) (Prices have been rebased to a starting value of 100 for comparability)]:
4.81 In relation to the above, I note as follows:
4.81.1 In the absence of any further earnings announcements issued by BBL, BBL's share price declined materially between September 2008 and October 2008;
4.81.2 Between 1 September 2008 and 15 September 2008, BBL's share price declined from $2.42 to $1.58, a decline of $0.84 (35%);
4.81.3 On 16 September 2008, the day in which Lehman Brothers collapsed, BBL's share price declined a further 34% (dropping from $1.58 to $1.05);
4.81.4 Over the coming days, BBL's share price declined further, dropping to a low of $0.76 on 18 September 2008. At this point in time, BBL's market capitalisation was approximately $264 million, compared to a book value of net assets of $2,060.5 million (representing an implied write-down to net assets of approximately $1.8 billion);
4.81.5 Whilst BBL's share price recovered from this low, peaking at $2.37 on 25 September 2008, the price again rapidly declined to $1.01 by 10 October 2008. I note that the trend over this period can be observed to closely follow that of the ASX 200 and S&P 500;
4.81.6 Thereafter, BBL's share price stabilised, closing on 31 October 2008 at $1.33; and
4.81.7 The declines in BBL's share price mirrored declines in Allco, Macquarie, the ASX 200 and the S&P 500.
195 Mr Potter then considered relevant BBL events in November 2008 (at pars 4.82 to 4.92 of his first report). At 4.82 and 4.83 of his report, Mr Potter said:
4.82 I set out a graph of BBL's share price as compared to the prices of Macquarie, the ASX 200 and the S&P 500 over the period 3 November 2008 to 31 December 2008 [Appendix 4, Potter calculation (Graphs) (Prices have been rebased to a starting value of 100 for comparability); Allco had ceased trading by this time]:
4.83 In relation to the above I note as follows:
4.83.1 In the absence of any further earnings announcements issued by BBL, BBL's share price declined materially between 3 November 2008 and 31 December 2008;
4.83.2 BBL's share price declined from $1.29 on 3 November to $1.00 on 7 November 2011, a decline of approximately 22%;
4.83.3 Over the period 10 November 2008 to 19 November 2008, BBL's declined substantially, dropping from $1.00 on 7 November 2008 to $0.25 on 19 November 2008, a decline of 75% over a period of eight trading days;
4.83.4 Following the decline to $.025, BBL remained in trading halt until 4 December 2008, where BBL's share price closed at $0.39; and
4.83.5 Thereafter, BBL's share price steadily declined, reaching $0.155 on 31 December 2008.
196 Mr Potter then considered in detail the announcements made by BBL to the ASX during November 2008.
197 At par 4.91 of his first report, Mr Potter said that he considered that the equity in BBL can best be described as having been highly risky from about mid-September 2008 onwards as a result of market-wide factors. He considered that this opinion was confirmed by reference to company-specific factors, being factors that indicated that BBIL's debt was speculative and, by necessary extension, the value of equity in BBL was increasingly becoming dependent upon restructuring efforts. He said that, in addition to reviewing the ASX announcements made by BBL, he reviewed press articles and analysts' reports during the period.
198 At pars 4.93 to 4.99, Mr Potter set out his conclusions regarding market events and their effect on BBL from September 2008 in the following terms:
4.93 I consider the events of the GFC and other news that is specific to BBL (such as the announcement made on 21 August 2008) to mean there would be considerable difficulty in reaching a view as to the extent that a separate news event of reduced earnings guidance from the company would affect BBL's share price, particularly where the announcement actually made contains negative news in any event. That is, it is more likely that there are too many confounding events to allow development of a reliable mathematical relation between the claimed reduced guidance and BBL's share price.
4.94 I also consider that given these issues, it is important to obtain an understanding of the market's expectations of future earnings. With this knowledge it would be possible to reflect on the likelihood of the market's reaction to the claimed reduced earnings guidance, assuming the market reacts in an economically rational manner. The consideration of the market's expectations is undertaken at section 5 and section 6 of this report.
4.95 The trends I have examined in this section of the report disclose a close relationship between BBL's share price and events in the global markets for financial institutions. All of BBL, Macquarie and Allco suffered a material decline in mid September 2008 that coincided with the collapse of Lehman Brothers in the United States.
