Friday, 01 March 2019 17:47

Knowing when to sell

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Mark Draper (GEM Capital) writes a monthly column for the Australian Financial Review.  In his January 2019 article he outlines some of the triggers investors should look for that provide clues for when to sell.

 

7 flags to tell you ‘it’s time to sell’

The days of the ‘buy and hold’ strategy has long been a ‘dinosaur’ and probably always was. Regular changes to technology, regulation, consumer tastes not to mention competitors can turn today’s hero investments into tomorrows dogs. 

Successful investing involves not only buying assets for a reasonable price, but also knowing when to sell.

The term ‘red flag’ is referred to by professional investors as events that take place that act as an early warning signal to sell.

Here are 7 red flags to help investors sell before ‘it hits the fan’:

  1. When directors sell shares in their own company, particularly when more than one director sells in a short period of time, investors should be nervous.  History is littered with examples of director selling followed by dramatic falls in share prices.  In August 2016 the CEO and Chairman of Bellamys both sold a combined total of 365,000 shares at around $14.50 per share.  In June 2018 two directors of Kogan sold 6,000,000 shares at $7 per share. The share price charts below tell the rest of the story.  INSERT Bellamy’s and Kogan charts (attached PDF’s)
  2. Crowded trades takes place when consensus opinion on an investment is universally positive which usually coincides with excessive valuation.  The ‘investment that can not lose’, verbalised by cab drivers and instant experts at barbecues  is usually a place to avoid.  Crowded trades could also be referred to as fads.

Who can forget the mantra in 2007/2008 about peak oil theory, when the oil price was around $150 per barrel.  Investing in energy was a one way bet according to common beliefs of the day, providing an excellent example of the crowded trade.  Oil today of course trades today at around $60 per barrel.  

  1. Poor behaviour from management which include directors/management using company assets for private use, related party transactions such as the company renting premises from directors and excessive management remuneration.
  2. A google search of Nepotism reveals “the practice among those with power or influence of favouring relatives or friends, especially by giving them jobs”.  Whether employing a relative or friend of management, or the company expanding into an unrelated business, so that a relative can run it, rarely results in getting the best person for the job.
  3. Most investors appreciate that a company’s share price follows the earnings.  Earnings should follow cash flow, so when earnings rise without a corresponding rise in cash flow, investors should beware.
  4. My father always said to me ‘everything comes from the top’, and how true this is with respect to investing.  Changes to management can play a big role in share holder returns.  A Financial Services executive employed to run a healthcare company?  A Milkman running a Childcare company?  True situations that didn’t end well for shareholders.  Investors should consider the background and experience of new management that is appointed to satisfy themselves that they are fit for the role.
  5. Valuation is the ultimate red flag. Buy low and sell high sounds simple but the only way an investor can do this is to first hold a view of what an asset is worth.  While this seems elementary, I continue to be surprised by investor behaviour which clearly demonstrates no regard for valuation.

Let us pay tribute to the poor souls who invested in Cisco Systems at the height of the dot.com bubble paying well in excess of 100 times earnings.    Almost 20 years later, the share price is still not back to its level at the peak of the dot.com boom.

And there were many examples of this behaviour in Australian technology stocks in the dot.com boom that didn’t even have a price earnings ratio due to the fact that the company’s didn’t have any earnings to show.  Crypto currency is possibly the most recent example of investors chasing returns from an asset without regard for intrinsic value.

7 flags to help investors keep from trouble.  As the great Kenny Rogers song said, “you gotta know when to hold ‘em, know when to fold em’, know when to walk away and know when to run.  Happy investing!

Livewire recently interviewed arguably two of Australia's best Global Investors.  They are Andrew Clifford (CEO Platinum Asset Management) and Hamish Douglass (CEO Magellan Financial Group).

The interview discusses their current views on the financial landscape and is a must see for investors.

 

Mark Draper (GEM Capital) writes a monthly column for the Australian Financial Review.  This article outlines the generational opportunity that is before investors in the doubling of the Chinese middle class in the next 5 years.  It was published during February 2019.

 

The growth in Chinese middle class is one of the strongest demographic opportunity for investors in a generation.  Most investors however, including the Global indices, have little in the way of exposure to this theme.

