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Michael Kodari
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+ About Michael Kodari

Michael Kodari is the founder of KOSEC – Kodari Securities, and one of Australia’s prominent experts in the stock market. With a strong background in funds management and stockbroking, Michael has worked with some of Australia’s most successful value investors and consulted to leading financial institutions. Michael writes for Australia’s key financial publications and is one of the nation’s most consistent, top performing investors. He has been referred to as ‘the brightest 21st century entrepreneur in wealth management' and ‘a trailblazer within the Australian stock market’, CNBC Asia.

The US economic outlook

Friday, January 13, 2017

By Michael Kodari

The US employment market delivered another strong performance to finish 2016 on a high. According to Bloomberg, it was the sixth year in succession where the economy added in excess of 2 million jobs. The economy added 156,000 jobs in December, below the forecast 175,000, while the unemployment rate rose to 4.7%.

On the face of it, the headline figures appeared to underwhelm, nevertheless, it was pleasing to see the figures for November revised higher. At 4.7% unemployment, many would argue that the US is very close to full employment – a state of affairs that may be contributing to the softness in the payrolls data.

It appears that there’s insufficient supply of labour for jobs requiring managerial and specialised skillsets and as such, particular rolls are difficult to fill. It is our view that this theme is being illustrated in the divergence between wage growth and employment growth.

Wage growth

In December, overall wage growth hit the highest level since 2009, rising by 2.9%. That could support consumer spending, stoke inflationary pressures and ultimately lead the Federal Reserve to tighten monetary conditions and increase interest rates faster than expected. It was therefore unsurprising to see US treasuries and the US dollar respond in kind, rallying strongly on the back of the data.

Americans aged 25-34

Also of note was the ongoing decline in the number of Americans aged 25 to 34 not working, a figure that fell below 22% for the first time since 2008. This is encouraging given it’s an age bracket that’s particularly supportive of household formation, which, in turn, could lead to positive developments for residential markets, credit growth and auto sales.

An interesting observation made by Goldman Sachs is the recent uptick in the prime-age rate of employment, driven by improvements in the number of disabled workers now more able to work, and many wilfully unemployed persons reassessing their vocational status.

To put it politely, such changes of heart come in light of improved job prospects, work tasks and remuneration where the “overall” benefits begin to outweigh those offered by welfare and disability services.

Areas for concern

Despite the positive indicators, there are a number of areas of concern. Headline wage growth is being impacted by the fact that retiring workers tend to be older and more highly paid workers, whom are typically replaced by younger and less highly paid workers. This is a structural trend that is unlikely to subside anytime soon in an economy with an aging work force.

From a longer term perspective, the ratio of active to retired workers in the US continues to fall indicating a greater number of retirees reliant on less workers which is of particular concern in a environment where debt to GDP is rising. Despite sentiments to the contrary, it is evident from this that the US will need to look at an effective immigration policy to avoid following a similar path taken by Japan.

Optimism over the short term

Refocusing on the shorter term and there are a number of indicators that leave us optimistic for ongoing strength in the US economy. Despite a strong employment market and improving wages, the US economy has remained fairly subdued. Part of the reason for the fairly slow recovery can be put down to the deleveraging of the US consumer which has seen consumers pay down household debts and increase their savings rate.

Additionally, the wealth effect brought about by rising asset prices, whether it be property or equities, places the consumer in a strong position. As it stands, the increase in the savings rate has been pronounced. As confidence builds, it’s conceivable that those savings will be deployed, leading to a pick in household consumption where its significance can’t be understated for an economy that relies on household consumption for close to 70% of its GDP growth.

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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3 important investment lessons from 2016

Friday, December 16, 2016

By Michael Kodari

If I were to picture our readers in this last fortnight of 2016, I would conjure up an image of festive cheer and good times with family friends. Whether it be on the golf course, at the beach, or on the yacht, now is a time for relaxation, enjoyment and perhaps a touch of recalibration. Whether we are taking stock of our personal achievements, family endeavours, or our investment portfolios, the end of one year and the dawn of the next is always a logical time to review, analyse and evaluate. And on the global economic front, what a year 2016 has been.

Domestically, we have seen the election of Malcolm Turnbull by the most slender of margins. Australia has moved away somewhat from a two party duopoly, and now has a number of minor parties that hold considerable sway in influencing decisions at a federal level. Turnbull will need to use his persuasive powers to good effect if he is to navigate the terrain to pass the legislation required to develop on the nation's outstanding 25-year record of economic growth. So far, the Liberal Party have also been successful in avoiding any infighting, but there are lingering underachievements such as the gay marriage plebiscite, corporate tax plan and ‘jobs but not so much growth’.

Brexit blues and Trump's triumph

When Nassim Taleb wrote the 2007 classic The Black Swan, he argued from a position of years of statistical and risk analysis that we are all reasonably poor at anticipating difficult-to-predict events. This hypothesis was perfectly captured with the UK’s decision in June to vote to leave the European Union. All the polling analysts had doubted that scenario would ever come to pass, so it was a major shock with the reverberations felt as far away as on the ASX. 

