Thursday, 12 October 2017 15:12

Business model disruption has only just begun

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From a presentation by Hamish Douglass (CEO Magellan Financial Group) in October 2017

 

There’s a lot of business model disruption in the world and many companies will be left behind by the changes. There will be winners and losers in the years ahead, but sometimes business model disruption isn’t obvious. There are first-order effects when you have changes to business models, but when new technology and new businesses develop, it affects other businesses and other industries and it’s often not foreseeable. This is Part 1 of a two-part transcript.

Watch for second-order effects

If you look at a photograph of the Easter Parade in New York in the year 1900, it is full of horses and carriages. If you fast forward to 1913, the photograph is full of petrol-powered automobiles. Think about what had to happen, such as rolling out petrol stations. Transportation fundamentally changed in 13 years. In 1908, Henry Ford rolled the first Model-T Ford off the production line which enabled an automobile to be mass-produced at an affordable cost.

Many first-order effects are fairly obvious. If you manufactured buggy whips, you effectively went out of business. If you collected manure in the streets, you went out of business. There were 25 million horses in the United States in 1910 and 3 million in 1960.

The second-order effects aren’t as knowable. The second-order effects are what the automobile enabled to happen. An entirely new industry could move goods around far more efficiently. People could start the urban sprawl and move further away. We developed regional shopping centres due to the automobile.

Consider a simple change in technology, the automated checkout, such as in Woolworths and Coles in Australia. Walmart started rolling out these automated checkouts in around 2010 at scale and the other major retailers started doing the same. The first-order effects were a loss of jobs of the people working the checkouts, and retailers reduced their costs. And if one major competitor does that, other competitors follow, otherwise their cost structure is out of line.

But what of the second-order effects? Chewing gum sales have lost 15% of their volume since the introduction of automated checkouts in the US. The checkouts have disrupted the business model of impulse purchases. People do not drive to the supermarket to buy chewing gum, but when you used to stand in those checkout lines, you would pick up some chewing gum. I think mobile phones have had a bit to do with it too, because you now do other things when you’re standing there.

Our job as fund managers is to try and spot the next Wrigley. In 1999, at the peak of the technology bubble, Warren Buffett was asked by a group of students why he doesn’t invest in technology. He said he could not predict where the internet was going but investing in a business like Wrigley will not be disrupted by technology. And look what’s happened. Wrigley sales had gone up for 50 years, every year, before this change happened.

The pace of change is accelerating

Technology adoption appears to be accelerating. The chart below shows the number of years it takes to reach 50 million new users. We saw the rapid adoption with smart phones, and it only took Facebook five years to move from 1 billion to 2 billion users. These new technology-related businesses can scale at an incredibly fast rate.

I think there’s a whole series of factors explaining why this is happening, and a lot of things are starting to come together.

First, globalisation and the internet have enabled products to spread rapidly to much larger audiences around world. A second factor is the digitalising of goods and services. We have digitalised books, newspapers, music and videos. With Facebook, Google or Netflix, all their services are digital goods. Instead of spreading atoms around the world, we’re now spreading bits around the world where an identical copy of a digital good is produced at zero cost.

Third, the mobile phone today is more powerful than the world’s most powerful super-computer in 1986, in the year I left school, which is absolutely incredible. And now we’re connecting all these devices in ‘cloud computing’, where massive data farms don’t need computers to sit locally, and you can share all this information. So there’s a whole lot of infrastructure and change that’s enabling very rapid change.

The incredible power of two digital platforms

Consider the ‘GAF effect’ from Google, Amazon and Facebook. I don’t mean specifically those companies, but how they are affecting industries and important business models. First is the advertising industry. Google and Facebook know an enormous amount about their users. Anyone who uses Google has something called a Google timeline (unless you’ve opted out of it). On your Google timeline, in your user settings, you can go back five years and it will tell you exactly what you did five years ago if you carried your mobile phone, and most people do.

It tells you what time you left your house, whether you walked to the bus, which bus you boarded, if you went to work or not because it knows the address. If you take any photos on a day, it will put those photos on the timeline. It will tell you where you went for lunch, when you went home and if you went to dinner, it will tell you the restaurant. And this goes for every other day of your life for the last five years. It’s collecting enormous amounts of data about you, as are Facebook and others. That enables these platforms to start highly-targeted advertising and make it incredibly efficient.

In the last decade, traditional print advertising has lost about 24% market share, and I predict this will go to zero. It is extraordinary that outside China, two companies (Facebook and Google) have taken nearly the entire market share of a global industry that had many, many players in the world – magazine producers, newspapers producers, classifieds producers. All this revenue has ended up with two digital platforms that have this massive network effect. Television advertising, which is the largest pot of advertising money, has not yet been disrupted. We’re starting to see the rise of YouTube but it is still relatively small, as shown below. It’s probably got between US$6-8 billion of revenue at the moment, but it’s an industry with US$150-180 billion of revenue outside China.

