In times of war, look hard before leaping to sell

War usually brings about uncertainty, and the natural reaction for some investors can be to sell during these times. History shows that selling at the start of a conflict can be a hazard to long term wealth.

Clay Smolinski, co-Chief Investment Officer and Portfolio Manager at Platinum Asset Management says that looking back on nine of the most significant global geopolitical shocks over the last 30 years, the markets tend to look through the periods of geopolitical conflict.  The table shows the ‘standard’ experience is for share markets to initially fall in the first week and month post the event, and then the market to recover over the following months as the conflict is unlikely to have a lasting material impact on economic fundamentals or company profits.

War

Smolinski highlights that the First Gulf War in 1990 and the Russian invasion of Ukraine in early 2022 follow a different pattern where markets failed to recover 12 months after the event.  He argues that the long term negative stock market reactions in those situations were due to factors other than the geopolitical tensions, such as the oil price shock in 1990 and 1991 and the increase in interest rates in 2022.  In the case of Russia’s invasion of Ukraine, the MSCI AC Europe index is near all time highs nearly two years after the start of the war.  

Hugh Dive, Chief Investment Officer from Atlas Funds Management believes that investors should think about the companies they own in their portfolio and the actual links to the conflict in question.  For example, is the military conflict likely to impact CSL’s sales of life saving biotherapies or will the conflict impact Woodside’s LNG sales or what consumers buy at Bunnings.

If the conflict is unlikely to impact sales in the companies investors own, then the initial share market panic can present a buying opportunity for long term investors according to Dive.  

Smolinski says that investors should consider the unique aspects of each conflict.  The stock market returns outlined in the table above are largely made up of countries where the conflict was not happening on their own home soil. Investments in Russia post the Ukraine invasion fared very differently.  

Smolinski believes it is important to think ‘will this business be bigger and stronger in 5 years time?’  if the answer is yes, a pullback in prices can provide a buying opportunity.

With reference to the current conflicts, Smolinski points to the risk that the focus on the Israeli/Hamas war diminishes the attention on Ukraine and gives Russia time to refocus, rebuild and carry on its war in the Ukraine.  The resistance effort within Ukraine requires continued aid from the US and EU and should this aid be diverted to the Middle East, it may change the calculus around ceasefire treaties from the Ukrainian perspective.

Platinum is also paying attention to the role China is playing on the world stage during these conflicts.  In particular, the uncomfortable position they are maintaining keeping Russia as an ‘ally’, whilst also keeping trade routes open and maintaining trade with both the US and the EU.  

Dive thinks the key risk in the middle east is if the conflict widens as it did in 1914 from a conflict between Austria-Hungary and Serbia, to engulf Europe.  This could disrupt global oil flows and the corresponding spike in energy prices would have a negative impact on the global economy.

Investors should continue to monitor these issues.

Dive says that investments that typically perform well during wartime include defence companies, energy companies and commodity companies particularly gold for its ‘safe haven’ status.

Investors can be drawn to other ‘safe haven’ investments such as food retailing, but care should be taken to ensure investors do not overpay for these assets simply to hide during geopolitical tension.

Smolinski suggests investments that can struggle during conflicts include airlines due to increased energy prices and reduced demand for travel.  Financial stocks also have been consistent underperformers during conflicts, with insurance stocks faring the worst.

The geopolitics of today’s world is uncertain, but it always has been.  Investors need to keep newsflow in perspective and act on information rather than running with the herd.

 

Mark Draper writes monthly for the Australian Financial Review - this article appeared in the 15th November 2023 edition.

October trading updates

In October each year, listed Australian companies with a June financial year end host their annual general meetings (AGMs). Fund managers rarely attend these events as they are designed to allow retail investors to pose questions to company management and vote on directors and the company’s remuneration report. Institutional investors do not vote in person but rather by instruction to the custodians holding their fund’s shares. They would have met with company management in August when they released their financial results.  

In this week’s piece, we will look at the quarterly trading updates given by a range of Australian companies to try and piece together what is going on in the Australian economy. While the broad-based fall in share prices since mid-September suggests that companies are struggling, the quarterly updates showed robust trading conditions for many Australian companies.

agm 1666575a

Normally, we don't pay much attention to AGM's and the trading updates given by management are usually very similar to the conditions the company was facing in August. However, this October has seen greater interest in company updates at the AGMs due to the sharply changing economic conditions. Over the last 18 months, the average mortgage rate has increased from 2.14% to 6%, along with cheap fixed-rate mortgages converting into higher variable rates dubbed the "fixed rate cliff" by the media. This should have seen cratering retail sales in 2023 and significant falls in house prices, neither of which have occurred. Consequently, Atlas has been looking closely at management presentations over the past two weeks at company AGMs. 

AGM & Trading Updates for Q1
Company  What Happened  Our Interpretation 
Woolworths Group sales up 5%, food inflation continues to moderate A good result with consumers trading down to cheaper alternatives
Coles Group sales up 7%, Ecommerce sales up 32% Supermarket Sales below market expectations with EBIT margins suffering 
Ampol  Total fuel sales volumes up 26%, EBIT up 65% Higher refining margins and fuel sales saw earnings above market expectations
Mineral Resources Lithium volumes up 80%, Iron ore voumes up 9%, Mining services up 14% Volumes up from mine expansions though offset by lower realised prices
Dexus $1.3 billion in divestments with the CEO Darren Steinburg stepping down  Market concerned about the falling office occupancy
JB Hi-FI Top line sales was flat compared to Q3 2023 A great result in which was thought to be a deteriorating market 
Wesfarmers  No explicit Update to guidance that Bunnings and Kmart are in good shape Sales continue to grow in hardware, office supplies and discount retail. New Lithium mine completed
Fortescue Iron Ore mined up 4%, Ore shipped down 6% Operational performance was in line with expectations 
Region 4% sales growth, 98% occupancy In line with market expectations
Woodside Sales volume up 10%, driven by 8% increased in production. Sales volumes were above consensus but offset by lower realised prices
Bapcor Lower retail and non-discretionary revenue The result was lower than what the market was looking for but not a structural problem with the business
Atlas Arteria Traffic volume up 2.3%, Revenue up 6.1% Traffic higher than pre CV-19,  revenue increasing at a faster rate due to inflation escalators
Transurban  Highest ever quarterly average daily traffic  Traffic higher than pre CV-19,  revenue increasing at a faster rate due to inflation escalators
CSL Retained guidance for profit growth of between 13-17% In line with expectations, expected boost once in Australian dollars
Harvey Norman Australian sales down -14% Weaker sales result than JBH indicating loss of market share to rival
Endeavour Group sales up 2.1%, driven by 5% price inflation but less items sold Weaker sales result, market concerned about Dan Murphy and BWS Strategy

 

Retail Mixed 

The non-discretionary grocers had a good start to their years, with Woolworths and Coles posting sales growth of over 5% for the first quarter. The grocers both mentioned that food inflation is moderating in late 2023 to between 2-3%, with the prices for some items such as fruit, vegetable and packaged meat now falling. Higher interest rates have seen shoppers trading down to cheaper home brand items, which deliver a higher profit margin, with Woolworths citing an 8% increase in home brand sales.  Liquor retailer Endeavour saw modest sales growth at BWS and Dan Murphy's of 1.8% and like the grocers, experienced value-conscios customers trading down to mainstream beer, rose and pre-mixed drinks.

JB Hi-Fi's first quarter was much better than expected, with Australian sales falling -1.4%, cycling off a very strong first quarter last year. Conversely, electrical goods rival Harvey Norman saw Australian sales falling by -14% but announced a surprise $440 million on market buy-back as a salve for investors. Atlas' calculations indicate that the company will be borrowing to buy back their shares, an aggressive move from an already highly geared company in a market with rising interest rates and weakening retail sales. JB Hi-Fi appears to be benefiting from their lower cost business model, which has seen them take market share off Harvey Norman.

Wesfarmers produced a fantastic first-quarter result, demonstrating that consumers are still willing to spend money and trade down to lower-cost products across their offerings. We see that Bunnings and Kmart, the lowest-cost operators across the hardware and discount department store markets, will continue to benefit and take market share over the short-medium term.

Miners 

The iron ore producers had in-line first quarters and are continuing to benefit from higher iron ore prices but will face headwinds over the coming months and years. BHP, Rio Tinto, and Fortescue are all facing inflationary problems, with higher oil prices set to be higher for longer and ongoing labour costs, which will increase production costs. We remain cautious towards the iron ore producers due to concerns about the sustainability of iron ore prices above US$100/t in the face of a slump in Chinese residential construction and a government plan to cap steel production at 1 billion tons per annum. 

Energy powering ahead 

Woodside Energy had a solid quarter, with production up +8% to 48 million barrels of oil. The company also announced that they had started producing at a new field in the Gulf of Mexico which was six months ahead of expectations, which saw full year guidance being upgraded.  Woodside Ahas little exposure to a weakening Australian consumer, selling energy into a global market primarily via long-term off-take agreements to utilities in Japan, China and Korea. Stronger energy prices in the latter part of 2023 and a weaker Australian dollar are setting Woodside up for a strong finish to the year. Similarly, oil refiner and petrol retailer Ampol released a stellar quarterly update in October, showing that profits were up +65% on the previous quarter. The company continues to benefit from higher fuel sales, strong margins from refining crude and, surprisingly, an increase in convenience retail sales. We had expected a big fall in convenience retail sales for Ampol due to higher petrol prices, but motorists are still buying Gatorades, Mars bars and Guzman y Gomez burritos after filling up! 

Toll Roads Stronger than Ever

After the Ampol quarterly that showed Australian fuel sales were up +11%, it was not a great surprise to see the toll road operators report strong traffic numbers in October. Transurban reported record quarterly average daily traffic across their network with 2.5 million trips per day, with traffic up +3% on the prior period. Similarly, Atlas Arteria saw traffic up +2.3% in the past quarter, mainly in their French assets, with revenue up a healthy 6.1%. Due to the impact of quarterly escalators on their inflation-linked tolls and long-term fixed-rate debt, higher traffic will see expanding profit margins. 

Healthcare robust, but weight loss Fears Dominate.

The past quarter has been tough for investors in healthcare stocks, with the dominant theme being concerns that GLP-1 weight-loss drugs will impact demand for a range of therapies treating sleep apnea, cardiovascular diseases and kidney damage.  Indeed, these weight loss drugs have even impacted the share prices of pathology testing companies under the assumption that a potentially slimmer society will result in fewer oncology, fertility, gastrointestinal and respiratory tests. 

Resmed has seen its share price hit the hardest,  losing a third of its market capitalisation due to the view that slimmer patients will see diminished demand for sleep apnea devices. While this may occur in the future, Resmed's quarterly update showed revenue of +16% and profits up +9%. Similarly, CSL's share price has been under pressure due to the unproven potential of the GLP-1 weight-loss drugs on the company's kidney disease treatments, despite dialysis comprising a small part of company earnings . At their annual capital markets day in October, CSL revealed that the company was trading strongly and confirmed guidance for profit growth in 2024 between 13-17%. 

 Our Take  

Global equity markets have fallen by close to 10% over the last three months, and at the close of October 2023, many companies on the ASX200 are trading near or even below the lows of March 2020 despite having better business operations and higher profits in 2023. Toll road operators Transurban and Atlas Arteria are trading at a 25% discount to their pre-COVID share price despite higher traffic volumes and toll prices. Similarly, healthcare companies Sonic Healthcare and CSL both have share prices below January 2020 despite having higher earnings per share and servicing more customers worldwide. While some companies will struggle in an environment where money is no longer free or falter due to higher geopolitical tensions, for many companies, these factors will have limited to no impact on corporate profits and distributions to their shareholders.

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine” – Warren Buffett.

 

 

This article was written by Hugh Dive, Chief Investment Officer Atlas Funds Management and reproduced on GEM Capital website with his permission.

Qantas - what should investors do now?

One of the key issues for investors is to determine whether the recent woes at Qantas are temporary or permanent.  If they are permanent, that spells danger, but if the issues are temporary it could provide opportunity.

Matt Williams, the head of equities at Airlie Funds Management says that the Qantas Domestic business and the Loyalty businesses are the most profitable in the Qantas group and the most highly rated by investors.  Qantas Domestic accounted for over 40% of operating profit and the Loyalty business generated $1bn of free cash flow in the 2023 financial year.  He says that this is unlikely to change and while the ‘fallout’ remains unknown, consumers will still fly and spend on their credit card.

Qantas earnings chart

Williams adds that earnings are very sensitive to changes in demand and demand has been very strong coming out of COVID.  Qantas Domestic capacity is almost back at pre COVID levels, while Qantas International capacity is 66% of pre COVID levels, which provides some opportunity for growth.  He is of the view that Qantas earnings are more likely than not to be closer to peak earnings in the short/medium term, particularly given the fall in Qantas average fares (both domestic and international) of 11% in the last 6 months of the 2023 financial year.  Jetstar domestic recorded a 17% fall in average fares.

Nick Markiewicz, portfolio manager from Lanyon Asset Management says that Alan Joyce is leaving the business with record profitability, but with low public support, fragile Government relations, and a near record capital expenditure bill.  From these facts one could make a powerful argument that short term profit objectives have been pursued ahead of the longer term interests of customers.  

Markiewicz believes that while the profit pendulum may have swung too far in one direction more recently, this needs to be considered against some of the reasonable long term decisions by management.  These include the establishment and growth of Jetstar, resetting union relations, the restructuring of Qantas (particularly the International arm) back to profitability in 2014 and the navigation of COVID.

Williams believes the problems at Qantas are fixable but they will take time and money.  Markiewicz is of the view that the history of corporate scandals suggests that the current furore around Qantas is likely to be short lived, particularly given the change in leadership.