A further, and perhaps more dramatic political upset occurred with Donald Trump’s triumph in the US election this November. Again, the media, influenced by a series of polling metrics, had failed to envisage the probability, and you, just like all of us, were left enthralled, amazed or appalled (depending on allegiance) with the final outcome. Despite losing most of all the major urban areas along the two coasts, Trump was able to capture huge swathes of southern and midwestern USA in a political outcome that will be studied for generations.

Indeed, 2016 closes with Trump yet to be inaugurated and he is already making headlines on a virtually daily basis. He is the first President-elect to be an avid disseminator of ideology and rhetoric through social media and his outspoken tweets are rocking the stock market as different sectors and businesses come under his 140 character radar.

Second guessing what will transpire across the next 12 months is an almost impossible task. 2017 will see Trump in power and it will be fascinating to see how he fares with Congress, international leaders and unforeseen political events obstructing him week after week. For instance, will Trump be able to soothe US-Chinese relations having decided that attack was the best form of defence following the uproar surrounding his calls from Taiwan? Another issue will be what leadership Trump can impart on the European continent as the EU faces one of its most challenging years since inception.

Not only is there the Brexit timetable and framework to work on, but the European Union will also be further rocked by issues emanating from at the very least Italy, Spain and France. Italy faces a new election for their next Prime Minister and further concerns about the liquidity of their domestic banks, while Spain has serious challenges with structural unemployment, especially among under 25s. There are suggestions in Italy that one-way European countries might return to better growth rates if Germany were to leave the Euro, allowing the currency to depreciate and provide better value for exporters. Most intriguingly of all, there is a French general election to come and there is widespread concern that Marie Le Pen, the National Front leader, will poll well. The National Front have a long-standing reputation for socially conservative and profoundly nationalist policies which will not sit well with the broader European, liberal project. 

Source: ABS, AMP Capital, Switzer

So it is perfectly possible to envisage 2017 as being another highly eventful year. Whatever does transpire, there are perhaps three lessons you can take to harness the advantages. The first is that change is inevitable, and that with technological developments, the pace of change is increasing month by month, tweet by tweet. The stock market will react with a degree of volatility because unforeseen changes have not been priced in yet and the process towards a fresh equilibrium takes time.

So for the stock market, the second lesson is that it pays to be active when monitoring the portfolio. This year has seen dramatic movements in the prices of businesses across the materials, energy and healthcare spaces. Financially sound businesses have been sold off aggressively as sentiment shifts, so simply setting and forgetting might be an unnecessary risk to take. 

The final, and perhaps most important lesson of 2016, indeed any year, is that no matter what has happened or will happen in the future, investing in equities can be the fastest way to grow your wealth. The above graphic shows the performance of the ASX as an index over the last 90 years. In that time, we have seen events like World Wars, famines, the rise of Communism, Oil price shocks, the advent of the internet and now, Donald Trump. Whether these events have been for humanity's better or detriment, whether these events have been anticipated or not, the ultimate lesson is that shares remain the highest returning asset class over the long term, and in our opinion, a wise investment no matter what 2017 has in-store.

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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The great rotation

Friday, December 09, 2016

By Michael Kodari

The sector rotation in the broader market continues for now. Basically, since the start of October, we’ve had indiscriminate selling pressure on very high quality businesses, but the question is whether that pressure can be expected to persist?

We think this phase has come to pass. As always, we only look to invest in businesses with growing Revenue and Net Profit, high Return on Equity, stable and growing NPAT margins, low Net Gearing and positive Free Cash Flows. For now, the market seems to be disregarding such qualities however in time, we feel that those positive traits will again become very difficult to resist.

A good example of the market irrationality at present is the recent 1HY result from Fisher & Paykel Healthcare (FPH). FPH delivered 26% net profit growth and 12% revenue growth for the half. These results exceeded market expectations, yet drew price target downgrades from numerous brokers, despite those figures exceeding their own forecasts. To us, that doesn’t seem logical, but after all markets aren’t necessarily rational.

To give you some perspective of the market divergence, the table below outlines each sectors performance since the start of October.

 

What we can see is that there are only four sectors in positive territory, while the remaining seven are in negative territory. The three sectors doing the best are financials, mining and energy - a complete reversal of what had occurred in recent years. If the ASX 200 was an equal-weighted index where each sector contributed the same weighting, the ASX would have fallen 3.65%, but as it turns out, the index was only 1.50% lower (as at 05/12/2016) given the ASX greater weighting towards banks and mining companies. To break things down even further, the average return of those sectors in the red is a significant -8.50% signifying the scale of the sector divergence that‘s been occurring.

Many investors would be at home scratching their heads and staring at their investment returns wondering where it all went so wrong. Cold comfort can be taken from the fact that some of the best performing fund managers from the last three years have lost in the vicinity of 8-9% for the month of October alone.

After a tremendous period for the healthcare sector, the space finds itself as the worst performing sector. After reaching all-times highs as a sector in July 2016, the sector has now retreated approximately 17% from those levels. To give some perspective, the healthcare sector only declined 24% during the GFC. I suppose the natural question to ask is, why has this occurred?

The answer is rarely a single factor and this case is no different. The healthcare sector has been under enormous pressure in the United States, with neither Hillary Clinton nor Donald Trump seen as sympathetic to the biotechnology or pharmaceuticals space, and as such, Australian Healthcare businesses have borne the brunt of those sentiments. However, beneath the surface there are other factors at play that apply not only to the healthcare sector, but other sectors as well. 

