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Paul Rickard
+ About Paul Rickard

Paul Rickard has more than 25 years’ experience in financial services and banking, including 20 years with the Commonwealth Bank Group in senior leadership roles. Paul was the founding Managing Director and CEO of CommSec, and was named Australian ‘Stockbroker of the Year’ in 2005.

In 2012, Paul teamed up with Peter Switzer to launch the Switzer Super Report, a newsletter and website for the trustees of SMSFs. A regular commentator in the media, investment advisor and company director, he is also a Non-Executive Director of Tyro Payments Ltd and Property Exchange Australia Ltd.

Follow Paul on Twitter @PaulRickard17

Is CSL Australia’s best ever company?

Thursday, August 15, 2019

When the government-owned Commonwealth Serum Laboratories was privatised and floated in 1994, investors paid the princely sum of $2.30 per share. A few years’ later, the shares were split into three, which reduced the effective cost price to $0.77. Yesterday, after the release of its full year profit report, CSL shares closed at $234.00. For investors in the original float, they have enjoyed a gain of 30,000%!

I can’t think of any other ASX-listed company that can boast that sort of performance for its shareholders. Maybe Mike Cannon-Brookes and Scott Farquhar’s NASDAQ listed Atlassian has matched it in recent years, but locally at least, CSL is the clear stand-out.

Year after year, CSL has met or exceeded profit guidance, delivering sales growth in excess of 10% and profit growth even higher. And for an Australian company where more than 91% of its revenue is earned outside Australia, that is a pretty remarkable story.

The other interesting think about CSL is that it makes so little “noise” in the community. The ultimate “quiet Australian”, the fact that it is Australia’s third largest company by market capitalisation, bigger than the ANZ, NAB or Westpac, is a surprise to many. Few have heard of the CEO, Paul Perreault, who keeps a low profile with the media.

CSL employs 25,000 people globally, with females representing 57% of the total employee base. It has been named in the Thompson Reuters Top 100 Global Diversity and Inclusion Index.

These are some of the factors that make CSL Australia’s best company, and some might say, best ever company. And as befits a great company, it delivered for shareholders again yesterday.

CSL’s full year profit of US$1,919m was up 11% on FY18 and towards the higher end of earlier guidance of US$1,880m to $1,950m. Adjusting for the impact of exchange rates, profit rose by 17% to $2,015m. This came on the back of an increase in sales of 11%.

The result reflected continued strong growth in CSL’s core immunoglobulin and albumin  therapies, high patient demand for specialty products Haegarda (sales up 61%) and Kcentra (sales up 14%) and strong profit growth from CSL’s influenza vaccine business Seqirus. CSL opened 30 new US blood plasma collection centres, a new research facility in Melbourne, and progressed phase III trials for CSL112 (a therapy that helps remove cholesterol from the arteries of patients following a cardiovascular event).

Profit was assisted by a lower corporate tax rate, and cashflow from operations was down 14% to US$1,644m as expenses and inventory rose. The final dividend of US$1 per share (approximately A$1.48) was also slightly lower than expected.

A highlight was CSL’s fairly bullish forecast for FY20, which was better than the market had been anticipating. Notwithstanding a change to its distribution arrangements of albumin in China (which will see CSL move to a direct distribution model rather than deal through third parties), CSL has guided for total sales growth of 6% (up 10% when adjusted for the change in China) and profit growth in the range of 7% to 10%. This translates to a NPAT for FY20 of $2,050m to $2,110m.

What do the brokers say?

Going into the result, the brokers were largely neutral on the stock. While all acknowledge the undoubted strength of the company and its fantastic track record, the stock is seen as expensive (particularly in comparison to its global healthcare peers), trading on a multiple of around 37.5 times FY19 earnings and 34 times prospective FY20 earnings. Additional concerns include CSL’s ability to continue to win market share in immunoglobulins, plus the impact of the distribution change in China.

According to FN Arena, there were 3 buy recommendation and 4 neutral recommendations.   The following table shows the recommendations and target prices for the major brokers.

On the back of CSL’s better than expected profit guidance for FY20, brokers are expected to revise their earnings estimates and target prices modestly higher in the coming days. However, CSL will most likely trade at a premium to the new consensus price.

Bottom line

There is nothing in this result that would give a shareholder in CSL a cause for concern and apart from profit taking, there is no reason to sell. Stick with the trend.

Despite the earnings multiple, CSL should be a core stock in investors’ portfolio. It is the best company in Australia, and in the listed environment, has no peer. If you don’t own it and are scared about the price, mark it down on the watchlist to buy next time the market has a blip down.

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CommBank: get the razor gang to cut costs

Thursday, August 08, 2019

The market voted with its feet yesterday on Commonwealth Bank when on an otherwise up day, its shares fell by 1.4% to $78.70. This followed the release of a disappointing full-year profit report. The clear message from the investor community was that the bank needs to work harder, smarter and faster to take out cost.

The Bank missed at a headline level with cash NPAT of $8.5bn coming in $300m short of expectations and down 4.7% on FY18. More worryingly, the second half profit of $3.8bn was down 18% on the first half result of $4.7bn.

The second half contains three fewer days than the first half for the Bank to earn interest on loans, so it is always a more challenging half year. And there are other extenuating circumstances, including the cost of customer fee removals, the cost of customer remediation and the extra risk and compliance staff the Bank has hired. But even allowing for these items, revenue fell and costs rose - “negative jaws”! This is the antitheses of the Bank’s much championed “positive jaws” (revenue growing at a faster rate than expenses), which it has delivered year after year and is one of the key reasons that it has been able to command a premium price relative to its major bank competitors.

