The month that was…

  • It was another strong month for the ASX, with the larger company focused ASX200 adding 1.3% in price terms for September and the Small Ordinaries an impressive 2.0%. Once again, the importance of mining and banking to the Australian economy was highlighted, with financials adding 4.1%, as both ASIC and APRA’s litigation against the sector was thrown out. As the calls for climate action increase, the economy continues to benefit, with the energy sector up 4.7% and materials adding 3.1% buoyed by gold and iron ore production. The defensive healthcare (-2.5%) and property trust sectors (-2.7%) were hardest hit. The S&P 500 delivered a solid return as another round of earnings season is set to begin, with the benchmark index up 1.7%. The positive return came amid increasing concern about the trade war, however, consumer numbers remain strong and markets were buoyed by the continued support of the Federal Reserve. The result took the year to date return to 19%, the best since 1997.

 

  • Central banks around the world responded to weakening global growth in September. The ECB moved their cash rate further into negative territory to -0.5%. Despite the protestation of the White House they also recommenced their QE policy, buying $20bn of assets per month in an attempt to stimulate the banking sector to lend again. The US Fed finally capitulated to pressure from President Trump, cutting rates by a further 0.25%. They were also forced to step into the overnight lending market, to the tune of $128bn, as inter-bank lending froze and interest rates spiked in a rehash of 2007. In Asia, the PBOC responded by cutting the bank reserve ratio by banks by 0.5%.

 

  • The increasingly combative Australian regulator’s took another hit, with APRA losing its case against IOOF. The judge indicating that APRA’s case was systemically weak and failed to prove that the reimbursement of customers from the super funds ‘reserves’ was inappropriate. This followed ASIC’s case against Westpac in relation to responsible lending laws being thrown out in August. September also saw the ATO ramp up pressure on SMSF trustees. They sent letters to 18,000 trustees holding more than 90% of their fund in a single assets (read direct property) with threats of fines and disqualification.

 

  • In a predictable and after the fact announcement, the OECD downgraded the outlook for the growth in the Australian economy to 1.7%. This coming just a few weeks after the weak June quarter result of just 1.4%. The OECD called for more taxation reform, including an increase in the GST and company tax cuts in an effort to stimulate investment. They noted the impact that trade uncertainty is having on investment decisions. Global growth in 2020 was reduced to 3.0% and 2.9% in 2019 as the US-China trade war, high savings rates and low business investment continue to bite. Whilst growth is slower than trend most economies remain in reasonable shape, with inflation in the US and Australia at 1.7% and 1.6%, and unemployment of just 3.7% and 5.3% respectively.

 

  • Australia achieved its first current account surplus in 44 years, bouncing back from a deficit of $2.9bn in July to $5.8bn in August as commodity prices remained well supported. This comes at a time when growth in the Chinese economy, which is our most important trading partner (chart below) continued to slow. Industrial output growth was 4.4% down from 4.8%, and exports fell 4.3% driven by a 16% reduction in exports to the US.

 

  • If the attacks in the Strait of Hormuz weren’t enough, Iran has reportedly increased geopolitical risk in the Middle East by facilitating an attack on Saudi Arabia’s key oil projects. Interestingly, this comes at a time when the Saudi’s were planning the IPO of this massive state owned business. The immediate reaction has been a spike in oil prices around the world, yet reports suggest at least half of production has already been reinstated. As history has shown, the cure for higher oil prices is higher oil prices as this would present a huge drag on an already weakening global economy

 

  • In a sign that the incredible flow of capital into private markets may be hitting its ceiling, the IPO of We Work was put on hold during the month. Some are suggesting public markets simply weren’t willing to pay the lofty valuation of a company that lost (yes, lost) USD$1.4bn in the first 6 months of 2019 alone. More importantly, they suggest that this may be a turning point after years of capital flooding into private equity, venture capital and other unlisted assets has increased competition in the sector. We aren’t sure how $1.4bn of money can be lost in 6 months, but here is an explanation of how We Work ‘makes’ money. Interestingly, public markets valued the company at just $15bn only a few months after the company raised venture capital on a valuation of $47bn!

