Saturday, 31 October 2015 13:37

GEM Capital Movie Night - 16th November 2015

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Everyone at GEM Capital is excited about our movie night coming up on Monday 16th November at Capri Cinema.

 

We not only welcome our clients along to enjoy the latest Bond 007 movie "Spectre" - but also welcome any friends that wish to come along too.  Don't forget to RSVP by 9th November 2015 to Melissa Jones Ph 8273 3222 or This email address is being protected from spambots. You need JavaScript enabled to view it.

 

The evening will commence at 6pm with an hour of drinks and mingling before we kick off the 007 action.

 

In the meantime - here is the official trailer.

 

We have reproduced this article from Forager Funds - originally written by Matt Ryan - it's a good lesson on the dangers from buying assets from Private Equity firms.

 

Want to know how to turn $10m in to $520m in less than two years? Just ask Anchorage Capital. The private equity group has pulled off one of the great heists of all time, using all the tricks in the book, to turn Dick Smith from a $10m piece of mutton into a $520m lamb.

Having spent the morning poking through the accounts, we’re going to show you how it all happened.

Firstly, Anchorage set up a holding company called Dick Smith Sub-holdings that they used to acquire the Dick Smith business from Woolworths. They say they paid $115m, but the notes to the 2014 accounts show that only $20m in cash was initially paid by the holding company.

dsh_1

It doesn’t look like they even paid that much, because they acquired the Dick Smith business with $12.6m in cash already in it. Dick Smith Sub-holdings was formed with only $10m of issued capital and no debt, and that is most likely Anchorage’s actual cash commitment.

So if Woolworths got paid $115m and Anchorage only forked out $10m, where did the rest of the cash come from?

The answer is the Dick Smith balance sheet, and this is always the first chapter in the private equity playbook: pull out the maximum amount of cash as quickly as you can.

In this case, first they had to mark-down the assets of the business as much as possible as part of the acquisition. This was easy enough to do with a low purchase price. You can see in the table below, that $58m was written-off from inventory, $55m from plant and equipment, and $8m in provisions were taken.

dsh_2

The inventory writedown is the most important step in the short term. They are about to sell a huge chunk of inventory but they don’t want to do it at a loss, because these losses would show up in the financial statements and make it hard to float the business. The adjustments never touch the new Dick Smith’s profit and loss statement and, at the stroke of the pen, they have created (or avoided) $120m in future pre-tax profit (or avoided  losses).

Now they can liquidate inventory without racking up losses. And boy did they liquidate.

At 26 November 2012, Dick Smith had inventory that cost $371m but which had been written down to $312m. Yet by 30 June 2013, inventory has dropped to just $171m.

dsh_3

That points to a very big clearance sale, and the prospectus confirms that sales in financial year 2013 were exaggerated by this. The reduction in inventory has produced a monstrous $140m benefit to operating cash flow, basically from selling lots of inventory and then not restocking.

The cash flow statement shows that Anchorage then used the $117m operating cash flow of the business to fund the outstanding payments to Woolworths, rather than funding it from their own pockets (note that the pro-forma profit was only $7m during this period).

dsh_4

And that, my friends, is a perfectly executed chapter 1: How to buy a business for $115m using only $10m of your own money.

Chapter 2 involves selling a $115m business for $520m, and it’s a little more nuanced. The good news is that, while private equity are focused on cashflow, equity market investors aren’t really focusing on how much cash has been ripped out of the business. All they seem to care about is profit.

So the focus now turns from the balance sheet to the profit and loss statement, and it’s time to make this business look as profitable as possible in the year following the float (allowing them to sell it on a seemingly attractive “forecast price earnings ratio”).

The big clearance sale in financial year 2013 leaves them with almost no old stock to start the 2014 year. That’s a huge (unsustainable) benefit in a business like consumer electronics which has rapid product obsolescence.

Remember that marked down inventory? Most of it was probably sold by 30 June 13 but there would still be some benefit flowing through to the 2014 financial year.