Television is next

The television advertising business model is the next to fall due to two big factors. We’re experiencing the rise of these streaming video services. Think of Netflix, Amazon Prime, Stan, and Hulu, and Apple wants to enter this game. These businesses are spending enormous amounts of money on content creation. Amazon and Netflix this year will spend US$10 billion creating original content. They are far outspending anyone else on the planet. Facebook just bid US$600 million for the Indian cricket video streaming rights and were outbid by News Corp’s Fox. I think that’s one of the last-ditch efforts to protect sporting rights and there’s a battle going on between the television and the movie networks. Apple and Netflix are bidding for the next James Bond.

They are taking viewers away from television and pay TV which reduces advertising revenues. Then on the other side, the costs of producing the content and buying the best shows is being bid up. It is not a great business model if your revenues go down and your costs go up.

We’re also seeing the advent of new video advertising platforms. The streaming services are not advertising businesses, they are subscription businesses. But YouTube and now Facebook (and they’ve just launched Facebook Watch) are advertising business models, and I believe that a huge amount of the revenues that are currently in television and pay TV are at risk. It’s fundamentally different, because this is targeted advertising. These platforms know so much about the users that advertisements can be delivered specifically to what the users are watching on these new platforms.

The television advertising model as it currently stands gives a number of companies in the world a huge advantage because there are massive barriers to entry to promote products on television if you want to advertise at scale. It will be much easier to enter one of these new platforms. You can do very specific programmes if you are developing a new brand on Facebook, YouTube or Google compared with advertising on television.

The Amazon effect

Amazon is a business with an estimated US$260 billion in sales (including Whole Foods), the second largest retailing business in the world after Walmart. It’s a fascinating company. They run a ‘first-party’ business, where Amazon buys the goods, stores them in their warehouse and then sells them to their users via the Amazon website or mobile apps. Then they have a ‘third-party’ business called Fulfillment by Amazon, where other retailers put their own inventory into Amazon’s warehouse and then Amazon sells that inventory to their customers as well. So customers suddenly have a much greater selection, and Amazon charges other retailers rent for having their goods in the Amazon warehouse, then charges a commission for selling to the user base.

Amazon also is a massive logistics company. They are expanding warehouse space by about 30% a year and they are incredibly advanced from a technology point of view. They have developed with a robotics company something called the Kiva robot, with about 45,000 of these robots in their warehouses at the moment. Humans are good at putting goods in a package, adding a label and sending them off. But it’s inefficient for the human picker to run around the warehouse to find the shelf where that good is stored in these massive, multiple football field-sized spaces. So these robots automatically go around the warehouse and bring the shelves holding the product to the packers.

The loyalty scheme called Amazon Prime started out with two-day free shipping, then same-day and 2-hour free shipping in a number of cities around the world. Amazon Prime members receive free video, free music and free ebooks with the service.

Amazon is a also a data analytics company. They understand enormous amounts of information about what the customer wants to buy. Amazon members see web pages that look different to anybody else’s. There are 50 million goods available in Amazon so customers receive a particular look into the world.

Amazon’s Jeff Bezos wants to fulfil all of his customers’ shopping needs. He worked out that if you want to be in their everyday shopping, you need to be in the grocery shopping habit. They started with Amazon Fresh, an online grocery shopping business that’s very niche. But if you want chilled vegetables or meats or ice cream, it’s inconvenient to have them delivered on the verandah if you’re not there for two hours. A lot of people want to look at their fresh fruit and vegetables and not have anyone else choose that for them. So Bezos bought Whole Foods, the largest fresh food retailer in the US. It had a reputation for expensive produce, lots of organics, incredible displays. On the first day Bezos took control, on the key lines people are interested in, he dropped the prices 35-45%. People shop for incredibly good, fresh groceries then everything else can be put together.

He wants to connect your home by the ‘Internet of Things’. Many goods like washing detergent and milk will have computer chips on them that will connect to the internet to know when you are running out. Washing machines and fridges will automatically generate shopping lists. He’s adopting a voice platform for your house with a digital personal assistant.

What’s next?

There’s a massive number of these revolutions. You may think Amazon and Facebook and Google are big at moment, but we’re in the early stages of where this technology and these businesses are heading. Advertising and retailing is the start. Next week, I’ll discuss which large companies will suffer, and bring in the perspectives of Warren Buffett and Charlie Munger.

