Wednesday, 05 September 2018 08:03

Best of the best - August 2018

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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.

 

Thursday, 16 August 2018 09:54

Learning to be a better investor from a billionaire

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This article appeared in the Australian Financial Review during August 2018 and was written by Mark Draper (GEM Capital).  The article was sourced from a 30 minute interview with Kerr Neilson (Platinum Asset Management).  The audio track can be heard at the bottom of this article.

 

 

 

 

What can private investors learn from one of Australia’s best investors?  I recently spent 30 minutes privately with Kerr Neilson, founder of Platinum Asset Management and Top 100 Global investor, with a view to share his wisdom.

Think about how the world is likely to be

Neilson suggests investors should spend time “conjuring up an image of the world as it is will be, rather than what is now”. This focuses on forward looking rather than relying on the past to develop an investment playbook.  “Investors need to remain agile to cope with the idea of new possibilities rather than reverting to the ways of the old”

Australian investors should be reminded of this by the current position Telstra finds itself in, and they should also be thinking now about to what extent Fintech companies including Apple and Google may disrupt the banking sector.

It is the competitor response that matters most

It is not just the behaviour of the company you are investing with that matters.

One of Neilson’s signature thought processes centres around “It is how the competitors respond that matters most”.  

Investment Research into retailing for example, would be incomplete without reference to Amazon.

Deal with the media overload.

Neilson believes the biggest problem investors face is dealing with the media overload.  This can create huge biases in behaviour of investors.  The most common is ‘availability bias’ where there is an obsession about the current news item which encourages investors to limit their scope to the most recent news and potentially lack perspective.  This can lead to either pain or opportunity.

Neilson quotes China as the perfect example of Availability bias.  “Certainly the country has too much debt, as do many countries, and yet we can find companies with attractive valuations that are growing at 15 – 25% per year and we are paying around 12 times earnings.  He adds “it is not as if all these companies are going to be forced to do things by their Government.  To the extent that this is a threat, we adjust the price we are willing to pay.”

Anchor decisions on fact, not momentum

Investors need to understand the reasons for owning particular assets and be clear about their expectations from them.  It is only then that an investor can take comfort in the face of an upset.  One of the problems he sees with passive investing (via index funds and ETF’s) is investors are simply buying momentum and the belief that ‘it has worked so well since the crash, why should we not do it’.  He believes investors should question passive investment from the perspective of “what are the circumstances that have created this and why should they persist”?  

Be aware of limitations of financial modelling 

While the rise of Artificial Intelligence is already at work in investment management, Neilson is of the view that financial modelling of companies has its limitations.  “It’s easy to observe winners in retrospect” he says. Recognising real talent, such as Bill Gates (Microsoft), before it is priced to perfection is where the real investment opportunities exist.

Great investors continually build their knowledge

The sources of available information has exploded with the internet.  Neilson highlights that if he wants to learn about computer chip design he can attend a lecture on YouTube.  “I agree with Buffett, it’s all about reading extensively and broadly” Neilson said. He also recommends investors should visit the website of companies they are investigating and listen to (or read the transcript) the quarterly/half yearly investor calls.  The Q & A section of these calls where management is put to the test by analysts is an excellent source of insight. 

Humility

The final take away from my time with Kerr Neilson was humility.  When asked what are the greatest mistakes he sees investors make, he came back with “We all make mistakes so we should be careful not to point the bone too eagerly”. When pressed on his proudest moment in investment management, Neilson’s response after a long pause was “pride comes before a fall, we don’t spend a lot of time on pride.  We at Platinum spend a lot of time on thinking about how many mistakes we have made and how to reduce those”.  

From my personal experience meeting with Institutional investors for over 20 years, the best investors are humble.

 

Below is a podcast of the interview.  Alternatively a full transcript can be seen by clicking on this link Full Transcript 

Thursday, 16 August 2018 09:32

The damaging visible hand

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This article is written by Hugh Giddy, Investors Mutual and has been reproduced with their permission on our website.

 

Students of economics learn early on that ‘there is no such thing as a free lunch’, an expression of the scarcity of resources. Those resources include things like labour and time as well as physical resources such as arable land.  Given that resources are not unlimited, much of early economic theory was devoted to the optimal and most efficient allocation or use of resources, as well as their valuation.  

