Three steps and a stumble

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In the wake of last week’s interest rate hike by the US Federal Reserve and its admission of two more thisyear, investors, analysts and central banks around the world are shifting their policy stance and exposures in what could be the end of easy money.

 Last week’s hike marked a pivotal point in economic history. Whilst you may not think a US rate hike may be that significant, it really is. It creates a massive knock on effect throughout the rest of the world. Firstly, raising interest rates has an immediate ripple effect with foreign currencies. The US dollar is used as a benchmark against its future economic growth. When rates go up, it’s usually followed by an appreciation in its currency. US Treasury Bonds are the first to reflect changes in rates. The Treasury yield curve will move up to reflect an increase in rate. Other securities must then offer a higher return than the risk free Treasury rate. This causes investors to shift their money into the US to take advantage of higher returns. In turn this causes the dollar to rise. Aussie dollar will fall. Currencies in emerging markets will fall. But it’s much more than just that. The rate hike pretty much marks the end of the rate cutting cycle. The days of easy money will soon be a thing of the past. Three rate rises since December 2015 and two more on the way have prompted major changes in interest rates around the world.

US Federal Reserve rate rising cycle

 Here are some of the ripple effects caused by a change in the interest rate cycle:

US dollar denominated debt – Emerging markets Since the GFC, emerging countries have taken on loads of US denominated debt amassing some $3.3 trillion in just a few years. Countries such as Turkey, Ghana, Nigeria, Argentina, Brazil, Thailand, Vietnam, Brazil, and South Africa perpetually run trade deficits and finance their current account deficits by building up US dollar-denominated debt. When there is an interest rate hike together with a spike in the US dollar, you get a double whammy effect:the exchange rate between the emerging country and the US widens and the US denominated debt owed by the emerging country increases. The real risk here is that the debt becomes unmanageable. Not only does this occur, but it could also trigger a capital outflow where investors may shift money back to the US where rates are rising.

Falling currency – If the US raises interest rates while other global central banks maintain or lower their interest rates, then the return on savings is more attractive in the US than in other countries. This means capital flows from foreign countries to the US resulting in the dollar’s appreciation. This causes the exchange rate of other currencies to fall. It is good news for the RBA who won’t need to raise rates urgently with a falling Australian dollar. A US rate hike can be a pain for countries like China that will likely see an increased capital outflow. The outflow of capital from developing markets will in turn cause their currencies to depreciate further. When foreign investment into emerging countries starts to dry up it will effectively put the brakes on economic growth that relies on such investments. The countries most at risk of this are Turkey, Brazil, India, South Africa, and Indonesia. Australia’s cash rate is materially higher than the US rate. That makes Australian deposits more attractive so foreign investors will buy Australian dollars in order to take advantage of that “yield differential”.

US dollar denominated debt – Corporate As well as countries loading up on foreign debt, the same thing can be said about corporations loading up on US denominated debt driven by low interest rates. Easy money as it’s called. This debt now makes them vulnerable to future interest rate increases, resulting in higher interest repayments and rising debt levels. It’s a vicious cycle. 

Australian banks – Mortgage & property market – When rates go up, it’s usually a headwind for the property market. Any increase in US interest rates would mean that wholesale bank funding costs go up. The big four banks get a third of their funding from bonds and the remainder from customer deposits. Therefore bond rates affect the cost of money for all of us. Banks can’t really offset the increase in wholesale funding costs with rates charged on deposits because they’re so low. So what do they do? They pass on the difference to customers by increasing interest rates independently of the RBA. Last week NAB increased rates. This week WBC upped its variable rate for owner occupiers by 0.03% to 5.32% on principal and interest loans. For owner occupiers paying interest-only they will see larger hikes of 0.08% and their rate climb to 5.49%. It’s quite simple, banks are borrowing too and they are simply passing this extra cost onto customers. In reality our banks have been itching to raise rates and this gives them the perfect excuse to do so. You can only expect more of these out of cycle bank rate rises independent of the RBA.

US 10 Bond Yield chart All assets are priced off bond rates either due to their yield differential or funding via debt.

