“A pessimist sees the difficulty in every opportunity, an optimist sees the opportunity in every difficulty.”
We thought this quote was appropriate given the position of both geopolitics and globalasset markets, but also when applied to the proposed changes to Australia’s taxation system. There is well-founded concern about the implications of the proposed removal of franking credit refunds, yet rather than dwelling on the problem, we have been and continue to pursue opportunities both in Australia and around the world. This quote also delves into the heart of our investment approach, in that with volatility comes opportunity, but generally most people are too pessimistic or uncomfortable to make what will become the most profitable investment decisions. There is every reason to believe that an inevitable crash will occur at some time in the future, yet this pessimistic view results in inaction or a poorly constructed investment strategy.We thought this quote was appropriate given the position of both geopolitics and global
Franking Credits & Investing for Income
As you would expect, many of our discussions with clients have been focused on concerns surrounding the proposed Labor Party policy to cut the refund of franking credits, which will apply to anyone not receiving an Age Pension. As a first step, it’s important to stress that there is a low probability that markets or individual shares will fall substantially following a Labor party victory. This is due to a number of reasons including:
- The substantial portion of major Australian shares owned by foreign institutions that already have no use for franking credits;
- The majority of Australia’s largest investors, particularly institutions and pension funds will still receive the full benefit of the franking credits as a deduction against their income tax, meaning it is unlikely their portfolios will change;
- The increased involvement of pension funds in what has been the DIY investor dominated preference share sector, with Uni Super’s $200m bid for the latest NAB preference share a perfect example;
- It is likely to be the major listed investment companies (LICs), which pay investors consistent fully franked dividends by virtue of paying tax at the company rate that feel the brunt of any volatility as opposed to managed funds, which are structured as unit trusts and simply pass the associated income onto the
- The fact that the Labor Party first must win the Federal Election with a sufficient majority and secondly, require the support of the Senate to pass the proposed legislation.
There is no doubt the implications for those receiving franking credit refunds will be substantial, yet we believe the legislation is unlikely to be approved in its current form with a cap on refunds the more likely result.
The proposed change and concern around income levels has lead us to important discussions around the income needs of investors and the ability to produce the required income in an ultra-low interest rate environment.
Whilst the proposed change will have a substantial impact for some, there is no simple solution to replacing this lost income should the legislation pass. For instance, consider the dividend currently offered from Westpac Banking Corporation shares (WBC), which is around 7.2% before franking credits are applied and 10.3% after. There are very few assets around the world that offer yields of 7.2%, let alone 10.3% without requiring the investor to take on a substantial amount of risk. Potential examples include mezzanine construction debt, unsecured personal loans, highly leveraged property or even Turkish (14%) and Russian (8%) Government bonds. Investments of this risk level are simply not suited those in or saving for their retirement in most cases.
So with an increasing income required to be drawn from superannuation, but lower interest rates, less franking credits and slower economic growth, the question of sustainability has come to a head. Investors can simply not expect to achieve an income of 6, 7 or 9% without either taking an extreme level of risk or giving up either the potential for capital growth, or capital in its own right.
We have always believed that the more appropriate strategy in this environment is for investors to seek total returns, from both growth and income, rather than focusing solely on income. The Australian market will eventually mirror the US, where more businesses reinvest their profits, or undertake share buybacks, and dividend pay-out ratios are closer to 30-40% rather than the 70- 80% they are today. We have already seen the implications of companies paying out the majority of their profits in dividends, becoming akin to a bond or term deposit, whereby their share prices simply stagnate.
At this point it is important for those investing through superannuation to keep in mind that the entire system was set up to ensure that your superannuation balance is withdrawn overtime so that it eventually becomes taxable. It was not intended as an estate planning tool, hence why the minimum pension payments increase regularly as you age from 4% to 5% at 65 and reaching a maximum of 14% in your 90’s. That does mean you should not seek to maximise your balance through sound investing and strategic advice.
Investment Committee Minutes
The Australian reporting season was quite poor, with increasing input and compliance costs crimping profit growth which fell 5.5% for the 136 companies that reported. Yet even as the Australian economy continued to weaken, with GDP growth of just 0.2% and retail sales of just 0.1%, the ASX staged a remarkable recovery, finishing up 10.89% for the quarter. This suggests that investors are willing to pay more for less earnings than were available before reporting season. Every sector in the ASX 200 delivered a positive return with Consumer Staples (5.15%) and Healthcare (6.28%) the weakest. The theme of the season was the increase in ‘capital management’ by boards who announced a substantial amount of special dividends, off-market buy backs and returns of capital to investors. This was particularly so in the mining sector, who after investing at poorly at the top of the market have elected to return capital rather than reinvest in their businesses.