Chinese middle class is forecast to double from around 300 million to 600 million people in the next 5 years.  While the definition of middle class varies widely, it is commonly characterised to include those but the poorest 20% and the wealthiest 20%.  It is natural as more people enter the middle class they will have more disposable income to spend on discretionary purchases.  Buying cars, property, healthcare, mobile phones and a change of diet are all examples of the opportunities that exist for investors from this demographic trend. 

Vihari Ross, Head of Research at Magellan Financial Group points to coffee consumption in China as a long term opportunity. Those with even modest discretionary income can afford this ritual.  Chinese annual coffee consumption is less than 1 cup per year per capita, versus the US consumption of around 300 cups per year per capita.  

Growth in Chinese coffee consumption is one of the key drivers behind Magellan’s investment into Starbucks according to Ross. There are currently 3,400 Starbucks stores currently in China,  the company is forecast to open 600 new stores in China each year for the next 5 years, which equates to annual growth of 15%.  With a pre-tax return of 85% on investment from these stores the investment case seems compelling.

Source: Magellan Financial Group

Andrew Clifford, CEO Platinum Asset Management says “China is the world’s largest physical market – not just for iron ore and copper but everything imaginable:  aeroplanes, autos, mobile phones, semiconductors, running shoes and luxury handbags.  Indeed, it is hard to imagine a physical market for which China is not the largest customer.”

Source: Platinum Asset Management

With growing car ownership in China, comes the need for insurance.  This helps explain Platinum’s investment into Ping An Insurance Group, the number 1 global insurance company on the 2018 Forbes Global 2000 list.  Ping An, which trades on a price earnings multiple of around 11 is growing rapidly and boasts a technology-first mindset.  Its Fintech capabilities are world class and its health business and life insurance businesses are also booming.  Needless to say, there are very few listed companies in Australia trading on a price earnings multiple of 11 that are growing their earnings.

To help put further perspective on what the next 5 years might look like for Chinese middle class, we look back 5 years. Dinner party conversations will be enriched by wheeling out some of these Chinese growth statistics.  In 2014 there were 25 million motor vehicles sold in China and in 2018 the number was 28 million.  Chinese box office revenue in 2014 was $5bn and in 2018 it took in $9bn. There were 640 million internet users in 2014 and in 2018 there were more than 800 million.  109 million overseas visitors entered China and in 2018 the number of tourists was over 150 million.  14 billion express post parcels were delivered in 2014 and in 2018 parcel delivery grew to over 50 billion parcels.  32 million Chinese passengers flew domestically every month in 2014, rising to around 50 million passengers per month in 2018.  (statistics courtesy of Platinum Asset Management)

To cope with the surge in air travel, China plans to build over 70 new civil airports by 2020 to make the total 260. That’s up from 175 in 2010.  The opportunity for inbound tourism into Australia is enormous (and bolsters the investment case for Sydney Airport).

The numbers are phenomenal and difficult to grasp for many Australians.  More importantly, investors who base the majority of their investments domestically are ignoring this generational tailwind.

Clearly there will be peaks and troughs in the Chinese economy, although it is still growing at around 6% per year, good by Western measures.  Just the growth of the Chinese economy each year is larger than the entire Australian economy.

Investors would be wise to look through the short term economic cycles and embrace the extraordinary opportunity that is before them.

Tuesday, 11 December 2018 13:34

AMP - two bagger or falling knife?

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Mark Draper wrote this article which appeared in the Australian Financial Review during the month of December 2018.

After spending the last 20 years despising AMP and selling any shares we ever came into contact with, it is interesting that we find ourselves potentially interested in buying AMP shares now that they are trading at an all time low.

Every investor dreams about picking the turnaround story that doubles in value.  Is AMP a two bagger or a falling knife?

It’s hard to find much in the way of positive news flow around AMP at present, which is normally a good place for investors to start as it can imply most investors have already headed for the exits.  The recent sale of AMP’s life insurance division was the last instalment of poorly received news with some in the market labelling it a ‘fire sale’ or ‘AMPutation’.

After the sale of AMP’s Life businesses, consensus earnings estimates are around 25 cents per share according to Skaffold software, which puts AMP on a current price earnings multiple of 10.

Skaffold which models intrinsic value based on assumptions of future cash flows currently has the share price trading at a small discount to intrinsic value.  