Remember the plant and equipment writedowns? That reduces the annual depreciation charge by $15m. Throw in a few onerous lease provisions and the like, totaling roughly $10m, and you can fairly easily turn a $7m 2013 profit into a $40m forecast 2014 profit. That allows Anchorage to confidently forecast a huge profit number and, on the back of this rosy forecast, the business is floated for a $520m market capitalisation, some 52 times the $10m they put in.

Anchorage were able to sell the last of their shares in September 2014 at prices slightly higher than the $2.20 float price and walk away with a quiet half a billion. Private equity are renowned for pulling off deals, but if there’s a better one than this I haven’t heard about it.

Chickens home to roost

Of course, all of the steps taken above have consequences. By the end of 2014, inventory had increased to $254m, with new shareholders footing the bill for repurchasing inventory. This should have resulted in poor operating cash flow, but most of this was funded by suppliers at year-end, with payables increasing by $95m.

Come the end of 2015 financial year, however, it really comes home to roost. Operating cash flow was negative $4m, as inventory increases further and suppliers demand payment, decreasing accounts payable. The business is required to take on $71m in debt to fund a more sustainable amount of working capital. As the benefit of prior accounting provisions taper-off, profit margins fall, and the company reports a toxic combination of falling same-store sales and shrinking gross margins in the recent trading update.

Following a profit downgrade yesterday, the shares are now valued by the market at $0.77, and investors in the float are sitting on a 65% loss of capital from the $2.20 float price.

This float, as we pointed out in Dick Smith Takes A Bath, Comes Out Nice and Clean, smelled funny from the very beginning. Sorry Dick Smith investors, you’ve been had.

Thursday, 29 October 2015 15:56

Busting tax myths for better reform

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An extract from Deloittes report on Tax Reform.

 

Australia’s tax reform debate is in desperate need of a circuit breaker, and our report Mythbusting tax reform #2 aims to achieve exactly that. It slices through the myths that clog clear thinking on super, negative gearing and capital gains, and recommends reforms that return simplicity, fairness and sustainability to the way Australia taxes superannuation contributions and capital gains.

This is the second of Deloitte’s mythbusting tax reform reports. The first focussed on issues that are central to Australian prosperity – bracket creep, GST and company tax. This second report covers matters at the heart of Australian fairness – super, negative gearing and capital gains.

Myth 1: Superannuation concessions cost more than the age pension

Super concessions do cost a lot – but nothing like the pension does.

The Treasury estimate of the dollars ‘lost’ to super tax concessions uses a particularly tough benchmark: the biggest possible tax bill that could be levied if super was treated as wage income. It also doesn’t allow for offsetting benefits via future pension savings, or any offsetting behavioural changes. Better measures of super concession costs are still huge, but rather less than the pension.

Myth 2: We can’t change super rules now, because the system needs stability to win back trust

So super concessions don’t cost more than the pension. Yet the costs are still pretty big. And that’s what puts the lie to this second myth. If our super concessions cost lots but achieve relatively little, then Australians are spending a fortune on ‘stability and trust’ in super settings while actually achieving neither. Governments can only truly promise stability if the cost to taxpayers of our superannuation system is sustainable.

Chart: Proposed reform of the tax benefit (loss) of diverting a dollar from wages to super

Deloitte Figure1 301015As the chart above shows, there’s a Heartbreak Hill at the centre of Australia’s taxation system: low income earners actually pay more tax when a dollar of their earnings shows up in superannuation rather than wages, whereas middle and high income earners get big marginal benefits. So one example of a better super tax system would be an updated and simplified version of the contributions tax changes proposed in the Henry Review – where everyone gets the same tax advantage out of a dollar going into super, with a concession of 15 cents in the dollar for both princes and paupers.

Making the tax incentives for contributing into super the same for everyone also comes with a pretty big silver lining. As current incentives are weighted towards the better off, there is a tax saving from making super better – a reform dividend of around $6 billion in 2016-17 alone.

Even better, because this is a change to the taxation of contributions – when the money goes in – it avoids the need for any additional grandfathering. Nor does it add extra taxes to either earnings or benefits.

