Sunday, 02 April 2017 22:28

Why we don't like Telstra

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Telstra is a favoured stock among many retail investors, assumingly for the current high franked dividend.

While Telstra's balance sheet is in pristine condition, which would allow it the flexibility to borrow in order to support this dividend, we remain concerned about Telstra's earnings outlook.  Not only have earnings virtually gone nowhere over the past decade, the NBN is likely to pressure Telstra's future earnings in the absence of a new growth stragegy.

NBN is a game changer for all Australian telecommunications companies as it results in them becoming a reseller of the NBN service, rather than selling their own data networks which attracted a higher margin.  This is likely to leave a 'black hole' in earnings for Telstra in coming years once the NBN is rolled out.  This is clear in the table below.

While the above table is forward looking, there is not much joy in earnings in the rear vision mirror for Telstra share holders.  This graph shows earnings per share, which have virtually 'flat-lined' over the past decade.  Source of this data is Skaffold software.

We conclude this article with a 3 minute video from Michael Glennon (Small Cap Investor) who outlines the reasons he does not wish to invest in Telstra.

Over the last few years, there has been a significant increase in the interest in Environmental, Social and Governance (ESG) investing. According to a paper released recently, over $8trn of the $40trn of money managed in the USA is now under some form of Sustainable and Responsible Investing (SRI) or ESG, up 33% since 2014 and up fivefold from $1.4trn in 2012 for money run by fund managers.

In many respects Australian fund managers have been caught unready for this change. If we look at the Mercer survey data for January 2017, the Global Equities strategy section contains 127 global funds that are sold in Australia. Of this, only 5 are classed as SRI funds. It is somewhat better for Australian equities with 157 funds in the survey, of which 13 are SRI. If we were to use the ratio of assets in the USA, the number of SRI funds should be 27 and 34 respectively.

One reason could be that there is a view amongst many people (and particularly fund managers) that “you can’t have your cake and eat it too”: that SRI results in lower returns for investors and the investors have to pay a price to be responsible.

In some ways this misconception, of accepting lower returns for being ethical, goes against another tenant of conventional investing wisdom: buy good businesses. The grandfather of long term investing, Warren Buffett, discusses a lot in his letters to shareholders the importance of ethics and the quality of the character of the people running the businesses he owns.

Implicitly he is saying that businesses that have an ethos and focus on ‘doing the right thing’ by staff and customers, should generate higher returns. Now admittedly he is discussing the character of the people rather than the nature of the business, and some people would find owning Coca Cola unethical.

And it is this differentiation between good people and bad unethical businesses that opens an interesting next line of inquiry.  Download the complete 4 page report from Morphic Asset Management by clicking on the link below.

Sunday, 02 April 2017 08:30

The Australian Housing Market - bubbling away

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Written by Shane Oliver - Chief Economist AMP

The cooling in the Sydney and Melbourne property markets evident in late 2015 in response to macro prudential tightening deployed by APRA has proved ephemeral. Price gains have reaccelerated and auction clearance rates & lending to property investors have rebounded. Over the last five years Sydney dwelling prices have risen a ridiculous 73% and Melbourne prices are up 47%. As a result the Australian housing market continues to cause much angst around poor affordability and high household debt. This note looks at the main issues.


Source: CoreLogic, AMP Capital

Is Australian housing overvalued?

On most measures Australian housing is overvalued:

  • On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average Australian houses are 39% overvalued and units 13% overvalued.
  • According to the 2017 Demographia Housing Affordability Survey the median multiple of house prices in cities over 1 million people to household income is 6.6 times in Australia versus 3.9 in the US and 4.5 in the UK. In Sydney it’s 12.2 times and Melbourne is 9.5 times.
  • The ratios of house prices to incomes and rents are at the high end of OECD countries.


Source: OECD, AMP Capital

Why is it so expensive and household debt so high?

There are two main drivers of the surge in Australian home prices over the last two decades. First, the shift from high to low interest rates has boosted borrowing and hence buying power. This has taken Australia’s household debt to income ratio from the low end of OECD countries 25 years ago to the top end. Second, there has been an inadequate supply response to demand. The following chart shows a cumulative shortfall relative to underlying demand had built up by 2014 and is still yet to be worked off despite record construction lately.


Source: ABS, AMP Capital

Consistent with this, while vacancy rates have increased they have only increased to around average long term levels. In Sydney vacancy rates are below average.

