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Income securities set to fall after Shorten’s tax grab

This morning Bill Shorten revealed his latest attack on the retirement savings of Australia’s self funded pensioners, proposing an amendment to the dividends and input tax credit rules. The change would see the tax refund normally returned to superannuation funds slipped unscrupulously into the coffers of a Labor government if elected.

Banks and corporations raise money by issuing Income Securities (technically  floating rate preference shares, convertibles or notes), which then trade on the ASX.  Such securities offer a quarterly return above the 90 day bank bill rate through distributions that have been already taxed at the company tax rate (typically 30%).

For example – a hypothetical fully franked distribution of $100 would carry with it a credit of $42.86 for tax paid.  Super funds in pension mode paying no tax, and funds in accumulation phase paying 15% would receive a cash refund for this credit in excess of their respective tax rate.

The better than bank interest return from these securities coupled with the liquidity of ASX listing, low volatility and low risk has made them popular with self-managed superannuation funds.

Labors policy to cancel the tax credit would mean that from July 2019, super funds will receive a lower return from the same security, entirely changing the risk/return metric and investment thesis.

In our opinion, the listed securities price  will need to be discounted for the lower yield in 2019.  Upon the announcement, we have sold all the listed securities/hybrids we had exposure to, as we believe the market will start to price this risk well beforehand.

The fact that we were able to move quickly and fluidly  is just another example of the benefits our clients receive from professional management under the individually managed account structure.

Contact us for more information:

Steven Everett No Comments

Lessons Learned from 2017

What can I say?  A good year but at times a little crazy…

As it draws to a close I thought it would be worthwhile reflecting on the past twelve months, and see what could be learned from it.

1. Donald Trump?

About this time in late 2016, my colleague David Manchee penned a note explaining the profound effect he expected the election of Donald Trump to have on global markets.  In David’s note  he discussed how despite the fact that Trump as a person is perhaps morally questionable, his policies designed to reduce regulation and create better conditions for companies in the U.S would result in the creation of jobs and better economic conditions across the country.

In particular, David mentions three key factors that would increase the incentive for businesses to invest in the United States being lower energy costs, less red tape and access to financing.  Since January the DJIA has set multiple record highs and even  some Australian companies with US facing earnings have outperformed the Australian market.

Chart: Dow Jones Industrial Average – 2017

According to the Politifact.com “Trump-o-meter”, from the array of promises “the Donald” made during the election campaign, those he can put in the complete pile are centered around making business conditions easier in the USA, encouraging Americans to shop locally and businesses to pay tax locally.  Incentivising American corporations to pay their tax at home will also go a long way to funding his promise to invest $550 billion in infrastructure which is reported to be underway.

So what’s the verdict?

It seems that David was correct in his analysis, and by disregarding Donald’s personal traits, and focusing on the fact that he is simply a businessman,  David foresaw that business conditions were likely to get easier under Trump’s presidency.

What is the take-away?

Don’t get bogged down in the details.  The most common sense outlook is likely the most probable.  Trump is a developer – developers like to build stuff and invest in projects.  It is easier to do that without unnecessary regulation and with access to financing.  Subsequently, Trump delivered just that.

2. Borrowing to invest.

By March, my focus had moved to borrowing and negative gearing.  It had been said by a few during 2016 that the Australian property market had run up too far and was due for a correction.  Come March ’17 and property prices continued to increase, so more and more were comfortable with borrowing large sums of money to start or add to their property portfolio.

Regulators did their best to try and cool the rising market by capping the lenders ratio of investor property loans, but until very recently this had little effect and Australia’s housing debt continued to rise.

On the 15th of May, David and I wrote an article suggesting negative gearing an equities portfolio as an alternative to property given the appearance of a crowded trade.  At the time the market was trading at a dividend yield of around 5%, and margin funds could be borrowed at about the same or slightly less.  Given that dividends can have franking credits attached and a deduction is available for the interest paid, the entire investment thesis including the tax advantages seemed to make far more sense at current prices.  Additionally, if you view both property and equity markets as a single entity, comparing the leverage ratios (like you would with a business), wouldn’t the one with least debt seem like the more viable option.

