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.  This month we met with Warrakirri Asset Management, who are launching a Diversified Agriculture Fund.

Whilst agricultural property has a tainted record in Australia, due primarily to the tax-driven Great Southern and Timbercorp schemes of the 2000’s, there is an increasing supply of investable opportunities run by professional operators in the industry. Warrakirri is a well-known name in the agricultural space with over 20 years’ experience directly operating farming properties and running discrete mandates exceeding $1bn for industry and other sovereign wealth funds.

In 2018, the group has decided to open their capabilities up to the wider market.

The company plans to launch the Warrakirri Diversified Agricultural Fund in 2019 and raise up to $100m in capital as part of the first raising. The capital will be used to buy, develop and own a diversified portfolio of high quality agricultural properties leased to the best operators in the industry. The targeted properties will be valued at between $10m and $30m and the fund will target a return of between 7 to 11% per annum over the 7 year investment period of the fund.

The management team intend to diversify the portfolio across all of Australia and include all aspects of the production cycle including water entitlements, livestock, vineyards, fruit and nut trees as well as processing and infrastructure assets like greenhouses. Importantly, the fund will have gearing capped at 25% and will be managed on a capital calls basis, with 25% of committed capital due on application and the remaining expected to be called within 12 months.

We will cover the investment in greater detail in a later issue, however, as many readers know some of the best performing investments in recent years have been agricultural property trusts like Arrow and Rural Funds Group. It is yet to be seen whether Warrakirri can deliver a similar return profile, however, given the heightened volatility in markets we see an increasing need for less volatile, non-market linked assets.

The fund requires a minimum investment of $100,000 and is restricted to wholesale investors only.

Under the Microscope – AMP Ltd

AMP was demutualized nearly 20 years ago, about 140 years after it was founded.  At the time of listing I actually worked for AMP Financial Planning.  The office was abuzz the day as AMP came on the boards, it traded up and up and up to nearly $20; in fact, it went higher a few weeks later, touching $25. The great Australian mutual was demutualised and the future looked amazing as a newly public listed company!   Fast forward to today and you can buy the same name company for about 10% of its all-time high, about $2.50 per share. In 20 years of being listed there have been lots of highlights, unfortunately most of them have been bad.

As the old saying goes, ‘Everything has a price’. Is $2.50 the right price to buy AMP?

It starts from the top!

Over the past six months the entire board and most of the senior management of AMP have been shown the door. David Murray AO is now the chair of the board, David of course was the foundation chairman of Australia’s Future fund and the previous CEO of Commonwealth Bank from 1992-2005. In our opinion he is the perfect Chairman for this role. The first point of order for David was finding a CEO that could drive recovery and then growth, and just this week Francesco de Ferrari started as CEO.

Over the past six months the entire board and most of the senior management of AMP have been shown the door. David Murray AO is now the chair of the board, David of course was the foundation chairman of Australia’s Future fund and the previous CEO of Commonwealth Bank from 1992-2005. In our opinion he is the perfect Chairman for this role. The first point of order for David was finding a CEO that could drive recovery and then growth, and just this week Francesco de Ferrari started as CEO.

De Ferrari comes to AMP as a so-called proven change agent, he has extensive experience in international wealth management and redesigning business models will be critical in creating the AMP of the future.  De Ferrari spent 17 years in executive roles at Credit Suisse in Asia and Europe.  If he is the right person, only time will tell. But new blood into these roles is a very positive sign for the recovery of AMP.

It seems like the new team at AMP  understand what type of public sentiment problem they have after the Royal Commission, as AMP launched a program in July to repair its reputation and “earn back trust” by compensating customers for lost earnings, strengthening risk management systems and controls, and cutting fees on its superannuation products. When Francesco De Ferrari met AMP employees on his first day as chief executive on Monday, he had four key messages – be optimistic, take advantage of opportunities, be agile and listen to customers.