What about investors and foreign buyers?

A range of additional factors may be playing a role in accentuating demand beyond that implied by population growth. These include negative gearing and the capital gains tax discount, foreign buying and SMSF buying. Negative gearing is just part of the normal operation of the Australian tax system. However, the interaction with the capital gains tax discount by enhancing the after tax return available to property investment may be resulting in higher investment activity than would otherwise be the case. This may particularly be the case when past property price gains have been strong encouraging investors to think future gains will be too. While commitments to lend to property investors slowed in 2015 after APRA tightened macro prudential controls, this has since worn off.


Source: ABS, AMP Capital

Foreign buying is likely also impacting – with indications that it is around 10-15% of demand – but it is also concentrated in particular areas and SMSF buying appears to be relatively small. But like lower interest rates, all of these should have a less lasting impact if the supply response was stronger.

Is a crash likely?

The surge in prices and debt has led many to conclude a crash is imminent. But we have heard that lots of times over the last 10-15 years. In 2004, The Economist magazine described Australia as “America’s ugly sister” thanks in part to a “borrowing binge” and soaring property prices. Most recently the OECD has warned of the risks of a property crash. However, the situation is not so simple:

  • Firstly, we have not seen a generalised oversupply and at the current rate we won’t go into oversupply until 2018 and in any case approvals suggest supply will peak this year.
  • Secondly, mortgage stress is relatively low and debt interest payments relative to income are around 2003-04 levels.
  • Thirdly, lending standards have not deteriorated like they did in other countries prior to the GFC. In recent years there has been a reduction in loans with high loan to valuation ratios and interest only loans are down from their peak.
  • Finally, generalising is dangerous. While prices have surged in Sydney and Melbourne, they have fallen in Perth to 2007 levels and seen only moderate growth in other capitals.

To see a general property crash – say a 20% plus average price fall - we need to see one or more of the following: a recession - which looks unlikely; a surge in interest rates - but rate hikes are unlikely until 2018 and the RBA will take account of the greater sensitivity of households to higher rates; and property oversupply – this would require the current construction boom to continue for several years. However, the risks on the supply front are high in relation to apartments.

What can be done to fix it?

Recent RBA commentary strongly hints that more macro prudential measures to tighten lending standards are on the way. These could include a further lowering in the 10% growth cap on the stock of lending to investors and tougher debt serviceability tests. This is in part about reducing the risks to financial stability when it’s too early to consider raising rates.

More fundamentally, policies to help address poor housing affordability should focus on boosting new supply, particularly of standalone homes which have lagged. This includes relaxing land use restrictions, releasing land faster, speeding up approval processes and encouraging greater decentralisation. This is largely a state issue. Policies designed to make better use of the existing housing stock (eg, by relaxing constraints on empty nesters downsizing) could also help.

Policies that are unlikely to be successful include increased first home owner grants (as in periods of high demand they just result in higher prices) and allowing first home buyers to access to their super (again this will just result in even higher prices unless supply is fixed before and will mean less in retirement).

Tax reform should ideally be part of the package and include replacing stamp duty with land tax (again a state issue), removing the capital gains tax discount that is a distortion in the tax system and lower income tax rates to discourage use of negative gearing as a tax avoidance strategy. Piecemeal cuts to stamp duty targeted at FHBs will just result in higher home prices. Abolishing negative gearing would just inject another distortion in the tax system and could adversely affect supply (although I can see a case to cap excessive benefits).

What is the outlook?

Generalised price falls are unlikely until the RBA starts to raise interest rates again and this is unlikely until later in 2018, which after a few hikes will likely trigger a 5-10% pullback in property prices as was seen in the 2009 & 2011 cycles:

  • Sydney & Melbourne having seen big gains are most at risk.
  • Prices are likely to fall further in Perth and Darwin this year, but they are close to bottoming and should rise next year.
  • The other capitals are likely to see continued moderate growth this year and a less severe down cycle around 2019.
  • But units are at much greater risk given surging supply and this could see unit prices in parts of Sydney & Melbourne fall by 15-20% as investor interest fades as rents falls.

What are the risks to the economy?

Slowing momentum in building approvals points to a slowdown in the dwelling construction cycle ahead. This combined with a slowing wealth affect from rising home prices means that the contribution to growth from the housing will slow. However, as this is likely to coincide with a fading in the detraction from growth due to falling mining investment and higher commodity prices it’s unlikely to drive a slowing in the economy. However, a likely decline in rents (as the supply of units hits) will constraint inflation helping keep interest rates low for longer.