Last February, CommBank CEO Matt Comyn said that the bank was targeting “no absolute cost growth” and a cost to income ratio of 40%. But this half, costs soared by 13% and the cost to income ratio blew out to an incredible 49.8%.

In a world of flat lending volumes, compressed interest margins, and no willingness or ability to increase fees (in fact the opposite, fee refunds or rebates), it is very difficult for a bank to grow revenue. The only avenue to improve shareholder returns is to reduce costs or return capital. Until very recently, CommBank hasn’t been in a position to do the latter.

On its own productivity measures, the Bank is falling short. Operating income per employee fell from $591,876 in 2018 to $568,644 in 2019, a fall of 4.0%. Employment costs as a proportion of operating revenue hit a five year high at 24.2%. The harsh reality is that CommBank has too many staff, too many managers and some of them are getting paid too much. It is time for a razor gang to bring out the axe.

Some positives

There were some positives in the result. After falling by 0.05% in the first half, the net interest margin (NIM) remained stable in the second half at 2.10%. Looking ahead, the Bank said that the impact of the two rate cuts announced by the RBA in May and July, plus a technical accounting change, would reduce NIM by a further 0.05% . This is a little less than the market expected. Further, Comyn acknowledged that there was now a NIM “tailwind” arising from a fall in the spread between the 90 day bank bill rate and the RBA cash rate.

The Bank was able to make headway in the home loan market, growing at a rate 1.3 times the system growth rate. It put this down to its speed of decisioning and turnaround times. There was also a gain in transaction deposit balances, the latter up 9% over the year.

With the dividend, CommBank maintained its second half dividend of a fully franked $2.31 per share for a full year payment of $4.31, unchanged on 2018. The second half dividend will be fully “neutralised”, with the Bank buying back on market any shares issued through the dividend re-investment plan.

CommBank’s capital position is strong, with the CET1 (common equity tier 1) capital ratio of 10.7% above APRA’s “unquestionably strong” target of 10.5%. Post the completion of the sale of the asset management business CFSGAM in August and CommInsure later this year,  the CET1 ratio rises to 11.8%. With the changes mooted by the Reserve Bank of New Zealand expected to consume up to NZ$3.0bn of capital, this means that CommBank will have around $4bn to $6bn of surplus capital.

The Bank is explicitly flagging the return of the surplus capital to shareholders. Interestingly, an “off-market” buyback, which is particularly tax effective for SMSFs and other low rate taxpayers, looks to be on the cards. The Bank said: “potential future capital management initiatives……..could include forms of a capital return including an off-market share buyback”.

What do the brokers say?

Going into the result, the major brokers were negative on CommBank, viewing it as expensive compared to its major bank peers. They had CommBank trading on a multiple of around 16 times forecast earnings, compared to around 13 times for Westpac and the NAB and 12 times for the ANZ. According to FN Arena (see table below), there were 3 neutral recommendations and 4 sell recommendations from the major brokers, with no buy recommendations. The consensus target price was $73.11, 7.1% below yesterday’s closing price of $78.70.

There is nothing in this profit report to suggest that there will be material changes to the broker recommendations, with the earnings profile a little weaker than expected and the  capital position a little stronger. CommBank will continue to be viewed as expensive relative to its peers.

Bottom Line

Until CommBank gets its act together on costs, the market will struggle to ascribe it too much of a pricing premium. The prospect of a capital return will provide support, and with the dividend of $4.31 secure and delivering a yield of almost 5.5%, CommBank will remain attractive to yield buyers. But don’t expect it to outperform in a bull market.

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Is there value in small and mid-caps?

Thursday, August 01, 2019

The share market might be hitting all-time highs, but investors in small and mid-cap stocks aren’t popping champagne corks. For the 12 months to 30 June, the market has returned 11.6%, including dividends. But for small caps, it is only a measly 1.9%. Midcaps are doing marginally better, with the Midcap 50 index (which covers the performance of stocks ranked 51st to 100th  in market capitalisation) up by 3.7%.

Normally, strong rallies on the share market are led by the cyclical stocks that get an earnings boost as economic conditions improve, turnover rises, and profits grow. These tend to be concentrated in the small and mid-cap parts of the market.

But the rally in calendar 2019, which sees the market up by 21% in price terms and almost 24% when dividends are included, has been driven by interest rates, iron ore and technology. The first two factors have played strongly to the fortunes of the top stocks.

Lower interest rates has been the most important factor. This started when the US Federal Reserve used the word “patience” on 20 December last year and expectations of three US interest rate increases turned into talk of two or three interest rate decreases. And our local Reserve Bank followed suit and cut interest rates in May and July due to concerns about the economy and unemployment. So called “bond proxy” or “interest defensive” stocks soared. These are stocks that have reasonably predictable and reliable earnings, usually independent of the economic cycle, and offer attractive yields in comparison to cash. These  include the likes of Transurban, Sydney Airport, Medibank, Woolworths, Coles, property trusts such as Dexus and Goodman and utilities such as APA.

BHP, Rio and Fortescue have also performed strongly following a surge in the iron ore price.  The latter hasn’t been on the back of an improving outlook for world growth and steel production, but rather due to a supply disruption to the world’s largest producer (the Brazilian miner Vale) after the collapse of a tailings dam in January.

And then there has been a huge rally in our local tech darlings – WiseTech, Appen, Afterpay, Altium and Xero (the so called WAAAX stocks). As our local market looks to reward growth and prices stocks on multiples of revenue, rather than multiples of earnings, some of these stocks are up by more than 100% in 2019. Our tech sector is now amongst the most expensive in the world, pushed by the relative paucity of local IT companies available to Australian fund managers to invest in.

2019 is proving to be a very strange year!

