The Experts

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Paul Rickard
+ About Paul Rickard

Paul Rickard has more than 25 years’ experience in financial services and banking, including 20 years with the Commonwealth Bank Group in senior leadership roles. Paul was the founding Managing Director and CEO of CommSec, and was named Australian ‘Stockbroker of the Year’ in 2005.

In 2012, Paul teamed up with Peter Switzer to launch the Switzer Super Report, a newsletter and website for the trustees of SMSFs. A regular commentator in the media, investment advisor and company director, he is also a Non-Executive Director of Tyro Payments Ltd and Property Exchange Australia Ltd.

Follow Paul on Twitter @PaulRickard17

4 key investor lessons from 2018

Thursday, December 06, 2018

The obligatory disclaimer used by fund managers saying that “past performance is no indicator of future performance” could also be said to apply to predictions based on what happened last year occurring again next year. However, with President Trump into his third year of office in the USA and a federal election due in Australia, I think 2019 could look a little like 2018 in regard to the lessons investors should consider.  

Here is my take on four key lessons from 2018.

1. President Trump sets the tone

Whether you love him or loathe him, there is no doubt that President Trump is the biggest single influence on world stock markets. Maybe because he is a maverick, unconventional or as some would say erratic, he wields more power over the markets than any of his predecessors.

Consider these actions since he came to office:

·      The huge cut in company tax rates, which propelled US and many other global stock markets to all-time highs. US company earnings grew at over 20% pa, consumer confidence and spending lifted as companies shared some of the largesse with their staff by paying  across the board bonuses, and the US dollar strengthened as monies were repatriated. The US economy went into overdrive;

·      The sabre rattling about North Korea, which had markets on edge for months until Donald pulled off a summit with President Kim Jon Un;

·      The trade spat with China and imposition of tariffs (initially 10% on about US$253bn of Chinese goods). Trump has threatened to lift the rate to 25% and impose tariffs on the remaining US$267bn of Chinese exports to the USA. While  these new measures are on hold for 90 days, the development of a trade war remains the biggest single threat to global growth and the continuation of the global equity bull market;

·      The bullying of Saudi Arabia and other OPEC members to increase oil production, which was one of the drivers for the sharp drop in the oil price from almost US$75 per barrel in late September to US$50 a barrel in November; and

·      More bullying, this time about the pace and extent of the increase in US interest rates, with Trump becoming a critic of US Federal Reserve Chair Jerome Powell.  Interestingly, Powell has recently switched tack and now says that US rates are “just below neutral”.

2019 will be Trump’s third year in office. Notwithstanding that his party has lost control of the Congress, Trump is likely to be just as influential on world stock markets in 2019 as he was in 2018. Watch Trump’s actions.

2. Government Intervention is increasing and is a major investor risk

I, like many others, didn’t believe that there was a need for a Royal Commission into misconduct in the Banking, Superannuation and Financial Services Industry. I got this wrong.

I also got wrong the impact it would have on the share prices of the four major banks and the AMP.

Almost out of the blue, the Morrison Government initiated a Royal Commission into Aged Care Quality and Safety. It is due to provide an interim report by 31 October 2019, and its final report no later than 30 April 2020. ASX listed companies in this sector, including Estia Health, Regis Healthcare and Japara HealthCare saw their share prices tank following the announcement.

Now, the Government is looking at energy companies and discussing legislation that may  force the divestiture of key power station assets. Described by some as “Venezuelan-style intervention”, it is partly in response to AGL’s woeful mishandling of the Liddell Power Station closure.

The common theme is that Government, in response to legitimate community concerns and the demonstrable success of the banking Royal Commission, is starting to take a more interventionist position in how industries and companies operate. This has particular risks for share investors. In the lead up to an election where “populist policies” are sure to get a run, and a change of government is almost certain, this is not going to go away. If anything, expect to hear more calls for “intervention” or “enquiries” in 2019.

3. The top 20 outperformed

This will surprise many, but the top 20 stocks on the ASX have outperformed the rest of the market in 2018. For the 11 months to 30 November, the ASX 200 has, after taking dividends into account and looking at total shareholder returns, delivered a return of  -2.7%. The top 20 has returned -1.2%.

While both are negative numbers and the difference is only small, it is somewhat remarkable given that the top 20 comprises Commonwealth Bank in first place by market weighting, Westpac in third position, ANZ in fifth position and the NAB in sixth position. Another poor performer, Telstra, is in tenth position. The power of dividends.

With the public hearings of the Royal Commission over, and a glut of special dividends/off market buybacks to come ahead of Bill Shorten becoming Australia’s thirty first Prime Minister, I expect this outperformance to continue in 2019. 