That sort of upbeat approach is just what the doctor ordered. A mood of doom and gloom has pervaded AMP ever since the wealth manager’s former head of advice, Jack Regan, made stunning admissions at the Hayne royal commission in April this year. So, if change is about starting at the top, AMP has got a big tick.

Quick decision to sell off insurance assets

The media and the funds management industry has loved debating the topic of the decision for AMP to sell off its insurance division and also its wealth protection business in NZ.  We are of the view that it should have been sold for more, but really, we are not in a position to know, nor are financial journalists. The decision has been made, and apart from the price we think it is a good move, as it simplifies the model substantially. Commissions and conflicts of interest are hard to control in investment products but in insurance products they are impossible, something that has not progressed in 40 years.  Many products still pay 110% of their first year’s premium as a commission to the adviser.   And when it comes to the client claiming a benefit, insurers will still do everything they can to not pay.  The insurance industry will continue to be disrupted by more nimble fintech’s, as a result it is a good long term move for AMP to be out of this end of the market. What remains is a simpler AMP business.  The three core growth businesses AMP Capital, AMP Wealth and Platforms and the AMP Bank.

Don’t discount the sales force

AMP has more financial advisers under their wings than any other company in Australia, in fact 20% more than the next biggest, IOOF. What the market is not understanding is the close relationship that many clients have with their AMP adviser, in fact some clients mightn’t even be aware that they are with an AMP adviser due to the various brands they operate under. Typically relationships are very close and it would need to be very powerful news to break the adviser client relationship.  Even in my time with AMP, the two key messages they taught every adviser was to foster close and caring relationships with clients and then how to sell solutions (with of course AMP products).  They had the sales process down to a perfect art. The products and service might need to change in the future, and we are sure de Ferrari is working on that at the moment, but their ability to service and sell is not in question.  The share price is saying that the Hayne inquiry will spell the end of AMP’s business model for financial advice. It is hard to see that happening but if it does there is still plenty of upside in the existing businesses.

AMP Capital

Go back to the investor report released by AMP in February and you will see very bullish forecasts about the company’s growth businesses. Former CEO Craig Meller said AMP Bank was expected to double in value over five years and AMP Capital, the jewel in the crown, was “targeting double-digit earnings growth through the cycle”. The same investor report said AMP was targeting earnings of about $50 million a year from its China joint ventures with China Life. China Life Asset Management Company is the fastest-growing new asset management company in China, while China Life Pension Company ranks first in trustee services and third in investment management market share.

Capital to be distributed or redeployed?

De Ferrari has an opportunity to reignite the capital return strategy previously so successful for AMP, because of the deal already done to sell their Australian wealth protection, Australian mature and ultimately its New Zealand wealth protection and mature business.

The company has already flagged a capital return in 2019 of 40¢ a share. The successful sale of the New Zealand operations should allow another capital return of 40¢ in 2020. In addition, AMP should be able to pay an annual dividend of 20¢ a share in 2019 and 2020.

This is a strategy that Andrew Mohl did very well post the near collapse of AMP at the start of the century.  He sold down non-performing assets and distributed the capital to AMP shareholders.  Essentially if the above is true an entry price of $2.50 could be reduced to $1.30 in under two years if you take the dividend and potential capital distributions.

AMP Wealth is, by all accounts a good business, it has assets under management of $192.4 billion and about two-thirds of this comes from internal channels such as AMP-aligned financial advisers. This division most recently has been in fund outflow, which is expected given the heat AMP has been feeling from the Royal Commission. The key question for investors in AMP is how long before AMP can regain the trust of investors and stem fund outflows.

AMP Bank has a lending book of about $20 billion and the loan book saw a small decline for the first time since 2015. This division carries the same risks as the other retail banks in the potential for bad debts. But put aside, banking is a very good business.

The Risks – there are many!

Risks for AMP include De Ferrari not being able to restore the company’s reputation, continued fund outflows, a financial market downturn that decreases fee revenue from funds under management and bad debts from the banking division – not to mention the outcome from the royal commission with respect to vertical integration and other issues.

