Tactical Investment Excluding Aussie Shares Now Available

Nucleus Wealth is happy to announce that we now can offer clients the ability to exclude all Australian shares from our Tactically managed portfolio’s.

This enhancement has been added due to some feedback from potential clients who were looking for a multi-asset tactically managed portfolio that does not have Australian share exposure but still gives the investment team the ability to adjust the risk levels in line with market forecasts. Note that this fund still invests in Australian cash and bonds.

To switch this feature on, simply select the ‘No Australian Shares’ option in the Ethical Themes selection page in our onboarding site.

If you are looking for a portfolio that can take advantage of a falling dollar, but still has the ability to de-risk as markets become fully valued, then feel free to login and check out what we could do for you.

March Performance

March was a shocker for the ASX with the ASX200 down over 4%. Investors in our tactical funds did much better, led by our income and accumulation funds increasing +0.4% and +0.3% respectively.  International shares performed much better than Australian shares (helped by a falling Australian dollar) finishing down 1.1%.  

In particular, our March performance was driven by our defensive investments. Government bonds increased, Thales (France/defense contractor +11%), Unilever (consumer products +10%), Meiji (Japan/confectionary +7%),  UPM-Kymmene (Finland/forestry +9%) and Swedish Match (Tobacco) were the standout performers.

We are sitting on a considerable cash balance in all of our Tactical portfolios – our Tactical Growth fund targets a 10% exposure to cash and bonds, our weight is currently 34%.  We have even more cash in the more conservative funds.

Investment Outlook

The fundamentals for shares look good, valuations don’t.

Which, despite all of the ups and downs of the last few months is largely where we have been for the past year.

There are two ways to “cure” high valuations: higher profits or lower stock prices.

Our tactical asset allocation continues to be based on getting as much exposure as we dare to over-valued equities that continue to get even more over-valued while maintaining protection in case it all unravels.

To be clear, we don’t think that we have reached the end of the current investment cycle, especially so as the long-awaited Trump tax cuts are on the verge of triggering a late-cycle US boom.

Can this be derailed by a trade war? Yes. We are treating Trump’s trade war as mainly posturing, but there are clear dangers if it becomes something more.  

March Performance

Nucleus March Performance

Nucleus March PerformanceThe returns above include fees and trading costs on a $500,000 portfolio. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. The benchmark returns do not include fees.

The Way Forward

As a reminder, we look at the key themes facing our portfolios as being:

  1. China: Rebalancing is occurring, the question is how fast Chinese authorities allow it to occur.
  2. Trump: Taxes are through as we expected. Our base case has been that trade wars will be more hot air than follow through, but events of recent days are putting that assumption under some pressure. 
  3. Europe: Grinding recovery. We are not expecting great things, but note the political risks have reduced. We also note that the high Euro is weighing on the economy and economic statistics have turned down.  The major long-term issue is still the significant imbalances between Germany and most of the rest of the Eurozone. 

US

Our core position is that Trump is trying to engineer a boom. It will not be sustainable and will likely be followed by a bust that leaves the US economy in a worse position but that is a future problem – positioning the portfolio for the boom is the current issue.

The proposed tax cuts are badly targeted by giving most of the benefit to the rich and to companies, trickle down is unlikely to work, the tax cuts are unsustainable, and they are only a short-term “sugar hit” for the US economy.  But it is going to be such a huge stimulus that you don’t want to stand in the way of it as an investor.

So, we want to play the boom, keeping a sharp eye on the bust.  Our portfolio positioning on this basis remains:

  1. overweight international stocks from an asset allocation perspective
  2. overweight stocks with US exposures – subject to valuation. The practical implementation of this has been buying non-US stocks that are exposed to the US.

China

In China data continues to weaken, suggesting that the rebalancing is occurring. A cut in the reserve rate this week might seem to some as a sign that the authorities want to return to debt-driven growth. Our view is that the reserve rate is more about managing the downward glide path.

Over the medium term:

  • the shift to consumption-led growth rather than investment-led growth will require a greater shift than many recognize. This shift will be a significant negative for commodities/the Australian dollar
  • current growth rates are unsustainably high, inflated by rapidly increasing Chinese debt. The increase in debt has been required in order to hit the growth targets, so removing the growth targets will help refocus local party officials to more sustainable policies
  • activity still seems to be slowing, although the last few months have been difficult to get an accurate read on economic activity due to winter pollution shutting down of a considerable amount of industrial manufacturing, in particular, steel production. We would expect that some of the strength in commodity prices in July/August reflected the bringing forward of production in front of the shut down. Then, the weakness in Q7 2017 represents the shutdown. Finally, there is likely to be a bounce in Q1 2018 due to “catch-up” production. So, the true trajectory is going to be difficult to ascertain accurately until we are through this period.
  • the Chinese housing market appears headed into a soft landing thanks to macroprudential tightening so a possible path ahead for rebalancing is a muted not busting housing cycle that supports consumption while weighing on investment;
  • we are probably 2-6 months away from being able to see whether the removal of growth targets makes a big difference or not – they have the potential to foreshadow a seismic shift to a more sustainable growth model. I suspect the outcome will be that with the Communist Party Conference done now the impetus will switch to slowing the economy as much as possible, but with any sign of unrest the debt taps will be turned back on.

Our expectation is that China is going to continue to “glide” lower to try to normalize the capital expenditure to consumption in-balance that we discussed in our recent webinar.

China Capex to GDP

It is our view that the Chinese economy will continue to slow over the coming years – Japanese style lost decades, and low inflation/deflation remain more likely than a dramatic bust, which means a grind lower for commodities and the Australian dollar.