I promise not to get too technical, but I think there's an important point to make as it goes a long way to partly explaining the recent sectorial shift on the market. Consider the fact that the Australian 10-year government bond has increased from 2% at the start of October to approximately 2.80% now.

When analysts value businesses, a key input used to discount future cash flows is the companies weighted average cost of capital, or WACC. As bond yields rise, as they have, so does a company’s cost of debt. This, in turn, leads to the WACC increasing as well. What this invariably means is that future cash flows are discounted by a larger value, resulting in a lower valuations for all businesses to which the higher rates are applied. However, the important distinction must be made that not all businesses are affected proportionately. Essentially higher growth businesses, often trading on higher P/E ratios, experience larger percentage declines in value, than those businesses with lower growth prospects. 

The table below illustrates that point. We have two companies, one high-growth business, and one low-growth business. The change in value assumes a 1% increase in each companies WACC from 9% to 10%. In reality, there are numerous variables which determine a company’s WACC, and certain variables have greater influence than others depending on the business. However, for this exercise, we’ll keep it simple and use standardised WACC for each business. As we can see, the decline in value for the high growth business is far greater than for the lower growth business.

Now consider the following traits associated with the healthcare sector: high growth and high price to earnings (P/E). The same qualities can be associated with another poor performing sector in recent months, the technology sector. What this shows in our opinion is that rising bond yields have affected not only the high dividend yielding and highly indebted business, but the higher growth companies as well. Therefore, bond yields have certainly been one of the factors accentuating the enormity of the sector rotation we’ve witnessed in recent months.  

Another factor undeniably driving markets at present is that we seem to have reached the capitulation phase for commodity bears. Year to date, the materials sector has returned 40%, unwinding some of the underperformance in recent years and masking the underperformance of the broader market. For those overweight, these materials businesses have achieved performance far better relative to those who’ve been underweight, but we feel that this trend cannot persist for much longer. The coal price has increased 200%, while iron ore jumped to a two-year high despite little changing with the long term fundamental picture. It is as if we are returning to the glory days of break-neck industrialisation in China which certainly isn’t the case.

Looking back over recent decades, many would be surprised to find that despite the commodity super cycle, the broader market has had less years of negative returns, with a superior total cumulative return than the materials space. Interestingly, the materials sector has had significantly greater volatility over that period, as well as inferior returns. We therefore hold the view that investors can improve their returns and reduce their volatility and risk by remaining underweight the materials space over the medium- to longer-term.

Moving forward, we implore investors focused on quality to remain undeterred, and over time, such sectorial shifts shouldn’t affect or change their investment philosophy. As always, investors should remain focused on delivering strong returns in excess of the index and we feel investors have good chance of doing so as long as they ignore the short-term noise and remain focused on high-quality businesses with growing earnings and high-quality balance sheets.

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Headed for another interest rate cut?

Friday, June 17, 2016

by Michael Kodari

The March quarter GDP was released this month and came in substantially higher than market expectations. Over the period, the Australian economy expanded by 1.1%, greater than economists’ estimates for a 0.8% increase, and contributed to a 3.1% annualised figure, versus the forecast 2.8% gain.

The primary driver of growth continues to be net exports, which jumped 4.4% to contribute 1% to growth as resource export volumes continued to grow. Household spending and government expenditure were the other main contributors increasing 0.7% and 0.9% respectively. That means final consumption expenditure added 0.5% to GDP. Household demand for services such as financial services, retail, food services and arts and recreation all helped propel household spending.

graph

Equally encouraging for the services sector was the pickup in business lending, which rose at the fastest pace in seven years. A slight lift in CAPEX intentions signalled that the transition from a mining led economy to a services based economy is not only ongoing, but gathering momentum.

The strong performance in net exports was more than enough to offset the ongoing weakness in the domestic economy, which is presently being inhibited by subdued investment in the mining and non-mining sectors. Fundamentally, the underlying issues holding back the economy at this stage remain subdued corporate income and weak household income growth, and the RBA is conscious of that fact.

Gross fixed capital formation declined by 1.7%, subtracting 0.4 percentage points from GDP growth. Private investment fell 4.2%, mainly due to a decrease in new engineering construction, new building and machinery and equipment.

graph Source: ABS

It is important to understand that the sizable boost from resource exports is uncommon in nature and cannot be relied upon on a consistent basis, with more 'normal' increases likely to contribute 1% p.a. to GDP growth, not 1% per quarter.

The terms of trade declined by another 1.9% for the March quarter, meaning that while GDP has been stronger than expected, Gross Domestic Income (GDI) growth for the economy is subdued. In recent months, the market has seen commodity prices stabilise and relative strength in the AUD. If this situation was to persist then it will become an issue for the RBA.

During the March quarter, trend real net national disposable income was flat at 0.0%. Through the year, real net national disposable income fell 1.1% compared with an increase of 3.2% for GDP, highlighting the constraints on domestic demand.