However, the longer term data shows that many years are “strange” and that “mean reversion” is the norm. This suggests that if one component or sector of the market does really well for a while, it will eventually have a period where it does poorly so that over the longer term, performance will cluster closely (i.e. revert to the mean).

The following table shows the performances of the different components and industry sectors that make up the ASX over the last 1 year, 3 years, 5 years and 10 years. The top 20 stocks, for example, have outperformed over the last 12 months, but underperformed over the last 5 years. As a group, they  did well in the first half of the decade, but not so well in the second half, meaning that the 10 year return (an average of 9.7%) is very close to the overall market’s 10.0% pa. The midcap 50, while having an off year in 18/19, is still the best performing component over 10 years at 11.0% pa.

Australian Sharemarket Total Returns to 30 June 19

Source: S&P Dow Jones

The same story with the industry sectors. With the exception of the energy sector, the returns over 10 years are clustered around 10% pa. There is more variability over the shorter periods, suggesting that mean reversion tends to apply.

It would be wrong to draw the conclusion that mean reversion will necessarily apply to the performances of the small caps and mid-caps.  However, there has been an improvement in the month of July relative to the top 20 stocks, and if the interest rate cuts and other stimulus measures work as the Reserve Bank hopes they will (boosting consumer confidence, consumer spending and in turn economic growth), some of our smaller companies will witness an improvement in trading conditions. If the market expects earnings to improve, share prices should rise.

Standing in the way of this could be Donald Trump and his trade war. But with a lower dollar, fiscal and monetary stimulus measures in place, and other parts of the market starting to look really expensive, a scenario that favours small and mid-cap stocks could be developing.

How can you play small or mid-caps?

It is hard for a private investor to play without a “managed position” due the challenges of building a diversified portfolio. An easy option is to consider index tracking exchange traded funds. Blackrock’s iShares has ISO, an ETF that tracks the Small Ordinaries Index (stocks ranked 101st to 300th by market capitalisation). Betashares has SMLL. There is also an ETF from VanEck which tracks the Midcap 50 index (MVE).

Theoretically, an active manager should be able to do well in this space because  companies are less well analysed and researched, and their buying or selling can have a bigger impact on the price. There is a plethora of managed funds in this area, as well as several listed investment companies. Two that aren’t trading at a significant premium to their NTA (net tangible asset value) are Mirrabooka (MIR) and WAM Microcap (WMI).   

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BHP’s action on climate change

Thursday, July 25, 2019

Call me a cynic, but it is hard not to think that BHP’s investment to “address climate change”  isn’t much more than a carefully orchestrated public relations (PR) exercise. My antennae were immediately raised when the first thing I saw on BHP’s website was a slick, beautifully filmed 45 second video. They were raised further when I read the 400 word press release.

On Tuesday in London, BHP CEO Andrew Mackenzie announced a US$400m ‘Climate Investment Program’. To be spent over 5 years, the program will “scale up low carbon technologies critical to the decarbonisation of our operations. It will drive investment in nature based solutions and encourage further collective action on scope three emissions”. Scope three emissions are indirect and are generated by BHP’s customers as they transport, transform and use BHP’s coal, iron ore, copper and petroleum, and are 40 times higher than emissions from BHP’s own operations.

While US$400m sounds like a lot, over 5 years, it averages out at US$80m a year. In FY19, BHP spent around US$8,000m in capital expenditure on new mining projects and expansion of existing projects – so this investment in “climate” is about 1% of capex.

Mackenzie pointed to the work BHP is doing to drive action on the capture of carbon from industrial processes. They have been working with Peking University on carbon capture and storage technologies within the steel industry, joined Responsible Steel, a group of steelmakers aiming to reduce emissions from the sourcing and production of steel, and  invested in direct air capture through a US$6m equity investment in Carbon Engineering Limited. Yes, the Big Australian is playing in the big league!

To be fair to BHP, I have no doubt that Mackenzie (and I am sure many of his staff, management team and Board) are very, very concerned about the threat of global warming caused by an increase in CO2. As a producer of fossil fuels, BHP is indirectly responsible for the emission of millions of tonnes of CO2. They see the problem as a global challenge, requiring global action across several dimensions and involving multiple solutions. They want to help and play their part

And while this is a positive commitment and a step in the right direction, it really isn’t much that much more. Short on detail, lacking any specifics, and interestingly, not considered to be “material” by BHP itself. It chose to release the announcement as a press release, rather than to the ASX as a market announcement. Under its ASX continuing disclosure obligations, BHP is required to tell the market first of anything that could be considered to have a “material” impact on its share price.

If BHP was serious about taking action on climate change, the first action it would take would be to close or sell its energy coal businesses. While the BHP PR machine likes to pretend that it is just involved in the production of metallurgical coal (that is the coal used in  the production of iron and steel), BHP produces around 27.5m tonnes of energy or thermal coal (that’s the coal used by “big polluting” power stations) at its Mt Arthur open-cut coal mine in the Hunter Valley and at Cerrejón in Columbia.

One interesting aspect of the announcement was about strengthening the link between  emissions performance with executive remuneration. From 2021, BHP says that this link will be “clarified” to reinforce the strategic importance and responsibility of reducing emissions as a business. If done meaningfully, such that progress on emissions reduction impacts executive pay, this could play out well in the investor world where an increasing number of institutional fund managers are placing ESG (environmental, social and governance) issues at the top of their investment filter. For example, the world’s largest sovereign wealth fund, Norway’s Government Pension Fund Global, recently announced it will divest from a slew of coal companies and oil explorers and producers .

BHP’s announcement to address climate change received widespread coverage in the media, including the “climate change friendly” ABC, Fairfax and The Guardian. It will play well in the cities and will be a positive BHP’s brand and standing in the investor community. But unless there are some hard actions that follow, and meaningful investment dollars behind these actions, it will go the way of most PR announcements.

