Investing responsibly, not as easy as you think

ESG or Environmental, Social and Governance investing, has continued to grow in popularity despite the pandemic. While the sector has been a feature of institutional and pension fund portfolios for many years, it remains in its infancy for self-directed investors and advisers. One of the biggest issues highlighted in our discussions and research has been the disconnect between the large pension funds, global fund managers, and the actual investors’ views on ESG and other issues.

In many cases, such as Australia’s industry fund sector, ESG is advertised as being core to an investment strategy, however it does not stop investments in gambling or mining companies, such as those who struggle to meet community expectations, like Rio Tinto Ltd (ASX:RIO) or Westpac Corporation (ASX:WBC) following their recent scandals. For example, Rio Tinto had very high ESG ratings for its policies on indigenous land rights, and it was rated the top mining company in Corporate Human Rights for two years running, in 2018 and 2019. Then, in 2020, it (legally) blew up a 46,000-year-old cultural site at Juukan Gorge in the Pilbara.

In some cases, it seems to be simply a glancing consideration of ESG factors, rather than a willingness to engage with their members and investors to understand their views. As a financial adviser, I am privileged to hear these on a daily basis from a diverse array of clients, friends and experts.

In my experience, one of the most confusing parts of the ESG discussion is the lack of a true accreditation process or central body. Before proceeding, it is worth noting that the Responsible Investment Association of Australasia (RIAA) is going some way to improve this. In nearly every meeting with a fund manager, one of our key due diligence questions relates to its ESG policies, and how they impact investment decisions. In most cases, the answer is simple: ‘We are signatories to the United Nation’s Principles of Responsible Investment.’

While being an important step in becoming responsible investors and custodians of client capital, the UN PRI are quite broad and tend to lack detail.  Despite the fact that the PRI process involves an extensive questionnaire, lodgement fee and regular disclosures around investment policy, it remains a voluntary and truly aspirational code of conduct, rather than anything enforceable. For instance, the Commitment made by fund managers is as follows:

“As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time)”.

And ultimately each signatory agrees to the following:

  1. We will incorporate ESG issues into investment analysis and decision making
  2. We will be active owners and incorporate ESG issues into our ownership policies and practices
  3. We will seek appropriate disclosure on ESG issues by the entities in which we invest
  4. We will promote acceptance and implementation of the principles within the investment industry
  5. We will work together to enhance our effectiveness in implementing them
  6. We will each report on our activities and progress

The issue, in my view, is that there is simply far too much flexibility and individual discretion as to what fits certain ESG criteria and what doesn’t. Or alternatively, whether avoiding a company on ESG issues is appropriate, or investing in that company but seeking to improve its ESG policies through proxy voting or other influences. It is the way that some of the world’s largest gaming, tobacco or even arms-related companies can end up in portfolios with little more than a short comment from the manager.

There is clearly a long way to go for the sector, particularly in communicating with the ultimate providers of capital, being you, our readers. In my view, a great starting point would be for the major global managers to offer investors the same ability, excluding tobacco or gaming options, that is offered to the much larger pension funds.

What was an average return for the financial year?

Sitting at home through another economic shutdown, I can’t help but notice the flood of industry super fund advertisements throughout breaks in the now daily AFL games. The sector appears to be making a concerted push to attract new members during the pandemic, in hopes of offsetting the huge withdrawals under the loosened hardship loophole. The advertisements remain focused on two things, performance and fees; in this short article I wanted to focus on the former.

There seems to be a substantial amount of misunderstanding and more importantly lack of access to appropriate benchmarks for DIY investors. Advertisements showing returns exceeding 10%, but with the important disclaimer that past returns are no guarantee, are abundant. In fact, the entire APRA Heat Map system for comparing funds has been based on performance, rather than risk or asset class allocations; meaning the focus is on the wrong area. Unfortunately, many funds both industry and retail, are gaming the system in two ways; 1) taking more risk (sometimes 90% in high risk assets) in a ‘Balanced’ option; 2) allocating high risk assets to the low risk or Defensive component. 

Where do I find an appropriate comparison?

In the first case, they should be compared to your objective return; generally quoted as a CPI + figure. For instance, Australian Super’s Balanced option targets a return of CPI + 4% over the long-term; in today’s world equating to a return of around 6.0% to 6.5%.

