Tuesday, 24 July 2018 16:48

Australian Sharemarket Outlook - July 2018

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GEM Capital recently hosted a client function with John Grace (Deputy Head of Equities - Ausbil Investment Management).  Ausbil are excellent investors who have enjoyed a very good track record over a long period of time.  They have enjoyed a very good investment return in the last 12 months as well.

The function was relaxed and conducted on a "Question and Answer" basis.

Here is the video of the function, together with a summary of the key topics discussed, together with the approximate time stamp in the video.

Topics covered:

0. Introduction to Ausbil and fund performance (1.00)
1. Overview of Macro Economic themes (2.30)
2. Banking Royal Commission (6.30)
3. One stock that has been our best call .... Bluescope Steel (10.00)
4. Telstra (and Telco sector) (12.00)
5. Question - Impact of Trade War threat (20.00)
6. Thoughts on household debt levels (30.00)
7. Benefits of Company Tax Cut (34.00)
8. Flight Centre (40.00)
9. Bionomics (46.30)
10. China - how is it changing (53.00)
11. Gold (56.00)
12. View on Australian Interest Rates (58.30)
13. Woolworths and Coles and Retail sector (59.30)

 

Tuesday, 24 July 2018 07:58

Housing Credit Crunch

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Livewire recently produced a video with Dan Moore (Investors Mutual) discussing the changes to Australian lending and the likely impact on the economy.

 

Transcript of video

Q. Are tighter lending standards having an impact and where is it being felt? 

Daniel Moore: We're definitely seeing the banks change their lending standards, particularly around loan to income ratios, which has been pulled back quite a bit. They're now sort of having a max of about six times income, which is reduction in the past. And that's having an impact on loan approvals and clearance rates of the market. 

Q. Self-managed super funds have been pulled back from some of their lending. Westpac initially, some of the other banks, is this another part of that puzzle and is it getting worse?

Hamish: We actually are more focused on investor lending. The investors in Sydney and Melbourne were taking anywhere between 50 and 60% of total mortgage flow at the peak about a year ago, which by international standards is just a witheringly high number. There's no international precedent for numbers anywhere near that high. So, it's true that the banks are pulling back from lending to self-managed super funds for real estate. At Watermark, we're much more focused on the impact of investors pulling back. The work that we've done suggests that borrowing capacity of investors is down anywhere between 10 and 20% and we think it's going to keep going. We know from channel checks with mortgage brokers that not all of the banks have rolled out the new loan serviceability requirements, they will do throughout the rest of the year. 

So the tightening should continue to go in our view. 

Q. So a negative for the economy or is there something positive we can say about it? 

Hamish: No not really. I guess long-term it rebalances the economy and millennials can afford a house. If you're a millennial that's probably a positive. So, lower house prices impacts the economy in a bunch of different ways. Directly it's through something called residential investment. Residential investment is building of new houses, renovating existing houses, and dwelling transfers. And there's a lot of literature that says when that peaks as a contribution to GDP as it has done in Australia about 12 months ago, that's a very good leading indicator for an economic slowdown and usually a recession. 

So there's not a lot of good news about the housing market and residential investment rolling over. 

Q. Daniel, housing affordability getting better certainly helps and makes the economic story a bit more sustainable, is that a positive or is there absolutely none as Hamish is suggesting?

Daniel: I think the one positive you can say is that the royal commission happened before the crisis rather than after. Improving lending standards is a good thing, but there's no doubt the short-term impacts are negative. There's a very close correlation between house prices and household gearing level. So as banks are less willing to lend consequentially you would expect house prices to fall. 

Improving lending standards is a good thing, but there's no doubt the short-term impacts are negative.

Q. If we're looking at the ASX listed stocks who is going to be most affected by this, and what should we be aware of there? 

Daniel: So if you look at probably the leading ... so the companies that are right at the pointing end, so the companies that are leveraged to house prices, or new housing. We sort of look at the property developers, we look at building material companies, and probably the retail sectors which sell household goods particularly the most expensive household goods. 

Q. So into that discretionary side, what are the areas that are really flashing red lights for you?

Hamish: I wouldn't disagree with anything that was said before. Most of the work that we've done that informs our view on Australian housing and its impact on the economy was based on what happened in the Netherlands and the UK earlier in the decade. And exactly as described, the mortgage banks actually do reasonably well, it's the rest of the economy that disintegrates. So, retailers go bust, commercial real estate collapses, people stop going to the movies, people stop going to restaurants, but they pay their mortgages. So, we're focused on many of the same areas. 

The mortgage banks actually do reasonably well, it's the rest of the economy that disintegrates.

Q. What would you do portfolio wise? Are there things you'd sell if this thing was going to take hold?

Hamish: Again, what you would sell is reasonably obvious. I think the one area that might be a little counter consensual is owning the housing banks. So again, when we looked overseas in the Dutch downturn houses prices fell about 20%, the banks lost four basis points on their mortgage portfolios, which is not a lot. That same number in the UK was six basis points, which is not a lot. And in Sweden it was about one basis point.

To answer your question in an interesting way, a counter consensual view that we have is that the housing banks actually will do reasonably well in this scenario, and then the businesses that will do badly are the ones that we described before. 

Q. Daniel you mentioned some of the housing stocks, building materials, any of those particularly a sell for you at the moment?

Daniel: I think if we think of the building materials companies, the one that's most exposed to residential housing in Australia is CSR Limited (ASX: CSR), so despite the multiple looking quite reasonable we think those earnings are at the top of the cycle.

In terms of retail probably the stock that's right at the pointing end, which has had a really good run in terms of earnings growth is Nick Scali (ASX: NCK), they're a furniture retailer. So they're probably two stocks we think are right at the pointy end. 