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AMP: a falling knife or bargain buy?

Thursday, July 18, 2019

Two of the investment “truisms” are “every dog stock has its day” and “don’t catch a falling knife”. Investors are now looking at AMP, Australia’s once great and largest financial institution and asking which of these apply. Is it a buy or just leave it alone?

There is no doubt that AMP has been a “dog” of a stock. Right from its very first day as a listed company in 1998 following demutualisation – probably the most chaotic trading day in the ASX’s history – when AMP shares opened at an astonishing $36 (about $20 higher than anyone had expected), traded up to a high of $45, before closing at $23, it has been in this category. Failed investments in the UK (the purchase of Henderson and National Provident Insurance), the attempted takeover of GIO and then the merger with its once fierce rival, AXA Insurance (formerly National Mutual), before the final humiliation and disgrace at the Banking Royal Commission. A litany of mistakes, poor decisions and underperformance over the last two decades – an absolute dog (with due apologies to dogs).

And this continued on Monday when the AMP announced that the sale of its life insurance business to Resolute Life, a “buyer of last resort”, was unlikely to proceed. The regulator in New Zealand, the Reserve Bank of New Zealand, wouldn’t sign off on the deal unless Resolute agreed to hold separate “ringfenced” New Zealand assets against the New Zealand insurance liabilities. This made the deal unattractive to Resolute and they bailed on the transaction.

This means that AMP will either have to keep the capital intensive life business, increasing the likelihood of a capital raising and diverting management’s focus from AMP’s new strategy, or do another deal with Resolute. This would come at a much lower price, partly because of the cost of the ring-fencing, but also because AMP says that since the deal was done, valuation changes and the Government’s Protecting Your Super legislation (which bans insurance on inactive super accounts) have wiped about $700m from the value of the life business.

The irony is that prior to the announcement, a handful of fund managers had criticised the Resolute deal and were arguing that it shouldn’t go ahead without shareholder approval. They were silenced by the market reaction, with AMP’s share price tumbling to $1.80.

AMP also announced that it was abandoning any plans to pay an interim dividend.

What’s AMP worth?

That’s the $64 question. Looking at the brokers, they have a consensus target price of $1.97 (range of a low of $1.50 to a high of $2.35). See Table below.

Source: FNArena, as at 17 July 2020

That’s of course a 12-month share price target and is based on earnings from continuing operations. However, another scenario is that AMP is broken-up and key business units are sold.

These would include AMP Bank, with its 110,000 customers and $20bn in assets. In FY18, AMP Bank made a net profit after tax of $148m. Valuing this on a multiple of say 10 times earnings, this gives it a valuation of around $1.5bn or approx. $0.50 per share.

Then there is the investment management business, AMP Capital. As at 31 December 2018, it managed assets of $187bn and contributed $167m in after tax profit. Although it is being impacted by investor outflows due to “AMP brand damage”, the AMP Capital team is widely respected. This business could be worth another $0.50 to $1.00 per share.  

The sale of the legacy life business to Resolute was originally priced at $3.3bn. Only $1.9bn of this was in cash, with Resolute making a $300m capital contribution and providing a further $1.1bn in non-cash consideration (mainly an upside for AMP of future earnings). Taking away the $700m diminution in value and other factors, the life business is possibly worth around $2bn – about $0.70 per share.

AMP has a NZ wealth management and advice business (which boast operating earnings of A$40m) that is slated to be sold via an IPO, and of course, the Australian wealth management and advice business with its thousands of financial planners, affiliated licensees and hundreds of thousands of clients. Who knows what this is worth, or what parts are even saleable?

Putting these together, a “break-up” of the parts valuation is north of $2.

Importantly, AMP hasn’t made any decision to go down this path (apart from the sale of the life business). But it is not hard to foresee a scenario where through growing market pressure, the Board is forced to confront this option. If the share price stays under $2, the calls will get louder.

What do the brokers say?

The major brokers aren’t enthusiastic about AMP, with only ‘neutral’ and ‘sell’ recommendations (see Table above). A number see risks “tilted to the downside”.

The main concerns centre around the possibility of a capital raising, increased advice remediation provisions, further delays to the “turnaround story” and a capital intensive and less agile life business diverting management’s focus from re-shaping the wealth division.

There aren’t too many upsides mentioned.

My view

I would like to say that the AMP is a “buy”, but I am not convinced the knife has stopped falling. Firstly, AMP hasn’t bounced quickly away from $1.80, which suggests there is institutional selling meeting retail bargain hunters. Secondly, I just don’t buy the story that AMP’s Australian wealth management business can be readily “turned-around”. Unless AMP can develop a market leading customer proposition or pricing offer, the crisis caused by “loss of trust” could be irreversible and terminal. Finally, I just have a sneaky feeling that we might see $1.50 before we get back to $2.

If the market starts to talk about a break-up and the AMP Board embraces the thought, it could be a different story.

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How do you choose the right ETF?

Thursday, July 11, 2019

Exchange traded funds (ETFs) are booming and have become one of the biggest forces driving share markets. In Australia, inflows into the major ETFs such as IOZ, VAS or STW are a key reason driving up the prices of the top 20 stocks, notwithstanding that some of these stocks are horribly over-priced.

If you are not familiar with ETFs, here is an example that demonstrates their utility. In one trade through your online broking account, you can buy the top 200 companies listed on the ASX. If the market goes up 2%, your ETF will go up 2%. If the market falls by 2%, your ETF will fall by 2%. You will get distributions, with franking credits, paid quarterly that match the market. And you will pay $20 or less in brokerage to do the trade, and can invest as little as $500.

