What is ESG?

As we meet more people around Australia, a common trait and questions continue to be raised around the ability to invest more sustainably and ethically particularly in regards to climate change. This is a theme that has been growing exponentially at the institutional level, but limited coverage or options have been made available for most investors. Given the plethora of acronyms already in the industry, we thought it appropriate to provide a short summary of how people can invest more sustainably through a concept called ESG.  Put simply, ESG stands for Environmental, Social and Governance criteria when it comes to investing. There are many ways to apply ESG principles, which we will discuss in future issues, however, at this point we just wanted to provide an introduction to the sector.

Environmental considerations refer to investing in businesses who are stewards of nature. This may sound a little green, however, in this criteria you are either looking at companies who are aware and managing their energy use, waste, pollution and are actively involved in natural resource conservative in some way within their businesses. Most importantly, businesses must be aware of the environment risks that they are exposed to and have a policy of how to manage those risks including contaminated land, climate change and emissions.

Social considerations are becoming increasingly important in our globalised world, as after years of exporting jobs to access cheaper labour, they are now moving home or into frontier markets. The social considerations refer to relationships with employees, customers, suppliers and communities. The key exposures relate to understanding the supply chain of products being manufactured, avoiding cheap and child labour, donating a portion of profits, allowing employees time to volunteer and offer strong working conditions. A movement called B Corporations is quickly gaining steam in the country, as it requires members to consider all stakeholders in running their business. Wattle Partners has been one of the few financial advisers in the country that is an accredited BCorp.

In recent months, with the likes of Woolworth’s underpayment scandal and Westpac’s Anti Money Laundering issues, Governance has become an increasingly important question. This begins at the top, focusing on the leadership of businesses, appropriateness of executive pay, quality of external audits and internal controls (including whistle-blower policies) and protecting shareholder rights. This extends to maintaining accurate and transparent records, allowing shareholders to vote on important issues and disclosing the conflicts of interest or any board members.

Each of these criteria can be applied on a positive or negative basis, which we will discuss in future issues.


What is Duration?

With Government, Corporate and Junk Bonds moving to centre stage in recent months, we thought it worth providing a refresher on duration.

Duration measures the weighted average of the time until each of a bonds fixed cash flows or ‘coupons’ are received. Confusion reigns supreme in discussions about duration, as it is also used to estimate the percentage change in a bond’s as a result of changes in market interest rates. The former version, known as Macauley Duration, finds the present value of the bonds future coupon payments and maturity value. The latter version, also known as modified duration, measures the expected change in a bond’s price to a 1% change in interest rates.

Now this latter point is increasingly important in a low interest rate environment. Whilst many believe that bonds are low risk assets, that offer little chance of negative returns or capital losses, movements in prevailing interest rates, or even the perceived credit risks of companies, can see the value of a bond reduce substantially. This is particularly important in increasing interest rate environments, and reflects the fact that higher returns would be available on newly issued bonds, meaning older bonds, issued at lower rates, must reduce in value to reflect the different circumstance.

Investors should be aware that the longer the duration is, the more sensitive the bond will be to changes in interest rates. If the yield to maturity of a bond rises, the value of a bond with 20 years left will fall substantially more than one with 5 years left.

Applying this to bond indices and managed funds, it’s important to understand that a long duration bond strategy is typically expecting interest rates to fall from their current levels and betting on this through higher duration. On the other hand, a short duration strategy is typically associated with investors expecting rates to increase and are therefore seeking to reduce their exposure with a view to rolling their positions at higher rates in the near future.

As a comparison, the PIMCO ESG Bond Fund carries a duration of 6.94 years, wheras the Vanguard Global Aggregate Bond Fund carries a duration of 7.1 years.

Downside Risk

– Alex Pollak from Loftus Peak –

Wattle Partners meets hundreds of investment managers each year as we undertake due diligence and seek opportunities for our clients. There are varying levels of quality and insight but occasionally we come across those who can answer our questions and back this up with appropriate data and analysis. We recently met Loftus Peak, as specialist international manager based out of Sydney, who have been delivering exceptional returns through their Global Change Portfolio for many years. We asked them to put forward an article regarding the downside risk in portfolios and pleased to republish this for our readers.

