Mark Draper

Mark Draper

 Mark Draper and Shannon Corcoran (GEM Capital) speak with Clay Smolinski (Co Chief Investment Officer from Platinum Asset Management) about the latest developments in the Chinese property markets and their property developers.

Clay provides important background to allow investors to understand what has previously taken place in order to get where we are today.  He discusses the problems and solutions with respect to Chinese developer Evergrande and he outlines why he does not believe that these issues are likely to turn into the next financial crisis.

 

Music by Joel Laundy

 

 

Wednesday, 01 December 2021 08:11

The case against crypto as an investment

The mania surrounding crypto assets makes the dotcom boom of just over 20 years ago look totally credible, many professional investors say.

It is clear that blockchain, the distributed ledger technology behind crypto, is real and will serve many benefits to society in years to come similar to the development of the internet.  The concern for many professional investors revolves around the specific crypto currencies themselves.

The RBA recently published a paper outlining three types of digital assets:

  1. Cryptocurrencies – these have their own currency unit and are not denominated in the currency of or backed by any sovereign issuer.  Bitcoin is the most prominent with a market cap of US $1.1 trillion.  Another example is Dogecoin which was started as a joke in 2013 now has a market cap of around US $30bn
  2. Stablecoins – are designed to have a relatively stable price, typically  through being pegged to a commodity or currency.
  3. Central bank digital currency (CBDC) – is a potential new form of digital money that would be a liability of the central bank.  It could be like a digital version of cash possibly accessible via wallets on phones.

Good investors consider not only the positive aspects of an investment case, but where they could be wrong.  Many crypto investors seem almost evangelical in their approach and scoff at alternate views to their beliefs.  There are indeed many similarities to 1999/2000 in the unwavering belief that new tech companies back then (coins today) would take over the world and never face anything but sunny futures without competition or regulatory change.

Michael Collins an investment specialist at Magellan Financial Group says that one of the flaws of crypto currency is that the system is based on mutual trust which is unstable because trust is fragile and sub-networks can emerge if members disagree on procedures.  Bitcoin in 2018 splintered after members adopted new protocols incompatible with prevailing ones.  

Another problem is that distributed ledgers appear just as vulnerable to cyberfraud as any other technology, which could suddenly ruin their value, even if bitcoins blockchain has proved secure so far.

Then there is the regulatory risk according to an anonymous institutional investor who said the most common transactional use is money laundering.  Investors can not pay tax with crypto, which implies it is difficult to argue it as a true currency.

Collins says that the other regulatory risk relates to financial stability.  If enough bitcoin circulated in an economy, monetary policy would lose its potence as a macro tool to control inflation and economic activity because it would have no influence over ‘parallel’ cryptos.  There are problems too with calls for central banks to issue their own digital money (CBDC) to the public to gain total control of the money supply and improve the payments system.  The biggest risk is that it would eradicate the four-centuries-old fractional reserve banking system because banks would no longer receive the same level of deposits on which they base their lending.   If bank deposits fell enough, the question then would be which institutions would conduct the lending that is the lifeblood of capitalism.

John Addis founder of Intelligent Investor believes crypto is a digital ‘wild west’.  He nominates another big problem with crypto is that it is ‘non-custodial’, which means investors maintain control of their own keys and assets.  If the keys are lost, the value is gone and if the system is hacked, or there is a scam, there is no recourse.  The Canadian crypto exchange, Quadriga, which collapsed in 2019, owed US$190m to 115,000 customers.

While ASIC recently approved a crypto based ETF, product approval by a regulator is in no way an endorsement or guarantee of investment success.  ASIC chairman recently urged investors to be careful investing in crypto, and highlighted the regulator is virtually powerless to intervene which means consumers are ‘on their own’.

Bill Gates sums crypto up beautifully with the words “my general thought would be that if you have less money than Elon Musk, you should probably watch out”.

When it comes to its true worth, bitcoins ultimate vulnerability is that it has no intrinsic value.  Gold has other purposes and besides is a means of payment.  Government backed currencies can be used to pay taxes and for services.  Bitcoin is  worth what the next person will pay for it which may become only a fraction of today’s price.