So they've had a good run and now it's time that things are changing. Not all investments are as safe as houses.

Thursday, 19 July 2018 09:51

How to profit from Market Myths

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In 1962, President John F Kennedy delivered Yale's graduating class of 1962 a piece of advice that all investors should hold dear:

"The great enemy of truth is very often not the lie - deliberate, contrived and dishonest - but the myth - persisent, persuasive and unrealistic .... We enjoy the comfort of opinion without the discomfort of thought"

All too often, investors rely on conventional wisdom.  Ideas that may have been true one dday, which are perhaps not relevant today. For those investors who fail to question the myths they have always believed, danger lies ahead.  On the other hand, great investment opportunities can stem from the continual questioning of conventional wisdom and the dispelling of myths.

This article has been reproduced on our website with the permission from Montgomery Investment Management.

Is discussed the myths surrounding Consumer Packaged Goods, and why they may be a dangerous place to invest.

 

Click on the image below to download your copy of this report.

 

Tuesday, 17 July 2018 13:10

My Health Records

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This information has been sourced from a Government website myhealthrecord.gov.au

All Australians will have an online My Health Record established by November 2018, which is an online reference point for medical professionals.  For those not wishing to have their medical records available online, they have from 16th July 2018 - 15th October 2018 to opt out.

We suggest you take a moment to review the information about My Health Records and decide for yourself how you want to deal with this issue.

 

 

My Health Record is an online summary of your key health information.

When you have a My Health Record, your health information can be viewed securely online, from anywhere, at any time – even if you move or travel interstate. You can access your health information from any computer or device that’s connected to the internet.

Whether you’re visiting a GP for a check-up, or in an emergency room following an accident and are unable to talk, healthcare providers involved in your care can access important health information, such as:

  • allergies
  • medicines you are taking
  • medical conditions you have been diagnosed with
  • pathology test results like blood tests.  

This can help you get the right treatment. You don’t need to be sick to benefit from having a My Health Record. It’s a convenient way to record and track your health information over time.

You control your record

You can choose to share your health information with the healthcare providers involved in your care.

If you wish, you can manage your My Health Record by adding your own information and choosing your privacy and security settings. For example, you can:

Next time you see your doctor, ask them to add your health information to your My Health Record. 

By allowing your doctors to upload, view and share documents in your My Health Record, they will have a more detailed picture with which to make decisions, diagnose and provide treatment to you. You can also ask that some information not be uploaded to your record.

A My Health Record for every Australian in 2018

This year, you will get a My Health Record unless you tell us you don’t want one. As more people use the My Health Record system, Australia’s national health system becomes better connected. The result is safer, faster and more efficient care for you and your family.

If you don't have a My Health Record, and don't want one created for you, you can opt out between 16 July and 15 October 2018. Find out how you can opt out

When will I get a My Health Record?

The new records will be available from 13 November 2018. If you want a My Health Record before then you can register now.

 

Information from healthcare professionals  

Healthcare providers such as GPs, specialists and pharmacists can add clinical documents about your health to your record, including:

  • an overview of your health uploaded by your doctor, called a shared health summary. This is a useful reference for new doctors or other healthcare providers you visit
  • hospital discharge summaries
  • reports from test and scans, like blood tests
  • medications that your doctor has prescribed to you
  • referral letters from your doctor(s).

Information from Medicare

Up to two years of past Medicare data may be added to your record when you first get one, including:

  • Medicare and Pharmaceutical Benefits Scheme (PBS) information held by the Department of Human Services
  • Medicare and Repatriation Schedule of Pharmaceutical Benefits (RPBS) information stored by the Department of Veterans’ Affairs (DVA)
  • organ donation decisions
  • immunisations that are included in the Australian Immunisation Register, including childhood immunisations and other immunisations received.

Information you can add to your record

You, or someone authorised to represent you, can share additional information in your record that may be important for your healthcare providers to know about you. This includes:  

  • contact numbers and emergency contact details
  • current medications
  • allergy information and any previous allergic reactions
  • Indigenous status
  • Veterans’ or Australian Defence Force status
  • your advance care plan or contact details of your custodian. 

What to expect when logging into My Health Record for the first time

The first time you log into your My Health Record there may be little or no information in it. There may be up to two years’ worth of Medicare information such as doctor visits under the Medicare Benefits Schedule (MBS), as well as your Pharmaceutical Benefits Scheme (PBS) claims history. If you choose, you can remove this information after you log in.

Information will be added after you visit your GP, nurse or pharmacist. You can add your personal health information and notes straight away.

Uploading old tests and scans

Your medical history, such as older tests and scan reports, will not be automatically uploaded to your My Health Record. Only new reports can be uploaded by participating pathology labs or diagnostic imaging providers.

Talk to your doctor about uploading a shared health summary to your My Health Record. This summary can capture important past health information such as results from previous tests or scans, which can be shared with your other treating healthcare providers. 

Friday, 13 July 2018 11:49

China - What just happened?

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Reproduced with permission from Charlie Aitken - Aitken Investment Management

 

This article is written by Charlie Aitken, founder of Aitken Investment Management.

 

Substantial outflows from emerging markets ETFs, driven by US Dollar strength, triggered large and relentless selling in the largest index weightings in Hong Kong (Chinese equities). Fears of a “trade war” have also weighed on China sentiment.

The Hang Seng China Enterprises Index (HSCEI) fell -7.6% in June, while the Chinese mainland benchmark, the Shanghai Composite Index (SHCOMP) fell -8.0%. From mid-January peak both indices are now down over -20%, triggering a technical “bear market”.