4.96 By mid September 2008 and following BBL's PB ratio for BBL had declined to less than 0.25 and fluctuated around that level until reaching 0.03 by 31 December 2008.
4.97 It is readily apparent that by that stage the market was expecting the well publicised restructure of BBL to result in material realised impairment losses via the sale of assets in a severely depressed global economy (so far as equities were concerned).
4.98 The position of BBL then further deteriorated so that by mid November 2008 BBL:
4.98.1 Announced a larger restructure and asset sale program;
4.98.2 Was in a dispute with a lender(s) regarding release of a EUR 71 million bank deposit (in relation to which, on 20 November 2008, BBL requested a trading halt for its shares on the ASX on account of this dispute);
4.98.3 Had received a further credit downgrade from Standard & Poors ("S&P") to CCC+; and
4.98.4 There was widespread market commentary to the effect that the BBL Group's overall survival and the viability of the planned restructure was subject to the cooperation of the banking syndicate.
4.99 In my opinion these events towards the end of 2008 mean that it was highly unlikely there were any expectations of positive earnings being achieved in the year ended 31 December 2008. As such the share price is most likely a reflection of expectations of significantly depressed trading results and what might occur in a restructuring of the company. In these circumstances, I consider that BBL's share price is most likely a reflection of expectations surrounding the possible restructuring outcomes.
199 Section 5 of Mr Potter's first report addressed analysts' expectations regarding BBL in the second half of 2008.
200 At pars 2.20 and 2.22 of his report, Mr Potter said that his examination of the available reports prepared by equity analysts during the period August 2008 to November 2008 led him to conclude that the analysts' consensus forecasts of BBL's earnings were at a level of earnings that was considerably lower than the earnings guidance announced by BBL. He also expressed the opinion that the majority of the analysts further discounted their opinion of the value of BBL due to issues including market uncertainty. Taking all these matters into account, Mr Potter concluded that, in the period from August 2008 to November 2008, there was an expectation by analysts that BBL's earnings would be lower than the guidance issued by BBL and, once the discounts were factored in, generally lower than the earnings guidance that Dr Coulton states that BBL should have issued. Mr Potter said that, by September 2008, certain analysts were already rating BBL as "speculative".
201 Mr Potter supported these conclusions by a detailed analysis set out in section 5 of his report.
202 At par 5.17, Mr Potter said:
Having regard to the above, I consider that it is apparent that even adopting their own expectations of BBL's forecast NPAT, being forecasts which are materially lower than the figure announced by BBL, analysts have further discounted their valuations of BBL in order to derive a 'target price'. This further reduction represents, in my opinion, a discount for the uncertainty that was associated with BBL - being an uncertainty that was being reflected in the value attributed to BBL by the market. The material increase in the discount applied by analysts to their own valuations of BBL (35.3% compared to 9.3%) represents an increase in the uncertainty associated with BBL.
203 After more detailed consideration of the analysts' reports, Mr Potter expressed his conclusions in respect of those reports in the following terms (at pars 5.19 to 5.21):
5.19 Because of the discounts to valuations made by the analysts, I am of the opinion that the consensus view of analysts was, in effect, that expected NPAT for the year ended 31 December 2008 was going to be lower than the reduced guidance that Dr Coulton considers should have been announced by BBL.
5.20 Having regard to the above, it is apparent that there was a deep degree of scepticism held amongst the analyst community regarding BBL's forecasts and management's ability to successfully execute its plan. In particular, I note that:
5.20.1 Even amongst those analysts who were more optimistic toward BBL, such as Deutsche Bank, there was an unwillingness to express a positive view on the business or its prospects;
5.20.2 On 15 September 2008 BBL was regarded as "speculative" by Citigroup;
5.20.3 On 23 October 2008 Citigroup attributed a target price based on a "50% discount to our bearish estimate of NTA" indicating substantial risks associated with BBL's ability to continue as a going concern;
5.20.4 On 6 November 2008 ABN Amro considered that declining asset prices and difficult credit markets made it likely that BBL would breach its debt covenants in 2009;
5.20.5 On 17 November and 19 November, Citigroup issued reports in which it equated BBL with Allco, noting that Allco had been placed into Administration and Receivership on 4 November 2008. BBL was regarded as "Speculative" by Citigroup; and
5.20.6 On 19 November 2008, in light of the substantial uncertainty surrounding the future of BBL, Merrill Lynch issued a "No Rating" on BBL, stating that the future of the business lay in the hands of the banking syndicate.