In the second case, you should seek out appropriate benchmarks. Unfortunately, in most cases we are attracted to the most available and best performing fund as a benchmark; which is clearly not accurate or insightful; particular in the case of the so-called ‘Balanced’ Fund. On this basis, we advise the use of Chant West’s Median Super Returns, available shortly after the end each month.

The team at Chant West work tirelessly to ensure that every fund they cover is closely assessed and actually fits into their allocations:

  • All Growth: 96 – 100% growth assets
  • High Growth: 81 – 95% growth assets
  • Growth: 61 – 80% growth assets
  • Balanced: 41 – 60% growth assets
  • Conservative: 21 – 40% growth assets

According to the information available on Australian Super’s website, the asset allocation of their ‘Balanced’ option actually fits into the High Growth group in Chant West’s analysis. As you can see, their market leading 8.8% per annum return for the last 10 years is only slightly above the 8.4% average for the sector. When it is (erroneously) compared against most DIY or SMSF portfolios, which are more conservative at around 30-40% in low risk assets, it looks like the best option around.

So what should my returns be for the financial year?

The table below shows the median return for each asset allocation for periods of 3 months, 1 year, 5 years and 10 years:

Category 3 Months 1 Year 5 Years 10 years
All Growth 9.7% -2.1% 6.6% 8.8%
High Growth 7.9% -0.9% 6.7% 8.4%
Growth 6.5% -0.5% 6.2% 7.7%
Balanced 4.7% 0.3% 4.8% 6.4%
Conservative 3.1% 1.0% 4.2% 5.4%

We have highlighted the ‘Balanced’ returns before for ease of comparison, representing the most common portfolio carrying 40% in defensive assets like cash and fixed interest and 60% in growth assets like equities, property and infrastructure. As you can see, the average return for the 2019-20 financial year was 0.3% and more importantly, the 10 year return is around 6.4%.

This is clearly vastly different from that reported by many major funds taking substantially more risk, so as they say ‘buyer beware’.

Six changes for 2021 and beyond

As the financial year comes to a close, it’s worth reflecting on what we have just experienced; not just in investment terms, but our health and community. COVID-19 will have long lasting impacts on our lives and has resulted in one of the most unique investment environments in history. Markets experienced one of the fastest collapses in history only be followed by the fastest recovery in history; this velocity of change seems to be a fact of life in the information age. In addition, bond markets experienced one of the most volatile periods ever seen, requiring the intervention by nearly every major central bank to the tune of trillions of dollars. Let’s take a breath….

With everything moving so quickly, its often difficult to step back and take a macro view of portfolios. There are so many spot fires, opportunities, capital raisings or threats that the idea of adjusting currency or duration in bond allocations moves further down the priority list. Yet history has shown it is these major asset allocation decisions that can drive substantial outperformance over the long-term. On this basis, there are six major changes everyone should consider as the end of financial year approaches, in no particular order.

