Aoris International Fund

Aoris is a specialist global share manager founded in 2017 by Stephen Arnold. Stephen previously managed the Evans & Partners Global Equity Strategy from 2011 to 2017, delivering a return of 18.3% per annum with over $1bn in assets under management. Stephen founded Aoris in an effort to bring his successful investment strategy to a broader group of investors.

What’s the fund?

This month we are reviewing the Aoris International Fund, which is a long-only global equity strategy. Aoris are unique in that they have a high conviction approach, holding just 10 to 15 companies and provide transparency into every investment at all times. Aoris have identified that avoiding the companies that fall into the bottom 20% of the market in any given year is the closest thing to guaranteeing outperformance. They understand that the poorest performers typically suffer from high debt levels, inflated valuations and poor returns on investment capital, which are key considerations of the team.

Why Aoris?

Aoris’ differentiating point is simplicity, and a focus on finding high quality companies. The research team achieves this by excluding a number of more popular sectors from the universe of opportunities. For example, Aoris will not invest in businesses with high leverage (financials/banks), low return on invested capital (energy), cyclical revenue (mining), regulated income (utilities), opaque (healthcare), narrow product offerings (IT) or commoditized products (retail). The result is that Aoris portfolio is tilted towards service providers and traditional industrial or diversified companies that are more suited to negotiating difficult economic periods. The result is a portfolio of high quality companies, operating in diverse industries offering true diversification.

Where does it fit in your portfolio?

Aoris meets the objective of the Value Bucket as the fund seeks to generate a return of between 8-12% per annum, with just 1-2% coming from dividends. This objective return is achieved by targeting companies offering 6-7% annual growth in their intrinsic value, or more importantly their profitability, 1-2% from dividends and 2-3% from market revaluations. More simply, the fund focuses on buying businesses that are growing earnings and revenue, not one or the other, and which have both breadth and diversification of those revenue streams, removing any cyclicality.

Why Invest?

Aoris exhibits two of the most important characteristics of successful active fund managers; low portfolio turnover and high active share. Low turnover is driven by their core, high conviction portfolio whilst active share relates to the fact that the underlying portfolio differs substantially from the benchmark index. The Aoris Fund will complement the alternative global funds in most portfolios due to the substantial difference in underlying investments. The fund will not hold the likes of Facebook, Amazon, or the major banks, due to their strict screening process, meaning there will be limited, if any, overlap with the other funds in your portfolio. The management team have shown a unique and repeatable ability to identify companies with economic and competitive resilience, even during the worst of times, and their focus on return on invested capital, continues to be a driver of real value in an increasingly expensive market.

The fund charges a competitive management fee of 1.1% plus a performance fee of 15%. We have successfully negotiated a discount to this fee on behalf of all clients of Wattle Partners.

What does it invest in?

Aoris will only buy and hold individual companies, they will not bet on companies falling in value. The portfolio is highly concentrated, at 10-15 holdings, meaning every investment will have a real impact on the performance of the portfolio. At present, the key holdings are spread across the globe, but with 51% of revenue coming from the US, 23% from Europe and 17% from Asia. These holdings include global luxury business Louis Vuitton Moet Hennessy (LVMH), make-up and skincare retailer Loreal, consumer credit reporting company Experian, consulting business Accenture and sportswear brand Nike.

How has it performed?

The fund is a long only strategy, meaning The fund delivered a return of 18.7% for the 12 months to August 2019, outperforming the MSCI benchmark which returned just 7.0%. Importantly, the fund has not had a single holding in the bottom 20% of the market since its inception.

Listed Investment Companies

One of the topics gaining the most attention in December and over the Christmas break was the proliferation of listed investment companies that have emerged in recent years. The sector has doubled in size following its exemption from the Future of Financial Advice Reforms, as they allowed fund managers to pay advisers, stockbrokers and accountants ‘stamping fees’ of up to 6% of the amount invested by their clients. Sounds very similar to the likes of Great Southern and Timbercorp doesn’t it.

As we have seen in history, whenever there is a loophole available, it will be leveraged by interested parties. The sector attracted attention after Chris Joye from Coolabah Capital provided an in-depth analysis (below) whilst news was released about Treasurer Frydenberg’s briefing on the subject in 2019. Interestingly, little has been done about the issue and ASIC is essentially powerless from protecting investors from being ripped off due to the loop hole. What follows is Chris Joye’s most recent column on the sector and recent changes.