4. All crazes come to an end

Finally, a statement about the obvious – all crazes come to an end. They always seem to go on a bit longer than you expect, but when the bubble bursts, it does so with a bang. That’s the case with Bitcoin. I couldn’t understand why any “rational” person would pay more than the cost to mine a bitcoin of about US$3,000, watched it trade all the way up to almost US$20,000 just before Christmas last year, before plummeting all the way back down. Yesterday, it was around US$3,830.

Bitcoin (USD) - Coinbase

Source: CNBC

I can’t tell you yet what the “craze” of 2019 will be – but there will be something, there always is! For traders, the story will be about knowing when to jump off the bus and leave something for the next punter.

 

Preparing for Prime Minister Bill Shorten

Thursday, November 29, 2018

It is now almost certain that Australia will go to the polls on Saturday 18 May 2019, the last possible day that a half Senate election can be held in conjunction with the House of Representatives. And if the outcome of the Victorian state election is any guide, the prospects of a change of Government and Bill Shorten becoming Australia’s 31st Prime Minister look increasingly likely.

On paper at least, some of the policies he has announced are troubling to investors and retirees. What are these policies, and what actions can you take now to prepare for this possibility of an ALP Government? Here is my assessment.

1. Capital gains tax discount

In the medium term, the halving of the capital gains tax discount for individuals from 50% to 25% could be the most significant change as this will apply to all investments – shares, property, managed funds, collectables etc.

Presently, an investor who holds an asset for more than 12 months pays tax on half the gain. This means that an individual who is paying tax at the highest marginal tax rate of 47% pays an effective tax rate on a gain of 23.5%.  

Under the ALP plan, only 25% of the gain will be exempted, so that tax at the marginal rate will apply to 75% of the gain. For an investor paying tax at the highest rate of 47%, the effective tax rate will rise to 35.25%.

The good news is that the ALP says that the change in tax rate won’t be applied retrospectively so that all investment made before the effective date of the change  (“sometime after the election”) will be fully grandfathered.

Super funds won’t be impacted, so that the current discount of one-third that applies to investments owned by a super fund (which effectively brings the tax rate down to 10% for an SMSF in accumulation phase) will be maintained.

No action required.

2. Negative Gearing

The ALP says that it “will limit negative gearing to new housing from a yet-to-be-determined date after the next election. All investments made before this date will not be affected by this change and will be fully grandfathered.”

The policy will also apply to other assets including shares which are purchased with the assistance of a margin loan, or an investment in a business using borrowed monies. While interest will still be deductible, it will only be deductible to the extent that the income and the allowable deductions are fully offset – you won’t be able to claim a ‘net’ investment loss.

In the residential property market, although grandfathering will protect investors with existing properties, the  impact on the market could be material if investors withdraw from the market. Offsetting this in the medium term could be an increase in rental returns.

If the property market comes under pressure, ASX companies involved in the industry could be impacted. This would include real estate listings and advertising groups REA Group (REA) and  Domain (DHG), real estate agent McGrath (MEA) and new home builders such as Mirvac (MGR) or Watpac (WTP).

No action required, but if you are considering investing in an existing rental property and negatively gearing, you may want to act before the change takes effect.

3. Franking credits

The ALP will stop the re-funding in cash of excess franking (imputation) credits. Persons in receipt of a government benefit such as a pension, or an SMSF where one member was on a government benefit on 26 March 2018, will be exempted.

The policy will apply from 1 July 2019, which means it will only affect future earnings and franked dividends that start flowing in the 19/20 financial year.

Importantly, the change will have no impact on taxpayers paying tax at a marginal tax rate of 30% or higher (above the company tax rate), very limited impact on most institutional investors, and no direct impact on foreign investors.

It will however impact low or zero rate taxpayers such as a SMSF in pension mode or a non-working spouse who owns shares, and some SMSFs/super funds in accumulation mode who have excess credits and presently receive a cash refund. If they don’t receive a cash refund, they aren’t directly impacted.

As a tax change, it will need to be legislated and pass through the Senate. The position of a “populist” Senate cross bench is unknown and could be interesting.

So, should you take any action now?

The major banks and “high yielders” such as Telstra and hybrid securities could be impacted if some of the “SMSF army” decide to reduce their holdings. The data says that they are on average overweight these stocks. Against this is the proposition is that the yield on these stocks will still be relatively attractive, notwithstanding the loss of the tax refund.