Recommendation – can’t do anything else but buy!

If AMP can get out of the woods, it should subsequently be re-rated to around 15 times earnings, assuming no deterioration or improvement from other divisions, the share price could be $4.50 (15 times 30¢ per share earnings).  Noting the CEO will receive a large incentive if the share price reaches $5. The dividend yield for investors with an entry price of $2.50(or $1.30 if you take in consideration the dividends and capital returns over the next two years) would also be very attractive under this scenario.

At these prices it is isn’t just us that think it is attractive. At its current market capitalization of $6 billion, AMP is worth only slightly more than it was at the depths of the financial crisis and is just 20 per cent larger than regional lender Bendigo and Adelaide Bank on those simple comparisons, it would seem AMP is more likely to be worth more in the future. In the last two weeks it is rumored Macquarie Bank have been putting their ruler over every part of AMP, and we are sure there are many more doing the same thing.

We have turned very positive on AMP, and believe all the risks plus more are priced in.  AMP advisers are a marketing and selling machine, the question is what AMP will give them to sell.  Anyone that holds AMP we think it is a perfect time to double down, and anyone that doesn’t a perfect entry in.

Lunch with Christopher Joye, CEO Coolabah Capital

As an independently-owned family office, Wattle Partners regularly has the opportunity to meet with and understand the views of some of the most experienced and intelligent investors in the world. In an effort to share these insights with our clients and readers we recently started hosting regular round table lunch events with some of the more insightful people we have met.

Last week a small group of clients and friends gathered in Melbourne to hear the views of Christopher Joye, the Portfolio Manager of the Smarter Money Group of funds. Chris’ entire career has been focused on modelling the risk of and investing into bonds issued by Australian companies. As a result he as an intimate knowledge of the inner workings of both the Australian financial system and the major banks. Chris has also been called upon to advise the likes of Scott Morrison, Malcolm Turnbull and the Treasurer of the Commonwealth Bank of Australia. Chris accurately predicted both a correction in Australian house prices and the number of Fed rate hikes that would occur in 2017-18, which no other economist had forecast. As a result, we were interested to learn his views of the year ahead. To say that Chris insights were interesting, would be an understatement. Nothing was off limits.

Throughout the 10 years since the GFC the majority of experts and investors have been concerned about disinflation or deflation, not inflation. Chris suggests we should be worried about the opposite, a large spike in inflation. He suggests that an inflation crisis may be on the cards in the next 3 to 10 years as the profligate policy of the last decade comes to a head.

His outlook for the global economy was generally positive, suggesting the US economy will continue to surprise to the upside on growth, inflation and employment. He believes Trump is a pragmatic politician, that knows how to say the right things and get results that are palatable for American’s, and that the trade war with China will end before it really begins. During his presentation he noted that if it wasn’t for a substantial spike in Australia’s participation rate, or those now willing to work, the unemployment rate would actually be just 3.1%. The strength in the economy has attracted more people into the work force.

In terms of investment markets, he shared the same view as us, in that the biggest influence on sharemarket returns and company valuations will be the change in the discount rate, or 30-year bond rate. It is this input that all investors and companies use to value the future earnings from businesses or investment, and with bond rates increasing around the world has been the main contributor to the recent bout of volatility. In Chris’ view the days of holding a long-only portfolio of blue-chip stocks are over, particularly in the period when interest rates begin to normalise. He suggested that long-short, market neutral and traditional hedge fund strategies represent one of the only ways that investors will have any hope of generating positive returns and protecting their capital in an increasingly difficult environment. This is a view shared by the Investment Committee and reflected in the increasing allocation to the Targeted Return Bucket.

