Election Result

Wattle Partner’s welcomes the result of the Federal Election on the weekend. We had previously stressed the importance of not changing investment strategy based on proposed but not yet drafted legislation, given the potential for losses if the result was not as expected.

As a financial advisory firm that specialises in superannuation and SMSF’s we had serious concerns around the potential impact of removing franking credit refunds for a select group of investors, but more so the manner in which the proposed legislation intended to treat people in similar situations differently. We believe changes to franking credit refunds may occur at some stage in the future, but that this is more likely to be in the form of a cap on cash refunds, rather than an outright banning.

Whilst the individual policies proposed including changes to negative gearing, banning of franking credit refunds, reducing the capital gains tax discount and introducing a tax rate on family trusts may on their own have merit, we believe they further threatened what is already a slowing Australian economy. As outlined in the latest quarterly review, the combination of each of these proposals was having an impact on the residential property market in particular, as well as consumer spending as Australian’s prepared for the worst.

Market Movements

At first there have been three core beneficiaries of the election result; the banking sector, healthcare, hybrids and infrastructure. Most of the banks have rallied in excess of 5% in early trade, due to a combination of stockbrokers and SMSF investors re-entering the market and a more positive outlook for residential property with the spectre of negative gearing removed. Healthcare companies, in particular Ramsay, have rallied a similar account as the proposed cap on insurance premiums was avoided. The hybrid market, which delivers fully franked dividends of around 6% also rallied as mum and dad investors re-entered the market. Finally, infrastructure businesses, Boral for instance, has benefitted from the Coalitions mandate for an infrastructure spending boom across the country.

As always, these are only short-term movements, but continue to justify the recent adjustment of portfolios towards those defensive sectors poised to grow in a slowing Australian economy.

Our Concerns

One of our major concerns during the election was the broad based assumption that Industry Union Fund’s would somehow be excluded from the franking refund policy, resulting in a huge in flow of capital.

Based on our research, along with the lack of drafted legislation, we believe this assumption was inappropriate and unlikely to eventuate. It ignored the impact of the actual increase in pensioners moving into these funds, the fact that refunds were banned for all people, not just those in SMSFs, and our expectation was that the proposed legislation would have been changed before being passed to avoid this fact. Industry funds were happy to let the assumption continue, without knowing themselves how it would be delivered.

Many people may not understand how industry funds actually work, in that your account is invested into a pooled structure, with both accumulation and pension investors. Your fees and franking credits reduce the tax of others as well as funding the growing financial advice arms of these businesses. The allocation of franking credits to your account is at the discretion of the trustee of each fund, if in any event the fund has excess franking credits at all.

Webster’s Ltd

With Australia’s water markets an election issue, we would be remiss not to provide an update and our view on one of Australia’s largest water rights owners, Webster’s Ltd (WBA). WBA is the combined Tandou entity, chaired by one of Australia’s most experienced business people, in Chris Corrigan, who stepped down from the booming Qube Holdings group to focus on this sector.

At last report, WBA holds just over 150k mega litres of water rights across the eastern Seaboard, but primarily in the Murray Darling Basin; noted by James Dunn as Australia’s largest water region. The group has operations across the east of Australia, including Tasmania, with around 20,000 irrigable hectares of property at any one time under management or ownership.  The groups biggest crops are in cotton, walnuts and almonds, with livestock including lambs a growing share of their business. The company has the ability to produce as much as 180,000 bales of cotton each year and currently delivers 90% of Australia’s annual walnut crop (that’s some sort of monopoly). Yet by far the company’s largest asset is it’s substantial water rights holdings which are carried at a book value of $162m on their balance sheet but which many experts believe are worth in excess of $350m at the present time. Given WBA’s market capitalisation is just $545m, the horticultural and agricultural assets nearly come for free to shareholders.

WBA was caught up in a 4 Corners report in 2017 which made allegations regarding the company’s water use, ownership and intentions following the purchase of the Tandou cotton farming properties in NSW and the associated water rights. Such was the coverage of the report that management saw fit to put out a press release, highlighting in their words ‘fabrications’ and lack of research undertaken in this ‘hack job’ by the ABC. Effectively, the reporters and several land owners were suggesting that Webster’s had breached various obligations regarding its use, storage and ownership of water. The company stands by its stated goal, which is to ‘own a wide range of water entitlements……and convert these entitlements into more valuable horticultural and agricultural products’.