5.21 The implication of the above is, in my opinion, that BBL was considered by a number of analysts to be a high risk, speculative investment from at least 15 September 2008; whilst there may have been the prospect for recovery, the downside risks were substantial, with substantial discounts being applied to net asset values.
204 Mr Potter then endeavoured to assess for himself the implied market expectation of BBL's NPAT for the year ended 31 December 2008 by reverse engineering the residual income model (RIM). He said that he had cross checked this calculation by applying the Gordon Growth model as an alternate means of assessing the implied market expectation of BBL's NPAT for the year ended 31 December 2008. Having done so, he concluded that the NPAT for the year ended 31 December 2008 implied by BBL's traded share price was lower than the NPAT that Dr Coulton considered BBL should have announced and that the implied market expectation NPAT was declining rapidly over the relevant period. Mr Potter then concluded that, had the earnings guidance suggested by Dr Coulton been given, a significant change in the price of BBL's shares was unlikely given that the market's expectation of BBL's NPAT was below the level that Dr Coulton said BBL should have announced.
205 In section 6 of his first report, Mr Potter explained in detail the way in which he had gone about his own assessment of the earnings that the market was expecting from BBL during the relevant period using the RIM.
206 At pars 2.23 to 2.28, Mr Potter explained in summary terms the way in which he used the RIM. He said:
2.23 In section 6 of this report I have undertaken my own assessment of the earnings that was expected by the market using the RIM. The RIM is a method for assessing the value of shares in a company.
2.24 The RIM provides that a firm's share value reflects the cost of its existing net assets (that is, the book value of equity) plus the present value of expected future net revenues to the extent those revenues exceed the required return.
2.25 As I outline in section 6 of this report, the RIM implies that if a firm can earn only the investor's required rate of return on the book value of its assets, then investors should be willing to pay no more than book value for its stock. Investors would pay more or less than book value if earnings are above or below this level. Thus, the difference between a firm's market value and its book value depends on its ability to generate residual income.
2.26 The RIM arrives at the value of each share by adding:
2.26.1 Recorded book value of net assets per share;
2.26.2 The discounted value of EPS less the cost of equity accruing to equity holders (calculated as the required rate of return for equity holders multiplied by the book value of net assets per share) for the forecast period up to the date of assessment of a terminal value; and
2.26.3 The terminal value, which is an estimate of the value of the amount in paragraph 2.26.2 indefinitely at the end of the forecast period.
2.27 The benefit of the RIM model is that unlike the discounted cash flow model of valuation, it relies on accounting measures of net income rather than cash flows which necessitate more assumptions and the majority of the share value is explained by the net book value of assets. Unlike the discounted cash flow ("DCF") methodology, the portion of the value attributed to the terminal value period (the period in perpetuity following the explicit forecast period), the period in which expectations are more unknown and relatively speculative, is minimised.
2.28 In relation to BBL and in the circumstances of this case, rather than use the RIM to assess the value of shares in BBL, I have used the RIM in order to derive a range of the market's expectations of BBL's implied NPAT for the year ended 31 December 2008, recognising that the application of any valuation model is not an exercise in precision. I have done so through a process known as reverse engineering. The range of more likely market expectations has been derived by the application of a range of assumed market expectations of growth, book value in net assets and with or without a terminal value. By testing a range of more likely market expectations I have assessed what I consider to be 'boundaries' of upper and lower expectations of implied Group NPAT for the year ended 31 December 2008.
207 Having performed his RIM analysis, Mr Potter expressed the opinion that it would not be reasonable to conclude that the earnings guidance proposed by Dr Coulton would have had a significant negative impact on BBL's share price as calculated by Dr Coulton.
208 Mr Potter provided a detailed analysis in support of his RIM assessment in section 6 of his report. I do not propose, at this point in these Reasons, to discuss the detail of section 6.
209 In section 9 of his first report, Mr Potter prepared an alternate calculation by which he assessed the potential impact on BBL share price of Dr Coulton's postulated earnings guidance under the net assets method. Using that method, Mr Potter considered that the impact of the earnings guidance proposed by Dr Coulton would have had little effect, if any, on BBL's share price.