 

Tuesday, 26 September 2017 18:51

Rocket Man Kim - Keep calm and BUY shares

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by Jack Lowenstein (Morphic Asset Management)

 

A few weeks ago, US Ambassador Nikki Haley to the UN intoned that “the North Korean can couldn't be kicked any further down the road because there was no more road”. But a few weeks seems to be a long time in rhetorical road building because the can has just had another boot applied, and is still on terra firma. 

Meanwhile after brief jitters when North Korean missiles were flying and the dust from underground nuclear tests was settling, global stock markets reached new all-time highs again last week, and several major central banks confirmed they were moving ahead with monetary policy tightening. 

Many investors ask us why we don’t tend to get more nervous about potentially catastrophic geopolitical events.

This note is a brief description of why we try to stay calm even in the face of potentially devastating instability on the Korean peninsula, and what might make that wrong. For the record, we used recent jitters to slightly top up our investment in Korea’s largest company Samsung Electronics, which makes it now the largest holding in our portfolios.

I first had to contemplate the implications of tensions on the Korean Peninsula and their potential resolution in 1990. In most regards, nothing has changed. That doesn't mean it never will - but probably not for some time. 

That year, when I was still a journalist at Euromoney magazine, I was sent to Seoul to write about the financial consequences of the Koreans copying Germany and reunifying. It must have looked like a smart idea from the distance of London, where people were still excited about the end of the Cold War and the demolition of the Berlin Wall. 

In Seoul, it quickly became apparent the proposition was laughable. 

The South, with its population of 45m or so had a per capita income generally estimated at eight times as much as that ‘enjoyed’ by the 25m in the North. Having only just escaped extreme poverty, itself, however it could little afford the cost of investing in the North to bring it up to its level quickly or cope with an influx of starving northerners moving south. So few in the leadership had any real interest in reunification, even if they had to go through the motions of aspiring for it in public. 

In North Korea, the ruling elite would lose all their privileges if not their lives if their regime collapsed, so they would never support reunification. 

The other four interested parties also had no real interest in demarche. China didn't want a western-leaning democracy on its doorstep. Russia didn't want to lose a distracting irritant to the other superpower, the US. The US didn't want to lose valuable forward bases in Korea and Japan that were nominally justified by a belligerent Pyongyang. And Japan didn't want to lose a fully engaged US military in the region. Nor did it have much appetite for a larger northeast Asian economic competitor.

Today similar factors apply. 

Pyongyang has buttressed its position through nuclearisation. “Rocket Man” Kim, as President Trump has undiplomatically dubbed him, would know his chances of preserving power, wealth or indeed his life would be negligible under a united regime.

South Korea could probably afford to integrate the North now, but the challenge from internal migration would be acute, given per capita GDP in the south is now at least 20 times higher than the north. 

Japan might worry less about Korean reunification than in the past, given the greater threat the present situation poses than in the past. The increased challenge from China now also justifies the retention of US bases in Japan to both Washington and Tokyo. A resurgent Russia, however, would probably be more opposed.

The Chinese dilemma is exquisite. Many in the Beijing leadership probably hate being held hostage by Rocket Man. But to give him up, would entail a loss of face. There would still be no interest in a country with a western orientation being directly on the border, even if it was agreed US bases would be closed.

Sadly the most likely way this impasse changes is by accident. And it is almost impossible to manage money in preparation for that kind of discontinuous event. 

Challenger superpowers like China are highly prone to start wars. Sometimes this is to distract from temporary economic setbacks, like the three wars Germany fought against Denmark, Austria and France between 1860 and 1870. Sometimes, like emerging Japan prior to WW2, wars can happen because a field commander can make a blunder and no one at the capital wants to lose face by bringing him into line. 

Pyongyang has too much to lose from deliberately attacking anyone, but what if a rocket veers off target and lands in Japan or South Korea? Or someone in the line of fire erroneously believes a rocket attack is under way?

My old friend Jonathan Allum of SMBC Nikko today drew my attention to the story of Stanislav Petrov who has died at the age of 77. On the 26th September 1983, he was the duty officer at a Soviet military facility that monitored the threat of missile attacks. The following is condensed from the BBC version of what happened that day.

In the early hours of the morning, Soviet early-warning systems detected an incoming missile strike from the United States. The protocol for the Soviet military would have been to retaliate with a nuclear attack of its own. But duty officer Stanislav Petrov decided not to report it to his superiors, and instead dismissed it as a false alarm.

