Robert Swift talks about how the TAMIM Global Equity High Conviction IMA is positioned heading into the Brexit vote and in particular reviews our 3 London listed investments.
Can we immunize the portfolio from Brexit or Bremain risk? Robert Swift – Head of Global Equity Strategies
Much has been written on the referendum on June 23rd when eligible UK citizens will be able to vote on whether to remain in, or begin to negotiate an exit from, the EU. You’ll be glad to know we won’t be making arguments for either choice in this article, and that this article will be brief.
It is a fascinating, and unprecedented, spectacle not least because the protagonists on either side transcend their traditional divisions. There has been much nonsense spouted, but by the Remain side in particular, and it is perhaps some of their insulting and patronising drivel that has caused the outcome to become closer than initially thought? We don’t trust polls but the bookies, who tend to be better predictors, have certainly shortened the odds on a Brexit. Consequently, if markets are sort of efficient, the closeness of the vote predicted by the bookies, should be discounted in the equity markets? Theoretically what only remains as a risk is if the vote is a resounding victory for one side or the other?
We’re not so sure and a narrow victory either way as well a resounding victory either way needs to be considered. While the numbers don’t warrant a big reaction (Total value of ALL trade and services between the UK and the EU accounts for around 1% of global GDP. Nobody for one minute is suggesting this will disappear overnight) there may well be one since markets love to overreact. Since we can’t predict what will happen we need to try and reduce portfolio exposure to a deleterious outcome. We think we can do this without going to cash by selling all UK exposure.
Here is what we have done. We own 3 UK stocks of which only one may be exposed to a shock in the UK economy and changes in interest rates and legislation. Two of the companies we own are multinational businesses, Glaxo, and HSBC which happen to have their main listing in the UK. They could just as easily be listed in New York, Shanghai, or indeed Frankfurt. If Sterling falls on a vote to Brexit they should benefit. Their US$ earnings are substantial so they are also a hedge against Euro risk. On a decision to Remain, they are quite likely to be favoured if investors wish to take on equity risk in a relief rally. Given the UK’s very large twin deficits we don’t think a vote for Remain causes a permanent and painful increase in the value of Sterling. Any such relief rally in Sterling is likely to be short lived.
The ‘pure’ UK company is National Grid which owns regulated electric and gas transmission assets. It also owns assets in the USA which actually comprise about 1/3rd of its asset base but it is overwhelmingly considered a UK company and its shareholders are predominantly UK based.
We find the company attractive because it has a stable and strategically important business, and has a high and growing dividend yield. This is a much better investment option than a UK bond or gilt at current interest rates. National Grid is unlikely to be affected by a close vote or an overwhelming vote either way. The UK is running seriously close to full utilisation in energy; NG is investing, and is being encouraged to invest by the regulator. The dividend yield will become really attractive if the Bank of England has to cut interest rates on a Brexit vote, to boost the economy. On the other hand if there is capital flight and an increase in interest rates to protect the pound Sterling, funding for capex is more likely to be directed TO this company than removed given the UK’s imminent energy shortages.
We believe these kinds of companies are attractive regardless of the outcome on June 23rd. We will be watching and relaxed doing so!
Robert Swift weighs in on the active vs. passive management debate and questions the risk levels in so-called passive strategies.
How much risk is there in my passive strategy? Robert Swift
Investment strategies, where investors simply invest in a fund that tracks a standard index like the S&P/ASX 200, have become increasingly popular both with institutions and private investors.
The reasons are clear – they are cheaper than most active strategies, people feel they know what they are buying and often the relevant target strategy can be hard for active managers to beat.
Not all is what it seems. This article will seek to demystify some of the hype surrounding these “passive” strategies and to highlight that while they are “passive”, it does not mean that they are without risk of disappointment.