So if the problems are fixable, does the current share price represent opportunity?  Markiewicz says the share price is at the same level as it was in mid 2017, despite net income doubling over this period.  As a result the Qantas price earnings (PE) ratio has fallen from around 10 times to 5 times earnings, which is amongst the lowest in Qantas history.  This also compares favourably to global peers, where the median PE ratio is 6.6 times, making Qantas one of the cheapest airlines in the world.

The share price appears to be factoring in risks such as changes in Government attitude toward Qantas, potential for increased competition and the need to upgrade the fleet in coming years.

Williams flags that history is littered with companies that have tried and failed to compete with Qantas (Tiger, Compass, Ansett, and Virgin 1.0), so its risky and he considers it a lower probability.

Markiewicz highlights the group’s fleet age has increased from 7.7 years in 2014, to nearly 14 years in 2022, putting it just below the global average. Management intend to purchase 65 aircraft over the next three years. This will see annual capital expenditures rise above $3bn for each of the next three years. This will directly impact profits, which will in turn, make future earnings far more sensitive to changes in revenue.

The more noticeable impact will be to free cashflow, which will likely fall to negligible levels as these aircraft are received. This raises risks for shareholders, as it increases the importance of the operating business sustaining record profits to fund these purchases, and means management may have to draw on the balance sheet (i.e increase debt) if they want to pay a dividend or continue buying back stock.

However new aircraft will add to the airlines customer proposition as well as significantly reduce fuel burn and other operating costs.

Investors should invest into companies that have rising customer satisfaction and strong balance sheets.  Generally profits follow customer satisfaction.  For Qantas this is a work in progress.

 

 

Each month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article appeared in the 20th September 2023 edition.

Cheat sheet for reporting season

Good investors constantly ‘take the temperature’ of the economy, and companies, in order to make decisions.  Company reporting season offers investors a smorgasbord of information, but investors need to assess what information is useful.

This reporting season draws to a close at the end of August and is expected to feature broad themes according to Hugh Dive, Portfolio Manager at Atlas Funds Management.  These include 1) effect of higher interest costs on earnings 2) impact of inflation on operating costs 3) lower Australian dollar and 4) slowing consumer demand as a result of higher interest rates.

Every sector needs to be looked at differently, so some of Australia’s leading fund managers share their views on what investors should be looking for from this reporting season.

The banking sector is probably one of the most widely owned in Australia, but Nathan Bell, Portfolio Manager at Intelligent Investor, highlights that most banks have produced next to no capital gains over the past two decades despite the largest credit and housing boom in history.  He expects investors will suffer more of the same over the next decade as net interest margins are not going back to the high levels of years ago.  CBA’s result showed lower net interest margin as a result of higher funding costs, depositors switching banks for higher deposit rates, which are offsetting the benefits from higher mortgage rates.  While Bell expects bad debts to remain low, margin pressure and relatively high valuations doesn’t augur well for future returns.

major banks net interest margin

Dan Moore, Portfolio Manager at Investors Mutual says that investors in discretionary retailers should pay attention to the level of inventories as this will highlight the outlook for margins.  High inventories is negative for margins.  Dive believes that the sales results for the first 4 weeks of July, which is announced when companies report, is a key indicator of future sales activity.

For supermarkets Moore is focussing on signs of consumers ‘trading down’ and switching to own label products which can protect margins.  Dive will be watching for wages pressure and goods inflation and whether these higher costs can be passed onto consumers.  An increase in a supermarkets net margin implies that higher costs have been passed on successfully to consumers.

Bell says that the ferocious competition in the Telco sector has recently been replaced with more sensible and higher pricing.  Average revenue per user (ARPU) is the key metric he is looking for to determine whether consumers are accepting price increases.  Given Telco’s low margins, small movements in ARPU can have a huge bearing on profits and dividends. Telstra recently announced ARPU increased by 5.4% and profits grew by 13%.  The 3 major telco’s have all increased their prices in recent times which should flow through to their financial statements this reporting season.  Moore also looks at customer growth relative to peers to highlight whether consumers are trading down to budget carriers.

The important aspects for the property sector according to Moore are the re-leasing spreads, which is defined as the difference between the new rent and the prior expiring rent.  Positive spreads indicate future rental growth and vice versa.  Industrial spreads are likely to be positive while office spreads remain under pressure.  Dive says that another focus will be on valuations and expects falls in shopping centres and office trusts with minimal movements in industrial.  The cap rate used to determine valuation is key, (higher cap rate results in lower valuation) so investors should make sure the cap rate used is appropriate.  

Bell thinks that profit results from iron ore miners will play second fiddle to expectations for the iron ore price. Supply is expected to increase over the next couple of years, plus China’s lower focus on fixed investment bodes poorly for Australia’s iron ore miners given their current high valuations.

Markets are forward looking by nature.  Profit reports that on the surface appear poor, but result in the share price rising, suggests the market was factoring in a worse scenario than what was delivered.  Investors should be alert to these situations as they can suggest an inflection point for company earnings and result in a profitable trade.

Profit reporting seasons presents investors with sign posts of what may lie ahead, but knowing which signs are important is key. 

 

Mark Draper writes monthly for the Australian Financial Review - this article was published on 23rd August 2023

The world is going green but it's still worth investing in oil and gas

Investors would be forgiven for believing there is no future in the oil and gas sector when listening to global politicians talk about 2030 targets of renewable energy production and emission reduction.  Clearly a world that is powered by green renewables is a desired outcome, but calling the death of oil and gas would seem premature.

Josh Snyder, Global Investment Strategist at GQG Partners, says the belief that everyone can drive electric vehicles (EV’s), and the air quality suddenly improves is simply not true.  Synder is very much for renewable energy, but he is of the view that the global discussion around energy transition is currently unrealistic and he thinks the role of oil and gas in the energy transition is likely to be measured in decades not years.  

He cites Norway, where 80% of new car sales are EV’s, and more than a fifth of the country’s fleet is now battery powered and yet total oil consumption has only fallen around 10% over the past decade.  While automotive gasoline useage has dropped by 37% in Norway in the last 10 years, demand for Diesel (to power heavy transport) and Jet Fuel has continued to grow.

Norway Fuel

The International Energy Agency forecasts oil demand continues to rise at least until 2028, at which point demand is forecast to be 5 million barrels per day higher than at 2019.  Snyder says that it may be an uncomfortable truth, but oil is central to everyday life in a way that will be difficult and expensive to change without impacting current living standards.  Consider these everyday items that use petroleum products in their manufacture – solar panels, plastic packaging for medical, computer components, electrical goods, cosmetics, furnishings, clothing in the form of polyester and aspirin.

Global Oil Demand

Hugh Dive, the Chief Investment Officer from Atlas Funds Management says that China signed a 27 year LNG purchase agreement starting in 2027 with Qatar for 4 million tonnes annually and an equity stake in the expansion of Qatar’s North Field LNG project.  The Chinese Government (2nd largest economy) clearly believes gas won’t be a useless molecule from 2030 onwards.

Put simply, the demand for oil remains elevated while supply is constrained due to a general underinvestment in exploration since 2014, and in particular during COVID when oil prices fell which resulted in oil companies conserving cash.

To some, Hydrogen is a threat to the oil and gas sector, but Dive says it is also an opportunity as hydrogen is difficult to transport as it is flammable and also corrosive to steel.  Oil and gas companies have experience in handling hydrogen as it is used to scrub sulphur and crack heavy oils into lighter blends.  Oil companies would be the natural companies with the experience and assets, such as pipelines, storage and tankers to transport green hydrogen globally.

Environmental/Social/Governance (ESG) focus has been both positive and negative for the oil and gas sector.  Snyder highlights that large banks have shrunk their lending exposures to the sector which has led to management teams having to be more disciplined in how they allocate capital.  This results in them becoming more share holder friendly where companies are keen to return money to share holders in the form of dividends.

Dive sees the US shale oil producers as an indicator of the marginal cost of oil, with their cost of production around US $60 per barrel.  This is an important likely floor for the oil price.  Currently the oil price is around US $70 per barrel.

Dive’s top pick in the energy sector is Woodside Energy because they have the lowest production cost ($US 8.50 per barrel) and the lowest gearing (7%).  He prefers Woodside to Santos as Woodside has minimal exposure to the East Coast Australian gas market which is subject to great political uncertainty and he is also attracted to Woodside’s 7% fully franked dividend.

Snyder’s top pick is Brazilian-operator, Petrobras. It has some of the lowest oil breakeven costs globally and richest reserves outside of Middle East and Russia, providing resilience through commodity cycles. Petrobras generates tremendous free cash flow (more than Chevron despite being one third of Chevron’s size) and an aggressive capital return policy. Currently trades at 4x 12-month forward PE and expected to pay ~20% dividend yield this year.

Oil and gas will be around for some time to come and investors could be missing handsome dividends by ignoring this sector.

 

Mark Draper writes monthly for the Australian Financial Review and this article featured in the 26th July 2023 edition

Artificial Intelligence - opportunities in more than big tech

540184720026Artificial Intelligence, known as AI has been a hot sector so far in 2023.  Computer chip designer Nvidia Corp, the current poster child of AI, has seen its share price rise around 200% this calendar year, while Microsoft is up around 50% so far this year.

The recent excitement has been ignited by the development and release of AI powered technologies with the most high profile being ChatGPT, an AI chatbot which is trained to follow a conversational instruction and provide a detailed response.  This format makes it possible for ChatGPT to answer follow up questions, admit its mistakes, challenge incorrect premises and reject inappropriate requests.  This was developed by OpenAI and released in November 2022.

Adrian Lu, an investment analyst at Magellan Financial Group describes AI as computers capable of thinking and understanding the world around them, that is they can reason, learn and act with autonomy.  He believes the pinnacle of AI is likely to be far away but engineers are getting better at building models that can mimic human perception, behaviour and abilities.  These models can already perform tasks better and faster than humans which promise vast productivity gains, as well as potential threats to investors.

Andrew Clifford, CEO at Platinum Asset Management says investors are excited that AI could be a major disruptive force in the global economy.  It reminds him a lot of the excitement around data on mobile phones back in 1999 when NTT DoCoMo first pioneered full internet access on a mobile phone in Japan.  It took around 5 years for that to translate into widespread economic outcomes and significant revenue for a company like Research in Motion (maker of Blackberry) which was then decimated by the release of Apple’s touchscreen iphone in 2007.  With that in mind Clifford is of the view that AI could be a genuine investable theme, but investors need to be careful in this initial period of excitement.

Investors have been quick to identify many of the primary beneficiaries of the ongoing development of AI already.  Lu characterises these as the ‘enablers’ of AI and highlights that many technologies had to come together to make AI possible, from semiconductors to software to hyperscale data centres.  Some of the leading companies in these enabling technologies have been among the greatest beneficiaries of the acceleration in AI spending so far, including Microsoft in enterprise cloud computing, Nvidia in AI accelerator chips, ASML in chipmaking equipment and TSMC in leading-edge manufacturing.  Investors now need to assess whether the current share prices of these companies represent an opportunity or a bubble.

Other beneficiaries from AI range from Industrial automation, consumer devices, automotive and healthcare are yet to be fully appreciated by the market according to Bianca Ogden, portfolio manager at Platinum Asset Management.  In the healthcare sector Ogden points to research and drug discovery.

AI is used to assist and ultimately design new therapies (small molecules and biologics) that have the desired attributes. The issue today is that the process from target to lead compound takes roughly 4-5 years and requires testing of a large number of molecules that then have to be refined over and over again.  AI is showing great promise to reduce that timeline significantly. Oxford-based Exscientia is one of these companies leading the way here and working closely with Sanofi, a company that has put together an impressive network of AI partners. Vancouver-based Absci is another interesting company who is working closely with Nvidia to make the discovery of antibody therapeutics more efficient using its own wet-lab generated database along with AI tools.

Lu highlights some of the risks to investors with AI including political and regulatory risks that will touch companies in different ways, and not just the AI enablers.  In particular intellectual property ownership, misinformation, data privacy and jobs displacement are among the key issues.

Clifford says that from an investment standpoint, the risks he is most mindful of are valuation risk (i.e. paying too much for an investment) and the risk of technological disruption. We remember Kodak, Blockbuster Video and Blackberry, where their businesses were decimated by new technology. It is very likely that AI will have that impact on various businesses over the coming years.

Technology moves fast and investors need to balance their thinking between the opportunities and the threats from AI.

 

Mark Draper (GEM Capital) writes monthly for the Australian Financial Review - this article appeared in the 28th June 2023 edition.

Best days are behind the banks

With unemployment at 3.5% and likely to rise, the full force of higher interest rates yet to be felt in loan losses, and the talk of recession, how should investors be thinking about the banks. 

Those who remember the 1990’s recession which pushed Westpac to the brink due to large commercial lending losses would be comforted to know that Australian banks today are largely focussed on residential mortgages.  Matt Haupt, a portfolio manager at Wilson Asset Management believes this is positive as in times of stress, residential mortgages are the safest place to be.  He says that even in severe downturns, residential loss rates are actually low.

Bad debts are a risk to banks, and the bears on the sector point to the risk of an expensive Australian housing market falling over, thereby increasing bad debts.  Hugh Dive, Chief Investment Officer at Atlas Funds Management quotes from Westpac’s recent profit result where the bank forecast two scenarios.  The base case was for a 7.8% fall in residential prices and 4.7% unemployment, and the worse case scenario was a 27% fall in property prices and 11% unemployment.  Currently Westpac has credit provisions of $4.9bn versus expected credit losses in the base case being $3.4bn and worse case scenario producing expected credit losses of $6.8bn.  Dive believes it is hard to see a 27% fall in property prices as they have already fallen 8.4% over the last 12 months, and providing employment holds up, thinks the banks are adequately provisioned.  