 

 

This article appeared in the Australian Financial Review on 1st December 2021

Wednesday, 01 December 2021 08:11

The case against crypto as an investment

The mania surrounding crypto assets makes the dotcom boom of just over 20 years ago look totally credible, many professional investors say.

It is clear that blockchain, the distributed ledger technology behind crypto, is real and will serve many benefits to society in years to come similar to the development of the internet.  The concern for many professional investors revolves around the specific crypto currencies themselves.

The RBA recently published a paper outlining three types of digital assets:

  1. Cryptocurrencies – these have their own currency unit and are not denominated in the currency of or backed by any sovereign issuer.  Bitcoin is the most prominent with a market cap of US $1.1 trillion.  Another example is Dogecoin which was started as a joke in 2013 now has a market cap of around US $30bn
  2. Stablecoins – are designed to have a relatively stable price, typically  through being pegged to a commodity or currency.
  3. Central bank digital currency (CBDC) – is a potential new form of digital money that would be a liability of the central bank.  It could be like a digital version of cash possibly accessible via wallets on phones.

Good investors consider not only the positive aspects of an investment case, but where they could be wrong.  Many crypto investors seem almost evangelical in their approach and scoff at alternate views to their beliefs.  There are indeed many similarities to 1999/2000 in the unwavering belief that new tech companies back then (coins today) would take over the world and never face anything but sunny futures without competition or regulatory change.

Michael Collins an investment specialist at Magellan Financial Group says that one of the flaws of crypto currency is that the system is based on mutual trust which is unstable because trust is fragile and sub-networks can emerge if members disagree on procedures.  Bitcoin in 2018 splintered after members adopted new protocols incompatible with prevailing ones.  

Another problem is that distributed ledgers appear just as vulnerable to cyberfraud as any other technology, which could suddenly ruin their value, even if bitcoins blockchain has proved secure so far.

Then there is the regulatory risk according to an anonymous institutional investor who said the most common transactional use is money laundering.  Investors can not pay tax with crypto, which implies it is difficult to argue it as a true currency.

Collins says that the other regulatory risk relates to financial stability.  If enough bitcoin circulated in an economy, monetary policy would lose its potence as a macro tool to control inflation and economic activity because it would have no influence over ‘parallel’ cryptos.  There are problems too with calls for central banks to issue their own digital money (CBDC) to the public to gain total control of the money supply and improve the payments system.  The biggest risk is that it would eradicate the four-centuries-old fractional reserve banking system because banks would no longer receive the same level of deposits on which they base their lending.   If bank deposits fell enough, the question then would be which institutions would conduct the lending that is the lifeblood of capitalism.

John Addis founder of Intelligent Investor believes crypto is a digital ‘wild west’.  He nominates another big problem with crypto is that it is ‘non-custodial’, which means investors maintain control of their own keys and assets.  If the keys are lost, the value is gone and if the system is hacked, or there is a scam, there is no recourse.  The Canadian crypto exchange, Quadriga, which collapsed in 2019, owed US$190m to 115,000 customers.

While ASIC recently approved a crypto based ETF, product approval by a regulator is in no way an endorsement or guarantee of investment success.  ASIC chairman recently urged investors to be careful investing in crypto, and highlighted the regulator is virtually powerless to intervene which means consumers are ‘on their own’.

Bill Gates sums crypto up beautifully with the words “my general thought would be that if you have less money than Elon Musk, you should probably watch out”.

When it comes to its true worth, bitcoins ultimate vulnerability is that it has no intrinsic value.  Gold has other purposes and besides is a means of payment.  Government backed currencies can be used to pay taxes and for services.  Bitcoin is  worth what the next person will pay for it which may become only a fraction of today’s price.

 

 

This article appeared in the Australian Financial Review on 1st December 2021

Friday, 05 November 2021 08:20

Before you invest in Hydrogen

With the Glasgow climate summit around the corner the market is buzzing with excitement surrounding hydrogen.