Classical economics provides a foundation for much of our understanding of the economy.  Adam Smith, in The Wealth of Nations of 1776, describes the benevolent workings of the invisible hand of the market. Self-interested competition in the free market tends to benefit society in general by keeping prices low, while still building in an incentive for a wide variety of goods and services to be produced and supplied.  
The workings of the free market break down where there are monopolies, where prices would not remain low without some supervision or restraint, and where there are negative externalities that are not naturally priced or costed such as the quality of the environment.

The poor performance of planned economies in general (leading to the fall of the Soviet block and evidenced in the disparity in wealth between North and South Korea) is generally attributed to the removal of useful price signalling and incentives that exist in free markets.  Free markets and the invisible hand undoubtedly have flaws, but history has shown price controls and manipulation inevitably lead to shortages, inefficiencies and distortions.

Over time most economies have begun to adopt several measures to mitigate against some of the undesirable or politically unpalatable effects of free markets including minimum wages, universal minimum healthcare, and public housing, as well as competition bodies to ensure that industries do not become so concentrated that the markets no longer operate effectively.

Modern economies have one outstanding characteristic that is different to traditional economies: there is potentially no scarcity in money that is not backed by something physical like gold. Furthermore, interest rates and therefore the credit markets are explicitly manipulated by governments or their agencies.  It is one of many areas where the visible hand is quite dominant, and the influence is far from benign.

We are living in a period where growth is much slower than it was before the GFC, arguably because some of the credit excesses pre GFC have not been erased by an extended recession, and a proper reset did not occur.  Despite quite high levels of overall prosperity and high material standards of living across much of the developed world, rising income inequality and upheaval in traditional service and manufacturing industries has contributed to political polarisation and a rise in populist parties and leaders.  This in turn has made politicians in general more populist and likely to meddle in markets and more reluctant than ever to embrace any necessary but unpalatable economic policies.

Examples of poor policies abound and three Australian examples are discussed below: the insulation scheme, energy policy and the NBN. The focus will then turn to interest rates and credit.

Insulation scheme

The Rudd government, as part of a package designed to combat the economic effects of the financial crisis of 2007-8, announced a home insulation programme in February 2009.  By the time the scheme was abruptly abolished in February 2010, four installers had died and a Royal Commission was then set up to investigate the deaths.  By artificially boosting demand for insulation in a very short period, against the advice of the companies who made insulation, the government ensured huge distortions in the market.  The local producers, CSR and Fletcher Building, had to step up production and import product to keep up with soaring demand.  Knauf, a private German company saw the demand bonanza and set up in Australia for the first time using imports from the USA.  Insulation is a product one would normally not ship between distant continents as it is bulky and of low value, but the policy led to significant higher cost imports.  When the scheme was aborted:

  • huge excess inventories of insulation had to be destroyed at considerable cost to the producers (as insulation has a shelf life because it is packaged tightly to minimise space at the end of the production process)
  • a new competitor was introduced who arguably would not have spent the money setting up distribution, warehousing and sales channels
  • four people had died in the rush to take advantage of subsidies without reference to safety and training.  

Energy Policy

In Australia we have had a very inconsistent approach to energy policy in the area of renewables and carbon emission minimisation. Going through all the history in detail would no doubt be an insomnia cure for readers, the intention is simply to highlight that government meddling has distorted normal business economics.  

Renewables have needed subsidies to make them economically viable, particularly in Australia where we have traditionally had abundant cheap coal and gas.  Gas drilling has been outlawed in several states creating a shortage.  Elsewhere new coal power plants are currently being built delivering electricity at much lower cost than power prices in Australia, while locally coal would not be considered as a new source of power.  
Over time renewables will come down in cost, and in the distant future we might conceivably get all our electricity from hydro, wind and solar combined with battery storage, but that is some time away. In the meantime, Australian manufacturing is struggling, shrinking in an environment of very high power prices. Because we have disincentives for power from our cheapest and most reliable base fuel source, the consequence is higher power prices. Of course many people disapprove of coal and the carbon emissions, but at present we can’t have the luxury of being green and having the cheap power manufacturers require to be competitive internationally.