Source: Skaffold

What is often overlooked by investors is that AMP still has 3 key divisions, which are Wealth Management (platforms and advisers), AMP Capital (funds management) and AMP Bank.

AMP Capital has assets under management of $192.4bn, with around two thirds of this coming from their internal channels such as AMP aligned financial advisers.  This division is currently in fund outflow.  The key question for investors is whether AMP can regain the trust of investors and stem fund outflows, or whether fund outflows are permanent?  

AMP Bank has a lending book of around $20bn and the loan book saw a small decline for the first time since 2015.  This division carries the same risks of the other retail banks in the event of potential for bad debts.

Nathan Bell, portfolio manager at Intelligent Investor says “within a few years after the recent AMP Life disposal and the sale of its New Zealand wealth management business slated for next year, AMP could have around $1.5bn of capital that could either be returned to share holders or reinvested to grow earnings. Incoming CEO De Ferrari (who starts on 1st Dec 2018) needs to increase the company's return on equity to 15% to earn all his bonuses, so theoretically investing the money would increase earnings by $225m, which in turn could see earnings per share move closer to 30 cents per share”.

Bell then suggests that if AMP was subsequently re-rated to 15 times earnings, assuming no deterioration or improvement from other divisions, the share price could be $4.50 (15 X 30 cents per share earnings). The dividend yield for investors with an entry price of $2.50 would also be attractive under this scenario according to Bell. 

The problem with finding investments that can produce such a high return at the tail end of a bull market is that these opportunities often come with ‘warts’, and AMP’s business units are under immense pressure, which is why Bell is eager to hear De Ferrari's strategy. There are also suggestions De Ferrari will renegotiate his contract, as his bonus targets will be very difficult to achieve following the board's widely condemned deal announced recently to sell its AMP Life business.

It is always useful to understand how senior management is incentivised and the incoming CEO receives a large incentive if the share price reaches $5.25.

Matt Williams, Airlie Funds Management is watching AMP closely but has rarely invested in the company over his career. He cites a revolving door of management and a business with high fixed costs that is not really a leader in any of its market segments as reasons to be cautious.  Airlie have recently met with AMP management but remain on the sideline at this stage.

Risks for AMP include De Ferrari not being able to restore the company’s reputation, continued fund outflows, financial market downturn which decreases fee revenue from funds under management, bad debts from the banking division not to mention the outcome from the Royal Commission with respect to vertical integration among other issues.

The best investment decisions are often the ones which make investors feel the most uncomfortable and on that count AMP rates highly, given the uncertainties.  The strategy from the incoming CEO is the next piece of the puzzle for investors to help determine whether AMP is a turnaround in the making or a falling knife.

Thursday, 08 November 2018 11:56

Why Buffett likes Apple

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Mark Draper writes a monthly column for the Australian Financial Review - this article was published in September 2018

 

Apple has not only featured in the media for its latest range of iPhones and Watches, but also because it is Warren Buffett’s largest investment.

Warren Buffett owns around 5% of Apple shares (via Berkshire Hathaway) which recently became the first company to crack the US $1 trillion market capitalisation level.  ($AUD 1,400,000,000,000)  To put this in perspective, the market capitalisation of the entire ASX200 is only about 25% higher than that of Apple alone. 

Even though technology is the one of fastest growing sectors globally, local investors are starved of IT opportunities in the ASX200 with technology comprising less than 4% of the index. Local investors with a focus on the domestic market may be missing out on Buffett’s wisdom.

Composition of the ASX 200

Buffett does not have a natural leaning toward technology manufacturers but at his recent annual meeting described Apple as a “very, very special product, which has an enormously widespread ecosystem, and the product is extremely sticky”.  So what is behind the investment case for Apple?

The best place to start is to ask, how many of your friends and family own an iPhone?

The iPhone is important to Apple as its sales represent around 60% of revenue, but what has changed in the last 5 years is the composition of iPhone sales.  Magellan Asset Management estimate that in 2012 around 45% of iPhone sales were to new users.  In 5 years this changed so that only 20% of iPhone sales are to new users, with 80% being sold as replacement handsets to existing users.