But here-in lies the problem: Melbourne and Sydney have gone bananas with investors and home owners snapping up heavily overvalued properties that they can only barely afford. What happens when interest rates revert to the long term averages? One in five homeowners will get themselves into hot water if rates start to rise. People tend to think that property prices rise forever and interest rates will stay low for quite some time. Wrong. They’ll get a rude awakening when they find out this week that rates have already begun to rise. Australian household debt currently stands at a record 187% of income with average household net debt now sitting at almost $250,000. A case of ‘Buy now, Pay later’. Here’s how bad it can get. A 2.5% rise in interest rates would push mortgage repayments on average up by $6,223 per year. It would also push mortgage interest repayments to 58% from 42%. With higher mortgage rates on the way, it will cause financial stress for many that own a house. It will dampen demand, and almost certainly put off new investors. It will however be a welcomed relief for a seriously hot property market that needs demand to cool and for prices to come off the boil. 

Lower commodity prices Many countries such as Australia are heavily reliant on commodity exports to support economic growth. Brazil and Russia depend on crude and gas prices, while Australia depends on iron ore and coal prices. There is usually an inverse relationship between commodity prices and the US dollar. So if the US dollar rises in value, commodity prices fall because they are denominated in dollars. When the dollar goes up, it means the commodities become more expensive for those who hold other currencies which has a negative impact on demand due to lower purchasing power and prices fall. Commodities are also traded in US dollars. So we could see further downward pressure on oil and gold. This is bad news for emerging markets because most commodities are in US dollars will generate less revenue in real terms. The Australian dollar is a commodities currency. That means it rises as commodities such as coal and iron ore rise. Iron ore makes up the bulk of Australian exports, so it’s little wonder that the Australian dollar is closely linked in to iron ore prices. Aussie ore must be purchased with Aussie dollars at the end of the day. As demand rises, so too does demand for the A$.

Stock Markets Rising interest rates are generally a headwind for stocks in the longer term but share markets do tend to climb for the first two years of a rising interest rate cycle. While there is no rule or definite correlation, in the past rising interest rates have spooked investors causing a sell off. There is an old Wall St adage ‘Three steps and a stumble’. That means watch out after the third interest rate rise, because stocks will fall. This is the third step, so we should see a stumble soon. The US markets is down 1.3% this week. We’ll soon know if the adage holds true. On the day of the rate rise both the ASX and Aussie dollar reacted positively. What the? Usually the rate rise would have seen the US dollar rise and Aussie fall. It could be that the absence of any surprise in the decision and expectations of three future rate rises that was pared back to just two, that may have caused the rise. Some even say that the false starts in September and October had many relieved that there was the hike and it was all priced in. Nevertheless, the norm is for higher US interest rates to put downward pressure on the share market because it becomes less attractive and the discount rate is higher.

The end of easy money The US rate rise marks the end of expansionary monetary policy and beginning of contractionary monetary policy. Expansionary monetary policy was used after the GFC to increase the money supply to lower unemployment, boost spending and stimulate economic growth. Interest rates tumbled to near zero. It worked a treat. Now it’s time to turn the tap off. Tightening monetary policy slows the rate of growth in the money supply in order to control inflation. The US economy is on a healthy footing as unemployment falls. As such rates need to rise to stop inflation from rising. What is for certain is that the 35 year old rally in the bond market is well and truly over. Whilst the interest rate cycle is definitely turned direction, it’s coming from a very low base and moving slowly. An article in the SMH talks about Macquarie conducting an investigation. The bank found that 18 previous Federal Reserve easing and tightening cycles since 1954 showed that rate rises particularly ones that occurred in the early part of the tightening cycle, were good for equities. Shares rose over 20% in the year after the first hike. Aussie shares rose during the start of a US tightening cycle at around 10% the following year. Going by that report, the start of a rate hiking cycle is a positive thing. However this is the third hike so the start of the rate rising cycle is maturing. Could it be that the next hike will see a market sell off?