It has been a brutal and indiscriminate technical sell-off in Hong Kong. However, we remain confident in the investment case for Chinese consumer facing companies and the major technology platforms which have pulled back to what we consider compelling investment arithmetic. We will explore that investment arithmetic later in this note.

While Chinese stocks listed in China had a very poor month, it seems somewhat odd to us that China facing stocks listed on developed market exchanges such as the NYSE or ASX proved broadly immune to any price falls. That most likely suggests this is a violent emerging market to developed market rotation, rather than a wholesale de-rating of all things China facing.

We believe this is a technical ‘clearance sale’ in leading Chinese equities and we want to emerge from this rotational correction holding the very best fundamental portfolio of tier one Chinese structural companies we can.

Outflows from Emerging Market equities

The US dollar rally that began in May has seen significant outflows from Emerging Market equities. We can use the IShares MSCI Emerging Market ETF (“EEM.US”) as a good proxy to illustrate this point. EEM has seen a 20% redemption of units on issue since April (approx. $7.7bn of outflows at today’s prices). China is the biggest weighting in this ETF at 30% and Tencent is the biggest single stock weighting at around 5.5%, so redemptions from this ETF and all other products like it lead to direct selling of Tencent and other large cap Hong Kong Listed equities.

The following chart shows the number of units outstanding in EEM (the blue line) versus the DXY USD Dollar index (the red line) which we have inverted. In simple terms USD strength has seen an exodus from Emerging Market equities. For context the outflow in EEM over the past 8 weeks is greater than the outflow for the entire of 2015 when the world was in a China-centric deflationary spiral.

In 2015 evidence of a fundamental slow-down in China was obvious everywhere from Chinese economic data, to global PMIs, trade data, commodity prices and even Australian listed China facing equities. The most obvious example is BHP shares which have historically had a very strong correlation to H-Shares. The chart below shows the HSCEI Index (H-shares) versus BHP. One of these 2 is sending us the wrong message on Chinese economic fundamentals. The gap in this chart will close one way or another in the second half of this year. Note the divergence started around the same time as the EM exodus (BHP is not part of EM equities).

Is China grinding to a halt?

Relative to the strong-growth seen in 2017 we are definitely seeing a moderation of growth in China. This was evident in our recent trip to China and can been seen in monthly data series such as the YoY change in Industrial Enterprise Profits and the Li Keqiang index (which measures YoY change in rail freight data, power consumption and bank lending). However as can be seen below the picture at this stage is fundamentally different to what we saw in 2015. The key question is, are HK equities pre-empting a move in fundamentals or is this a market driven panic? 

What are markets pricing in?

Whilst the 2015 bear market in Chinese equities saw a combination of very high starting valuations and badly deteriorating economic fundamentals the picture today is quite different. The market PE for domestic Chinese equities is already below the trough of 2015. 

We see plenty of inconsistencies in global cross asset market prices at the moment. It feels like Hong Kong listed Chinese equities are pricing in a harsh slow-down in global growth whilst other equity markets (and other asset classes such as gold and commodities) are taking a more optimistic view. 

Below we present a snapshot of AIM’s four biggest Chinese holdings.

We believe all these businesses have very bright futures and are very attractively priced at current levels. They are the leaders of their industries, have expanding moats, have massive addressable markets, and are all platform businesses or benefitting from technology. We believe their earnings growth outlook is unchanged, we have recently met with management teams, and we have great confidence in their business strategy and execution abilities.

While it was a disappointing end to the financial year for those of us who are structurally bullish on China, we remain of the view that the potential for strong total returns remains in FY19 particularly given the entry points and highly attractive valuations of our core high conviction Chinese investments above.

Don’t run away from the clearance sale: take advantage and buy the best Chinese consumer brands while they are cheap.

Monday, 02 July 2018 11:12

The Best of the Best - June 2018

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The Investment Team at Montgomery Investment Management regularly produce a report "Best of the Best".

We bring you the June 2018 edition.

This report is put together by the investment team, and not a marketing spin doctor.

 

Click on the image below to download your copy.

 

Monday, 02 July 2018 08:35

Tax Cuts - what it means for you

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The 1st July 2018 brings in the first round of income tax cuts that have been ferociously debated in parliament.

 

The table below outlines the level of tax that is currently paid for a range of incomes and projects the value of future tax cuts.

Income Current Tax Paid Tax cut from 2018/2019 Tax cut from 2022/2023 Tax cut from 2024/2025

Tax Paid in 2025

 $20,000  Nil  $0  $0 $0 $0
$40,000 $4,547  $290  $455  $455 $4,092
 $60,000 $11,047  $530  $540  $540 $10,507
$80,000 $17,547 $530 $540 $540 $17,007
$100,000 $24,632 $515 $1,125 $1,125 $23,507
$150,000 $43,132 $135 $2,025 $3,375 $39,757
$200,000 $63,632 $135 $2,025 $7,225 $56,407

 

The person earning $40,000 will pay 6% less tax in 2018/2019 and then in 2022/2023 will pay 10% less tax than they currently do.  

A person earning $150,000 will pay 0.3% less tax in 2018/2019 and then in 2022/2023 will pay 4.6% less tax than they currently do.  So while the gross dollar value of tax saving is higher for the $150,000 income earner, they are actually receiving a lower percentage tax cut.  The contribution to the tax base of someone earning $150,000 is also 10 times the value of the $40,000 income earner.  We dispute the view that is held in some sections of the media that suggests those earning lower amounts of income are being discriminated.

