Mark Draper

Mark Draper

Wednesday, 16 January 2019 05:37

Some reasons for Optimism for 2019

This article was written by Andrew Clifford (CEO Platinum Asset Management)

 

Keep Calm and Carry OnThe clear opportunity in markets is the value presented by cyclical assets in a world that is growing reasonably well with mild, positive inflation.

The clear threat is very highly priced secular growers, especially in tech, and more interestingly in safety – in low volatility/high quality businesses – much beloved by both algorithmic traders and investors seeking havens.

The outlook for corporate profit growth into 2019 appears solid, if unspectacular. On the other hand, many equities globally are priced for dire outcomes. The result could be strong performance for cyclical assets in 2019 and beyond.

Current consensus earnings expectations in the 20 largest equity markets globally for the next 12 months are for 10 per cent growth1. Consensus expectations may prove too high, but are far from implausible relative to earnings expectations of 11 per cent among companies we own in the Platinum International Fund2.

And yet many major markets are trading very cheaply. For instance, South Korea on eight times earnings, China on nine, Germany on 11 and Japan on 123.

Leaving aside the abstraction of market multiples, many very good global companies are trading on low valuations. For instance, Samsung on six times, BMW on seven, Daimler on six, Itochu on six, Skyworks Solutions on 10 and Glencore on eight4.

Once it was hard to find a stock on 10 times earnings.

Cyclicals are cheap

Company BMW Daimler  Samsung  Itochu  Glencore Skyworks Solutions
PE ratio 7x 6x 6x 6x 8x 10x
Earnings yield  14% 17% 17% 17% 13% 10%

Source: FactSet

We think there is a significant divergence between investor perception and reality; investors are pricing dire outcomes in the global economy when they are pricing cyclical assets so cheaply.

It is entirely possible there will be a continued de-rating of financial assets buoyed by the easy money policies of the past 10 years, such as high-flying tech stocks and high quality/low volatility stocks. The global economy, however, is in reasonable shape, growing at approximately trend rates. Indeed, this is precisely why rates are rising.

Is safety safe?

The result of investor uncertainty, plus passive investing, has been huge outperformance of both tech stocks and high quality/low volatility stocks.

While tech stocks such as the FANGs (Facebook, Amazon, Netflix and Google/Alphabet) attract a great deal of commentary, the performance of low volatility/high quality stocks such as Procter & Gamble or Nestle has been remarkable.

The share prices of many such companies are at record highs, at earnings multiples well above 20 times. Many such businesses have barely grown operating earnings in five years and have been gearing their balance sheets to buy back stocks. In a rising rate environment, they appear vulnerable.

Global growth

Global growth appears solid, if unspectacular, as we head into 2019. The International Monetary Fund, for instance, expects global GDP growth of 3.7 per cent5, in line with 2018, and this seems realistic to us based on what we can see through our portfolio of companies.
Global manufacturing’s Purchasing Managers Index (PMIs) are indicating ongoing mild expansion, with the November reading coming in at 52. This compares with 50 in 2015, consistent with zero growth.

Within this, PMIs in China are at neutral 50 readings, Europe slightly expansionary in the low 50s and the US strong in the mid-50s6.

JPMorgan Global Manufacturing PMI to November – mildly expansionary

Source: FactSet

China has already stimulated

After major tightening of financial conditions in 2017 and 2018, these have recently loosened significantly. The cumulative effect of capacity closure in heavy industry, diminished investment in infrastructure and other fixed assets, plus restrictions on consumer and small-to-medium-enterprises, and the impact of trade disruption has been, in effect, an over-tightening of financial conditions in China in 2018.

In response, Chinese authorities have cut reserve requirements in the banking system, lowered effective tax rates for individuals and increased liquidity in the banking system (as indicated in the Shanghai interbank offered rate, or Shibor).

One might expect this to lead to increased economic activity in China in coming months.

Shibor: indicates loosening financial conditions

Source: Bloomberg. Data to 23 November 2018. Shibor is the Shanghai interbank offered rate – a short-term interest rate.

Trade war

Simply put, the US is not “winning the trade war”; everyone is losing. The US trade balance has deteriorated over the course of the year and export PMIs have collapsed globally, including in the US.

To understand why, imagine you must run supply lines for a firm in Hamburg, Seattle or Guangzhou and you don’t know what tariffs will apply on January 1, 2019. A tough job.

Now imagine being the Chief Financial Officer of the same firm. Should you abandon current, highly efficient supply lines in China and invest in capacity in Vietnam, Cambodia or Bangladesh? You don’t know if tariffs are permanent or a bargaining chip that will disappear soon. Another tough job.

Export PMIs globally reflect uncertainty

Source: FactSet, Markit/HIS, Deutsche Bank. Data to October 2018

Perhaps all this is masterful positioning ahead of negotiations, but this stretches credibility in our view. The simpler explanation is that this is politicking.

We expect ongoing headlines and market skittishness surrounding trade aggression. We would note this is a headwind for global profit growth, given the long, intricate supply lines of large companies (for instance, one large chipmaker has 16,000 suppliers, according to the Economist).

US trade balance

Source: Bloomberg

In summary, markets have been made turbulent by trade disputation and macro-economic fears, as well as rising US interest rates. Higher rates argue for lower (PE) multiples on equities and this process has been ongoing over the course of 2018. We expect this to continue in 2019, with the tech and safety trade (low volatility/high quality stocks) looking vulnerable.

On the other hand, cyclicals usually outperform later in economic cycles, as accelerating growth drags rates higher. We have seen none of this in this cycle, and this may be in prospect given the remarkable value apparent in cyclicals.