At present, owners of coal and gas generation have little incentive to invest in new generation or allocate capital to existing power plants.  Not only do renewable power sources receive subsidies, renewable plants have priority in supplying electricity to the grid, and it is expensive for baseload power to turn generation up and down depending how much wind there is.  Unsurprisingly, coal fuelled Hazelwood has closed in Victoria, almost all generation except renewables closed in South Australia and Tasmania, and Liddell (coal) is scheduled to close in NSW in 2022.  The previous excess supply of electricity has disappeared, and electricity prices have increased.  We have built renewables but of course renewables need the sun to shine or the wind to blow at the same time as there is demand for electricity.  Gas peaking plants are used to supplement renewables but are more expensive.  

The Government, wearing a populist hat, does not like the higher electricity prices which have resulted from uncertainty and their policies, and hence is seeking to restrain prices.   This will remove incentives to invest in the sector and possibly lead to shortages and emergency measures as happened in South Australia, and in Tasmania which had to buy expensive diesel generators because the rainfall was insufficient to provide all the required hydro power.  It is almost certain that government intervention in recent years has destroyed effective market signals, and politicians don’t welcome the unintended consequences.

NBN

In the telecommunications sector, the newly elected Federal Government decided in 2007 that Australia should have a national fibre optic network to carry broadband telecommunications, in a spirit of “nation building”. Tenders were submitted by various private parties including Telstra but none were accepted and overnight the Government Telcommunications Minister Stephen Conroy instead decided to form the NBN Corporation as a monopoly and to use Government funding to construct and operate the new network.  Estimates of the build cost quickly rose from tender levels (less than $10bn) towards $30 and $40bn, with the final number (over $50bn) still outstanding for a network that is not going to consist of as much fibre as originally claimed and speeds that have so far disappointed most users. The sorry tale of this white elephant will no doubt be material for a lengthy book in future.

The effect of the NBN has been to decimate the fixed line revenues and earnings of incumbent operators from Telstra and Optus to TPG and Dodo.  Unsurprisingly, companies reacted to mitigate the loss.  In particular, TPG has sought to cherry pick sites that would ordinarily be profitable for the NBN such as CBD buildings and apartment blocks where density makes for excellent economics in the context of pricing that is set with a view to cross subsidizing costly services to remote areas.  TPG has also bought spectrum to allow it to offer mobile services in the densely populated east coast cities, with the principal intention of offering mobile broadband as an alternative to the NBN (circumventing the NBN’s charges) rather than to become a major mobile player in itself.  The Government’s visible hand has greatly disrupted the industry, and few could argue that the project has been or will be an economic success.  It is certainly not living up to the fanfare with which it was announced.

In a low growth environment where many companies face challenges to maintain and increase profits, dealing with government interference can create significant unforeseen headwinds.  It is also hard for investors to anticipate these headwinds because they not only create market distortions; it’s often hard to find any beneficiaries other than lawyers and lobbyists as neither consumers nor businesses benefit over time, and hence such irrational policies are difficult to forecast.

Interest rates and credit

The greatest influence on the corporate and investment landscape by the visible hand of government is through interest rates and money.  Over time governments and their agencies have effectively devalued money through years of inflation which would not have been possible with disciplined monetary policies.  Inflation effectively favours borrowers over savers and therefore redistributes income without growing the value of the pie.  In recent decades credit growth has vastly outstripped income growth as banks have competed to lend to customers with increasingly poor creditworthiness, as lower interest rates have improved the affordability of the interest portion of loan service.

Because interest rates are effectively set or at least manipulated by governments, the huge expansion of credit is a direct result of government policy or at least government complicity.  Since the GFC the deliberate expansion of money and credit has been very explicit as Quantitative Easing has been pursued in many developed countries despite there being little or no evidence of any efficacy other than boosting financial asset prices.

Credit tends to support both asset values and consumption as many people now buy things they cannot immediately afford whereas a few decades back people only could buy what they had already saved up for.  Easy liquidity has driven up many asset values such as real estate, shares, commodities and bonds of varying quality.  Very low and even negative interest rates have destroyed useful market signals that would normally occur as investors have been pushed to take on risk beyond their usual preference in a desperate hunt for yields greater than the near zero safe yields.  