"If I had sent my report up the chain of command, nobody would have said a word against it… The siren howled. All I had to do was to reach for the phone; but I couldn't move. I felt like I was sitting on a hot frying pan…Twenty-three minutes later I realisedthat nothing had happened. If there had been a real strike, then I would already know about it. It was such a relief”

A subsequent investigation concluded that Soviet satellites had mistakenly identified sunlight reflecting on clouds as the engines of intercontinental ballistic missiles… 

A salutary tale. Let’s hope the world stays this fortunate. But these really don’t seem to be risks we can hedge.

Tuesday, 05 September 2017 08:02

North Korea and investment markets

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Written by Shane Oliver - Chief Economist AMP
 
Tensions with North Korea have been waxing and waning for decades now but in recent times the risks seem to have ramped up dramatically as its missile and nuclear weapon capabilities have increased. The current leader since 2011, Kim Jong Un, has launched more missiles than Kim Il Sung (leader 1948-1994) and Kim Jong Il (1994-2011) combined.

Source: CNN, AMP Capital
 
The tension has ramped up particularly over the last two weeks with the UN Security Council agreeing more sanctions on North Korea and reports suggesting North Korea may already have the ability to put a nuclear warhead in an intercontinental ballistic missile that is reportedly capable of reaching the US (and Darwin).

US President Trump also threatened North Korea with “fire, fury and, frankly, power” only to add a few days later that that “wasn’t tough enough” and “things will happen to them like they never thought possible” and then that “military solutions…are locked and loaded should North Korea act unwisely”. Meanwhile, North Korea talked up plans to fire missiles at Guam before backing off with Kim Jong Un warning he could change his mind “if the Yankees persist in their extremely dangerous reckless actions”. 
 
This is all reminiscent of something out of James Bond (or rather Austin Powers) except that it’s serious and naturally has led to heightened fears of military conflict. As a result, share markets dipped last week and bonds and gold benefitted from safe haven demand, although the moves have been relatively modest and markets have since bounced back.
 
At present there are no signs (in terms of military deployments, evacuation of non-essential personnel, etc) that the US is preparing for military conflict and it could all de-escalate again, but given North Korea’s growing missile and nuclear capability it does seem that the North Korean issue, after years of escalation and de-escalation, may come to a head soon. It’s also arguable that the volatile personalities of Kim Jong Un and Donald Trump and the escalating war of words have added to the risk of a miscalculation – eg where North Korea fires a missile into international waters, the US seeks to shoot it down, which leads to a cycle of escalating actions. This note looks at the implications for investors.

Shares and wars (or threatened wars)

Of course there have been numerous conflicts that don’t even register for global investors beyond a day or so at most if at all. Many have little financial market impact because they are not seen as having much economic impact (eg the war in Afghanistan in contrast to 1991 and 2003 wars with Iraq, which posed risks to the supply of oil). As such, I have only focussed on the major wars/potential wars since World War 2 and only on the US share market (S&P 500) as it sets the direction for others (including European, Asian and Australian shares).
 
  • World War 2 (September 1939-September 1945) – US shares fell 34% from the outbreak of WW2 in September 1939, with 20% of this after the attack on Pearl Harbour, and bottomed in April 1942. This was well before the end of WW2 in 1945. Six months after the low, shares were up 25% and by the time WW2 had risen by 108%.
  • Korean War (June 1950-July 1953) – US shares initially fell 8% when the war started but this was part of a bigger fall associated with recession at the time. Shares bottomed well before the war ended and trended up through most of it.
  • Vietnam War (1955-1975) – For most of this war US shares were in a secular bull market but with periodic bear markets on mostly other developments. Rising inflation and a loss of confidence associated with losing the Vietnam war may have contributed to the end of the secular bull market in the 1970s – but the war arguably played a small role in this.
  • Cuban Missile Crisis (October 1962) – Shares initially fell 7% over eight days as the crisis erupted but this was part of a much bigger bear market at the time. They bottomed five days before it was resolved and then rose sharply. This is said to be the closest the world ever came to nuclear war 
  • Iraq War I (August 1990-January 1991) – Shares fell 11% from when Iraq invaded Kuwait to their low in January 1991 but again this was part of a bigger fall associated with a recession. Shares bottomed 8 days before Operation Desert Storm began and 19 days before it ended and rose sharply.
  • Iraq War II (March-May 2003) – Shares fell 14% as war loomed in early 2003 but bottomed nine days before the first missiles landed and then rose substantially although again this was largely due to the end of a bear market at the time.