Winners and Losers Winners – Banks stand to benefit from US interest rate rises as their net interest margin rises. NAB has already lifted its home loan rates citing increased wholesale funding costs in the bond market. NAB is expected to earn some $200m just from the increase. Westpac (WBC) has done the same with CBA and ANZ to follow suit. US rates also look favourably on QBE which is a winner from a rate hike. Why? Because QBE generates about a third of its revenue from the US and its portfolio is loaded with US bonds. So obviously a higher yield means higher returns. Tourism stocks such as Webjet (WEB), Corporate Travel (CTD), Mantra (MTR) and Sealink Travel (SLK) will benefit from a lower Australian dollar attracting tourists from overseas. Offshore earners such as Computershare (CPU), James Hardie (JHX), Ansell (ANN), Boral (BLD), CSL and Ramsay Healthcare (RHC) all benefit from a higher US dollar. Stocks in consumer staples, cyclical resources

Losers – It’s time to sell bond proxies. Income seeking investors bought companies that displayed bond market type qualities such as income and safety because bond yields were too low. As a result stocks like Sydney Airport (SYD), Transurban (TCL), APA Group (APA), Westfield (WFD) and Spark Infrastructure (SKI) saw increased demand as retirees bought these bond proxies for safe income. Telcos, infrastructure, pipelines, utilities and REITs were the main sectors. With bond yields on the rise, there will be a reversal of this bond proxy trade. As a general rule REITs, telcos and utilities all underperform in times of rising yields. Just by looking at the charts, you’ll see that these bond proxies have already started to pull back.They have to because they are sensitive to interest rate movements, demand high PE’s yet they trade on low ROEs. The best option is for retirees to switch back into fixed interest bond like investments or into cyclicals.

With easy money monetary policy now well and truly over, investors should adjust their portfolios in preparation for higher bond yields and interest rates. This means switching out of bond proxies and into cyclicals, offshore earners, banks and QBE. Goldman Sachs is forecasting the RBA to raise rates this year (November), which will more than likely be the catalyst for these bond refugees to start their exit. So why not get out before the herd exits? Well there’s one exception to the general rule: If Trump spends big on infrastructure, won’t that be positive for the sector? Whilst rising rates is usually a headwind for this asset class, the impact could be offset by Trump’s rebuild America will boost infrastructure related stocks. Despite this factor, Goldman Sachs says “With rates moving higher, bond proxies now look more expensive.” A 25% drop in bond proxy share prices wouldn’t be out of the question, if US 10 year bond yields rose to 3.83% from 2.5%. Whilst the general rule is – When rates are low, yields are hard to find, infrastructure stocks do well. The counter argument you may hear from some analysts is that most infrastructure companies such as Transurban (TCL) have assets that are inflation linked. So as interest rates go up, so does inflation which feeds directly into Transurban’s toll revenue which rises inline. Despite this, there will still be a sell-off as bond proxy investors worry about rising bond yields and switch. It’s a self-fulfilling prophecy. The other problem is rising rates makes it harder for these infrastructure companies to service their rising debt levels. In the end, investors hold infrastructure stocks because they’re rate sensitive. So when rates rise, these stocks will be sold for the same reason they were bought. They will usually pull back to their real valuations. Resources space are a good place to be. Think about switching into BHP, RIO, Alumina (AWC), South32 (S32), Bluescope Steel (BSL), QUBE (QUB) or Seven Group (SVW). Which-ever way you dice it, the days of easy money are over and the great bond market rally is now a thing of the past. Interest rates are set to rise and cheap money will now cost more. Safe haven bond proxy stocks such as infrastructure and property trusts might come under a bit of pressure as they lose their status.Bond yields are starting to rise not only in the US but worldwide. This ends a 30 year decline in yields. The Australian Government Bond has risen to 2.82% from 1.83% in August. The RBA has signalled that it will hold rates as is. No one is expecting the RBA to raise rates anytime soon, but next year it could become a reality. Our message to investors: Interest rates have already started to rise but are still low. You need to be ready to reposition your portfolio accordingly. Look for real earnings growth when selecting companies. An eventual rise will affect almost all sectors of the share market so remember ‘Three steps and a stumble’.

SMSF Compliance – The most popular mistakes

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At the end of every financial year the ATO publishes the top compliance mistakes made by SMSF trustees, as reported by independent SMSF auditors across Australia. This is an important part of the ongoing regulation of the industry that now has some 500,000 funds in existence.