 

  • There is growing pressure for industry funds and advisers alike to reduce expectations for investors after several years of stronger than targeted returns. The typical balanced fund targets a return of CPI + 4.0% with the average of around 7-8% over the last 12 months. But as it stands and as highlighted by the likes of Schroders, such targets are getting more difficult to achieve. The traditional Government bond allocations which should make up 40-50% of portfolios are now offering negative returns and sharemarkets remained challenged. Recent returns have been delivered by taking more risk but the likes of ex Lazard CEO Rob Prugue are concerned about the focus on return ‘scorecards’ rather than security of members retirement funds.

 

  • In one of the more enlightening fund manager presentations we have attended, David Harding of Winton fame, visited Melbourne to discuss the difficult conditions for his trend following fund. After delivering  during the GFC the fund has been a stalwart in Australian portfolios but returns since have been positive but weak. Harding discussed the problem of crowding in his trend following approach, which reduces the potential returns on each investment decision stated his ‘hope’ for 2020 was higher returns. He also discussed the difficulty many scientists and engineers have in investment markets, believing it is a science and not a combination of both art and science.

 

Marley Spoon

This column has been quite successful with our most recent smaller company reviews. Webster, which we suggested was a buy at $1.60 received a takeover offer of $2.0 per share, whilst iSentia is up from 25c in August to 42c today. This week we take a closer look at meal delivery app, Marley Spoon (MMM).

Who is Marley Spoon? MMM is a recipe and food deliver service. This means that the company delivers a box of fresh food, including vegetables, meat and snacks, along with a recipe to its customers on a weekly basis. It is the primary competitor to Hello Fresh in Australia. Many may of heard of Youfoodz, which is a prepared, re-heat meal deliver service, Marley Spoon is the complete opposite. It’s customer receive the exact amount of food they require and cook fresh meals using the contents of their box.

The offering has become increasingly popular with millennials and busy professionals alike as it provides a lower cost and generally healthier alternative to the options available on Uber Eats and Menu Log. With a young child, I’ve been recently converted to the recipe and meal kit delivery, buying as many as three to four meals per week. It allows my family to avoid the regular trips to the supermarket but most importantly minimise the amount of waste that typically comes from this.

The company operates across 6 different countries, including the US, UK, Belgium and Germany. It was listed in 2018 but founded in 2014 in Germany, where it is also listed. It operates in a fast growing, but incredibly competitive sector and hence regularly posts large losses. Into 2019 the company has delivered 25 million meals across the world.

What happened? 2019 has been a busy year for MMM. The company reported 54% in revenue compared to the previous year and importantly forecast that they would deliver their maiden operating profit in 2020. For a technology company just 5 years old this is a remarkable result. To add to this good news, earlier in 2019 the company announced it had entered a strategic partnership with Woolworths. The deal involves Woolworth’s investing $30m into the business and both teams working together to learn from each other. The investment means WOW will own 9% of the equity along with preference shares. On the one hand, Woolworth’s world leading supply chain will be invaluable for MMM in their fight for market share with Hello Fresh. On the other hand, Woolworth’s will gain valuable insights into the meal delivery market and if the company is particularly special, just buy them out. MMM has a market cap of just $60m.

Financials: The injection of capital from Woolworths and later Silicon Valley-based Union Square Ventures has let the company focus on improving their product and not about raising more capital. The results are already being seen by investors. Net revenue increased 55% from $39.5m to $61.4m euros, whilst active customers hit 172,000 after increasing 38%. The fastest growth is coming from the US, which saw revenue double (98%), Australia was also strong at 44% and Europe just 20%. The benefit of the business model is that it is based on repeat orders and loyalty, with 91% of revenue coming from repeat customers. The company focuses on its contribution margin, being the profit before market and administration fees, where it leads its competitors at 33% in Australia and 24% globally. This improving contribution margin has resulted in the EBIT margin, or earnings margin, reducing from a loss of 49% in 2017, to just -28% today, with the likelihood of a profit in 2020. Following the capital injection the company has limited debt but still relies on further equity raises in to continue expanding it’s business. As with most fast growing technology-based companies, the biggest expense is marketing and advertising.