Our portfolio positioning on this basis remains:

  1. considerably underweight Australian stocks from an asset allocation perspective
  2. underweight resource stocks within equity portfolios

Tactical Asset Allocation Portfolio Positioning

In our tactical portfolios, we own cash, bonds, international shares and Australian shares. We tend to blend these portfolios for clients so that each investor receives an exposure tailored to their own risk and income requirements.

The broad sweep of our asset allocation over the last 12 months was to ride the Trump Boom, switch into Europe in March / April as the US became overvalued and then switch back into the US as the Euro rallied and the USD fell. 

We have been using rallies in stock markets to reduce our holdings.

In March the Income fund increased by 0.4%, the Accumulation by 0.3% and the Growth fell by 1%.  We remain underweight shares in aggregate, overweight international shares and significantly underweight Australian shares.

Over / Underweight positions by portfolio

Asset Allocation
Source: Nucleus Wealth

Tactical Foundation Portfolio

Our tactical foundation portfolio is designed for investors with lower balances, it uses exchange-traded funds for its international exposure rather than direct shares. The reason for this is parcel sizes,  you can’t buy half a Google (Alphabet) share directly and so we use exchange-traded funds which buy baskets of stocks instead. The tactical portfolio is a balanced fund, not as aggressive in its holdings as the growth fund nor as conservative as our income fund.

In February this fund decreased by 1.3%.  The fund continues to be underweight Australian stocks.

Equities

Our biggest call is underweight energy. In particular oil producers. This has not been a good call over the last six months, and our outperformance has been despite the underweight to oil rather than because of it.

We have been doing a lot of soul-searching on this call over the month. The broad overview is:

  • Oil demand remains strong, and with (relatively) synchronized global growth we expect this to continue. 
  • The supply side is stronger. US production continues to reach new highs, Libya and Nigeria’s production recovered from interruptions. The lone negative is Venezuela continuing to decline. The ability of US shale oil to react quickly to higher prices means that supply is much more responsive than its been in the past. The US has now become an exporter of oil.
  • On the political side is where we see most of the action. OPEC and Russia are withholding supply to keep the price high, and US bombing in Syria plus Trump threats raise the spectre of sanctions returning to Iranian production.  
  • On the trading side, speculators hold record balances. This can be read two ways: (1) everyone else is going long, the oil price is going higher (2) the oil price has been pushed to current levels by speculators and will fall when they unwind their positions.

So, the question from here is whether we hedge our risk to political events by buying oil stocks in the face of fundamentals that suggest the oil price should be materially lower. If the risk were greater or the oil price lower, I would probably hedge. Given the current situation and current prices, we are going to stay underweight oil. But the debate rages on.

Our sole holding in the energy sector, Neste Energy is up around 50% over the past few months, which has shielded up a little from the rising oil price.  Neste is a Finnish oil refiner, making a significant investment in green technologies and is well regarded by a number of sustainable rating firms including being in the Global 100 most sustainable companies, the Dow Jones Sustainability index and CDP.

We are underweight financials – mainly as we can’t find US financials that are cheap enough to justify purchasing. We have been trawling the European banks for value. Insurance continues to be a sore spot, but we made some gains over the month with Everest Re and Direct Line. We are looking to continue to build holdings in the sector with the view that after such severe losses in 2017 that insurance premiums will rise significantly.

We have a reasonable tech / IT exposure. There are a number of smaller tech stocks that we own, in particular, a range of semiconductor stocks where we like the growth outlook. It is worth noting that part of the reason for Apple increasing the price of its latest phone is an increase in memory and components. This is a positive for semi-conductor stocks more generally, especially if a “feature war” breaks out in the smartphone space. We current hold a range of stocks that should be helped by this trend (Lam, Applied Materials, Skyworks, and to a lesser extent Cisco).

Performance to date

Portfolio performance can be cut a number of different ways. At its most basic level, you should care about the total return. At the next level, you should care about the total return relative to some sort of benchmark.

As you dig deeper, you should also be interested how the return was achieved – for example if your fund manager is taking lots of risk but only performing slightly better than the market then you should be concerned. Similarly, if you can get market returns but at a much lower risk then that may be an appropriate trade-off.

Our portfolios to date have been both out-performing benchmarks, and taking less risk. The disclaimer is that they have only been running for seven months, and that is not enough time to make definitive judgements.

For the sake of comparability, we have used the Vanguard MSCI World ETF (ASX:VGS) to compare to our international portfolio – VGS is an index fund investing in the same stocks that we do.

Epilogue

In summary, our view continues to be that Australian investors are better off holding international investments at this point in the cycle.

We retain relatively large cash balances to hedge against volatility and to look for a cheaper entry point. If markets continue to be weak then we will look to buy more equities. We are concerned about the potential for trade wars, which will be a key focus for us over the next few months.

Our intention is that our portfolio is positioned to take advantage of our key themes but minimise risk in the event that our themes take longer than expected to resolve themselves.

We usually find that big picture macro themes take a long time to resolve themselves in financial markets, but when macro theme resolve themselves they do so quickly – usually too quickly to reposition your portfolio if you are not already invested.

Register your interest now (if you haven’t already):

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

Nucleus Insights : Australia – Boom or Bust Commodities ?

Joined by Leith Van Onselen and David Llewellyn-smith in the studio with Damien Klassen and Tim Fuller. Todays full house takes a look at future of Australian Commodities and what would this mean for your portfolio.  How to spot opportunities in a boom or bust and find out how we position portfolios for upcoming commodity market changes. 