WBA is coming to the close of a period of transition, which began when the company decommissioned the cotton farm operations at Tandou, due to concerns about the availability of water from the Menindee system, and converted the property to livestock farming of lambs.

The group also sold another cotton farming property, Bengerang, for $132m in 2018, to a series of private investors and pension funds. This and more recent decisions to purchase further almond and walnut orchards in the Riverina district in NSW has seen the company sharpen it’s focus on the region where they have the greatest competitive advantage. For the 12 months ending 30 September 2018, the company remains reliant on the Agricultural division, which included cotton, wheat and livestock, for $153m in revenue and $43m in profit, and the Horticultural division delivering $53m and $10m in profit respectively. Unfortunately, comparisons to previous years offer little value to the substantial land sales and change of strategic direction that have occurred.

Whilst some may question the best use of limited water in Australia, there is no doubt that cotton, almonds and walnuts offer some of the great return on investment for farmers particularly in export markets. The walnut orchards alone deliver a profit margin of around 20%, with WBA delivering the second highest yields on record in 2018 and selling prices increasing 17% globally. As with all agricultural businesses, there was some weakness in the 2018 crop due to non-pollination events, however, management’s recent decision to divest a number of non-core properties has allowed them to continue to invest in further plantings, as well as purchase additional and surrounding properties. The company’s walnut operations, which are vertically integrated, are one of the few Australian monopolies still available to investors to take part in.

Where many agricultural investors go wrong, is in over-leveraging their business and not maintaining sufficient diversification of their income. WBA is well placed on both areas, first, their gearing ration is just 28.5% after using the sale proceeds to reduce debt, and secondly, their income is spread across annual crops, like cotton, and perennial crops like walnuts and almonds, which once producing provide a consistent income. This has more recently been complemented by a move to increased livestock capabilities following the purchase of 50,000 hectare property for lambs at Backpaddle. Following the recent transactions, PSP Investments, a global pension fund, own some 19% of the property, and Chris Corrigan himself 13%; this provides important support for further capital raisings and asset purchases.

Overall view

In our view, the change in direction of WBA comes at an opportune time and offers an excellent entry point for investors. The company trades expensively on a Price-Earnings ratio of 30x, however, this is muddied by the combination of a transition year for the company’s finances and the fact that some 60% of the company’s shares are owned by insiders. Continued improvement in 2018-19 operations, which have been highlighted by management should see earnings grow strongly in the years to come.

We believe some level of valuation premium is reasonable given the monopoly position in walnuts and the large water, relatively high security, water entitlements. Outside of BlueSky’s Water Fund, which trades at NTA but offers limited liquidity, WBA is one of the few true water investments left in Australia. We believe the company will continue on its expansion into perennial crops where is has a competitive advantage and is likely to do through further capital raisings. The strategy being undertaken is not unlike that of Harvard Endowment, which has spent many years buying up pristine Napa Valley property in order to take ownership of the water located underneath. For this reason, we would not be surprised to see further pension fund interest in the company’s assets. Given Qube Holdings strong turnaround, we would not expect someone like Chris Corrigan to walk away to waste time in WBA unless he sees real opportunity in the sector.

It’s a buy for us.

Around the markets…

In this section we look to provide an update on newsworthy events that have occurred with investments that don’t necessarily meet our requirements today, but which we believe should be of interest to investors and readers.

Macquarie Group (MQG): Unexpectedly announced it would be moving into the mobile telecommunications game. The company has established a business called Nu Mobile, that focused on offering mobile plans that come with used handsets. The move appears to be focused on cost conscious consumers who may not necessarily be able to afford the huge price increase on the latest iPhones and increases competition in an already cut throat market. The service will be delivered on TLS’s network and interestingly Macquarie already owns some 1m handsets which is leases to other providers; so another string to the bow of this diversified investment bank. The move is not expected to be material to profits, and broker remained concerned about valuation, with 3 buys but 4 holds.

Wesfarmers Ltd (WES): After attempting a hostile acquisition of rare earths miner Lynas Corp and being rebuffed, WES continued it’s hunt for an entry in the battery and energy storage market, offering a $776m takeover offer for Kidman Resources. Kidman owns a number of lithium projects in Australia, with WA’s Earl Grey one of the biggest in the world, and has a joint venture agreement with SQM the largest lithium producer in the world. Management appear to be pivoting to what they know best in the world of commodities and attempting to get into the battery boom after a recent lull in takeover activity. Whilst the brokers are positive on the diversification strategy, they have concerns about Bunnings withstanding a housing slowdown and the consensus is a hold, with 5 brokers, and 2 suggesting a sell.

