The Wattle Watch

In any given month, Wattle Partners meets with many different professionals offering a new investment product, idea or scheme. Most are a pass from us, but now and again some pique our interest. The following is an outline of the opportunities that we think deserve a second look.

 

THB Global Microcap Fund

We recently met the team who manage the THB Global Microcap fund. We have been talking to Brookvine their Australian partner for some time. Essentially the fund gives a dedicated exposure to US Small and Micro-cap stocks, THB or Thomson Horstman and Bryant has been managing this fund since 1982, has a small team of 17 people and manages just under $800 million US. The definition of a US Small or Microcap stock is something still very large in our Australian language, the average company has a value of Us$530million. The funds aim is to outperform the Russell Micro cap Index net of fee by 4% every year. The fund since inception has been doing this comfortably, with a return since 1998 of 14.8% per annum versus the index of 8.2%, and the S&P of only 6.7%. The interesting thing to note is that the annualised volatility of their fund is only slightly above that of the S&P 12.8% vs 10.1% They have been able to achieve such a return by having a true long term view, while constructing, well-funded, low risk companies that have been able to grow revenue, earnings and book value through internally generated cash flows. Essentially the ream has a well proven process of generating ideas, doing the fundamental research and then construction portfolio, while applying risk monitoring while the position is held.

Reasons for liking this sub sector

  • 45% of the US Microcap universe has no published earnings estimates, offering opportunities for active management;
  • The sector is neglected by the major research houses on Wall Street;
  • Management skill has enormous impact on the direction of smaller, mostly single product line companies;
  • 60% of all microcap companies have zero debt;
  • Microcap companies typically have strong alignment with ownership and control;
  • The returns of this sector has been enormous, in fact your portfolio would have done 3.2 times better than investing into the S&P 500.
  • The median CEO is paid total compensation of $1.7million in the microcap sector, versus the S&P 500 where it is $11.7million.
    Should you consider investing?The fund offers investors an exposure to a very interesting space in the US Market. They fund has done very well for a very long period, the management and process seem very sound. Not for everyone, but one that investors looking for a real return over the next 5 years should consider. The fund is available at a minimum of $50,000 and has a cost of 1.25% per annum.

    CBA XI CAPITAL NOTES

    Commonwealth Bank of Australia, or Commonwealth Bank, will raise AUD 750 million in a debt form instrument—to be listed on the Australian Securities Exchange, or ASX, they will be called CommBank PERLS XI Capital Notes, their ASX code will be CBAPH. This issue will provide Additional Tier 1, or AT1, regulatory capital for Commonwealth Bank.

    Any holders of a holder note the CommBank PERLS VI Capital Notes (ASX Code: CBAPC) will be asked if they want to reinvest CBAPH.

    CBAPH is a fully paid, convertible, transferrable, redeemable, subordinated, perpetual, unsecured note with a AUD 100 face value and mandatory exchange date of April 26, 2026.

    Mandatory exchange on that date is subject to exchange conditions. CBAPH may be exchanged earlier as a result of a trigger event or Commonwealth Bank exercising an option to call the security two years early on April 26, 2024.

    Distributions are discretionary, noncumulative and fully franked with a dividend stopper. Distributions will be paid quarterly in arrears, based on the 90-day bank bill swap, or BBSW, rate plus a margin in the indicative range of 3.70% to 3.90% per year. For example, using the current 90-day BBSW rate of 1.91%, this equates to a gross running yield in the range of 5.61% to 5.81% per year

    Face value: AUD 100 per security.

    Minimum subscription amount: AUD 5,000 (50 units).

    Amount to be raised: Commonwealth Bank plans to raise AUD 750 million via the issue of 7.5 million securities, the securities will pay 90 Days BSBW plus between 3.7-3.9%. This assumes the CBAPH distribution is fully franked.

    Frequency of distributions: Quarterly on March 15, June 15, Sept. 15, and Dec. 15. × Franking: Distributions are fully franked. If a distribution is not franked, the cash distribution amount will be increased to compensate for any franking shortfall.

    Dividend stopper: If a CBAPH distribution is not paid in full within five business days of the scheduled payment date,

    (refer to Septembers monthly for a full article on franking credits and the affects legislation change)

HOT MARKETS – Are always the same!

Hot markets always end the same way …..

How to make sure it doesn’t happen to you

The last few weeks have exposed the glaring problem with momentum and more importantly when self-directed investors succumb to the fear of missing out. There are an increasing number of horror stories from the ASX after a volatile month, but it is those most loved and talked about companies of early 2018 that have been hit hardest. A few particular lowlights are as follows:

  • Technology darling, Afterpay (APT), has fallen 44% from its 2018 high;
  • Amazon competitor, Kogan.com (KGN), has fallen 72% from its high;
  • Sukin Skincare owned, BWX, is down 66% after rebuffing a management buyout;
  • Low-cost jewellery retailer, Lovisa, is down 40% from its 2018 high;
  • Long-short listed investment company, L1 Capital, is down over 30% after floating in

Even though almost every investment book, successful investor and in fact most financial advisers stress the importance of not chasing the hottest stocks or investments, it seems that most people are still prone to doing so. We experience this daily in our own lives as the majority of interest raised from our articles is around the smaller, speculative companies we have covered in the past.