Our view: The experts say you should buy shares in companies you know and understand. Having used Marley Spoon, I would have to agree. The company is one of just two real competitors in the sector in Australia and both are growing incredibly quickly. That being said, it is very much a microcap company that will rely on further capital injections to remain viable and is therefore not for everyone.

The reasoning is simple; the company provides a service that makes people’s lives easier. But it doesn’t end there. It offers people healthier and highly cost effective options that allow them to continue cooking their own meals, but in a substantially shorter time. The company is acutely aware of the huge amounts of waste that occurs in the grocery and restaurant sector and is focused on minimising this via portion control and a ‘source-to-order’ supply chain. This means they only buy enough ingredients for their current customers, no more no less. So you can eat well and feel good about your impact on reducing waste. In our view, the partnership with Union Square and Woolworths has taken Marley Spoon to another level and represents an exciting opportunity.

A closer look…..

As we have highlighted on many previous occasions, the extraordinarily low interest rates around the world are forcing investors to take on more risk just to sustain (rather than grow) their income each year. Now, this is all well and good if these investors have undertaken due diligence and understand what it is they are investing in. Unfortunately, this isn’t always the case. With this mind, we wanted to take a closer look at the very popular Neuberger Berman Global Corporate Income Trust. We have broken our analysis down into a few simple sections:

Who is Neuberger?

Neuberger is a New York based fund manager with expertise across most sectors of the market including equities, fixed income and alternatives. They were established in 1939 and have over $455bn under management globally with closer to $7bn under management in Australia, primarily with institutions. It’s important that investors do not confuse size with security, as whilst the manager itself is extremely successful and huge by Australian standards, they do not control the performance of the underlying investments.

What is the fund?

The Corporate Income Fund is a specialist income focused fund that invests solely into senior bonds issued by global listed companies. This includes secured and unsecured senior debt which are both positioned at the top of the capital structure and first in line in the event that an issuer defaults on their obligations or moved into bankruptcy.

What does it invest in?

The Corporate Income Fund invests into what is commonly referred to as ‘junk bonds’, ‘high yield’ bonds or unrated credit. At present, the portfolio holds less than 1% in what are considered investment grade bonds, with a rating above BBB with the remainder allocated as follows:

The fund is managed according to a number of overriding allocation restrictions with the primary one being an asset allocation of 60% to the US, 20% to Europe and 20% to emerging markets. Management aim to hold between 250 to 350 individual bonds with an external rating by one of the majors of BB or B. The geographic and sector allocations are as follows:

What are the risks?

In our view, the risks of this investment are substantially higher than many of both its investors and the financial planners who recommended it truly understand. The fund invests bonds issued by institutions that fall many rungs below the likes of the Commonwealth Bank on the credit ratings scale. For instance, the largest current holding is Petrobras bond, lending money to the Government-backed Brazilian gas and oil producer.

More importantly investors are exposed to an immensely higher risk of default on the loans made through this fund than through the likes of a Bond Fund issued by PIMCO or Schroder’s. Yet the managers are extremely clear with this fact in all their publications reporting that essentially none of the underlying investments would pass the investment grade requirement. This represents a substantial risk to investors for many reasons, but primarily, the risk of default is substantially higher. The table below shows the probability of default for various bonds rated by market-leader Standard and Poor’s (S&P) over many decades. As you can see, the CCC rated bonds, which makeup 11% of fund today, have a 26% probability of defaulting in the first year of their issue, which increased to 50% (yes 50%) after just 8 more years. This is substantially higher than the .08% probability of one of Australia’s banks going bankrupt.

The managers rely on a substantial amount of diversification to reduce the impact of any one issuer defaulting, however, in many cases this sector of the bond markets is already highly leveraged. For instance, the largest exposures are to cyclical or struggling sectors including energy and media all of which are being disrupted on a daily basis.