Bank Provisioning

Dive says that at this point in the cycle the Australian banks are more conservatively positioned than they were during GFC.  For example, the average loan to valuation ratio on CBA’s mortgage book is less than 50% according to their most recent profit report.  We would need to see some big property falls before banks actually feel the pinch, but possibly the newer private credit funds maybe where the ‘excitement’ will occur when bad debts tick up as they have been taking on the credit risks the banks have declined.

The other most important number is net interest margins.  Net interest margin is earned by lending out funds at a higher rate than by borrowing these funds from depositors or money markets.  CBA’s margin was the highest in recent reported results at 2.10%, while NAB was sold off heavily on the day of its result after reporting its margins had fallen by 0.04% in the second quarter of 2023.

Haupt believes that bank margins have peaked in this cycle.  Rising interest rate environments are good for bank margins and margins were expected to keep rising until the RBA stopped increasing interest rates.  However aggressive competition for mortgages and deposits started to kick in late last year, resulting in falling margins.

Dive agrees that margins have peaked but notes that both CBA and NAB have dumped their cashback offers for new mortgages and increased their variable rate by 0.1%, which indicates a lessening of the aggressive competition.

The big question is how the banks achieve profit growth against a backdrop of a cautious consumer and falling margins.  Haupt is of the view that bank profitability has peaked in this cycle and that the best days are now behind us.  He says it feels like investors have to wait for the interest rate cutting cycle to start and finish before he can get excited about margin expansion and this feels a long way off.

Migration and the reopening of the Chinese economy however are likely to be tailwinds in the future for the banking sector as they should contribute to growth in lending.

Other risks to the banks include the ACCC inquiry into deposits, competition and liquidity.  Dive says that the ACCC is likely to find that banks have historically been slow to increase deposit rates when interest rates rise, but this has now changed and doesn’t see this as a material risk.  

Haupt says that liquidity issues arise when there is a loss of trust in the financial system.  A credit crunch impedes the ability of banks to rollover existing funding and access new funding.  He believes this risk is low.

So while the banks appear well provisioned for problems in their home loan books, profit growth is likely to be difficult to come by for a while.

 

Mark Draper (GEM Capital) writes monthly for the Australian Financial Review - this article was published on 30th May 2023

Finding the sectors where old is gold

With the ageing of the population having become an investment megatrend, investors need to assess what consumer-led changes are likely to occur.

Investment Megatrends are powerful transformative forces that change the economy, business and society and have been changing the way we live for centuries.  Electricity, cars and the internet are some common examples.

Nick Markiewicz, a portfolio manager from Lanyon Asset Management says the Australian population is ageing quickly as a result of declining fertility rates as living standards rise, as well as rising life expectancy.  Based on current demographic forecasts from the Australian Institute of Health and Welfare, the proportion of Australia’s population aged over 65 has more than tripled from around 5% in 1922 to 16% currently and is expected to increase to 21% by 2066. In other words, the population over 65 is expected to grow at twice the rate of the Australian population more broadly.

Figure 1.1

Investors need to assess what consumer led changes are likely to occur as the population ages.  Older people with more leisure time tend to travel, require financial services, get sick more often which can also lead to changes in accommodation, and ultimately die.

At an economic level, other changes that are likely include a slowdown in GDP growth as the working age population stagnates, rising deficits as the Government has fewer workers which it can tax to fund higher spending on aged care and healthcare programs.  These programs, coupled with pension spending account for a quarter of commonwealth spending and are projected to rise significantly.

Nathan Bell, Head of Research at Intelligent Investor believes that the ageing population is great news for Australia’s healthcare companies.  Some are the world’s best including Sonic Healthcare (pathology), CSL (blood products and biotech), Resmed (sleep apnea) and Cochlear (hearing).

Bell says that the older Australia’s population gets, the sicker it gets and the more medical tests are required from the likes of Sonic Healthcare.  The number of pathology tests conducted in Australia has increased from 119.5m in 2015/2016, to 150.9m in 5 years.  (Source:  https://aihw.gov.au)  This represents a compound growth rate of around 5% per annum which means that the pathology industry is growing at a faster rate than the broad economy.  Bell is of the view that Sonic is reasonably priced due to fears of falling revenue due to fewer COVID tests, however the base business (ex-COVID testing) is in good shape and growing steadily.

Another medical industry benefitting from the ageing population is diagnostic imaging.  Growth in diagnostic imaging has been at a similar pace to pathology with the number of services rising from 22.8m in 2015/2016 to 27.7m in 2020/2021.  (Source http:aihw.gov.au)  Bell likes a radiology company, Integral Diagnostics in this sector.  Bell flags that Intregral’s profits have been hurt by restricted medical procedures during COVID lockdowns, but if they recover and recent acquisitions pay off then it could once again regain favour in the market and reward investors.

One of the biggest risks to healthcare companies is the potential for Government to change healthcare rebates, particularly as pressure grows on Government deficits.

It is this reason that Markiewicz is preferring to play the ageing of the population via the financial services sector. Markiewicz puts forward Challenger as a beneficiary of the ageing population as they provide annuities to retirees, offering them protection against the risk of outliving their savings.  Challenger is by far the largest provider of annuities in Australia with a market share exceeding 80%.  Markiewicz expects  Challenger to benefit from a growing target market and increasing take up of annuities over time which is likely to be enhanced by regulatory reforms by Governments such as the Retirement Income Covenant.

Investing on a megatrend thematic alone is an easy way to lose money.  Investors must ensure they are avoiding substandard or risky businesses within sectors that on the surface are beneficiaries of the ageing population.  Both Markiewicz and Bell nominate the aged care sector as one to tread carefully, despite mouth watering demographic changes.  This is because a large portion of their earnings are derived from Government funding.  After Government cuts to age care funding in 2016, the listed ASX aged care providers share prices fell sharply.  The recent Royal Commission into the aged care sector has also resulted in rising costs.

Megatrends are not a guarantee of investor success, but there can be important tail winds to recognise.

 

 

Mark Draper writes monthly for the Australian Financial Review - this article was published in the Wednesday 3rd May 2023 edition

How to recession proof your portfolio

With the recession drums beating louder following 10 straight interest rate rises in Australia, it’s worth dusting off the recession playbook to ensure that investor’s portfolio can withstand the heat. 

A recession is a period of temporary economic decline during which trade and industrial activity decline, generally identified by a fall in GDP in two successive quarters.  Recessions are a normal part of the business cycle, but it is the depth of a recession that investors should consider most.  A deep recession is normally characterised by high unemployment.

Dan Moore, portfolio manager at Investors Mutual, says that markets are forward looking so they usually fall well before a recession actually starts, often 6-12 months before.  Share markets also tend to bottom well ahead of the economy recovering, and quite often when the news is at its worst, which explains why sometimes the best time to invest is when the news flow seems like the worst possible time.  

The table below shows share market returns from the S&P 500 in the US during the last 11 recessions.  The key takeaways are that the average negative return from the S&P 500 during the 12 months before a recession was -3% and that the average return for the 12 months after a recession was 16%.

 Recession returns

Most recessions are characterised by rising unemployment, but this indicator also lags financial markets.  In November 2007 the share market peaked before the GFC and unemployment was 4.7%.  The market ultimately bottomed in March 2009 and unemployment reached 8.7%.  Unemployment only started to improve in November 2009, but by that time the share market had already risen 50% from the March lows.

Hugh Dive, portfolio manager with Atlas Funds Management, believes that the sectors that tend to do well during a recession are those that offer non-discretionary goods and services or benefit from cost-conscious consumers trading down during hard times.  These sectors include utilities, health care and consumer staples such as supermarkets.

Moore also likes Telcos in difficult economic times. 

Sectors that tend to do poorly during recessions include discretionary retailers, construction companies and some real estate according to Dive.  

Investors seeking to protect themselves during a recession / downturn should seek specific qualities from their investments.  Moore suggests investing in companies that are industry leaders with a competitive advantage as they usually have higher profit margins that can help ride out the storm.  A strong balance sheet, which generally means lower debt levels is very important to ensure the company can avoid dilutive equity raisings if the downturn becomes severe.  Recurring revenue and a capable management team also make a difference in tougher times.

Moore says that Telstra and Brambles both look well placed and both companies are industry leaders that sell essential products and services.

Dive nominates CSL to be well placed to deal with tough economic times as historically in the US, plasma donations have risen when the economy is suffering.  CSL’s health products are not linked to the economic cycle and its balance sheet is strong.  One of CSL’s major competitors on the other hand is also financially stressed which could provide CSL with a tailwind in years to come.

According to Dive, during recessions, investors want to own companies that generate consistent cash flows to service debt, invest for growth, pay dividends and potentially acquire weaker competitors that may be available at a discount.

For example, during the GFC the Australian banks strengthened their competitive position with Westpac taking over St George and CBA taking over BankWest.  Similarly in 2009 Amcor took over Alcan Packaging in a move that propelled the company on a course to become the largest packaging company in the world and raise its margins.

Both Dive and Moore warn investors against selling out of their investments in anticipation of a recession.  Moore says always having some cash is useful to take advantage of market falls, but increasing cash holdings in anticipation of a recession is fraught with danger.  This is largely because economists are famous for predicting far more recessions than actually occur, and even if there is a recession an investor must also be able to pick when markets are likely to bottom and then have the stomach to reinvest.  

With storm clouds gathering, investors should ensure their investment strategy can withstand, and ultimately benefit from, a downturn should one eventuate.

 

Mark Draper writes for the Australian Financial Review each month - this article featured during April 2023.

How to position for re-opening of Chinese economy

ChinaInvestors in Asia have endured a difficult few years.  The combination of China’s COVID zero policy together with it’s crackdown on property developers, regulation of  the tech sector and increased geopolitical tension with the West have made investment returns hard to come by.

Cameron Robertson, portfolio manager at Platinum Asset Management believes that the poor sentiment towards China has dampened investor interest across the whole of Asia.  As the Chinese economy picks up, there is a chance this could reignite interest across the region more broadly.

2022 witnessed the slowest pace of growth in the Chinese economy since 1976.  Chinese retail sales (ex-autos) in November 2022 fell almost 6% during lockdowns.  For perspective, at the worst point of the GFC, US retail sales fell around 10%.

Nicholas Markiewicz, portfolio manager at Lanyon Asset Management says that most pundits saw the 20th party congress in late October 2022 as the government’s ‘turning point’, but he has noticed subtle policy shifts from the Chinese government in the months before that.  He believes the crackdown on the technology sector appears to be more or less over, property developers are in the process of being recapitalised and the government is beginning to thaw relations with the West.

Many investors associate a stronger Chinese economy with demand for Australian iron ore.  However with China recently consolidating purchases of raw materials under a single state owned buyer called China Mineral Resources Group in an effort to control prices, the iron ore trade may not be the one way bet it has been in the past.  Investors should consider other ways of participating in an Asian rebound. 

Robertson and Markiewicz are investing in the Chinese consumer theme.  Robertson says that during COVID household bank deposits increased by 42% and he thinks that we could see the same sort of ‘revenge spending’ that we saw in other economies following the end of lockdowns.  While the sharp rally at the end of 2022 and in early 2023 has captured some of the benefits of the changed environment, Cameron remains optimistic about Chinese parcel delivery company ZTO Express, which is a natural beneficiary of consumer spending.

Markiewicz suggests that the doubling of the savings rate during COVID means that Chinese households have an additional US $800bn in their bank accounts.  He says that the most obvious plays are the large domestic consumer platforms and Lanyon’s preferred pick is Alibaba which still trades at a heavily depressed valuation.

Outside of direct consumer plays, travel is clearly another segment likely to benefit from China’s reopening.  Airbus and Boeing continue to dominate the commercial aviation market according to Markiewicz, with Airbus having an 8 year backlog, no debt, and still writing new orders for Chinese airlines.

He adds that for those with apprehensions about investing directly in Chinese companies, there are still many Western consumer businesses that derive significant revenue from China and likely to experience a strong recovery.  BMW for example derives nearly 40% of its sales from China, has one of the world’s best balance sheets and trades on a single digit earnings multiple.

Robertson says that pre-COVID, around a third of Thailand’s tourists came from China.  As the flow of tourists from China gathers momentum, money is expected to return to the Thai economy and that will have wide ranging effects across that market.

ASX listed investment, Auckland Airport is another likely beneficiary of reinvigorated Chinese tourism.  According to a recent ASX announcement, New Zealand is one of 20 countries open to Chinese travel agencies. 

The changing of conditions in China are likely to have other second-order effects, such as increasing demand for energy.  This could bring another squeeze on energy markets at some point which could benefit Australia’s world class energy companies including Woodside and Santos. 

While it is often considered that higher energy prices resulting from China’s reopening may contribute to inflation, Robertson suspects that the impact is likely to be at the margin.  He believes that the inflationary environment we’re seeing across the Western economies is driven by a broad range of complex factors, such as shifting supply chains, monetary policies unleashed by our central banks over recent years and automation.

The landscape has changed materially in China over the past year, which could well deliver good medium returns in the Asian region for alert investors.

 

 

This article was written by Mark Draper and featured in the Australian Financial Review in March 2023

5 areas investors should be wary of in 2023

DohInsideWarren Buffett’s two golden rules for investing are, 1. Don’t lose money 2. Never forget rule one.

To assist investors adhere to these rules, some of Australia’s leading investors shine a light on where some of the dangers may be hiding in the current markets.  These dangers are in 5 categories:  crowded trades, expensive investments, earnings downgrades, business models and popular short positions.

crowded trade is a popular position or theme embraced by large numbers of investors.  Crowded trades may not be wrong, but are usually associated with high prices, bubbles and irrational behaviour.  Matt Williams, Portfolio Manager at Airlie Funds Management says that the resources sector is currently a crowded trade.