Investors should ask themselves whether this is the next ‘big thing’.  But before rushing into the new Hydrogen ETF, or buying Fortescue Metals on the basis of their interest in hydrogen, investors should pause for thought.

Hydrogen is seen as being crucial to achieving net zero carbon emissions given that when burned, hydrogen emits mainly water.

Jodie Bannan an Investment Analyst with Platinum Asset Management says that the first thing to consider is hydrogen is not a primary energy source that exists by itself in nature. It requires primary sources of energy (coal, natural gas or renewable electricity) to split it from oxygen in water or carbon in hydrocarbons. This means there is energy lost with each conversion and transport to end use and this needs to be considered when thinking about suitable applications. 

Natasha Thomas a Portfolio Manager at Ausbil Global Infrastructure highlights that there are two main ways to make hydrogen – via electrolysis of water which uses a great deal of electricity to split water into hydrogen and oxygen, or reforming natural gas into hydrogen and CO2.

Hydrogen made from electrolysis of water using renewable electricity is labelled ‘green’ hydrogen and according to Thomas is more expensive.  Market cost estimates range between US $5.00 - $8.00 per kgH2, with the price estimated to fall to US $1.25 - $2.70 per kgH2 by 2030.  This is attributed to the falling costs of renewable electricity generation and scaling up electrolyser manufacturing.

Thomas compares this with market cost estimates for ‘grey’ hydrogen (from steam methane reform) at US $1.00 - $1.75 and blue hydrogen (steam methane reform followed by capturing and storing the CO2 by-product underground) which costs US $1.40 - $2.45 per kgH2.

Bannan believes that a hydrogen price of around US $1.50 per kgH2 is needed to put it on parity with fossil fuel depending on the use.

 

 

In 2020 the International Energy Agency (IEA) reported that demand for hydrogen was 90 million tons.  Bannan said that about 48% was produced using natural gas based steam methane reform, 30% is a by product from oil refining, 18% using coal and 4% from water electrolysis.

In terms of the uses for hydrogen today, currently over half is mixed with nitrogen to make fertiliser or used in oil refining and methanol production.  

In looking to the future Bannan believes that new opportunities for hydrogen applications come from the growing need to eliminate CO2 emissions from process industries that are hard to electrify such as steel, cement and gas fired power plants.

Thomas adds that other future uses are likely to include transportation either as hydrogen-based fuels for shipping and aviation or as hydrogen fuel cells for electric vehicles.  As global transportation currently generates 24% of direct CO2 emissions from gasoline and diesel combustion, the use of green hydrogen would significantly reduce emissions.

Despite the momentum in hydrogen around the world, its place in the global energy mix still has many unknowns.  The IEA forecasts by 2050 hydrogen could make up 10% of the global energy mix and Bloomberg NEF forecasts that green hydrogen by 2050 could be cheaper than natural gas in some regions.

This brings investors to the opportunities in the hydrogen sector.  Bannan says there are traditional companies such as industrial gas companies that transition to hydrogen production over time.  Then there are technology pure plays such as fuel cell makers, electrolysers and carbon capture companies.  New technology is required to lower the cost of hydrogen production and the technology companies are often building capacity ahead of demand which is a key risk to consider.  Most of the technology companies are estimated to be loss making for the next five years.  These companies may not have the balance sheet to fund themselves or are reliant on government funding or tax incentives which may be unreliable. 

If investors believe that green hydrogen will be successful, Thomas believes the biggest opportunities are in the renewable energy sector which provide electricity to hydrogen production.

Energy infrastructure companies such as natural gas pipeline networks and equipment storage providers that may already be supplying the gas sector already, also stand to benefit from hydrogen and may be a lower risk of gaining hydrogen exposure.

The developments in hydrogen have some way to go. Any delays in rolling out green hydrogen could be met with scepticism, but investors would be brave to bet against its progress.

 

 

Every month, Mark Draper (GEM Captial) writes a column for the Australian Financial Review.  This column was published in the first week of November 2021.