Whilst a great deal of SMSF compliance contraventions are corrected following consultation with the ATO, the legislation is unambiguous when it comes to using your SMSF to provide assistance to a member of relative and the heaviest penalty can be devastating. In the case that any compliance breach is sufficient to make your SMSF non-complying you all income and capital gains within the fund will be taxed at the highest marginal tax rate of 46.5%. In addition, if the fund has made a loan to a member, and early access to superannuation assets has been deemed to occur, the ATO may also assess the member who receives the loan with a tax liability. This is indeed a situation that all trustees should wish to avoid.

Most common mistakes
In order to assist SMSF trustees in avoiding these mistakes, the ATOpublishes a summary of the most common investment mistakes; the top five are as follows:

  • Loans or financial assistance to members – 20.9% – This is the biggest concern and risk for the ATO as in most instances this results in a member gaining illegal early access to their superannuation benefits, breaking the ‘sole purpose’ rule, and bringing into question the security of superannuation assets;

  • In-house assets – 18.3% – SMSF trustees are eligible to hold up to 5% of their fund in in-house assets, unfortunately most breaches have resulted from members using their retirement benefits to support their own businesses, well in excess of 5%;

  • Separation of assets – 12.9% – This breach can be as simple as not having every investment registered in the full name of the SMSF, for instance, having shares registered in the name of the trustees or corporate trustee only;

  • Administrative contraventions – 12.9% – The primary source of these contraventions is inaccurate paperwork, which can be easily rectified;

  • Borrowing – 8% – SMSFs are restricted from using any of the fund’s assets as security for a mortgage or other loan, except under the non-recourse loan exemptions associated with purchasing property.

SMSF Gearing – Simple mistakes
The SMSF Gearing or Limited Recourse Borrowing Arrangement exemption which applies to SMSF’s borrowing to purchase property investments has only muddied the waters for trustees. The complicated structure required to protect your SMSF from lenders (including the Bare Trust) has opened up the floodgates for an even greater number of contraventions. Some of the major errors being made by trustees over the last few years include:

  • Not paying the entire purchase price from the SMSF;

  • Not arranging the stamping of the Bare Trust Deed

  • The lender acting as the holding trustee of the Bare Trust;

  • The Bare Trust being listed as the Lender;

  • The SMSF Trustee acting as the buyer rather than the Bare Trust.

It is clear from the ATO’s recent updates and the hefty penalties that have made the news in recent months that the ATO is serious about protecting the sanctity of Australian’s retirement benefits. It is imperative that investors continue to view their SMSF as a vehicle for their retirement benefits and not an extra pool of capital for their business or lifestyle.

My two cents – An Oily Inflation

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 The US Federal Reserve has signalled that it will almost certainly raise rates whenit meets later this month. The chance of a rate rise now stands at 94% on Monday making it a done deal. Fed officials say there is now a strong case for rates to be higher provided economic data remains good. It will be the first time in months that the Fed has raised rates and it will highlight its aggressive stance. A decade of cheap money is now over and that means those carrying high levels of debt need to be aware that higher rates are on the way. The cost of money worldwide will start to tick up, it’s all changing. The RBA however isn’t so keen to raise rates just yet. Either way it doesn’t really matter as the banks will and have raised independently. It’s already started with Westpac, St George, Bank of Melbourne, BankSA, Rams, ME and Ubank hiking mortgage interest rates by up to 60bps on Monday, and the other major banks expected to follow. They’re raising rates because funding costs (usually in US$) have risen. About a third of the banks’ funding comes from wholesale debt which costs more overseas. When rates go up in the US, it becomes more expensive to borrow from foreign banks. This all spells the end of the rate cutting cycle here in Australia and the beginning of rates heading towards their long term average.  So how does this affect Australia?