This in turn has allowed highly speculative companies and start-ups to prosper because they have had access to unusually cheap funding, in turn creating problems for their established competitors who may be relatively disadvantaged by having a more traditional and conservative approach to funding.  As Amazon has proved, it is very difficult to compete with a business that is very well funded by investors and lenders without having to deliver profits or cash flows for years.  A business that can sell things very cheaply and offer great service overall will virtually always succeed assuming that a lack of profits in the medium term is not a problem for the lenders and backers.  These are unusual times in that a lack of profitability is not necessarily perceived as a problem.  Abnormally low interest rates may have assisted consumers by creating competition in the short term but will not have helped should the disruptors become so strong they are effectively monopolies.

Governments’ visible hand in fostering the huge build up in debt and very loose credit conditions globally has also created a great deal of vulnerability for the economy.  High debt levels mean anything that changes perceptions of risk and therefore the willingness of private lenders to extend credit could have a major negative impact on the economy.

At IML we are very cognisant of the heightened risks in the economy and therefore continue to favour more defensive companies with more reliable and steady earnings.  This style has underpinned returns for our investors through a number of booms, busts and fads, and will continue to do so.

 DSC8761This article was written by Mark Draper and appeared in the Financial Review in the month of July 2018.

Mark writes a monthly column for the Australian Financial Review.

 

Good investors are rewarded for not just what they purchase, but just as much by what they let pass.  Could it be that much maligned short sellers could actually help investors avoid some of the stock market ‘bombs’.

Short selling is defined as the sale of a security that is not owned by the seller or that the seller has borrowed.  Short selling profits when the value of an asset decreases in price, enabling it to be bought back at a lower price.  By examining what short sellers typically look for as their targets can help retail investors avoid investment traps.

With this in mind I spoke with Andrew Macken, Portfolio Manager at Montgomery Investments who spent several years working with world famous short seller Jim Chanos.

Short sellers are sophisticated investors looking for weaknesses in businesses and business models.  Macken believes “there are 4 key characteristics that make a great short”.

  1. Structural decline at industry level.  These are structural headwinds within an industry that are likely to last for years not quarters.  Technological obsolescence is a good example of this characteristic such as video rental stores being disrupted by online content providers.
  2. Divergent Expectations.  This exists where market expectations built into the share price are overly optimistic.  Dominoes Pizza is currently one of the most heavily shorted stocks in the Australian market as short sellers question whether future growth may be at a lower level than what is currently reflected in the share price.
  3. Asymmetric risks.  This is when the downside risk is unequal, or greater than the upside risk.  These characteristics can lead to waking up one morning and seeing a share price down 30%. A stretched balance sheet is a good example of this, where one day the business is fine, and the next day the business fails to meet a debt covenant or refinance commitment.  Centro Properties was a high profile case study of this.
  4. Misperceptions.  These are instances of aggressive or creative accounting.  There are numerous ways in the accounting world that a business can be portrayed in a manner that is more flattering than the reality.  This can commonly occur during acquisitions where adjusting items such as goodwill can result in overstating future earnings. Fraud is the ultimate misperception. The Dick Smith IPO, which was labelled the “Greatest Private Equity Heist of all time” by Forager Funds Management is a classic example of a misperception and a detailed analysis on this can be found on their website.

Andrew’s ideal approach is to consider shorting companies that exhibit all four of these characteristics.

Those who own shares in a company that is being heavily shorted, means that sophisticated investors are flagging that some or all of these problems may exist in that company.  An increase in short selling activity could be an early warning signal that a problem exists.  So how can investors determine the level of short interest in a company.

ASIC provides a daily list of short positions on Australian listed companies on their website.  This information should also be available from a stock broker or financial adviser.  The information expresses how much of the company’s shares in percentage terms have been short sold.

Investors may be alerted to potential issues by watching trends of short selling activity and establishing whether the short positions are increasing.  

Clearly short sellers do not always get their calls right, just ask those who recently got burned being short in the Healthscope takeover offer.  But investors would be wise to keep an eye on short activity.  This could allow investors time to reconfirm (or otherwise) the investment case for a stock they own, or intend to buy, that is subject to material short interest.  As they say in sport, the team that makes the fewest mistakes wins, and maybe short sellers can help retail investors make fewer mistakes.

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)

 

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.

 

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.

 

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]

 

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