The existence of a bubble in high growth technology companies was obvious, the market was being driven by investors whose sole purpose was to invest in shares that have already gone up. The sealer for us was when we reviewed the recent flow of investment into Australia’s best performing shares. The evidence was clear, retail investors with a fear or missing out, identified by the fact that they generally trade with Commsec or other online brokers, began outnumbering the institutions in the scale of their buying earlier this year. In fact, the majority of institutions and insiders were actually selling down their holdings of Afterpay and Kogan some time ago.

In sharemarkets, but particularly in the ASX where DIY investors dominant in a way not replicating overseas, there is dumb money and there is smart money. Unfortunately, the former tends to be in the hands of those who need it most and who rely on their

investments to fund their lifestyle. It isn’t just in chasing the hottest stocks that DIY investors are prone to lose capital, there are many ways that parts of the financial sector are actually out to get your capital. In the following sectors we look at a few ways to avoid the mistakes that occur in hot markets and provide a sure-fire strategy that will keep you on the right path.

Look out for vested interests

Even though the finance industry is one of the most heavily regulated in the world, it remains rife with vested interests, hidden commissions and strategies aimed at extracting your capital with little concern for how it performs once it invested.

One such example is the proliferation of listed investment companies of LIC’s that have been flooding the sharemarket in recent years. We speak to DIY investors and SMSF trustees regularly and they al seemingly prefer the use of an LIC over an identical managed fund. But why have they become so popular and why are so many being issued today?

Well, the structure of an LIC is a closed end fund, which means there are no redemptions or applications from the underlying assets. On the other hand a managed fund is structured as a unit trust, with units redeemed and issued on a daily basis. Why does this matter? Being a closed end fund means the investment manager will always have the same amount of capital to invest, and more importantly to charge fees on.

Take for instance L1 Capital and its highly touted but poorly performing long-short fund. The associated brokers managed to raise $1.2bn for this LIC, on which they will now receive a management fee of some 1.35%, that’s $16m per year regardless of performance. There is little wonder that the managers elected to return capital to investors in their managed funds.

An additional issue connected with the proliferation of LIC’s is the way in which they are sold to investors. In general, any stockbroker, financial adviser or planner that is recommending you invest in one of these IPO’s or LIC issues, is receiving a commission of between 1% and 2% of the capital you invest. There is little wonder that the list of brokers associated with most IPO’s these days include up to 12 ‘co-managers’ or ‘joint- lead managers’; in the early 2000’s it was only one.

Well-timed product launches

We are amazed on a weekly basis by how quickly the ETF and LIC providers are able to get a product to market when a particular sector or group of companies is popular. In the last few months we have seen ‘disruption’ funds, lithium battery funds, cyber security and before that the famous BEAR fund, that bet on markets falling.

ETF’s and LIC’s used to be highly diversified investments, offering a solid option for less involved investors to gain a general exposure to the benefits of the sharemarket. Unfortunately, they are becoming increasingly specific, more volatile and higher risk. They tend to come to market at the most opportune moment but then consistently outperform, in our view they are not specialists but opportunists, driven by sound marketing but poor investment nous.

In our experience, the issue with these products isn’t their approach, but the patience and process that investors take in buying them; which in most cases is none. Most people are simply attracted to the most popular options, or those supported by well-known names in the investment industry, but give little consideration as to how they form part of a broader portfolio.

Cherry picking fund managers

The most successful long-term investors have several traits in common, but one of the most important has been their willingness to partner with specialist managers around the world. Some of the highest performing funds, including the likes of Australian Super, the Future Fund and Yale Endowment, invest the majority of their capital directly with fund managers. Yet for some reason, the DIY investors of Australia show little interest in following this proven approach.

Many investors we meet are willing to copy the most popular investments that fund managers present on, but not willing to invest in their funds. Why is this? The amount of portfolios we see that contain the best 5-10 picks of the most popular fund managers is simply concerning. The underlying funds that these picks form part of usually include some 30-50 individual holdings with a success rate of 60% each year at the higher end of expectations. Attempting to cherry pick those ideas that you agree with is dangerous, particularly when markets turn. The reasons that most managers are successful is because most specialise in a specific area or sector of their market.

On a separate but related topic, we have been seeing an increasing number of well-known Australian fund managers either expanding into overseas shares or beginning to short companies in their funds. Investing globally requires extensive networks, greater research support and connections, which most domestic specialists simply do not have; it pays to stick with those who have been there for many years before.

Taking advice from journalists

The presence of high profile journalists on our TV screens, in the newspapers and at the hundreds of conferences held each year gives the perception that they know what they are talking about. Yet a quick look back on their previous predictions suggests they would be lucky to know more than most DIY investors. Investors need to be wary that these people are paid to have an opinion on a daily basis, every day they need to say something different. They aren’t paid to make you money, they are paid to sell newsletters and their own products.

One perfect example was the growth in issuance of high dividend, high yield and other similar funds focused on the ASX. This sector is seemingly one that every commentator believes they can deliver returns from, yet performance has shown they cannot, with the majority underperforming the index whilst charging substantially higher fees. Vanguard was one of the few that issued a high yield strategy many years ago, yet they have been joined by an extensive list of ETF providers and experts, like the Dividend Harvester or Australian Income Fund.

When it comes to any type of investment, we suggest investors seek to partner with the best in each sector. These people don’t run newsletters, they run their own funds and invest their own capital.