And because the incentives are simpler and fairer, the current caps on concessional (pre-tax) contributions can also be simpler and fairer. They could be abolished completely for everyone under 50, and the cap could be raised for everyone else (subject only to a safety net of a lifetime cap). That would put super on a simpler, fairer and more sustainable basis.

And, depending on how the super savings are used (to cut taxes that really hurt our economy, or to fund social spending, or to help close the Budget deficit), the resultant package could appropriately help Australians to work, invest and save. For example, this reform alone would pay for shifting the company tax rate down to 26% from the current 30%.

Myth 3: Negative gearing is an evil tax loophole that should be closed

The blackest hat in Australia’s tax reform debate is worn by negative gearing. Yet negative gearing isn’t evil, and it isn’t a loophole in the tax system. It simply allows taxpayers to claim a cost of earning their income. That’s a feature of most tax systems around the world, and a longstanding element of ours too.

Yes, negative gearing is over-used, but that’s due to (1) record low interest rates and easy access to credit, (2) heated property markets and (3) problems in taxing Australia’s capital gains. Sure, the rich use negative gearing a lot, but that’s because they own lots of assets, and gearing is a cost related to owning assets: no smoking gun there.

Myth 4: Negative gearing drives property prices up, but ditching it would send rents soaring

And those who argue the toss on negative gearing raise conflicting arguments on its impact on housing.

Let’s start with a key perspective: interest rates have a far larger impact on house prices than taxes. The main reason why housing prices are through the roof is because mortgage rates have never been lower. And, among tax factors, it is the favourable treatment of capital gains that is the key culprit – not negative gearing.

Equally, while negative gearing isn’t evil, nor would ditching it have a big impact on rents. By lowering the effective cost of buying, negative gearing long since raised the demand for buying homes that are then rented out. Yet the impact on housing prices of negative gearing isn’t large, meaning that the impact of it (or its removal) on rents similarly wouldn’t be large.

Myth 5: The discount on capital gains is an appropriate reward to savers

The basic idea of a discount on the taxation of capital gains is very much right. There should be more generous treatment of capital gains than of ordinary income, because that helps to encourage savings (and hence the prosperity of Australia and Australians), and because the greater time elapsed between earning income and earning a capital gain means it is important to allow for inflation in the meantime.

But we overdid it. We gave really big incentives for some taxpayers (such as high income earners) to earn capital gains, versus little incentive for others (such as companies). And the discounts adopted back in 1999 assumed that inflation would be higher than it has been – meaning they’ve been too generous.

So the capital gains discount is no longer meeting its policy objectives. That not only comes at a cost to taxpayers, but to the economy as well. One possible option would be to reduce the current 50% discount for individuals to 33.33%.

Deloitte’s report ‘Mythbusting tax reform #2’ was prepared by tax and superannuation specialists from Deloitte in conjunction with economists from Deloitte Access Economics. See full report for disclaimers.

There is little doubt that Australia's property market, particularly in the eastern states is at an extreme point.  Whether this corrects sharply, or over an extended period of time remains to be seen.

What is clear though is the elevated level of Australian property prices.  The table below featured in a recent edition of the Economist and shows the level of over-valuation relative to both rents and also relative to income.  On either methodology, Australia's property market appears expensive and investors exposed to the property cycle either directly or by owning shares in building companies or property developers would be wise to exercise caution.

The Conversation Brendan Coates, Grattan Institute and John Daley, Grattan Institute

Allowing first homebuyers to cash out their super to buy a home is a seductive idea with a long history. Like the nine-headed Hydra, which replaced each severed head with two more, each time the idea is cut down it seems to return even stronger.

Both sides of federal politics took proposals to the 1993 election to let Australians draw down their super. After re-election, then Prime Minister Paul Keating scrapped it amid widespread criticism. Former Treasurer Joe Hockey raised the idea again in March and was roundly criticised by academics and the media. This month the Committee for Economic Development of Australia (CEDA) has again resurrected the idea.

House prices have skyrocketed again over the past two years, particularly in Sydney. So politicians are attracted to any policy that appears to help first homebuyers to build a deposit. Unlike the various first homebuyers’ grants that cost billions each year, letting first homebuyers cash out their super would not hurt the budget bottom line – at least, not in the short term. But the change would worsen housing affordability, leave many people with less to retire on, and cost taxpayers in the long run.