It is like suggesting that a person with a $500,000 mortgage receives a higher benefit from a 1% interest rate cut than a person with a $100,000 mortgage.  They are both treated equally in terms of the cut, but the higher mortgage saves more due to simple mathematics.  In reverse the person with the higher mortgage pays more when rates rise.

So it is with income tax, those who earn more, contribute more to the tax base for the purposes of health, education etc.  So when tax rates are reduced it is also logical that the dollar value for those earning higher incomes is also higher.

 

Tuesday, 05 June 2018 11:32

Let's take a look at the Banks results

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Article reproduced with permission from Montgomery Investment Management.

 

In the midst of the Royal Commission into Misconduct in Financial Services, the major banks have released their latest half yearly results. The market headed into the reporting period with a high degree of apprehension given the public backlash emanating from the revelations coming from testimony at the Royal Commission to date.  In a number of articles over a long period of time, we have discussed our concerns about the outlook for revenue growth given the impact on loan book growth, that is likely to result from the turn in the long term structural decline in interest rates globally. Expected is a slowing of loan book growth, as volume growth is no longer boosted by the falling cost of debt, which has allowed households and businesses to sustain progressively higher levels of debt.

The first half results showed signs of this playing out, with loan book growth, based on the average balance for the period, continuing to slow on a sequential basis.

 

 

 

Screen Shot 2018-05-14 at 5.24.13 pm
Source: Company Data *CBA data represents the 3 months to 31 March 2018

Slowing loan growth has been offset in recent periods by rising net interest margins, as a result of the repricing of interest only and investment property mortgage rates. In 1H18, the banks benefited from some easing in the level of competition for deposits.

However, over the last couple of months, the banks have been exposed to rising benchmark short term wholesale interest rates (BBSW and LIBOR) relative to official central bank rates. This is expected to see the funding costs of the banks shift from being supportive for net interest margins to now presenting a headwind.

Net interest margins were down for three of the four majors, with negative mix in mortgages (switching to lower rate principal and interest mortgages) and a full period impact of the bank levy offsetting any residual repricing benefit.

The other factor to take into account is the impact of trading and markets activity on the net interest margin. This is a very volatile part of the equation. For ANZ (ASX:ANZ) and National Australia Bank (ASX:NAB), a weaker trading performance relative to 2H17 reduced net interest margin (NIM) in 1H18, while for Westpac (ASX:WBC) it boosted NIM materially.

Given the volatility of this income, this is a low value driver of NIM and should be looked at in a historical context when projecting into forward periods due to the likelihood of mean reversion. This is particularly relevant for WBC’s result in which the Markets and Trading component of the NIM is well above historical levels and therefore should be treated with a degree of caution when forecasting from this base.

The chart below shows the annualised rate of growth in net interest revenue for the four major banks in 1H18 relative to 2H17. Growth, excluding the impact of trading, provides a better indication of the underlying sustainable rate of growth in the period as it strips out the volatile impact of trading activity on NIM.

Screen Shot 2018-05-14 at 5.25.26 pm
Source: Company Data *CBA data represents the 3 months to 31 March 2018

Non-interest income was similarly soft, particularly once trading revenues and one-off profits from the sale of investments and businesses are excluded. This resulted in total revenue growth in the low single digits. We note that the Commonwealth Bank of Australia (ASX:CBA) trading update provided limited detail on the underlying drivers.

However, according to CLSA Australia’s banks team, net interest revenue was negatively impacted by a restructuring charge on a hedge from a funding issue last year, as well as a reduction in trading revenue and a proportionally more significant impact from the increase in Bank Bill Swap Rate (BBSW) in March given CBA’s announcement was for three rather than six month earnings.

Operating cost growth was mixed with higher growth from NAB and CBA while ANZ continues to reduce its cost base. The Royal Commission resulted in elevated cost growth in the period, and this will continue into the rest of this calendar year and potentially beyond. Excluding this, revenue would have increased in the March quarter.

Screen Shot 2018-05-14 at 5.26.58 pm

Source: Company Data *CBA data represents the 3 months to 31 March 2018

NAB’s increase excluding the upfront redundancies and write downs from its cost reduction strategy reflects an uplift in investment in the near term to assist the transformation of the business over the next few years. However, based on its guidance for flat operating costs between FY2018 and FY2020, aggregate costs over this three years period will be higher than average analysis forecasts prior to the announcement of the cost reduction programme in November last year.

Screen Shot 2018-05-14 at 5.28.04 pm

Source: Company, UBS, JPM, CS, DB, CLSA, Citi

Slowing revenue growth is continuing to turn up the heat on management to reduce operating costs as an offset.

Provisions for bad debts were once again a positive for the net profit outcome.

Unlike in recent results, the main source of surprise came from lower new individual provisions rather than write backs of prior period charges. This is despite a continuation of the modest increases in mortgage arrears. Of most concern was CBA’s comment that “there has been an uptick in home loan arrears, influenced by a small number of customers experiencing difficulties with rising essential costs and limited income growth”. This could be the first signs of a squeeze on household budgets that has been a core part of the bear thesis for those warning about the outlook for the bank stocks.

While ANZ and Westpac (ASX:WBC) continued to reduce their collective provision balance as a proportion of credit risk weighted assets (meaning these banks have less of a buffer against a downturn in credit quality), NAB actually increased its collective provision balance.

Screen Shot 2018-05-14 at 5.29.06 pm

Source: Companies

Bank capital levels were generally in line with market expectations, with ANZ surprising to the upside. CBA highlighted the future impact of the Prudential Inquiry by APRA which will require it to increase its operational risk regulatory capital by A$1billion from 30 April 2018. The introduction of AASB 9 will also see CBA increase its collective provision balance by A$1.05 billion. These two issues will reduce CBA’s Common Equity Tier 1 *(CET1) ratio by 53 basis points. CBA expects a 70 basis point increase in its CET1 ratio from the sale of its Australasian life insurance operations in the next 8 months, but this will also reduce CBA’s sustainable earnings and capital generation in future periods.