And the verdict?

Despite the liquidity risk and high transaction costs, the perceived security of ‘bricks and mortar’ has lulled Australians into a false sense of security.  The charts above and below clearly show that property prices are being pushed higher with borrowed money whereas equities continue to grow in the face of declining leverage.

What is the take-away?

The refusal of many to consider geared equity investment has created a market inefficiency.  In the US, investors took the opportunity to leverage their investments at the low prices post GFC and have reaped the rewards, while Australians have been reluctant to take the same approach.  To date the ASX has under-performed global markets and this skew toward gearing property may be the reason why.  Here is a chart from an article I sent to the Australian Financial Review back in May this year which tells the story in more detail.

US Gearing

3. A test of conviction.

Anyone invested in lithium stocks this year will confirm it has been a nail-biter.  Many analysts were forecasting that global lithium demand would likely subside and coupled with increased supply would put downward pressure on prices.  Some even went as far as to label it a fad.

As most who follow David and I will know, we have been proponents of the lithium sector for a long while now and Orecobre (ORE), an Argentinian lithium producer, is one of our largest overweight positions.  Well… March this year was a test as global hedge funds turned the daggers on Orecobre seeing the stock over 20% short sold, and despite repeatedly having to defend the future of battery storage and electric vehicles to many lithium dissenters, we maintained composure and conviction.

The verdict?

Many underestimated the overwhelming support of moving to greener sources of energy and how quickly the technology would advance to fill this need.   To fully appreciate how lithium-ion battery technology is going to change the way we travel and power our homes and business, all one needs to do is watch this video of Elon Musk talking to a TED audience this year.

What is the take-away?

Be prepared to trust your judgement when the research stacks up.  The pace at which our world is changing is ever increasing, and with any disruptive technology there will always be those who think it won’t catch on.  The power of disruption can be a double edged sword, and the ability to understand how technology will change marketplaces around the world is  now one of the most important aspects of investment management.

Which brings me to my final reflection from 2017.

4. Do not underestimate the power of disruption.

All year we have been hearing about the threat of Amazon landing on our shores, and not a single player in the Australian retail sector has been spared.  Notwithstanding that the online retail giant didn’t start trading in Australia until only this month, company valuations have in some cases halved and boards placed under immense pressure trying to develop strategies to incorporate an online sales offer.

In January, David and I discussed what impact we thought the Amazon threat might have on Myer as we personally, and a very small proportion of our clients are holders.  At the time, the stock was trading at around $1.30, and the valuation seemed less than demanding trading at a significant discount to its peers.  Acknowledging that Amazon and other online retailers were going to shake up the sector, we decided that at current prices most of the downside was likely priced in and felt confident that management was moving in the right direction with their omni-channel marketing.

With that in mind, and given that Solomon Lew had just purchased a substantial stake in the company we decided to hold.

The verdict?

  Currently Myer shares trade around 70 cents, so I think it goes without saying that given the chance again, to sell would be the right decision.  It was easy to underestimate the task that stood before the board.  Like a ship, the bigger the boat, the longer it takes to turn.  As technology evolves faster, more and more incumbents are going to be faced with the same challenge, and complexity of the task is directly correlated to the size of the business.

What’s the take-away?

Companies under threat of disruption are hampered by more than just the task of reinventing their business.  As sentiment turns, access to capital becomes tougher and the news paints the firm as “yesterday’s fashion”, which has the effect of enticing customers to explore the offering from the disrupter.

I have no doubt that in time, Myer and other Australian retailers will transition into the new retail environment, and other firms challenged by disruption will do the same.  However if I am faced with the same conundrum in the future, the obvious decision is to take the money off the table until the transition is complete.