It is important to first understand that they are typically based on the market value of companies. The largest companies in the index are the largest ones in the portfolio. This means you can end up investing proportionately more in the largest market capitalisation and most expensive companies and can potentially also have larger exposure to industries that than is reflected in the real economy. Reduced to its simplest a market capitalisation strategy simply keeps investing in the biggest companies regardless of their valuation. At some point this valuation may become too stretched and therefore dangerous to keep investing. A passive strategy will not care about the valuation of the largest companies but merely keep investing any subscriptions. Consequently, they may be anything but “calm and safe” as the word passive may imply?
The actual volatility, or the price swings, of an index fund may be very high especially if it has high weightings in just a few stocks. For instance, at 31/5/2017 the 20 largest companies in the ASX300 represents 54% of the index market capitalisation. If the largest companies share common business models and an event occurs, then the share prices of all will move together. We highlighted recently the similarity of the Australian banks and how their share prices moved together more than any other bank sector.
Passive or “index” funds have also been shown to underperform certain investment styles like Value or Growth or “Quality”– where an active fund may focus on lowly valued companies or high growth companies. Investment managers have attempted to replicate exposure to these investment styles through what are commonly known as “Smart Beta” funds. These are becoming increasingly sourced through Exchange Traded Funds (ETFs).
While they appear to be better than simple market capitalisation weighted index approaches, they also contain risks of which investors should be aware. To keep costs down and to pass the test of being an ETF the “investment rules” that define these style portfolios are often very crude and simplistic. Using low Price to Book value ratios to select the preferred stocks in the ETF, for example, will give a Value tilt but the tilt will come without any regard to the risk of the aggregate positions. The crucial difference between an index or “smart Beta” passive approach and a portfolio is that the portfolio should be designed to maximise return while managing the risk. The standard “smart Beta” indices do not manage the risk of the $ invested but only select stocks in weights which reflect their style exposure. “Smart Beta” makes dumb portfolios.
We can explain this with an analogy. We use the analogy of shopping for food in a supermarket. Let’s say that you have to shop for food to prepare dinner. You know what dinner should look like – a sensible mix of the food groups. This sensible mix we can call a portfolio. It is optimal like a portfolio in that it will meet a number of criteria not just meet a certain tilt to price. A “smart Beta” approach to shopping for dinner would be to look for the ingredients on the basis of price. A certain $ budget would be allocated and the shopping basket (or stocks) would be selected only on the basis of price to weight of tin or price to quantity of food. You would get some ingredients that are specifically suitable for your dinner menu, but it would not be exactly what you want. A portfolio management approach would use price as an input BUT ALSO try to optimise the ratio between price paid and the amount of the specific food item to make up the dinner ingredients. The portfolio management shopper would perhaps pay up for an ingredient that was essential to diversify the other items on the menu? The portfolio management shopper should look to get a more appropriate mix of the ingredients in the basket and care about price AND relative weights to make dinner.
Like so many things in life, there is always a risk when things get too popular and so much money pours into particular strategies. Those stocks that are in indices, be they simple market cap weight indices or a crude Value or Growth fund can get pushed up too far due to the sheer weight of money going in to them, whilst those stocks lowly considered or outside these indexes or style benchmarks can become neglected and potentially undervalued. These neglected stocks may potentially be more attractive investments going forward as is the case now – we believe.
For example, in the USA this year there has been a big focus on Growth / Momentum stocks which has meant most of the market rise can be accounted for by the movement of just a few stocks – Facebook, Amazon, Apple, Alphabet (formerly known as Google) and Netflix. The last time we saw this kind of rise was in 1999 in the USA Tech bubble.
Many of these Smart Beta strategies are currently perceived to be the new “holy grail” of investment management. The limitations of these investment approaches may only become truly apparent after the event. We have only to think back to the Tech boom bubble in the late 1990s and the ultimate bust of so many dot com companies in the fall out of 2000-2 to see the dangers of fashions in investing.
So, the advice is to look behind the shiny wrappers and bold claims and try to see how intelligently these strategies have been put together. What empirical evidence there is to support these approaches, and whether these trends are likely to continue?