As the market continues to run hot, the number of higher risk opportunities expands along with it. At the end of this cycle it has been the likes of fractional property investing, corporate bonds and even direct loans to property developers that have gained the most attention. Each of these investments have many benefits that they can offer investors as part of a truly diversified portfolio, yet the risks are too often hidden by those recommending them. As a general rule, if you are being sold something that is being advertised based on it’s yield or performance over the last 12 months, its probably not sustainable.

Anchoring your purchases

One final issue that increasingly impacts on DIY investors ability to make decisions in volatile sharemarkets is the anchoring of the purchase price of their investments. CSL’s recent performance is a perfect example. CSL has fallen from a high of $230 to $180 today; if you owned 1,000 shares you would have lost $50,000 in capital in just a few weeks. Yet most DIY investors will not even consider this as a ‘loss of capital’, they have anchored their investment to the original purchase price of say $30, meaning they are still well ahead of where they started. This is one reason why many investors showed no willingness to sell Rio Tinto at $150 in 2007 nor remorse after it inevitably halved in value.

So, what’s the solution?

It’s actually quite simple and what we at Wattle Partners do on a daily basis. The majority of DIY investors and their portfolios have little to no framework for their investment decisions. They simply add the most popular stocks in what is best described as a hodgepodge of ideas that becomes their portfolio. There is no decision tree, nor investment policy or rules around where they should be investing and when investments should be sold.

We are strong advocates of the need for a tailored and comprehensive Investment Policy being used for the investment of any amount of capital. We are one of the few in our industry actually delivering on it. Many of the investments outlined in this article may in fact be fine, as part of a broader portfolio, however, this is not how they are generally being used. There is an increasing trends of marketing groups going direct to the DIY investor and consumer, resulting in decisions with no consideration to their role within portfolios.

Betting on a future of electric cars and battery power

As the world scrambles to replace fossil fuels with clean energy, Lithium-ion batteries have had and are fast becoming the major source of energy storage in off-grid renewable energy. The answer lies within the reactive alkali metal’s ability to power our phones, tablets, laptops, electric cars and houses.

Unlike burning fossil fuels for energy, the carbon used in  Lithium-ion batteries does not burn or cause emissions in the process. The carbon electrode serves as a rechargeable hydrocarbon for storing energy. The battery can be charged and discharged making it an ideal component of today’s modern day electric vehicle. In fact, Lithium ion batteries have the highest charge capacity of any practical battery formulation in history. The ability to store energy is what has created this enormous opportunity. The current electricity grid distributes electricity mainly from fossil fuels to households throughout the country very effectively, blackouts are rare. Given there is no ability to store any of this electricity it is an engineering masterpiece.

Think about how energy is generated at multiple isolated power plants, then travels through tens of thousands of kilometers of power lines, to come out exactly when you need it, and then consumed. The planning and adjusting required to produce just enough energy to meet low demand, and then keep up with peak hour demand is a very hard process.

However, if energy could be stored locally (and produced locally, but this is a different conversation) this, removes the constant demand and careful planning and allows for a much more efficient use of energy.

Incremental improvements in Lithium-ion batteries have now allowed automakers to actively use lithium ion batteries to power an electric revolution. So much so, that electric vehicle supply in China is expected to be one of the main drivers of global demand for lithium. By 2030, Goldman Sachs expects China to supply 60% of the world’s electric vehicles, up from 45% in 2016.

Tesla cars in fact are powered solely by the electrical charge stored in Lithium batteries. The Tesla Model S contains about 12 kilograms of lithium in each vehicle. Batteries installed in electric vehicles, will also affect the electric grid reducing the stress. The largest battery created by Tesla is the Powerwall. It can store enough electricity to power the average American home for more than three days.

So as you can see, the opportunities in Lithium storage are endless with consensus estimates for global electric vehicle penetration, seem way too conservative.

Wall Street analysts are tipping a 4% penetration in 2020 and 15% in 2025 while key battery component makers such as LG and Samsung SDI, are predicting a considerably higher 6-10% penetration by 2020. Irrespective of the numbers and estimates, they all point to one thing; higher penetration of electric vehicle demand in the near future. This insight draws an important conclusion – demand for the raw materials required to produce Li-ion batteries are on the rise, namely lithium, cobalt, nickel and graphite. It puts the mining industry at the heart of this Electric Vehicle Growth story. As we know, Lithium isn’t the only material required. Here’s four cathode chemistries and an example of what they are used for:

But for this purpose of this article we will focus solely on lithium.

Lithium can be extracted from brine salt mines or mined from hard rock deposits. Brine is dominated by South American countries and the Australian producers mine hard rock deposits. The countries in the “Lithium Triangle” host a staggering 75% of the world’s lithium resources, they are:

Argentina, Chile, and Bolivia.

Market-friendly Chile, is the easiest of the three to do business in. Argentina is making up lost ground but is relatively a volatile place both politically and economically. And Bolivia, whose resources are as large as Argentina’s, has barely exploited its Lithium reserves. There is another formidable challenger that handles business investment with open arms and that is Australia. Costs are generally higher because lithium must be expensively crushed out of rock and shipped to China for processing, but conditions are a lot friendlier. For that reason, the amount of Lithium exported from Australia rivals that of Chile. In 2016, Australia exported 74,250 tonnes versus 76,000 exported in Chile.

How to invest in lithium?