Our View

Be careful what you wish for. To be honest, we don’t believe an investment of this risk level is suited to the majority of superannuants, pensions and mum and dad investors that make up its share register. The fund was opportunistically listed at a time when Australian investors were seeking alternatives to fully franked dividends under the threat of a Labor Government; to this we say well done. The managers were able to leverage off this concern to raise close to $1bn in ‘forever capital’. If you were not aware, the benefit of an LIC or LIT (listed investment trust) for managers is that the capital raised will remain forever, there are no redemptions or purchases, the units are simply traded on the stock exchange. So Neuberger have effectively locked in 0.85% of management fees on $1bn in perpetuity.

PIMCO Global Bond Fund

What’s the fund?

This month we are taking a closer look at the PIMCO Global Bond Fund. The fund is a traditional, long-only bond fund meaning the managers buy and hold the individual investments. There are no short positions and the funds positions are actively managed. The underlying investments are generally limited to investment grade bonds issued by Government, Semi-Government institutions, corporates and mortgage securities.

PIMCO is renowned as one of the world’s premier fixed income managers. PIMCO or Pacific Investment Management Company was founded in 1971 in Newport Beach, California and has grown to invest $1.84 trillion on behalf of individuals and institutions across the world. PIMCO employs over 2,700 investment professionals across 17 offices spanning the globe.

PIMCO are widely known for creating the ‘absolute return’ approach to fixed income investing, as opposed to simply letting markets be markets. The firm’s investment approach is very much driven by Macroeconomic views. These are constructed, collated and challenged through an intensive investment committee and review process. It involves regular Cyclical Forums, which seek to anticipate 6 to 12 month market trends, as well as the annual Secular Forum which projects trends over the coming 3 to 5 years. The firm then relies on individual experts to provide bottom up perspectives on individual securities, companies and sectors.

The fund is managed by the highly experienced Andrew Balls, who is the Chief Investment Officer for Global Fixed Income. He is based out of London, has been with PIMCO for 13 years and previously worked as a correspondent for The Financial Times newspaper.

The Australian fund has been running since April 2004 and has over $6.4bn in assets under management. The fund is benchmarked against the Bloomberg Barclay’s Global Aggregate Bond index. In addition to the core Global Bond Fund, PIMCO have recently launched an ESG or Environmental Social Governance overlay which seeks to ensure its investments have a positive impact on the world.

Where does it fit in your portfolio?

The 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 bond 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. Management have experience investing over four decades and various major events from the Global Financial Crisis, to the Asian Crisis and various global conflicts.

Why invest?

With term deposit rates now falling well below 2%, but the risks to sharemarkets seemingly growing by the day, what you do with your Capital Stable allocation will have a larger effect on your returns.

The PIMCO Fund offers a core global bond exposure, diversified across emerging and development markets, corporates and governments. The nature of the underlying fixed income investments mean the fund will provide a hedge against equity market volatility and benefit from increasing demand for lower risk assets or a further compression in bond yields.

In recent months, experts suggest that this may be a time to be reducing exposure to bond markets. 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, markets and companies. This affords the managers flexibility to reduce the duration of their portfolio, currently around 7 years, and target specific periods on the yield curve where they believe opportunities are presenting. Duration is a measure of a bond’s sensitivity to movements in interest rates, as opposed to term to maturity which is the average term of each bond within the portfolio. Both are measured in terms of years, with a higher duration meaning any changes in interest rates will have a greater effect on the value of the portfolio.

PIMCO’s flexible mandate means they can be exposed to the potential for rate increases or decreases in various periods in the future. 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. The fund currently holds its largest overweight position 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.

What does it invest in?

The PIMCO fund is wary of its benchmark index, but is not required to replicate it. The managers charge a management fee of 0.69%, and are paid to make major investment and allocation decisions on your behalf. The benchmark holds over 24,000 individual holdings by 4,500 issuers based all over the world. The managers seek to identify the best risk-reward opportunities from this universe whilst maintaining a core fixed income exposure through Government bond holdings. Some of the important details on the underlying portfolio include:

  • Credit ratings: 91% of all investments are held in investment grade debt rated above BBB. The average rating is A+.
  • Duration: The portfolio is predominantly weighted to Developed Government Debt, where 3.9 years of the 7.4 total duration are sourced and with a focus on the US, 3.3 years duration. More broadly the portfolio is allocated as follows:
  • Yield curve: The yield curve explains the relationship between the term to maturity and return offered for various bonds, with the general expectation that the longer the term, the larger the yield or return. The fund is currently diversified as shown below. As you can see, the largest weightings are to longer term bonds, specifically those with 5 to 7 and 10 plus years to maturity.