A revolution is coming for conflicted financial advisers – Coolabah Capital

In one of the biggest shake-ups of the financial advice industry in years, the government’s Financial Adviser Standards and Ethics Authority has blanket-banned conflicted sales commissions, including previously acceptable “stamping fees”, for advisers recommending listed investment funds to both retail and wholesale clients. These conflicted payments were already banned under the 2012 Future of Financial Advice (FOFA) laws, which reshaped the financial planning market by ensuring advisers were only ever paid by their clients and not by product manufacturers, like fund managers, trying to motivate them to sell their wares to retail and wholesale customers.

The presence of sales commissions paid to advisers created endless mis-selling crises where inappropriate products were foisted on consumers in the name of capturing the associated fees, which FOFA brought to an end. The 2019 royal commission firmly reinforced FOFA’s intent by concluding that “there must be recognition that conflicts of interest and conflicts between duty and interest should be eliminated rather than managed”. Yet in 2014 the Coalition granted listed investment companies (LICs) and listed investment trusts (LITs) an exemption from FOFA.

In contrast to normal unlisted managed funds and exchange traded funds, this meant that a fundie launching an LIC or LIT could pay unlimited sales commissions to retail advisers promoting these products. This has unsurprisingly led to an explosion in fund managers raising tens of billions of dollars from mums and dads for complex hedge funds and junk bond funds by paying advisers enormous upfront sales commissions of between 1 per cent and 3 per cent of the money they source from their clients.

Under FASEA’s new Code of Ethics, which becomes legally binding on all Australian advisers from January 1, 2020, this will no longer be possible. Advisers are already talking about how the code will eliminate the gargantuan sales commissions paid by LICs and LITs and force them to compete purely on their merits like all normal investment products that have been bound by the FOFA laws.

FASEA’s code will also apply to many stockbrokers who these days are more often than not required to be RG146 qualified as a retail adviser.

Magellan presciently anticipated this development by recently raising $860 million for an LIT that paid no commissions to brokers and advisers.

Standard 3 of the code says an adviser “must not advise, refer or act in any other manner where you have a conflict of interest or duty”. It then provides specific case studies under a guidance note of what represents an illegal breach.

One example involves an adviser’s firm taking “advantage of the carve out from the conflicted remuneration provisions introduced by the FOFA reforms” for stockbroking fees. It then says that where an adviser recommends a product to earn extra stockbroking commissions, they breach the standard and cannot do so.

Another case study deals explicitly with the stamping fees advisers capture from IPOs of LICs and LITs. The guidance states that an adviser “keeping the stamping fee rather than…rebating it [is] unfair to [the adviser’s] clients”. “The option to keep the stamping fee creates a conflict between [the adviser’s] interest in receiving the fee and his client’s interests. Standard 3 requires [the adviser] to avoid the conflict of interest. It is not sufficient for him to decline the benefit as it may be retained by his principal. Either the firm must decline the stamping fee altogether, or [the adviser] must rebate it in full to his clients.”

The ban on stamping fees for LICs and LITs for all advisers is therefore black and white. Some advisers have speculated that FASEA’s code might only apply to retail, not wholesale, clients, thereby allowing them to still capture conflicted sales commissions when recommending products to wholesale customers. This column has confirmed that all registered advisers must comply with the code’s standards irrespective of whether they deal with wholesale or retail customers.

This means FASEA’s code extends well beyond FOFA’s reach, which only protects retail investors.

Under the Corporations Act, an individual can be classified as a wholesale client if the adviser can obtain an accountant’s certificate showing they have net assets of at least $2.5 million, or a gross income for each of the past two financial years of at least $250,000. The problem is that many individuals who earn more than $250,000 a year, or have a home worth $2.5 million, know absolutely nothing about finance, investing or markets. This includes scores of retirees who have seen their homes appreciate beyond $2.5 million.

Since roughly 80 per cent of all LICs and LITs are trading below their net tangible assets, with many inflicting large 10 per cent to 20 per cent losses on clients who bought them in the original IPO, advisers open themselves up to catastrophic compensation claims for losses incurred by any clients other than the most sophisticated institutional-style investors.