Chris’ presentation then turned to what he knows best, the Australian banking sector and the balance sheets that support them. He was outspoken in his concerns regarding the exponential growth in bank balance sheets in 2013, which he addressed via his column in the Australian Financial Review. Whilst it took some time, the macro-prudential measures implemented by APRA have rectified this situation and required the major banks to reduce their leverage from some 90 times back to 30 times. He congratulated APRA for successfully creating a property correction during a boom, rather than allowing a crisis to drive performance; the major question is whether it can remain an orderly correction. The major concern is the implications of the Royal Commission in terms of lending and risk taking and whether this comes at an incredibly bad time given the slowdown has already commenced; only time will tell.

Interestingly, it appears the Royal Commission is the only one in the world to come before a banking crisis, however it has been far too specific in highlighting individual cases of unethical behaviour or human intervention rather than systematic issues. He believes that bank equity or shares will be impacted in the short-term, as they pull back on lending, are required to hold additional capital and their return on equity falls as a result. Longer-term Chris suggests the banks become one of the most attractive investments due to their ability to cut costs and invest in innovation. The banks are likely to become simple transactional institutions, taking deposits and lending to people and businesses, however, they have so much data that they can leverage this to their advantage. He expects a similar course of action to Telstra, insofar as they will seek to close branches, cut staff numbers and further automate their manual processes. They also have the largest IT and R&D budgets in Australia which bodes well for the future.

One of the major threats to the economy is an overshooting of the slowdown in lending caused by the Royal Commission. The real threat is the ‘wealth effect’ and the confidence issues that occur when house prices fall leading to further weakness in retail and consumer spending. This could be exacerbated by the introduction of responsible lending legislation, which is effectively making lenders responsible for the repayment of the loans they make, rather than the borrower. Interestingly, he noted that the majority of loan applications include understated expense figures and that the lambasted ‘benchmark’ expenses where higher and more conservative, suggesting it has been a storm in a teacup. In the short-term, Chris believed that bank debt and hybrids represent a better investment opportunity than ordinary shares, and that they would be supported by a likely upgrade in Australia’s credit rating which would introduce more investors.

He noted that the proposed franking credit policy has already been priced in and that it is unlikely to raise any additional money for the Labor Government. He noted that there is substantial negative polling on each of the franking, CGT and negative gearing policies as proposed, and as a result Scott Morrison may still have a chance.

How to protect your portfolio and feel good about it….

In our most recent UWJ Quarterly Journal, we highlighted the growing interest in ESG or environmental, social and governance issues when it comes to investing. As we have seen in recent months companies are being forced to give more consideration to issues like climate change and organisational culture or risk losing access to the capital markets they rely upon. To date, the ESG approach has primarily been applied to sharemarkets, not bond markets, and to be honest on many occasions it appears to be more of a marketing strategy rather than an investment one.

As part of our extensive due diligence process we have been seeking opportunities to add further diversification to our clients Capital Stable or low risk allocations within their portfolio. Unfortunately, the bond strategies available to most investors in 2018 fall into two distinct strategies; long-term (and hence interest rate sensitive) index-like bond funds and short-term floating rate strategies.

These strategies effectively allow you to benefit from only two outcomes, increasing short-term rates, or decreasing long-term rates, they provide little exposure to the remainder of the yield curve. In the PIMCO ESG Bond Fund, we believe we have found a suitable alternative for those seeking lower risk returns and protection from sharemarket volatility.

Why now for global bonds?

It is clear that interest rates have bottomed in most major economies with the threat of rate hikes continuing to grow. This is seen by many as a time to be reducing exposure to bonds. Yet, this oversimplifies the operation of bond markets and the all-important yield curve. The benefit of PIMCO’s strategy is that it is benchmark unaware and they are able to take active positions based on their long-term expectations for individual economies and markets. This affords the managers flexibility to reduce the duration (or average maturity) of their portfolio, currently around 5 years, and target specific periods on the yield curve where they believe opportunities are presenting. This means they can be exposed to the potential for rate increases or decreases in various periods in the future (Note: bond positions increase in value when rates (or rate expectations) fall). One such opportunity, is the threat of a slowing US or global economy in the next 3 to 5 years, which is likely to trigger a strong period for bonds.

Who is PIMCO?