Footnotes:
1 Source: MSCI, Credit Suisse. At 2 December 2018.
2 Using median FactSet consensus estimates on an annual basis for expected “FY1” (current unreported financial year) and “FY2” (following unreported financial year) net income, we compute the weighted harmonic average for the growth rate from FY1 to FY2 for Platinum International Fund’s positions. Excluding shorts, cash and loss makers.
3 Source: MSCI, Credit Suisse. At 2 December 2018. All multiples on a “next 12 month” basis.
4 Source: FactSet. At 2 December 2018.
5 Source: //www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWORLD" style="box-sizing: border-box; color: rgb(51, 122, 183); vertical-align: baseline; transition: all 0.3s ease; background-color: transparent;">https://www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWORLD>
6 Bloomberg. PMI is a survey-based measure of activity, with results of 50 indicating neutrality, greater than 50 expansion, and lower than 50 contraction.

This information has been prepared by Platinum Investment Management Limited ABN 25 063 565 006 AFSL 221935, trading as Platinum Asset Management ("Platinum"). It is general information only and has not been prepared taking into account any particular investor’s investment objectives, financial situation or needs. Prior to making any decision to invest in the Platinum International Fund you should obtain professional advice and read the latest product disclosure statement (PDS), a copy of which is available from Platinum’s website www.platinum.com.au. The commentary reflects Platinum’s views and beliefs at the time of preparation, which are subject to change without notice. The commentary may also contain forward looking statements, which have been based on Platinum’s expectations and beliefs. No assurance is given that future developments will be in accordance with Platinum’s expectations. Actual outcomes could differ materially from those expected by Platinum. No representations or warranties are made by Platinum as to the accuracy or reliability of the information contained herein and to the extent permitted by law, no liability is accepted by Platinum for any loss or damage as a result of any reliance on this information

Tuesday, 11 December 2018 14:20

Interview with CIA Deputy Director

Tuesday, 11 December 2018 14:04

AMP - opportunity or basket case?

This article appeared in the Australian Financial Review during the month of December 2018.  Mark Draper has spent his entire investing career never having bought an AMP share but finds himself interested now that the price is trading at an all time low.  Here is the article.

 

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

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

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

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

Source: Skaffold

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

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

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

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

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

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

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

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

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

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

Tuesday, 11 December 2018 13:54

Air New Zealand Christmas Ad

Tuesday, 11 December 2018 13:34

AMP - two bagger or falling knife?

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

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

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

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

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

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

Source: Skaffold

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

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

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

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

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

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

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

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

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

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

Thursday, 08 November 2018 11:56

Why Buffett likes Apple

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

 

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

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

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

Composition of the ASX 200

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, 08 November 2018 11:35

Bank Reporting Season scorecoard FY 2018

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

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

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

Bank reporting season scorecard October 2018

Click to enlarge

Scaling back the empire

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

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

Profit growth hit by remediation

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

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

Bad debts stay low

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

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

Shareholder returns hold as dividends steady

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

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

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

Interest margins

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

Total returns including share prices

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

– No star given –

Our overall view of the future

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

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

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

GEM Capital has made a submission to the Senate Inquiry into the removal of cash refunds from franking credits as we are of the view that this proposal singles out retirees to pay a high price in the name of budget repair.

Here is the Executive Summary of our submission.  A full copy can be downloaded by clicking on the icon at the bottom of this article.

 

"I am an Investment Professional who provides financial advice to retirees (and has done so for over 20 years).  Personally I will not be impacted by the proposal to remove franking credits as I will be able to use the franking credits.  It is in my capacity as a financial adviser to retirees, who most certainly will be impacted by this proposal, that I offer this submission.

Summary

I am of the view that the ALP proposal as it currently stands, to scrap cash refunds from franking credits, is very poor for the following reasons:

  1. This proposal is inequitable across different sections of the tax base.  Bill Shorten has argued that scrapping cash refunds from franking credits is aimed at the ‘big end of town’.  He then realised the reality is that it impacted the lower classes and he has since spared those receiving age pensions.  The reality is that the high income earners and high net worth individuals are unlikely to be materially impacted by this proposal.  Those who will pay the largest proportional price seem to be mainly ‘middle class’ retirees, while those at the higher and lower end are likely to be unaffected.
  2. This proposal is highly likely to encourage retirees to spend their capital and become more dependant upon the welfare system.
  3. This proposal provides a significant disincentive to save for the majority of Australians.
  4. This proposal adds further complexity to the taxation system, with accompanying compliance costs, that also rely on Centrelink’s systems for its integrity toward the exemptions.  I wonder whether the additional compliance costs have been included in the modelling of savings.
  5. This proposal changes the goal posts retrospectively to middle class retirees who do not have the option to build further capital to compensate for such material changes to their income.
  6. Retirees in our client base, already dealing with the changes to Asset Test for Age Pension effective 1st January 2017, are extremely anxious about further changes to their retirement income which materially impact their level of disposable income.  This is taking place at a time of record low interest rates and low prospective rates of return in financial markets. 
  7. This proposal may also result in retirees taking additional investment risk to achieve higher income returns to offset the loss of franking credits.  This could raise the prospects of capital loss, which could result in them becoming dependant upon welfare at a later stage, at a cost to the Government."

Wednesday, 10 October 2018 20:35

Just how far will property prices fall

Written by Roger Montgomery (CEO Montgomery Investments)

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

Source:  IRESS

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

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

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

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

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

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

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

Sign the Wilson Asset Management petition here

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