Hugh Dive, Chief Investment Officer from Atlas Funds Management nominates  lithium as a crowded trade.  He says there are currently 62 lithium stocks on the ASX but only a few are profitable.  The majority of lithium miners are exploration companies or companies with a resource that may or may not be economical to mine.  He believes the great bulk of these lithium companies will never see their projects developed and are likely to head towards insolvency as investor patience wanes.

Investments that look expensive according to Dive include consumer staple companies and the tech sector.  Dive supports this by saying that the food retailers have done well out of COVID lockdowns, but are now moving through tougher comparable sales periods that will see declining earnings and higher costs from labour and supply chain issues.  While Woolworths and Coles are efficient retailers, paying over 21 times earnings that are declining, doesn’t make much sense.

Reporting season is just around the corner with investors braced for earnings downgrades as a result of higher interest rates and consumer caution.  Williams is most worried about earnings downgrades for consumer exposed retail companies and the building sector.  The difficulty for investors is to determine what is already priced in.  For example James Hardie has sold off by 35% in the last 12 months and may well already have adjusted for expected earnings downgrades. 

Nathan Bell, Portfolio Manager at Intelligent Investor says that business models likely to struggle in the higher interest rate environment are those that have borrowed lots of money, particularly for shorter terms.  He suggests many of the new breed of fintech companies could have this issue exposed if higher interest rates send a deflationary pulse through the economy.

Williams believes that business models most at risk are those that are not yet profitable and hence rely on equity markets to fund their operations.  This is prevalent in the tech sector and investors should exercise great care when investing in companies that do not make a profit.

Investors are always wise to be aware of stocks that are being heavily shorted.  A short position is essentially betting against the market, and the short position profits when prices decline.  Some of the most heavily shorted companies in the ASX200 currently include Megaport (tech), Sayona Mining (resources) and Core Lithium (resources).

Williams nominates REIT managers exposed to the retail sector as a source of potential danger as they continue to face a difficult environment as the economy softens.  They are also negatively impacted by rising rates on valuations and borrowing costs.

Dive is cautious on the iron ore sector going into 2023, which has been a short term beneficiary of China amending their COVID Zero policy on the basis that it leads to a rise in construction activity.  Dive’s concern centres around China recently announcing the establishment of a centralised state-owned buying company for iron ore to consolidate the purchases of iron ore for the 20 largest Chinese steel makers.  This will likely reduce the pricing lower the four main iron ore producers currently enjoy from selling their iron ore to a fragmented group of steel makers.  With China consuming 70% of globally traded iron ore, more disciplined centralised buying leads Dive to believe that the price of iron ore is likely to face downward pressure.

Bell is wary of the oil and gas sector.  He says that while a higher oil price may increase short term profits, paying high multiples for capex heavy companies that don’t control their product prices is usually a recipe for disaster.

Avoiding permanent capital loss increases investment returns.  2023 has its unique list of things to be wary of.

Medibank Private - will the patient recover or is this terminal?


The share market has wiped out $1.87bn of equity value from Medibank Private following the cyber attack with the share price down close to 20%.

As with any investment event, investors need to determine whether this event is temporary in its impact, or permanent.  If the event is temporary it may represent an opportunity, but if the event results in permanent change or damage then investors need to realign their thinking.

Hugh Dive, the Chief Investment Officer at Atlas Funds Management highlights that Medibank has taken a hit to this years profit of $25 - $35m in one off costs relating to customer service initiatives, reissuing customer ID’s and external experts.  Medibank has also deferred the statutory premium increase until January 2023 at a cost of $62m which is offset by lower than expected claims expense. These costs would appear temporary in nature.

Nathan Bell, Head of Research at The Intelligent Investor says that more permanent financial impacts are likely to come from ongoing higher IT expenses as it beefs up cybersecurity, and also potential fallout from a probable class action.

Bell says that the potential result from a class action is difficult to quantify.  The most the Australian Information Commissioner has awarded in damages for non-financial loss associated with a privacy breach was $20,000 per individual.  This incident was related to someone’s health information being published on a website, causing distress.  Medibank says that 480,000 customers had health claims data stolen containing some potentially embarrassing information.  A similar damages award to this group of 480,000 would be larger than Medibank’s market cap.

Precedent can be helpful when thinking about the potential effects of legal action, and Bell points to the data breach by Premera Blue Cross in 2015, which is a US health insurer with a similar number of policy holders affected.  The company settled the class action for US $32m (AUD $48m).  Premera Blue also had to commit US $42m (AUD $63m) to improve data security, which means that it might be wise for investors to leave room in their valuation for a much larger IT spend by Medibank than management has already set aside.

Dive confirmed that Medibank self-insure against cyber risk, but Medibank management advise that the type of insurance available wouldn’t have paid out for the hack.  While the class action lawyers are circling, the class action may struggle as the right to sue for the tort of breach of privacy or invasion of privacy is quite novel in Australia.  The class action would have to prove that Medibank’s cybersecurity was incompetent or negligent which could be challenging for the plaintiff.  Dive also questions whether the Government would be happy to allow Australia’s largest health insurance provider with 29% market share to be financially crippled.

Other than the risk of financial damage from a class action, the other key risk is that Medibank customers switch to other providers.  NIB mentioned at their AGM in November that they are starting to see some unhappy Medibank customers contact them, but the transition costs of private health insurance are high.

Dive said he would be surprised if HCF/BUPA/NIB used the cyber attack as a way to opportunistically gain market share by offering no waiting periods for hospital cover, which is usually 2 months before making a claim or 12 months for a pre-existing condition.

Contrasting these risks, Medibank is debt free with surplus capital and trades on a price earnings multiple of 16 times.  It offers investors a fully franked dividend of 5%pa.  Prior to the data breach Medibank reported 14% customer growth since June 2022. Consensus valuation for Medibank is around $3.20 per share (source Stockdoctor).

But Bell is cautious about referencing consensus valuations, as the final cost of the breach is unquantifiable and uncertainty could linger for years due to litigation, which could weigh on the share price.

The question for investors is whether the market has over-reacted to the cyber attack by slashing almost $2bn from the value of Medibank versus currently only a once off $35m hit to profits. 

Investing is a game of probabilities, and investors need to balance off Medibank’s attractive price on offer against the risks from customer loss and potential legal action.

 

Each month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article featured in the 30th November 2022 edition

Beaten up REIT's - time to revisit

0ee70163e29bae5db9d4be0d088a4c1c MThis year’s dog can often be next year’s star for investors.  The second worst sector so far in calendar 2022 belongs to REIT’s, second only to the tech sector.  

Hugh Dive the Chief Investment Officer at Atlas Funds Management says there are two reasons for the REIT sell off.  Firstly the whole sector has been derated.  The REIT index was trading on a price earnings multiple of 21 times in January 2022 and is currently trading on a multiple of 14.9.  Secondly, interest rates have risen for the first time in a decade with the 10 year bond rate up by around 150% so far in 2022.  REIT’s are viewed as an interest rate sensitive sector.

Pete Morrissey the Head of Real Estate Securities at Dexus Asset Management highlights that the REIT’s with higher gearing, aggressive cap rates and lower levels of interest rate hedging suffered the most along with those with funds management businesses contributing to their earnings.

Higher interest rates are negative for the REIT sector as they increase the discount rate (referred to the cap rate) used to value the expected cash flows from owning property which reduces the asset value.  Higher rates can also increase the interest costs for REIT’s so if rents do not keep pace with interest costs, income distributions can decline.

Cap rates are a measure that helps evaluate real estate investment and a higher cap rate results in a lower property value, so the higher the cap rate, the better it is for the investor.

Each REIT uses its own cap rate to determine its valuation.  A comparison of two industrial trusts, Centuria Industrial REIT (CIP), and Dexus Industria REIT (DXI) shows that CIP uses a cap rate of 4.19%, while DXI is using a far more conservative cap rate of 5.04% to determine valuation.  This means that investors need to consider the merits of the individual trusts as not all REIT’s are equal.

Dive believes that while cap rates will expand, there are still transactions in the physical markets being settled in the 4% range for industrial and office property, and 5% for supermarkets, so the pressure to revalue assets downward isn’t intense.

Dive says the broad based sell off in REIT’s in August and September saw most trusts fall 17%, with little consideration for the differences in underlying tenants, lease escalators, debt costs or debt structure. 

Morrissey believes there is reason for optimism and points to many REIT’s now trading at 30% plus discounts to their June 2022 net tangible asset backing.  He says that the market reaction has provided investors with the opportunity to invest in REIT’s at deeply discounted values while collecting income yields averaging around 6%.

Morrissey prefers REIT’s with strong balance sheets and above average hedging of debt to protect their interest costs.  He also likes REIT’s that offer inflation linked earnings growth in the current environment.  Morrissey likes non-discretionary supermarket anchored retail REIT’s due to earnings predictability, tenant covenant quality and longer lease terms.  

Supermarket landlord Shopping Centres Australia has an average term of its debt of 5.5 years and is 80% hedged with rents linked to CPI.  It will see a kicker in turnover rent from food inflation, and as mortgage payments rise we may see budget conscious consumers limit restaurant visits in favour of cooking at home.

In addition to non discretionary retail, Dive also likes the Industrial, Educational and Medical sectors.

Morrissey remains cautious on the office sector due to the high level of uncertainty created by working from home.  He adds that Office REIT’s are some of the cheapest going around and it is clear that quality office buildings remain in demand for many businesses as culture can only be built in the office.  Dive is limiting exposure to REIT’s with earnings from property development due to the volatility of their earnings.  He is also cautious on discretionary retail REIT’s.

The REIT sector in general is far better equipped to handle rising rates in 2022 than it was in 2007, when many trusts used the short term wholesale market to fund their debt.  On average, in October 2022, the REIT sector has a gearing level around 20% with  debt maturity of 5.1 years.  While some REIT’s may struggle with a slowing economy and higher debt costs, other trusts are likely to see minimal or even positive impacts from changing economic conditions resulting in a stable and growing income stream.  Among the price destruction of 2022, the REIT sector is likely to present investors with some good opportunity.

 

This article featured in the Australian Financial Review on Wednesday 2nd November 2022.  Mark Draper writes monthly for the AFR.

 

 

** Mark Draper owns shares in Shopping Centres Australia and Dexus Industria REIT

Dangers of market timing recessions

When there is a fall in the market investors are bombarded by opinions from ‘experts’ speculating on how far markets will fall.  These experts are currently debating how far interest rates will rise and whether or not we enter recession.

Recession is defined as ‘a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters’.  Investors need to appreciate that periods of recession are a normal part of the business cycle and for investors reasonably positioned, are temporary in their effect.

Hugh Dive who is the chief investment officer at Atlas Funds Management believes that the chances of Australia slipping into recession are much lower than the USA and Europe due to the different composition of our economy, minimal direct impact from the Ukraine war (in fact several sectors are benefitting), lower inflation which should reduce the need for the RBA to raise interest rates as hard as some expect.

Dive cites strength in the labour market as a key indicator for investors to watch with the ANZ Job Ads currently the strongest it has been in over a decade.  Typically recessions are accompanied by high unemployment.  During the 1982-83 recession the unemployment rate peaked at 10.5% and in the 1991-1992 recession the unemployment rate peaked at just over 11%.

Dan Moore portfolio manager at Investors Mutual points out the current rate of unemployment in Australia is 3.5%, the lowest it has been in over 45 years which is likely to be as good as it gets.  Moore says that other indicators including rising interest rates and relatively high inflation, at least in the short term, point to more difficult economic conditions.

The key question for investors right now is whether they should sell everything and move to cash, or stay invested in the markets.

To some, during periods of market stress the least risky option appears to be for investors to sell everything and move to cash.

History however shows a different story for those who sell during a downturn and miss out on the rebound when it occurs.  The average bear market in Australia declines 29% and lasts 14 months, versus the average bull market rising by 157% and lasting 65 months.  For reference, the Australian market last peaked in August 2021.

 

Dive believes that successfully timing the market both to exit at the top and re-enter at the bottom is beyond the ability of virtually all investors, a feat not managed by even the most exalted fund managers.  In early 2020 a few fund managers were patting themselves on the shoulder for reducing their equity exposure early on in the pandemic.  These same fund managers spent the remainder of 2020 and 2021 holding too much cash, cursing the fast recovery and missing out on gains.

Dive points out that famed investor Jeremy Grantham received positive press for calling the major bubbles of 2000 and 2007. However Grantham famously predicted doom for equity markets in 2010, 2011, 2012, 2013, 2014, 2015, 2017 and 2021.  Those who predict gloom regularly, will look like a genius every few years, but if an investor had heeded these calls, they would have been sitting in cash, earning a negative real rate of return for most of the past decade.

Moore highlights that selling for market timing purposes gives an investor two ways to be wrong.  The decline may or may not occur, and if it does, you’ll have to figure out when the time is right to reinvest.

There is no doubt that investors face a challenging set of circumstances which include rising interest rates, high inflation, China’s COVID zero policy and the Ukraine war.

To navigate the current environment, Moore suggests investors be conservative and seek high quality investments.  He defines high quality investments as those with recurring revenues, strong balance sheets (ie not too much debt), capable management and businesses with a strong competitive advantage.  Brambles, Aurizon and Amcor are examples of such businesses according to Moore.

Dive says that during high inflation periods investors must seek companies with the ability to pass on higher costs to their customers.  The recent company reporting season showed companies such as ASX and Woolworths inability to pass through higher costs, whereas Amcor and Transurban passed through increased costs to maintain profit margins.

