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.