Mark Draper (GEM Capital) and Shannon Corcoran (GEM Capital) recently spoke with Hugh Dive (Chief Investment Officer Atlas Funds Management) about the key themes he saw from the most recent company reporting season.

Running time around 30 mins.

Music clip by Joel Laundy.

Mark Draper (GEM Capital) and Shannon Corcoran (GEM Capital) talk with Nathan Bell (Head of Research at Intelligent Investor) about the investment cases for Sonic Healthcare, Telstra and Magellan Financial Group.

 

 To listen to the podcast, click on the link below.  Podcast time 41 mins.

 

Music clip by Joel Laundy

Wednesday, 06 October 2021 08:55

The Great Energy disconnect

Each month Mark Draper (GEM Capital) writes for the Australian Financial Review.  Here is the column that appeared in the 6th October 2021 edition.

 

The oil and gas sector is one of the most unloved sectors in the market according to Luke Smith, Resources Portfolio Manager at Ausbil Investment Management.

The demand destruction for energy resulting from pandemic lockdowns saw oil futures briefly trade as a negative value in April 2020 as oil demand endured its largest fall since 1945.  Since that time the oil price has recovered from around US$20 per barrel to now over US$70 per barrel.

Hugh Dive, CIO at Atlas Funds Management adds that LNG is currently selling for around 4 times the price it was 12 months ago.

Dive says that normally share prices in energy companies are highly correlated to the underlying prices for oil and gas, but currently there is a disconnect.  Despite the oil price rising 250% from US$20 per barrel to over $70 barrel since April 2020, the share price of Woodside has barely moved, and the energy sector trades well below their pre COVID levels.

Gaurav Sodhi, analyst at Intelligent Investor believes that oil equities are severely mispriced by investors who have given up on stocks that don’t tick the ESG box (Environment, Social, Governance).  

Smith says that the long term oil demand outlook is structurally challenged for reasons including the automotive industry moving to electric vehicles over combustion engines.  This is causing some investors to question whether the current strength in energy prices is sustainable.  Of the broader commodity set, oil markets have been one of the hardest hit by COVID, and given the materiality of transportation to demand, is yet to fully recover.  Transportation represents 60% of overall oil demand and during COVID lockdowns passenger vehicles, buses, freight, maritime and aviation transportation was severely impacted.

We have seen a recovery in road and maritime activity according to Smith, however uncertainty remains around the return of international travel.  Jet fuel represents 7% of overall oil demand.

 

 

Dive is of the view that world oil markets are rebalancing after the collapse in demand during 2020, which can be seen in the chart.  While policies in Western countries will reduce oil demand through moves to clean energy, these are likely to be offset by increases in demand from China, India and other Asian countries.

Smith’s near term bull case for energy revolves around the lack of investment in new supply since the prior downturn in oil markets in November 2014.  He believes that the combination of reduced investment overall, and misdirected investment away from large scale oil developments, supports the expected tightness in markets over coming years.

Dive says that climate change remains a risk to the energy sector, but paradoxically these concerns may see few new major producing assets being developed, putting upward pressure on oil prices.  While rich countries such as Norway can mandate that all taxi’s are Tesla’s,  developing nations are unlikely to accept lower growth rates and slower reductions in poverty to meet climate targets set by rich European nations.

The recent fund manager survey conducted by BofA Securities, showed the energy sector was the most underweight sector in the market relative to its history.  

Sodhi is of the view that oil prices are likely to be higher than most anticipate.  He says that there is little doubt that equity prices don’t reflect oil prices, and that it is easy for investors to ignore the energy sector when energy producers are not making money.  As oil producers start to print good cash flow numbers, perhaps as early as next reporting season, the market will either change its mind or investors will get rewarded with dividends.  

Ausbil’s preferred investment in the sector is Santos due to superior management and its diverse portfolio of low cost assets with an exceptional growth outlook.

Dive and Sodhi like Woodside which they describe as ‘fantastically cheap’ with a cost of production below US$5 per barrel, low gearing at 19% and a huge franking account balance.  