For investors, this means more consistent earnings in the form of recurring earnings, rather than one off handset sales.  Magellan portfolio manager, Chris Wheldon describes the iPhone sales figures “as a subscription that Apple users are willing to pay every 2- 3 years, to remain in the Apple ecosystem”.

While revenue from iPhone sales YTD to 30th June 2018 is up an impressive 15%, what is more impressive according to Wheldon is the growth in the ‘Services’ business which is up 27% YTD.  The Services business comprises of revenue from digital content and services including the App Store, Apple Music, iCloud, Apple Care and Apple Pay.  Apple Music is now the most popular paid streaming service in the United States. 

The Services business was the second largest division within Apple contributing over $27bn in revenue for the 9 months to 30th June 2018, which represents almost 15% of total revenue.

The Services business is largely recurring in nature and its strength relies on the number of Apple devices connected to the ‘ecosystem’.  Earlier this year, Apple CEO Tim Cook stated in January 2018 that its active installed base of devices had reached 1.3bn, which includes iPhone, iPad, Mac and Apple Watches. 

The ‘Wearables’ division which includes products like Airpods and Apple Watch is also growing strongly.  In the last quarter of 2017, for the first time, Apple shipped more Apple watches than the entire Swiss Watch Industry, making Apple the largest watch maker in the world.

Wheldon believes the market may not yet fully appreciate the quantum and growth in the Services and Wearables businesses which could account for 35% of the total business in the future.

The technology bears would point to the high valuations of the dot.com boom at the turn of the century.  To this end it is interesting to note that Apple currently trades on a forward looking 2019 price earnings ratio of around 16 (less if adjusted for cash holding), which for a business whose earnings are growing at a double digit rate does not seem excessive.

Investors can invest in Apple through many avenues, either by owning it directly or via listed invested companies/trusts from leading managers including Magellan, Platinum and Montgomery Investments.  Some ETF’s also provide an entry point to technology companies.

Using technology is second nature in our everyday lives, so why wouldn’t investors make it second nature to their investment strategy as Warren Buffett has done?

Thursday, 08 November 2018 11:35

Bank Reporting Season scorecoard FY 2018

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Article written by Hugh Dive - Atlas Funds Management and reproduced with permission from Hugh

On Monday this week, Westpac ruled off the 2018 financial year profit results for the Australian banks. In the words of Queen Elizabeth, 2018 could only be described as an annus horribilis for Australian banks and their investors. The CEO of one major bank lost his job, the revelations of the Financial Services Royal Commission resulted in remediation provisions and a spike in legal fees (which should see new sports cars and houses at Palm Beach for sections of the legal community this Christmas), fines were levied and credit growth slowed. An environment of fear has weighed on bank share prices.

There are common themes emerging from the banks in the 2018 reporting season. We will differentiate between the major trading banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Bank reporting season scorecard October 2018

Click to enlarge

Scaling back the empire

The main theme from 2018 was the breaking down of the allfinanz model that the banks built up carefully over the past 30 years. Allfinanz or bancassurance refers to the business model where one financial organisation combines banking, insurance and financial services such as financial planning to provide a financial supermarket for their customers. This is based on the somewhat false assumption that the bank’s employees can efficiently cross-sell different financial products to their existing customers at a lower cost than if this was done by separate financial institutions. It creates some of the conflicts of interest that have been on display at the Royal Commission.

Over the past year, the Commonwealth Bank sold its life insurance business to AIA and the asset management business a week ago to Mitsubishi UFJ for a very solid price. Similarly, ANZ exited both its wealth management and life insurance businesses. NAB also announced plans to sell MLC by 2019. Additionally, Westpac has reduced its stake in BT Investment Management (now renamed as the Pendal Group). These moves acknowledge that creating vertically-integrated financial supermarkets was a mistake. If adverse rulings are made on vertical integration in the Royal Commission’s Final Report, most of the banks will have already made moves to simplify their businesses, so shareholders won’t be exposed to significant ‘fire sales’ of assets by motivated sellers.

Profit growth hit by remediation

Across the sector, profit growth was subdued in 2018 as the banks grappled with slowing credit growth, the application of tighter lending standards, customer remediation and legal costs. The table above looks at the growth in cash earnings inclusive of these costs. Whilst many companies encourage investors to look through these charges, ultimately these are real costs that impact the profits available to shareholders, and in aggregate the four banks have set aside $1.3 billion to cover customer remediation.