And there are ETFs that give access to overseas markets – so you can do exactly the same and buy the top 500 US companies or the 100 companies that make up the NASDAQ. Or you can invest in Asia, or Europe or specific countries. ETFs are multi-asset class, covering not just shares, but fixed interest, property and commodities such as gold. Here is the full list of categories:

  • Shares, fixed interest, property and commodities
  • Local and international
  • Broad market and component (for example, small caps or mid-caps)
  • Industry sectors (for example, healthcare or information technology)
  • Thematic (high yield, robotics etc)

When you invest in an ETF, you are investing in a managed fund traded on the ASX. It is an ‘open-ended’ fund, meaning that it can grow in size as more investors purchase units, or contract in size as investors exit their holdings. Most ETFs are designed to closely track the performance of an underlying index. The ETF then invests exactly in proportion to the stocks that make up that index – so that in the case of an ETF tracking the benchmark S&P/ASX 200 index, it buys the 200 stocks in the same weighting as their weighting in the index. The ETF is effectively on “auto-pilot”.

This “auto-pilot” approach, also known as “passive management”, allows for very low management fees because there is no expensive fund manager to feed. In some cases, the management fee is less than 0.10% pa. Other advantages include improved transparency (ETFs are required to publish their portfolios), and in most cases, strong liquidity, meaning the ability to exit an investment when you want to at a fair value. ETF issuers promote liquidity arrangements by engaging professional market makers to deliver an active market in their stock.

Importantly, if you invest in an ETF passively tracking an index, you should expect to get the index’s return minus the management fee. Nothing more, nothing less.

Some ETFs employ active management – that is, where the investment manager chooses the stocks to invest in. This is a newer form of investment, and while employing an identical structure to an ETF, is sometimes referred to as a “quoted managed fund”.

What are the risks of investing in ETFs?

Of course, the major risk is to the performance of the underlying assets. If you invest in an ETF that tracks gold and the price of gold goes down, so will the value of the ETF. But there are other risks which are particular to ETFs, and specific to just some ETFs.

Firstly, not such a big issue with Australian domiciled ETFs , but there are ETFs that invest in “synthetic” assets such as derivatives. For example, a gold ETF that rather than investing in the physical gold bullion, invests by buying gold futures. Because this is a horizon removed, it will typically be a more volatile and hence a little riskier.

Not all indices are “widely adopted benchmarks”. Some are constructed (because they don’t exist, so the ETF manager develops a criteria and creates an index), while others are barely used. This doesn’t automatically imply that you are taking on more risk, but an extra degree of caution is recommended.

And then like any investment in a managed fund, there are risks relating to the manager and the liquidity of the ETF. While managers are regulated by ASIC and must meet a minimum capital requirement, you still would prefer to have a manager that is credible, experienced and with the capital reserves to support and develop the ETF. Liquidity is a function of this, because typically the bigger, better supported ETFs from the strongest and most respected managers will be the most liquid.

What to consider when choosing an ETF?

Start with the type of exposure you want and the relevant index. If you want broad based exposure to the Australian sharemarket, then you need an index that tracks the top 200 or top 300 stocks  – you probably don’t want an index that just tracks the top 20 stocks. This means VAS, IOS, STW or A200. I prefer VAS because it tracks the top 300 stocks. The same if investing in the USA – IVV or VTS. If you want a strong technology bias, then consider at an ETF that tracks the NASDAQ.

Avoid synthetic ETFs. Be careful with ETFs using constructed indices – the index methodology should be considered.

Who is the manager? Blackrock (iShares), Vanguard and State Street are global giants in the ETF world. Betashares and ETF Securities are largely Australian focussed and have been responsible for many of the innovations on the local scene.

What is the management fee? If it is an index that is capable of being closely tracked, you should get the index return less the management fee, so all other things being equal, the fee becomes relevant.

Finally, size and track record count, typically leading to stronger liquidity. That doesn’t mean you shouldn’t consider investing in lesser known, smaller ETFs, but there is also not much upside in sticking your neck out.

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ScoMo: you do need to stop screwing senior citizens

Thursday, July 04, 2019

At the start of 2015, the Reserve Bank’s cash rate was 2.5%. On Tuesday, this was lowered to just 1%. Yet over this period, there has been no change to the Government’s deeming rate – and this is hurting the real incomes of thousands of aged pensioners. The Government is again screwing our elderly citizens.

If you are not familiar with the concept of the deeming rate, this is an assessment rate used  in the calculation of government aged pensions. To qualify for an aged pension, you are assessed under both an assets test and an income test, and the test that produces the least amount of pension is applied. Of the two tests, the income test impacts about twice as many as the assets test. The deeming rate is used in the income test.

Rather than calculate the actual income for every single investment, the Government applies a formula to determine your income from financial investments. This based on the deeming rate, and is applied to financial assets including bank accounts, term deposits, account based superannuation income streams or pensions, shares and managed funds.

For a single pensioner, the first $51,800 of financial assets are deemed to earn 1.75% pa, and everything over that is deemed to earn 3.25%. For a couple, the threshold is $86,200 (as per the table below).

Deeming rates and thresholds as at 1 July 2019

For example, Mavis is a single pensioner with life savings of $300,000 — $50,000 in a pensioner security account and $250,000 in term deposits. For the income test, her financial assets are deemed to earn 1.75% of the first $51,800 and 3.25% on the next $248,200 – a total income of $8,973.

The income test incudes income from all sources, including employment income, but it is typically the deemed income on financial assets that has the most impact. To get a full pension, a single needs to have income below $4,524 a year ($174 per fortnight). For each fortnightly dollar of income earned above that amount, the pension reduces by 50 cents  per fortnight.  When the income gets to $52,686 ($2,026.40 per fortnight), they are ineligible for an aged pension.