Looking forward to 2018, I am excited by the data suggesting that the global economy is returning to growth, and as much as disruption is a threat it also creates a new opportunity every day.  The past 10 years have helped shape Australian firms to be leaner, sharper and more resilient.  Couple that with the significant investment (both time and money) into local emerging technologies and you have a recipe that could see the Australian stock market finally catch up with our global peers.  Additionally, the prediction for low growth in the property market may see capital transition into equities which will provide further tailwinds.

It’s an exciting time to be investing in Australia and I hope 2018 can provide as much experience and success as 2017 has.

Author: Steven Everett – Belvedere Share Managers

 

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Freelancer Founders lapping up unwanted shares

Steven Everett, Brisbane Australia

Sydney based Freelancer (FLN.AX), is the world’s largest online freelancing and crowdsourcing marketplace.  Since listing on the ASX in November 2013, the Company has more than doubled its users to 26 million, and increased annual revenue by 395% to A$52.7 million.  Despite what seems to be a stellar result for the tech start-up founded by Matt Barrie back in 2009, the share price has fallen from the 15 November 2013 opening price of A$2.50 all the way back to today’s closing price of A$0.53.  Just 3 cents higher than the initial public offering.

But it seems Barrie and founding investor Simon Clausen still have faith in the outlook.  Nearly A$2.4 million worth of faith to be precise.

Between March and November this year Clausen and Barrie have bought on market just over 3.8 million shares, increasing their ownership collectively to 77% of the Company at an average price of A$0.61 per share.

They still have a long way to go before they buy back the A$35 million worth sold back in 2015 at $1.40 per share, which according to Barrie was at the behest of the bankers that ‘begged’ him to increase liquidity (Caitlin Fitzsimmons, Australian Financial Review 5 August 2015).

Perhaps the reason for the weakness is the proceedings currently before the Federal Circuit Court brought by former employee Matthew O’Kane (Misa Han, Australian Financial Review 25 October 2017), however even with that in mind I struggle to comprehend that after multiple acquisitions, a fourfold increase in revenue, and doubling the user base that Freelancer could be worth only a mere 9.6% more than what was affirmed by a bunch of investment bankers when they underwrote the IPO back in 2013.

A review of the Company’s recent announcements did provide some reasons to be pessimistic; such as flat earnings growth and a tough first half FY2017, but it also gave many reasons to be optimistic.  Despite an 18% drop in gross payment volume across the Freelancer platform and a 24% drop across ‘Escrow.com’, (a payment facilitator acquired by the group in 2015), net revenue remained unchanged versus the previous corresponding period.  The decline in Escrow payments was said to be the result of system features being turned off for upgrades in January 2017, and some user attrition after implementing identification checks to increase anti-money laundering security.  Effectively the ‘Paypal’ of high-end goods, Escrow holds the buyer’s funds for the seller until the purchased goods are sent to, and approved by the buyer.  The nominal fee charged for the service is a small price to pay to reduce transaction risk for both parties.  Even ebay.com endorses the platform on their website stating, “You should only use Escrow.com, ebay’s approved escrow service.”

Also announced was the release of the Escrow API, an interface that allows developers to easily integrate and use Escrow’s payment platform.  As the propensity for consumers to make purchases online increases, as does online fraud, I would assume a trustworthy payment facilitator would be a welcome addition to any high-end online marketplace.

Prior to the market update in October this year that saw the price rally 28%, critics called Freelancer the fallen tech star reporting that for the share price trend to turn, the Company needs to return to growth (John McDuling, Sydney Morning Herald 9 October 2017).  The second half of FY17 might be the turn of the tide on the back of the cryto-currency boom as the Company noted an 82% increase in the demand for Bitcoin specific skills by platform users (Freelancer Press Release, 25 October 2017).  It will also be the moment of truth for the changes implemented across Escrow and Freelancer during the year to see if they produce the required results.