Incredulous Question #3312 from the Royal Commission

There are so many issues coming out of the Royal Commission into banking that its hard to maintain the outrage.  Here is yet another one that might have slipped through in the torrent of mis-deeds:

https://www.smh.com.au/video/video-business/video-businessday/amps-behaviour-could-result-in-jail-time-treasurer-20180418-547vf

Hayne: “As beneficiary you can’t call for the asset which is held on trust for you? Is that right?”

AMP: “Yes, that’s correct,” 

Hayne: “An unusual form of trust, I would have thought. “

long pause

Hayne: “The benefiary can’t call for the asset, is that your position?”

AMP (eventually): “No, in order to move they would need to sell that asset.”

Hayne’s point is there are a multitude of ways that platforms get customers to stay, and denying in-specie distributions is just one of them. 

Say you bought a fund through AMP and put it on their platform, being charged 2.5% per annum for the privilege. Then, a few years down the track you go to another planner and you want to keep your investment but simply access it through another platform. On the platform discussed above, AMP will make you sell the asset and realise a taxable gain. Which AMP is betting that you won’t want to do, locking you into the AMP platform for longer.  

Having been in the industry for a long time on the wholesale end, and then going through the process of putting my fund onto a retail platform it was horrifying to see the fees and the conditions on some platforms. 

There are a whole range of platforms that I could not in good conscience recommend to any of my clients and I have no idea how advisers can. I have pulled the same face Hayne does on the video, and asked the same incredulous question about the definition of “custody” or “trust” on more than one occasion…  

My tips for best of breed platforms:

  1. You want in-specie distribution. i.e. when you leave your manager you don’t have to sell the assets. This is the most tax efficient and shows confidence from the manager and the platform that they will rely on performance to keep your investment rather than high exit costs. 
  2. You need a 3rd party, reputable custodian. This prevents fraud.
  3. You shouldn’t be paying more than 0.5%. And the fees are coming down over time – you should be seeing the decreases rather than being locked into a rate from 10 years ago. 
  4. Buy/sell spreads on fund or trading costs should be low. Less than 0.5% generally, for large-cap funds less than 0.3%. 
  5. My preference is for separately managed accounts rather than unit trusts as it means that your tax position isn’t mixed up with everyone else’s. Not everyone offers this yet. But the better managers do.

 

 

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

On a mission for (royal) commission.

The collective offices of financial planners around the continent are no doubt quiet this week as the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services call up the big boys of the advice world for hearty “please explain?”

The first company in question, AMP,  is of personal interest to me, considering I completed their popular career transition programme, Horizons in 2012. Whilst the teaching and experience learned about financial planning was not bad, the introduction of the morally hazardous vertically integrated advice model common in the majors left a little to be desired.

Suffice to say 80% of my colleagues felt the same way and we all soon headed for the exit upon its completion.

Interestingly, notably absent from the honors roll are all the big names present when I graced those haunted hallowed halls. To be honest, it is a little disappointing that most of the management who made the decisions aren’t at the commission to defend those decisions.

Instead appears Anthony ‘Jack’ Regan, recently appointed (from New Zealand?) to front the firing squad, and it’s not going well:

By mid morning on day two of the second round of hearings at the Hayne royal commission, AMP has admitted to making a further nine false statements to ASIC about its practice of charging customers fees for services they didn’t provide taking the total number of falsehoods to 19.

“There’s so many you will have to rely on my account Mr Regan” counsel assisting Mr Michael Hodge QC told AMP’s Mr Regan.

One only hopes that once the dust settles on this, whoever is left at AMP see it in their heart to award Mr Regan a military pension, in light of his service on the front line.

But, what I am wondering is where are all of the Australian execs? Why did the AMP feel it had to fly in a New Zealander to answer for his Australian counterparts?

 

IAG: Driverless cars 20 years away

David Harrington from IAG channels Upton Sinclair: “It is difficult to get a man to understand something, when his salary depends upon his not understanding it”.

From the Australian:

Australia has 700 pieces of different regulation that need to be changed before driverless cars can take to the roads, according to Insurance Australia Group, which says the advent of self-driving cars is well off into the future.

Speaking at an investor day in Sydney yesterday, David Harrington, IAG’s head of strategy said only 2 per cent of all vehicles on the road in Australia and New Zealand had “assisted” driver technology — meaning the take-up of fully automated cars would progress far slower than some believed.

“So, we’re actually quite early even in the phase of driver assistance and so while we believe in driverless vehicles, they’re still quite a long way down the track,” Mr Harrington said.

“But we think that curve is going to move very quickly and so by the time you get to 2030 we expect that 50 per cent of all vehicles in Australia will have assisted-driving technologies and by 2040 it’ll be more like 90 per cent.

“It takes on average 19 years or 20 years to turn over the fleet in Australia and that’s how long it will take people to buy new cars, replace old cars and have cars that have this technology.”

David is right in one respect. Australia is a long way behind other countries –  the Infrastructure Australia paper from last year seems to recommend that we stay that way, and the Federal Government is doing nothing except considering a small cut to the luxury car tax.   

I’ve written on this a few times lately, I would recommend listening to the execs from companies that are near the front (e.g. GM or Waymo) rather than anyone from an industry that will be decimated by driverless cars in a country that is waiting to see what everyone else does. My view is that driverless taxis look like they will be cost competitive with public transport (see here for some calculations) – suggesting most people will never own a driverless car. 