Loftus Peak on Downside

We are often asked how the portfolio would perform in a downturn. We have had several smaller corrections in the five years since our inception, with the largest downturn in the December quarter of 2018. CNN noted at the time “The Dow fell 5.6%. The S&P 500 was down 6.2% and the Nasdaq fell 4%. December was a particularly dreadful month: The S&P 500 was down 9% and the Dow was down 8.7% — the worst December since 1931. In one seven-day stretch, the Dow fell by 350 points or more six times. This year’s Christmas Eve was the worst ever for the index.”

Since inception, we have generated solid returns based on a multi-year time frame. We believe the key to investor protection from broad market declines is delivered by our stock selection and portfolio construction process. Our process is inherently biased towards large market capitalisation quality companies which are expected to survive downturns due to strategic business positioning in secular growth trends and have strong balance sheets.

We run a  large capitalisation concentrated portfolio and hence are much less exposed to the long tail of smaller companies. It may well be that individual returns from selected small capitalisation companies can do very well, but in our view a bias to the large capitalisation disruptors with solid cash flows and the ability to move into other adjacent businesses (eg Apple into music and TV) makes for a lower risk portfolio. Focusing on large capitalisation names has meant the portfolio’s median market capitalisation is currently US$81 billion, which has the added benefit of high liquidity and the ability to quickly move into cash where necessary.

Loftus Peak’s valuation methodology is based on the bedrock that the value of a share is the discounted value of its future cashflows. This approach was successfully refined over a decade at Loftus Peak’s predecessor firm TechInvest, where similarly consistent outperformance to that of Loftus Peak was achieved. (It is worth noting that key members of the Techinvest team continue to implement this investment approach under the Loftus Peak banner). The focus of our valuation model is on understanding the potential addressable market size of the companies in 2-5 years from now and the resulting margin profile.

These filters are part of the process to screen out companies which may be disruptors, but do not work as investments because of price.
A simple case in point is Uber. There is little doubt that the company is up-ending the taxi industry, with a global disruption model which will ultimately replace the traditional transport model (taxis, hire cars etc). We avoided this company on listing, and thereafter, and continue to do so, for the simple reason that the numbers don’t really work. First, and most important, the losses from the group are not being reduced, but are widening, as the model (actuals to 2018, our estimates in 2019) below shows:

Uber: Not so much

Source: Company filings, 2019 Loftus Peak estimates

Forecast revenue in 2019 of US$13.9b (which itself is up 23%) is expected to yield only a 15% increase in gross profit; this is major red flag since the business reveals weak leverage (meaning that the amount of gross profit goes up by less than the increase in sales). This is exacerbated all the way down through the expense line items, such that the bottom line shows the operating loss (essentially pre-interest and tax earnings) tripling to -US$9b. Operating cashflows are similarly weak.

This would not automatically exclude the company from Loftus Peak portfolios. For example, if in coming years these losses lessened sufficiently – so that it achieved profitability fast enough – this would drive an increase in value in the company which would show in the multi-year discounted cash flows, and so share price. Here it becomes a matter of judgement on the business itself. We know Lyft (and Grab, and Chinese player Didi, and Ola) are all competing with Uber – so there is likely to be increased competition. This implies that losses will not be narrowing enough any time soon, and indeed that revenue growth may even slow. The way we believe the numbers will evolve means that the company does not easily fit into our portfolio – so it is disruptive, but the valuation doesn’t stack up. Netflix is a company that did make it into the portfolio, yet it often gets bad press for its results. We believe the company isn’t that well understood – it has been profitable for five years now, as the table below shows (again, all numbers are actuals except 2019)

Netflix: It works

Source: Company filings, 2019 Loftus Peak estimates

The questions which have been raised are around the company’s ongoing debt increases, which are necessary as it rolls out new content faster than its revenue grows. This amounts to an US$18b liability over the next four years (aside from that which it expenses annually against revenue) shown as a contingent liability. The company’s debt stands at around US$16b (after the additional US$2b it announced in October).