  • Hedge currency exposure back to AUD – Every market participant has a view on the movements of the AUD, but as Buffet suggests ‘forecasts may tell you a great deal about the forecaster; they tell you nothing about the future’. As many ‘experts’ are predicting a stronger AUD as there are predicting a weaker AUD. On the positive, there is Australia’s (excluding Victoria’s) strong recovery from COVID-19, on the other is our worsening relationship with China. Here is a simple solution to help clients sleep at night: remove one risk from your portfolio that can be efficiently hedged, currency. 
  • Sell retail exposures – Despite the prospect of incredible returns should consumers flock back to retailer’s post lockdowns, the sector simply carries too much risk to warrant a position in the short-term. The list of reasons is extensive, starting with news that some 50% of retail tenants simply aren’t paying their bills during the lockdown and extending to the many ‘renegotiations’ occurring where stores refuse to open, negotiate discounts or just back out of leases altogether. This has a long time to play out and the downside risk still outweighs the upside in my view.
  • Active over passive – Now is not the time to be adding passive, index exposures to portfolios. By all historic measures both the ASX and S&P500 are overvalued. The issue, in my view, is the look through on earnings. How many companies in the S&P500 or ASX200 can you confidently say will meet, let alone beat, consensus earnings estimates for FY20? Very few given many of the companies themselves have removed their outlook guidance. There are, however, many individual companies that are still growing, think Amazon, Apple, Microsoft, Afterpay; they appear much better bets than buying the whole basket.
  • Reduce duration – The duration tailwind is dead. After several decades of falling interest rates spanning my entire 15-year career, it appears we are finally near the bottom. 10-year bonds now offer interest of just 0.6% and many corporates, like Woolworths or Amazon are issuing similar debt at record low levels. Despite the implications for sharemarkets, interest rates can and will increase in the coming decades and duration will lead to capital losses. Most bond indices have duration of around 6.5 years, meaning a 0.25% increase in rates will lead to a 1.6% capital loss.
  • Go global – The global lockdown has exposed the Australian economy for its lack of diversity and reliance on China, for both travel, commodities and educational exports. Equity portfolios must reflect the changing nature of global trade and Australia’s position within this. My view is that global equities should be at least equal to if not exceed Australian exposures. Moreso, the focus needs to be buying companies that have large addressable audiences, are growing cash flow, have scaleable business models and are capital lite.
  • Focus on total returns – What does a dividend deferral really mean? It seems that most of those companies, including our major banks that form the majority of many portfolios, have actually cut rather than ‘deferred’ their payments. This will have huge impacts on retirees that rely on their dividends to fund their lifestyle. It’s time to make a change, we need to start focusing on long-term returns and actively managing cash flow in portfolios, not dividend flow. When sharemarkets are high, sell shares to pay pensions, when markets are low, sell bonds to pay pensions. The super system forces ever higher pension withdrawals that are simply unattainable when the focus is solely on income. 

Alternative Assets

Wattle Partners has adopted the philosophy to ‘challenge everything’ as we move into the post COVID-19 world. There seems to be some level of complacency creeping into markets, investment advice and all matters of economics in recent months meaning it is becoming increasingly importance to question the conventional wisdom. It is now abundantly clear that the traditional approach of holding long-term bonds and ‘blue-chip’ shares will find it difficult to deliver the required returns in the years to come, for differing reasons, and that one of the most important strategies will be extracting every dollar of returns from low risk allocations as possible and also protecting downside in the equity components of portfolios. The only way this is likely to be possible, is to increase the use of non-traditional, alternative assets.

The asset class is much broader and deeper than many understand, hence we provide a short summary this month and will embark on more detailed analysis in future issues. Essentially, alternative assets are anything that isn’t a stock, bond or bank account, which by their definition suggests they have less correlation with these asset classes and therefore offer diversification benefits to portfolios.

  • Land – The name speaks for itself, owning land directly to benefit from its scarcity over time;
  • Timber: Timber tends to grow consistently year after year and remains a key input into many products starting with paper;
  • Precious Metals: Gold bullion, silver, platinum, palladium, the list extends with some offering both industrial uses and currency alternatives;
  • Cryptocurrency: Becoming more widely accepted by the day, offers unique exposure to the future of global currency;
  • Infrastructure: Anything from power plants, solar farms, airports, electricity grids to roll roads and rail roads.
  • Long-short: Equity or bond strategies that bet on shares going both up and down, offering downside protection;
  • Event driven: Primarily equity strategy that seek to invest where companies are subject to takeover offers, mergers, asset sales etc.
  • Activist: Similar to event-driven but with the manager themselves advocating for change;
  • Market neutral: Similar to long-short but where the long positions equal the short positions in size;
  • Global macro: Traditional hedge fund strategy investing based on major macroeconomic events like inflation or GDP growth;
  • Arbitrage: Exploiting mis-pricings, whether between markets (small vs. large) or where a takeover offer is in play;
  • Distressed: Opportunistic strategy that seeks to buy bonds of struggling companies and help them recover;
  • Quantitative: Investment decisions based solely on computer driven ‘screens’ of an asset class;
  • Private equity: Ownership of non-listed companies;
  • Private credit: Direct loans, traditional to small and medium sized businesses;
  • Venture capital: High growth, technology driven investments into loss making companies.

How businesses can start planning for the new financial year

As a business owner myself, I’ve found the COVID-19 shutdown as an incredibly useful time to not only prepare for the new financial year, but for the next decade for our business. There is nothing like being inundated with client requests, new business, and typical administration matters whilst juggling family life to bring the need for change to a head.