Quick stats for the day:

  • Waymo and Jaguar are launching 20,000 self-driving taxis in 2020/21.
  • GM are looking to launch “mass production” of self-driving taxis in 2019, probably targeting similar numbers.
  • There are another dozen or so companies not far behind.
  • Total number of yellow cabs in New York:  13,587 servicing 241 million customer trips per year.

I’m not sure when driverless cars will hit in earnest, but I’m investing like they will be here much sooner than 2040. 

 

 

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

Is dividend imputation distorting Australian capital?

There have been changes proposed by the Labor party to imputation credits. We have put together a quick series looking at a number of aspects for investors:

  • In Part 1 (link) we looked at the winners and losers from the proposed changes
  • In Part 2 we look at some peripheral issues (a) at how management cheat by using buybacks (link) to inflate the value of their own options (b) the tax effectiveness of international shares for Australian investors (link).
  • In Part 3 (link) tax decisions that Australian investors should consider – can you get in front of any changes?
  • In Part 4 (this post) how companies allocate capital and how franking distorts the process for Australian companies

Dividend Imputation – is it distorting Australian Capital?

There have been changes proposed by the Labor party to imputation credits. There is a lot of debate about the pros and cons for investors, the other relevant question is whether imputation credits have distorted the capital allocation decision in Australia in a good way or a bad way.

My take is that there are distortions which have a positive effect on capital allocation in Australia, but the distortions are not as significant as they look at face value.

I expect the changes proposed by Labor would have little effect on the capital allocation decision. The experience from overseas is that when the benefits of franking credits are completely removed, dividend payout ratios fall but there are no conclusive effects on the capital structure.

Given the proposed changes only affect a subset of franking beneficiaries, I expect there would be little change to how Australian companies allocate capital. 

Capital Allocation background

My experience is that companies go through the following process:

1. Start with Free Cashflow1

2. Decide the minimum level of dividend to pay. Usually, this involves paying at least the same dividend as the prior year if possible. 

3. Decide how much to invest in growth capital

4. (a) If cashflow is still positive.  Decide what to do with the remaining cash between: (i) paying down debt / increasing cash (ii) returning more cash to shareholders via a special dividend, or higher dividend or buying back shares

4. (b) If cashflow is negative.  Decide how to fund the shortfall between: (i) increasing debt (ii) raising equity

Capital Allocation effect of imputation credits

In Australia, there is an additional complication: franking credits. Franking credits are of no value to the company and are valued by investors, and so it makes sense for companies to pay a high enough dividend to use all of the franking credits. 

This means that for step 2 (above) the process becomes: “pay a dividend to maximise the amount of franking credits paid to shareholders”.

If this was the case you would expect to see a difference in the payout ratio – and there is:

Payout ratios - Australia vs Global
Source: Factset, Nucleus Wealth

However, this is only half of the story.  As you can see in step 4a above, companies return capital to shareholders through dividends or buybacks, and when you add the two together the difference between Australia and the rest of the world goes away:

Buybacks + Dividends / Profit
Source: Factset, Nucleus Wealth

This indicates that the total payments to shareholders is similar for Australian companies vs the rest of the world – it is just that Australian companies tend to use dividends rather than buy backs.

I also note Australian companies far more frequently have dividend re-investment plans – basically raising capital in order to pay a dividend.

Dividend re-investment plans make sense if you have excess franking credits but can’t afford to pay a dividend – otherwise, dividend re-investment plans are just shuffling deck chairs.

Are buybacks a good thing?

I have a problem with management incentives and buybacks (see post from last week), but excluding that (very solvable) issue, buybacks are not that different to paying dividends except: (1) gains come as capital rather than income (2) buybacks are usually more tax efficient as investors get the returns as capital gains which taxed more concessionally and only taxed when the shares are sold.

From a tax perspective, contrary to popular belief, for most investors there is little difference between owning international shares and Australian shares (link). 

 

Do franking credits result in less tax avoidance?

The studies suggest that for purely domestic companies, yes. For subsidiaries of international companies no.

It does make sense that if domestic companies know that shareholders will receive franking credits then the company would be less likely to avoid the tax.

Also, perhaps more importantly, if a company has a choice of paying tax in either:

  • another country at a lower rate but receive no franking credits or
  • in Australia at a higher tax rate but receive franking credits

then it does make sense to pay the tax in Australia (up to a point).

Anecdotal evidence also suggests that for some companies it may be worth bringing forward tax payments in order to create franking credits that can then be paid to shareholders.

However, none of this makes sense for foreign companies. And the studies concur.

So, its a positive that having franking results in less tax avoidance from Australian companies. The foreign companies avoiding tax were probably going to avoid tax regardless of whether Australia has franking credits or not.

International Experience

Australia is one of the few countries internationally that has dividend imputation. However, quite helpfully if you are interested in looking at changes there were seven  European countries that had dividend imputation and then removed it after joining the European Union including Germany, France and Spain.

This provides a useful backdrop as we can now see the effect that removing dividend imputation had on companies in those regions.

Payout Ratio France
Source: Factset, Nucleus Wealth

However, when looking at capital structure, there appear to be no difference in capital structure pre-imputation credits vs post imputation in the countries affected. 

I view this as further support of the view that companies are making capital expenditure decisions separately from the return of capital decisions.

Capital Expenditure Effects

There is a whole topic hidden here so I’ll just touch on the key points.

Falling capital expenditure

Capital expenditure (capex) has been falling for fifty years. Some lament this as being a symptom of too much focus on short term profits – I’m not convinced we have enough evidence to draw conclusions.