But as the table above shows, the company is on track to double its pre-tax income this year, having tripled it the year before. At this rate, the company is on track to generate more than US$30b in free cashflow within our forecast horizon. Revenue is still growing at around close to 30%.

We are not concerned about the competition from Disney+ and HBO/Warner, since the real prize is to capture time spent presently viewing linear television (whether cable or free to air, eg in Australia Foxtel or Seven/Nine/Ten). This market is yet to fall to streaming (though it is well in hand). To put numbers around this, there are more than 1.5b+ billion households around the world receiving cable or free to air TV signals, which over the next ten years could probably stream (as broadband capacity grows.) Netflix is in 150 million of those households; it’s a true growth business. Disney+ and HBO/Warner acknowledge this – they are walking away from their cable TV models towards their own Netflix-like streaming product, and sacrificing tens of billions of dollars of revenue in the process. Forget the theme parks, the real white-knuckle ride will be the one the shareholders of those two companies are on.

Meanwhile, the number one contributor to return in Loftus Peak portfolios over the past five years, Amazon, was chosen because it made the cut on both these screens. We bought the company in 2014 not for its retail business, but for its emerging place as the number one cloud provider in the world.

As we noted to clients in February 2015, when the Amazon price was around US$300/share: “The market bid up Amazon 20% on the decision to break out the numbers behind Amazon Web Services (AWS) its cloud-based web hosting business. AWS formed a major part of the 40% revenue increase in the “other revenue” line in the 10k filing, which was US$1.74b in the quarter. The market thought AWS was worth $28b (US$60/share). The 20% jump in the share price looks like the market digesting the news – AWS is already a very significant player with corporate clients like Netflix, Mashable etc.” We had done the work well before this and invested accordingly, because we had seen AWS business growth in the market and the impact this would have on valuation of the company.

Lastly, a note about the index managers. Irrespective of whether Uber makes it as an investment, if it finds inclusion in an index then the index players will likely hold it. It’s not that the managers themselves don’t understand how businesses work, just that the business model of index funds is to hold the index – whatever its composition. We take a much more nuanced approach. Our multi-year DCF approach, which involves thorough internal debate on the assumptions around revenue, market size and profitability, coupled with our portfolio construction methodology is the edge that helps us protect the portfolios we manage from market downturns.



Ideas from the Sohn

As highlighted in the introduction to this report, the Sohn Hearts & Minds conference was held in Sydney during November. One of the highlights, outside of the substantial funds raised for Australian Medical Research, is the stock tips provided by Australia’s brightest fund managers. In fact, most managers sponsor the conference to the tune of $50,000 to $100,000 solely to have their few minutes on stage. This year’s top picks were as follows:

  • Airlie Funds – Mineral Resources – MIN has iron ore and lithium operations rated as some of the best in the world but struggled in recent years. Airlie are betting on their mining services to continue delivering and an improvement in lithium prices to justify restarting the Wodgina project.


  • Cota Capital – Smartsheet – SMAR is a cloud based platform used by 90% of the US’ largest 100 companies to assist in planning, capturing, managing, and reporting on work across business units and offices.


  • Tribeca Capital – A2 Milk – The firm remains committed to the growth story of A2 Milk and its reliance on the Chinese middle class to continue to stoke demand in an increasing flooded market.


  • Regal Funds – Nickel Mines – NIC is a major producer of nickel pig iron based in Indonesia. It has performed poorly in recent times but the team at Regal expect infrastructure spending to see demand for stainless steel benefiting the company.


  • Munro Partners – The Trade Desk – One of Wattle’s favourites, Munro, nominated TTD which is disrupting the way media and ads are bought and sold by business. They expect the company to benefit from the streaming wars due to their ability to target ads to different people watching the same program.