Annual income limits for full and part pensions

Let’s look at Mavis again, with her $300,000 life savings in the bank — $50,000 in a pensioner security account and $250,000 invested in a term deposits. She has no other financial assets (including superannuation). Under deeming, her income is assessed to be $8,973 or $345 per fortnight.  Because this exceeds the threshold of $4,524 ($174 per fortnight), her pension is reduced from $926.20 per fortnight ($24,081 pa) to $840.60 a fortnight ($21,856 pa). It may not seem a lot, but it is still a reduction of $85.60 a fortnight.

What’s the problem with the deeming rate?

Because the deeming rate hasn’t kept pace with actual investment returns – that is, lowered in line with reductions in the cash rate – Mavis and thousands of aged pensioners have suffered a decline in real incomes .More likely hundreds of thousands, as there are more than two million elderly Australians receiving a part pension.

Back in 2015 when the RBA cash rate was 2.5%, Mavis was getting around 3.25% on her pensioner security account and around 3.5% on her term deposits. Today, she would be doing well to get 1% and 2% on those same investments. While her government pension has kept pace with inflation and there has been some relief from the indexing of the deeming thresholds, her external income has almost halved. This has been slashed from approximately $10,375 pa to $5,500 pa – a fall of almost $188 per fortnight.

If the deeming rates had been lowered by 1.5%, Mavis’s pension would have gone up –  compensating in part for the fall in her external interest income.

Mavis has been screwed.

Of course, Mavis could have invested a little more aggressively and chased higher investment returns by investing in shares or other riskier investments – but is the outcome we want from our senior citizens, many of whom are in their eighties and nineties? Remember, this is the generation that is largely pre compulsory superannuation, in some cases has been savaged by the GFC, and is typically living in retirement accommodation with a modest nest egg to cater for that “rainy day”. Preservation of the nest egg is a key worry.

 Why hasn’t the Government changed the deeming rate?

Pretty simple. From a Treasury perspective, changing the deeming rate costs money. Lots of money. Hundreds of thousands of aged pensioners would become eligible for higher pensions, and thousands of others, who are currently ineligible, would become eligible for a part pension.

Another possible explanation is that our politicians just don’t understand. Age pension eligibility, and deeming in particular, are complex, and with a generous  superannuation scheme and comfortable remuneration arrangements, something that most politicians are unlikely to personally experience. There is probably a bit of truth in this. To be fair to the Morrison Government, they have announced a review of “retirement incomes policy”, but this was done before the election and the RBA has cut interest rates twice since then.

What should the Government do?

Immediately, cut the deeming rate by 0.5% or even more. Get the review of retirement incomes done, which should include a review of the rules around eligibility for the aged pension. If it is decided to keep a “deeming rate”, tie the level to the RBA cash rate so that future governments can’t screw our senior citizens.

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I’m still in term deposits. Have I missed the boat with shares?

Thursday, June 27, 2019

With the Great Financial Crisis (GFC) of 2008/09 seeming not that long ago and given all the scary stories that the mainstream media has reported over the last decade – from debt and deficit crises through to the China bubble and fake cities and a local housing market implosion – it’s not surprising that some investors have been reluctant to be share investors. They have preferred the safety of term deposits and other fixed income investments but as interest rates head down to a big figure beginning with a ‘1’ or a ‘0’, share market yields of 4% to 5% or even higher are looking pretty attractive. And with the Aussie share market moving close to all-time highs, they are asking themselves ”have I missed the boat”?

Nothing goes up for ever, or in the one direction. So is it too late to invest now? And what do you invest in?

Firstly, the big picture.

The chart from the Reserve Bank below shows the performance of the Australian, USA and world share markets on a logarithmic scale over the last 25 years from December 1994. These are accumulation indices, which consider both share price and dividend returns. The standout conclusion – share markets provide fantastic returns over the long term.

The scary part is the market crashes – 1987, 2000/2001 and 2007/2008 – when the market dropped by 20% to 30%. But there are two points to note. Firstly, the market rebounds quickly. Secondly, it takes out its previous high, which is exactly what we are seeing in Australia at the moment as it retests the high of 2007 achieved about nine months before the GFC started.

The chart also confirms the old share market adage that goes “it’s time in the market rather than timing” that counts. Few fund managers or share market professionals think that they can consistently buy at the bottom or sell at the top but no one wants to do it the other way around.

My answer to the question: “is it too late?” is “No”. It’s never too late for a long-term investor to buy shares. If you need access to your capital in the short term and can’t stand a 25% fall in the market – which as surely as night follows day, will happen at some time in the future -  then it probably is a little late. We are 10 years into a bull market, and while there is no rule that says that it can’t go on for another 10 years, history says that this is less likely. On the flipside, the question to ask is: “can I afford not to invest in the share market?”

So how do you invest without taking too much risk (or at least to cut out most of the specific company  risk)? There are two ways to do this – invest on the ASX in a fund with a professional investment manager, or establish a diversified portfolio of shares, at least 5 stocks and preferably 10 to 15.

The easiest way to invest is to buy an exchange traded fund (ETF). These are passively managed funds listed on the ASX that track broad market indices such as the S&P/ASX 200 (an index comprising the top 200 companies). They aim to replicate the performance of the underlying index by investing exactly in accordance with construct of that index. If the underlying index goes up by 2%, the ETF should go up by 2%, and if the index falls by 2%, the ETF should also go down by 2%. Because they are almost on “auto-pilot”, ETFs of this nature charge very low management fees, sometimes as low as 0.10% pa. Vanguard’s VAS (ASX :VAS), iShares IOZ (ASX:IOZ) and State Street’s STW (ASX:STW) are some of the leading ETFs.