The Montgomery Funds own shares in Westpac and Commonwealth Bank  This article was prepared 15 May 2018 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Westpac or Commonwealth Bank you should seek financial advice.

Mark Draper (GEM Capital) recently spoke with Joe Lai who is the portfolio manager of Platinum Asia fund.

We are pleased to bring you the podcast from this discussion and for those who prefer it, here is a transcript of the interview.

 

Joe specifically talks about why he believes China is unlikely to experience a debt crisis despite the constant media attention it receives and he outlines the magnitude of the investment opportunity in China.

 

 

Speakers:  Joe Lai (Platinum Asset Management) and Mark Draper (GEM Capital)

Mark:  Joining us here is Joe Lai from Platinum Asset Management and in particular, Platinum Asia, who Joe runs the listed investment company, Platinum Asia, as well as the unlisted version of Platinum Asia that you find across the spectrum. Thanks for joining us, Joe.

Joe:  Hi, Mark, thanks.

Mark:  We’ll start with the Asian markets because they’ve had a big run, albeit from the low base.

Joe:  Yeah.

Mark:  18 months ago, 2 years ago. So, is this run—sustainable is not the right word, but is this as good as it gets or can investors expect decent returns from the Asian sector going into the future?

Joe:  Yeah, look, I mean, what we believe the opportunity in Asia is one of a long-term opportunity because the growth rate in Asia is going to be, you know, robust, and going forward for quite a long time. And also, the scale of opportunity is just unparallel compared to anything else we’ve seen for a very, very long time.

Growth rate on China, even we’re saying that China is growing at—slowing a bit from the heady days of 8 or 9% growth, to about 6 to 6-1/2% growth, that would be still one of the fastest growing regions of the world.

And outside of China, we’ve got countries like India and also the ASEAN countries. I mean, these are countries with, you know, collectively, more than a billion people and for the region itself, it’s close to three billion people. They are going to grow in a way—in excess of 3-4% on average. Again, the scale is huge.

Mark:  And compare that to the American market, the American population I think is somewhere between 3-400.

Joe:  Yes, about 300 million people and it’s growing much slower.

We look at that long-term trajectory, I think, is very, very good. And then we look at the markets. I mean, there’s a lot of concern about valuations and whether we’ve peaked. I mean, the U.S. market is definitively expensive if we look at price to earnings multiple or price to book multiple. In fact, if we look at a lot of EPS growth that the American market has been able to generate, a lot of it has been through financial engineering.

What I’m talking about is borrowing money, companies borrowing money, and do share buy-backs, to reduce the number of shares outstanding to—

Mark:  Which then increases earnings per share.

Joe:  Yeah, absolutely. But in the case of Asia, that has not been the case. Perhaps the Asian corporates or CFOs are a little bit behind in terms of doing engineering, engineering the balance sheets. But certainly a lot of the upside in Asia has been a result of actual earnings growth in the last few years as opposed to EPS growth or a great deal of market re-rating or the PE ratio going up.

Mark:  You talk about 6-1/2% growth, but I think—and which is less than 9% growth—but the reality is that China’s been growing at a big rate for a long period of time. Is it possible to put some perspective on the size of the economy? Say compared to where it was historically? Because 6-1/2 might not sound great, but 6-1/2 on a big number is a big number.

Joe:  Yeah. I mean, the size of the Chinese economy is by no means small. At the moment, it’s probably slightly more than 10 trillion U.S. dollars and U.S. is probably 16, 17. On an aggregate basis, it is still smaller, but however, when we look at many of the industries in China, they’re already bigger than that of the U.S. I mean, these may be an interesting fact which a lot of people may not realize, if we look at the passenger car market in China, they’re running at about—selling about 28 million passenger cars a year. U.S. is about 20 million.

That market alone, which is a big part of the economy really, it’s already about 40% bigger than that of the U.S. or Europe. 

The other part of it is this: That market is still growing. I mean, still growing at about 5% to 10% a year and most people buying cars in China are not reliant on car financing. That’s very different to, I guess, the more developed markets. Eventually, how big this market will grow into, it’s hard to estimate. That’s one.

But when we look at the property market clearly, the Chinese market is a lot bigger than anything else in any other parts of the world, literally, two, three, four times the size of Europe or U.S. If we look at the smart phone markets—I mean, I’m talking the smart phone here which is, I’m sure are made in Taiwan or Mainland China. China domestic smart phone market is about half a billion. 

Mark:  It’s about 500 million.

Joe:  It’s 500 million.

Mark:  New handsets every year.

Joe:  New handsets a year. U.S. is about a 150 million, so even that market, which is—you wouldn’t say is a back water, sort of like—we’re not talking about sports shoes or T-shirts, we’re talking about a smart phone. Sure, some parts are coming from Japan or Taiwan or U.S. to make the smart phone, but they’re producing a lot of these parts domestically in China as well, as they climb the technological ladder.

The smart phone market it literally  two, three times the size of U.S. or Europe and the car market is 50% bigger than U.S. or Europe. That is the scale already. We’re talking about when the economy is about, probably two-thirds the size of the U.S., officially. So, I guess, that’s how far they’ve come and they’re going to—the aim for them is to climb the technological ladder and to clean up the environments going forward.