Importantly, it is important to understand how the strategies operate and not get caught up in purely mechanical and computer driven investment approaches just because their current performance is good. Recognise that all investment decisions involve judgement and experienced people are required to manage a portfolio, not just a set of rules.
We like to use two famous quotations when we describe our process which seeks to use quantitative or computer driven models but only with a human being in charge.
“Not everything that can be counted counts; and not everything that counts can be counted”
“I would rather be approximately right than precisely wrong”
This week Guy Carson provides his take on the active vs. passive management debate. Should it even be a debate?
A Broken Index: Why investors should seek true active management in Australia
Guy Carson
Recently Warren Buffett made headlines across the globe by reminding everyone of a bet he made nine years ago. That bet was that any set of five hedge funds could not beat the S&P 500 on a ten year basis. At the nine year mark, Buffett is comfortably ahead. Consequently this kick-started a debate across the globe around the efficacy of active versus passive management which has been raging ever since.
In Australia, we believe this debate needs to delve further. The construction of the Australian benchmarks means index investors are taking concentrated bets and worse than that, so called active managers are running portfolios by massaging around these bets. This is due to an index that is top heavy and concentrated in a number of sectors. To illustrate this point we can compare the largest holdings in the S&P 500 to the ASX 200. The top 10 companies in the Australian index have a combined weight of 43%, whilst in the US its 19%. When we look at the top 20 companies in Australia they represent 56% of the index versus 28% in the US.
In buying the Australian index you therefore take a concentrated exposure in twenty companies with a long tail. The greater problem comes when you start to delve into the composition of those twenty companies and you find:
The four largest companies (the banks) representing 25% of the index essentially do the same thing. Whilst the big four banks do have subtle differences, a majority of their profits come from residential mortgages. In addition, all four are currently being hit by increased capital requirements and additional levies.
A supermarket duopoly that has been disrupted in recent years by low cost entrants.
A former national Telecommunications company that has seen most of its competitive advantages disappear in recent years.
And a high exposure to highly cyclical commodities markets.
When we compare the Australian index in totality to the US index we can see these concentration problems arise. The two largest sectors in the Australian market (financials and resources) represent over 50% of the weighting whilst in the US it is 37%. Buying a passive index fund in Australia means you are betting over half your capital on the Australian housing market and commodity prices, most notably Iron Ore, LNG, Gold and Coal. In the US, the two largest sectors are Information Technology and Healthcare, the two fastest growing sectors globally in recent years.
This all brings us to active management and here lies a major issue for Australian investors currently using managed funds. A lot of the tools used in portfolio management have the benchmark (in this case the ASX 200) as a starting point. Active fund managers will manage to a targeted tracking error. In layman’s terms, tracking error is a statistical measure of how far you differ from your underlying index. Due to this constraint, active funds will usually have limits to how far they can differ from the index by sector.
To illustrate this point we had a look at the most recent quarterly report from a well-regarded Australian Equities manager with a growth focus. The top three holdings within the fund were Westpac, CBA and NAB with a combined weight of 22%. Given the growth focus of the manager it is surprising that their top three holdings reported Cash Earnings per share growth of 1%, 0% and 2% respectively at their most recent results. In addition with payout ratios above 70% and a regulator enforcing stricter capital limits, these banks have little capability to grow any time soon. Now, this fund manager would most likely tell you they are “underweight” the big four relative to the market weight, as it seems fairly clear that they are unlikely buying these shares for their earnings growth.
The most likely reasons they own the shares is twofold:
Their above mentioned tracking error budgets and portfolio restrictions means their process will force them to buy the banks.
Career risk, if an analyst or a fund manager took a significantly negative position against a sector of such great concentration and was to get it wrong then they would most likely be looking for a new job.
As a result, active funds in Australia tend to have the same concentration risk as the underlying benchmark. An investor seeking to invest will end up with similar problems if they were to go through a passive fund or an active one. If the banking sector falters, investors in either camp will suffer. To see how this would play out over time, one only needs to look at Japan. If you were to go back to 1993, the banking sector was almost 20% of the Nikkei; it is now sub 10%. The Nikkei over that time on a price basis has gone up by only 12% (or 0.5% annualised) and the banks have been a key drag.