PIMCO, or Pacific Investment Management Corporation, is one of the world’s largest and most successful fixed income investment specialists. The firm was founded in 1971 in Newport Beach, California, by the well-known and highly respected Bill Gross. The company has over $1.7 trillion in assets under management and employees 2,400 staff across 14 global offices. The core of PIMCO’s approach is their top-down macroeconomic analysis, which relies on their 775 investment professionals to identify the macroeconomic direction of the global economy.

Why PIMCO?

PIMCO’s success and the experience of their investment team speaks for itself. The company has since its founding been dedicated to knowing more than their competitors and achieve this by training and retaining the best investment analysts in the industry. The company has specialist teams operating in all aspects of global fixed income markets offering investors access to an unprecedented universe of investments. PIMCO has invested across several decades, seeing ever major crisis since 1970, and therefore have both the data and experience to understand how to invest in what is becoming an increasingly difficult market for all asset classes.

PIMCO has become a world-leader in embracing the importance of ESG (Environment, Social and Governance) factors in their investment approach, which is utilised in the investment process for this fund.

Why Capital Stable Bucket?

The ESG Global Bond fund is a diverse, actively managed portfolio of global fixed income securities. The fund’s benchmark is the Bloomberg Barclay’s Global Aggregate Index which seeks to measure the returns of a diversified pool of bonds issues by companies around the globe. The fund meets the requirements of the Capital Stable Bucket, being to generate a return of CPI+3% per year and ensure that your investment will retain its value in difficult market conditions, as it invests primarily in investment grade bonds and actively manages the risk in the portfolio. The underlying assets include bonds and similar fixed income securities issued by developed and emerging market Government’s, Semi-Government institutions, Corporates and high yield issuers.

Performance & Top Holdings:

The ESG Fund option we are recommending has only been in operation since 2017 hence the performance data is limited. This fund does however replicate that of PIMCO’s core Global Bond Fund, which has been operating for over 20 years and has generated an annualised return of 7.14% over this period and 8.37% over the last 10 years.

More recently returns have slowed as bond markets adjust to the threat of continued increases in interest rates and the impact they will have on the yield curve. At present the ESG fund invests around 63% of the portfolio in AAA-rated securities and just 6.2% in sub-investment grade of high yield bonds. The managers are highly selective in the issuers they are willing to lend to, hence the longest duration positions within the portfolio are to Governments and investment grade corporates. The fund carries a current duration of 5.66 years and offers a yield to maturity of 4.04%.

Reasoning:

We believe that the allocation between Capital Stable and Risk Bucket investments will become increasingly important as volatility continues to increase in both bond and equity markets. The PIMCO Fund offers a core global bond exposure, diversified across emerging and developed markets, corporates and governments. The nature of the underlying fixed income investments mean the fund will provide a hedge against sharemarket volatility and benefit from increasing demand for lower risk assets or a further compression in bond yields. The fund currently holds 54% of its investments in bonds of this maturity, meaning investors stand to benefit if their assessment is correct.

The fund also applies a number of ESG screens across the portfolio excluding companies involved in weaponry, pornography and tobacco and embracing those committed to improving environmental and social practices. The fund charges an MER of 0.69%, offers quarterly distributions and daily redemptions.

SMSF Balance over $1.6m? Here is one way to beat the cap!

Whilst the current malaise may suggest politician’s offer little to retirees, the 2017 Federal Budget offers an excellent opportunity to top up your superannuation balance during retirement. Passed in December 2017, the downsizer contribution legislation allows all Australian’s to get an extra $300,000 into superannuation tax-free regardless of whether their balance is above or below the $1.6m cap.

The strategy, which is available from 1 July 2018 is quite straightforward, with the details as follows:

  • The contributor: The person contributing must be over 65 years of age and there is no maximum age.
  • The home: To be eligible the proceeds must be received from the sale of your principal residence, be subject to the CGT exemption, and you must have owned the property for at least 10 years;
  • The contribution: The contribution must be made within 90 days of receiving the proceeds of your property sale;
  • The contribution cap: The cap or amount available to be contributed is the lesser of the proceeds of the sale or $300,000 per person.
  • Other caps: The contribution does not count towards the non-concessional or concessional caps and is not subject to the $1.6m total superannuation balance (TBC) cap.