Source: REIA, AMP Capital

A property crash would have bigger impact given the exposure of banks, but as noted above such a development is unlikely.

Implications for investors

 

  • While there is a strong long term role for residential property in investors’ portfolios at present their remains a case for caution. It is expensive on all metrics and offers very low net income (rental) yields of 2% or less. This leaves investors highly dependent on capital growth.
  • But it is dangerous to generalise. Apartments in parts of Sydney and Melbourne are probably least attractive. Best to focus on areas that have lagged behind.
  • Finally, investors need to allow for the fact that they likely already have a high exposure to Australian housing. As a share of household wealth it’s nearly 60%.

 

 

 

 

Australian shares delivering around 9%pa income sounds too good to be true.  In this article, we take a look at a couple of professionally managed investment strategies that have been able to achieve this over the last 5 years.

With cash rates at 1.5% and the Australian cost of living rising at a rapid pace, those who require income from their investments face a dilemma.  Do SMSF’s remain in cash and fixed interest and either burn capital, reduce their living standards due to the low rates, or do they pursue higher income strategies elsewhere.  According to the recent ATO statistics, the allocation of SMSF’s to cash and fixed interest  is 26% (Source ATO Annual Statistics overview)

The Australian share market currently offers investors a higher income yield than cash, with potential for capital appreciation over time as can be seen in the chart below.

While the income yield from Australian shares is above 5%pa (incl franking) some professionally managed funds employ strategies to enhance this yield for income hungry investors.

Plato Investment Management are launching a listed investment company (called the Plato Income Maximiser) which uses the strategy of the Plato Australian Shares Income Fund that has been in operation for over 5 years.  This fund is unique in that it is a long only fund (not using derivatives) that achieves higher income by buying securities on the ASX300 in the lead up to a dividend payment and then selling once the dividend has been paid.  Historical evidence shows that share prices tend to appreciate in the lead up to a dividend payment, which the fund uses to boost returns.  In the 5 years to 28th February 2017 this strategy returned income to investors of 9.1%pa with some capital appreciation.

CEO of Plato Investment Management, Dr Don Hamson talks about the Plato fund with Commsec in the video below.

 

 

 

 

 

 

 

 

 

 

 

 

 Other high income equity strategies focus on investing into high income stocks, and then bolster income by writing call options over some of their holdings.  A call option is an agreement that gives an investor the right but not the obligation to purchase a share at a specific price during a specific period in exchange for a financial payment.  Many investment managers offer this style of high income equity fund including Investors Mutual, Colonial First State, AMP just to name a few.

For example an investor who owns 1,000 CBA shares could write a call option that would allow another investor to purchase their shares for a set price of say $90 (currently CBA trading at around $83) and in exchange for this agreement, receives a payment.  This payment is considered additional income over and above the dividend that the investor receives. In the event that the CBA share price rose above $90 it is likely that the investor who wrote the call option initially, would be obligated to sell the CBA holding for $90. 

Therefore it is important to understand that an investment strategy revolving around writing of call options carries the risk of limiting the upside when share prices rise.  These strategies tend to outperform during flat or ‘down’ market conditions and underperform during strong markets.

We are not criticising equity income strategies that use call options, we are merely making a comparison which demonstrates the limiting of upside.  Below we have compared the Investors Mutual fund that use call options, to the Plato fund which does not.  The figures are to the end of February 2017 sourced from company websites.  Readers can see the limiting of upside returns in the strategy using call options over the last 12 months when the market has been positive.

 

Plato Aust Shares Income Fund 1 Year 3 Years pa 5 Years pa
Income 9.6% 9.1% 9.1%
Growth 13.3% -0.2% 4.7%
Total Return 22.9% 8.9% 13.8%

 

Investors Mutual Equity Income Fund 1 Year 3 Years pa 5 Years pa
Income 7.9% 8.3% 8.8%
Growth 6.9% 1.7% 3.3%
Total Return 14.8% 10.0% 12.1%

 

Both of these managers are highly rated, so the purpose of the comparison is not to place one manager above the other, simply to highlight the difference in strategies during a period of strong market returns (which is shown in the 12 month numbers).