Westpac reported the strongest cash earnings by cost control, very low bad debts and a lower level of customer remediation charges. NAB brought up the rear due to both $755 million in restructuring costs and $435 million in customer remediation charges.

Bad debts stay low

A big feature of the 2018 results for the banks has been the ongoing decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay. Additionally, declining bad debt charges year on year creates the impression of profit growth even in a situation where a bank writes the same amount of loans at the same margin. Bad debts fell further in 2018, as some previously stressed or non-performing loans were paid off or returned to making interest payments. The main factors causing this fall has been the low unemployment rate and a near absence of major corporate collapses over the past 12 months.

Westpac and Commonwealth Bank both get the gold stars with very small impairment charges courtesy of their higher weight to housing loans in their loan book. Historically home loans have attracted the lowest level of defaults.

Shareholder returns hold as dividends steady

Across the sector, dividend growth has essentially stopped, with Commonwealth Bank providing the only increase, two cents, over 2017. In an environment where loan growth is slowing, provisions rising and the management teams regularly appearing either in front of the Royal Commission or before our political masters in Canberra, it would be imprudent for the banks to raise dividends.

In 2018, dividends were maintained across the banks, which was a surprise in the case of NAB. It paid $1.98 in dividends on diluted cash earnings per share of only $2.02, a very high payout ratio and not a sustainable situation given that the bank’s capital ratio is below the APRA target of 10.5%.

Looking ahead, dividend growth is likely to be subdued in 2019, as the banks digest the outcome from the Royal Commission. ANZ and Commonwealth Bank shareholders can expect capital returns in the form of share buy-backs to offset the dilution from asset sales. In 2018, ANZ bought back $1.9 billion of its own stock, with an additional $1.1 billion due over the next six months. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 9.4%, an attractive alternative to term deposits.

Interest margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate declined in 2018, reflecting higher wholesale funding costs and borrowers switching from interest only (which attracts a higher rate) to principal and interest mortgages. This switching was done in response to regulator concerns about an overheated residential property market, and in particular the growth in interest-only loans to property investors. Looking ahead to 2019, margins should recover courtesy of a rate rise of around 0.15% announced in mid-September. All the banks put through a similar rate rise with the exception of NAB, and it will be interesting to see whether NAB increases its market share as a result of this or follows suit at a later date.

Total returns including share prices

All the banks have delivered negative absolute returns, also trailing the S&P/ASX200 which eked out a small gain of 0.24%. The uncertainty around the outcomes from the Royal Commission, rising compliance costs and slowing credit growth has weighed on their share prices. Westpac has been the worst-performing bank, mainly due to concerns about lending standards in the $400 billion mortgage book, though we are yet to see any adverse evidence in the form of rising bad debts.

– No star given –

Our overall view of the future

It is hard to be a bank investor at the moment and some fund managers are advocating avoiding them all together.

We view that at current prices, investors are being paid an attractive dividend yield to own solid businesses that have a long history of finding ways to grow earnings and navigate political minefields. Looking at the wider Australian market, the banks look relatively cheap, are well capitalised and unlike other income stocks such as Telstra, should have little difficulty maintaining their high fully-franked dividends. Additionally, the share prices of ANZ and Commonwealth Bank will see the benefit of share buy-backs, as the proceeds from the sales of non-core assets are received. The key bank overweight positions in the Maxim Atlas Core Equity Portfolio are Westpac, ANZ and Macquarie Bank.

Hugh Dive is Chief Investment Officer of Atlas Funds Management. This article is for general information only and does not consider the circumstances of any investor

Wednesday, 10 October 2018 20:35

Just how far will property prices fall

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Written by Roger Montgomery (CEO Montgomery Investments)

 

For the last two years, we were feeling rather lonely suggesting that the property boom would end abruptly. Today, property prices are falling, and we are no longer a lone voice. The question is: how much further will they fall?

A number of changes are contributing to the declines in property prices.

For a start, rising bank fund costs are leading to higher mortgage rates. Then there’s a tighter definition of responsible lending following the Royal Commission – which will mean fewer individuals qualifying for a loan to buy property, and those that do get a loan will receive less. And on top of that, there’s been the introduction of lower debt-to-income limits and a wave of borrowers being migrated from interest-only loans – which hit a peak of $159 billion in 2015 – to principal and interest.