This is pretty much a US driven story, but its effect on Australia will be quite substantial even though we’re half a world away. The US dollar remains the world currency and life line of the global economy. The minute rates go up in the US it slowly spreads across the globe. Some analysts are saying there will be another 3 interest rate rises for 2017. At its final meeting for 2016, the RBA left the official cash rate on hold at 1.5%. Now in case you didn’t know, interest rates and inflation are both linked. Inflation refers to the rate at which a basket of goods or services rise. As a rule of thumb, as interest rates are lowered (current), people tend to have more money to spend as they are able to borrow more. Inflation usually increases. The opposite is also true, as interest rates are sky high, consumers tend to save more and the end result is consumers not spending. The economy slows and deflation kicks in. Got it? Good. But here’s the problem, Australia’s inflation rate is strikingly low at 1.5% which is well below the targeting 2%-3% target range set by the RBA. The real reason inflation sits so low, is because the economy is anaemic. In a strong economy you’ll see consumers spending, businesses investing, unemployment falling and inflation rising. It’s high because companies can increase prices without losing customers because they are willing to pay higher prices because they have money. Then to bring inflation back in line, the RBA will increase interest rates to discourage borrowing and encourage savings. The economy slows and inflation pulls back. In Australia, consumers are hoarding cash and only spending the bare minimum. Housing construction is the only sector where spending is high. Business investment continues to fall. The conundrum here is that if the RBA raise rates, inflation will go lower. The RBA can’t raise rates, it needs to keep inflation in line.

 So how does the Government raise inflation without destroying the housing boom or without raising rates? The answer is – It will need to spend money. This year’s May budget will require spending on roads, rail, bridges, health, NBN and construction. This might just get inflation ticking up again so that interest rates can rise. This will put a cap on the housing market and keep the economy humming along. But there is another factor that might help inflation. That is oil. As the price of oil moves up or down, inflation follows in the same direction. Why? Because oil is a major input in the Australian economy. It relies on oil for transportation and energy. Oil prices have tumbled significantly over the past few years. The crude oil price fell from US$105 a barrel in 2014 to a low of US$33 a barrel in 2016. Lower oil prices in Australia lead to lower costs of production for those operating in mining, transportation and manufacturing. Oil is also an important part of the household sector budget. Petrol prices started to fall by around 30% since July 2014. This means there’s extra money in the back of your average house hold’s back pocket every week from money saved on petrol.

 Looking at the chart above, we’ve plotted the WTI oil price and Australian inflation. You’ll notice how closely correlated both are. Back in 2008 during the GFC the oil price plummeted. Inflation followed. Over the next 7 years both recovered until oil had another collapse in 2014/2015. What we’re seeing now is inflation set to accelerate as the rising oil price pushes up costs at the petrol pump. The WTI oil price is trading at around US$53 a barrel. Citi analysts are predicting oil to rise to US$70 a barrel by the end of 2017 supported by an OPEC deal to cut production. So we can only assume, that as the oil price moves up, inflation will follow in the same direction. A sustained rise in crude prices will put upward pressure on inflation and almost entirely crushes any expectation of a rate cut. So the message is: If oil rises then you can expect inflation to follow in its footsteps. It also means that rate cutting cycle is over and property prices are set to cool. Gold is a popular inflation hedge. Investors tend buy gold during inflationary times, causing its price to rise. So if you are to profit from rising inflation look at gold, oil stocks, fixed interest securities and consumer discretionary stocks.

Transparency

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As active investment managers, we are constantly looking at how our competitors are doing and there are none bigger than the industry super fund sector. There is an inherent trust in the sector and perceived safety that comes with investing with a large ‘not for profit’ institution, even if that institution is spending hundreds of millions each year advertising on ‘The Voice’, at the Australian Open or even opening its own bank. In light of the constant media coverage we were interested to find out exactly how the funds were performing and what level of transparency into their investments they actually provided to members. One of the main reasons we started Sornem Private Wealth is because we believed that every personal a) has a right to know exactly what their life savings are investing into and how they are being invested; and b) they should have the option to control some aspect of this process. Our interest was piqued by a survey completed by Market Forces in 2016, which included two key findings:

  1. 86% of people believe they have a right to know where their super is invested;
  2. 83% of industry super fund assets are not disclosed.