At the same time, the proportion of manufacturing has been falling. Also, many manufacturers have been outsourcing large parts of their supply chain – for example, Boeing outsourced over 70% of the 787 supply chain vs closer to 35% for the 747, which means more and more of the value that Boeing adds is from services. Service companies do not need to spend much on capital expenditure. 

It may be that higher payments to shareholders is depressing capital expenditure, or it may be that structural changes are depressing capital expenditure, it is hard to tell. I’m yet to see a study that separates the two components effectively enough to draw conclusions.

Poor returns on acquisitions

A number of studies conclude that for large capitalisation companies that acquisitions in aggregate destroy value (small companies are different).

Having capital constraints therefore helps. The decision process to raise debt or equity to undertake an acquisition is presumably more detailed than to spend cash that is just sitting on the balance sheet. This is a vote in favour of franking, as higher payout ratios will mean that Australian companies will need to raise debt or equity more frequently.

Secondly, for Australian companies the availability of franking credits makes domestic investment more attractive than international.

Therefore franking is probably helpful at the margin.

Valuation

There are no end of studies addressing the valuation of franking credits.

The net effect is that they are valued somewhere between 0% and 50% – this is likely due to a mix of timing (franking credits are not paid immediately) and foreign shareholders (who get no benefit).

Presumably the removal of franking credit refund will reduce this number at least a little. 

Corporate Debt market

Australia has a very small corporate debt market relative to the size of our economy and equity market. 

There is debate over the reasons, but having imputation credits is likely to be a contributor because:

  • franking credits make equity more attractive vs than debt for companies (compared to countries without franking)
  • franking credits make dividends more attractive for investors vs interest payments from debt

The removal of franking credit refund should slightly tilt the playing field back in favour of corporate debt. 

Conclusion

Franking credits have distorted the Australian capital allocation, with a distinct preference for higher payout ratios in Australia and fewer buybacks.

However, this is at worst a neutral outcome, and probably a good discipline for Australian companies. 

Franking credits are at least partially responsible for the stunted development of Australia’s corporate debt market.  

Franking credits have been good for tax receipts, and support investment in Australia by domestic companies. 

Labor’s changes are relatively minor, unlikely to make much difference to any of the above.

 

 

Footnotes

 

1. Free cashflow = Cash from operations less replacement or required capital expenditure (i.e. capital replacing existing plant & equipment or capital needed to keep the business operating at current levels). 

 

 

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

Frankly, its a bit on the nose.

The dust is starting to settle a little on the Labor party’s recent proposal to stop the refund of unused franking credits and lines are slowly being drawn in the sand in preparation for battle.

An interesting (but unfortunately obvious) emergence has been the ‘inbetweener’ advocation of battlers that are potentially going to be adversely affected having done the right thing and put aside money for potentially their own self-funded retirement.

For those opponents of the changes, an easy path to take is highlighting the worst case examples of where franking credit refunds will have the biggest impact.

How to conjure a loser from changes 

One recent example highlighted a single female retiree, aged 75, who had total assets of $600,000 including a share portfolio of $500,000 and therefore was above the asset tested age pension cutout of $556,500 (homeowner).

The proposed changes see a calculated drop of around $11,000 in franking credit income which against the supposed $30,000 annual drawdown I agree is substantial. But the question remains, is this a realistic, or contrived scenario?

Upon considering the situation, my financial adviser warning light starts to burn brightly.

Immediately you begin to wonder why a person in their 70’s would have 100% of their liquid wealth tied up in one equity market. Franking credit benefit aside, the volatility this poor lady would be enduring daily would require nerves of steel at 40, leave alone age 75.  An easy example of this volatility is the recent drop in the ASX20 over March which would have seen the portfolio fall by around $20,000 for the month!

It’s an interesting choice of an illustration that clearly lends itself to emotive bias over what would exist in the real world. The fact that it gets repeated by experienced financial advisers (who just happen to be in the SMSF sector of which franking credit refund benefits make for a great sales case) is a little more befuddling.

To get a better idea of the impacts, we should start by giving this lady a portfolio that is more realistic and then have a look at the franking credit impacts, as shown below. I have assumed a dividend yield for the Australian component of 5%, and a mix of 45% defensive vs. 55% growth assets (which is at the upper end of investment aggression for what you would typically see in a properly setup portfolio for a person at this age and stage).

 

 

Given Example

More Realistic

 

Weight

 

Weight

 

Total Balance

 

 $             500,000

 

 $            500,000

Cash

 

 

20%

 $            100,000

Fixed Interest

 

 

25%

 $            125,000

Australian Shares (100% Fr)

100%

$              500,000

35%

 $            175,000

International Shares (0% Fr)

 

 

20%

 $            100,000

Total

100%

 

100%

 
   

 

 

 

Franking Credit benefit

 

 $               10,714

 

 $                3,750

           

 

Given the above, the impact now drops to $3,750, which whilst not insignificant, is roughly a third of the previously illustrated impact, and highlights that for most cases found ‘in between’ the have and have nots, the impacts of the proposed changes are not quite as dramatic as initally indicated.

Further thoughts on the proposal

At this point I should make it clear that these changes, recently watered down to exclude current Age Pension recipients, will of course be detrimental to retirees existing cashflow and do exhibit signs of a bit of a ‘new tax’ on self funded retirees, absolutely. However, as the surge into taxless structures such as SMSF pension accounts continues it is easy to see why some Government revenue tweaking may need to be installed to stem the losses that would otherwise continue unabated.