  • Montaka – Floor & Décor – Montaka have chosen a more defensive business, FND, which is a US based flooring retailer expected to benefit from full employment and a stronger housing market. The company is delivering same store sales growth of 15% per year.


  • Cooper Investors – Fortive – FTV was a spin off from industrial company Danaher and is now a technology company seeking to detect leaks in infectious healthcare situations as well as being a manufacturer of electric vehicle charging stations.

Strategy updates

A number of unexpected regulatory announcements were made during the year.

Trust Stuffing        

The loop hole that allowed some families to ‘stuff their trusts’ was removed following the Federal Budget. The loop hole was allowing people to transfer additional and personally owned assets into a testamentary trust and benefit from the lower marginal tax rates this provides to minors.

Testamentary trusts, as the name suggests, are created out of the will of a deceased estate, and are able to hold the assets of the will on behalf of the beneficiaries. They provide substantial benefits in that minor children who are beneficiaries are assessed under adult marginal tax rates, rather than punitive child rates. The change in legislation removes the ability for families to transfer their own assets into the trust and benefit from these lower tax rates. Whilst it was available, the strategy was barely used in our experience.


The Australian Securities and Investment Commission released a White Paper suggesting investors think twice about starting an SMSF and suggesting a minimum balance of at least $500,000 was required. This was met by substantial blowback from accounting and advice experts alike, with the SMSF Association in particular questioning their calculations. In our experience, the cost of maintaining SMSF’s are only falling with tax return and audit available for as little as $1,500 per year. Thus far the union fund sector remains immune from the impost of higher regulation, at a time when their power and potential conflicts only continue to grow.

Who is Softbank?

The name Softbank has become synonymous with modern day technology companies, but who are they? Softbank was founded in 1981 by Masayoshi Son. In 2019, it sits as the 36th largest listed company in the world, larger than both Intel and Johnson & Johnson. As always, the company has somewhat humble beginnings, retailing computer parts in Japan before becoming a publisher. Eventually, the company became a dominant internet services and communications company after purchasing Vodafone Japan and Yahoo! Japan in the 2000’s.

The success of these acquisitions saw the renowned Masayoshi Son move front strength to strength and specialise in investments in high growth technology companies. Softbank was one of the earliest investors in Jack Ma’s Alibaba and retains a 29% shareholding today. They also have investments in US mobile provider, Sprint, ARM Holdings a British semi-conductor manufacturer and Chinese insurer Ping An. More recently though, Softbank has become a fund manager of sorts, raising two rounds of $100bn for their ‘Vision Fund’.

The Soft Bank Vision Fund 1 and 2, both seek to invest into venture capital investments on behalf of Softbank and external investors. One particularly dominant external investor is Saudi Arabia, as it seeks to diversify its fossil fuel reliant on economy. The fund aims to access venture capital and private equity on behalf of its diverse pool of Government and Investment Bank clients with a particular focus on artificial intelligence, robotics, data, financial technology and communications infrastructure.

Some of the most high profile investments made thus far include all three ride share services, Uber, Didi and Ola, as well as corporate technology Slack and Australian founded real estate ‘tech’ platform Compass. As we know, most of these companies are growing quickly but struggling to move towards profitability in an incredibly competitive market. Whilst the headlines are increasingly negative it is far too early to decide whether Softbank’s foray into being a VC fund manager is a success or failure at the  current time.

What happened to We Work?

In a world where accessing capital is as easy as it has ever been, it is those companies able to harness investors obsession with growth that demand the highest valuations. Increasingly, traditional companies like manufacturers, are seeking to affiliate themselves with technology buzzwords like big data, artificial intelligence and the internet of things. Yet, recent months have shown that astute investors are either tiring of high growth companies or have are more closely questioning their lofty growth predictions. We Work isn’t alone, but it’s a company worth taking a closer look at in light of last month’s events.

Moreover, an analysis of We Work wouldn’t be complete without introducing Softbank, one of the key backers of technology companies around the world.