Before proceeding, we must note that after this survey Australian Super released a tool allowing investors to see how their individual option was invested. Whilst this is a good start, it only provides transparency on the 30th of June 2016 and has not been updated since. What was really stunning to us was that the 83% made up $1tn in undisclosed assets. This is $1tn in people’s savings, leaving people with no idea where they are invested. It’s no wonder why people have preferred investing in property over the last decade; at least they can see it! Going through a number of industry fund websites, it becomes evidently clear how bad disclosure actually is. One fund for instances provides the top 20 Australian shareholders, the next only a list of the managers that they engage and the next just a list of properties and infrastructure assets that they own a share in. The inconsistency is incredible and makes it incredibly difficult for new members to make informed decisions. If you think about is this way, would you buy shares in a company that is not disclosing what their operations are, where they are doing business, or what risks they are exposed to? So why should you be comfortable investing your life savings into a fund that doesn’t provide full disclosure. The Cooper Review, which is gathering cobwebs somewhere in Canberra, suggested that industry funds should disclose all holdings every 6 months; unfortunately, this has not yet come into force. The lack of transparency afforded to industry funds actually puts them at an advantage to their competitors. Members of industry super funds cannot see what assets they are invested into and thus cannot determine the level of risk taken to achieve their ‘industry leading’ returns. Because all the member sees is a single daily unit price, the managers can dial up (or down) the risk at any time. Or alternatively, they can invest into more complicated products like hedge funds, private equity and infrastructure as so-called ‘defensive’ assets and substantially increase the returns; in fact they have done just that. One issue that has been concerning us is the weighting that the industry super funds have to so-called ‘bond proxies’ or those assets that have a strong link to interest rates. Think infrastructure, Government bonds, utilities, property and financials like banks and insurance companies. On the one hand, most industry funds have generated strong returns by investing directly into infrastructure assets like toll roads, airports and electricity grids, as low interest rates supported debt funded acquisitions and made income payments were more attractive. In fact, the performance has been so strong that some funds now allocate these assets, which obviously carry all kinds of risks, to the defensive or ‘safe’ portion of their portfolios. Whilst this has been an excellent investment strategy, what concerns us is that this exposure is being replicated in the other asset classes within their portfolios. As the chart below shows, the ASX today has some 60% of its value in ‘interest rate sensitive’ assets. Given most industry funds simply replicate the underlying index, members may be even more exposed to a single sector than they think.

 As we all know, the most important thing when it comes to investing is to look forward and seek to understand what is occurring in the world around us; as the returns of the past mean nothing for the future. As investors, we would like to know what the industry funds planto do with their weightings to infrastructure, where they believe returns are likely to come from and how they will achieve them, before we would even consider investing. Given most holdings are not updated until the end of financial year, we don’t believe this will be forthcoming any time soon.

Computer Hardware – Apple and Samsung

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 When we mention computer hardware we all have a pretty good idea of what it is. It’s all the nuts and bolts and gizmos that go inside a computer right? Well yes, but there’s so much more than just that. Computer hardware is the collection of physical parts of a computer system. This could include the LCD screen, hard disk, CPU, motherboard, video card, keyboard and mouse.  Basically Computer Hardware in short – is the physical components you can touch that make up a computer system. There are so many different kinds of hardware components that can be installed inside and connected to the outside of a computer. Certain hardware components are easy to recognise such as the keyboard or monitor. And then there are others that are more difficult such a RAM or Graphics cards. A computer system is made up however of not just hardware but also of software. Both are required for a computer system to work. The companies that design and manufacture these hardware devices are some of the most profitable and valuable companies in the world. These include companies such as Apple, Samsung, Hewlett Packard, Intel, Dell and IBM are some of the most recognisable brands. Unfortunately there aren’t any local hardware manufacturers most are either American, Chinese or South Korean.