We would also highlight that the soon to be listed, Plato Income Maximiser is a listed investment company, which is different to the other income funds which are available in the format of a unit trust.  The benefit for SMSF trustees of investing in a listed investment company structure is the ability of the company to smooth dividend payments, where as a unit trust must pay out all income received to investors during the financial year in which it is received.  This can result in income being somewhat ‘lumpy’.

Finally the other difference between a listed investment company and a unit trust is that investors can purchase units in a trust by purchasing them directly from the investment manager, where as a listed investment company must be purchased via the ASX, or in the case of Plato Income Maximiser, can be purchased in the IPO which closes in April 2017.

This blog article is of general nature only and describes the new fund and is not in itself making an investment recommendation.  Investors are urged to read the prospectus and seek professional advice before investing.  The prospectus can be downloaded by clicking on the 'Download' icon below.

Friday, 24 March 2017 21:32

Morphic Ethical fund to list

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Jack Lowenstein and Chad Slater formerly from Hunter Hall are about to list the Morphic Ethical Equities fund.  Morphic was established in 2012 and has managed the Global Opportunities fund in that time which has generated a 17%pa return for investors since its inception.

Morphic Graph

 

Morphic is 30% owned by Westpac, and 70% owned by management, an ownership structure that we like.  Jack Lowenstein will be putting in significant money of his own into the listed investment company which is further evidence that management's interests are aligned with share holders.

The Morphic listed investment company will be aiming to pay out a steady stream of franked income once it has built up a profit reserve account and will invest ethically by not being to invest in companies that engage in:

Environmental Damage 

Oil and Gas

Gambling

Tobacco

Alcohol

Uranium Mining

Old Forrest logging

Morphic Ethical Equities fund will also have the ability to short stocks, (take a position to profit from a falling share price) and interestingly may short companies that fail it's ethical screen.

Investors who apply for shares in the IPO will receive a share of $1.10 in addition to an option for each share they purchase.  The option allows them to purchase an additional share at the same price of $1.10 in the next 18 months, or alternatively the option will carry some value and may be traded on the market.

We have spoken to the managers of the IPO - who have received good support from investors and they are anticipating that Morphic is likely to raise around $100m in this offer.

Management fee is 1.25%pa of net asset value of the fund which is reasonable for a global fund, plus a performance fee if the fund returns better than the international market.

GEM Capital is likely to receive an allocation of shares in this fund and the advisers will be co-investing into the fund too.

CEO Jack Lowenstein recently spoke on Sky Business News to Peter Switzer and we bring you that interview below.

Of course before investing, investors should seek professional advice and read the prospectus which can be downloaded below by clicking on the "Download" icon.

 

 

download button 1

 

 

Wednesday, 22 March 2017 22:29

China - It's better than you think

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Mark Draper and Shannon Corcoran (GEM Capital) recently spoke with Joseph Lai (Portfolio Manager Platinum Asset Management) about China and the current state of the economy.

Joseph believes that the Chinese market is cheap and that the risks of a banking crisis in China are overblown.

You can listen to the podcast here.

 

 

Apple RainbowApple is among the largest companies in the world.  The company enjoys strong brand recognition globally and extensive market penetration for its flagship products, most notably the iphone.  While speculation around the success of Apple Watch, Apple TV, iPad, or even the likelihood of an Apple Car often captures headlines, we estimate that iPhone and iPhone related services represented around 70% of Apple's revenue and 80% of Apple's gross margin in 2016.  Despite its relatively high price, there is strong demand for the iPhone in both developed and emerging markets, with China now contributing 21% of Apple's total revenue.

We recently met with Dom Guiliano (Chief Investment Officer, Magellan Financial Group) who outlined the investment case for Apple Inc, which is a major holding in Magellan funds.  You can listen to the podcast below.  You can also download the paper that briefly outlines the Investment Case for Apple, which clearly is far more than an electronic device manufacturer.  This can be downloaded by clicking on icon below.

Media

Monday, 27 February 2017 20:28

Donald Trump - the policy agenda

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The biggest event for global financial markets in 2017 is likely to have taken place on 20th January - when Donald Trump was sworn  in as the 45th President of the United States.

The implications for the US economy and financial markets from President Trump is likely to involve three phases.

Phase one was 'risk off', with the unexpected election victory by Trump seeing the US equity market and the US dollar sell-off and US bond yields rally.  This phase, however, lasted less than 24 hours, with the market quickly moving into the second phase.