Given that almost 82% of the outstanding shares are held by the top shareholders, I would imagine if the 2H17 report demonstrates a return to growth that the move to the upside will be substantial.  For that reason, I have added my name to the registry by purchasing a parcel at $0.62 on the day of the API announcement.  In hindsight it appears that I may have bought too soon, but I will be looking to add in the coming days hopefully in the low $0.50’s.

Regardless of my confidence, the question remains as to whether the recent on market buying by Barrie and Clausen is a sign of good times ahead, or simply blind optimism from the proud parents.

Steven Everett No Comments

Fletcher Building Engages KPMG to Conduct Internal Review

Fletcher Building Products (FBU) provides a range of building and construction services with a large foothold in the New Zealand residential development and infrastructure sector.  Helped along by the Australian and New Zealand residential construction booms, the share price for FBU almost doubled between February and September 2016 and management continued to impress shareholders with earnings upgrades and consistent business growth.

However, in March this year a full year earnings downgrade was announced to the market, citing unexpected costs on some current projects that were eroding profit margins.  Alarm bells started ringing.  Generally when construction companies tender for projects they use assumptions to produce cost estimates, and these assumptions will normally be used for all estimates until pricing changes or historical data from completed projects calls for an amendment.  At the time we flagged that the under-estimation of construction costs would have likely extended further than just the few projects currently underway, and that there was a risk that further downgrades might be forthcoming.  Here is the footage of our Director David Manchee explaining our thesis on Sky Business News the day the company made the initial announcement.

Last week management announced that global accounting firm KPMG had been engaged to ‘conduct a review of the two largest projects in its B+I business and the two largest projects in its Infrastructure business’.  I hope for all shareholders the result of this review will determine that we were wrong, and that future projects will not suffer the same fate but all we can do now is wait and see.  Since announcing the initial downgrade, the share price for Fletcher Building has fallen 30%.

Significant market reactions to negative changes in outlook is becoming the new norm, and for our clients we have added value by taking money off the table as soon as downside risk becomes the overarching factor.  In some cases we will repurchase the same companies at a later date but once the risk returns to the upside and most times for a discount to the original sale price.  If you would like to know more about how Belvedere may add value to your investment portfolio, please add your details below and we will be in touch.

Steven Everett No Comments

BWX Limited Acquires US Based Mineral Fusion

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BWX Limited is a listed company which owns, manufactures and distributes a range of beauty and skin care products. The range of Sukin products in particular is the Company’s most successful range.  In addition to being priced affordably, the range is made with naturally derived ingredients, cruelty free and vegan, appealing to the growing market of socially and environmentally conscious individuals.
BWX caught our eye in early 2016 as a company with great potential, boasting a compound annual growth rate of almost 30% year on year, a unique offering, solid management and fantastic outlook. Their Sukin range of natural cosmetic products had been well accepted by the market in Australia, and demand quickly spread to include North America, China and the U.K with products now featured in the Boots & Co. chain of chemists.  The Company also maintains a strong Daigou (grey market exports) sales channel and has products featured on a number of Chinese e-commerce platforms, with plans to solidify the Chinese expansion strategy during calendar year 2017.
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This week the board announced the US$38.4 million acquisition of California based Mineral Fusion LLC, providing the Company with a strong footing in the US market for their well performing Sukin brand.  This purchase also provides access to Amazon and Wholefoods which Mineral Fusion has current standing contracts.  In fact, management made mention that the Mineral Fusion are also achieving 30% compound annual growth rate in sales volume, and achieves 10 times the average dollar return per area of shelf space in the Wholefoods stores.  This acquisition adds to their vertical integration strategy after adding Lightning Brokers, a national distributor of skincare products to their portfolio in February 2016.Monday’s conference call once again provided confidence that management have well and truly got their finger on the pulse with guidance re-affirmed for the full year FY17.

That being said, BWX is a young, smaller company expanding very quickly and the current valuation reflects this growth. With such growth, particularly into International markets, there is always execution risk.  Acknowledging this risk, there is also considerable upside in this sector which is fast growing globally.