Technology One Ltd (TNE): The small cap manager darling Technology One, which offers custom enterprise software to businesses, suffered after an unexpected downgrade. That downgrade was to earnings growth of ‘just’ 45% for the year, however, greater concerns came from the lower than expected profit result, some 10% off expectations. The market is becoming difficult for companies priced like TNE, which still trades on a 42x P/E earnings ratio, but remains supported by small cap specialists like Pinnacle and Hyperion. The brokers have turned negative with 2 sells and 2 holds.

Fiat Chrysler and Renault: The two global automotive giants announced they were in discussions for a merger of their businesses, which triggered a rally in European markets. The combined entity would own Ford, Fiat, Renault, Citroen, Alfa Romeo and Jeep among other brands. Interestingly, once combined that behemoth would be worth only the same as Tesla despite making thousands more cars each year.

AP Eagers Ltd (APE): Appears to be finalising its takeover of AHG or Automotive Holdings Group after lifting their all share offer to around $2.3bn. The company will become a huge player in Australia and NZ with 229 new car dealerships and 12% market share. The board of AHG has recommended the offer.

Westpac Banking Group (WBC): Westpac reported a somewhat messy result with margins declining and earnings falling by 1.5%. Whilst mortgage re-pricing, or higher interest rates charged to customers, helped to support the bottom line it wasn’t enough to offset $1.1bn in remediation costs. The poor performance of WBC has been put down to its higher than market share of the interest only section of the market, which is seen as being higher risk. WBC of course benefitted more than its competitors from the property boom, and is no doubt more exposed today as a result. The dividend was maintained, however, the pay out ratio is looking stretched particularly in light of a full year fall in earnings. The brokers are mixed with 2 buys, 3 holds and 3 sells.

Adelaide Brighton Ltd (ABC): ABC announced an earnings downgrade that we had previously flagged on the back of their large exposure to the residential housing sector. That being said, the share price bounced back quickly following the Federal Election on the hope that the market will stage a recovery under Morrison’s status quo approach. Management announced a 10-15% fall in 2019 earnings due to the downturn in NSW and Victoria where it has its largest exposures. Earnings growth has likely been put on hold given the more competitive environment, however, the appointment of Raymond Barro, as Chairman may see speculation of corporate activity increasing. The brokers are wary with 4 holds, 2 sells and 1 buy.

Blue Sky Alternative Investments Ltd (BLA): BlueSky finally capitulated in May going into receivership, after the operating business breached covenants on the $50m convertible notes (or loan) provided by Oaktree Capital in 2018. Oaktree is the world greatest distressed debt investors, so the decision was likely based around taking control of the company to extract the best assets and performance fees from the underlying investments. Alternatively, Oaktree may see this as an opportunity to enter the Australian market at a very low price, given the reach that BlueSky has in the SMSF and institutional space. It’s a disappointing result given the majority of Blue Sky’s underlying funds including private equity, water and venture capital are actually performing ahead of expectations. Importantly for investors, each of the underlying funds is operated as a stand-alone entity and will not be impacted by this change. The Private Equity and Venture Capital divisions are independent subsidiaries with their own financial service licenses, earnings and employees.

Model Portfolio Update

It was a mixed month for the Wattle Model Portfolio, as the core domestic holdings benefitted from a Liberal National Party election victory, but the global managed fund exposures were impacted by increasing trade war concerns towards the end of the month. The ASX outperformed it’s global peers for the month, bucking the correction trend due primarily to many income seeking investors returning to the market following the positive result on franking credits and the expectation of several rate cuts to come. Whilst we don’t believe that rate cuts should be the first point of action, it seems inevitable they will be moved, offering opportunities in markets for at least the next 6 to 12months.

The Model Portfolio bucked the trend of most benchmarks, including both union funds and corporate super, delivering a positive return in a generally negative market. This was due to our focus on undervalued, defensive but profitable companies exposed to the few growing sectors in the economy, including the Boral, Ramsay and Telstra. The strongest sectors in the quarter were Communications, as the TPG-Vodafone merger was denied, and Telstra announced further progress in its transformation. Materials benefitted from Fortescue’s special dividend and continued strength in iron ore prices, whilst Energy was hit by weakness in the oil price. Healthcare and Financials both benefitted from the election result, as the potential cap on health insurance premium increases supported the continued volume growth in private hospital admissions. Unfortunately, the global technology stocks and anything exposed to the China-US trade war were hit, yet we remain confident of a final positive outcome before the end of 2019.