In order for the domestic economy to return to anywhere near ‘trend’ levels, improvement in the domestic economy is required to incentivise non-mining sector investment. Interest rates are low, labour is cheap, and the exchange rate has come down. These three things should all be positive incentives for businesses to invest for the future but so far hasn’t happened. The reality is, until downward pressure on the domestic income abates, a sustained pickup in economic activity and inflation is unlikely.

For now, the stronger than expected GDP figures have kept the RBA at bay, who decided to leave rates at 1.75% in early June. We believe the RBA will cut rates again before 2017, but choose to wait for the June quarter CPI data, as well as overseas events such as the Brexit vote next week. That leaves August as the likely month for the next 0.25% cut.

graph Source: ABS

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Bright spots in US jobs data

Friday, June 10, 2016

By Michael Kodari

After adding the fewest number of workers in seven months in April, the US economy threw up another surprise in May after adding the fewest number of workers in almost six years. The economy added 38,000 workers in May, the fewest since September 2010, convoluting the outlook for Federal Reserve interest rate rises. The number significantly missed even the most negative forecasts raising questions about the strength of the US economy and the outlook. According to Federal Reserve “the overall labour market situation has been quite positive. In that context, this past Friday's labour market report was disappointing.”

It is worth highlighting that prior to the April Jobs number, the non-farm payrolls had by and large been significantly better than economists’ expectations. It’s therefore conceivable that the current set of subdued numbers are balancing out some of the more excessive gains in prior months to ultimately reflect a more stable run rate. As always, it’s important not to place too much emphasis on a single reading, sentiments echoed by Janet Yellen who stated that “although this recent labour market report was, on balance, concerning, let me emphasize that one should never attach too much significance to any single monthly report.”

Nevertheless, the evidence suggests that the overall employment picture has softened despite the headline unemployment rate declining to 4.7%, the lowest levels since November 2007. The labour force participation rate declined to 62.6% percent as the number of Americans who left the workforce grew, while the number of workers working part-time that would prefer to be working full-time increased to 6.4 million people up from 6 million in the April.

A bright spot in the report was a pickup in wages as the data indicated that average hourly earnings rose by 0.2% in May in addition to an April figure that was revised higher to 0.4%. Wage growth has now increased 2.5% over 12 months for the year ending May 2016, a significant pickup that is supportive of consumer spending and sentiment.  `

After interpreting all those numbers the question becomes; what is the likely impact on the pace and timing of any US interest rates increases?

Our reading of the data is that the US economy and the labour markets remain strong. Much will be made of the significant drop off in jobs growth and ostensibly it doesn’t look great, however it’s not uncommon for wage growth to gather momentum as jobs growth moderates. For the past 8 years, month after month investors have been told that despite strong jobs growth, lacklustre wage growth was an obstacle to interest rate rises. Well now the shoe is on the other foot, and wage growth is showing signs of sustained strength while jobs growth is weak. Our opinion is that the Fed doesn’t have the luxury of waiting for all its stars to align, and runs the risk of losing its credibility with financial markets. 

The facts are the US labour market is creating jobs faster than workers, and the labour market is tightening as indicated by accelerating wage growth. As such, it's unsurprising that inflation seems to be on a predictable path towards the Federal Reserve’s 2% target. The connection between wages and inflation is quite simple. As wages rise, employers are faced with rising input costs. In order to maintain margins and overall profitability, businesses are in essence forced to increase the prices they charge on goods and services, which subsequently drives inflationary pressures. 

Time and time again in recent years, the Fed has had the opportunity to move away from zero bound interest rates, but on each occasion it has stepped away from the edge at the last minute. This time appears no different. After having seemingly prepared the markets for a rate increase in recent weeks the negative jobs data seems to have spooked the horses and expectations have again been pushed out.

Our view is that improvements to rising wages, household balance sheets, debt serviceability, and consumer sentiment all clear the way for rates to move higher with July and September the most likely months.

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Should you invest in gold?

Friday, June 03, 2016

By Michael Kodari

Gold, what to make of this mysterious and enigmatic commodity?

Unlike most other commodities, gold rarely gets consumed and tends to lay lifeless in secure vaults for years on end. It’s for those reasons gold lacks the typical supply and demand dynamics that drive price discovery leaving it up to human emotion and technical analysis to determine price movements. The common investment case for gold comes from its perceived “safe haven” status that is meant to see gold help investors counter the risks and uncertainties that may confront financial markets. Aside from investment demand, jewellery sales is the other main driver of the gold demand with golds industrial use limited by its cost, despite being the most conductive element on the planet. 

A weakening economic outlook and heightened levels of uncertainty have typically been supportive of the gold price, as indicated by the strong performance of gold during the volatile start to 2016 shortly after reaching a six-year low in December 2015. Gold prices have rallied from levels seen in early January, despite a recent rebound across risk-on assets including equities, EM currencies, industrial metals and oil as lingering risk aversion seems to be supporting ongoing global gold inflows.

Global jewellery demand appears soft, falling 3% year-on-year in 2015 while Central Bank demand his risen modestly by 1% year-on-year. Chinese buying trends are also highly important given they account for around 40% of gold demand every year. The People's Bank of China has been steadily increasing their reserves in recent times, up from 1,054 ton in 2009 to 1,762 tons as at the end of 2015. Growth in Chinese retail gold demand has been less convincing, with anaemic economic performance weighing on consumer sentiment.