Tough times don’t last, tough investors do.

 

Mark Draper (GEM Capital) writes for the Australian Financial Review each month and this article was published on 5th October 2022

What to takeaway from company reporting season?

Company reporting season can provide an enormous amount of information to investors, not only about the previous 6 months, but also what lies ahead.

The standout winners were the energy sector which benefitted from higher oil and gas prices not only because of the Ukraine war, but from years of under investment since 2014.  Woodside Energy generated free cash flow of US $2.568bn for the 6 months to June 2022 and forecast that demand from Asia for gas is likely to peak in the mid 2040’s, which suggests that the energy sector may enjoy higher earnings for longer than many would have believed.

David Prescott who is the founder of Lanyon Asset Management said that the common themes coming out of reporting season were inflation, particularly in relation to input costs, lingering COVID 19 issues disrupting supply chains and adding costs, tighter labour markets and a resilient consumer despite the consequences of rising interest rates.

Nathan Bell, the head of research at Intelligent Investor said that the results from reporting season were very stock specific and gave the example of Xero’s results which suffered from slower than expected growth in the UK while fellow tech company Wisetech had a superb result.

Building materials companies Adelaide Brighton and Boral struggled to recoup input cost increases whereas James Hardie and Reece passed on input costs quite easily according to Matt Williams, portfolio manager at Airlie Funds Management.

With inflation likely to remain elevated for some time, investors need to assess to what extent companies can pass on higher costs to their end customers.  Cleanaway reported weaker earnings margins partly due to higher diesel prices, but the report also stated their contracts allow to claw back higher fuel prices, indicating higher costs are likely to be recouped in future reports.

Toll roads showed that they can be beneficiaries of rising inflation as toll revenue is largely linked to inflation.  Atlas Arteria reported record dividends thanks to their interest on debt being fixed for over 5 years, while their income largely is rising with inflation.

Williams said that higher interest rates negatively affected listed property trusts as increased interest costs dampened the outlook for income distributions.  This would appear to be largely factored into share prices of property trusts which have endured a tough first 6 months of the calendar year.  The art form for investors is to understand what expectations about the future have been built into current share prices.

Prescott said that recent interest rate rises did not have a noticeable impact on the earnings of companies reporting at 30th June 2022.  But he added that the outlook statements from various senior managers however portrayed a slightly different story.  Management inability or reluctance to provide formal guidance emphasises the great unknown as to how rising rates will impact future operating profits.

Higher interest rates were yet to have a substantial impact on retailers with JB Hifi and Wesfarmers (Bunnings) reporting good numbers.  Interest rates only began to rise in May this year, so it is too early to understand their impact on consumers.

Williams highlighted QBE as a beneficiary of rising interest rates by increasing investment returns on their fixed interest portfolio.

Bell believes that company profits (particularly from consumer facing companies) will be tested when the nearly 50% of Australian borrowers on fixed rate loans have to refinance in the next 12 – 24 months at far higher rates than they are currently paying.  This is likely to reduce consumers spending power and change spending habits.  Early evidence of this came from the Woolworths result where CEO Brad Banducci said “inflation is beginning to impact all aspects of our customers’ shop and we are seeing a gradual change in customer shopping behaviour. We are seeing some customers trade down from beef into more affordable sources of protein and trade across from fresh vegetables into more affordable frozen and canned offerings.”

Healthcare company CSL is recovering from the effects from COVID lockdowns that reduced plasma collection, and other companies are still reporting COVID costs.  Wesfarmers for example invested $49m into their team to provide paid pandemic leave during lockdowns.  There is potential earnings upside here as the costs of dealing with COVID slowly unwind.

Investors are faced with a complex environment today, but would be well served to read media releases and presentations that companies release during reporting season to provide clues on how to best navigate it.

Each month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article was published on 7th September 2022

Aged Care Investments - Tread Carefully

Investors would think that with the ageing of the population, loading up their portfolio’s with aged care stocks would be a no brainer. Judging how difficult it was to obtain comment from fund managers about the sector, maybe that’s not the case.

The key attractions for investing in aged care are the tailwinds provided by an ageing population. Hugh Dive who is the Chief Investment Officer from Atlas Funds Management says there are currently 4 million Australians aged between 65 and 84 and the Australian Bureau of Statistics forecast that this will increase to 6 million by 2030. He adds he is not an investor in the sector however.

In 2021 the Government spent $24bn on aged care, with the largest spend on residential aged care.

The other attraction to the sector lies with development of new facilities as operators can receive a large amount of their capital back when the first residents enter the facility.

In Australia, there are two remaining ASX listed ‘for profit’ Aged Care providers, Estia Health and Regis Healthcare in addition to ‘not for profits’ such as Calvary Healthcare that took over Japara in 2021.

Theoretically the standard of care should be the same in both the for profit and not for profit sectors as minimum standards of care are regulated. A leading fund manager who spoke on the basis of anonymity said that those facilities that had received sanction notices were from all parts of the sector, which shows no divergence in quality of care between the ‘for profits’ and the ‘not for profits’ or government run facilities.

One major difference between the major players is that the ‘not for profit’ sector does not have to pay payroll tax and do not have to pay income tax. This possibly led to Calvary buying the listed operator Japara and could result in the ‘not for profits’ being able to employ more staff. Fund managers cite this unlevel playing field as a reason for caution for the ASX listed operators.

Government incentives for senior Australian’s to remain in their own home is a threat to the aged care sector as the Australian Government seeks to limit the cost to the Healthcare budget.

The other major risk appears to be the ever changing regulatory environment.

The recent Royal Commission into the sector has recommended a range of changes that are positive and negative, but most likely add to costs for the providers:

- Mandated minimum care hours from October 2023 and a 24/7 Registered Nurse rostering will improve conditions in aged care but also increase costs

- ACAR (Aged Care Approvals Round licencing system) abolition will be a positive when it occurs in June 2024 as the ACAR currently restricts both the number and location of residential aged care places.

- The new Australian National Aged Care Classification which starts in October 2022 will see an increase of $28.20 (per resident per day) in the base rate of funding in return for requiring higher staffing.

Inflation is likely to crimp margins within the aged care sector given that around 75% of revenue is allocated toward employment expenses whereas revenue is largely regulated. Dive says that the sector also faces higher non-wages costs from energy, cleaning to medical devices as well as higher incremental costs from COVID-19. These costs are increasing more swiftly than the increase in government support for aged care, and this has been shown in recent results from ASX listed operators who both reported a first half loss in 2022.

It is always useful to consider global experiences and to this extent Dive highlights that in the US there are 3 large listed nursing home chains and 8 Real Estate investment trusts (REITs) that specialise in nursing/retirement homes. In the US an aged care operator will lease a retirement home from a specialised retirement home REIT. The investment performance of the sector in the US is not dissimilar or probably worse than the experience in Australia. In 2016 giant operator Kindred Healthcare decided to delist from the NYSE, revealing it owed US$423 million in unpaid rent to its landlord Welltower REIT.

Despite the seductive demographics, the high level of changing regulation plus the reliance on government funding for most of the sector makes aged care a challenging sector to derive consistent profits for investors.

 

 

This article was written by Mark Draper (GEM Capital) and featured in the Australian Financial Review on 10th August 2022

China continues to offer huge investment opportunities

China is certainly on the nose for investors.

The most common reasons for this revolves around China’s position on Russia, Taiwan and the government changing rules under the ‘common prosperity’ program.

Cameron Robertson who is the co-portfolio manager for Platinum Asia ex-Japan strategy says that people overplay China’s relationship with Russia with respect to the war. He acknowledges that they did not vote in support of the UN resolution condemning the invasion, but they were one of 35 countries that abstained. It should be noted that there were 5 countries that voted in support of Russia, China was not among these.

Alasdair McHugh a director at Baillie Gifford adds that China has distanced itself from Russia since the Ukraine invasion. The foreign minister of China has officially referred to the Russian invasion as a ‘war’, having not done so previously. McHugh believes that the idea that China is ‘all in’ with Russia is wrong as the threat of secondary sanctions if China continues to do business with Russia is a much higher stakes game than what we’ve seen with Russian sanctions. Baillie Gifford’s base case is that China is likely to tread carefully, not least because exports to the US and EU are in excess of US $1trn versus just US $68bn to Russia. McHugh does not think that Beijing will risk losing access to markets in the developed world.

Robertson says that Russia’s invasion seems to have worried people about parallels with China-Taiwan, but thinks people under-estimate how different these two scenarios are. China is a country with huge foreign trade relationships with the West, and trillions of dollars of USD assets, so even just the threat of sanctions are a much bigger stick. Meanwhile Russia’s own attempts have really shown the risks of pursuing such a path as there is no one saying “that looks like a success for Russia, we want to follow that path”. Taiwan has one major political party that is somewhat sympathetic to China, so there is still the glimmer of hope of a peaceful accommodation in China’s eyes – whereas attacking would surely harden resolve against any (even nominal) reunification efforts.

McHugh claims that the current focus on ‘common prosperity’ in much of the Western media portrays this as some sort of attack on capitalism. Helped by the insights we’re gathering from Baillie Gifford’s Shanghai office, he understands common prosperity to instead be about sustainable and inclusive growth. Many companies are well-aligned to such policy directions and he therefore continues to see exciting opportunities ahead.

McHugh believes that China remains a great opportunity for long term growth, and to provide an idea of the scale he says that China has 160 cities with more than 1 million inhabitants versus only 10 in the US. That is a lot of potential consumers.

Robertson asserts that China is out of favour and cheap, which is commonly a buy indicator. The discount of the Chinese market can be seen from the chart below which compares the price to earnings (PE) ratios of several countries share markets.

China PE ratios

Source: Minack Advisers

Exposure to China has a role to play in investor’s portfolios, tapping into the dynamism of this country and riding the wave of technological innovation that is taking place as new industries develop there.

Robertson highlights AK Medical is a leading provider of hip and knee orthopaedic replacement joints in China accounting for roughly one fifth of the domestic market, providing high-quality cost effective solutions. Their products are internationally competitive, seeing acceptance even in developed markets like the UK. The business expects they will sell around 180 million hip and knee implants this year, up from around 80 million just five years ago. Currently only one out of every 2,000 people in China has a joint replacement each year, this compares to wealthier countries where we typically see rates of one in every 200-300 people having joint replacement surgery each year.

McHugh showcases NIO (electric vehicle maker). NIO’s Chinese name literally means ‘blue sky coming’. It is rapidly scaling production of EVs and thereby supporting China’s climate ambitions. Its trailblazing battery swapping model is inherently more conducive to battery recycling, thereby reducing waste – and it protects the car’s resale value as battery degradation isn’t a factor.

Investing in out of favour sectors is hard, but to ignore one of the world’s largest markets could be a big mistake.

 

This article was published in the Australian Financial Review during May 2022.

Why Toll Road Are Attractive

In uncertain times, toll roads can provide investors with high levels of certainty.

A toll road by definition from the Cambridge dictionary is ‘a road that you have to pay to use. Your journey will be quicker but more expensive if you take the toll road’.

Generally there are three types of toll roads – ‘greenfields’, which are under construction, newly opened toll roads in ‘ramp up’, and mature roads. Hugh Dive who is the Chief Investment Officer at Atlas Funds Management is of the view that mature roads are preferable as investors can more accurately assess the traffic numbers and the earnings.

Dan Moore, Portfolio Manager from Investors Mutual says that history shows traffic forecasters tend to be overly optimistic and forecasting errors in the past saw the original owners of greenfield toll roads, Cross City Tunnel and Lane Cove Tunnel go into receivership.

It is important to understand that toll road investors don’t own the physical land or the road they build, they merely own the right to collect tolls for a specific period which is known as the concession period. After this period, the road reverts to the government and the debt repaid. Dive says that the finite life of a toll road concession is sometimes used as a reason not to invest in the sector but believes that this approach is too simplistic and doesn’t account for the actions that toll road operators can take to extend the life of the concession. In 2015, Transurban added extra lanes on the M2 motorway in Sydney and in exchange, saw an 11.5 year increase in the concession period for the Lane Cove Tunnel and an increase in truck tolls of 33%.

A toll road contract usually allows for tolls to increase, commonly in line with inflation, which makes their operational earnings resilient during periods of higher inflation.

Toll roads are attractive according to Moore due to their high level of recurring revenue, with built in price escalators, particularly if they are located in an area with a growing population.

Dive says that toll roads are long dated monopoly assets as no rival is going to build a competitor road next door to an existing road. Once construction is complete, ongoing costs for a toll road are low which results in high margins, which can be up around 80%.

Dive also likes the Government support for the sector and uses the example in NSW where Revenue NSW collects unpaid tolls on behalf of Transurban, suspending a drivers licence if they don’t pay. Trucks are required to use the recently completed North Connex and will receive a $194 fine if they attempt to use the ‘free’ roads above the tunnel.

While high fuel prices present some risk to toll road investors Moore believes that this is not a major concern for investors as most traffic is non-discretionary. He says that recessions accompanied by high unemployment is a bigger concern. The chart below supports Moore’s view as it shows continued traffic growth on the Sydney Harbor bridge during the oil crisis during 1973 – 1974.

sydney harbour traffic 2

Political risk, commonly referred to as sovereign risk is another factor when investing in infrastructure. Dive highlights the two key risks are:

Expropriation, which is the concession taken away from the toll road operator and
Regulation, where the government defaults on the toll road’s contractual obligations, ie not allowing tolls to increase in line with the formula stated in the contract

Political risk are quite low in the western world according to Dive and highlights these risks have largely been confined to developing countries such as South Africa and Malaysia.