Apple (NASDAQ:AAPL)
We all know who Apple is. Steve Jobs started Apple in 1976 in the garage of his house and it has since become a historic site. Apple’s very first computers were stacked in boxes in Steve Jobs’ bedroom when he was only 21 years old. Jobs and friend Steve Wozniak built 50 basic computers in Jobs’ parents’ house. The ‘Apple 1’ computer was built on order for a local computer shop before the duo shifted their makeshift operation downstairs to his garage. Now the company is worth well over $600bn and is the world’s most valuable brand. Headquartered in Cupertino, California, Apple Inc (AAPL) has been at the forefront of the computer hardware industry since its founding. It first produced the Apple Macintosh computer and then went on to create the MacBook, iPod, iPhone, iPad and Apple Watch smartwatches. Apple sells its products through retail and online stores such as JB Hi-Fi, direct sales and third-party network carriers such as Telstra and Optus. It has been dubbed as the most recognisable and popular brand in the world. With sales of $199.bn and assets of $261.9bn you can understand why. The company has come a long way from just manufacturing PC’s and iPods. Its flagship iPhone product is still the breadwinner. In-fact the iPhone contributes over 65% of the company’s total revenues and over 75% of its gross profits. 2016 was a difficult year for the iPhone which saw its first decline in sales which were down 12.5%. This was due to lower uptake of the iPhone 6S and higher competition from Samsung and other phone makes. But things are looking OK for 2017. Bulls

  • Apple’s flagship iPhone 7 product is expected to do well this year. The new phone comes with superb primary camera of 12MP, touch focus, geo-tagging , simultaneous 4K video and 8MP image recording , face/smile detection & HDR.
  • The new iPhones will feature Apple Pay which becomes available around the world. Apple critics say Apple Pay is innovation of the highest order and will become the future payment system.
  • Apple own its own platform – iOS unlike Samsung. Therefore telephony sales margins are high. The company is not required to pay fees to use a platform like Android.
  • Apple has its own ecosystem of interconnectable devices thereby avoiding competition from third parties. Recently it replaced the standard headphones with the AirPods.
  • The company has invested heavily in Artificial Intelligence which has many applications going forward.

Bears

  • Competition is rife. iPhone has very tough competitors such as the Samsung Galaxy and the Google phone. iPhone unit sales declining in fiscal 2016 but holding their margins.
  • All of Apple’s phones are manufactured in Taiwan and China. If Trump introduces an import tax, Apple’s costs will go up and it will need to restructure its operations or pass the costs onto the client.
  • Apple makes more money from iPhone than they make from any other product. Therefore there is downside risk in relying on one flagship product. Samsung on the other hand, is a conglomerate that produces phones, semiconductors, white goods to TVs.
  • Another seems to have hit a brick wall. With Jobs the company was innovative it produced so many wonderful products such as the iPhone, iPad, Apple Watch, and Apple TV. But where to now?

Unconventional View
The iPhone 7 is doing a lot better than its predecessor due to better features such an improved cameras and water resistance. Customers who have been burnt, literally, from the Samsung Note 7 are actively switching to the iPhone. To add to it, iPhone is expected to launch a brand new redesigned 10th anniversary iPhone towards the end of the year. Apple‘s new wireless headphones, the Airpods, went on sale towards the end of 2016 and is another area that’s creating a real buzz. Airpods are the headphones that come with the iPhone 7. They enable users to listen to music and phone calls wirelessly, much like other Bluetooth headphones do. That could be a game changer for Apple. On the fundamentals Apple trades on a PE of around 14.45x which is neither cheap nor expensive. Its ROE is quite high at 36% but its falling, which isn’t a good thing. On the chart APPL looks fairly attractive. The stock recently broke out on the upside and has formed a short term uptrend. Whilst Apple can be marked off as a mature business with limited upside, don’t write them off just yet. All it takes is for them to develop a new innovative whizz bang product and Apple will be back on top.

 Samsung (005930.KS)
The company grew from humble beginnings in 1938 as an exporter of dried fish to China, to being the world’s largest electronics company. Samsung was founded by Byung-Chull Lee in 1938 in Taegu, Korea and started off exporting fish and flour in Korea to China. He called it Samsung, which means ‘three stars’ in Korean. It then began to expand its offerings and ventured into life insurance and textiles during the 1950s and 1960s. Then in 1969 Samsung Electronics was formed as a division of the mammoth Korean chaebol Samsung Group. Samsung’s first black and white TV went on sale in 1970, PCs by 1983 as well as refrigerators, washing machines, microwaves, VCRs, colour TVs and tape recorders. By the 90s the company was developing the world’s first 64Mb DRAM which took the world by storm. Sales helped drive earnings to $14.94bn in 1994. Then as part of a new focus to diversify away from memory chips, Samsung ventured into telecommunications and its first mobile phone was released in 1995, which did not work. It then made a second attempt and released one of its first Internet-ready phones in 1999. Mobile would eventually grow into Samsung’s most profitable business. A lot of the company’s businesses were divested and the business restructured after the Asian crisis. Samsung started manufacturing HD TVs in the early 2000s along with Blu-Ray players and home theatre equipment. It’s now makes some of the best HD TVs you can buy. It was in 2010 that Samsung unveiled its first Android phone, the Galaxy S and the Galaxy Tablet. It sold over 24 million units worldwide and completely dominates the Android market.