The most important and comparable details for the underlying portfolio are as follows:

  1. Fund duration – 7.41 years – reflecting a high level of exposure to interest rate movements and the expectation that further rate cuts or increases will have a substantial impact on the value of the portfolio. This is broadly in line with the benchmark duration of 7.19 years.
  2. Yield to Maturity – 1.88% – reflecting the income that would be received by investors if the underlying bond portfolio was held to maturity. Whilst low in historical terms, this compares favorably to the many negatively yielding Government bonds around the world.
  3. Average coupon – 2.64% – reflecting the interest paid by the underlying bonds.
  4. Average maturity – 11.04 years – reflecting the average maturity of all bonds within the portfolio based on their size.

How has it performed?

The fund has performed incredibly well in the short-term, benefitting from continued moves by global central banks to 0% rates around the world. The 12 months to 31 August saw the fund deliver a return of 8.6%, albeit a little below the 10.0% delivered by the benchmark over the same period. The funds underperformance was due primarily to their focus on higher quality, investment grade bonds rather than the broader investments that form part of the benchmark.

Longer term returns have also been strong, 4.29% compared to 3.87% over the last three years and 7.79% per annum over the last 10 years. Obviously, the returns in the future will be determined by movements in interest rates and bond markets but with a worsening global outlook, inflated valuations in equity markets the fund is well positioned to benefit from a period of volatility. Most importantly, it shows little correlation to equity markets.

What income does it provide?

As with all managed funds, the PIMCO Fund must distribute all income and realised capital gains each year. Therefore, distributions are dependent on both the performance of the underlying investments and whether any investments are actually sold or mature. As an actively managed strategy, the fund regularly turns over their underlying holdings and also receives distributions from most investments on a quarterly basis. The result is a long history of quarterly returns with averages as follows:

  • 3% for 12 months;
  • 9% for 3 years;
  • 1% for 5 years;
  • 4% for 10 years.

Are transition to retirement pensions still relevant?

Transition to Retirement or TRIS pensions are commonly misunderstood by superannuation members and advisers alike. The TRIS legislation was introduced in the early 2000’s in an effort to ease the transition from full-time work into retirement for many Australian’s.

The eligibility was simple, if you had attained your preservation age, which ranged from 55 to 60, you were entitled to access your superannuation benefits on a ‘transitional’ basis. This transitional basis meant you could only draw on your superannuation balance as a ‘pension’ with a maximum withdrawal of 10% of your account balance per year.

By drawing this type of pension you were entitled to the same tax exemption as those in ‘full’ pension mode (i.e. post retirement). This meant all income and capital gains on assets supporting a TRIS pension would avoid the 15% superannuation income tax rate. The benefits were enormous, for those still working and over the age of 60, you were able to make pre-tax contributions, reducing your annual income tax bill, and replace this income by drawing a tax free pension from super.

In 2017, this strategy effectively came to an end. The legislation implemented from 1 July 2017, removed the tax exemption on assets supporting transition to retirement pensions. The result?  TRIS pensions are now only beneficial to a small group of retirees aged over 60 (and therefore drawing a tax-free pension) and who actually require the income they are drawing.

For instance, in the past most would commence a TRIS pension just obtain the tax exemption on all income within the fund and then replace the minimum pension drawdown with regular contributions. The imposition of the $1.6m balance cap and removal of this tax exemption has basically rendered the strategy useless.

As a side note, it’s worth keeping in mind that turning a TRIS pension into a full pension only requires the meeting of a full condition of release. These conditions include ‘retirement’ from full-time employment for any amount of time, attaining 65 years of age, or simply ceasing an employment arrangement that was already in place. For those changing profession or receiving redundancies late in their careers this can represent a great tax planning opportunity.