Considering Nucleus Wealth has many SMSF clients, I feel the need to respond in the defense of the SMSF sector. It is obvious that these impacts are deleterious to one of the benefits of choosing an SMSF over other pooled options. Absolutely.

It is important to remember that there are still a number of great reasons to consider one or to remain in one including:

  • control and transparency,
  • combining family assets in the superannuation system,
  • a broader palette of investment options
  • and if the changes come into force, the ability to utilise unused franking credits from one member against another in the fund. 

Conclusion

Yes, there will be an impact on previous potential returns for those classed as ‘in-betweeners’ and above from the changes, but it important to focus on your portfolio and not be too persuaded by spurious examples. There are other areas of the investment world, particularly overseas, that offer the potential for better capital returns and have the benefit of a falling dollar tailwind. Superannuation still offers the superior solution for most Australians to build retirement wealth.

Ultimately, it is always a risky move to arrange your affairs solely on the basis of saving tax, and once again these recent proposals have shown that legislation can giveth and in turn potentially taketh away.

 

 

Uber self driving crash

I have blogged a number of times about self-driving cars being the key to working out the path for oil prices and so it is important to work out if the recent pedestrian death by an Uber self-driving car is a sign that self-driving cars are further away than we expected.

Electric Car Economics

An electric car is more expensive than an oil powered car (due to the cost of the battery), but cheaper to run (oil is expensive per unit of energy, lower running costs due to fewer moving parts, less energy loss with batteries and more efficient power generation).

This means the economic calculation is about amortising the cost of the battery over the distance travelled. 

By my numbers, the current cross-over is about 100,000km per year and falling with decreasing battery cost. This means that a private electric car is not economically better (because most drivers don’t drive 100,000km per year), but an electric taxi is.

Levelised cost of driving

Driverless Taxi Economics

Self-driving cars will be very cheap as the most expensive component (the driver) is removed. The simplest way is to look at car hire companies:

  • Car hire companies are happy to rent a car to users for $60 a day with about a 75% utilisation rate = $45 a day to the car company. Let’s call that the capital cost of a car.
  • Now let’s add a third to the cost to cover the battery and the driverless technology – puts us back at $60 per day.
  • Given its driverless, it can operate for 24 hours a day – but call it 15 hours to take into account time to charge the battery, cleaning, slow periods, servicing and to make the math easier.
  • So, the car owner needs to make $4 per hour to make a return.
  • Assuming 1.5 trips per hour (roughly the average), add in electricity costs, 10% to the booking company and about $3.00 per trip is the end cost to the user.

It is pretty compelling. Basically, a driverless taxi would be cost competitive with (human driven) public transport.

The timeline

There are a range of tests currently being run. The ones I am looking at most closely include:

  • Waymo/Google have done the most testing and have progressed to testing without human backup drivers in Arizona. They are planning on rolling out 20,000 taxis in partnership with Jaguar Land Rover starting in late 2018.
  • GM/Cruise are possibly more technologically advanced than Waymo with an integrated (i.e. manufacturing + technology) solution in the US. They are targeting a 2019 rollout and have a petition to change laws for driverless cars in the US which will be ruled on in coming months.
  • nuTonomy is running pilot operations in Singapore, is looking to expand to 100 cars in 2018. Singapore conditions (a small heavily populated land mass, no snow and relatively autocratic government ) are one of the most likely to support driverless cars in initial stages.  
  • Easymile has been running driverless bus trials (on mainly fixed routes) in a range of cities around the world.
  • Baidu (AKA China’s Google) is investing heavily and has released a free software platform (Apollo) which allows other Chinese car companies to use Baidu’s technology. Given government support and the Baidu platform, China will likely be a key player in driverless technology.

The Crash

A pedestrian walking a bike, not on a pedestrian crossing, was killed by a Volvo using Uber’s driverless technology in Arizona. The vehicle appears not to have seen the pedestrian and the safety driver appears not to have been watching the road. Uber has ceased operations while the investigation continues.

The question is whether this will set the driverless community back several years or not. 

Technology

There are lots of companies trying to develop driverless technology and standardised information is hard to get.  One rough guide is the Californian statistics which show the number of “miles per disengagement” – the number of miles before a driver has to take control of the vehicle:

Source: Arstechnica, Calfornia DMV

Now there are lots of caveats to this chart. It only contains Californian statistics, companies self-report and so could be under-reporting and it says nothing about types of roads or conditions. But Waymo/Google and GM/Cruise are clearly a long way ahead of the competition. 

Uber is not on this chart, Uber reportedly have internal goals to reach 13 miles per intervention. Waymo/Google are at 5,600 miles per intervention and 1,200 miles for GM/Cruise.

A recent report by Navigant also has Uber well behind other players in the space: 

Finally, there are suggestions from internal sources that Uber has been cutting corners and may not be as safety conscious as the traditional car makers.

Similar claims arose about Tesla following a high profile crash last year.

Conclusion:

While there may be some extra caution from regulators, given Uber appears to be considerably behind the market leaders it would seem that this would be an issue specific to Uber.

The outcry over this death doesn’t seem to support banning trials, and I’m guessing that even if the investigation is damning that Uber will be singled out for restrictions rather than the entire industry. 

It seems commercial trials will start this year, and my expectation is that the takeup will be quick. Given the current trajectory, by 2025 the majority of new cars are likely to be electric, driverless and taxis. 

Its hard to prejudge the winners given the economics are still unknown. But the losers are more obvious. Oil. Car mechanics. Anyone who drives for a living. Possibly the entire car sales retail chain. Prestige cars will be more resilient.