Source: AMP Capital
 
The basic messages here are that:
 
  • http://www.ampcapital.com.au/custom/reskin/images/bg-bullet-dot.png); padding-left: 11px; margin-bottom: 5px; background-position: 0px 8px; background-repeat: no-repeat no-repeat;">Shares tend to fall on the initial uncertainty but bottom out before the crisis is resolved (militarily or diplomatically) when some sort of positive outcome looks likely; 
  • http://www.ampcapital.com.au/custom/reskin/images/bg-bullet-dot.png); padding-left: 11px; margin-bottom: 5px; background-position: 0px 8px; background-repeat: no-repeat no-repeat;">Six months after the low they are up strongly; and
  • http://www.ampcapital.com.au/custom/reskin/images/bg-bullet-dot.png); padding-left: 11px; margin-bottom: 5px; background-position: 0px 8px; background-repeat: no-repeat no-repeat;">The severity of the impact of the war/threatened war on shares can also depend on whether they had already declined for other reasons. For example, prior to World War 2, the Cuban Missile Crisis and the two wars with Iraq, shares had already had bear markets. This may have limited the size of the falls around the crisis.

Possible scenarios 

In thinking about the risks around North Korea, it’s useful to think in terms of scenarios as to how it could unfold:
 
  1. Another round of de-escalation – With both sides just backing down and North Korea seemingly stopping its provocations. This is possible, it’s happened lots of times before, but may be less likely this time given the enhanced nature of North Korea’s capabilities.
  2. Diplomacy/no war – Sabre rattling intensifies further before a resolution is reached. This could still take some time and meanwhile share markets could correct maybe 5-10% ahead of a diplomatic solution being reached before rebounding once it becomes clear a peaceful solution is in sight. An historic parallel is the Cuban Missile Crisis of 1962 that saw US shares fall 7% and bottom just before the crisis was resolved, and then stage a complete recovery. 
  3. A brief and contained military conflict - Perhaps like the 1991 and 2003 Iraq wars proved to be, but without a full ground war or regime change. In both Iraq wars while share markets were adversely affected by nervousness ahead of the conflicts, they started to rebound just before the actual conflicts began. However, a contained Iraq-style military conflict is unlikely given North Korea’s ability to launch attacks against South Korea (notably Seoul) and Japan.
  4. A significant military conflict – If attacked, North Korea would most likely launch attacks against South Korea and Japan causing significant loss of life. This would entail a more significant impact on share markets with, say, 20% or so falls (more in Asia) before it likely becomes clear that the US would prevail. This assumes conventional missiles - a nuclear war would have a more significant impact.
     
Of these, diplomacy remains by far the most likely path. The US is aware of the huge risks in terms of the likely loss of life in South Korea and Japan that would follow if it acted pre-emptively against North Korea and it retaliates, and it has stated that it’s not interested in regime change there. And North Korea appears to only want nuclear power as a deterrent. In this context, Trump’s threats along with the US show of force earlier this year in Syria and Afghanistan are designed to warn North Korea of the consequences of an attack on the US or its allies, not to indicate that an armed conflict is imminent. Rather, comments from US officials it’s still working on a diplomatic solution. As such, our base case is that there is a diplomatic solution, but there could still be an increase in uncertainty and share market volatility in the interim. Key dates to watch are North Korean public holidays on August 25 and September 9, which are often excuses to test missiles, and US-South Korean military exercises starting August 21.

Correction risks

The intensification of the risks around North Korea comes at a time when there is already a risk of a global share market correction: the recent gains in the US share market have been increasingly concentrated in a few stocks; volatility has been low and short-term investor sentiment has been high indicating a degree of investor complacency; political risks in the US may intensify as we come up to the need to avoid a government shutdown and raise the debt ceiling next month, which will likely see the usual brinkmanship ahead of a solution (remember 2013); market expectations for Fed tightening look to be too low; tensions may be returning to the US-China trade relationship; and we are in the weakest months of the year seasonally for shares. While Australian shares have already had a 5% correction from their May high, they are nevertheless vulnerable to any US/global share market pull back. 
 
However, absent a significant and lengthy military conflict with North Korea (which is unlikely), we would see any pullback in the next month or so as just a correction rather than the start of a bear market. Share market valuations are okay – particularly outside of the US, global monetary conditions remain easy, there is no sign of the excesses that normally presage a recession, and profits are improving on the back of stronger global growth. As such, we would expect the broad rising trend in share markets to resume through the December quarter.

Implications for investors

Military conflicts are nothing new and share markets have lived through them with an initial sell-off if the conflict is viewed as material followed by a rebound as a resolution is reached or is seen as probable. The same is likely around conflict with North Korea. The involvement of nuclear weapons – back to weapons of mass destruction! – adds an element of risk but trying to protect a portfolio against nuclear war with North Korea would be the same as trying to protect it against a nuclear war during the Cold War, which ultimately would have cost an investor dearly in terms of lost returns. While there is a case for short-term caution, the best approach for most investors is to look through the noise and look for opportunities that North Korean risks throw up – particularly if there is a correction.
Tuesday, 05 September 2017 07:30

New Magellan listed trust - with a loyalty bonus

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Magellan Financial Group have announced a new listed investment vehicle, the Magellan Global Trust.