It would be straightforward for many normal wholesale clients to argue that they do not fully understand hedge funds or leveraged junk bond funds, and relied on their adviser’s recommendation with or without a formal statement of advice.

It would also be easy for them to make the case that the adviser’s recommendation was being influenced by the large conflicted sales commission they received for pushing the product.

Here the guidance note explains that a key legal test is whether “a disinterested person, in possession of all the facts, might reasonably conclude that the form of variable income (eg, brokerage fees, asset-based fees or commissions) could induce an adviser to act in a manner inconsistent with the best interests of the client or the other provisions of the code”.

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.

 

 

Magellan Infrastructure Fund

What’s the fund?

This month we decided to provide an update on Magellan’s Infrastructure Fund, which was added to the Thematic Bucket several years ago to gain an exposure to falling interest rates and the high quality cash flows associated with monopolistic infrastructure assets.

Why Magellan?

Magellan was formed in Australia in 2006, by Hamish Douglass and has grown to manage over $76bn in assets for institutional and retail investors around the world. The Magellan team have been focusing on infrastructure investing since 2007 when this fund was launched, which has allowed them to build a competitive advantage through networks, deal flow, proprietary data and in-house modelling. The fund has grown from $0 to $1.7bn in 2019 through strong performances (16.6% p.a. over 10 years) and the guidance of the Portfolio Manager Gerald Stack. Magellan differentiates its approach to most competitors in the sector by limiting the investment universe to those infrastructure assets that are essential to the efficient functioning of a community and not sensitive to competition. They understand that investors are seeking the CPI + 5.0% returns that come from monopoly-like assets, not the volatility that comes with cyclical businesses. Therefore they avoid companies subject to political and sovereign risk, whose income is impacted by commodity prices or which require excessive population and usage growth to justify their valuations.

Where does it fit in your portfolio?

The assets owned by Magellan are unique and can never be replicated or disrupted with one such example being a network of 40,000 telecommunication towers that are now relied upon to deliver data by all businesses and consumers in their daily lives. This means they will become increasingly important as the global population grows and put the owners in the position to benefit from increased spending and demand. The infrastructure sector benefitted from falling bond rates around the world, which inflated valuations, with many investors now concerned about the prospect of increasing rates. The weaker economic outlook for 2019 and 2020 has shown that bond rates may not increase as quickly as expected, increasing the value of the regulated income streams of true infrastructure assets. Very few asset classes offer a true inflation hedge, with infrastructure, particularly listed, one of the only investments that has delivered in the past through its combination of consistent demand and regulated income. Importantly, it is those assets that provide this type of hedge that Magellan focus on identifying.

Why Invest?

It is important to own assets and companies that are difficult to replicate, and which provide the most secure income streams possible to investors. Investing in infrastructure assets, including evolving electricity grids, cleaner energy sources, telecommunications and other utilities offer investors an opportunity to be part of the foundations on which the future global economy will be built. Whilst interest rates will remain important for valuations they are far less important for listed infrastructure assets than unlisted ones like those owned by industry super funds. This is because listed infrastructure assets are revalued daily by the market, whilst unlisted assets can be valued as rarely as every 1 to 3 years providing the illusion of security. This affords the ability to both profit from mis-pricings that regularly occur as well as achieve more diversification than the substantial size of unlisted assets allows. The underlying exposures can also be changed quickly should one particular asset or sector become more or less attractive. We believe the consistent and regulated income streams of true infrastructure assets, have an increasingly important role for Australian investors.

What does it invest in?

The Global Infrastructure Fund invests only into world-class listed infrastructure companies, with a preference for those who deliver reliable and predictable earnings, from consistent demand. This means they avoid businesses relying on such inputs as energy prices, population growth etc. to generate higher returns. Most of Magellan’s underlying investments have utilised historically low interest rates to extend their debt facilities (as far as 10 years) at incredibly low levels, reducing the risk of increasing bond rates, whilst the key focus of management has been to purchase only regulated assets that have the ability to demand higher compensation should inflation increase and focus on those that are integral to daily life.