Obviously, Australia is different than Japan with one of the key distinctions being immigration but the example does highlight the risk associated with concentrated indexes. Whilst Japan has been largely considered an investment disaster due to an index that has barely moved over the last 25 years, the structure of the index has changed considerably during that time. The banking sector has detracted whilst other sectors have grown, most notably sectors such as technology and global consumer focused companies.
In Australia, it isn’t hard to envisage a similar scenario in the future. Ultimately in ten years’ time it is unlikely that the banks will have the weight they currently do. The pressures of record household debt and increased regulation will likely weigh on their performance. On the other side, Information Technology currently makes up 1.8% of the index and we’d be worried for the Australian economy if this wasn’t significantly higher over time.
Quite often we get asked our opinion on where the Australian market is heading and we give our honest answer, we don’t know. What we do say with some confidence is regardless of index performance we believe the sector mix will change over time. As a result we believe truly active management that ignores the index is the only way forward for Australian investors.
We made the mistake of investing in the Murray River Organics (ASX:MRG) IPO at $1.30. The stock has fallen by 73% to $0.35 in the company’s turbulent 6 month listed history, and we sold out at $0.65, 50% below the IPO price. Rather than sweeping this under the carpet we see this as an opportunity to learn some valuable lessons. In this article we share around some humble pie.
Why we invested in MRG in the IPO
a) Industry tailwinds
The trend of growing demand for natural and organic foods has been well entrenched for many years, and we believe provides strong tailwinds for over the long term:
Source: PAC Partners
b) Compelling relative valuation
MRG’s prospectus forecasts suggested the company was listing at an EV/EBITDA of 11x versus the global average for listed organic and differential food stocks of 13.2x, and the multiples would drop off materially in the coming years as MRG’s vines mature:
Source: PAC Partners, Jan 2017
Source: Morgans, Jan 2017
c) Scarcity factor In addition to the industry tailwinds MRG appeared well positioned to take advantage of the current global under-supply of organic raisins:
Source: PAC Partners, Jan 2017
What happened next…
1) IPO concluded successfully in December 2016 based on the FY17 prospectus forecast: $15.9m EBITDA, $6.6m NPAT:
Source: MRG prospectus
2) MRG’s H1 result – on track & re-affirmed prospectus forecasts.
3) First profit warning May 4th: new FY17 forecast $12.5-13.5m EBITDA, $4.2-4.9m NPAT:
“The FY17 pro-forma revenue is expected to be down by $10 million, with approximately half of this reduction being attributed to the previously communicated 5-6 week delay in harvest season caused by an unusually cool and wet spring, coupled with more recent wet weather. The other half of the reduction is attributable to slower than anticipated uptake in sales following delays to the refurbishment of the Company’s Sunraysia processing facility, during which dried vine fruit could not be processed, as well as a lower contribution from Cluster sales following the previously communicated write-down of some Cluster inventory.”
4) Second profit warning May 22nd: new FY17 forecast $6.5-7.5m EBITDA, $0.1-0.8m EBITDA:
“The reduction in sellable dried vine fruit from the 2016-2017 crop, due to the recent and previously announced cold and wet weather experienced in the Sunraysia region, has resulted in the Company revising its estimated FY17 pro forma EBITDA to be in the range of $6.5-7.5 million and pro forma FY17 NPAT in the range of $0.1-0.8 million.”
What we got wrong
a) Management
This is the most humbling mistake for us to own up to since we are so focused upon identifying management teams who are honest, competent, shareholder friendly and motivated. The great thing about investing is that everyone is faced with mistakes upon occasion, and thus has a choice how they deal with them – we can all chose to either learn a lesson or not to.The background to our experience with MRG’s management dates to the pre-IPO presentations when we saw them present. We thought the CEO came across as competent, honest and knowledge-able, and were of the opinion he would be a great leader for the business looking forward. We then met him again at a conference a few weeks after the IPO and were again impressed for the same reasons. We were reassured that everything was on track and the company’s prospectus forecasts would be achieved. This meeting was the week before the company announced its first major profit warning. Yes, you read that right. Management were presenting to investors the day before the profit warning with the message that everything was on track.