Other considerations for investors is the capital structure of the company according to Moore. Excessive debt levels, makes any company more susceptible to short term risks and can lead to untimely dilutive equity raisings which impact investor returns.

Investors can gain access to this asset class through the two ASX listed toll roads in Transurban (largely Australian roads) and Atlas Arteria (European roads). Exposure to toll roads can also be achieved by investing in infrastructure funds offered by several funds management groups.

In a low interest rate environment, toll roads can help drive investors dollars further.

 

This article was published in the Australian Financial Review (AFR) on Wednesday 20th April 2022. Mark Draper (GEM Capital) writes monthly for the AFR about investment topics that impact investors.

 

Investments to Avoid in 2022

The current investment environment feels a lot like 1999 just before the dotcom bubble burst, with a hint of 1994.

Investors would probably need to be over 40 to remember the fallen angels of 1999 when the dotcom bubble popped. Back then the new paradigm was that price to earnings ratio’s were irrelevant and it was price to revenue that mattered. Sound familiar?

One of the most high profile busts in 1999 was One Tel. At it’s peak, One Tel had a market capitalisation of $5.3bn in November 1999 making it one of Australia’s largest companies at the time. It reported a record operating loss in August 2000 of $291m, before entering receivership in May 2001.

1994 saw the Australian 10 year bond rate rise from around 6.3% in January 1994 to over 10% by the end of 1994. Long term interest rates are important as valuations of shares and property are anchored to them and generally speaking as rates rise, property and share valuations fall.

Fast forward to 2022 and investors could be forgiven for thinking they have been cryogenically frozen from the periods of 1994 and 1999. Long term interest rates have doubled in the last 6 months, and share markets are laden with many companies trading at lofty valuations, making little or no profit today.

While history doesn’t exactly repeat itself, the lessons from these two time periods can help investors today avoid repeating the mistakes of the past.

Hugh Dive, the Chief Investment Officer at Atlas Funds Management believes that investors should look to avoid tech stocks and growth stocks on high price earnings multiples as rising interest rates will be unkind to them. The companies Dive refers to have minimal to no earnings today but the promise of large profits in the distant future. Asset valuation models are sensitive to interest rates, and higher rates result in lower valuations.

Nasdaq dotcom bubble

Dive says that rising interest rates make the “boring” profits and dividends of companies such as Amcor, Ampol and Transurban look more attractive than a tech company promising large “blue sky” cash flow in 20 years time. This occurs as the present value of profits delivered today are worth more when rates rise than profits that may or may not be generated in 10 to 20 years time.

Matt Williams, portfolio manager at Airlie Funds Management is wary of loss making tech companies but acknowledges that there will be some winners amongst them and nominates Spotify and AirBnB as looking interesting. Williams says crypto and NFT’s are obviously impossible to value making them speculative.

Williams adds that investors should be careful of some of the reopening beneficiaries which are now priced for perfection. Qantas and Flight Centre for example now have enterprise values higher than what they were pre-COVID which means that investors are already factoring in a strong travel recovery. Ultimately we will revert back to pre-COVID travel levels at some point but it’s taking longer than what was previously envisaged.

Another high profile casualty of rising interest rates is Government Bonds. Dive is of the view that investors should stay away from bonds. He says that bonds have enjoyed a 40 year bull market as 10 year rates have fallen from 16% in 1982 to 2% today. The capital value of bonds increase as rates fall, but as long term rates rise, the capital value of bonds fall. As a rule of thumb, for every 1% rise in long term rates, investors can expect the capital value of a 10 year bond to fall by around 9%. Superannuation investors in Balanced, Conservative or Fixed Interest funds are likely to have a large allocation to Government Bonds and would be wise to review these funds.

Williams sums up the current environment by saying that the market dynamics will change as central banks slowly but surely wind back monetary settings from “ridiculously easy” to just “easy”. Volatility will create headlines and headlines build psychological pressure in investors minds to “do something”. That “something” should be to think 5 – 10 years ahead and look to buy great companies that are being sold cheaply by the market.

 

Mark Draper writes monthly for the Australian Financial Review - this article was published in February 2022

Semiconductors - The New Oil

Semiconductors (semis) are to the technological revolution what oil was to the industrial revolution. Today there is a severe global shortage of semi’s, and it matters.

The shortage has resulted from a combination of natural disasters impacting manufacturing regions on top of what was an already fragile supply situation. Severe frosts in Texas saw Intel shut production for a few weeks, and Taiwan, which is responsible for over 50% of all semi manufacturing, is suffering from severe drought. Semi manufacturing is a very water intensive process according to Delian Entchev (Senior Analyst, Aoris Investment Management). He says that up to 20 million litres of water a day is required for one factory.

The shortage matters not only to those investors with exposure to semi companies, but investors also need to think about the domino effect on other industries that rely on semis.

The obvious products relying on semiconductors are PC’s, tablets and smartphones but many investors would be surprised to learn that semis are in other household items such as a fridge, lawn sprinkler, tv and microwave.

The auto industry is another large market for semis and has been one of the high profile casualties of the chip shortage. Several car factories around the world were forced to temporarily shut down production due to insufficient supply of semis. Ford Motor Co anticipates a $2.5bn chip shortage cost.

Recently the CEO’s of Cisco and Intel, respectively major buyers and producers of semi’s, predicted that the shortage could last another couple of years because demand continues to increase and production can’t be ramped up overnight.

Runways for Growth

Entchev says that the average petrol engine car contains around $100 of semis while a full battery electric car contains up to $1,000 of them. Clearly the shift to electric cars will provide a growth runway for semis.

Douglas Isles (Investment Specialist, Platinum Asset Management) says that other growth tailwinds for semis include the move to 5G, the Internet of Things, autonomous driving, artificial intelligence and machine learning.

The semi design industry generated revenues of US $466bn in 2020 and leading IT research firm, Gartner estimates that the industry can grow on average by 5-6%pa over the next 5 years.

Entchev says that there are many different ways that investors can participate in the semi industry growth including:

- Suppliers of materials such as silicon wafers on which semis are built

- Producers of semi manufacturing equipment

- Companies that provide outsourced manufacturing of semis

- Software used to design semis

- Chip designers such as Intel and Samsung

Isles says that Platinum Asset Management has had a large exposure to the semi sector since 2018, but their investment in Samsung goes back over 20 years. Samsung has evolved to become a dominant player and today adjusting for cash on its balance sheet trades on about 12 times forward one year earnings (source: Factset)

Entchev says that Aoris’ preference is to invest in businesses that indirectly benefit from the advancement in semis, as it is very difficult to predict which semi companies will win in the future. A good example is Accenture, the largest global IT consulting business, which helps its customers deal with the technological changes that semis enable, like cloud computing.

Investors could also gain exposure to the semi industry through global managed funds and global ETF’s.

Risks

The semi industry is fast moving where customer needs can change quickly resulting in today’s products becoming redundant.

It is generally considered that this is a cyclical industry, with two of the largest end markets being to automotive and industrial customers, however Isles said following industry consolidation the economics of semis has improved.

And then there are the geo-political uncertainties surrounding Taiwan which dominates semi manufacturing. One of the most important developments in the semi industry has been outsourced manufacturing. In the 1970-2000’s semis were all made internally by the companies that designed them. Taiwan Semiconductor Manufacturing Company (TSMC) with support from the Taiwanese government created the first company dedicated to manufacturing designs from other companies. Today TSMC has 52% share of all semi manufacturing and over 80% share of the most advanced chips.

The electronic components of devices that we take for granted today are an important long term investment thematic.

 

 

The article was written by Mark Draper (GEM Capital) and appeared in the Australian Financial Review during May 2021.

Why The 10 Year Bond Rate Matters

The most important number right now for professional investors is the 10 Year Bond rate.

The 10 Year Bond rate is an important anchor point for investors as a ‘risk free rate of return’ that is used in valuation models to calculate the value of assets including equities, property, infrastructure and fixed interest investments.

In short, lower bond rates result in higher asset values and by contrast, higher bond rates result in lower asset values.  Since 1994, investors have enjoyed the tail wind of falling bond rates, but the tide has turned since the last quarter of 2020 which has seen Australian 10 year rates rise from around 0.7% to around 1.7%.  That is a 140% increase.

In valuation terms, Arvid Streimann (Head of Macro, Magellan Financial Group)  says that a 1% increase in 10 year bond interest rates generally result in a 9% decrease in the capital value for 10 year bonds and around 15% for equities.

The factors influencing movements in bond rates according to Streimann are expectations of inflation and real economic growth.  Rising bond rates generally imply increased economic activity.  In recent times however Central Banks have artificially lowered long term rates through their Quant Easing (aka money printing) programs.

The chart below shows the difference in government bond prices for both a 1% and 2% rise in long term rates.

Bond chart

Investors in funds that are called ‘conservative’ or ‘stable’ usually have a high exposure to bonds and are at risk of loss from rising rates and would be wise to review these investments given the landscape has changed.

Streimann says that the impact of rising bond rates on the equities market is more nuanced. He points out that equity valuations fall due to rising bond rates but not all equities are treated equally. Those companies with higher levels of debt suffer a double whammy as they also receive a drop in earnings as they pay higher interest costs over time. Vince Pezzullo (Deputy Head of Equities Perpetual) says that expensive growth stocks are more vulnerable to rising bond rates as they have distant prospective profits that are now discounted at a higher rate than before.

Pezzullo believes that if rising bond yields are signalling economic recovery, then cyclical exposed value stocks including energy, financials and mining, are likely to be beneficiaries as their business models have the most to benefit from the upswing in the economic cycle. Streimann highlights the banks as a potential beneficiary of rising bond rates as they tend to earn higher rates of return on their loan portfolios which can boost profits.

The other issue for equity investors is that not all investors use the same bond rate when valuing assets, and some investors don’t use this valuation method at all. Investors need to have an appreciation of the bond rate assumption being applied when reading research reports.

History generally doesn’t repeat itself unless people have forgotten about it. The last time bond rate movements caused extensive market damage was 1994 which is a long time ago. Pezzullo says the similarity to then and now is that markets were relaxed about the low inflation economic recovery, while the US Federal Reserve decided to push ahead with a surprise interest rate rise as growth accelerated. During 1994, the Australian 10 year bond rate rose from around 6% to over 10% resulting in short term damage to bonds and shares.

Streimann says the main difference between 1994 to today is the level and speed of communication courtesy of the internet, from the Central Banks. It’s all about expectation versus reality and the Central Banks are articulating the economic indicators such as the unemployment and inflation rates required to be reached before raising rates. This lowers, but doesn’t eliminate the probability of a bond market led panic.

Bond markets are currently stating that they believe Central Banks are likely to raise rates earlier and possibly higher than Central Banks have said on the back of an inflation scare. The question is whether the Central Banks are willing to view an inflation scare a transient and leave rates low. Investors would be wise to stay tuned to the communication coming out of the Central Banks for any changes in message. Either way investors must prepare for an investment landscape with rising long term rates. 

The article was written by Mark Draper (GEM Capital) and appeared in the Australian Financial Review on Wednesday 24th March 2021

What we learned from reporting season

The only thing certain about the future right now is that the future is uncertain.  So as we complete one of the strangest company reporting seasons we have ever seen, investors should reflect on the company profit announcements to see what they can learn about what may lie ahead 

Matt Williams (Portfolio Manager, Airlie Funds Management) says that while overall profits were down 20% compared to the previous year, the dire predictions in late March proved to be too bearish and there are now more profit upgrades than downgrades.  He said “The economy has strongly outperformed the accepted bearish scenarios of late March, retailers have produced phenomenal numbers”.

“The COVID-19 pandemic has not been uniformly bad for all Australian companies.  Travel related companies and listed property trusts with shopping centre assets have had a tough 6 months, while electrical retailer JB Hifi, hardware and office retailer Wesfarmers, AfterPay and Domino’s Pizza all saw record revenue over the past 6 months, benefitting from consumers being quarantined at home” according to Hugh Dive (Senior Portfolio Manager, Atlas Funds Management).

Nathan Bell (Head of Research & Portfolio Management, Investsmart) picked up on the travel sector which saw airlines and travel retailers at the epicentre of the COVID-19 storm.  “You could hear the desperation in Alan Joyce’s voice as he pleaded for state borders to reopen after announcing a $4bn loss”.  Bell also highlighted the almost 100% drop in passenger numbers since COVID-19 emerged for listed Sydney and Auckland airports.  He is of the view that leisure travel ultimately recovers and even if business travel only recovers to 70% of past highs due to a permanent shift to online meetings, both airports represent good value at current prices.  “People are once again going on holidays in the northern hemisphere, which is another good omen for this pair of airports.  Vietnam, Taiwan and Korea recently reopened their domestic borders and passenger numbers are now 10 – 20% above 2019 levels, suggesting pent up demand” he adds in support of the investment case for a rebound in airports.

Food and alcohol retailers (such as Woolworths and Coles) reported solid results as they benefitted from changing consumer purchase patterns, but they now trade at huge valuations.  Their valuations suggest future returns are likely to be far more muted if not negative should the impact of Job Keeper payments and people raiding their super funds wear off.

Dive points to the fact that “cash flows from the government were a significant feature of the August results season, albeit one that was understandably not highlighted by management when they presented their results.  JobKeeper and higher JobSeeker payments have helped companies such as JB Hifi and Afterpay as cash flows from the Government have supported retail sales despite the significant rise in unemployment”.  Investors would be wise to resist extrapolating the impact of these Government payments over the past 6 months into the future.

While the Telco sector reported earnings hits from lower global roaming charges and reduced retail sales during lockdowns, the 5G networks will cover the majority of the population in the next 12 months which represents revenue growth opportunities.  More rational mobile pricing should also help the Telco’s.