An aversion to macro risk and ongoing weakness in global growth however may continue to drive investor appetite. These days we have one third of the world's developed sovereign debt markets in negative yield territory after Europe and Japan cut interest rates in an attempt to counter deflationary pressures and become increasingly desperate to drive growth. We can see in the chart below the inverse relationship that has developed between the 10-year US government bond in the blue, and the Gold price in the black, since the year 2000. With bond yields falling to historically low levels, gold and treasury bonds become a like-for-like when it comes to a “safe haven” asset. Obviously, gold doesn’t pay a yield and it never will, but with bonds paying record-low income or even negative income, the historical yield differential between the pair has become immaterial, supporting demand for gold.

 

Another highly important relationship, particularly for Australian-centric gold investors, is the interrelationship between the gold price and the Australian dollar. Given the gold price is denominated in US dollars, as the Australian dollar depreciates against the US dollar, the Australian dollar gold price appreciates. 

The table below outlines the relationship by comparing the gold price the Australian dollar, and the Australian dollar gold price between 2011 and 2016. What we can see is that from June 2011 to June 2016 the gold price denominated in USD has fallen by 20.80%. Over that same period, the Australian dollar has declined from 1.07 to 0.72 (or -32.45%). Given the fall in AUD, the value of gold in Australian dollar terms has in fact risen by 17.26% over the same period, pushing Australian dollar gold close to record highs and helping to place Australian gold producers in a far superior position than their global peers.

The inverse relationship between an AUD and the share prices of Australian gold producers reflects the favourable position of Australian based gold producers. The chart on the below illustrates the performance of the ASX Gold index since 2014, when compared with the performance of the Australian dollar it’s clear that as the AUD falls Australian gold companies perform well. 

Despite the strong performance, I wish to leave you with a word of caution. Precious metals tend to be the domain of conspiracy theorists and capitalism sceptics. There are certainly arguments to have 5-10% of your portfolio exposed to the precious metals, but at KOSEC we believe its best left at that. Unless you believe we are going to see the end of the fiat money system as we know it, then holding too much gold doesn’t make sense. As Warren Buffett says, "The problem with gold is that you are betting on what someone else would pay for them in six months. The commodity itself isn't going to do anything for you…it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now, than it is to buy something that you expect to produce income for you over time."

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The outlook for property prices

Friday, May 27, 2016

By Michael Kodari

Questions relating to the domestic housing market have recently made their customary appearance across headlines in both the mainstream and financial press. 

Over the last couple of years, the RBA has looked to juggle a transitioning employment market and an elevated currency by lowering interest rates to records low. These circumstances have given rise to a property price surge, raising concerns that prices are become unaffordable and unsustainable. Naturally that “bubble” term has made its way into the vernacular.

Many of the concerns over the property market stem from the apparent psyche of many property investors, who seem disconnected from the concept that housing prices could in fact go down as well as up. Leveraging up to the eye-balls and buying property after property, although lucrative in the past, can’t be a sustainable strategy. An ever-present threat to housing prices lies in irrational exuberance spurred on by cheap money, lax capital requirements, and the failure to correctly measure and manage the credit risk. Credit risk is essentially the risk of loss stemming from a borrowers failure to repay a loan, or otherwise meet a contractual obligation. Credit risk can be divided into two segments. Firstly, there is the probability that a mortgage holder will default due to loan specific factors such as geographical location or loan-to-value ratio. The second segment looks to capture the series of events whose outcome is indeterminable. For example, the risks associated with, excessive LVRs (segment 1) and being over optimistic about the future path of housing prices (segment 2) can ultimately lead to a property downturn.

A deterioration in credit standards, coupled with the relaxation of loan-to-value ratios, is something the RBA has examined in recent times. However it is unlikely the RBA will feel the need to introduce ‘macro-prudential’ measures, instead leaving that to the free market psyche of the banks and banking regulator, APRA. The ultimate risk to the housing market is if housing prices begin to fall, and creditors can find themselves in a situation where the value of their loans can exceed the collateral securing those loans. Such a situation is further compounded when LVR’s are elevated, so it’s important that lenders remain prudent and disciplined with their LVR’s as housing loan approvals reach levels well above pre-GFC levels. 

The key question is, are housing prices likely to fall in the current environment? Although household debt, and the ratio of average dwelling prices to average disposable incomes have reached historically high and perhaps disconcerting levels, it’s worth considering that record low interest rates make servicing the debt increasingly manageable as indicated by the chart of household finances below. When you take into account the rate of employment, it becomes difficult to see why property prices would come under immediate pressure considering the percentage of the population working and relatively benign costs associated with debt servicing. 

An issue facing the RBA is that the interest rate cuts aren’t having the full desired effect. The idea is that when interest rates fall, borrowers have the option to use excess funds to consume goods and services. However, figures from the RBA show borrowers are shunning that idea, instead choosing to maintain the level of their mortgage payments with the aim of paying off the loan more quickly. As a result the ‘mortgage buffer’ has increased from 10% to 16%, meaning that many borrowers have significant breathing room in the event they lost their jobs. This could help sustain the housing price boom for a little while longer, although it highlights that consumers are failing to direct their spare cash towards sectors of the economy needing stimulation, such as retail.