At present, the fund is well diversified with 37% invested in the US, 21% in Asia and 26% in Europe. The largest allocations are to Airports (19%) and Toll Roads (14%) considered the kings of infrastructure assets, with Gas Utilities (13%), Integrated Power (16%) and Energy Infrastructure (10%) the next largest. Each asset is an industry and regional leader including Aena Airports in Spain, which manages 46 airports in Spain and 17 globally including London Luton, Aeroports De Paris, Crown Castle in the US, which owns 40,000 mobile phone towers including 5G, and Transurban the monopolistic toll road provider in Australia. Other key holdings include:

 

INSERT PICTURE

 

How has it performed?

The fund has performed strongly since inception, adding 9.1% per annum, compared to the Infrastructure Index which delivered 6.2%. More recently, it has returned 14.5% over the last 10 years and 22.1% over the last 12 months, both above benchmark. This has been driven by a number of factors, including falling bond rates, but most importantly the recovering global economy since the end of the GFC and the lack of appropriate infrastructure spending around the world.

What income does it provide?

The Magellan Fund is no different to other managed funds, in that it only distributes income when it makes a profit, whether this is source from income, capital gains or a combination of both. That being said, the consistent income produces by the underlying assets means the fund has been a strong source of income since inception including:

  • 2019 – 3.80 cents (3.01%)
  • 2018 – 5.36 cents (4.35%)
  • 2017 – 11.27 cents (9.09%
  • 2016 -9.29 cents (8.21%)

It’s important to note that as with all managed funds, investors should expect the unit price to remain flat over time, or slowing increasing with performance, and to fall around December and June when distributions of cash are made, not unlike when a company becomes ex-dividend.

Nanuk New World Fund + Lunch

What’s the fund?

This month we are taking a closer look at the Nanuk New World Fund. Nanuk is one of the only Australian fund managers dedicated solely to identifying investment opportunities and risk associated with environmental sustainability and resource use.

Nanuk Investment Management was established in 2009 The investment team have extensive experience across global equity markets and is led by Tom King OAM, who is an engineer by trade and spent several years working as an investment adviser to the Packer family. Paul Chadwick, who was most recently head of Global Macro strategies at GMP Australia. Paul is supported by Tim Ryan, who founded Orion Asset Management and has over 36 years’ experience, as well as Eric Siegloff, who was deputy CIO of ING’s European multi-asset investment management division. Nanuk has offices in Sydney, London and New York and offers three wholesale funds to investors seeking sustainable, environmentally focused investment strategies.

Why Nanuk?

Nanuk is one of the only Australian fund managers dedicated solely to identifying investment opportunities and risks associated with environmental sustainability and resource use. The team is dedicated to becoming world leaders in the space and is one of just a few groups globally who have the experience and capability to deliver returns and meet their self-directed mandate. The investment process is focused around remaining active and aware of the changing nature of the environment and the impact that businesses can have on it, with a fundamental value driven approach to identifying investment opportunities. Nanuk believes that resource constraints and environmental challenges like climate change, pollution and water scarcity necessitate significant changes to business practices globally and that these changes will present significant long-term investment opportunities and risks.

Where does it fit in your portfolio?

The fund meets the requirements of the Thematic Bucket as its sole purpose is to invest in listed companies around the world that are associated with the broad theme of environmental sustainability. More specifically, they seek to invest in companies involved with clean energy, energy efficiency, industrial and manufacturing efficiency, waste management, pollution control, food and agriculture, advanced and sustainable materials, water, healthcare and technology. There is growing expectation that businesses in both the developed and developing world will commit to having a more positive impact on the environment and community they work within and Nanuk is a first-mover in this sector.

Why invest?

The New World Fund is one of the only truly global managers in Australian that focus solely on investing into sustainable, environmentally and ethically aware businesses. Recent performance has shown that it is those companies focused on investing sustainably that generate the greatest returns over the long term. Whilst the team is small, they leverage off extensive relationships and broker networks to obtain research and insights into the investment universe. The fund applies both negative and positive screens to the identification of its investment universe which includes around 1,600 ‘sin stocks’ that are involved in oil, gas, coal and similar industries. The fund will invest into around 60-70 stocks at any given time which are selected using a fundamental approach based on a combination of basic valuations with a macro/thematic overlay which considers the growth opportunities in the various sectors. The fund has grown to $200m under management and continues to attract additional capital from both institutions and retail investors as the importance and value of new technologies and energy efficiency seemingly grows by the day. The fund is long-only, it cannot short companies, which means it will be volatile and an investment term of at least five years will be required. The fund offers daily liquidity, charges a management fee of 1.2% and is only available to wholesale investors.