It is a bad idea for five reasons.

First, measures to boost demand for housing, without addressing the well-documented restrictions on supply, do not make housing more affordable. Giving prospective first homebuyers access to their superannuation will help them build a house deposit, but it would worsen affordability for buyers overall. Unless supply increases, more people with deposits would simply bid up the price of existing homes, and the biggest winners would be the people who own them already.

Second, the proposal fails the test of superannuation being used solely to fund an adequate living standard in retirement. The government puts tax concessions on super to help workers provide their own retirement incomes. In return, workers can’t access their superannuation until they reach a certain age without incurring tax penalties.

While paying down a home is an investment, owner-occupiers also benefit from having somewhere to live without paying rent. These benefits that a house provides to the owner-occupier – which economists call housing services – are big, accounting for a sixth of total household consumption in Australia. Using super to buy a home they live in would allow people to consume a significant portion of the value of their superannuation savings as housing services well before they reach retirement.

Third, most first homebuyers who cash out their super would end up with lower overall retirement savings, even after accounting for any extra housing assets. Owner-occupiers give up the rent on their investment. With average gross rental yields sitting between 3% and 5% across major Australian cities, the impact on end retirement savings can be very large. Consequently, owner-occupiers will tend to have lower overall lifetime retirement savings than if the funds were left to compound in a superannuation fund

Frugal homebuyers might maintain the value of their retirement savings if they save all the income they no longer have to pay as rent. In reality, few will have such self-discipline. Compulsory savings through superannuation have led many people to save more than they would otherwise. A recent Reserve Bank study found that each dollar of compulsory super savings added between 70 and 90 cents to total household wealth. If first homebuyers can cash out their super savings early to buy a home that they would have saved for anyway, then many will save less overall.

Fourth, the proposal would hurt government budgets in the long run. Superannuation fund balances are included in the Age Pension assets test. The family home is not. If people funnel some of their super savings into the family home, gaining more home equity but reducing their super fund balance, the government will pay more in pensions in the long-term.

Government would be spared this cost if any home purchased using super were included in the Age Pension assets test, but that would be very hard to implement. For example, do you only include the proportion of the home financed by superannuation? Or would the whole home, including principal repayments made from post-tax income, be included in the assets test? The problems go away if all housing were included in the pension assets test, but this would be a very difficult political reform.

Fifth, early access to super for first homebuyers could make the superannuation system even more unequal than it is today. Many first homebuyers are high-income earners. Allowing them to fund home purchases from concessionally-taxed super would simply add to the many tax mitigation strategies that already abound.

Consider the case of a prospective homebuyer earning A$200,000. Their concessional super contributions are taxed at 15%, rather than at their marginal tax rate of 47%. Once they buy a home, any capital gains that accrue as it appreciates are tax-free, as are the stream of housing services that it provides. Such attractive tax treatment of an investment – more generous than the already highly concessional tax treatment of either superannuation or owner occupied housing – would be prone to massive rorting by high-income earners keen to lower their income tax bills.

What, then, should the federal government do to make housing more affordable?

Prime Minister Malcolm Turnbull has tasked Jamie Briggs with rethinking policy for Australia’s cities. Mick Tsikas/AAP

Helping fix our cities

Above all, new federal Minister for Cities Jamie Briggs should support policies to boost housing supply, especially in the inner and middle ring suburbs of major cities where most people want to live, and which have much better access to the centre of cities where most of the new jobs are being created. The federal government has little control over planning rules, which are administered by state and local governments. But it can use transparent performance reporting, rewards and incentives to stimulate state government action, using the same model as the National Competition Policy reforms of the 1990s.

Other reforms, such as reducing the 50% discount on capital gains tax and tightening negative gearing, would also reduce pressure on house prices and could be implemented straight away. Such favourable tax treatment drives up house prices because it increases the after-tax returns to housing investors. The number of negatively geared individuals doubled in the 10 years after the capital gains tax discount was introduced in 1999. More than 1.2 million Australian taxpayers own a negatively geared property, and they claimed A$14 billion in net rental losses in 2011-12.