In those long days working from the home office it became apparent, as I am sure it did for many business owners, that there had to be a better way. The constant printing, signing, and scanning of documents, multiple conferencing apps and team members working flexible hours highlighted some very obvious bottlenecks for us, that no doubt impacted on the experience of our customers. I’ve identified three key areas where I believe business owners should be focused as we move into 2021 and beyond.

Embrace Technology

It’s been said before, but COVID-19 has amplified the need for small businesses to embrace technology. As Microsoft CEO Satya Nadella stated, the business world has seen ‘2 years of digital transformation in 2 months’. My six easiest ways to streamline your business are:

  • Simplify task management and workflow – Replace your spreadsheet’s and to-do lists with Monday.com, which provides editable automations to fit all types of businesses. 
  • Reduce physical paper use – Most businesses can now accept digital signatures, its time to embrace Docusign to speed up contracts and invoicing, rather than relying on multiple signatories.
  • Move to the cloud – Few are aware that Telstra is Australia’s leading enterprise consultant and is able to support businesses transition from physical servers to cloud storage using Microsoft’s Azure or Sharepoint platform.
  • Reconsider travel – Do you really need to be hitting the road or skies every other week? Reach out to your customers and replace taxi rides with Zoom calls whenever you can.
  • Communication schedules – Communicating with your customers has never been more important with people spending even longer online at home. Engage a social media scheduling app like Hootsuite, and plan your posts months in advance.

Simplify

Or right-sizing for lack of a better word. Now is a great time to question everything. Do you have too many internal processes? Or not enough? Are you providing services you aren’t being remunerated for? You can apply this to every part of your business.

  • Renegotiating – The shutdown is now being described as ‘The Great Reset’ through which retailers, restauranteurs and any consumer facing businesses have an opportunity to reset rental expectations in a new world. Are you getting value for money for your lease? Is it in line with similar businesses in your area? Is your landlord supporting your business? With many businesses in trouble your tenancy is likely to be more valuable than ever, so use this leverage to open negotiations sooner. With so many businesses under pressure, can you sublet some of your space to bring in additional income; all important options to consider.
  • Staffing – As unfortunate as it is, recessions bring a unique focus on what is truly important to your clients, your business and ultimately your family. Has the work from home experiment exposed weaknesses in your business model? Has it become obvious that certain roles within your businesses are no longer required, or that some staff aren’t being fully utilised? Job Keeper will assist in the short-term but ultimately you need to do what is best for the growth of your business.
  • Freelancing and consulting – The unfortunate impact of COVID-19 is that people of all levels of experience and skill have lost their jobs; unemployment hit 7.1% in May. This presents a unique opportunity for proactive businesses. First, with so many technology platforms on offer, engage an expert consultant that can customise them for your particular business. At times we shy away from the one-off consulting fees, but in many cases, they can create efficiencies in the hundreds of thousands of dollars. There is no better time than the present to consider outsourcing simple tasks to freelancers or consultants, be it data-entry, design, content creation or communication. It’s time to think about what roles can be outsourced, what inefficiencies can be removed and which teams members need more support.

One final suggestion to consider is: Is it time to plan an exit strategy?

Particularly relevant for older business owners, but with the world changing so quickly, will your business still be what it is in 10 years’ time. Do you have the skills, experience and most importantly the energy required to transition to the new world? If your business has is still performing well despite COVID-19 now could be as good a time as any to realise the many years of hard work and move to the next stage of your life. Having guided many family groups, including my own, through the transition from 70-hour weeks to an active self-funded retirement, I’ve seen firsthand how rewarding it can be. Whether that means pursuing other business interests, charitable causes or working on your golf game; there is no time like the present.

Why Lendlease is a Sell

You may remember us writing about the ‘diversified’ development, construction and property management business Lend Lease. It was sold out of our model at a price of around $15 from memory and has proceeded to fall a further 33% amid the COVID-19 shutdown. Yet walking around the suburbs it seems that the construction sector is the only one that has not really been impacted by these restrictions. 

An article published in the AFR last week piqued our interest, announcing Lend Lease’s intention to securitise, or on-sell the cash flows expected to be received from pre-sold apartments at their major buildings in Sydney. Confused? Well it seems that Lend Lease has a cash flow issue for its $100bn in work in hand, and is attempting to sell the profits or future settlement from apartments yet to be finished onto an external party to provide short-term fund. In theory it makes sense, you bring forward profits to reinvest into anotehr project; yet we arent operating in normal conditions.