This ASX listed trust will commence trading on 18th October 2017, targetting an income yield of 4%pa and will be invested similarly to the Magellan Global Fund which has been established since 2007.

Existing investors in Magellan funds (both listed or unlisted) can apply for units in a priority offer and receive 6.25% worth of bonus units on the first $30,000 applied for.  Bonus value is up to $1,875, and to be eligible the Magellan Global Trust must be held until 11 December 2017.

The Priority Offer is open to any person who has a registered address in Australia or New Zealand and who, as at 5.00pm (Sydney time) on 1 August 2017, was a direct or indirect holder or investor in any one of the following (each an "Eligible Vehicle"):

  1. a)  Magellan Financial Group (ASX: MFG);

  2. b)  Magellan’s Active ETFs: Magellan Global Equities Fund (Managed Fund) (ASX: MGE), Magellan Global Equities Fund (Currency Hedged) (Managed Fund) (ASX: MHG) and Magellan Infrastructure Fund (Currency Hedged) (Managed Fund) (ASX: MICH);

  3. c)  Magellan’s unquoted registered managed investment schemes: Magellan Global Fund (ARSN 126 366 961); Magellan Global Fund (Hedged) (ARSN 164 285 661); Magellan Infrastructure Fund (ARSN 126 367 226); Magellan Infrastructure Fund (Unhedged) (ARSN 164 285 830); and Magellan High Conviction Fund (ARSN 164 285 947); and

  4. d)  at Magellan’s discretion, any fund or investment strategy for which Magellan is the investment manager or adviser.

 

GEM Capital will be flagging this issue to its clients directly, but in the meantime we attach a fact sheet about the offer.

 

Download Magellan Global Trust Fact Sheet

 

Download Magellan Global Trust Product Disclosure Statement

 

Thursday, 31 August 2017 09:44

Company reports can mislead investors

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We tracked how investors read company reports and here's how they're misled

File 20170828 27564 jnov8i The study used an eye-tracking device to ensure that all information included in the management report was read and considered in light of judgment formation. www.shutterstock.com Andreas Hellmann, Macquarie University

Investors would have spent a fair amount of time over the last few weeks poring over financial documents, as listed companies report their earnings and plans for the year to come. But our research shows they could have been misled just by the order of information in these reports.

We found that investors place more emphasis on the last piece of information in the management report included in company documents. Non-professional investors also ranked the performance of the company higher on more occasions, if the last piece of information is positive.

We invited 66 non-professional investors in our laboratory to read a management report of a fictitious mining company containing a short series of complex and mixed information. The positive information contained in the report told of increases in financial profitability and a strong operating cash flow. Negative information included a declining share price and increases in costs.

We randomly assigned the participants to two groups. The first group read the textual information included in the report in a sequence of positive information first and negative last. The second group read exactly the same information, but for them it was presented in the opposite way, negative before positive. We used an eye-tracking device to ensure that all information included in the management report was read and considered in light of judgement formation.

The investors we studied actually used the fictitious information in their investment decisions. Over 60% of participants were less inclined to invest in the fictitious company when negative information was presented last.

Easily mislead

Research into the behaviour of investors shows that the presentation order of financial information influences their judgements on company performance.

Because of the limited attention span and working memory capacity of the human mind, investors give more weight to information received later in a sequence.

So although financial information is often regarded as objective, neutral and value-free, the deliberate presentation ordering of information is able to influence non-professional investors. Companies could use this to try and hide negative information in the middle sections of a narrative and disclose positive information at the end of a sequence for the greatest effect.

Presentation ordering is not the only trick companies may use to influence the perceptions of annual report readers.

Graphs can attract investor’s attention and can be more easily retained in their memory than other narratives. Because of this, companies use significantly more graphs highlighting favourable rather than unfavourable performance.

One concern that arises from our findings is that readers of financial information may be mislead into believing there is more objectivity in practice than actually is the case. With regulatory efforts largely related to quantitative information, companies have much more flexibility in terms of how they present narrative information accompanying the financial statements in their reports.

Perhaps further guidance on the presentation of the management commentary is required by the global regulators to restrict the possibility that companies may influence the impressions conveyed to users of accounting information.

The ConversationMaybe next reporting season investors should take another look at what information companies include in their reports.

Andreas Hellmann, Senior Lecturer in Accounting, Macquarie University

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

Thursday, 01 June 2017 07:37

Is Telstra good value after the dip?