Bulls

  • Is a conglomerate with multiple revenue sources from electronics to phones to white-goods. The company has been around for decades and is an effective product innovator.
  • Samsung dominates the smartphone market with the top selling Samsung Galaxy smartphone. It has the largest market share followed by Apple. The Galaxy series has huge demand among the customers with its special features, sophisticated look and good quality.
  • Samsung manufactures high quality televisions and also dominates this market along with LG and Sony. Its TVs are considered high-quality devices that offer unique features, such as the curved screens but they tend to be more expensive than sets produced by other brands.
  • Despite the phone disaster, Samsung’s profit rose 50% and at the highest level in more than three years due to its semiconductor business which is soaring due to strong demand. It contributes more than half of the company’s earnings.

Bears

  • The company’s reputation and brand was tarnished this year due to exploding batteries in its Galaxy Note 7. It was forced to recall every smartphone sold and stopped all sales and shipments. It was a costly mistake as Samsung worked with government agencies and carriers around the world to provide refunds and exchanges for the phone. Samsung’s exploding phones disaster could cost the company $17 billion.
  • The US Court of Appeals for the Federal Circuit has reopened a long running case between Apple and Samsung. Apple is accusing Samsung of copying the design of the iPhone for its Galaxy S series. If proven, Samsung could be up for hefty damages and will effectively have had to pay Apple a percentage of each sale. This could really be a game changer.
  • Samsung lacks its own platform. It uses Google’s operating system for its Galaxy products and therefore its margins are a lot thinner than Apples. Software and OS production has a high profit margin. Whilst Samsung is a hardware leader it’s too dependent on software from other parties. This is a major disadvantage.
  • Samsung is at disadvantage over its competitors because it loses a focuses on too many products.

Unconventional View
Samsung has a lead over Apple in phone sales. Samsung shipped 81.3m phones in the 1Q16 compared to Apple’s 42m phones during the same period. Samsung’s market share is 27.8% versus Apple’s 14.4% driven by its latest Galaxy S7 smartphone which sold 10 million units in March alone but the company has been inthe spotlight for all the wrong reasons. It’s been a tough year for Samsung Electronics with costly product recalls and exploding handsets. Samsung has not only lost market share as a result but the threat of injury or fire from its devices has damaged its reputation. It also led to a global recall of 2.5m units including unsold stock and revealed that it was faulty batteries that were the cause. The product was scrapped in the end wiping off roughly US$5.3bn off its operating profit in one of the biggest tech fails in history. Whilst the company survived the fiasco, Apple and other Android smartphone brands have taken advantage and gained market share. Samsung’s brand intent fell from 32% to 19% with interest shifting to devices such as the Google phone and Huawei. Apple remains the first smartphone for Aussies with brand intent having a 62% rating. Whilst its phone exploding problems have been a real headache for the company, it hasn’t dampened investor demand. Remarkably the company’s share price has continued its steady rise and is hitting all-time highs. The initial recall caused a fall in the share price, but the stock has since recovered. The reason being, phone sales aren’t the main revenue generator. Samsung not only sells phones but it sells TVs, display screens, semiconductors and consumer electrics. Up until 2014 phone sales made up the majority of the company’s revenue but now its main revenue source is semiconductors and display units. As handset profit margins shrink and competition rises, Samsung shifting its focus to display units and semiconductors. As it’s done in the past, Samsung is trying to stay ahead of the game and investors like what they see.