Model Portfolio Update

It was a quarter of recovery for the worst performing companies during August’s reporting season. With long beaten down sectors like Consumer Discretionary, Financials and Energy leading the market, and the Model Portfolio upwards. There were consistently strong returns and few major detractors in another difficult period for markets. Yet, after a strong start to the financial year, the bond proxies weakened in September, likely the result of profit taking and a general preference to move more capital into lower risk investments following a weaker Australian GDP result. This has since been reversed as volatility increased in October.

AMP Ltd (AMP) was one of the standouts for September, with the new-CEO closing out the retail portion of the recent capital raising adding $134m to the wealth management conglomerates balance sheet. Yet it was a combination of good news from the groups AMP Capital business and a hard line in the banks negotiations with aligned advisers that supported the share price. AMP Capital head, Adam Tindall, reported assets under management at the group had ballooned to over $200bn as the global demand for real assets like infrastructure, airports and electricity grids shows no signs of slowing. AMP Capital is highly regarded and trusted in this sector. This follows the division contributing 35% to earnings for the financial year and recording a five year growth rate of 16%. The company remains well positioned as the global ‘search for yield’ continues with institutions and pension funds not willing to lock away capital in negatively yielding bonds.

Boral Ltd (BLD): In a similar vein to AMP, BLD recovered strongly during the quarter, quickly making up the losses following management’s lowering of growth expectations in 2020. The company presented to shareholders and brokers in the US, reporting better than expected supply of fly ash with both prices and margins forecast to improve in 2020. The company also suggested volumes in their US windows and trimming products are improving as the consumer rebound sees an improving outlook for the residential property market. This was also reflected in building approvals spiking 7.7% in August, following an 8.4% gain in July, well above expectations of closer to 3%.

Santos Ltd (STO): STO was a direct beneficiary of the attacks on the Saudi Arabian oil production facilities. However, any rally is likely to be short-lived as OPEC increase supply and it has become evident that the damage was not as substantial as initially reported. The major driver of STO’s profit and share price in the years to come, now that the debt problems have been removed, will be the trajectory of the oil price. The biggest driver of the oil price is generally the level of global trade and economic activity, both of which are showing signs of slowing due to the US-China trade impasse. When combined with increasing pressure on Government’s to take action on climate change, there is no doubt that oil will become increasingly volatile and remain as cyclical as ever.

Orbis Global Equity Fund (ETL0463AU): After an extended period of underperformance, Orbis showed signs of improving, adding 2% for the month of September. The firms strategy has always been about buying companies that are unloved, or the contrarian view to the rest of the ‘market’. This is often confused as being ‘deep value’ or oversold assets, but rather expands to include misunderstood or ignored companies. As highlighted previously, transport consolidator XPO Logistics, which had been subject to a short selling attack, has begun to recover after expanding their service offering into warehousing and logistics for the likes of JD Sports. This is an increasing important sector for consumer facing businesses seeking to improve cost and delivery efficiencies. The largest holding in NetEase, which is a Chinese IT business offering massive multiplayer only games also recover strongly after some weakness in August. Finally, Nasper’s whose largest investment is a 30% stake in Tencent, rallied strongly following the demerger of its investment business. The holding in Tencent had traditionally traded at a substantial discount but it’s separation into a separate entity has seen this almost completely removed, rewarding patient shareholders.

Antipodes Global Fund (IOF0045AU): Along with Orbis, Antipodes experienced a difficult 2018-19 financial year, but for differing reasons. Antipodes is a long-short strategy, that allows the portfolio managers to both buy and sell short individual companies. Through this flexibility they can substantially reduce the level of exposure to global sharemarkets and do so regularly. The managers do this because they are seeking to generate a positive return in all environments, not simply to match the more volatile benchmark index. In the case of Antipodes, management reduces the market exposure to just 50% during December 2018 and only slowing increased it in the 10 months that have followed, missing out on the strong, albeit difficult to justify returns. The fund recovered strongly in September due to a large holding in Samsung Electronics, which benefitted as semi-conductor sales improved once again and Pharmaceutical producer Roche Holdings, which benefitted from a move back into defensive companies following further monetary stimulus announcements.