Although we still remain positive for the outlook of the company, we have taken some profits after the recent announcement given the fast run up of the share price and expect a pull-back which will provide the opportunity to add again, or an entry.  Either way we intend to continue to follow the BWX story very closely as in this competitive investment market, it is difficult to find attractive growth stories that aren’t quickly engulfed by the “crowded trade”.

If you would like some more details about BWX or other less covered companies in our watch list feel free to contact us.

Steven Everett No Comments

Codan Limited Upgrades Guidance

Codan Limited today announced that they expect to outperform their FY18 profit guidance of $20-$25m.  It was reported in the announcement that the Company will likely achieve a first half profit of around $15 million and that historically their second half profit exceeds that of the first.

I have been following Codan for some time and started buying in the past few weeks.  Here are the reasons why Codan appealed to me as an invest-able Company:

 1. The valuation is appealing

At the current price Codan trades at around 5 times EV/EBITDA and a price/earnings of circa 9 times.  Acknowledging that the Company has experienced lumpy earnings over the years, these metrics are based on what management refer to as their “base-level” business and seems quite conservative.

2. Codan have been in business for over 50 years

The business was founded by three university buddies in 1959 and one of the founders is still the Company’s largest shareholder.  This says to me that management and the board are experienced and prepared for changes in business cycles, as they have likely seen many over the years.  Additionally, governments often look for long-standing ownership and management when awarding contracts because stability is an important factor given that government approval process can be lengthy, and trying to shift suppliers quickly if one were to fail to perform is difficult.  Not surprisingly, Codan has standing contracts with the United States government, supplying military communication equipment.

3. Diversified portfolio of products

Last year’s record result was primarily attributed to their Minelab metal detectors and the overwhelming demand received from their expansion into the African market.  Before making the decision to invest, I thought I would drop into the local gold prospecting equipment retailer and see what I could find out.  The veteran shopkeeper had nothing but good things to say about the Minelab products, including their innovation, durability and after sales support.  In his opinion they are the best currently on the market.

Other products include radio communication and defence electronics, but what I find more exciting is Minetec, a real-time underground scheduling and monitoring system that improves safety and productivity.

Click here to watch the Minetec explanation video.

Recently there was speculation that the Company had landed a large mining player as a new Minetec customer, but the Company responded by saying that there were in negotiations but no agreement had been formed as yet.

4. Strong balance sheet

After a bumper result in FY17, the board decided to payout the excess cash generated to shareholders via a special dividend.  Total dividends paid for the year were 13 cents per share.  Given that the Company has no debt, another stellar result will likely result in the same outcome.  Moelis seem to have the same opinion in their research report, forecasting a full year FY18 dividend of 10 cents per share or 4.6% based on yesterday’s closing price.  Oh, and did I mention the Company has no debt.

Conclusion

I don’t think there is a lot of downside here, and that the only reason the share price isn’t higher is that this is a lesser known Company in what most would consider a boring industry.

It seems I am not the only one with this opinion, Cannacord Genuity  recently produced a research report forecasting a full year 2018 net profit after tax of $31 million and I tend to agree, maybe even slightly higher.  Like Moelis, Cannacord’s price target is $2.60.