Undoubtedly, I mean, they will continue to progress further. Compared to where they started, I guess, since liberalization, the GDP per capita of China, if we look back 35 years ago, it would be very close to that of North Korea. I mean, it’s amazing. This country has taken off where some of the countries haven’t moved on at all. That’s, I guess, the scale and opportunities there.

Mark:  And part of that is driven by population growth, but it’s more than population growth. It’s the rising wealth in middle class here, so you’ve spoken about car ownership, you’ve spoken about mobile phone and internet access.

Joe:  Yeah.

Mark:  What are some of the other things that you’re seeing in China that as middle class develops, they’re spending money on, that by extension creates investment opportunity, clearly.

Joe:  Okay. I mean, that’s a lot of stuff—which a lot of things which are changing for the better. I guess if we sort of go back one step. I mean, what is underpinning sort of this growth in income and all productivity is because they’ve done the appropriate amount of investment in various things. If you travel to China these days, you’ll see that they’ll have first class infrastructure in roads, telecommunication, a 4G network. The high-speed rail, which just completely opened up the country. Even the smaller cities offer a few million people.

So, you mentioned you’re doing business that you can actually ship things around and things just work.

Mark:  Yeah.

Joe:  And also, the investment in education is actually quite interesting. Each year there’s about 8 million university graduates that China produces.

Mark:  8 million is a third of the population of Australia every year as your graduates. [Laughs]

Joe:  Yeah. And this number actually has ramped up in the last five or six years, so there has been some effort to increase the supply of skilled labor into the economy where because there has been a desire for the economy to lift productivity, to climb the technology ladder, they knew that they needed people. And of the 8 million, half of which are actually engineers and scientists. I mean, it’s actually what they need. That’s very different, I guess, to other countries which actually haven’t grown their university graduates or the focus on engineering and science may have actually gone backwards in the last 5 or 10 years.

Investment in infrastructure and education are key for—to sort of the strong underpinnings for economic development for the country.

So, looking forward, we mentioned about cars and we mentioned about smart phones. These are markets which are already bigger than in the U.S. compared to—sorry, bigger in China, compared to I guess developed countries in those market size.

There are some areas which China is still smaller in aggregate than Western countries. And we sort of have experienced some of it in this country, like things relating to consumption of insurance, healthcare, some of the luxury goods, some of the—I guess things which are more, I guess, differentiated or tastes which they’ve yet to acquire.

I guess in this country we’ve seen the vitamins doing well. Perhaps some of the milk stuff from New Zealand and also wines going well. These are some of the stuff, I mean, we’re not directly involved in those because these are sort of, I guess, local companies. But the markets which I mentioned, insurance and healthcare, and some of the technology companies, I mean, the insurance market in China is small compared to that of Western countries on a per-capita basis.

Even if you go to places like Shanghai, the insurance penetration is literally a fraction of that of Hong Kong or Taiwan, but you know that it is an essential product that people would want, once they have money and they want to protect their wealth, they want to protect their family’s livelihood.

Mark:  You’re talking life insurance or you’re talking car insurance, house insurance, etc.?

Joe:  Yeah, yeah. So that’s interesting. And we’re seeing private companies in China doing very interesting things. Some of these industry leaders are doing things which are leading, I think, most of the world. For example, we own one of our biggest, or bigger, positions is a company called Ping An Insurance. I mean, they’ve actually applied artificial intelligence in a big way. I mean, literally spending literally billions of dollars over the last, about three or four years, on improving their ability to serve the customers by using AI. They’ve got a voice recognition product that when you call up, they can, I guess verify your identity without you telling them anything. I mean, you know, when we call up Telstra and ask you for date of birth or address to certify that’s who you are, but here they’ve got technology to go to Mr. A and then we know this voice and then if this voice matches, that’s him. 

So, that’s something like that. And also, when the people have car accidents, they’ve got this thing on the smart phone, this app on the smart phone where they can launch their claim. I mean, they can photo of the car, where the damage is, and actually utilizing artificial intelligence to work out what is the damage and also the cost of repair. Then this is, I guess, good for controlling fraud. It’s good also for customer experience.

I mean, these are just some of the things which are happening very rapidly in China because it’s the investment cycle in China of experimentation, try something out. If it works, use it. If it doesn’t, let’s move on. It’s much faster than most other countries.

And then of course healthcare. The next area is healthcare. So the market in China is more and in fact, we’re seeing this to be growing rather quickly because—

Mark:  Have they got a national healthcare scheme at the moment?

Joe:  Absolutely, Mark. I mean, that’s been ramping up. The desire from the government is to improve the livelihood of those people who sort of didn’t share as much in the fruits or dividends on economic growth in the last 20 years. Over the last few years there’s been progressive rollout of coverage in terms of health insurance. I mean, it’s not perfect. But nowadays, most people in China are covered by one kind of insurance or another, mostly public based and then some are local government based. But what it means is that going forward, we think that the consumption of healthcare will continue to grow, almost irrespective of the growth or GDP growth of the country.

And as the people get more discerning in terms of their healthcare, they will start to use some of the drugs which Western countries are used to. Like if you actually look at the top 10 selling drugs in most Western countries, including Australia, these days, most of those drugs are what are called biologics and they’re actually quite expensive. Expensive drugs which can target specific diseases very accurately. Gone are the days of using one drug to treat everything. It’s almost very titled medicine.

I mean, I was a medical doctor before I did this, working in this industry and the type of drugs I’m seeing today is truly amazing and China is starting to adopt these drugs as well. We own some companies which are producing some of these biologics in China. They’re not the easiest to produce and these drug are not even in the top hundred in the Chinese league of drug sales, whereas some of these drugs are already top 10, including these countries.

That to us is very interesting and it’s going to grow multiples the pace of the economy.