Our concerns

Our original concerns around Lend Lease remain but have since been added to by the incredible events and changes occuring due to the pandemic. We suggested selling the business after they announced a substantial writedown on a number of major projects, due primarily to cost and delivery blowouts; our concern being that this issue was more widespread than it appeared. The company subsequently rallied some 30%, before falling 50% to where it is today.

During this time, management announced the sale of their engineering division to Spanish giant Acciona, but this will actually cost Lend Lease at least $500m, if not $1bn based on the views of some research analysts. Not only did it cost money, but they were required to retain a number of troublesome projects including Melbourne’s own Metro Rail Tunnel which is now at a standstill as negotiations with the Government continue over cost blowouts; sounds all too familiar. More recently, management attempted to sell the Services division, which was previously known to have one of the worst NBN installation contracts, but has since improved; yet the primary bidders in ASX-listed Service Stream pulled out late in 2019.

There is little doubt the company has delivered a strong growth profile, with over $30bn in property assets under management through their funds and a pipeline of some $112bn in residential and commercial property projects across the world. Yet is this area where we are becoming concerned. Lend Lease is increasingly looking like Macquarie Group pre-GFC with a substantial amount of its own capital invested into its projects, meaning when markets fall, as they are now, cash flow, gearing and other pressures increase. Consider for instance that they currently have some 37,000 residential units that need to be sold around the world, in what can only be considered an extremely uncertain environment.

Our biggest concern, however, now lies in the combination of residential and commercial property they manage on behalf of primairly institutional investors like pension funds. Recent superannuation changes and market volatility have seen substantial switches between investment options and demands for increasing transparency on asset valuations in properties just like these. The last few week’s has even seen rare redemption requests for Industry Funds Management direct property options as funds like Host Plus cash up to fund drawdowns. What does this look like for Lend Lease? Will they also need to offer redemption requests, will the values of these assets be reduced, effectively reducing the value of the properties still under construction? Or will borrowing from tomorrow be enough to avert disaster?

Whilst their current debt isnt demanding, falls in revenue across every business unit except low margin construction and cash flow conversion of just 5% should be concerning for investors. In an environment where everything is on sale, we think there is better value with less uncertainty elsewhere.

Government Announcements

As we all come to terms with the short-term and unknown longer term implications of the Coronavirus, and what a Stage 3 Lockdown could mean, the Federal and State Governments have been on the front foot announcing a series of measures to assist businesses and individuals during this difficult time.

The swift reaction by hospitality and retail businesses of standing down or sacking workers within just a few days of self-isolation announcements was somewhat unexpected but evidence of the ‘everyone for themselves’ survival instinct that occurs in such uncertain times. A summary of the major policy announcements so far include:

  • The minimum pension drawdowns for 2019-20 and 2020-21 have been cut by 50%, as they were during the GFC. That means if you are under 65, you only need to draw 2% of your 1 July 2019 balance, or 2.5% if between 65-74. The same discount applies for each of the other age brackets.
  • For small businesses, the ATO is offering a Cash Flow Boost, by crediting any business activity (BAS) or PAYG amounts that are payable on a monthly or quarterly basis. Specifically, businesses with turnover of less than $50m will not be required to pay PAYG to the ATO on behalf of their employees where it is less than $50,000. In fact, every business will be afforded a $10,000 credit whether they withhold tax or not.
  • The Federal Government is offering early access to superannuation under a loosening of the hardship provisions. This will allow those who are unemployed, eligible for job seeker payments or have been made redundant or lost working hours of 20% or more since 1 January 2020. It is limited to $10,000 this financial year and next.
  • Closer to home, the Victorian State Revenue Office will be refunding payroll tax paid by businesses thus far in 2019-20 but only for those with payroll below $3.0m. This is a case refund and no further amounts will be payable for 2019-20 or the first quarter of 2020-21.

It’s worth noting this is simply the first round of support measures which come on top of the various actions taken by the Reserve Bank in recent days. Both State and Federal Government’s appear acutely aware of the risk that mass unemployment would have for the future of the Australian economy.