210 In sections 7 and 8 of his first report, Mr Potter provided detailed commentary on Dr Coulton's methodology and calculations. At pars 2.43 to 2.74 of his first report, Mr Potter set out in summary form his responses to Dr Coulton's first report. In summary, he disagreed both with Dr Coulton's methodology and with his application of that methodology.
211 Mr Potter disagreed with Dr Coulton's assumption that the market's expectations of EPS were "anchored" on the $643 million figure provided in the BBL's earnings forecast. Mr Potter explained why at pars 2.49 to 2.56 of his first report and, in more detail, at pars 7.8 to 7.54 of his first report. Dr Coulton appeared to accept the validity of Mr Potter's criticisms as to the repetitive use of the $643 million figure when he revised his calculation using the Bloomberg analysts' consensus earnings figures in his later reports.
212 Mr Potter also disagreed with Dr Coulton's selection of the share price benchmark against which he purported to assess the hypothetical impact of the disclosure of the matters which he contended should have been disclosed. Mr Potter considered that taking the average closing price of BBL shares over the 20 days prior to the valuation date was a flawed approach. Mr Potter considered that the correct approach, on the assumption that Dr Coulton's methodology was appropriate, would be to take the share price at each particular valuation date.
213 At pars 7.68 to 7.86, Mr Potter provided a detailed answer to the 20 day theory advanced by Dr Coulton. He said:
7.68 As outlined in paragraph 7.5.1, Dr Coulton calculates the average closing price over the 20 trading days prior to the valuation date, excluding the actual valuation date on the basis that doing so avoids "using a closing price that is influenced by the event under consideration".
7.69 I disagree with Dr Coulton's approach.
7.70 The closing share price on each specific valuation day reflects the value attributed to the shares in BBL by the market on each specific day.
7.71 A widely accepted finance theory to explain asset prices is the efficient markets hypothesis [Annexure 20, Brealey, Myers, Partington and Robinson, "Principles of Corporate Finance," The McGraw-Hill Companies, Australian Edition, 2001, Chapter 13, pages 361-393 and Annexure 28, Brealey, Myers and Allen, "Principles of Corporate Finance," The McGraw-Hill Companies, United States, 10th Edition, 2011, Chapter 13, pages 312-340]. An efficient market is one in which information is widely and cheaply available to investors and all relevant and ascertainable information is already reflected in asset prices. Competition amongst investors to obtain all relevant information has the result that the traded share prices at all times reflect true or fundamental value. As prices reflect all relevant information, then they will change only when new information arrives. Because new information cannot be predicted ahead of time, then share price changes must reflect only the unpredictable and the changes must be random.
7.72 It is also widely accepted that the share prices for individual firms traded on stock exchanges reflect, or track, the fundamental prices [Annexure 19, Koller, Goedhart, Wessels, "Valuation - Measuring and Managing the Value of Companies," Fifth Edition, McKinsey & Company, 2010, Chapter 15, pages 325-343 and Chapter 17, pages 369-384].
7.73 A number of studies have been undertaken and found that new information is reflected in traded share prices almost immediately [Annexure 20, Brealey, Myers, Partington and Robinson, "Principles of Corporate Finance", The McGraw-Hill Companies, Australian Edition, 2001, Chapter 13, pages 367-368, footnote 15]. These studies would suggest that the share price on the date of each valuation is appropriate. There are recognised forms of efficiency:
7.73.1 Weak form: where current prices fully reflect historical information and prices that is available to all;
7.73.2 Semi strong form: where the current market price incorporates all publicly available information; and
7.73.3 Strong form: where the current market price reflects all publicly and privately available information allowing for the possibility of insider trading.
7.74 In this case I am concerned with the semi strong form of market efficiency. The extent to which the exchange traded price reflects the information available to the market on each of the relevant claimed announcement dates.
7.75 There have been a number of studies undertaken since the development of the efficient markets hypothesis which have identified and investigated several potential observed anomalies that could indicate inconsistencies or unexplained events contrary to the efficient market hypothesis. An example of one of the theories developed from behavioural finance that is contrary to efficient markets hypothesis is the overreaction hypothesis.