So when looking for ways to gain Lithium exposure there are two main ASX listed stocks Orocobre (ORE) and Galaxy Resources (GXY). For this article we have chosen Orocobre (ORE), as it operates within the Lithium Triangle and is extracting Lithium from Brine salt mines.

Orocobre (ORE) – Is a lithium miner in Argentina listed on the ASX. The company’s flagship mine is its Olaroz Lithium Facility and Borax Argentina SA. Its primary focus is on the exploration and development of lithium, potash and salar mineral deposits. The miner was an early mover in this space, indeed the Olaroz development was the first new brine-based lithium asset to be built in over 20 years when it was commissioned in 2015. It was perfectly timed with the rapid rise in demand for electric vehicles.

The company recorded strong annual sales revenue of US$152m on total sales of 12,080 tonnes of Lithium. The recent June Quarter production was up 28% to 3,596 tonnes, all this revenue is now turning into cash with the company holding more than US$319m in cash. Its Phase 2 expansion project of Olaroz is fully funded. The miner has had positive talks with Toyota Tsusho Corporation with well advanced plans for a proposed 10,000 ton per annum Naraha Lithium Hydroxide plant to be built in Japan.

Toyota is targeting every model in the Toyota and Lexus product range to have available as a dedicated electrified model by 2025. We see the Toyota agreement with Orocobre that is providing long term, stable supply of lithium in response to growing global demand, as having enormous upside potential. Lithium demand is expected to continue growing with the shift from fossil-fuel powered vehicles to electric vehicles (EV), in addition to the steady growth of lithium-ion batteries for electric devices. Demand growth to date has seen the lithium price more than doubled in the past few years.

ORE shares have however come under pressure of late, one catalyst for the fall could be concerns that an increase in production in Argentina and Australia will lead to an oversupply in Lithium. We think these concerns are too short sighted. Orocobre and other miners are confident that prices will remain favourable for the foreseeable future. In fact there is growing concern about whether there will be enough lithium to keep up with rising demand driven by the rapid growth of the electric vehicle market. Car companies such as Tesla have voiced concerns that Lithium will fall into a supply shortfall over the comping years.

Either way, the message is clear, the world needs more lithium than is currently in supply and this trend isn’t changing anytime soon. On the contrary, electric car production is expected to increase more than thirtyfold by 2030. That means more batteries and more lithium, unless they find something else. Like any of these substantial changes or disruptions, there is a million ways to try to make money from the change, Lithium is an interesting way to bet on a future of electric cars and battery power, our then speculative pick would be Orocobre (ORE).

What we liked & disliked October 2018

What We Liked 

  • Telsa – Tesla Shares are hitting record highs after informing the market of their last quarterly result. Recording net income of $311.50 million versus a loss of $619.40 million this time last year. Revenue was also half a billion higher than forecast. Management expect this trend to continue in the fourth quarter. Add this to Musk’s announcement that the Model 3 was the best-selling car in the US, and production was tracking well, he also announced a net $5,000 reduction in the Model 3, and a reduction in options on the more expensive models which will allow production to be increased substantially. Lastly, they have started rolling out their Chinese expansion with the purchase of land for a new

 

  • We applaud the government and FPA on the new requirements that all financial planners must have a relevant university degree. It has been a stain on the professional industry that just about anyone can hang their shingle out as a financial planner or adviser, with as little  as  a  few  weeks  of  study.  From  the  1st     of January, new advisers will be required to hold a relevant degree before they are eligible to commence a ‘supervision year’ and to sit the exam. Existing advisers will have two years, until 1 January 2021, to pass the exam and five years, until 1 January 2024, to reach a standard equivalent to a degree. We would have liked to see the requirement for existing advisers to be more aggressive, however it is moving in the right direction finally. The change is likely to see a substantial reduction in planner numbers but particularly accountants who also offer

 

  • A bear market creates opportunities, and after disliking the lack of real investment opportunities in the previous month, the horror month in markets has actually given us a few.

 

What We Disliked 

  • The blood bath in risk assets in October was a function of heightened fears of declining profit margins from rising input This should also lead through to greater inflation pressures (which was covered in detail in the latest UWJ Quarterly) in the U.S. and higher bond yields. Even though the rate of inflation dipped last month in the U.S., rising output prices from manufacturers (who themselves are facing higher input costs) will be passed through to the economy and other companies. The ability for companies to protect margins will depend on the price elasticity of their products. Inflation still remains the number one concern in our mind.

 

  • The S&P 500 dropped 9% over the month, and our local market was down 6.1%. The bears are out, and they are not happy. The risk of higher rates, inflation and a trade war has terrified the market throughout October. Investors should know by now that cash is king, especially when the market gives you an opportunity to buy everything at a discount.

 

  • Property prices in Australia have kept falling, with an overall fall from the top to the bottom of 15% generally It’s the “house price fall we had to have”, according to Deloitte Access Economics’ latest business outlook. Our final thematic printed issue of Unconventional Wisdom journal is dedicated solely to the Australian property market and the outlook ahead.

 

  • Trump has again shown that he is more a smart businessman than a politician, when markets seem very gloomy, he talks to Fox News about how confident he is that a ‘Great deal’ with China can be done at his meeting with China’s President Xi Jinping. Market sentiment rebounded substantially with the hopes of a trade war between the US and China being short lived. Probably the real issue is whether 2019 is a Bull year or Bear year.