These structural changes will continue to impact property prices for some time.

One indication that prices might fall further than the 10 to 15 per cent suggested by some of my fund manager friends, is recent research produced by UBS that suggests the sanguine attitude held by borrowers towards their loans is misplaced. The research reveals a widespread lack of knowledge exists among borrowers about the terms of their interest-only loans and the extent of the increase in repayments that will need to be made when they are moved onto principal and interest.

UBS has uncovered some startling facts. When asked why borrowers took out an interest only mortgage, 18 per cent responded they “can’t afford to pay P&I”, 11 per cent said they expected house prices to rise and to sell the property before the interest only period expires and 44 per cent noted it gave them more financial flexibility. One can safely assume some proportion of the 44 per cent were also in the can’t afford P&I camp.

When combined, there are a substantial number of borrowers who have taken out an interest-only loan for the wrong reasons.

Moreover, many of these borrowers don’t understand the product they have been sold. Among owner-occupiers only 48 per cent understand their interest-only term expires within five years, which is the maximum term typically offered. Meanwhile 18 per cent observed they don’t know when their term expires and 8 per cent believe their interest-only term will last more than 15 years. A 15-year interest-only loan doesn’t exist.

The serious problem, however, is not that many borrowers will be shocked by how quickly their life will change, it is how much it will change.

34 per cent of all interest-only borrowers stated they “don’t know” how much repayments will rise. Meanwhile, 53 per cent expect repayments to rise up to 30 per cent and only 13 per cent of respondents indicated they expect their mortgage repayments to rise more than 30 per cent. Repayments will rise by at least 30 per cent and that is without interest rate rises in the interim.

UBS have gone a step further and calculated the step up for investors and owner-occupiers with a $600,000 interest only mortgage moving over to P&I. Depending on the duration of the principal and interest mortgage, the step up can be as much as 91 per cent! In other words for some borrowers repayments could double. Clearly, the majority of this cohort are unprepared or underprepared for the inevitable increases.

But why are we concerned? And why are all these people being forced onto principal and interest loans? The answer is APRA, in response to the Financial System Inquiry some four years ago. APRA imposed on the banks a strict limit of 30 per cent of all new mortgages written that can be interest-only. In 2014 and 2015 up to 49 per cent of mortgages written were written on interest-only terms but when these loan vintages mature in 2019 and 2020, only 30 per cent, including any brand new mortgages written, will be permitted to be on interest-only terms.

Of course the banks are fully aware of this situation and they understand that because it is the marginal seller of property – this weekend’s vendor – that will determine property prices for everyone, they must try to move as many people onto principal and interest that can afford it. That way those who can least afford the step-ups will be extended another interest-only loan for a further five years.

No wonder some of my friends who have mortgages – some have used them to fund purchases of real estate in Japan’s ski resorts – are already being asked to move over to P&I. By doing so it reduces the pressure on the banks to force people across who can least afford it.

Inevitably of course this creates an overhang of property that acts like a ceiling on prices at least until the next wave of buying breaks through it.

Until then expect even lower returns from residential property than those returns that were already locked in by paying a very high price.

Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This article appeared in the Weekend Australian Financial Review during the month of September 2018.

 

With the Coalition’s acts of self harm, the prospect of Bill Shorten’s imputation credit concoction becoming law, appear more likely.

Originally aimed at the “big end of town” it is important for investors to understand whether they are in fact impacted by this proposal.  Since the original announcement in March by the ALP to scrap imputation credit cash refunds, a concession to pensioners, and to some SMSF’s has been announced. The concessions allow for the cash payment of surplus imputation credits to continue for those on the age pension or allowances, or for a SMSF that has a member receiving age pension, as at 28thMarch 2018.

While this concession may lead to some SMSF’s thinking about recruiting a new member who is in receipt of an age pension to the fund, I would suggest SMSF trustees first consider the potential estate planning fallout from adding new members to their fund before proceeding.

The group left most exposed to Shorten’s attack are self funded retirees and SMSF’s, particularly those in pension phase. A perverse outcome of the proposal is that high income earners and ultra wealthy Individuals are likely to be largely unaffected leaving those such as middle class retirees bearing the brunt.