7.76 The earlier over reaction hypothesis studies undertaken in the United States [Annexure 21, De Bondi and Thaler, "Further Evidence on Investor Overreaction and Stock Market Seasonality", Journal of Finance, 1987, Vol 42, No. 3, pages 557-581] and one particular study in Australia [Annexure 22, Gaunt, "Overreaction in the Australian Equity Market: 1974-1997", Pacific-Basin Finance Journal, Vol 8, No.3-4, pages 375-398, 2000] to a lesser extent, suggested that investors overreacted to unexpected news so that the exchange traded prices temporarily departed from their fundamental values. Stocks that performed well in previous periods (winners) and stocks that performed poorly in previous periods (losers) both tended to revert to their mean value in subsequent periods. The likelihood of market overreaction has however been found to be less likely where a large price change follows the release of information publicly and the use of more recent data to study the effect [Annexure 23, Larson and Madura, "What Drives Stock Price Behaviour Following Extreme One-Day Returns", The Journal of Financial Research, Vol 26, No. 1, pages 113-127, 2003. See also Annexure 24, Clements, Drew, Reedman and Veerarahavan, "The death of the overreaction anomaly? A multifactor explanation of contrarian returns", Australian Academic paper, Investment Management and Financial Innovations, Vol 6, Issue 1, 2009].
7.77 Since then research conclusions have been inconsistent and controversial. In particular, a number of researchers argue the overreaction hypothesis can be explained by failures in the design of the research undertaken [Annexure 25, Ball and Kothari, "Nonstationary Expected Returns: Implications for Tests of Market Efficiency and Serial Correlation in Returns", Journal of Financial Economics, Vol 25, pages 51-74, 1989]. The overreaction hypothesis has also been rejected in research undertaken in Australia [Annexure 26, Brailsford, "A Test for the Winner-Loser Anomaly in the Australian Equity Market 1958-87", Journal of Business Finance and Accounting, Vol 19, No. 2, pages 225-241, 1992. See also Annexure 27, Donovan, Evans and Simpson, "A Re-Examination of the Over-Reaction Hypothesis in the Equity Market: Australian Evidence 1980 to 1997," Curtin University School of Economics & Finance, Working Paper No. 6, pages 1-21, 2000].
7.78 In conclusion, it is generally accepted that the studies undertaken to date surrounding the overreaction hypothesis and other potential anomalies are inconclusive and that the efficient markets hypothesis remains [Annexure 28, Brealey, Myers and Allen, "Principles of Corporate Finance," The McGraw-Hill Companies, United States, 10th Edition, 2011, Chapter 13, pages 312-340, in particular pages 335 and 336].
7.79 Dr Coulton suggests that the market was not informed of a revision to BBL's forecast earnings, being a revision that should have been made known to the market.
7.80 As I understand it, the thesis of Dr Coulton is that had up-to-date earnings guidance been issued, BBL's shares would have traded at a lower price than they actually traded. It is not possible, in my opinion, for the absence of a disclosure that is claimed should have been made to adversely affect the price at which the shares in BBL actually traded.
7.81 The approach that I would adopt, if I were to assess the impact on the price of shares on a particular day, is to adopt the actual closing price on the specific valuation day. It is the price on this particular day that is said to have been affected by the absence of the disclosure, rather than the average price in the 20 days preceding the nondisclosure.
7.82 In addition to being conceptually preferred, I consider that the adoption of the closing price on the actual valuation date to be preferred, as doing so removes the effect of both:
7.82.1 Market movements generally; and
7.82.2 Company developments specifically, on BBL's share price.
7.83 In that regard, I note that BBL's share price was highly volatile and was on a downward trend over the period between August 2008 and December 2008. The adoption of an average closing share price therefore inappropriately incorporates both market and company-specific price movements into the determination of the hypothetical price of shares in BBL had the 'correct' NPAT forecasts been issued to the market.
7.84 I graph BBL's closing share price over the period 1 August 2008 to 8 December 2008 as follows [Appendix 4, Potter calculation (BBL share data)]:
7.85 As illustrated, there were substantial movements in BBL's share price, with the price declining sharply over the period. For instance, BBL's share price declined from $5.81 on 12 August 2008 to $5.43 on 13 August 2008, representing a decline of $0.38 or 6.54%. Dr Coulton's approach ignores entirely the effect of this actual decline in assessing the hypothetical price that BBL's would have traded on 13 August 2008.
7.86 Further, Dr Coulton's approach places equal weight on the closing price of BBL's shares on each day between 16 July 2008 and 12 August 2008 (where BBL's share price traded as high as $7.40) in assessing the hypothetical value of BBL's share price on 13 August 2008. I consider that Dr Coulton's approach is without foundation.