 

Home & Contents Insurance

Home and Contents insurance is designed to protect you against  the most common threats you may face. While it is impossible to lead a risk- free life, it aims to provide individuals with a peace of mind from any uncertainties. For  many Australians, their home is one of the most valuable assets they have.  So it makes sense to safeguard the physical structure and contents of your home from any unfortunate events.

  Home Insurance 

Home insurance is designed to protect your home. When buying your home insurance, it is important to ensure that you purchase the right amount of cover that is sufficient in covering the total costs of rebuilding your home if it’s completely destroyed. Damages to your home outside of your control may be caused by natural disasters, bushfires, floods, storms etc. In the case of a fire destroying your home entirely, insurance payouts may be significant in rebuilding your life and that of your family.

Types of building insurance

There are 2 types of building insurance.

  1. Sum-insured cover – This type of cover is most common as it allows you to specify an amount “sum insured” for the cost of rebuilding or repairing your home. This is good option if you know how much it will cost to rebuild your home.
  2. Total replacement cover – If you don’t have the expertise to calculate the exact amount of cover required to rebuild your home, the total replacement cover is an option for you as it reduces any shortfall between the amount insured and the total cost of rebuilding your home to the state it was prior to an event occurring. This option can minimise the risk of being

Calculating the cost of your home

Your home is one of the most valuable assets you may own and it can be difficult for you to determine what is the most appropriate level of cover you need. There are 2 main methods in calculating how much cover your home needs.

  1. Cost per square metre. This is a basic method and is based on the size of the house and the materials
  2. Fundamental estimation. This is a much more comprehensive method that takes into consideration a number of factors, including local wage rates, material costs, the quality of finish used, the nature of the building site and

Many insurers also offer online calculators. It requires you to answer a set of questions, for example, is it built on a flat or sloping land, what type of roof you have, what are the walls of your home made of etc. It will then provide you with an estimate of the cost of rebuilding your home from scratch.

Events covered

There are many types of home building insurance policies available to suit a wide range of living circumstances. It is important to consider what specific risks you need to insure your home from. Depending on the location of the property, you may be more susceptible to fires, or if you live near a river, you may be more exposed to flooding.

Above is a list of events/covers that highlight what can be covered within your policy. Descriptions will vary between insurance companies.

Contents Insurance

 What is coveredUnlike home insurance, contents insurance provides cover for the damage and loss of your personal belongings in the home. This cover is not only for homeowners but also those that are renting. If the unexpected should happen, landlords insurance will only cover the property they own and not your possessions.

There are two main types of contents insurance:

  1. “New for Old” – This covers you for the cost of replacing your belongings (damaged or lost) with new This option tends to charge a higher premium as the cost to replace the item is of higher value.
  2. Replacement Value – This only covers the market value of  the  It is important to review your policy regularly as the value of most of your possessions will depreciate over time.

A standard contents  insurance  policy  will cover your possessions if they were damaged or lost in a specified event such as theft, burglary and storm. It also covers for accidental damage/breakage e.g. the TV accidentally dropped from your wall mount, stains on your carpet or damages  to your floorboards from moving is also included. Some policies also have the option of covering you for any items taken away from the home e.g. Mobile phone, jewellery, laptops, cameras etc. Insurers will normally set a limit for unspecified items. There are some items that may not be covered under the standard policy. Valuable items such as, your jewellery, collectibles (painting, stamps, books) will need a separate valuation and listed separately under your policy.

Optional extras

Before taking out the policy, it is best to identify what other expenses and services are provided under the policy. Many Australians always assume that an insurance company rebuilding your new home will automatically include removal costs. Please refer to the Product Disclosure Statement to ensure what costs are covered and whether limits apply.

Protection Against Inflation

Upon your policy renewal, insurers can provide you with the option of automatically increasing your sum insured to reflect the current costs of rebuilding your home. Your premium will be adjusted accordingly.

Shortfall Cover

This option provides you with the peace of mind and safeguard you against any shortfall cost you may incur. If the sum insured is insufficient to meet the cost of replacing or rebuilding your home,  insurers  can pay  up to a certain amount e.g. an additional 20% of the sum insured, so that your building is complete.

Debris Removal

Many policyholders fall into the trap that if an insurer will cover the replacement of the home building, they will also cover other cost associated with removing the debris and other damaged items from the home. With this option, the insurers will cover up to a certain amount e.g. 15% of the sum insured for any debris or rubbish removal, demolition, and building and professional fees charged (e.g. engineer, surveyor, architect).

Cover for an Unoccupied Home

Your home may be covered if it is unoccupied, however, additional excess will apply to any claim made during this time   if the home has been unoccupied for more than a certain period of time.

Storage of Personal Items

The rebuilding of a new home can take time before you can move in. Another option to consider is having your undamaged personal contents stored while your home is being rebuilt. Insurers will cover up to a certain amount e.g. 10% of your home contents sum insured in addition to your total sum insured.

Being under insured

Being under-insured is very common among many Australians. Statistics have shown that more than 30% of Australians do not insure their home or personal belongings. No one believes that anything will happen to them. If the unexpected happened, do you have enough cover to replace all your possessions?

Ruth, a retired nurse had made the decision to sell her family home and downsize. 3 weeks after the home was sold, she received a call advising her that her home had caught fire. She had spent her entire life in this home and she could not believe this happened to her. The home assessors believed that it was due to an electrical fault that started in the kitchen. Ruth was underinsured in both her home and contents insurance.