Over the long term, the pace of recent is undoubtedly unsustainable, but it’s worth taking into consideration the nuanced makeup of Australian societies geographically where cities hug the coastline, and the 10 biggest cities are home to more than 70% of the population. Characteristically, the population operates a land grab of sorts, competing for scare centralised land near to major cities and the infrastructure that supports them. Add to that one of the most highly favourable areas of the income tax system and you have an attractive pillar of modern society. 

The presence of negative gearing and its well-known tax advantage allows taxpayers to use a loss on one investment as a deduction against another profitable investment, or other source of income. In many ways, low interest rates combined with generous income tax subsidies exists in place to prop up the housing market, albeit at the expense of deposit taking retirees. One underrated option to address the negative gearing argument is the notion that if the gross income generated by a property investment is less than the interest repayments, then that loss can be offset against the future income on that same asset only, rather than wages and other separate investments. 

The purpose of this article is not to dispel the possibility of a property market correction. In fact, forecasting the direction of the Australian property market is something that’s brought many an esteemed forecasters undone. The purpose however is to attempt to allay fears of an imminent setback, a setback that in KOSECs opinion, is likely to be delayed until interest rates begin to rise and/or employment begins to move substantially higher. Perhaps a period of price consolidation or modest price rises is the most likely outcome in the near term. Nevertheless you, like I, should remain alert and be cautious of the threats that lurk.

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Is the share market overvalued?

Friday, May 20, 2016

By Michael Kodari

After five successive weeks of gains on the ASX, headlines have crept into the media questioning whether the ASX is now overvalued and ready for a correction. We understand that just because the stock market has gone up for a few days, it doesn’t automatically mean the market must be overvalued. In fact, there are a few basic indicators that investors can use to gauge broad market valuations. I stress the basic measures I’m about to go through aren’t to be taken as gospel and are meant to provide a guide only.

The most common indicator people refer to is the 12 month forward dividend yield of the market compared with the cash rate, or a discount rate such as the 10 year Government bond rate which has recently reached an all-time low and currently sits at 2.34%. Think about that for a second, accepting in a rate of return of 2.34% for 10 years, granted it’s of low risk, but you’d be hard pressed to support a primitive standard of living even with $1m in a superannuation fund. The idea is that given the inadequate deposit and bond rates, investors will be forced up the risk curve into equities, particularly higher yielding equities that can generate a higher return on investment. The sheer volume and demand for stocks such as the banks has the ability to support, if not push up prices. 

You also have a situation at present, where barring New Zealand, Australia has the highest dividend yields in the world. The carry trade becomes awfully attractive for many overseas institutional investors such as those from Japan or Europe who can borrow for next to nothing. The carry trade is essentially when foreign investors borrow in their home country and take the money and invest funds in a higher yielding jurisdiction such as Australia. 

The average market price to earnings ratio (P/E) is another way investors are able to determine whether the market is erring on the side of being overvalued or undervalued. After the recent strong run the ASX is now trading on P/E of 15.70 compared with the longer term average of 14. Ostensibly, that says the market is on the expensive side of the ledger, however a closer inspection reveals otherwise. For example if you take a look at the miners and energy companies, many of them are trading on P/E ratios well above their long term averages. The table below outlines the 5 year average P/E ratio of BHP, RIO, WPL and STO as well as the 1 year forward P/E ratio for each of those businesses. Granted, the mining and energy sectors composition of the index has diminished in recent times, however, their significance is still material and is having the effect of inflating the market P/E.

The final measure we’ll look at it is the measure often referred to as the Fed model, given it’s the measure the US federal reserve often looks at when assessing market valuations. Essentially, the model compares the gap between the earnings yield of the market and the 10 year bond rate. The earnings yield is essentially the inverse of the P/E ratio, where earnings are divided by price, to provide the percentage of each dollar invested that was earned by the market. 

Currently, the market earnings yield is 5.07%, below the 5 year average of 5.76%, indicating that earnings in the market is somewhat weak. However, when compared with the 10 year government bond yield, the explanatory power is enhanced. At the time of writing, the 10 year bond was trading on a yield of 2.22% and therefore the spread - or gap between the earnings yield of the ASX and the 10 year bond - is 2.85%. To put it into perspective, in 2014, the spread was 2.27%. Therefore, we can see that spread has widened in the past 2 years and arguably, stocks have become cheaper relative to bonds.

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Investment traps to avoid

Friday, May 13, 2016

By Michael Kodari 

With the advent of the ‘internet of everything’ and 24-hour TV news channels, investors can find themselves inundated with superfluous and biased information. Debt crisis here, central bankers there, and the list goes on. At the end of the day, investors need to strip investing back to its barest and simplest form. 

After all, the equity market is all about investing in quality businesses. When you put your money into ‘stocks’, you are purchasing a part of a business, entitling you to a portion of that businesses future earnings stream and profits. Investors often lose sight of what it is they’re actually doing, distracted by the flashing lights and rapid number movements on their trading platform. 