Banks reported much lower profits due to a mix of low credit growth, low interest squeezing margins and increasing bad debts.  Bell says of the banks “the bull case for Australia’s largest banks rests on them trading at large premiums to book value despite reporting single digit return on equity figures.  If this happens, Australia will be the exception to the rest of the world.  We don’t see why Australian banks are an exception as more people deleverage in the years ahead and property investors look beyond property for large capital gains”.  Ultimately the loan repayment deferrals will also need to be bought to account as well.

Williams said that in his discussions with company management, the key themes about the future were:

-       What happens at the end of the Government stimulus where retailers would appear most exposed.  

-       Opening up of state borders

-       Economic reform

With around 70% of companies either not issuing future earnings guidance or withdrawing earnings guidance, coupled with some market sectors trading on extremely high valuations, the job of assessing investment value is difficult.  The best opportunities ahead are less likely to be found in this years’ reporting season stars.  

 

This article was published in the Australian Financial Review during the month of September 2020.

How to profit from electric cars

Australian investors would be forgiven for largely ignoring the prospect of electric cars in their investment decision making with only 6,718 new electric vehicles (EV) sold in Australia during 2019 (includes fully electric EV, and plug in hybrid EV).  For perspective, the total number of new vehicle sales in 2019 was 1,062,867.  Astute investors however, are aware of the electric vehicle tsunami that is coming and are positioning to profit from it.

Alasdair McHugh (Director, Baillie Gifford) highlights “that currently only around 1% of the global passenger car fleet of 1.4 billion vehicles are electric.  Therefore the opportunity for EV’s to replace the remaining 99% of passenger vehicles is substantial.  Even against headwinds of ride-sharing, public transport developments and cycling/walking to work, the shift away from internal combustion engine (ICE) vehicles to EV’s leaves a vast market to penetrate.”

Nick Markiewicz (Consumer Analyst, Platinum Asset Management) believes that the size of the EV market “will ultimately depend on the end goals of Governments and regulators, adoption rates of EV’s among consumers and how automakers choose to meet their targets”.  While there is a wide range of views from credible pundits and automakers about EV penetration rates ranging from 10 – 60%, given the automotive sector is USD $2 trillion industry by turnover, even small adoption will still result in a large, high growth industry.

The most sophisticated market so far is China, which accounts for 47% of EV sales last year.  The Chinese Government has a goal for 40% of all new car sales to be EV’s by 2030 according to Baillie Gifford.

The chart below shows new car sales by region over the past 15 years.

 

Elsewhere in the world France has announced a ban on the sale of ICE vehicles from 2040 and in the UK, the ban will take effect from 2035.  

Investors can seek to profit from the EV boom not just by owning high profile automakers such as Tesla, and Chinese automaker Nio, both owned by Baillie Gifford.

Markiewicz believes that traditional makers “like BMW and Toyota still have a relatively bright future, and do not deserve to trade at their current multiples.  Both have deep electric vehicle expertise, with Toyota producing its revolutionary hybrid in 1997, and BMW launching the i3 in 2011.  Unbeknown to many, BMW and Toyota are already two of the largest electric vehicle producers in the world”.

While the manufacture of EVs requires fewer mechanical parts than ICE vehicles, it does need many new electric and electronic components and batteries.  Baillie Gifford like Samsung SDI in the battery supply chain and Platinum like LG Chem, who are battery producers. It is also interesting that EV cars are heavier resulting in increased tyre wear compared to conventional cars.

Some opportunity exists in Australia in owning resources companies who produce nickel, lithium and cobalt, which are used in battery production, alternatively investors can invest in managed funds to gain broader exposure to growth in electric vehicles.

The biggest threat, according to McHugh, to investing in the EV industry “is the emergence of a new type of energy efficient ‘fuel’ that could power cars, for example ‘electrofuels’.  One possibility is hydrogen gas (H2) made with renewable electricity.  At the moment there are scientific barriers to entry for this technology; storing the gas within the bodywork of a car is difficult and could be dangerous, and therefore expensive”. 

Second order effects of EV’s that investors need to consider is the impact of EV’s on the demand for oil, and the oil price.  Markiewicz says that the impact is “likely to be at the margin – there are 1.4bn passenger vehicles in the global car fleet which account for 20% of crude demand today. EVs are only 2% of new vehicle sales, and the global fleet only turns over every ~15 years. As a thought exercise, even if EVs were 50% of all new vehicle sales today, it would still take 15 years to displace 10% of the world’s oil demand (0.7% demand destruction per year). At the same time, oil demand will grow elsewhere. Hence, even under bullish scenarios for EVs, changes to oil demand are likely to be quite small – impairing growth, rather than absolute demand”.

Owning EV manufacturers may be the obvious investment for this thematic, but investing in other related components in the EV chain may be just as interesting.

 

This article was written by Mark Draper (GEM Capital) and featured in the Australian Financial Review in July 2020.

Cheap Bank Shares - not risk free

Investors holding the banks as a safe yield play have had a wake up call courtesy of COVID-19.  NAB have cut their dividend by over 60%, ANZ and Westpac have deferred their interim dividends and decide in August whether to make a payment.  

Bank share prices have fallen by around a third since the February 2020 peak, but investors need to ask themselves whether they are in fact cheap, or do better opportunities exist elsewhere.  The bank bulls would point to Australian bank shares trading at a lower book value than they have historically been, a common measure to value a bank.  

Book value is determined simply by subtracting the banks liabilities from its assets and then dividing by the number of shares on issue.  Nathan Bell (Portfolio Manager Intelligent Investor) highlights that Australian banks trade at a premium to their US and European peers on a price to book value.  For example CBA currently trades at around 1.5 times book value, and 5 years ago traded at over 2.5 times book value.  European Bank, ING trades at a book value of around 0.4 times.  While Australian banks are trading at lower price to book values than they have been for some time, they are not necessarily cheap by global standards.

Matt Williams (Portfolio Manager, Airlie Funds Management) highlights that forecast Price to Earnings ratios for Australian banks in 2021 are 11.1, which makes them more expensive than UK banks at 8.2 times earnings and US banks at 10 times earnings.

One of the major risks to any bank relates to bad debts.  The COVID-19 crisis now adds the spectre of a serious bad debt cycle.

It seems universally accepted that COVID-19 will cause the first Australian recession in 30 years.  Recessions increase unemployment and when people lose their jobs, their mortgage repayments can be at risk.  The RBA is forecasting the unemployment rate to rise to around 10% during 2020, a level not seen since the 1990’s recession, and not even reached during GFC.

History of Australia’s unemployment rate

To put current provisioning for bad and doubtful debts into historical perspective Williams says “bad debts peaked at around 1% of gross loans following the 1990’s recession which compares to present day consensus forecasts for bad debts peaking in 2020 at 0.4% of gross loans.  The current provisioning is materially lower than what happened in the 90’s recession and the GFC.”

The base assumptions around current consensus bad debts assume a multi year ‘U’ shaped recovery.  Williams adds “If the recovery is more ‘V’ shaped and unemployment outcomes are better than feared then the banks are on the cheap side of fair”.  Conversely, if unemployment outcomes turn out to be worse than expected, bank shares would most likely fare poorly.

Bell sees the small business sector as the source of the greatest risk to consensus forecasts on unemployment and bad debts.  Small business is defined as those businesses with less than 20 employees.  According to the ATO’s 2019 annual report, of the 4.2 million small businesses that operate in Australia, 800,000 of them had entered into a payment arrangement to pay their tax liability.  That implies almost one in five small businesses couldn’t pay their tax bill, and that was before COVID-19 hit.  

According to Australia’s Small Business Ombudsman report in 2019, Small business contributes around 33% to Australia’s economic output, and employs around 44% of all Australians.  What happens to the small business sector matters a lot to the economy and to the unemployment rate.  Unlike listed companies who can raise capital through the share market, small businesses have limited options which usually revolve around the owner mortgaging their home.

Bell says “we won’t know the final position until government support falls and loans stop being extended and we see the real impact of COVID-19 on the economy, particularly small business.”

He adds “the bull case for banks rests on investors being willing to pay a premium over book value despite single digit return on equity figures due to low interest rates.  This has not been the case in major markets overseas, so it would be our version of Australian exceptionalism.”

Williams says the best environment for banks consists of slowly rising interest rates, low unemployment, strong migration resulting in economic growth, but those days appear over.

So while bank shares are cheaper than they have historically been, they are clearly not a risk free trade.

 

This article was written by Mark Draper (GEM Capital) and appeared in the Australian Financial Review in June 2020

Infrastructure - opportunities and threats from COVID-19

COVID-19 has challenged the assumption that infrastructure investment offers defensive revenue characteristics that tend to hold up during periods of economic stress.  

Investors need to appreciate that not all infrastructure assets are the same, and that each sub-sector will react differently to COVID-19.

Infrastructure can broadly be separated into at least 3 categories:

  1. Regulated assets, including electricity transmission lines, gas pipelines and water distribution systems.
  2. Transportation assets, including toll roads, tunnels, bridges, seaports and airports.
  3. Communication assets, including radio and television broadcast towers and wireless communication towers.

So far during the COVID-19 crisis, the revenues and share prices of regulated assets and communication assets have shown great resilience.  This makes sense as a business such as Spark Infrastructure, who provides the power line infrastructure to supply electricity to homes in South Australia and Victoria, will continue to be paid to transmit electricity with or without COVID-19.

The infrastructure sector that has seen the most disruption through the lockdown of populations has been the transport assets which includes toll roads and airports.  Transurban (tollroads) and Sydney Airport have seen share price falls of around 25 – 40% since the end of February 2020.  These assets would seem to provide investors with great opportunity for future profit, due to the high level of uncertainty that is currently reflected in their share price.

There has been much made of Sydney Airports debt, however if the airport closed tomorrow, it has enough funding to cover all expenses and refinancing requirements for at least a year.

Clearly passenger numbers at Sydney Airport will be down for some time, however analysts can arrive at a valuation materially higher than the current share price even allowing for some dramatic falls in passenger numbers.  A model we have read includes a 90% fall in international traffic for the next three months and then a 50% decline for the remainder of the year.  This scenario assumed for domestic passengers a 60% decline for three months and a 20% decline for the remainder of the year.  Short term earnings fall by around 40% under this scenario, but shareholders have over 80 years remaining of a 99 year lease over the Sydney Airport, which makes short term earnings movements less relevant.

What is more relevant is whether Sydney Airport is likely to breach any of its debt covenants, and whether it needs to raise capital by issuing new shares at discounted prices and diluting existing shareholders value in the process.

Sydney Airport’s debt covenants are not publicly available, but analysts are of the view that they are no more onerous than those originally set out in 2002.  Under the above modelling, Sydney Airport would be unlikely to breach its debt covenants.

Transurban, which is an owner of multiple toll road assets faces some risk of particular roads breaching debt covenants, but as a group Transurban looks to be well capitalised and not likely to need to raise capital on the basis that the lockdown period lasts for 3 – 6 months.

The key risk facing investors with respect to transport infrastructure assets revolves around knowing how long the population lockdown will last for.  The modelling outlined earlier shows that Sydney Airport would be unlikely to need to raise capital if the lockdown lasted for 3 months, but a lockdown of 6 months would intensify pressure on debt covenants and a capital raising.  The length of the lockdown in ‘unknowable’ at this stage but the message is clear, the longer the lockdown, the more damage is done to earnings and to valuations.  

Investors would be best served to think in terms of scenarios, rather than absolute points at this stage and remain flexible in their thinking to accommodate new information as it comes to hand.

Out the other side of COVID-19, as with past disruptions it is highly likely that airport traffic and toll road traffic recover to reach new highs. A case could also be made for greater motor vehicle transport as commuters could seek to avoid the health risks associated with public transport.  Lower bond rates could also provide a tailwind to infrastructure valuations.

While no-one knows how COVID-19 plays out yet, what we can say with certainty is that that toll road traffic should return faster than air travel passenger numbers.  This means that toll roads should offer less earnings risk than airports at the present time.  

  

This article was published in the Australian Financial Review during April 2020.

Property Trusts after COVID-19

Following the most savage sell off in REIT’s since GFC, investors are left to decide whether to buy the lower prices or sell on the basis that COVID-19 has forever changed property.

During the month of March, the REIT’s index fell 35%.  While the sector fared worse during GFC, this sell off has been fast and brutal. 

Investors need to understand that not all REIT’s are created equal and they generally fall into 3 sectors:

  1. Retail
  2. Office
  3. Industrial

One of the major risks for property investors is vacancies and COVID-19 may cause vacancies through business bankruptcies.  The retail property sector is at the epicentre of this risk.  This risk would appear to be in current prices and Hugh Dive (Portfolio Manager Atlas Funds Management) is of the view that “some of the sentiment towards retail appears excessively bearish.”  He makes this point by backsolving the current share price of GPT Group’s property portfolio of retail, office and industrial assets.

The table below shows that at current prices, GPT investors are assigning GPT’s 12 shopping centres a value of $650 million.  According to Dive “this appears to be unlikely for a collection of assets that generated profits of $326 million last year.  If you demolished the shopping centres, the land value is most certainly worth a lot more than this.”

Pete Morrissey (CEO Real Estate Securities, APN Property Group) says that “COVID-19 is a catalyst to speed up the tenant turnover/bankruptcy and rent reversion cycle that was likely to continue for several more years into a compressed period.  While this may bring pain to landlords and tenants it could also see the emergence of a more vibrant, customer focussed retail sector.  Those properties that are well located with owners focused on meeting consumer needs will continue to drive solid return outcomes once markets stabilise.”