“The Insurance Council of Australia estimates that more than 81% of Australian homeowners are underinsured. Households fail to correctly assess the value of their home and contents”. Insuring the most valuable asset for less makes as much sense as insuring a Ferrari at the insured amount of a Toyota Camry.

By having your home underinsured in the event of a natural disaster could leave you having to pay out a significant amount compared to the cost of increasing the level of cover on your home insurance policy. Australia experienced its most horrific hailstorm in Sydney 1999, where 500,000 tonnes of hailstones caused damages totalling $2.3 billion. Sadly, only $1.7 billion of this damage was insured.

How premiums are calculated

The premium for contents insurance is based on the likelihood of a claim being made on your policy in the future. Your insurer may take into account many different factors when calculating your premium.

  • The age of the policy owner
  • The insured amount of your home and contents
  • The risk profile of the location, including crime rates and the risk of natural disasters such as floods, bush fires and cyclones.
  • The excess amount you choose

Comprehensive insurance offers peace of mind for policyholders. Your insurance premiums may be higher in the short term, however it wont leave you feeling emotionally and financially stressed when you need to cover the excess on a claim such as in the event of a natural disaster.

Important things to note

  • 24/7 Emergency Claims Assistance– Events can happen unexpectedly and knowing that your insurer is available at anytime will provide you with a peace of mind.
  • Flexible Excess Payments – Insurance premiums can be very Some insurers will offer you flexible excess options that can reduce your upfront costs.
  • Lifetime Repair Guarantee – In the event that you have made a claim and repairs have been completed on your home, there  are  insurers  that  offer   a lifetime guarantee on authorised building

Burglary

One of the top causes of home and contents insurance claims in Australia is due to theft. In Australia, households experienced at least one burglary (2.5%) from 2016 to 2017. Only 75% reported the incident to the police. 49% of those had property damaged and 74% of the households had property stolen. 1 in 10 households that were broken into were confronted by the offender. The table below illustrates the percentage of households that had been broken into by state in 2017 . Northern Territory had the highest percentage of break-ins versus the population (5%) of households, followed by Western Australia (4.3%). South Australia had the lowest percentage of break-ins versus the population at 1.9%.

The claim process

In 2016, Australian insurance companies approved 3,361,016 claims from policyholders and paid out an average of $124.6 million in claims. Approximately 5% of policyholders will make a claim in the year and only 3 per cent of claims each year are denied.

In the event you are involved in an unexpected accident, disaster or other loss that is covered by your insurance policy, you will need to lodge a claim as follows:

  1. Contact the insurance company as soon as you can. This will ensure the insurer is made aware and can therefore start assessing your
  2. The insurers may request certain documents and evidence to prove what has been lost or damaged. E.g. Photographs of the damage, a police report, receipts, valuation
  3. Home Assessors may be required to attend the property to assess the
  4. Once all the required documents have been received, your case manager will review the claim before a decision is made. If your claim is accepted, the insurer will fulfil the terms of your policy through repairing or replacing damages to the property or items through a payment. If your claim is denied, the insurance company must provide a written report of the decision to deny the claim and information about its complaints handling

Home and Contents insurance is a way of managing risks. With any luck, you may never need to use this, however if you happen to be affected by an unexpected event, be certain that you are adequately insured as the impact it could have on your finances, your lifestyle and potentially your future can be devastating.

Buffet on Inflation…

Warren Buffett has been warning about inflation for 40 years!

 

When you start talking about the impact of inflation on our portfolio, you cant go past reviewing what one of the most successful investors, Warren Buffett, the chairman and CEO of Berkshire Hathaway, has said about the topic

Throughout his life. Buffett has offered many wise words on just how much inflation affects portfolios. Now that inflation may be back it’s worth looking back at what Buffett has said about inflation in the past. Most people know Buffet’s famous equity quotes, however in the end his quotes on inflation might be stick with us the longest.

But Buffett devoted significant portions of Berkshire’s annual letters in the late 1970s and early 1980s — amid high inflation in the United States — to discussing what rising prices mean for stocks, corporate balance sheets and investors. Buffett lived and invested through a period when inflation hit 14 percent and mortgage rates spiked as high as 20 percent — amid what some called the greatest American macroeconomic failure of the post-World War II period.

He has never lost the fear of inflation, ever. In June 2008, as the price of gas went above $4, Buffett said “exploding” inflation was the biggest risk to the economy. “I think inflation is really picking up,” Buffett said on CNBC. “It’s huge right now, whether it’s steel or oil,” he continued. “We see it everywhere.”

Do you remember what happened after that?

In 2010, “We are following policies that unless changed will eventually lead to lots of inflation down the road.” He added, “We have started down a path you don’t want to go down.”

At the 2013 Berkshire Hathaway annual meeting, Buffett had already warned, “QE is like watching a good movie, because I don’t know how it will end. Anyone who owns stocks will reevaluate his hand when it happens, and that will happen very quickly.”

Buffet is most famous for a classic piece in the Fortune magazine in 1977, Buffett outlined his views on inflation: “The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply  consume capital…. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker — but not your partner.”

The world, and economy, are very different places now than when Buffett’s annual letters to Berkshire Hathaway shareholders took up inflation and investing. Income-tax rates have changed. Back then, bond yields were much, much higher, as were savings rates. And it’s just the first signs of inflation that now have been spotted. It was the rise in wages in the last nonfarm payroll report that first rattled markets.