There are no quick fixes to housing affordability in Australia. Yet any government that can solve the problem by boosting housing supply in inner and middle suburbs, while refraining from further measures to boost demand, will almost certainly find itself rewarded, by voters and by history.

Brendan Coates, Senior Associate, Grattan Institute and John Daley, Chief Executive Officer , Grattan Institute

This article was originally published on The Conversation. Read the original article.

Wednesday, 30 September 2015 10:49

A Tale of Two Chinas

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Nike surprised the market last week with a 30% increase in Chinese sales. The resulting 8.6% weekly share price rise took the gain for 2015 so far to 30.0%. The Nike market performance (shown in yellow in chart below) has been the mirror image of the Caterpillar outcome (shown in blue). Last week, the Caterpillar share price fell another 9.6% to bring to 29.0% the fall during 2015.

The performance differential signals that the long-awaited pay-off for companies positioned to take advantage of the growth of Chinese consumption is becoming meaningful. The maturation of the Chinese economy will increasingly undermine macro-themed generalisations about Chinese exposure.

Forecasting GDP movements, which may have contributed to investment success in the past, will have lost some potency as strategic business positioning becomes a more important determinant of investment outcomes.

(Sourced from EIM Capital Managers)

Monday, 31 August 2015 08:05

Why have the banks corrected recently?

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Banks have been top performers before correcting

The banks represent a large portion of Australia’s share market. The ’big four’ banks have been top global performers (in local currency terms) and a very large driver of our stock market rally particularly since the Euro-crisis days of 2012. All four major banks have outperformed the index. For the past three years rates have been falling and are now at all-time lows, so the banks were able to grow their mortgage books at the same time as problem loans dissipated due in part to these lower rates. As a result, the profits of the ’big four’ have doubled from 2008 levels. This has led to a sustained, steady rise in stock prices, bank profits and a growing stream of dividends.

Since their recent reporting season, all our major banks have run into a volatile patch with the sector giving back much of its year-to-date gains. The market has been underwhelmed by the financial results delivered by the banks in May and now in August. With all of the banks increasing their capital by issuing shares the dilution could signal the end of their record profits and dividends.

Why have they given back gains?

Many of the drivers of that growth in profitability and earnings are now slowing and this will lead to some contraction in valuations.

One driver has been cost reduction. Banks have kept a keen eye on costs over this period by capping the growth in employees and implementing productivity and cost-out initiatives. This has led to what the banks call ’positive jaws’, which basically means an increase in profit margins. But cost pressures are re-asserting themselves, meaning this area of margin expansion may be more difficult to achieve going forward.

Another big driver of profits has been the release of balance sheet provisions for bad and doubtful debts. These are reserves the banks hold against loans that are in arrears or at risk of impairment. As interest rates plummeted to all-time lows, these problem loans started to improve to such an extent that the banks are obliged by accounting standards to release those reserves to profits. But with the provisioning for these loans now below pre-GFC levels, they represent a one-off profit driver which may reverse if the cycle weakens. So while profits should still grow this year, some of the factors that were driving these profits are starting to run their course. In the recent reports and updates in August we have seen some slight tick up in provisions, which implies that this trend is unlikely to contribute to profits going forward and may impair growth if the economy softens.

Bank shares have given back some of their large gains

Source: AMP Capital and Bloomberg

Final thoughts

While profits are at all-time highs, earnings growth is slowing and with high starting valuations the banks have come under pressure. Together with industry regulation to increase capital and reduce lending within the investment mortgage market, a more subdued outlook for bank profits is expected along with more challenging times ahead for shareholders as returns on equity moderate.

As banks make up a large part of the Australian share index, most investors will hold these stocks. While banks have recently given back some of their gains made over the past year, they still provide attractive dividends which are an important feature in a yield-starved world.