The case against investing in energy according to Sodhi revolves around the possibility of the Saudi’s potentially wanting to monetise their huge resources faster than expected.  They could flood the market with oil, thinking that getting something for oil is better than leaving it stranded.

Energy shares are cheap and investors need to assess whether they represent good value or are a value trap.

Tuesday, 14 September 2021 13:19

Investment GEMs podcast - September 2021

Mark Draper (GEM Capital) and Shannon Corcoran (GEM Capital) recently spoke with Clay Smolinski (Co-Chief Investment Officer, Platinum Asset Management) about whether he is optimistic or pessimistic about COVID.

We also spoke with Clay about what the recent regulatory changes introduced by the Chinese Government mean for investors ..... plus more.

Click on the image below to listen to the podcast.

 

Thursday, 09 September 2021 13:43

Utilities - high income with growth

Investing in utility companies is the equivalent of buying “Water Works” or “The Electric Company” on a monopoly board.  It’s not the excitement of owning Mayfair, but they pay a steady income to their owners.  Utility owners on the ASX also enjoy relatively high levels of income, some as high as 6%, within a stable business.

Utilities according to Hugh Dive, Portfolio Manager at Atlas Funds Management are characterised as businesses that have some form of monopoly, extensive capital to construct their assets, steady demand and varying degrees of government regulation.

 

Gerald Stack, Head of Infrastructure at Magellan Financial Group likes to illustrate the idea of utilities by referencing electricity.  There are four distinct aspects to the provision of electricity starting at power generation.  The electricity is then transported over high voltage transmission lines before the voltage is reduced and transported over distribution lines to consumers.  The final stage is that electricity is marketed to consumers through retailers.  

Only the transmission lines and the distribution lines are considered utilities by Magellan as they are the only parts of the electricity chain that are monopolies.  Generators and retailers are excluded by Magellan as they are subject to competition and are therefore generally not considered utilities.  This is an important aspect of investing in utilities, as investors owning parts of the chain that are subject to competition and price changes, will receive a different outcome.

Stack believes that investors should own utilities for their predictable, reliable profitability which typically means that dividends are also reliable and predictable.  

Dive says that utilities can provide a hedge against market falls.  During the sharp 21% ASX fall in March 2020, regulated utilities were among the least impacted stocks on the ASX.  Spark Infrastructure and APA Group only declined by 4% while Ausnet posted a 1% gain.

Investors can gain exposure to Australian utilities via ASX companies including Spark Infrastructure (powerlines and transmission), Ausnet (gas pipelines, powerlines and transmission) and APA Group (gas pipelines).  Alternatively investors can access exposure via Infrastructure funds, which also have the benefit of being able to seek global opportunities.

Dive and Stack both agree that the main risks to investing in utilities relate to regulation and interest rates.

Investors need to understand that utilities can earn income that is regulated, or revenue which is contracted.  Typically regulated income allows the utility to earn what the regulator assesses as a fair rate of profit and usually the regulatory regime is fixed for a period before being reviewed.  For example electricity distributors in Australia usually operate under 5 year regulatory periods.  Contracted revenue occurs when there is a legal contract for services between the utility and the end user.  

Investors also have to feel comfortable with the jurisdiction they are investing in.  Australia, UK, US and Canada are generally considered regions where investors have comfort in the regulatory framework and can obtain recourse through the legal system.  Some developing countries require more caution in this area.

Utilities are often financed with a significant amount of debt, therefore a change in interest rates can have a material impact on operating profits without the protection afforded by regulation, according to Stack.  However the regulatory regime will normally allow for protection from the impact of changes in interest rates so that profitability is largely unaffected.  Changes to interest rates can not only impact operational profits, but also the assessment of fair value of the utility by the markets.  Generally lower interest rates result in higher utility values and of course the reverse applies.

A significant pick up in inflation that could lead to central banks raising interest rates could lead to a reduction in appetite for investment in regulated utilities.