Other economic factors are eerily, or at least partially, similar. In the Vietnam War era the government’s rapid increase of the federal deficit began the inflation cycle that peaked in the late ‘70s. The latest projections from a government budget watchdog forecasts that the annual deficit will double from what was expected just two and half years ago ($600 million), to $1.2 trillion in 2019, due to the tax cuts and just-approved spending package.

It’s worth remembering that the worst stock performance of the 1970s came not when  inflation  peaked   but  when  it  first spiked rapidly. From 1972 to 1973, inflation doubled to more than 6 percent. By 1974 it was 11 percent. In those two years, the S&P 500 declined by a combined 40 percent.

Inflation was higher in 1979 and 1980, topping out at 13.5 percent, by which time the S&P 500 had long returned to positive performance, though on an inflation- adjusted base. It was a lost decade for stocks.

So who better than Buffett to explain some of the basic mechanisms at work when stocks run into inflation? As Buffett stated in one of his inflationary era letters, when it comes to inflation and stocks, there is one unsolvable problem: “Berkshire has no corporate solution to the problem. (We’ll say it again next year, too.) Inflation does not improve our return on equity.”

Here are some other thoughts from Buffett on investing during inflationary periods.

    1.When you are doing great, it is the time to remember inflation.

Buffett wrote at a moment of good performance for Berkshire, “Before we drown in a sea of self congratulation, a further — and crucial — observation must be made. A few years ago, a business whose per- share net worth compounded at 20 percent annually would have guaranteed its owners a highly successful real investment return. Now such an outcome seems less certain. For the inflation rate, coupled with individual tax rates, will be the ultimate determinant as to whether our internal operating performance produces successful investment results — i.e., a reasonable gain in purchasing power from funds committed — for you as shareholders.”

A business earning 20 percent on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail.”

     2. During high inflation earnings are not the dominant variable for investors.

“Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you:

  • forego 10 hamburgers to purchase an investment;
  • receive dividends which, after tax, buy two hamburgers; and
  • receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then
  • you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat

“High rates of inflation create a tax on capital that makes much corporate investment unwise – at least if measured by the criterion of a positive real investment return to owners.”

“This ‘hurdle rate’ the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners — has increased dramatically in recent years. The average tax paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.”

    3.Understand the math of the ‘Misery ’

“The inflation rate  plus  the  percentage  of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) — can be thought of as an ‘investor’s misery index.’ When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.”

    4.Inflation is a ‘tapeworm’ that makes bad businesses even worse for shareholders.

“A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the ‘bad’ business. To continue operating in its present mode, such a low- return business usually must retain much of its earnings — no matter what penalty such a policy produces for shareholders.

“… Inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the ‘bad’ business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the  past —  and  most  entities,  including businesses, do — it simply has no choice.

“For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

5.Focus on companies that generate rather than consume

“Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their existing physical volume of business. There is a certain mirage-like quality to such operations. However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings attached cash.”

 6.Look for companies that can increase prices and handle a lot more business without having to spend a lot.

Of course, most of us are not billionaire buyers of corporations outright, but Buffett’s words on what makes for a great acquisition in the 1981 letter touch on inflation as one of two key factors that make a great acquisition candidate:

“Companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.”

7.Think about tomorrow, especially when the pace of change picks

“Several decades back, a return on equity of as little as 10 percent enabled a corporation to be classified as a ‘good’ business — i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at more than 100 cents. For, with long-term taxable bonds yielding 5 percent and long-term tax-exempt bonds 3 percent, a business operation that could utilize equity capital at 10 percent clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10 percent earned by the corporation to perhaps 6 percent to 8 percent in the hands of the individual investor.

“Investment markets recognized this truth. During that earlier period, American business earned an average of 11 percent or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were “good” businesses because they earned far more than their keep (the return on long-term passive money). The value- added produced by equity investment, in aggregate, was substantial.

“That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time.

But when change is great, yesterday’s assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.”

8.Corporations cannot out-manage government.

“One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, 15 years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil. “We intend to continue to do as well as we can in managing the internal affairs of the business. But you should understand that external conditions affecting the stability of currency  may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.

9.There is no solution to inflation, but there’s reason (maybe just a little) for hope.

 Buffett wrote in 1980, “The chances for very low rates of inflation are not nil. Inflation is man made; perhaps it can be man-mastered. The threat which alarms us may also alarm legislators and other powerful groups, prompting some appropriate response.”

The recent reaction in the share markets in stocks does not suggest faith in that response being adequate.

There are many things to take from the these messages from Warrens’ inflation thoughts.

The one thing we can all get from this is   if Warren is worried about inflation so should you!!!!

 

Inflation Linked Bonds

Why inflation matters for your portfolio

Inflation has been such an important talking point in global markets over the last decade. Whether it has been the specific targeting of higher inflation under the Japanese policy of Abenomics, the threat of deflation in Europe or the lack of wage growth inflation in Australia and the US. Yet, even as central banks around the world have flooded asset markets with unprecedented and extraordinary amounts of liquidity, higher inflation, over 3% for instance, has yet to return. Is it just a matter of time?

We are sure most of our readers understand the concept of inflation, in that it reflects the general rise in the prices of goods and services in an economy. However, we aren’t confident that a lot of investors understand how much of an impact it can have to their portfolios over the long-term and why it should be an important consideration for their investment strategy. This is particularly relevant for SMSF trustees and retirees who effectively require a certain and growing income stream throughout their retirement to fund real and increasing expenses.