What does it invest in?

 We have provided more detailed information in the section that follows, but summarise the current allocation of the fund as follows:

 

How has it performed?

The short-term performance has been exceptional, with the fund delivering 28.8% for the 9 months to 30 September 2019. This exceeded both the MSCI World Index, 21.3% and the FTSE Environmental Index, +24.8%. Longer term returns are also strong, with the fund averaging a return of 17.6% per annum over the last three years and 14.6% since inception, both ahead of all benchmarks. The strategy has benefitted from the increasing efficiencies available to businesses investing into more sustainable technologies and the increasing direction of capital towards these companies in the face of global climate action.

We were lucky enough to be joined by the Chief Investment Officer, or Portfolio Manager of the Nanuk New World Fund, Mr Tom King, at our latest client round table. Rather than focus on the funds recent performance, which has been exceptional, Tom put forward his views on the outlook for both the global economy and the sustainability revolution that is the core of his investment approach.

The presentation began with Tom drawing attention to the likes of Apple, who had reported overnight, and the fact that the first smart phone was created just 12 years ago. He noted very few, if any people, could predict how important and ubiquitous the smart phone would become in our daily lives. It was this underestimation of the acceptance of new technologies that Nanuk is seeking to identify but in relation to the sustainability of our very way of life.

The presentation opened with a fairly straightforward summary of those areas where the sustainability revolution was likely to impact the economy the most:

  • The transition to clean energy;
  • Improving industrial efficiency;
  • The production of food;
  • Healthcare technology and treatment;
  • Energy efficiency;
  • The use of scarce water resources;
  • Recycling of waste and pollution control; and
  • Advanced and more sustainable materials.

Without going into extensive detail, rather we direct you to the slides available https://sponge-capybera-dlkm.squarespace.com/s/SEMINAR-Second-Wave-Oct-2019.pdf, we highlight a number of particularly pertinent points that were made during the presentation.

  • At a time when many are suggesting the oil sector is heading for a renaissance and that the adoption of electric vehicles (EV) was overstated, Tom explained Daimler’s recent decision to stop development of all internal combustion engines. Tom suggested that by the mid 2020’s there will be more EV than internal combustion cars on the roads around the world.
  • Whilst explaining the evolving cost curve of energy production in Australia and around the world, he highlighted that under nearly all conditions, nuclear power is and will remain too expensive to power our economy. In fact, most renewable energies were actually cheaper than running existing coal and gas fired stations, as shown in the table below. This included the cost of the associated battery storage required to support renewable sources.

The questions naturally moved towards the value of pumped hydro power, like Snowy 2.0, however, it was clear from the discussion that firstly, it is an expensive way to produce power with large amounts of loss, and secondly, there were very few unused sites available to build similar projects.

The discussion moved towards the importance of action being taken on CO2 emissions, with some interesting facts including that the global herd of cattle emits as much greenhouse gas pollution each year than the US as a country. More importantly though, he estimated that the time taken from the point of adoption of pollution targets to the point of no return for technology, has been around 10-20 years in history.

A table discussion began around why Australia had not been successful in establishing our own manufacturing facilities for the production of batteries at a global scale, with many believing we should be getting started now. Tom put it down to the lack of an integrated vertical supply chain compared to the likes of China and the comparatively expensive cost of labor and energy which are the two key inputs.

Tom provided some analysis around the history of technology improvements and highlighted that the forecasts of the production cost reduction of most technology, including renewables, was excessively conservative. For instance, forecast cost reductions for lithium batteries in 2030 were actually hit in 2017, 13 years ahead of schedule. Solar was subjective to a similarly conservative expectation of adoption:

In moving towards his darker outlook for the future, he outlined the key contributors to greenhouse gas emissions from the UN, which were as follows:

Tom noted that these technologies generally formed part of the first wave of sustainability and were the so-called low hanging fruit, like solar energy and electric vehicle adoption. He outlined his 8 themes of the second wave as follows:

  • Electricity – transition to renewables and storage;
  • Electrification of transport
  • Fossil fuel to electricity by hydrogen capture and feedstock changes
  • Production changes in agricultural, diet changes and waste reduction
  • Improving the energy efficiency of buildings
  • Improving waste reduction and recycling
  • Many small changes to water efficiency.