The second phase, which ies expected to be the dominant factor throughout 2017, is supported by the view that Trump's policies will be expansionary and stimulatory - especially his company and income tax cuts, increased infrastructure spending and reduced regulatory environment.

This phase has already seen a strong rally in equity markets, the US dollar, a sell off in bond markets and is expected to be the primary factor driving markets throughout 2017.  A noticeable increase in both business and consumer confidence has taken place since the election.

Further out, however phase 3 may not be as positive.  Although the timing for phase three is very difficult to determine, it could be anywhere between 2018-2020, this phase is likely to involve an increase in inflation and a more aggressive monetary policy tightening cycle from the US Federal Reserve resulting in higher than expected interest rates.

In terms of the main policy agenda for President Trump, the following is expected (+, - and ? symbols indicate the direction of impact on the economy and markets)

+ Significant fiscal stimulus through a) large income tax cuts (3 rates 12%, 25% and 33%) b)company tax cuts (to 15% or 20% from 35%) and c) a 10% repatriation tax for cash currently held offshore by US corporates

+ Increase in infrastructure spending ie $300bn government spending, with private sector involvement potentially up to $1 trillion.

+ Increase in military spending - current and veterans

+ Reduce regulatory burden, especially on energy to achieve "complete American energy independance"

 

- Strongly protectionist stance - name China as a 'currency manipulator' and impose 45% tariffs on selected imported goods

- No support for TPP and change / withdraw from NAFTA - both important trade agreements

- Scale back climate change regulations

- Critical of US Federal Reserve policy, pro-audit, Chair Janet Yellen to be replaced in early 2018

- Isolationist stance of foreign policy - critical of NATO / some allies and China.  Closer to Russia.

- Tough stance on immigration - building a wall

 

? Repeal and replace Obamacare.

 

It has been estimated that Trump's policy agenda will increase the level of US Government debt by around 20% of GDP over the coming decade. 

 

 

 

The key question for investors over 2017 and beyond is wil this be money well spent?  Will President Trump's policies lead to a permanent shift higher in US's potentional economic growth rate?

This information is an extract from a presentation we attended by Stephen Halmarick (Chief Economist Colonial First State)

We will be producing a podcast that explores more about Trump's policy agenda in March with Dom Guiliano (Chief Investment Officer - Magellan Financial Group)

Sunday, 26 February 2017 22:22

What the "Dumb" money is doing - Sportsbet on Trump

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Investing is a game of probabilities.  So is politics.

With the leading global book makers being wrong on Brexit and Donald Trump, they are now providing punters an opportunity to win their money back with Donald Trump, providing odds on Donald Trump being impeached, to visiting North Korea in his first term.

We provide screen shots from Sportsbet.com that highlight what's on offer.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Late last year OPEC announced that it will cut oil production by 1.2 million barrels per day to 32.5 million.  To put this number in perspective, OPEC represents around one third of global oil production.  These cuts will take effect in January 2017, lasting for 6 months and is the first time since 2008 that OPEC has cut production.  Currently although Iraq is producing more than agreed, the compliance from other OPEC members has been very high.

Already there has been some reaction in the oil markets with the price of oil rising in the last quarter of 2016.

Around 12 months ago, we shot a video featuring Clay Smolinski (Platinum Asset Management) who suggested that the oil markets would likely come into balance where supply meets demand during 2017.  This of course was well before the OPEC production cuts were announced, as the balancing of the oil market was underway at that stage.  The OPEC production cuts simply speed up the process.  The graph below confirms his prediction.

What stands out from the above chart is how close supply and demand tend to be.  Even when the oil market was in dramatic oversupply during 2015, the oversupply was around 2 million barrels per day.  The over-supply gap at the end of 2016 was small which underscores the significance of a production cut of 1.2m barrels per day.

It was also suggested at that time, that the oil price was likely to recover to around $70 per barrel as it is at this level that oil companies can make sufficient profit to reinvest into exploration to ensure supply can be maintained.  Currently the oil price remains in the $50 - $55 per barrel range, but the production cuts, providing they are maintained are only starting to be reflected in oil inventories now.

Higher oil prices are positive for companies who derive income from oil or products referenced to the oil price such as LNG.

At GEM Capital we have been investing in companies that can benefit from a rising oil price, and with fund managers who also share this view such as Ausbil and Platinum Asset Management.

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