In order to account for the long-term effects of inflation, investors need to focus on the ‘real’ return they receive from their investments i.e. the return adjusted for inflation. Consider for instance the situation where you are investing into a 3-year term deposit paying interest of 2.5%. If inflation is 2.1% per annum, the after inflation return, or what you can spend, is just 0.4%. If the funds were held in a cash account at  1.5%, the  after-tax   return  is  negative,  at -0.6%. This has been one of the driving forces behind today’s bull market run as investors have been forced to  take  more  risk in order to deliver  positive  real returns for their clients.

Hedging against inflation

For many years there has been an expectation that the likes of property, gold bullion or equity markets, through their  connection to  the  economy,  would  actually  provide a hedge against inflation. Many believed that they would simply be able to increase their profits and cash flow to deliver higher returns to investors. Unfortunately, in the real world this has generally not been the case. One of the most well-known investors in the world when it comes to assessing and protecting against inflation is Bridgewater Associates, which is run by billionaire Ray Dalio. Bridgewater have advised some of the world’s largest pension funds about how they can most effectively manage the risk associated with the pension liabilities against the threat of increasing inflation; which in their cases can be disastrous.

Through their many decades of experience, Bridgewater have built some of the most complex models to explain how as they call it ‘the economic machine’ actually works. One of the most relevant for the purpose of this report, is their work on how various asset classes react in the four main economic environments, being:

  • Rising economic growth
  • Falling economic growth
  • Rising inflation
  • Falling inflation

As you can see from the series of tables, the long-held assumption that equities provide a hedge against inflation simply does not hold up. In fact, the data confirms that equities perform most strongly in periods of rising growth and falling inflation and tend to deliver negative returns when inflation actually increases. Conversely, Government and other bonds perform well when growth is falling, and inflation is falling, as this is usually associated with interest rate cuts. This leaves only two main asset classes that offer protection when inflation is rising, inflation- linked bonds and commodities.

What are inflation linked bonds (ILBs)?

The most common inflation-linked bond is the ‘capital indexed bond’ or CIB. Under the terms of these bonds various in inflation are added and subtracted from the capital price of the bond. For instance, if the issue price of the bond is $100 and inflation in year 1 is 3%, the value of the bond at the end of Year 1 will be $103. This is known as the adjusted capital price or value. Importantly, it isn’t solely the capital value that is changed if inflation rises, the coupon or interest payment, which is typically a fixed percentage, is reapplied to the adjusted capital value for each payment. Using the previous example, if the coupon was 3%, then the interest payment in year 1 would be $3 and in year 2 it would be $3.09 ($103 * 3%).

ILB’s may sound like complicated instruments, however, they are no different to a typical Government bond. They have actually been around since the 1700’s but given they could represent a growing liability to Governments seeking to increase inflation, there issue has not been widespread until more recently. In fact, some figures suggest the supply of ILB’s has increased tenfold in the last decade as investors sought additional security and Governments attempted to take advantage of a benign inflationary environment. Many believe this may be coming to an end.

 

A comparison of cash flows

In the table above, we have provided a real- world example (from Wrase, 1997) of how inflation-linked bonds operate and most importantly differ from a traditional or ‘nominal’ bond. For the purposes of the case study, the following assumptions have been used:

  1. A real coupon of 3% on the ILB;
  2. An inflation rate of 2% per annum over 10 years;
  3. A coupon of 5.06% for the nominal

As you can see from the table above, the inflation linked bond offers a consistent ‘real’ interest payment whilst the value of the higher nominal payment of the traditional bond reduces each year due to the impacts of inflation. More importantly, the value of the capital you will receive from the inflation linked bond, $1,218.9, is 22% higher than the traditional bond and more than enough to cover the lower nominal interest payments received during the period.

Why should they have a place in your portfolio?

In our view, all investors face three key risks when moving towards retirement: market; inflation and longevity. Against a backdrop of rising inflation and a transition towards lower risk asset allocations investors are decreasing their market risk and increasing the inflation and longevity risk associated with their portfolios. This is an interesting conundrum.

Whilst low-risk investments should represent a higher proportion of wealth as investor’s age, weight must be given to the future purchasing power of accumulated wealth and the need to ensure retirement capital grows at least in line with inflation. ILB’s represent an attractive solution. ILB’s allow investors to remove all market risk whilst hedging away the impacts of inflation over the long-term.

ILB’s provide a guaranteed real rate of return to investors. This means that the real return on an ILB remains the same throughout the life of the investment. It is important to note, however, that the fixed rate nature of the interest payments on ILBs means that they can subject to similar interest rate risks to that of ‘normal’ bonds.

ILB’s are effectively a risk less asset in terms of preserving the real value of your capital and your future purchasing power. The evidence suggests that they provide a nearly perfect hedge against inflation and have a low correlation with almost all other asset classes, being the only investment that has consistently increased in value when inflation rises. They are by no means the perfect investment, for instance investors may lose capital in a deflationary environment, and they are subject to the standard credit and counterparty risk that comes with making any bond investment.

With inflation pressures expected to rise (they are actually being targeted) in Australia and the US and increasing allocations to low-risk investments, we believe every investor should consider the benefit and appropriateness of an allocation to ILB’s in their portfolio. If you are interested to learn how, please contact us.