Mark:  Are you seeing homegrown healthcare companies compete with the West?

Joe:  Yes.

Mark:  Or are you seeing Western healthcare going to Asia?

Joe:  Yeah, I mean, that’s an interesting question, Mark. I mean, it has certainly been a mix of the two. And the fact is, I mean, it would go to the issue of scale and accountability. I mean, China is almost unparalleled compared to most other countries. But bottom up work suggests that in early days, foreign companies would go into China and sell their drugs or medical devices and actually at a quite high price, because it’s seen as like a luxury good. You know, they can charge—the prices we pay in Australia would be literally a fraction of how much these local Chinese people paid previously.

As you can see, the dynamic, together with sufficient capability, but domestic eyes and capital to invest in R&D, what have you, creates this dynamic where the pressure for the locals to actually substitute for the imports is very high because they can see that if they do well, first of all, they’ll make a lot of money. Second of all, there is some government support for the locals. Thirdly, it is—they also, I think, recognize that they’re doing a benefit for the local people who may not be able to afford imported drugs.

In the case, just some examples, in the case of insurance, I mean, I think some listeners may know insulin, basically it’s used to treat diabetes. There’s different types of insulin and in most parts of the world, this market isn’t only. It’s dominated by four or five, probably four companies. Sales are different, the same kind of insulin, but at a very high price.

In China, there’s already drug companies making insulin, which is actually very uncommon. I mean, it’s almost happening nowhere in the world, so we’re sort of investing in one of them to provide, I guess, cheaper version of high-quality insulin in the country. 

The other element, the other example I can cite, is cardiac stents. These are things which are used to treat blockage of the arteries, in the heart. Again, this is, in the rest of the world, is an oligopoly, controlled by a few big U.S. and European companies. In China, more than half, in fact, maybe 60% or 70% of the cardiac stents are made domestically, by domestic companies. 

Mark:  Right.

Joe:  And some of them are trying to sell it overseas. They’re very successful. We are sort of invested in one of the companies there as well which makes cardiac stent for the locals. They’ve actually gone around the world in acquiring the second player globally, or third player globally, of pacemakers…what else? Orthopedic prosthesis, to bring it back to the country. To maybe make it at a lower price, but huge market. But the product itself is—the products themselves are superior to what the locals have been making previously.

So, I mean, we find that to be rather a prospective area to have some money.

Mark:  One of the perineal things that seems to be around the Australian media is the expectation of a Chinese credit crises or a banking collapse over there. Can you give us a feel for whether that’s reality or misguided?

Joe:  Yeah, look. I mean, okay, I think it’s misguided. It is understandable why there has been a concern because China has ramped up as a country, rammed up its debt load since the global financial crises. And a lot of it is the stimulus which they implemented. But the good news is this is something that everyone knows about. I mean, if there’s anything that we can trust the local Chinese authorities to do, is to count. They can actually calculate and count where the problems are. I mean, it’s been like literally six, seven years since even Western countries or people outside the country started to talk about geez, there’s debt. You can imagine and I think you can believe that the local authorities who are interested in a 30, 50-year future for the country or more, to want to diffuse any problem that may have arisen as a result of the stimulus.

What are we looking at today? China’s debt to GDP is actually about 250%. And okay, to put it into context, that is actually similar to most developed countries. I mean, USA is about 250, 260. European area is about 250. Japan is about 400% to GDP, so it’s a lot higher and it shows that a country with a trade surplus actually can sustain very high level of debt, because it means that they’re not relying on foreign capital to fund their debt when they run the trade surplus. And Japan is the case, is a good example.

If the absolute accurate good level is high and it’s ramped up quickly, but it’s not disastrous and in fact, it’s manageable. And the second thing is, almost all the debt in China is domestic. In other words, they’re not reliant on foreign countries or people or corporations to keep buying their bonds. They can actually buy their bonds themselves with the savings.

Mark:  Like its self-funded.

Joe:  And the other benefit of having all the debt in domestic currency is that if really push comes to shove, they can print money, which I guess most countries have done in the last five—or since the GFC. There’s all these levers they can pull. 

The next thing is, as we mentioned before, this problem is not unrecognized and if you Googled—I mean, there has been some—basically its getting managed and that’s been, I think, increasingly recognized by people. The Bridgewater guy, Ray Dalio, I think he recently did an interview, mentioned about that. It’s interesting, he said, well, you know, in the GFC, we have I guess developed countries, central banks reacting to the problem. But here we actually have a forthright regulator trying to deal with the problem and in fact, he thinks they’re doing a good job. But anyhow, that’s just an aside.

But what I believe is that China is already trying to reduce the growth of the loan and they call this process deleveraging, which means slow down the growth of loan and then look where the problems are. They’re probably more than halfway through this process and I think at the end of it, the banking system will actually look rather nice. And then after that, even now, you ask the question: What else can we say that’s wrong with the country? I mean, it’s actually a difficult thing to come up with. [Laughs]

Mark:  Donald Trump has helped in that respect because he’s, through his Twitter account, talked about potential trade wars. Is that something that is concerning you guys?

Joe:  Look, I mean, the fact is, I mean, I find it so hard to predict what Trump—what Mr. Trump is going to say or do. But if we—I guess put it this way, if we go down the path of an all-out trade war, it’s clearly not good for markets, and particularly, I think, it may change the way how people assess the U.S. market, especially given the valuation of that market because put up tariffs and whatever, it is going to harm them just as much as harm everyone else. Just increasing inflation, reduce the ability of people’s real—or reduce real income for the people.