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Written by Tim Kelley - Montgomery Investment Management

 

Telstra (TLS) is not high on the list of businesses we would most like to own. Having said that, it is not a terrible business, and at the right price it makes sense to own it, particularly given its steady dividend stream. So, with TLS’s share price down around 20 percent over the past year, we decided to assess its value.

One of the appealing features of TLS is its stability. Over many years, the company has delivered consistent revenues at consistent margins for consistent earnings. On the face of it, this should allow us to value the company fairly readily.

However, for several reasons the future for TLS looks different to the past: Firstly, migration to the NBN will take a large bite out of TLS’s fixed-line business, offset somewhat by a series of one-off and recurring payments it will receive from NBN Co. for handing over its copper and HFC networks. Secondly, there is the matter of TPG Telecom (TPM) planning to become Australia’s fourth mobile network operator.

Given this, we think it makes sense to split the valuation into four components:

A “business-as-usual” valuation of TLS based on historical financial metrics; A valuation of the earnings “hole” left by the migration to NBN; The present value of payments TLS will receive from NBN Co; and An adjustment for the impact of increasing competition in mobile.

We consider each of these in turn.

“Business-as-usual”

As noted above, TLS has historically been a very stable business, and the “business-as-usual” valuation is a relatively straightforward extrapolation of historical financials. Using an 8% cost of capital and a 1.5% p.a. growth rate, we arrive at an estimated value of just under $50 billion for the equity in TLS, or around $4.20 per share.

NBN earnings hole 

We then come to the NBN earnings hole. TLS has provided guidance as to the EBITDA impact it expects when the migration is complete, and our “business-as-usual” valuation gives us an implied EBITDA multiple with which we can capitalise this impact. We estimate that this amounts to a fairly meaningful $17.4 billion of equity value, equivalent to around $1.46 per share.

Payments from NBN Co.

Happily, this earnings hole is largely compensated for by one-off and recurring payments it expects to receive from NBN Co. TLS has provided estimates of the value of these payments, but we believe the discount rate applied to these payments should be lower than the one TLS has used (which is generally 10%). We have evaluated TLS on the basis of an 8% WACC, and we see these payments as having somewhat lower risk than the overall TLS business, and so we apply a 7% discount rate. On this basis, we estimate the value of payments yet to be received from NBN Co at around $16.9 billion after tax – a larger figure than quoted by TLS, and one that substantially makes up for the value lost from TLS’s fixed line business.

Increasing competition

Finally, we consider the impact of TPM’s entry into the mobile market. As a point of reference, we note the impact of the 2012 entry into the French market by low-cost operator, Free mobile. In that example, ARPUs for the leading player, Orange, declined by 10-15% over several years, as the new entrant moved to take market share of 15%.

This sort of outcome would imply a very material loss of value for TLS. However, for a range of reasons, we expect TLS to experience a less dire outcome. These reasons include:

Free benefitted from a roaming agreement with Orange. However, the ACCC has indicated it does not support roaming in Australia. This is an important constraint on TPM which plans to spend relatively little on its network build and will achieve relatively limited population coverage; Approximately 53% of TLS mobile subscribers are outside the major cities, and therefore less vulnerable to competition, as TPM focuses its network spend on the major cities; A large part of TLS’s mobile revenues are derived from business subscribers, who would also be less susceptible to a TPM offering; and Across its entire customer base, TLS maintains a price premium position in the Australian market due to perceptions of coverage and quality. TPM’s low-cost offering will more directly impact Optus and Vodafone (and is thought to potentially be a strategy to pressure Vodafone into a consolidation).

Our valuation of Telstra

Taking these factors into account, we anticipate a couple of percentage points of lost market share for TLS, and perhaps a 5% decline to ARPUs. On this basis, we estimate that the value of TLS falls by around $4.3 billion, or around $0.36 per share – still a material impact.

We then assemble the different valuation components into an overall picture, as follows, to arrive at an estimated value for TLS equity of around $44.8 billion, which equates to around $3.77 per share.

Against today’s share price of $4.42, this makes TLS look around 15% expensive, although it should be noted that we consider large sections of the Australian equity market to be expensive, so this conclusion perhaps comes as no surprise. It is also worth noting that different judgements around discount rates might lead other analysts to a different conclusion.

The Montgomery Alpha Plus Fund – which is fully-invested and uses a machine learning model analysing many different variables to drive investment decisions – holds a modest position in TLS in its long portfolio. For the Montgomery Fund, however, we are particular about valuation and are happy to hold cash when value is scarce. Accordingly, TLS does not find its way into our long-only funds at the current price, regardless of its dividend-yielding appeal.