Dive summed up his views on retail property with “human beings have consistently enjoyed shopping and dining in public areas for two and half thousand years since the agora was built in Athens in the Fifth CenturyBC and it is hard to make the case that COVID-19 in 2020 totally changes that behaviour”.

A common theory with office space is that COVID-19 will permanently change the demand profile for office space as companies move their employees toward working from home.  

Morrissey says “While we don’t disagree entirely with this we do question whether corporates will be willing to forego the obvious gains from staff networking efficiencies and personal interactions/collaborations across their organisations.”  He also introduced the prospect that tenant space savings from staff working at home could be offset by social distancing requirements being introduced to the office.

Dive believes “that COVID-19 will reduce the demand for office space and rents will fall, but we don’t see a fundamental decline in value of office real estate.”  This is largely due to the tight vacancy rates in Sydney and Melbourne that should provide some support to rents over the coming years.

Industrial property would seem to be the most insulated sector from the impact of COVID-19.

“Industrial property, in particular logistics is likely to see a minimal impact from COVID-19 as their tenants are likely to see solid demand through 2020” according to Dive.  

Morrissey agrees and adds “increasing infrastructure spending, growing e-commerce, and a renewed focus on shoring up local supply chains will be an ongoing tailwind to drive industrial property demand.  Low vacancy rates across the sector indicate that industrial property is not over-supplied”.

Those investors who remember the highly dilutionary capital raising’s from REIT’s during GFC should take comfort in the low gearing of the sector today.  Average gearing today is around 28% compared to GFC levels of around 40%.  Dive is of the view that while we have seen a few small opportunistic capital raisings in 2020, we are unlikely to see a large number of jumbo ‘life or death’ capital raisings in the REIT sector like we saw during GFC.

Investors can gain access to REIT’s by either purchasing them directly via the ASX, or through diversified property funds such as those offered by Atlas Funds Management and APN Property Group.  ETF’s are another way of gaining property exposure, but investors should be aware that the property index is dominated by retail property if choosing to index their property exposure.

It is said that it is always darkest just before the dawn.  Long term investors could well make good long term returns from sifting through the REIT wreckage.

 

This article was written by Mark Draper (GEM Capital) and was published in the Australian Financial Review on Wednesday 13th May 2020.

Alibaba - why the smart money likes it

With the Chinese middle class population forecast to double to over 600 million over the next 5 years, which in turn increases consumer spending, it is not difficult to see why the ‘smart’ money is investing in Alibaba, one of China’s largest companies that is likened to Amazon, eBay, Paypal and Google all rolled into one.

Alibaba was founded during the 1990’s by Jack Ma who realised at that time China lacked technology in the business world.  Alibaba, now one of China’s largest companies, listed in 2014, and today is highly profitable with a market capitalisation of over US$580bn.  This is about 6 times larger than Australia’s largest company CSL.

Alasdair McHugh (Product Specialist Baillie Gifford) is attracted to Alibaba due to their very strong position in ecommerce transactions in China where their market share is over 60% by gross merchandise value and likely to rise further.  He also likes the fact that the original co-founder and visionary Jack Ma is still involved in the business.  

According to the China Ministry of Commerce, total retail sales across China increased 8% in calendar 2019, for a total of RMB 41 trillion (AUD $9 trillion).  Consumption contributed over half of China’s economic growth.  Online retail sales for the year was RMB 8.5 trillion (AUD $1.87 trillion) up 19.5% from the year before.  It is clear that consumption is now a major driver of economic growth in China, and online retail is an important driver of consumption growth. Alibaba’s dominant position means it is well placed to capture this growth.

The scale of the opportunity is extraordinary and underestimated by certain investors, particularly some from the west who still consider China as a risky emerging market.  But McHugh suggests that those who still treat China as an emerging market are overlooking the fact that the addressable market for Chinese consumer spending is 1.3 billion people.  

Illustrating this point was the recent ‘Singles Day’ held in November 2019 where another record was broken with total sales of RMB 268.4bn (approx. AUD $59.2bn).  Almost 1.3 billion packages were delivered by Alibaba from ‘Singles Day’ orders and of those 960 million were delivered within one week.  This is equivalent to 2.3 times the combined online sales of Black Friday and Cyber Monday in the US.  It reflects the strength of Alibaba’s digital economy and of Chinese consumers consumption power.

Joe Lai (Portfolio Manager Platinum Asset Management) says that “mobile monthly average users on Alibaba’s retail marketplaces in China reached 824 million in December 2019, an increase of 39 million from the previous quarter”.  

Beyond the ecommerce business, Alibaba operates the largest cloud computing business in China, Alibaba Cloud.  Many believe that this business can ultimately become the largest division within the company despite it presently representing less than 10% of overall revenue.  Revenue from Alibaba Cloud grew by 62% over the year to December 2019.

A fascinating aspect of Alibaba’s recent quarterly earnings update related to the company’s involvement in procuring and delivering 40 million units of medical supplies worth around AUD$100 million to Wuhan which has been impacted by Covid-19.  This shows a company that is so much more than an online retailer. 

Lai points out that “The Alibaba ecosystem keeps delivering new sources of value to shareholders.  Amid the Covid-19 lock down in China, Alibaba’s new enterprise communication app, DingTalk, has achieved new prominence.  Alibaba introduced a new digital health check in feature on DingTalk, which as at February 2020, had recorded more than 150 million daily health check ins.”

While currently investors are obsessing over Covid-19, Alibaba management said “17 years ago, the ecommerce business experienced tremendous growth after SARS.  We believe the adversity will be followed by changes in behaviour among consumers and enterprises and bring ensuing opportunities.  We have observed more and more consumers getting comfortable with taking care of their daily living needs and working requirements through digital means.” 

With the huge growth in China’s middle class and online commerce in coming years, combined with Alibaba’s dominance across retail, financial and computing businesses it’s clear to see why the company is in Platinum and Baillie Gifford portfolios.  Investors can of course buy Alibaba directly either on the Hong Kong or US exchange and can also gain access to it through managed global funds.

 

This article appeared in the Australian Financial Review during March 2020 - written by Mark Draper GEM Capital

AMP - Still howling

AMP is attempting one of the most complicated turnarounds in corporate history (if not a gold medal winner).  Brett Le Mesurier (Senior Analyst – Shaw and Partners) says “I can’t recall another company which is fighting its distribution, has declining revenue margins, increasing net outflows, implementing a substantial expense reduction program and facing potentially large remediation and litigation costs all at the same time.”  The question for investors is whether AMP is cheap enough at current prices to warrant being part of a portfolio when all these issues are considered.

Matt Williams (Portfolio Manager – Airlie Funds Management) however believes that if the company were to be broken up, the sum of parts could be worth more than $2.20 per share, but stresses that this is not currently AMP’s plan.

AMP’s strategic plan currently involves selling its life business which it hopes to realise $1.8bn.  Other parts of its strategy involve slashing ‘Buyer of Last Resort’ (BOLR) contractual payments to its advisers by almost 40%.  BOLR was a contractual arrangement where AMP would guarantee to buy an advisers business for 4 times recurring revenue.

It’s future strategy for resetting the culture of AMP wealth management includes terminating many of its advisers and offering a digital advice platform for certain client segments, while those advisers who will remain are to service ‘higher end’ clients.

AMP Capital, the funds management arm of the business is the jewel in the AMP crown.  While it could operate on a stand alone basis, $116bn of the $200bn it manages comes from internal sources and this provided 30% of its income in the first half of 2019.  The value of AMP Capital depends on the future of those funds.

Williams says “The major issue for us is whether the operational and cultural reset needed in AMP wealth management is just too big an ask. The new management team is untested against the mammoth task ahead.”

He adds, “We wonder whether a better outcome for shareholders might be a company led breakup of the whole business. We question whether the AMP brand in wealth management is salvageable and think board and management should re-test that hypothesis before going too far down the path of spending ~$1bn in re-setting the business.”

For the bears, Le Mesurier outlines 7 key risks.

  1. AMP now has an unsettled distribution force as a result of the reduction of the BOLR. The previously high multiple encouraged advisers to recommend AMP products to their clients.  This issue possibly ends with a settlement involving further payments from AMP.
  2. The revenue margin decline in the wealth management business has been greater than management has expected for a number of years and this may continue to be the case.
  3. The revenue margin on the North product at 0.54% in first half of 2019 was less than the average cost of running the wealth management business which was 0.65%. North is the only product generating net inflows.
  4. The net cash outflows in the wealth management business are approximately 6% p.a. of Assets under management currently.
  5. The sale of the life insurance business has not been completed. It has failed once already and the price has been reduced.
  6. There is no guarantee that the expense reduction target will be met. The last time AMP attempted such a program, the costs increased.
  7. The customer remediation provisions may well be inadequate and they may face substantial litigation costs.

Le Mesurier adds “AMP’s remediation provisions seem to be inadequate in comparison with the actions taken by the major banks.  The banks’ provisions are approximately double AMP’s and their adviser networks were much smaller and had a greater weighting towards salaried advisers. For AMP’s provisions to be adequate, their record keeping and the provision of advice would have to be much better than the major banks but their performance at the royal commission would not give confidence that was the case.”

The chart below, which includes the increase to remediation costs following the recent bank profit results, (red bars) shows the remediation costs measured per adviser.  Should AMP’s cost per adviser rise to the level of ANZ, the additional cost for AMP shareholders could be north of $3bn.

The crucial time for the company and shareholders is when (if?) the life sale completes, and the accompanying investor update, but this turnaround is not for the faint hearted.

 

This article was written by Mark Draper (GEM Capital) and was featured in the Australian Financial Review in the week of 24th November 2019.

 

Waste Management - turning trash into profit

Investors seeking an industry sector  - that is almost certain to grow would be wise to take a look at the Waste Management sector.

Andrew Mitchell (Ophir Asset Management) is attracted to the sector because “Waste is a huge industry which will increase with population growth.”  He also likes the high barriers to entry in particular segments of the waste sector such as municipal collections and commercial waste.

The chart below shows the growth in core waste in Australia over a decade with a compound annual growth rate of 1.2%pa.

 

There are three main segments of the waste industry:

  1. Municipal (council kerbside household waste)
  2. Commercial / Industrial waste
  3. Building and demolition (construction and infrastructure)

Municipal and Commercial waste is generally considered ‘recession proof’ among professional investors while building and demolition waste is more cyclical.

Waste Management companies of the future are increasingly focussed on recycling, particularly following the introduction of the Chinese ‘National Sword’ policy last year.  China used to be the biggest importer of recyclable materials globally.  It took 30m tonnes of the world’s waste each year, including Australia’s.  Put simply, China used to buy the world’s recyclable waste, and it largely banned it overnight.  Australia will need to build its own recycling facilities to dispose of the waste appropriately.

Mitchell believes that “it’s becoming a social imperative that more is done with waste.  The call for more to be done on sustainability and recycling is growing louder within the community.  We believe Australians are becoming more accepting now of paying for the cost of sustainability.”

Emma Goodsell (Airlie Funds Management) says “the waste management industry is increasingly focused on building out critical recycling infrastructure.  The issue for the whole waste supply chain is that the cheapest way of doing things is usually the worst for the environment (ie landfill).  So it requires government intervention, in the form of levies on the cost of disposing a tonne of waste into a landfill, to adjust the playing field and allow for investment in recycling assets.”

The graph below shows the growth in recycling over a decade, with compound annual growth of 2.4%pa.

Landfill levies collected by the NSW government alone are approaching $1bn per year and are increasing.  Australia recycles or converts waste to energy for around 50% of waste according to Mitchell, so is considered middle of the pack by global standards compared with the US or developed European peers where this figure is around 80% plus.  Mitchell sees Government landfill levies as a potential revenue pool for Waste Management companies who are able to divert waste from landfill.

Goodsell points to Cleanaway’s joint venture with Macquarie’s Green Investment Group for a Western Sydney plant that will convert waste to energy as an example of business diverting waste from landfill.  This plant is likely to have the capacity to cut landfill volumes by 500 kilotonnes per year.

The biggest risks of investing in this sector would seem to be regulatory.  There is a lack of cohesion between State Governments which results in the waste industry being effectively different in every state.  Landfill levies can vary significantly from state to state and until recently Queensland didn’t charge a landfill levy which saw large movements of NSW waste shipped across the border.  Lack of uniformity in bin sizes across states increases costs as trucks need to be designed differently for each state.

Mitchell believes that Governments are slowly realising that more needs to be done in the waste sector, particularly with more national cohesion noting that there is now a Federal minister for waste reduction.

The ASX is home to one of the worlds’ largest listed waste management companies,  Cleanaway (formerly Transpacific Industries), and Bingo Industries is a relatively new addition to the ASX.  Mitchell is attracted to Cleanaway as “we like the more stable and defensive earnings streams of Cleanaway (mainly municipal and commercial) whereas Bingo operates in the more volatile/cyclical building and demolition space.  There are also a lot lower barriers to entry in that part of the market (Bingo Industries)”.

Most investors would associate waste management with garbage collection, where as the future lies with the recycling of waste.

 

This article was written by Mark Draper (GEM Capital) and appeared in the Australian Financial Review during October 2019

Generational Investment Opportunity in Chinese middle class

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

 

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

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

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

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

Source: Magellan Financial Group

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

Source: Platinum Asset Management

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

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

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

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

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

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

Generating Sustainable Retirement Income - FREE REPORT

One of the most common questions financial advisers are asked is "how much can I spend in retirement without running out of money", and "do I have enough to retire on?".

To help those who are contemplating retirement, or already retired and questioning their existing reitrement funding plans, we have produced a straight forward guide that outlines some key concepts that we believe retirees should consider when establishing their financial plans in retirement.

 

This report covers tax, age pension guidelines, how much should be held in cash and fixed interest and brings it all together with a couple of case studies.