An alternative to an index tracking ETF is one of the broad-based listed investment companies (LICs), such as Australian Foundation Investment Company (ASX:AFI), Argo Investments (ASX:ARG) or Milton Corporation (ASX:MLT). Actively managed, these LICs invest in a broad portfolio of stocks and aim to provide reliable returns with a bias towards higher dividends. Some have been in operation for almost 50 years and because of their size, also charge low management fees. Over the long term, their performance has been very strong, but in the last couple of years, they have underperformed the market a touch. The good news is that they are now trading at a small discount to their underlying net tangible asset (NTA) value.

A newer subset of the ETF style are actively managed quoted funds. Two aiming to provide higher income returns while broadly matching the overall market are the eInvest Income Generator (ASX:EIGA) or the Switzer Dividend Growth Stock (ASX: SWTZ).

If you are considering individual stocks, you need to consider at least 5 stocks and more likely 10 to 15 stocks to establish a diversified portfolio. The stocks should come from across the industry sectors (you don’t want all banks or all mining companies), and be roughly weighted according to the importance of that sector. The table below shows the main industry sectors, their relative weightings, and the largest stocks by market capitalisation in each sector.

As at 31 May 2019. Source: S&P Dow Jones

A first timer might want to start with some companies that they are familiar with or use their services, and then build out the portfolio over time as confidence and knowledge grows. Get to know the companies, how the market values different companies and how it trades. A starting portfolio of 5 stocks could include your bank, your supermarket chain, your telco, a big miner such as BHP and healthcare leader CSL.

There are many different ways to get started and it’s not too late to get started. But you will need to be prepared for a bumpy ride, because that’s what shares do – they go up, they go down, and then go back up again.

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June 30 is getting nearer – get your tax act together now!

Thursday, June 20, 2019

The end of the financial year is just 10 days away and because it falls on a Sunday, you really only have a few business days to act. And while you should never do anything for tax reasons alone, you are mad if you don’t try to optimise your position. Here is a run-down of the actions to consider. 

1. Can you bring forward or accelerate expenses, or defer revenue?

If your cash flow is sound and you have a taxable income (that is, you will be paying tax this financial year), you can consider bringing forward expenses and/or deferring revenue. Essentially, a tax deferral strategy where you shift the burden from paying tax this financial year to next year.

Pre-paying interest on loans (for example, a business loan, investor home loan or margin loan) is a classic example. Technically, you can pre-pay interest for up to 13 months in advance and claim the interest expense as a tax deduction in the current tax year.

Taking out an annual subscription to an investment newsletter or professional journal, which will generally be tax deductible, is another example. You can also consider accelerating the payment of other general expenses.

If you are operating a business or are a contractor, you may want to push back invoicing customers so that you defer the receipt of revenue to the 19/20 tax year.

2. Are you a small business that needs some equipment?

In April, the Government announced the expansion of the instant asset write-off scheme which allows businesses to claim a 100% tax deduction upfront on the purchase of equipment. Businesses with an annual turnover of up to $50m are eligible and the equipment threshold has been raised to $30,000.

Some important points to note:

  • The threshold excludes GST, so you can potentially purchase an item that costs up to $33,000 (including GST)
  • Can be new or second-hand equipment
  • It is available on a per item basis and can apply to multiple assets. Potentially, you could spend (say) $150,000 purchasing 5 units of the same item each costing $30,000 (separately invoiced), or 5 different items each costing $30,000.

The main caveat is that you must have sufficient taxable income to apply the tax deduction, and of course, the cash flow.

3. Have you taken any capital gains?

When assets are sold or otherwise disposed, capital gains tax is payable. The main exemption is the family home. The gain (essentially the sale proceeds less the cost base) is counted as part of your assessable income and taxed at your marginal tax rate. If you have owned the asset for more than 12 months, individuals are eligible for a 50% discount (meaning they only pay tax on 50% of the gain), while super funds are eligible for a one-third discount (they pay tax on two-thirds of the gain). There is no discount for companies that own assets.

Capital gains can be offset by capital losses, and if the losses can’t be applied, they can be carried forward from one tax year to the next and then applied to offset a capital gain. If you make a capital loss, don’t forget about it.

If you have taken a gain in 18/19, consider these questions:

  • Do you have any carried forward capital losses from 17/18 that you can apply?
  • Have you taken losses on other assets in 18/19 that you can apply?
  • Do you have assets in a loss situation that you should sell now to crystalize a loss? 

While you should never do anything just for tax reasons, crystalizing a loss on a non-performing asset can often make sense Potentially, you can always re-purchase the asset if you subsequently decide that the sale was a mistake.

Conversely, If you have taken capital losses during the year, you may want to consider the disposal of assets in a gain situation.

One other point to note. If you have multiple parcels of the same asset (for example, shares acquired through a dividend re-investment plan) and you sell part of that asset, you can choose which parcel(s) you sell. There is no set formula (such as FIFO (first in first out) or LIFO (last in first out)) to apply, meaning that you can select the parcels which best optimise your CGT liability. 

4. Can you claim a tax deduction on a personal super contribution?

There are two caps that limit how much you can contribute into super. A cap on concessional (or pre-tax) contributions of $25,000 and a cap on non-concessional (or post tax) contributions of $100,000.

Concessional contributions include your employer’s compulsory super guarantee contribution of 9.5% and any salary sacrifice contributions you make. There is also a third form which is a personal contribution you make and claim a tax deduction for. Previously, this was only available to the self-employed under the ‘10% rule’, but this rule has been scrapped and anyone can now claim this tax deduction.

There are two important caveats. Firstly, you must be eligible to make a super contribution. If you are under 65, or aged between 65 and 74 and pass the work test, you will qualify (there are some particular rules for the under 18s). Secondly, you aren’t allowed to exceed the $25,000 cap on concessional contributions.