The rally was spurred on by a rebound in global risk taking as the US Federal Reserve indicated it was putting rates on hold, the Bank of Japan continued its market intervention, the European Central Bank re-commenced its lending program and economists began to predict rate cuts in Australia. The best performing market around the world was the Shanghai Composite (20.09%) after being sold off heavily in the December quarter. Around the world markets are being driven primarily by monetary and fiscal policy decisions, with the latter becoming increasingly important amid a slowdown in global trade. Both the US and China have announced or passed substantial tax reform packages, with various members of the EU and even Australia to follow. The Australian economy remains as reliant as ever on the Chinese to take our exports, with the current 34% under threat following recent bans on coal imports at a number of Chinese ports. It was the Chinese who helped our economy survive the Global Financial Crisis, by spurring the mining boom, they then assisted in the transition to our residential construction boom, but are there any booms left for Australia? The latest GDP figures suggest the growth sector of the economy in 2019 and looking forward will be Government spending, as fiscal policy comes to the fore at a time when the RBA is too worried about stoking house price growth through an interest rate cut.
Looking forward, forecasts for global growth continue to be cut as an overleveraged developed work copes with the threat of an overleveraged or less tan confident consumer and an ageing population. The emerging economies continue to support global trade figures, particularly India and China, but will this be enough? We don’t subscribe to the ‘late cycle’ theory nor the importance of a ‘per capita recession’ in Australia as these are simply economic terms based on backward looking information. At this point, we expect the global economy to keep tracking along at slower than historic levels, but with a great deal of transition and volatility. This was exhibited during reporting season where some 40 companies saw their share price move in excess of 10% when they reported and at least 10 moving by more than 20%. Companies are continuing to adjust to this outlook, with a combination of historically low interest rates, weak productivity gains, ageing demographic and slower economic growth contributing to weak income growth across the world.
We continue to stress the benefit that you have as a self-directed investor, being the ability to control the investment of your capital. You do not need to rush into making decisions, nor do you need to be fully exposed to sharemarkets at all times or forced to invest new contributions into expensive assets as soon as they are received (as is the case with many popular industry funds). You can own any asset you like or hold cash and wait for markets to fall before deploying it
After the worst quarter for markets in close to decade, almost every major market recovered strongly in the first quarter of 2019; in fact the S&P 500 posted its strongest quarter since 2009. The ASX 200 rallied 10.9%, supported by the mining (17.8%), technology (20.7%) and communications (16.9%), all of which had fallen heavily in the previous quarter. We also saw a rally in bond proxies including utilities (11.6%), property (14.7%) and industrials (11.7%). Following the trade truce in February, the Shanghai Composite (20.1%), S&P 500 (13.6%), Nasdaq (16.5%) Nikkei (5.9%) and European CAC 40 (13.1%) all delivered similarly solid returns. The performance was supported by an about face in central bank policy around the world, however, the threat of slower growth saw some weakness in the final week of March. The Model Portfolio had delivered an extremely strong quarter, with just three investments delivering a negative return, that being AMP Ltd (-12.03%), Orora Ltd (-2.61%) and the Winton Global Alpha Fund (0.03%). Looking more closely, the Value Bucket (+7.62%) was the standout with its combination of resources, including Santos Ltd (26.90%) and smaller companies, Pengana Emerging Companies Fund (10.08%), benefitting most from the return of the risk on trade around the world. The contrarian Orbis Fund (+7.43%), which seeks highly undervalued companies around the world benefitted from well-timed investments in beaten down sectors, including Facebook and healthcare companies.
The Thematic Bucket also performed well (+6.22%), with all investments delivering a positive return, but driven by the Asian consumer focused Platinum International Brands Fund (15.14%) as the Chinese Government announced sweeping fiscal and monetary policy. Ramsay Healthcare (12.96%) reported more strongly than expected, confirming our view that recent weakness was cyclical not structural, whilst the theme focused Munro Fund (6.46%) saw its newest holding, Worldpay, receive a substantial takeover offer. The Income Bucket (+7.11%) benefitted from the perceived weakness of the Royal Commission’s final report, with investors flocking to the major banks following the removal of uncertainty, ANZ (6.42%) and NAB (4.99%) were the major beneficiaries. Telstra (20.52%) rallied after TPG’s announcement that it would be cancelling the rollout of its 5G network. The standout, however, was the franking credit focused Plato Fund (16.27%), which benefitted from record levels of ordinary and special dividends announced during reporting season. As expected, the Targeted Return Bucket (2.22%) delivered a positive return, but below that of the higher volatility Buckets, with growth-focused Pinebridge (6.98%) the strongest, supported by an improving Invesco Global Targeted Returns Fund (2.87%). Overall, the Model Portfolio benefitted from the Investment Committee’s preference to invest into what many experts believe to be boring, old fashioned businesses, but which we view as being profitable and exposed to the right sectors of the economy to generate returns in what appear to be more difficult conditions ahead.