But I think if one, I guess, try to rationalize it, everyone knows that it’s a bad outcome for all and so it makes—it actually makes no sense for anyone to want to go down this path in a big way. There may be skirmishes and there may be some people making statements to actually have across the board withdrawal basically of globalization. I just don’t see how anyone can effectively support that.

The reaction from, I guess, the key countries, interesting. We see these aluminum steel tariffs, which, Trump talked about. China actually didn’t say much about it. They actually said, it’s not good.

Mark:  Canada was vocal.

Joe:  Yeah, and the reason is, as you know, Mark, that the percentage of Chinese imports into U.S. in these two products is literally less than 5%. I think the percentage of Chinese imports or steel imports in the U.S., China constitutes maybe 2% or something like that. It’s very low percentage. Certainly, it’s a very, like less than 1% output of Chinese steel industry. So, they go, okay. 

But whereas Canada is a much bigger part and Mexico and also Brazil and maybe even Korea or Japan.

They’re not too worried but I guess if we go down this path, then it would be something. But also last week, I mean, China sent one of the leaders—this is a guy below the presidency—over to the States to talk to the people in the White House about this issue. It is something that, in a way, they don’t want to—

Mark:  It’s not the steel and aluminum and such, it’s the bigger issue of whether it’s more widespread.

Joe:  Yeah. It becomes more widespread and because everyone—and so they do want to stave off this—Mr. Trump going down this path by, I think they will announce some things to try to appease him. Whether it’s enough or not, I think it will, I guess, calm down the situation somewhat. But of course, if there is real impact made to the various economies, particularly in China, they would retaliate in the form of maybe tariffs on some of the agricultural imports from the States and maybe cars. I mean, the truth is, most car companies—a lot of foreign car companies, from China’s perspective, are reliant on the Chinese market for profits.

Mark:  GM, Ford. They’re all there.

Joe:  GM, Ford, yeah. And it is the biggest car market in the world. It makes no sense to go down this path, but I can’t really predict one way or another.

Mark:  It’s a good answer. And sorry to drag down the tone actually of this conversation about Asia with Donald Trump.

Joe:  That’s all right.

Mark:  But that’s just something to cover off. 

Joe:  Yeah.

Mark:  It is a generational opportunity to invest in the Asian region and thanks very much for your time to explain some of how you guys are going about harnessing this opportunity for investors. Thanks, Joe.

Joe:  Thanks, Mark.

[End of Audio]

 

Monday, 04 June 2018 14:26

Telstra - Good Value or Value Trap?

Written by

Mark Draper (GEM Capital) is writing a monthly column for the Australian Financial Review.  This article will appear in the print edition of the Financial Review on Wednesday 13th June 2018.

At the time of writing, Mark did not own Telstra shares.

 

If you have any story ideas that you would like us to write about, we would love to hear from you.

 

 Here is the article.

 

Telstra look’s cheap on a valuation model (see chart below), but is it a value trap?

The trouble with valuation models is that they rely on assumptions.  We are of the view that it is better for investors to spend time thinking about what is likely to alter the inputs of valuation models, such as margins and competition rather than finessing the model itself.

Telstra has a dominant market position, the best infrastructure in the country and receives high margins for its services and yet trades on a Price Earnings ratio on a historic basis of less than 9 times. 

The latest trading update from Telstra showed deteriorating earnings and falling margins.  The bright spot for Telstra was that free cash flow was at the upper end of forecasts, while earnings was at the low end.  The dividend at 22 cents per share for this year was confirmed, putting the stock on a juicy yield of over 7% fully franked. The dividend on a medium term view however is under a cloud, particularly once the one off NBN payments stop.  It is important for investors to look beyond todays yield and to concentrate on the future earnings of Telstra in order to determine value.

Telstra earns most of its money from broadband and mobile divisions, so it is critical that investors understand what is happening in these divisions well.

The core earnings of the Mobile division are under pressure.  After years of customers flooding to Telstra’s mobile network, a recapitalised Vodafone is growing market share and TPG will turn on their network later in 2018, initially offering free service for 6 months and then offering plans at a jaw dropping rate of $9.99 per month.  Average revenue per user in Telstra’s mobile division is around $65 per month today, but TPG and other competitors are likely to force this to below $50 per month according to analysts at Intelligent Investor. Telstra currently enjoys margins from its mobile business of around 40% but this margin as well as customer numbers are under threat.  

The NBN offers no comfort for Telstra share holders either, as around 180 NBN resellers are fighting for market share.  The economic model of the NBN looks challenged, but even if access charges to NBN resellers were to fall, there is no certainty that the price cut to access charges would improve margins, or simply be competed away.  As the NBN grows it transforms Telstra from an asset owner into a reseller.

5G, which is to be launched next year, potentially makes parts of the NBN redundant according to several institutional investors.  That is a potential positive for Telstra as they would receive income directly from their 5G customers, most likely at a higher margin than reselling the NBN.  The unknowable question however is how much will Telstra need to spend to buy 5G spectrum.  

Roger Montgomery from Montgomery Investment Management currently believes the ability for Telstra management to cut costs is under-appreciated by the market.  Telstra has already announced cost savings of $1.5bn, but if larger savings can be made, this could help fill an earnings blackhole of around $3bn.

Telstra is an outstanding mobile operator with infrastructure advantages, but the risky thing is its ambition to offset declining broadband and mobile margins with a plan to become a global technology business.  If management can execute this strategy well, shareholders would be rewarded, but it carries material execution risk.  

Telstra management plan to provide a critical update to the market during June 2018 about their future plans for business.

It seems that there is universal agreement that Telstra’s earnings decline in the foreseeable future. So despite the share price having some valuation appeal we are likely to wait until the June update from management before making our next move.

Souce: Skaffold