 

 

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

International shares and tax

There have been changes proposed by the Labor party to imputation credits. We have put together a quick series looking at a number of aspects for investors:

  • In Part 1 (link) we looked at the winners and losers from the proposed changes
  • In Part 2 we look at some peripheral issues (a) at how management cheat by using buy backs (link) to inflate the value of their own options (b) (this post) the tax effectiveness of international shares for Australian investors.
  • In Part 3 (next week) how companies allocate capital and how franking distorts the process for Australian companies
  • In Part 4 (next week) tax decisions that Australian investors should consider – can you get in front of any changes?

Tax effectiveness of international shares

International shares have a poor reputation for tax effectiveness that doesn’t match the reality – and if Labor’s imputation reforms go through then the difference between an Australian investment and an international investment will be negligible:

Tax effectiveness of international shares

Source: Nucleus Wealth

Let me start by saying that investing for tax reasons is fraught with danger.

You should always start with investing for returns – tax is (at best) a secondary consideration. If you expected even a 2% better return from international shares over Australian shares then there is no tax scenario that would make you prefer Australian shares.

If your assets are in a superannuation fund in pension mode

Under current tax laws,  then Australian shares will return about 1.5% more than international shares. The difference arises as you are not paying tax and you will get cash back from franking credits. 

Under Labor’s proposed changes there will be no difference between investing in Australian shares and investing in international shares if you don’t qualify for a pension.

If your assets are outside of superannuation

Under current tax laws, if you are on the maximum marginal tax rate, there is no significant difference between the tax position – Australian shares give you a very slightly higher return, but international shares give you better timing as let you defer your tax payment until you sell the shares.

At a 39% marginal tax rate (i.e. earning $80k-$180k) there is about a 0.4% difference. Again Australian shares give you a higher return, but international shares give you better timing as let you defer your tax payment until you sell the shares.  I would contend that anyone who thinks they can forecast Australian vs International returns to within 1% is having themselves on.

Finally, at a 0% marginal tax rate the effect is the same as for a superannuation fund in pension mode: a 1.5% benefit under current tax laws falling to no difference under Labor’s proposed changes.      

Conclusions

Under current taxation, anyone in pension mode or on a 0% tax rate should have a slight tax preference for Australia shares over International shares worth about 1.5% per year. But to put that into context,  in the last month alone Australian shares have underpeformed international shares by almost 2%. 

Under Labor’s proposed tax changes, anyone on 0% or the top tax rate should have no tax preference for international vs Australian shares. 

Someone in a middle tax bracket can get a gain of around 0.5% per annum by investing in Australian shares, but you would have to know that you will continue to be in that tax bracket when you sell the shares as otherwise the calculation changes.  So, at best, a very minor preference for Australian shares.

Simply put, don’t invest for tax – invest for returns.

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

The buyback phantom menace

Bad timing for buybacks

The last few weeks have confirmed our view that most of the cash from Trump tax cuts will end up as dividends or buybacks. At the same time, we are awash with articles warning of the dangers of buybacks, from Vox to the FT  to the Harvard Business Review.

 

I’m hoping none of these arguments are intended to be smokescreens for the real issue with buybacks, but the arguments presented (buybacks take away investment dollars, buybacks manipulate share prices, buybacks encourage too much leverage) are a phantom menace, and instead divert attention from the real problem with buybacks:

Management who get paid with share options, and then use buybacks rather than pay dividends are giving themselves free money at the expense of shareholders.

To illustrate, first consider what happens when a dividend is paid:

Return from Dividends
Source: Nucleus Wealth

Now compare that to a buyback:

Comparing returns from a buyback to returns from a dividend
Source: Nucleus Wealth

So, let’s say you are the manager (or a board member) of the above company with employee options exercisable at $16.50 in 2 years time and you are considering your choices.  Which would you prefer to:

  1. pay 100% of profit back to shareholders as a dividend, your share price stays at $16 and your options expire worthless or
  2. use 100% of profit to buy back shares, your share price increases to $18+ and you make a lot of money on your options.

It is not a complicated maths problem.

And even better from a management perspective there is no accounting cost for the above gift from shareholders – its just taking a little bit of the potential share price growth from everyone which can seem like a victimless crime.

How to fix the problem

Very simple. The strike price of staff options should be adjusted for buybacks. 

This removes the conflict of interest but still allows management to use buybacks to manage debt levels and return cash to shareholders.

What about Earnings Per Share growth?

 Earnings per share growth is also distorted by buybacks:

EPS growth and buybacks

So, if management gets rewarded for hitting earnings per share targets then this will give them a free kick.  

The IRRC Institute surveyed directors in 2016 and had the following to say:

However, most directors said that their companies are aware of the relationship between buyback programs and compensation and that they make deliberate, informed choices to ensure that they reward executives for desired behavior rather than for financial manipulation of share prices. Anticipated buyback effects on EPS are usually factored into EPS targets, they say, and unanticipated effects can be adjusted out.

I think the above statement is wishful thinking. While some boards may be aware of the problem, I don’t believe targets are being mathematically adjusted for buybacks to ensure that earnings per share isn’t manipulated. Maybe, in a few cases, targets are set “a bit higher” to account for expected buybacks.

In smaller companies, directors are less likely to be aware of these problems, let alone deal with them.

I would prefer EPS targets for management to be explicitly adjusted for the effect of buybacks.

Do buybacks take away from investment or create leverage problems? 