Orora Ltd (ORA): The bottle and cardboard box manufacturer had experienced a poor start to 2019, as signs of a slowing US economy impacted the outlook for their growing US business. The share price began to turn as the Federal Reserve put rates on hold and both consumer sentiment and retail sales in the US showed signs of improving. The company has been acquiring numerous business in the retail marketing space in the US and spending substantial amounts on both innovation and energy efficiency within their business. Management announced that they expect earnings to be above FY18 but highlighted a slightly slower than expected start to 2019. They noted the US operations were improving in March/April which bodes well for the close of the financial year. Input costs continue to place pressure on the bottom line, however, purchase agreements for renewable energy supply are offsetting the increased cost of Kraft paper and starch. The company will benefit from the weakening in the AUD and the extraction of synergies from the purchase of Pollock and Bronco Packaging in Texas, which fit the same business model as Australia.

Ramsay Healthcare Ltd (RHC): Ramsay was one of the immediate beneficiaries of the election result, as the business relies on private insurance premiums to fund some 80% of their domestic procedures. The Labor Party had proposed a 2% annual cap on insurance premium increases which the market had assumed would lead to lower revenues for RHC. Right or wrong, the policy was not successful and no cap has been applied. After finalising the acquisition of Capio in Northern Europe, the company now manages some 480 global facilities in 11 countries and employs 77,000 people. Recent data from the UK’s NHS indicated Ramsay’s volume growth is on the improve with operations further supported by the first increase in tariffs in both the UK and Europe in many years. The companies deal with Baxter Healthcare for the bulk purchase of infusion pumps whilst small on its own, indicates the purchase power and cost benefits afforded by its scale. At the end of the month, long-time CFO Bruce Soden made the decision to step down after 31 years.

Qube Holdings Ltd (QUB): The integrated logistics and transport business, Qube, announced the acquisition of mining services business LCR Group during the month. The acquisition was made to allow Qube’s other operating divisions to deliver additional services, including existing customers in heavy transport, mining and mobile crane businesses, with an increasing focus on renewable energy. The business came at a cost of $135m and was funded from undrawn debt facilities, it is unlikely to have a material impact on profits in the short term.

GAM Absolute Return Bond Fund (AFM0002AU): GAM announced the payment of a further 9% of the remaining capital at the beginning of May, taking the total capital return to 80% of that invested. We understand that management have also agreed to sell the remaining assets to an external party at their cost price with the deal expected to be settled in July/August of 2019.

Plato Australian Shares Income Fund (WHT0039AU): The Plato fund was recommended to provide an overweighting to high yielding, fully franked dividend paying Australian companies in the lead up to the Federal Election. In May, investors benefitted from both the announcement and completion of a number of special dividends and buy backs as well as the success of the Liberal Party. The fund benefitted from the Woolworth’s and Caltex buy backs, renewed strength in the banking sector and special dividends from Rio Tinto, Fortescue and BHP. The fund delivered an income of 15.1%, that’s correct, for the 12 months to 30 April, losing 0.8% in capital, but still outperforming the ASX 300 by 2.1%. Whilst the flow of special dividends and buy backs is likely to slow, we continue to see substantial value in this specialist income and franking due to the exposure it provides to the less volatile, more defensive businesses in the Australian economy.