A common trap investors fall into is the habit of cutting their ‘winners’, while letting their losers run. There is some truth to the saying “you’ll never go broke taking a profit”, although it certainly is possible to have numerous winning trades but have one losing trade that leads to losses on a portfolio. For example, assuming equal weighted trades, if an investor locks in a 10% profit on 9 different trades, but has a 90% loss on one trade, then that single mishap can undo all the hard work and erase any profit. 

It’s also worth considering that a 50% loss on an investment requires a 100% recovery in the same asset to square the books. Investors may therefore be best served by limiting their downside, while letting their winners run, and in any case, it’s often the winners that are performing well for a reason.  

Another typical misconception made by those investing in the market for the first time is to shy away from stocks with high dollar prices. The primary reason for this is simple psychology. I think it’s important to outline that the absolute value of a company’s share price has no bearing on a company’s performance going forward. The per-share price of a stock is often thought to convey some sense of value relative to other stocks, but nothing could be further from the truth.

A company’s share price is simply the value of the entire company (market capitalisation) divided by the number of shares on offer. Take a hypothetical company with a market capitalisation of $100. 

- If the company had 100 shares on offer the share price would be $100/100 = $1 per share

- If the company had 10 shares on offer the share price would be $100/10 = $10 per share

What we can see is that regardless of whether the share price is $1 or $10, the company value remains the same. It’s the same concept as an orange. You can cut up an orange in 3 pieces or you can cut it into 100 pieces, but at the end of the day, an orange is an orange. 

The aim of investing is to select companies that have the best chance of increasing the total value of the company. Overtime, a company’s share price tends to follow its earnings growth. Therefore, as a company grows its earnings, the share price will likely follow regardless of whether the share price is $1 per share, or $100 per share.

Don’t get caught up on the per share price of a stock when making an investment. It really doesn’t tell you much at all. Focus instead on the market capitalisation to get a picture of the company’s value in the market place. Besides, it’s often the small speculative companies that tend to have lower share prices, and the market is littered with stories of people buying companies at $0.10 per share because they are cheap only to find that the stock goes on to trade at $0.05 per share, or a loss of negative 50%.

Just a quick example for you. The most famous investor in the world is an investor called Warren Buffet. He runs a company called Berkshire Hathaway listed in the US. This company has a share price of around $215,00.00 per share. Five years ago, the share price was approx. $120,00.00 per share. That’s a return of almost 80% over that period, highlighting that the dollar value of a share had no bearing on the share price performance. In 1980, the price per share was $275. 

The dividend fallacy is also a common trap KOSEC has addressed before in previous articles. Investors often have a tendency to neglect high quality prospects and favour companies for little real reason other than being large organisations that pay high dividends. Such a habitual preference for dividends, although simplistic and marketable, can be one-dimensional and counterproductive to investment performance. 

In recent times, a number of global factors have prompted the thirst for yield. Interest rates have again been reduced, depressing term deposit rates placing significant pressure on the retirees who depend on the interest rates for income. At present these retirees are essentially earning nothing in real terms and will struggle to fund their retirements should low deposit rates persist.

At KOSEC we believe in identifying companies that deliver reliable dividend income growth. As a general rule, the most benefit to shareholder equity is achieved when management chose to reinvest the company earnings back into the business. Earnings that then go on to earn the high return on equity rate, effectively compounding growth year after year. Investors need to remain conscious of the fact that dividend payments are, in essence, sacrificing future company growth for immediate gains in the form of income.

Investors often make the mistake of favouring certain companies because they are considered ‘blue-chips’ investments. The term ‘blue-chip’ however tends to be very ambiguous. Are ‘blue-chips’ well known household names, or are they fundamentally sound businesses with growing earnings profiles? BHP or WOW are often cited as an example of a blue chip company, however in recent times, their share price performances have been anything but stable and safe. 

Investors need to note that it doesn’t matter if it’s a household name like BHP and WOW, businesses with the best management teams, highest quality assets, and lowest costs. The fact is these businesses may be ‘price-takers’ that are at the mercy of the prevailing market price of the commodities, as in the case of BHP, or a risk from industry disruptors such Aldi. As a result, the forward earnings profile of the companies have deteriorated, unsurprisingly causing the share prices to fall considerably over the past 12 months.

In many ways we believe in keeping things simple. Following the simple structure of identifying sectors of the economy that are booming before going a step further and selecting established businesses within those sectors that are financially sound and have a track record of performing strongly.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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2 winning stocks

Friday, May 06, 2016

By Michael Kodari

The budget has come and gone for another year so I thought we could look at the budget from abroad sense and identify those companies that stand to benefit the most. Overall and the budget doesn’t appear do much to address the deficit, rather than cutting spending it relies on tax revenue increase to balance the budget. As always, the primary risk to the numbers are the assumptions the government has made pertaining to Chinese growth, the flow of tax revenue and the terms of trade. Of these the terms of trade pose the biggest risk to the numbers in KOSECs opinion.

At this point in the cycle there’s an argument for the government to step in and pick up the stack. In theoretical terms when the private sector is performing strongly, such as the mining boom years 2009 – 2013, the government should concentrate on paying off its debt and repairing the deficit. Unfortunately the labour government did the opposite during these years, running up debt and causing the deficit to expand. On the contrary when the private sector is going through a soft period, the argument is the government should sweep into action and buffer the economy through its soft patch, essentially acting as a counterbalance to the broader economy.