I don’t think so. You can certainly cloud the argument by comparing a buyback with returns on investment and the effect on gearing and a range of other issues – and then the logic and calculations can get complicated enough to make it unclear.

But to me these are distractions. In my view most companies start with free cashflow1  and then go through the following investing/financing decisions relatively independently:

  1. How much expansionary or growth capital expenditure would the company like to invest (i.e. capital expenditure to expand the business)
  2. Should the business have more or less debt
  3. How much capital should be returned to shareholders

The first decision (investment) is usually independent of the second two decisions in most large companies. Investments are judged vs some sort of hurdle (e.g. projects should generate a return above x%).  With corporate debt yields close to record lows, and the world awash with capital I find it unlikely that worthwhile investment is not being made due to lack of capital. The Harvard Business Review has one of the better analyses of the issue.

The next two decisions are interlinked in so far as the whole system needs to balance. For some companies, the board will decide how much capital to return to shareholders and the balance will go to increasing/decreasing net debt.  For other companies, the board will target a debt level and the remaining cash will be returned to shareholders.

Either way, for capital returned to shareholders the decision process is in this order:

  1. decide how much capital to return to shareholders
  2. decide whether the capital be returned be via a dividend or a buyback 

Comparing buybacks to debt levels or capex is not meaningful in my view as the decisions are made separately.

A more likely culprit for the increase in borrowing is the low corporate borrowing rates making debt more attractive. A more likely culprit for the low level of investment is the lack of demand and depressed levels of capacity utilisation. i.e. companies are borrowing more because it is cheap to borrow, companies aren’t investing because they still have spare capacity.

Do buybacks have trading problems? 

Maybe.  A company buying back stock after a bad announcement can be looked at as manipulation to keep the price high – especially if management has share options expiring or margin loans. But, it can also be looked at as providing liquidity in times of stress or as an opportunistic purchase by management at a lower share price.

If you were a regulator cleaning up buyback regulation, completely removing the company from any trading decisions or having them pre-committing the amount of trading may be worth considering to avoid manipulation.

Do management make bad investment decisions?

At face value, yes:

Bad timing for buybacks

Even Costco with renowned value investor Charlie Munger on the board was busy buying stock in 2007 at the peak and by 2009 it had almost no buyback.

But this is again the wrong question to ask. 

If you take the view that the first decision is “how much capital to return to shareholders?” and then the second decision is “should it be via a dividend or a buyback?”, it makes sense that companies had lots of capital to return in 2007 (when profits were high) and then didn’t have capital in 2009.  i.e. in 2009 the answer to the first question was “not much” and then the answer to the second was “try not to cut the dividend”, which left almost no money for buybacks. 

Another valuation issue to note is that the table at the top of this post is not sensitive2 to the valuation of the company – if the stock maintains its price / earnings ratio then it is no better or worse for investors if the example is done on 30x price/earnings or 5x price to earnings:

Buyback at higher price

So, if the valuation doesn’t change (or the earnings multiple stays the same) then there is no difference to shareholders from a buyback or dividends.

When the earnings multiple goes up, investors would prefer that management had been doing buybacks (as it “forced” the investor to own more stock by the company keeping the cash), and vice versa.

But this is hard to pin on management when it doesn’t work – you are the investor. If you own too much of an expensive stock that is buying back shares then the onus on you to sell some of your stock, if you own a cheap stock that is paying dividends then reinvest the dividends yourself.

In either case, you shouldn’t be hoping that management will make your investment decisions for you. 

Are there any other issues that are relevant?

Most countries tax capital gains more lightly than dividends, and tax on dividends needs to be paid every year whereas tax on capital gains only needs to be paid upon the sale of shares. This means that for most investors a buyback will deliver a better after-tax return than a dividend. 

Stockbrokers (and their corporate advice departments) don’t get paid when companies pay dividends. They do when companies buy back shares. So, the advice that companies get from brokers is unlikely to be balanced.

It is possible that buybacks increase the value of the stock relative to its earnings through increased demand. i.e. the price/earnings ratio of the stock is higher. If this is the case (it probably is in the short term) then it makes buybacks even more attractive for both investors and management.

Final recommendations

For regulators:  The strike prices of employee options should be adjusted for buybacks – you are probably the only hope for shareholders because both boards and management are in on the scam. 

For investors: ask the companies you invest in why the strike prices of employee options aren’t adjusted for buybacks, try to have management earnings targets adjusted for buybacks.  When you are looking at EPS growth to compare companies, you may need to adjust for buybacks in some cases.

For managers: Keep buying back shares rather than paying dividends if you have options or earnings per share targets. Hope that investors and regulators don’t catch on.

For boards:  Keep buying back shares rather than paying dividends if you have options. If you are on a board and have options, you may be regretting reading this post. You are legally meant to be looking after shareholders and so now that you know, you should probably do something about it. Make sure any management earnings targets are adjusted for buybacks.

 

Footnotes

 

1. Free cashflow = Cash from operations less replacement or required capital expenditure (i.e. capital replacing existing plant & equipment or capital needed to keep the business operating at current levels). 

2. This is close to true. For the pedantic, it matters what share price the new shares are bought at, but we are usually talking differences in returns of less than 0.1% . For the really pedantic, over time the investor getting dividends (and presumably not re-investing them) will have a lower exposure to the company and so will be less affected by falls in price if the expensive company becomes less expensive.  This investor will also miss the upside if a cheap company becomes less cheap. While we are being pedantic, if the buyback meant that gearing gets too high then that would affect valuation as well.

 

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.