The month that was…

  • In a positive move for investors, workers, retirees and most likely the economy, Scott Morrison won what many experts had considered the ‘unwinnable’ election. He will return to Government with a majority and a number of major personalities out of his way. Scott Morrison won on a status quo approach and by raising real concerns about the potential impact that Labor’s higher tax environment would have on a weakening economy. Now we can only hope the Coalition is able to cobble together a long-term energy policy and halt the rise in living costs.
  • The Australian Sharemarket bucked the global trend, delivering a positive performance of around 1% for May, as the rest of the world was hit by growth concerns and the escalation of the US-China trade war. The S&P 500 fell 7%, the Hang Seng 10% and the FTSE close 4%. Global growth concerns are increasingly reflected in bond rates, with the Australian 10 Year Government Bond hitting an all-time low of 1.46% after starting the month at 1.79%. The threat of a US recession increased as the bond rate fell similarly from 2.50% to 2.12%. The weaker bond rate saw Australia’s exchange rate continue to weaken, moving below 70c. US GDP growth was confirmed at 3.1% for the first quarter.
  • Microsoft reported strongly delivering 16% growth in revenue for the third quarter. The result was driven by the increased focused on cloud and business services, rather than the Office product, which actually saw the company move past a market cap of $1tn; just the third listed company to do so. Apple is coming under increasing pressure from various sources, with an anti-trust lawsuit against its dominant but restrictive App Store business, which represents some 35% of revenue. The company is also being hit heavily by the US’s tariffs announcements, as the majority of the iPhone is built in China, with the potential for an increase of $160 in the production costs. The company is down from a high of $230 to just $180 and now trades on a P/E ratio of just 15x.
  • It was a bad month for forecasters and economists in Australia, with the majority failing to predict the result of the Federal Election or the RBA’s decision to hold rates steady. Interestingly, close to half of the highly paid economists got the RBA’s call wrong and not one poll predicted the flood of votes to the Liberal National Party across the country. As always, it just reiterates the importance of not making investment decisions on expert forecasts and planning for several rather than a single outcome.
  • It is, however, becoming increasingly likely that interest rates will be cut in June, with the Governor announcing as much at a speech in Brisbane. Inflation remains under control, as does employment, however, weaker property prices have begun impacting the economy, with reports of mortgage delinquencies and cancelled settlements growing. In our view the RBA is likely moving too fast in cutting rates once again, leaving very little room to move should the economy weaken further.
  • ASIC continues to push harder with penalties for vertically integrated financial advice businesses claiming to be independent, with industry super the latest caught in the net. HOST PLUS received a $12,600 fine for claiming it’s financial advice was independent in recorded telephone calls; we ask will members be paying for this?
  • The ACCC’s decision to block the merger between TPG Telecom and Vodafone was derided by the financial sector and saw TPG’s share price fall heavily. The ACCC seems to be believe that TPG will recommence the construction of their 4G and 5G networks as a standalone entity even after this was cancelled earlier in 2019. The decision is expected to be appealed, as was that of QR National, which ensures Telstra remains in the box seat for growth as its competitors focus remains elsewhere.
  • It was reported during the month that APRA and the RBA are considering alternate strategies to revive the struggling lending market and spurring the major banks to open their wallets for borrowers once again. We understand the RBA/APRA are considering reducing the 7.25% benchmark rate which banks are required to use to determine the serviceability of the loans they provide. At this stage it is believed a 0.5% reduction to 6.75% is likely, given the muted outlook for interest rates around the world, which could potentially release 5% more capital to all borrowers.
  • The economic news around the world was mixed, with Australian unemployment increasing to 5.2%, from 5.0%; however the major drive was an increase in those looking for work by 0.2%. US Core Inflation remained steady at 2.1% whilst housing starts recovered growing 5.7% month on month suggesting consumer sentiment is improving. Neither was enough to see monetary policy move, with both the US Federal Reserve and RBA on hold. Things are also looking up in Europe, where inflation hit 1.7%, GDP growth was revised to a positive 0.4% reading as Germany and Italy returned to growth and Spain pushed ahead following their election.
  • The US-China trade war continued to escalate with the US proceeding with an increase in tariffs to 25% for some $200bn worth of imported Chinese goods. The banning of Huawei began filtering into the country’s largest Tech stocks with the likes of Google no longer willing to operate on its platform or utilise its products. As expected, the trade war is actually hurting US businesses, with farmers in particular being hit by weaker exports, resulting in a recent aid package being announced. Like most, we don’t believe the US President’s tweets are particularly helpful to markets, but agree that much needed pressure is being placed on China’s history in relation to intellectual property and foreign competitors. Tariffs and subsidies are of course not uncommon, it is when they are one sided that it becomes an issue.
  • We aren’t sure about you, but whilst we value some of the input provided by the likes of Invest Smart and Intelligent Investor, it seems the product pushing has moved to another level in the post Royal Commission world. We must have counted three invitations from Alan Kohler regarding an investment in a new ‘Ethical ETF’. Interestingly the Paul Clitheroe-backed Invest Smart recently purchased Kohler’s Constant Investor business, and are now launching any number of in-house investment opportunities. As always, we suggest proceeding with caution.
  • UK PM Theresa May stepped down, after putting years of effort into finalizing Britain’s exit from the EU. Her timing to take over the leadership couldn’t have been worse with her own party playing hard ball on any level of negotiations with the EU and basically costing her career. Boris Johnson, the likely replacement is pro-Brexit, however, it is still to be seen whether any agreement can be made before the Halloween deadline.