Wednesday, 26 August 2015 06:17

The rise of middle class in Asia

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Investors should pay heed to changing demographic trends as a clue for future potential growth opportunities.   There would seem no greater demographic shift taking place right now, than the rising of the Asian middle class.  The chart below (sourced from the Financial Review) shows the growth in Asian middle class between now and 2030.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investors should ask themselves what changes take place in a person's life as they earn more and build wealth?  How does their diet change?  Once basic needs such as food and shelter are provided for, what do people with more disposable income spend money on? 

We have sourced some interesting statistics from a presentation we hosted with Platinum Asset Management that highlight some interesting spending habits taking place in China in 2014.

 

1. 32 million passengers flying per month

2. 640 million internet users

3. 25 million motor vehicles sold

4. $5bn in box office revenue at the movies

5. 14bn e-commerce parcels delivered

 

When looking at these numbers from a place like Australia with a population of around 23 million, it is difficult to get your ahead around the sheer size of the opportunity at hand.

There are large demographic shifts taking place in middle class in Asia - how is your investment strategy positioned to profit from this?

 

Last week's sell off in share markets, prompts many investors to ask ..... what next?

History has a habit of repeating itself so it is with this in mind that we sourced a table from Bloomberg recently that shows the market movements following a 5% weekly fall.

It's interesting that 7 out of ten times, the market has been higher, 3 months after a weekly fall of 5%.

The occasions when the market was not higher 3 months after a sharp weekly fall, was during times of a systemic market problem (such as Lehmann Brothers bankruptcy in 2008).  So investors need to ask themselves whether or not current events are likely to result in systemic failure in the financial system.  If not, then history suggests that in the majority of occasions, markets will be higher in 3 months.

The table below refers to the US share market.

 

Mark Draper (GEM Capital) spoke recently with Andrew Clifford (Chief Investment Officer - Platinum Asset Management) about the recent volatility in the Chinese share market.


Andrew provides some perspective on what is going on at the moment, and why he continues to believe in the medium term benefit of investing in China.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

China’s Share Market, Dangers Signs or Opportunity?

Mark Draper: Andrew, the Chinese Share Market has had a pretty interesting run over the last, really 5 years. It has come up from a low base and then we have had a pretty significant correction in recent times. Is this the beginning of the 1929 saga as it been regularly put forward the media or are you able to put some perspective for us?

Andrew Clifford: I think you just need to step back a bit and see where the run-up in this market began. If you go back 18 months ago the market was down 65% over the previous seven or so years which really makes it one of the great bear markets of history. There are not many bear markets that were going down that far for that length of time and so you know what started to happen was that there was some sense that policy was going to be eased particularly around lending restrictions over in the market, and as markets do when they sort of see that, took off on a great run. Now undoubtedly parts of the market became very speculative. They were very much driven by individual investors, lots of margin debt and it all fell apart. Now the government interferences were really not being helpful but if we step back and think about the longer term these Chinese A shares, it is very interesting that it is a market where there’s very little institutional investment . Over a longer period of time payers like pension funds and insurance companies have minimal, if any exposure to shares and it’s not likely to be the case five years down the track. There are fears the government will have to liquidate this rescue fund they put together. Indeed they should have had the rescue fund but the long history of these rescue funds and there being many in 1987 in Hong Kong and 1997 a number of countries across the region, indeed I think in 2001 we also had them and you know the governments have a very strong staying power. In the order of forty or fifty billion dollars of stock bought. Well perhaps it sounds like a big number but in the context of the Chinese government it’s not really, it’s a very large economy. So we think as investors people get too excited about these day to day moves, for us we’ve got some great companies, some of them listed in the A share market in China. The really good companies actually haven’t come off that much then, more of the order of 15 or 20 percent rather than the very dramatic falls and the more speculative parts of the market and indeed for us that just an opportunity to buy some more of these companies.

Mark Draper: So you’re really saying that normal market function, it comes off a low base and really some investment opportunity rather than something very ...

Andrew Clifford: Essentially it’s a little more wild than your average market but that’s what happens when as it is today 80 percent of investments are retail investors but through time, for the moment that’s actually the opportunity for longer term buyers and over time I think that will change.

Mark Draper: Andrew, thanks very much for your time.

Andrew Clifford: Yeah, thank you.