What does We Work do?

We Work has a simple business model. They enter leases for entire buildings or floors in sought after areas of major global cities, refit or renovate these spaces and then seek to less them out to many smaller companies, entrepreneurs and creative types.

Their offering includes private offices and common meeting spaces, but the group generally owns no assets outside of the modern fit outs they deliver. So the business model is simple, rent spaces, create cool offices then sub lease these at a profit. The last part of this model being the hard part, as We Work haemorrhaged $220k per hour in 2018. In fact, the companies losses of $1.9bn exceeding their increasing revenue of $1.8bn, hence the need for constant capital injections.

The company was not unlike any other ‘technology’ company, albeit technology seemed to play only a small role. They were seeking to growth their scale sufficiently enough to eventually eek out strong profits in various ways with accounting and financial services two of these. The company attracts tenants out of home and cafes by offering printing services, free refreshments, coffee, office cleaning and hosting networking events in an effort to bring people together.  This all makes sense in an increasingly casualised employment sector but in our eyes, it is very simply a property leasing company.

The company is not unlike ServCorp who provide serviced offices, with the difference being ServCorp tends to lease existing office buildings, provide secretarial services and charges higher prices to do so. In our view, the We Work model may be fundamentally flawed. As the type of tenants that typically inhabit these spaces work for themselves, or are involved in venture capital companies, the majority of which are likely to fail.

Consider for instance the sector of financial advice. Financial advisers are dealing with sensitive information, both financial and emotional, on a daily basis. They must also securely store confidential client information behind several layers of protection. Whilst the private offices offered by We Work may be suitable for the former requirement, most would find it difficult to meet the secondary option. That is without considering the security of a shared internet connection.

Taking this a step further, the We Work approach typically does not attract the highest quality tenants; they attract those seeking to keep costs low and unwilling to commit to longer term leases. The very nature of these businesses is that if their business is under pressure they can simply walk away, flexibility not afforded to those leasing their own premises or employing staff.

So what went wrong?

Put simply, investors and fund managers saw through the technology haze. Upon receiving the prospectus for We Work, it was obvious to many investors that the company was still some way from profitability and required many things to go right in order for this to be achieve. In our experience, the technology sector is great at one thing, capturing the emotion of investors and employees alike, who see through their issues and only have eyes for the future.

In a time where passive or index management is dominating active decision makers, We Work reiterated their important role in the market. Active managers effectively decide whether companies like We Work and Latitude Financial become listed companies. It is these active managers that provide the capital that allows these new companies to list on stock exchanges and if it isn’t forthcoming, than the listing doesn’t happen. In comparison, a passive investor will buy any investment that enters their relevant index.

The company was seeking to list at a valuation of $48bn, but according to reports had some $49bn in rent payable in the coming months and insufficient cash to fund their operations for the next 12 months. Business Insider reported that We Work’s high profile CEO had actually trademarked the term ‘We’ and sold it to his company for close to $6m; red flags should no doubt have been seen then. Yet the business continued and eventually required a $9.5bn buyout from its majority shareholder Softbank. This saw the value of the company fall from close to $50bn to just $9.5bn in just a few hours.

After agreeing to the deal, Softbank paid some $1bn to the outgoing CEO and announced a ‘right-sizing’ of the business model. In plain English, right sizing means the company and management made poor decisions with shareholders capital that now need to be rectified. In We Work’s case, they appear to have taken on too many new offices and were having trouble leasing these out profitably. If this is the case in what is a generally supportive economic environment, it’s worrying what impact a recession would have on their business model.

As part of this right sizing, the new board axe 4,000 staff or 30% of the global workforce, and offered to buy back shares issued to employees based on an $8bn valuation for the company; most of these shares were issued at substantially higher levels.

As union funds and individual investors alike increase their allocation to high risk private equity and venture capital investments like We Work, many are questioning the longevity of this strategy. Most of these business will inevitably fail, it is simply par for course for this sector, so the question must be is now a good time to be increasing allocations?