While utilities are traditionally known as an income play for investors, there is potential too for growth.  The need for communities to reduce carbon emissions to ‘net zero’ offers significant opportunities for electric utilities.  Key steps in the transition include significant increases in the amount of renewable energy and the electrification of economies including electric cars.  Renewable energy projects and the need to increase the capacity and reliability of the electricity grid offer significant investment opportunities.

High income with growth, it’s little wonder that the utilities sector is starting to attract takeover attention.

 

Every month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article appeared in the 8th September 2021 edition

Wednesday, 11 August 2021 07:56

Smart ways to play reopening trade

To many Australians right now, the re-opening of the economy must seem like a mirage.  Investors should consider the opportunities that come from depressed share prices in sectors hit hard by lockdowns, otherwise known as the re-opening trade.

The re-opening trade seeks to invest in businesses that have been negatively impacted by COVID-19 and are trading well below their valuation based on a normal operating environment.  Obvious candidates include travel, shopping centres, airports and even private hospitals which have suffered due to cancellation of elective surgery.

Investors must ask themselves whether the current state of lockdowns and border closures is a permanent feature or not.

Nathan Bell (Head of research, Intelligent Investor) says that reopening the economy will be as bumpy as it is inevitable, as the cost to taxpayers and businesses is already stratospheric and Australia can't afford to be left behind the rest of the world.

So far, the number of hospitalisations and deaths in countries with highly vaccinated populations that are reopening, such as the UK, are low for those who've been vaccinated. Provided this continues, international borders between similarly vaccinated countries will be opened according to Bell.

The vaccination rates in the US, UK, China and Europe are high, evidenced by the graph below.

 

In Europe the average number of departing passengers hit 2.1 million per day in the last week of June, up 39% on the 1.5 million recorded just three weeks before.  

Hotel occupancy in the US has doubled from 35% to 70% in the first six months of the year and US airlines expect passenger numbers to be close to normal within a matter of months.  Dan Moore (Portfolio Manager, Investors Mutual) says that US consumer spending is actually ahead of pre-COVID levels.

In China, 99% of pre-COVID aircraft are flying again.  The International Air Travel Association recently forecast that global passenger numbers recover to pre-COVID levels by 2023.

These statistics indicate that Australia could head toward a speedy recovery in the travel sector once the vaccine program becomes well advanced.

Moore is looking at countries who are ahead of the curve with vaccinations and analysing data such as mobility, employment activity, consumer spending, housing and industrial production as a way of developing a lead indicator for Australia.

Moore’s advice to investors seeking to profit from the reopening trade is firstly to look for depressed share prices, but checking this is not due to a large dilutive equity raising.  He then suggests investors ask themselves whether the company’s future prospects are permanently impaired.  Moore favours focussing on companies with a strong balance sheet so they can weather short term set backs, and are industry leaders.  He cites United Malt, one of the largest global suppliers of malt to the beer and whiskey industry as a good example.

Moore likes Virgin Money, a UK bank that is priced at a fraction of its Australian counterparts when measured using a price to book basis.  The reopening of the UK economy has seen an increase in consumer spending, resulting in growth in credit card lending and mortgages for Virgin Money.

Moore is wary of some travel companies that do not have strong balance sheets.

Bell’s advice about the best ways of playing the reopening trade is “carefully”.  He says that  many stocks impacted heavily by COVID have already had a full recovery baked into their stock prices, while others have vulnerable balance sheets that could disintegrate if the economy doesn't get back to 'normal' relatively soon.

Bell adds that Stocks such as Star Entertainment, Auckland Airport and skydiving company Experience Co will be direct beneficiaries of the great reopening with solid balance sheets and plenty of room for their valuations to increase as profits and dividends recover.

Another sector that has been hard hit by the pandemic is the energy sector whose share prices are not yet reflecting the recovery in the oil price.

The key risk facing investors choosing to invest in the re-opening theme is a return to lockdowns in countries with high vaccination rates such as the UK, US, the Nordic countries and Israel.  

Investors will learn a great deal about this in the coming months.

 

Every month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article was published on Wednesday 11th August 2021.

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