 

  • The likely winners of these many transitions were:
  • Solar, wind and energy storage
  • Smart energy grid technologies based around demand response
  • Electrification of heat
  • Hydrogen (power to gas)
  • Sustainable materials
  • Recycling
  • Controlled environmental agriculture
  • Plant based protein
  • Waste management and processing
  • Electric vehicles including buses
  • Rail transport
  • Big data and AI
  • Advanced manufacturing

 

  • And the likely losers:
  • Fossil fuels including oil, coal and natural gas
  • Centralized electricity grids
  • Petrochemicals and plastics
  • Traditional ‘Portland’ cement
  • Blast furnace steel production
  • Air transport
  • Crop based biofuels
  • Agricultural chemicals
  • Beef/lamb

Tom brought the discussion back towards his conclusion, that the sustainability revolution was inevitable. He noted that the election result in Australia was not based on climate policy, but various other matters and highlighted that some 85% of Labor voters wanted action on climate change but just 16% of Coalition voters. Looking more closely, the trend is being driven by millennials and young people, meaning every election will see more voting for action. Tom suggested that the approach taken by the French Government in recent trade negotiations, effectively forcing their trade partners to undertake similar action on the climate if they wish to benefit from the French economy.

Finally, the presentation was concluded through a discussion of many of the underlying investments but with an important precursor. This was that the Nanuk fund was not established to bet on unknown technologies with shareholder capital but to back proven technologies as they become ubiquitous in our lives. He noted that solar panel shares are on average down 90% over the last 10 years, even as solar panel installation has reached mass levels.

As we have highlighted on several occasions, the Nanuk strategy is an example of how businesses around the world get on with the task of tackling major issues, solely because it is in their best interest.

A closer look…..

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

Who is Neuberger?

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

What is the fund?

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

What does it invest in?

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

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

What are the risks?

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

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

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

Our View

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

PIMCO Global Bond Fund

What’s the fund?

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

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

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

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

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

Where does it fit in your portfolio?

The Global Bond fund is a diverse, actively managed portfolio of global fixed income securities. The fund’s benchmark is the Bloomberg Barclay’s Global Aggregate Index which seeks to measure the returns of a diversified pool of bond issues by companies around the globe. The fund meets the requirements of the Capital Stable Bucket, being to generate a return of CPI+3% per year and ensure that your investment will retain its value in difficult market conditions, as it invests primarily in investment grade bonds and actively manages the risk in the portfolio. The underlying assets include bonds and similar fixed income securities issued by developed and emerging market Government’s, Semi-Government institutions, Corporates and high yield issuers. Management have experience investing over four decades and various major events from the Global Financial Crisis, to the Asian Crisis and various global conflicts.

Why invest?

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

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

In recent months, experts suggest that this may be a time to be reducing exposure to bond markets. Yet, this oversimplifies the operation of bond markets and the all-important yield curve. The benefit of PIMCO’s strategy is that it is benchmark unaware and they are able to take active positions based on their long-term expectations for individual economies, markets and companies. This affords the managers flexibility to reduce the duration of their portfolio, currently around 7 years, and target specific periods on the yield curve where they believe opportunities are presenting. Duration is a measure of a bond’s sensitivity to movements in interest rates, as opposed to term to maturity which is the average term of each bond within the portfolio. Both are measured in terms of years, with a higher duration meaning any changes in interest rates will have a greater effect on the value of the portfolio.

PIMCO’s flexible mandate means they can be exposed to the potential for rate increases or decreases in various periods in the future. One such opportunity, is the threat of a slowing US or global economy in the next 3 to 5 years, which is likely to trigger a strong period for bonds. The fund currently holds its largest overweight position in bonds of this maturity, meaning investors stand to benefit if their assessment is correct. The fund also applies a number of ESG screens across the portfolio excluding companies involved in weaponry, pornography and tobacco and embracing those committed to improving environmental and social practices.

What does it invest in?

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

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

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

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

How has it performed?

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

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

What income does it provide?

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

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