This lucky country's economy is on a record-breaking 14-year roll. The big question: Will it continue?

Just imagine: From a few convicts dropped ashore in 1788, Australia has developed into a first-class global economy. The reforms enacted by former Prime Minister Bob Hawke and Treasurer Paul Keating during the 1980s set the stage for a remarkable run of prosperity. Specifically, they slashed import tariffs, floated the currency and reduced the power of big labor. The current prime minister, John Howard, who has been elected four times, has continued and expanded these reforms riding a wave of economic growth – 14 years of uninterrupted 4% to 5% growth.

The national debt has been virtually eliminated, the currency is strong, the government has recently signed a free-trade pact with America, and it is starting to negotiate a pact with China. Australia received $42 billion in foreign direct investment in 2004.

This is all great news, and our portfolio allocation in the Australia iShare (AMEX: EWA) has done very well, with a 105% gain over the past two years. The Australian iShare is up 15% so far this year and provides investors with exposure to about 60% of the total stock market.

Some Warning Signs

The question is of course, what should we do now. When things are going this well for so long, investors need to be skeptical and weigh the potential upside with the downside risk.

- A shortage of skilled and semi-skilled workers and relatively high labor costs (minimum $400 a week).

- Complicated and rigid labor rules continue to hamper productivity growth, which seems to be slowing.

- The total tax take by the Australian federal government is 22%, which is higher than the rest of Asian competitors and the U.S. (average of 16%).

- From 2000-2004 housing prices were up 100%, and household debt is now 160% of disposable income.

Australia is taking some measures to address these matters. It recently enacted a $17 billion cut in personal income taxes over three years, and the independent central bank is raising rates. The leadership has also introduced a package of “radical” labor reforms, which if enacted would also be a big plus. The aim is to give employers more flexibility and to bring labor negotiations down to the local level. The measures would increase probationary period for new employees from three to six months, exempt businesses with less than 100 employees from unfair dismissal laws, and favor individual contracts over collective bargaining. All of these measures will be fought by the Labor Party and trade unions.

While much is made of Australia's dependence on China and commodity exports, the Australian economy is well diversified, with 5% of gross domestic product attributed to mining, 5% to tourism and 80% to services. It also has the third-largest stock market in the region and a leading regional financial center.

Taking Profits

After looking closely at the situation, I have decided to keep Australia in our portfolio, but will take some profits by halving our position. Here is my reasoning:

- The decline in housing prices has been incremental and has therefore not affected banking, consumer and construction stocks as expected.

- International fund managers are underweight on Australia.

- The market is not especially expensive. The 12-month forward price-to earnings ratio is about 15, in line with the average over the past three years and below a high of 18. But keep in mind that this low multiple is based on forward and aggressive forecasts of corporate profits.

- Average dividend yield for Australian stocks is around 5%.

One company to keep an eye on is BHP Billiton (NYSE: BBL), the world's biggest mining group, which reported an 85% rise in net profit, compared with a year ago, to $6.5 billion for the year ended June 30, 2005. The Anglo-Australian firm set a new Australian corporate profit record, and after being up sharply in 2003 and 2004, it has confounded skeptics by going up 26% so far this year. The company's good fortune, like that of other mining concerns, comes from rising demand in China.

Another great Australian mining company is Rio Tinto (NYSE: RTP), which has a lower valuation because it doesn't have oil and gas operations, which contribute about 30% of BHP's total revenue.

Last Bit of Advice

The center of gravity for the world's economy is shifting to the Asia-Pacific region, and Australia is in the sweet spot. Keep an eye on housing prices and corporate profit performance, but for now keep some exposure to Australia in your global portfolio.

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