Unfortunately, this strategy is only available once and cannot be applied to caravans, houseboats or other mobile homes. In order to be compliant, you must complete the downsizer contribution into super form and provide it to your accountant or the trustee of your fund.

What We Liked & Disliked – November 2018

What we liked

  • The economic data in Australia continues to suggest we are one of the strongest developed economies in the world. The unemployment rate remained at 5% in October whilst the participation rate continued to increase, hitting 65.6% as more people are encouraged to enter the workforce. The continued slowing of growth in the residential property market appears to have remained orderly, meaning we may just avoid a crash.
  • The US reporting season was incredibly strong, with Blackstone estimating 27% year on year earnings growth over 2017, yet investors seem to be discounting this strength. Supporting this was a 0.6% increase in consumer spending, back by a 0.5% increase in incomes in October. Interestingly, the S & P 500 now trades on a forward P/E multiple of 15x, not stretched by any measure.
  • BHP Billiton & Rio Tinto have started what appears to be a gold rush of capital returns to investors, both expected to close substantial share buybacks in December. We expect an increasing number of companies to join the party as they seek to release the excess franking credits on their balance sheets before a potential Labor Party win.
  • As expected, Xi Jinping and Donald Trump agreed to disagree on the next moves in their ‘trade war’. They agreed to hold off on the application of any further tariffs for at least 90 days and formally negotiate the terms of a new trade arrangement. Markets around the world rallied strongly as a result.
  • US Federal Reserve Chairman, Jerome Powell backtracked in November, indicating that the Fed Funds Rate is closer to the ‘neutral’ rate than expected, triggering a surge in sharemarkets around the world. In October, his comment that the neutral rate was ‘a long way off’ triggered the worst of the volatility.

We we Disliked

  • It’s been confirmed, 2018 has been the worst year ever for investors. According to Deutsche Bank, 90% of the 70 global asset classes they cover are on track to post negative returns for the 2018 calendar year. This exceeds the previous high of 84% in 1920 and is a long way from the 1% that delivered a negative return in 2017. Does this mean 2019 will be good or bad year?
  • Jack Bogle, the founder of Vanguard, has offered a dour forecast for investment returns over the next decade, suggesting shares will average 4% and bonds 3.5% per annum, both significantly lower than the 11% and 8% returns achieved over the last 30 years thanks to the benefit of falling interest rates. His solution? Low cost index funds…
  • The apparent monopolization of the superannuation industry in the hands of union-run industry funds. The combination of strong recent returns backed by falling interest rates and the negativity towards large corporates following the Royal Commission is seeing increasing flows towards the industry fund sector. Are these investors simply chasing past returns? Or is this a changing of the guard for capital markets into the hands of just a few union-controlled investment vehicles.
  • The Chinese economy has shown signs of weakening with the all-important Manufacturing PMI printing once again at just 50.2 points. With ratings above 50 suggesting expansion, the weaker than expected results suggests the US-China tariffs are impacting exports and general manufacturing activity. A weaker Chinese economy would be devastating for Australia, with any number of export sectors reliant on their demand, not to mention their interest in Australian property.
  • The collapse of engineering services business RCR Tomlinson was swift and deeply disappointing. Whilst we have never invested in RCR, the fall from grace is all too common. The company raised $100m from investors in August, with major shareholders including Allan Gray, BT (Pendal) and Perpetual, but appointed administrators in November with a market capitalisation of $231m. According to early reports, it appears the engineering company was winning competitive tenders, particularly in the growing solar sector, at profit margins that simply could not be achieved, and was unable to find sufficient skilled employees to complete them. We suggest investors avoid other engineering companies like Lend Lease and Downer EDI, at least in the short-term.