Let’s take an example. Tom is 45 and earning a gross salary of $100,000. His employer contributes $9,500 to his super, and he has elected to salary sacrifice a further $5,000. Potentially, prior to 30 June, Tom can contribute a further $10,500 to super and claim this amount as a tax deduction, which he does when he completes his 18/19 tax return. He will also need to need to notify his super fund.

5. Can you boost a partner’s super and get a tax offset?

If your spouse earns less than $37,000 and you make a spouse super contribution of up to $3,000, you can claim a personal tax offset of 18% of the contribution up to a maximum of $540. Potentially, a tax rebate for you of $540 while boosting a partner’s super!

The tax offset phases out when your spouse earns $40,000 or more. Importantly, your spouse’s total super balance must be under $1.6m and they can’t have exceeded their non-concessional super cap of $100,000.

6. Can you get the Government to chip in and boost your partner’s or kid’s super?

There aren’t too many free handouts from Government. The government super co-contribution remains one of the few that is available. If eligible, the Government will contribute up to $500 if a personal (non-concessional) super contribution of $1,000 is made.

The Government matches on a 50% basis. This means that for every dollar of personal contribution made, the Government makes a co-contribution of $0.50, up to an overall maximum contribution by the Government of $500.

To be eligible, there are 3 tests. The person’s taxable income must be under $37,697 (it starts to phase out from this level, cutting out completely at $52,697), they must be under 71 at the end of the year, and critically, at least 10% of their income must be earned from an employment source. Also, they can’t have exceeded the non-concessional cap or have a total super balance over $1.6 million.

While you may not qualify for the co-contribution, this can be a great way to boost a spouse’s super or even an adult child. For example, if your kid is a university student and doing some part time work, you could make a personal contribution of $1,000 on their behalf – and the Government will chip in $500!

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Was the market right to be wary about AGL’s bid for Vocus?

Thursday, June 13, 2019

AGL’s $3 billion bid for struggling telco Vocus smacks of desperation and the market was right to give it the “thumbs down”. AGL shares closed yesterday at $19.55, down 6.5% since the non-binding indicative proposal was announced.

Pitched at a price of $4.85 per share, AGL has been granted exclusive access by the Vocus Board to conduct due diligence for the next 4 weeks. AGL is the third suitor to review Vocus, the last, Swedish group EQT Infrastructure, walked away less than a week into its due diligence processes. It had indicated a price of $5.25.

The good news is that the market also thinks that AGL will see “reason” and the bid will  wither on the vine. Vocus shares were yesterday changing hands at $4.30, a massive 55c  below the bid price.

So why did AGL bid for Vocus?

AGL is desperate to find new revenue sources as it faces declining wholesale energy prices from generation, and in the medium term, reducing volumes as coal fired power stations are phased out. Part of this is its own fault – the way it mishandled the announcement of the planned closure of the Liddell Power Station means that it has no friends in Canberra, no friends at the ACCC, no friends in the media and no friends in the public. The “big stick” legislation the Coalition government is introducing is about getting square with AGL.

Strategically, AGL had been pinning its hopes on the development of a services business involved in the smart distribution, monitoring and measurement of energy, particularly green energy. Applications include smart meters, optimised roof-top solar, electric charging stations for motor vehicles and the “internet of things”.

But this new business, like many organic businesses, is a slow burn and is developing off a very low base. The market knows that power prices are going to fall and AGL’s profit will be hit.

Acquisition is the next strategic option. The “big stick” legislation means that AGL will be precluded from bidding for a competitor, so it has decided to consider an adjacency – the telecommunications industry.

With customers increasingly connected, there is a convergence of sorts between the energy and data value streams as the traditional energy sector transforms. Further, the capabilities in integrating and managing complex assets and customer portfolios are similar in both industries.

That’s the high level strategic rationale for AGL’s interest in telecommunications. More specifically with Vocus, AGL says:

·       Revenue and operating cost benefits from the integration of the customer platforms and development of a multi-product offering across energy and data;

·       Accelerating “untapped” growth from the integration of Vocus’ high quality broadband fibre infrastructure network with AGL;

·       Improving the offer to AGL’s wholesale and enterprise customers by the provision of an integrated data and energy service; and

·       Vocus’ data centres adding benefit to AGL’s wholesale electricity generation portfolio.

I get that this means that AGL thinks it can sell a “bundled” package of electricity, gas, broadband, mobile and other services to Vocus’ Commander, Dodo and iPrimus customers, and vice-versa to AGL’s existing retail customers, but I don’t really get how this applies in the enterprise or corporate space. Nor can I see where the benefits lie in relation to Vocus’ New Zealand business.

Vocus is a $2bn revenue business, with $900m from its consumer and business division, $300m from its New Zealand operation, and $750m from Vocus Networks which services enterprise, government and wholesale clients. This is by far and away the most profitable division, and includes Australia’s second largest national inter-capital fibre network, the Australia Singapore undersea cable, and the north west cable system connecting the mainland with oil and gas facilities in the Timor Sea.

How these fibre assets and relationships with Government and enterprise clients fit into AGL’s business – that is, deliver additional operating benefits or revenue synergies – remains to be seen and prima facie, AGL’s rationale looks thin at best. Further, it is an acquisition, and the history of acquisitions achieving their financial objectives, particularly those away from an area of core competency, is poor. The reality is that in Australia, more acquisitions fail than succeed.

The market is right to be wary about AGL’s bid for Vocus. It is struggling to understand the impact of any convergence between data and energy and how the acquisition of Vocus will enhance the AGL customer proposition such that the acquisition premium can be recouped. Calling it an act of desperation might be a little tough, but on paper at least, it is not even getting past first base.

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