Governments have the luxury of accepting lower rates of return than the private sector, while also having a much longer time horizon than the corporate sector. It’s important to decipher the politics from the economics. The liberal government will cry poor, and will harp on about need to reduce the budget deficit and halting the growth the debt burden, a task they’ve failed to achieve in the past 3 years in office. Ostensibly that ideal makes sense. However we have construction coming off the boil, a mining boom fizzling out, weak non-mining CAPEX, negative disposable income growth and now price growth outside the target band, now is arguably the time for the government to increase its spending on productivity boasting projects.

What’s the point of having an AAA rating if the government doesn’t use it? Although Australia’s budget deficit and debt is growing, it’s off a low base. The debt is essentially the equivalent to person on a wage of $100,000 a year, taking out a $20,000 - 30,000 Loan. Hardly an unmanageable level. Governments can not only borrow more than the private sector, they also can borrow at the lowest rates, and over the longest terms. There is an argument that the budget we should’ve looked for new and sizable infrastructure spend, not simply shifting money between previously and newly proposed projects.

Although a growing deficit isn’t ideal, it’s the structural decline in certain components of the deficit that are the biggest issue. The welfare issue in Australia is undeniable, essentially 1 in 2 Australians receive welfare in a system where too many rely on to tax revenue coming from too few. The Government at present raises $197 billion from income tax, while pays out $153 billion Social Security and welfare. The treasurer has outlined in the past that 8 out of 10 taxpayers are required to go to work every day to pay for the welfare bill, and he’s right. Only 44 percent of income earners are net taxpayers, meaning that the other 56 percent receive more from the government in welfare then they pay in tax. 

There seems to be an inability for the government to claw back hand-outs once they’ve been made. It seems people are quick to accept the government’s generosity, but screech and holler when asked to give up those benefits. Can someone answer this, why do those already on welfare still receive 1.7 percent more than new welfare recipients as compensation for the carbon tax despite Australia no longer has a carbon tax? What about middleclass welfare, if the deficit is so bad why is a household earning $110,000 a year entitled to $120 a week per child? Why not $70, $50 or zero? If the Governments budget was delivering a surplus year after year then by all means let’s have these services, but unfortunately the budget can’t support these sorts of payments, or so we’re told.

From looking at figures like these it’s clear that Australia Government doesn’t necessarily have an income problem, rather the problems are found in the components of government spending. Arguable the government should look to redirect savings made from areas such as welfare, towards infrastructure spending where the economic outcomes are superior. After all the best welfare program in many instances is a job.

As with every budget there are the winners and losers listed on the ASX. Let’s take a look at a couple of those:

McMillan Shakespeare Limited (MMS)

McMillan Shakespeare is a leading Australian provider of salary packaging and motor vehicle leasing services. The salary packaging industry tends to be fragmented. MMS however is the clear market leader with 50 percent market share. Nevertheless despite this dominance, it services only a small portion of the potential market, which in theory is the entire Australian working population of almost 12 million workers. 

Readers might recall that in the lead up to the 2013 federal election the then labour Government went into the election with a policy to get rid of fringe benefits tax (FBT). As it turned out the liberal party won the election and the changes never came into effect. However the policy remained in the psyche of the market where the concern was that if re-elected, labour would reintroduce the policy and FBT would ultimately be abolished. 

Well investors can now rest a little easier. Just after Tuesdays budget Bill Shorten sent a letter to the National Automotive Leasing & Salary Packaging Association (NALSPA) indicating that Labour, if elected would follow the Turnbull Governments policy apparently giving the sector some clear air for at least the next 3 years. 

Prior to the 2013 election MMS was trading at a high of $18 and a 1 yr forward P/E of close to 20, only to fall to a low of close to $8 after the initial Labour Government announcement. These days MMS trades on a forward P/E of around 12 indicating that there is significant upside in the share price should the market rerate this business now that at least a portion of the overhanging risk seems to have diminished. 

JB Hi-Fi Limited (JBH)

JB Hi-Fi on Tuesday received double boost in the form of an interest rate cut and the continuation of favourable federal budget spending incentives. The extension of the $20,000 tax write off for small businesses stands to boost household coffers by around $1 billion some of which will be spent on the brown goods offered at one of JBH’s 194 branded electrical stores across Australia. Last year we saw a very strong response in JBH share price in the aftermath of the 2015 Budget and we can expect a similar response this year particularly given the cut in interest rates.

The support to the housing market and pipeline of apartments in Melbourne and Sydney bode well for JBH. Anyone who has every shopped at a JB Hi Fi would remember the vast amounts of floor space dedicated to CD’s and DVD’s. Overtime with the advent of the likes of iTunes and Netflix, JB Hi-Fi was quick to identify the shift and introduce small home appliances to fill the gap. A shift to selling products ranging from coffee machines to fridges proved advantageous given its coincided with a housing construction boom. 

You only have to acknowledge the recent high density construction boom in Sydney and Melbourne to understand the potential in the home appliance area keeping in mind that the contents of many of these properties will require goods provided by JBH upon completion.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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