This is why this job can be so humbling. We clearly misjudged management on all levels. We don’t want to dwell on the negatives about MRG’s management in this article but it is clear they didn’t tick any of the boxes we were aiming to tick.
b) Our assessment of weather risk
Weather risk will always be a key consideration when investing in an agricultural exposed company like MRG. We did indeed consider this risk in depth before investing. At the time we took comfort from management and broker reassurances that the prospectus forecasts already factored in short term risks including weather. This was a big mistake on our part as poor weather ended up being a primary contributor to MRG’s subsequent profit warnings which made it painfully clear that weather risk had not in fact been factored into the company’s prospectus forecasts.
c) Our assessment of the company specific risks
Beyond the challenging weather conditions, the company mentioned the refurbishment delays at the company’s Sunraysia processing facility as being a major problem since dried vine fruit could not be processed as a result. In addition, there was as a lower contribution from Cluster sales following the previously communicated write-down of some Cluster inventory.
Both of these issues have had a significant impact on the company’s sales and earnings in MRG’s brief listed life, and we clearly under-estimated both of these risks. We both issues relate to our judgement of management as there was an underlying assumption that management were on top of these logistical issues ahead of listing. MRG certainly has revealed an unusually long list of problems to the market in its 6 months on the ASX.
d) Investing in the IPO rather than awaiting some listed trading history
Arguably most of our mistakes in this example would have been avoided if we had avoided buying MRG in the IPO and had awaited some listed trading history, preferably at least a few years. By watching the stock as a listed entity for a period we would have had a far clearer picture of the company’s key risks.
e) Under-estimating the implications of the company’s unusually short escrow period
This was an unusual one. MRG had a very short escrow period for pre-IPO shareholders which meant there was a massive increase in the supply of stock hitting the market at exactly the wrong time, into bad news. In hindsight we should have asked ourselves why the management team and brokers would support such a short escrow period. We are not suggesting that management were aware of all of impending problems when they wrote the prospectus but it does look as if there was pressure from some pre-IPO shareholders to create an exit point as soon as possible. This is the opposite of what we are normally aiming for; a long term and committed shareholder base.
Lessons learnt:
Only invest in IPOs where we have a history of following and understanding the business and management – Our MRG investment experience has reinforced in our minds the benefits of investing in companies with a long term trading history which reveals the ins and outs of how a business works and evolves.
Avoid agriculture exposed companies unless we are certain weather risk is mitigated – The reality is it is almost impossible for agricultural companies to mitigate against weather risk and when poor weather hits it will generally impact upon earnings far more than any financial model will predict.
Make sure all your research is independent – do not rely on broker research – When we invest in a company it is our responsibility to get it right and we cannot rely on external research in any shape or form. MRG’s lead brokers got the company’s financial forecasts very wrong just a few months before the end of FY17 but we should not have factored their analysis in as much as we did.
Be careful of IPOs with short escrow periods – This is the first time we have encountered such a short escrow period and it has highlighted to us that this is a warning sign which should not be ignored.
Your first loss if your best loss – selling on the first profit warning was absolutely the right strategy despite feeling “wrong” at the time – We sold our entire MRG stake at between 63c and 65c after the first profit warning. This was a remarkably hard and humble step to take but in hindsight it was the right step.
Conclusion:
Learning from your mistakes is one of the greatest opportunities all investors face. As a result, we wear our scars proudly and look to learn as much as possible from our mistakes. Investing in the MRG IPO was arguably our biggest mistake in the underlying portfolio’s 2 years and 2 month trading history. We won’t be making the same mistake again.