High profile fund manager, Geoff Wilson believes that “Investors should not give up the fight.  If Labor wins government at the next election, it may either realise the error of its ways due to public protest and abandon this flawed policy, or have it blocked in the Senate”

Therefore it would be wise to hasten slowly before making changes to investors portfolio’s in response to this proposal, however I am of the view that investors should begin thinking about how they may react if the proposal is ultimately legislated.  

Firstly, investors need to quantify the magnitude of the potential change on an asset by asset basis.  To illustrate this the graphic below shows total shareholder return of some Australian securities over the last financial year dissected between growth, income and imputation credit.

Source:  IRESS

The message here is clear, total return is the main game, and investors need to keep the value of imputation credits in perspective. A focus on investment fundamentals such as company earnings, which ultimately drive value, rather than focussing simply on franking would be of far more benefit to investors.

Bank Hybrids which have become a retail investor favourite should be reviewed as a material component of the return consists of the imputation credit.  Rather than focusing just on tax however, bank hybrids should be reviewed in light of the ALP’s proposed changes to negative gearing and its likely impact on the residential property market and by extension, bank earnings.

Investors in listed investment companies should not panic.  In our conversations with management of listed investment companies, it is clear they are already considering their own plan B which might involve a change in legal structure to protect investors from fallout of the ALP proposal.

Those investors who use multiple investment structures, such as SMSF’s, family trusts and or companies to house their wealth, should analyse which of those structures are likely to be able to continue to use imputation credits.  The aim would be to own assets paying franked income in structures where the imputation credit can be utilised, and own assets paying unfranked income in structures that can not.

Investment managers investing in global shares are one of the beneficiaries from a removal of imputation credit cash refunds.  Well known names such as Magellan, Montgomery Investment Management and Platinum Asset Management are likely to attract investors into their ASX listed investment trusts that pay unfranked income alongside solid long term performance track records.

So it’s time to plan now, and act later, unless investors wish to take up Geoff Wilson’s call and participate in online petitions such as those being conducted by Wilson Asset Management and Plato Asset Management.

Here is a link to Wilson Asset Management's online petition if you have not already joined it.

Sign the Wilson Asset Management petition here

Friday, 05 October 2018 16:27

No mysteries behind rising power prices

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Over the past few months, rising energy prices have dominated newspaper headlines, treating readers to the sight of politicians wringing their hands, promising to get to the bottom of this issue and find out who is responsible. Large power generators, energy retailers and transmission companies are accused of being behind the rising cost of lighting, heating and cooling our nation’s homes.

Whilst the profits that companies such as AGL Energy, Spark Infrastructure and to a lesser extent Origin Energy have increased over the past decade, we see that a significant proportion of the increase can be attributed to energy decisions made by various governments. As an economist, these price increases were predictable based on changes in the supply and demand curves of energy in Australia. There is scant evidence that they are the result of a long-term insidious plan by energy companies to capture a greater share of the nation ’s pay packets.  In this week’s piece, we are going to look at energy prices impacting Australia’s consumers and industrial users alike.

Energy prices this century  


The above chart shows household gas and electricity prices in Australia and compares them to inflation. Using June 2000 as the baseline year, the CPI [Consumer price index which measures the prices paid by consumers for a basket of goods and services including energy] has risen by 61%. Over this same period, electricity has risen by +226% and natural gas by +207%.  As you will note from the above chart, energy price rises roughly matched inflation up until 2008, however energy prices have accelerated in relation to CPI particularly since 2012. It is worth noting that electricity prices are influenced by natural gas prices in that gas is used in gas-fired power peaker plants that can be fired up in response to peak periods of electricity demand.
 

 Gas Prices Up – a new source of demand


Due to the size of the Australian continent and the absence of pipelines linking the major fields off the coast of WA with Eastern Australia, gas prices are greatly influenced by geography. As you can observe from the below table, due to the lack of physical infrastructure WA’s gas from the giant offshore LNG fields is sold to consumers in Seoul and Tokyo rather than Sydney and Melbourne.