Written by Richard Watt - Fidelity Investments
 
Political risks subside 
Perceived political risks in Europe have detracted from European equity performance over the past year, with around US$100bn flowing out of European markets in 2016. With the election of Emmanuel Macron as the next French President, much of that risk has been reduced and investors may now focus on the performance of European companies.
 
Here we look at the key benefits that the Macron win may bring to the European economy and its equity markets.
 
Pro-reform, pro-integration 
Macron is a reformist and pro-European. He is in favour of greater integration in Europe, the strengthening of European institutions and a common Eurozone budget that would protect from future economic shocks. He has campaigned on reforms of the labour market in France, reforms of the tax system and tax cuts, and raising the retirement age, which is currently one of the lowest in Europe. 
 
Along with this, he plans to invest EUR50bn into the French economy. This would be funded by reducing the size of the French state - by far the largest of any European country.
 
All of this would be hugely beneficial to what is a relatively uncompetitive French economy, and to the future strength and stability of the Eurozone.
 
Political risks diminishing 
Sentiment towards Europe has been particularly strong since the first round of voting in France two weeks ago, seeing European and French markets up 7-8%. With either the upcoming UK or German elections representing an existential risk to Europe, much of the political risk is behind us. Investors will likely focus on corporate fundamentals and earnings. 
 
Earnings turn
Since the financial crisis, while US companies have seen margins and earnings recover, European earnings are still below their peak. The underperformance of European stocks relative to US stocks has been exclusively driven by the lack of earnings delivery of European companies. 

European earnings revisions turning positive 

Source: Fidelity, Datastream, Morgan Stanley , data as of 6 Apr 2017. N12M ERR (%) = 12-month earnings revision ratio. 3MA = 3-month moving average.

What we are now seeing is a strong recovery in European stocks, with earnings starting to come through. Margins are recovering and the most recent earnings season in Europe has been the strongest in more than 10 years. 

Particularly compelling for European equities is their valuation. As they have been out of favour for much of last year they are trading at a multi-year discount relative to the US on a price-to-book basis. And today, record high numbers of European companies have a dividend yield that exceeds their bond yield.

European P/B vs US P/B

Source: Datastream, GS Research, data as of 31 March 2017. 

Percentage of stocks with dividend yield > bond yield

Source: Datastream, Goldman Sachs Global ECS Research, December 2016. Stoxx Europe 600.  

Conclusion
Europe has been significantly out of favour for some time due to political risk. The French result today puts much of this behind us and European equities are looking attractive compared to the US and other markets and asset classes. We are now starting to see companies deliver strongly on earnings, removing another key detractor from investor sentiment. 
 
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets. 


This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity Australia product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading it from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

Wednesday, 03 May 2017 08:36

French election in 3 charts

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The final phase of election for President of France comes to a close on May 7th. After the first round of voting, voters are left to choose between Marine Le Pen (hard right) and Emmanuel Macron (Centre). We know that Marine Le Pen stands for France leaving the EU, which would be particularly problematic given France was a founding member of the EU.

The issue of leaving the Euro currency would be complex. In our opinion this is the last of the key elections in Europe this year given that there seems to be high quality candidates from both sides in the German elections later this year. The financial markets were relieved to see the final two candidates of Macron and Le Pen, as it was earlier feared the 'Hard Left' may get through to the final round against the 'Hard Right'. The French share market rose by over 4% the day following the election result.

That said, the final election result is still yet to be decided, so we thought it timely to bring you the latest thinking in this important election. The first round voting was close but Macron was the ultimate winner securing 24% of the vote, with Le Pen in second place.

 

There are some similarities to the Trump election in the composition of voting, where Le Pen is appealing to the 'rust belt' in France, gaining support from those negatively impacted by globalisation.

 

Finally, we finish on the voting intentions of French voters for the Final Round and note that unlike the US election and Brexit, the French polls have been very accurate.  The polls currently suggest a comfortable victory for Macron - but we are likely to be more comfortable once the final result is known.

 

 

Hugh Giddy and Anton Tagliaferro (Investors Mutual senior management) recently wrote about the Trump induced rally in share markets.  The title of their publication is "Trump's election as President - has it changed the world that much?

The article covers their views of the US and China in particular, written in an easy to follow manner, and littered with some amusing quotes.

You can download your copy of this article by clicking on the icon below.

 

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Monday, 01 May 2017 10:55

Will Amazon destroy retail as we know it?

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Mark Draper (GEM Capital) recently spoke with Clay Smolinski (Platinum Asset Management) about the threat to retailers of Amazon.  Clay talks about how investors should be thinking about Amazon.