This week we take a look at the peer-to-peer lending space. In a time when term deposit rates are negligible, is it time to look at alternatives for your income? How can you achieve the income you want while minimising the inevitable increase in risk associated with consumer loans?
The 80’s were memorable for a number of reasons. Fluorescent clothing, Olivia Newton John, the Americas Cup win and an average interest rate on one-year term deposits of 13%. There was no Government guarantee of deposits and CBA had not even listed (that happened in 1991 at $5.40 per share).
Since then rates have been volatile but on a steady downward trend for the last 35 years. Likewise, inflation has come down significantly from highs of over 12% in 1982.
Source: RBA
What conclusions can we draw from this chart? Obviously, term deposit rates are at a record low. But this is only part of the story. To determine the real value of a term deposit we need to look at the real return. That is, the term deposit rate less the rate of inflation. If that gap is small our real return is small. If inflation is greater than the term deposit rate as it was in 1998, 2001 and 2008 investors are actually losing money by putting it in the bank.
The chart below shows the real rate rates of return on term deposits since December 1981.
Source: RBA
It is clear that the real return on bank deposits has been decreasing over time. Some of this can be explained by the lower risk – attributable to the Government bank guarantee. But really, this shows that term deposits are just not a good deal. Real returns of less than 1% should not excite anyone.
But fortunately, there has never been more choice for Australian’s looking for a better fixed income return. With a moderate increase in risk investors can earn significantly greater returns. The banks have been doing this for years it is high time that retail investors get a chance to invest in similar assets. The chart below shows the rates that banks have charging on various types of loans since 1981.
Source: RBA
A few things stand out. Mortgages and small business loan rates have been coming down since April 1995 and we all know why. Disruptors such as Aussie Home Loans and RAMS forced the banks to start pricing fairly.
But, personal loans are basically at the same place as they were 20 years ago. This is during a period when default rates have been low and the economy has been strong.
But the story is more interesting when we look at real returns to the banks on personal loans.
Source: RBA
Real rates have actually gone up over the last 20 years. This is in the context of a generally stronger economic conditions and low default rates.
So let’s draw all this together. Term deposits are at historically low returns. More importantly, real returns on term deposits have come down consistently for the last 20 years, in some cases hardly keeping pace with inflation.
In contrast, the real return on personal loans has been increasing giving the banks exceptional returns for the risk.
Peer-to-peer lending
Until recently, access to the personal loan asset class was limited to banks and credit unions. Peer-to-peer lending gives retail investors the opportunity, for the first time to access this asset class.
In the USA and the UK, peer-to-peer lending has become very mainstream with over $20 billion dollars lent in 2016.
In a nutshell, peer-to-peer lenders match people looking to borrow money with people who have money to lend. Most peer-to-peer lenders have chosen to focus consumer credit and small business loans. Small loans like this allow greater diversification and lenders benefit from substantial data available to the peer-to-peer platforms which allow them to make informed credit decisions.
Leading peer-to-peer lenders, like RateSetter and Society One, target the top tiers of creditworthy borrowers. They compete against the banks (not payday lenders) for borrowers. Rates offered to borrowers are often lower than what that borrower would pay to a bank as peer-to-peer platforms operate more efferently than banks and pass on costs savings to borrowers and lenders.
There are two peer-to-peer models that have developed, one from the USA and the other from the UK.
What are the risks and returns?
Peer-to-peer lenders are not banks, so they do not benefit from the Government deposit guarantee. However, many investors have found that by choosing a platform that allows some sharing of the risk between investors (eg. a shared provision fund) or ensuring a diversified portfolio of loans they can earn healthy returns with an acceptable level of risk. For example, RateSetter’s current market rates after fees are:
Source: RateSetter website, 20 June 2017
The best peer-to-peer platforms provide lots of information to allow investors to assess the risks. Data like historical default rates, size of provision fund, number of borrowers and key borrower characteristics. Some platforms, like RateSetter, allow investors to download their entire loan book so that investor can conduct their own analysis on the loans and track record of the peer-to-peer platform.