214 Mr Potter also disagreed with the NPAT adopted by Dr Coulton. He did so largely because of the failure on the part of Dr Coulton to take account of the fact that BBL's NPAT was not the same as the B&B Group's NPAT from time to time.
215 Having explained the issue in section 7 of his first report, Mr Potter stated his conclusions (at pars 7.91 and 7.92) in the following terms:
7.91 As at each valuation date I set out Dr Coulton's forecast of Group NPAT and my assessment of BBL's share of Group NPAT as follows [Appendix 4, Potter calculation (BBL earnings)]:
Potter opinion on Dr Coulton's application of his PE ratio approach
7.92 Accordingly, for the reasons outlined, I consider that Dr Coulton has miscalculated BBL's PE ratio, meaning that Dr Coulton has incorrectly assessed the effect on BBL's share price under this methodology, being a methodology with which I otherwise disagree.
216 At pars 2.64 and 2.65, Mr Potter calculated BBL's PE ratio, eliminating the errors which he identified in Dr Coulton's approach. At those paragraphs, he said:
2.64 Based on BBL's market capitalisation and the earnings guidance that was issued for the year ended 31 December 2008 I have calculated BBL's PE ratio. I graph this as follows [Appendix 4, Potter calculation (BBL PB ratio)]:
2.65 As illustrated, if BBL's announced earnings guidance for the year ended 31 December 2008 is adopted, the PE ratio implied by BBL's actual market capitalisation drops below a multiple of 1.0 (which first occurs on 15 September 2008). By 3 November the PR ratio reaches 0.80, declining to 0.16 on 19 November 2008. A PE ratio of below 1.0 is nonsensical, suggesting that the market has valued BBL's entire business at less than the current's years 'expected' earnings. This indicates that, in my opinion, the market's expectation of the NPAT that BBL would achieve in the year ended 31 December 2008 is far lower than the earnings guidance that BBL announced. Accordingly, I consider that Dr Coulton's approach, which is premised on the market having adopted BBL's earnings guidance, is flawed.
217 Mr Potter then proceeded to consider Dr Coulton's PB ratio methodology.
218 He stated his conclusions briefly at pars 2.70 to 2.74 of his report in the following terms:
2.70 I disagree both with the methodology applied by Dr Coulton and with Dr Coulton's application of that methodology. I address these disagreements in turn.
Potter disagreement with Dr Coulton's closing share price
2.71 As with my comments regarding Dr Coulton's application of the PE ratio method, disagree that it is appropriate to assess the PB ratio at a particular date by reference to BBL's closing share price over the 20 days prior to the valuation date. The approach that I consider is appropriate is to assess the PB ratio based on the market capitalisation of BBL at the actual valuation date, this involving adoption of the closing share price as at 8 December 2008. This is addressed further in paragraph 8.8 to paragraph 8.9 of this report.
Potter disagreement with Dr Coulton's calculation of net assets per share
2.72 Whereas Dr Coulton calculates forecast net assets per share of $1.88 based on the number of BBL shares on issue at 8 December 2008 (refer to paragraph 8.11), the net assets per share adopted in calculating BBL's PB ratio at 8 December 2008 assumes:
2.72.1 Reported net assets for the BBL Group at 30 June 2008; and
2.72.2 Issued shares at 30 June 2008.
2.73 I consider that the appropriate approach to adopt in assessing the PB ratio at 8 December 2008 is to adopt integers as at 8 December 2008. As such, the integers that I consider should be applied are [Refer to paragraph 8.11 to paragraph 8.19]:
2.73.1 BBL's share of expected net assets of $2,923.5 million (accounting for both a correction so that net assets only reflect BBL's share of net assets, rather than total Group net assets and the expected increment in net assets reflecting the expected profit between 1 July 2008 and 8 December 2008); and
2.73.2 Issued shares at 8 December 2008 of 367,537,951.
2.74 Accordingly, I consider that Dr Coulton has miscalculated BBL's PB ratio, meaning that Dr Coulton has incorrectly assessed the effect on BBL's share price under this methodology, being a methodology with which I otherwise disagree.
219 Mr Potter provided a detailed analysis in support of his conclusions in respect of the PB ratio approach in section 9 of his first report.