 
Until the construction of the construction of three liquefied natural gas (LNG where natural gas is cooled to -161 C to allow transportation) in the last five years, producers of natural gas on the East Coast of Australia could only sell their gas into the East Coast domestic market. This resulted in gas being priced below world prices for East Coast consumers. For example, in 2008 the wholesale price of 1 gigajoule of natural gas was $15 in WA versus $5 in NSW. The opening of these three export LNG plants in Gladstone in Queensland by Origin Energy, Santosand BG in 2015 and 2015 allowed the export of natural gas from  Eastern Australia to Northern Asian customers that were willing to pay over $10 per gigajoule.

Additionally, unlike in WA which mandates that 15% of gas produced in the state is reserved for domestic consumers, no such gas reservation scheme was enacted on the East Coast of Australia. AGL’s plan to construct an LNG import terminal by 2020 to serve the Victorian gas market will further link the prices that Australian consumers pay for natural gas to the world market, with gas expected to be imported from the USA and Qatar.

Consequently, with a new source of demand for natural gas being introduced and East Coast gas markets opened up to world prices, domestic prices naturally gravitated towards the higher export price. The construction of these three LNG export terminals has not only had negative consequences for consumers but due to the elevated construction costs of around $71 billion have also been a burden for shareholders with returns below expectations.
 

Gas Prices Up – new sources of supply halted


At the same time that demand for natural gas was increasing, a range of decisions were made by governments in NSW and Victoria to restrict new supply. Arguing about the benefits and harms of coal seam gas is beyond the scope of this piece, but economics dictates that if demand is going up and supply is unchanged, prices will naturally rise. In 2012 Victoria imposed a moratorium on coal seam gas exploration and in 2015 the NSW government banned new gas exploration. This saw AGL announce that it would not proceed with their projects in NSW and that they would be relinquishing their exploration licences. This action contributed to the energy company recording an impairment charge of $640 million in 2016.  We note that in April 2018 the Northern Territory reversed its ban on gas exploration outside towns and conservation areas in a move designed to put downward pressure on power bills.

Generation Costs Up – changing the mix and reducing supply


In the electricity market prices have been driven higher by the Federal Government’s Renewable Energy Target. This will require electricity retailers to acquire a fixed proportion of their electricity from renewable sources and is likely to result in  33,000 GWh of Australia's electricity coming from renewable sources by 2020. Politicians seem surprised that regulations have added to electricity costs, following the closure of coal-fired base-load power stations in favour of more expensive renewables. For example, in 2017 Energie closed the Hazelwood power station that had previously supplied up to a quarter of Victoria’s electricity and AGL have announced that they will be closing the 1,680-megawatt Liddell coal-fired plant in 2022. Whilst we recognise that burning coal to generate electricity releases carbon into the atmosphere contributing to global warming, it is also a very cheap and consistent method of generating electricity. Additionally, coal-fired power plants are well-placed to provide a base-load of consistent generation, as these plans can generate electricity continuously, without requiring the wind to blow or the sun to shine.

Until the battery storage technology catches up to allow generators to store significant amounts of electricity, relying on solar and wind power generation requires natural gas-fired generation to step in to maintain consistent supply. As discussed above, this source of electricity generation is more expensive today that it was 10 years ago. Switching power generation to renewables – whilst socially desirable – comes at a cost, and this is reflected in higher energy bills. Further, in any market when supply is removed and demand remains relatively constant, prices tend to rise. This effect has proven profitable for incumbents who have generators, such as AGL Energy.

Our take

Rising energy costs have impacted consumers and industrial users alike, but they have not arisen in a policy vacuum nor as part of a conspiracy. We see that they are the logical outcome of decisions that have changed the supply and demand for energy and that various companies have predicably acted to generate profit from these shifts. In the Atlas equity portfolio, we own positions in AGL Energy and Spark Infrastructure, both of which have benefited from changes in the energy markets in Australia over the past ten years. Neither of these companies are involved in the LNG export terminals that at this stage look to be a poor investment for shareholders.

Hugh Dive CFA - Atlas Funds Management

Wednesday, 05 September 2018 08:03

Best of the best - August 2018

Written by

Every two months Montgomery Investment Management prepares a report for investors that contains information about today's financial markets.

 

This issue has several interesting articles including:

 

1. US Market Overpriced, but is it a problem?

2. Rising rates, a falling $AUD put the squeeze on mortgagees

3. Catalysts that ended prior bull markets

 

To download your copy, click on the image below.