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Steven Everett 1 Comment

Trump’s Market Effect is Profound

Trump’s victory has had a profound effect on not just US markets but global stocks and bond markets. In Australia some stock segments are up dramatically, whilst bond and bond type stocks (for example real estate funds, utilities and infrastructure companies) are being de-rated. Whilst there has certainly been a lot of commentary about the causes, this is our take on the reasons and why the trends of the last 8 years have now changed.
After years of increasing regulation and higher taxes, business confidence in many industry segments was on its knees and private investment has been stagnant. Whilst politicians have been  talking  the positives of greater consumer protection  and green energy, they weren’t acknowledging  the negatives of higher energy costs to manufacturing and the debilitating effects of greater and greater regulation. Companies around the world have not been investing in expansion and banks aren’t lending to business projects. Hence economic activity has been stagnant and there has been enormous under employment around the world.
Hardly anyone gave Trump a chance of winning the US Presidential Election and no one thought he could win in a fashion that provides the Republicans control of both houses of parliament. Media concentrated on the personal side and not policy whilst voters clearly did the opposite. He is pro-business and investment and hence American jobs. He may be morally questionable but his policies are offering hope (aka jobs in political terms) to large parts of the US that have had 8 years of economic quagmire, and subsequently the same to investors in equities. Consider the economic potential of these three policy changes-
1. Infrastructure
It is estimated that the US has been under-investing in infrastructure for 30 years, so there is no shortage of excellent projects that will improve the productivity of the country, not to mention create a lot of traditional construction jobs.  The question is always how to fund them. US global companies have large sums held outside the US and have been discouraged to return the funds due to tax impediments. Trump has offered these companies tax credits which will offset the tax liable if the funds are invested in US infrastructure.  As most infrastructure projects like roads are tolling, banks are happy to lend the majority of the construction cost. The funds coming onshore and invested to get the tax credits will provide the balance. Hence Trump has a very real chance of funding the US $1 trillion infrastructure projects.
2. Support for the traditional energy sectors
This will include coal and fracking for oil and gas. This will create serious jobs and have the effect of lowering the cost of energy in the US. Given a major cost of manufacturing is energy it will have the effect of making US manufacturing far more globally competitive.
3. Banks
Trump has openly stated his outrage that very few Bank execs were punished for their actions leading to the GFC. However he is pragmatic and knows as a developer, the banks need to be encouraged to lend to traditional industry and to new projects. He has already stated he believes the overriding restrictive policies placed on banks globally have gone too far and he will lighten the reigns. This policy change will be extremely positive for economic activity as more businesses receive expansionary funding.
Individually any of the three policies are positive for US economic activity and far greater than other economic policy that has occurred for years. Collectively they are huge. As investment increases and wages grow the multiplier effect is even greater.
The global positives are that he has rewritten the political landscape. It will make politicians far more aware of the need to provide plausible policy to encourage jobs and wage growth across the country. There are a number of  elections and issues in Europe and Trump will have to back down on his aggressive trade threats, but there is a real upside to global growth now that hasn’t been there since the 2008 GFC, and that is very positive for business.
A stronger US economy will be clearly positive for Australian businesses with operations in the US. Further, as the largest economy in the world any US pickup has an impact on trade and economic development globally. The uptick in our resource stocks is a prime example of the market believing demand for base metals such as Iron ore and copper will increase.
Australian Portfolio Positioning.
Our clients trust us to manage their Australian share portfolios and in doing so it is our role to be overweight sectors we believe in, and to avoid sectors that either look to have headwinds in their business or have a valuation based risk. Over the last few months the overall All Ordinaries Index has declined and risen again. Beneath this, there have been dramatic changes in the values of different sectors. Simplistically, banks and the large resource stocks are up around 20% while infrastructure and real estate type companies (referred to as Bond proxies) are down 20%. Other darling sectors such as Telcos have been hit even harder on valuation questions.
Recognising the change in global sentiment and markets is imperative. We cannot pick daily movements so we look to what sectors will have tailwinds and hence investor demand, and which will not. Accordingly we continue to hold our banks and the majority of holding in the large mining companies as they are still under owned and globally there is a scramble to gain exposure. Conversely all things being equal the bond proxies will have bounces but it is likely that rates will be heading up and therefore their medium term trend will be down.
The sectors that are catching our attention are now the cyclicals which would benefit from a growing US and international economy when they are priced for low growth. Stock selection and timing have become the new imperative to portfolio management.
If you would to discuss portfolio management in more detail, please send us an email or call.

David Manchee
Director
Belvedere Share Managers