My sense is that some of the recent underperformance in the financials sector is due to concerns about the prospect of a Shorten government. Given the uncertainty around the legislation and that only part of the investor community is impacted, I am not convinced that we are going to see a further markdown on these stocks.

Listed investment companies (LICs) paying fully franked dividends could be more severely impacted, particularly if they are trading at a premium. This is because they have retail investor bases (very few, if any, institutional or foreign investors), a finite number of buyers and if trading at a premium to the LIC’s net tangible asset value, are arguably over-valued.

Consider selling LICs trading at a premium.   

4. Industry specific policies

Industries that are subject to regulation, or rely upon the Government for subsidies or spending, are always vulnerable to a change of government and a redirection of priorities or policies. This category includes healthcare, telecommunications, energy, education, aged care, financial services and media.

Healthcare is right up there, and one of the earlier announcements from the ALP was a proposal to cap the increase in health insurance premiums to 2% pa. There has been some commentary that this policy is under review as it could have unintended consequence on some of the smaller regional health funds. If the policy is implemented, potential losers would include Medibank (MBL) and NIB (NHF). Private hospital operators Ramsay Health Care (RHC) and Healthscope (HSO) could also feel the pressure if the insurers are being squeezed.

Sectors that could be positively impacted includer renewable energy, education and infrastructure, although the timing might be too far off for investors to capitalise on this opportunity.

In the short term, review exposures to sectors that could be negatively impacted, particularly companies in the hospital/insurance sector.

 

Your Questions Answered

Monday, November 26, 2018

Question 1: In regard to the BHP buyback offer, you mentioned a special dividend payable in January 2019. Our assumption is that this dividend is to be paid on shareholdings left after the buyback offer has been completed. We are in pension mode in our SMSF and if we participate in the buyback, we would top up our BHP to the level of the old holding. How would the special dividend affect the purchase price of the BHP shares? Our expectation is it will increase and negate the advantages of participating in the buyback. Is our assumption correct? Would we be better off to just retain our current holding and accept the special dividend?

Click here to take a free 30-day trial to the Switzer Report to read the full answer and more.

 

Is Coles a sell?

Friday, November 23, 2018

530,915 Australians are now direct shareholders in supermarket chain Coles, following its demerger from Wesfarmers, making it one of Australia’s most widely held companies. It will also have one of the most inverted share registers, with a massive 97.2% of shareholders owning less than 5,000 shares each and the top 0.02% of shareholders owning 63.6% of the total number of shares on issue.

The question that shareholders in the newly ASX-listed Coles (COL) will be asking is: what do I do with my Coles shares? Sell, buy more, or hold?

Strategically, many will look at the supermarket industry and say that there are enough headwinds – competition from discount supermarket operators, such as Aldi, Costco and Kaufland; margin pressure from customers and suppliers; the threat of the Amazon juggernaut – to give this company the flick. And that’s without even considering the impact a refreshed Woolworths or IGA can make. Sure, Coles will pay a handy dividend, but this is a low growth, low margin, increasingly competitive industry.  The facts speak for themselves, with Coles EBIT (earnings before interest and taxes) declining from $1,779m in FY16 to $1,522m in FY17 to $1,414m in FY18. The Coles investment thesis  is not compelling.

Others will look at the history of demerged companies and say that over the medium term, they usually perform pretty well. Think S32 from BHP, Orora from Amcor, CYBG from NAB, Pendal from Westpac, BlueScope (eventually) from BHP, Dulux from Orica and Treasury Wine Estates from Fosters.

Why these have worked is hard to say. One theory is that “big isn’t always better” and that a refreshed management team removed from the bureaucracy and constraints of “head office” is set free to thrive. But there have also been a couple of disasters – PaperlinX from Amcor and OneSteel (later called Arrium) from BHP readily come to mind – so it’s not a lay down misere.

On reflection, it is hard to see how Coles fits the bill of a typical demerged company. It hasn’t been starved of capital (it accounted for about 60% of Wesfarmers capital), nor has it been the “unloved child”. And as a conglomerate used to owning and managing disparate business, ranging from department stores to fertiliser production to mining, Wesfarmers “head office touch” has always been relatively light.

And that brings us to valuation. Although some analysts are still crunching their numbers, broker consensus for Coles is for forecast earnings in the range of 65 to 75 cents per share. Based on last night’s closing price of $12.75 per share, this puts Coles on a multiple of 17.0 – 19.6 times FY19 earnings. Its competitor, Woolworths, is trading of a multiple of 21.2 times forecast FY19 earnings and 20.2  times FY20 earnings.

Given that most analysts expect Coles to trade at a discount to Woolworths, Coles looks fairly priced. However, the history of demergers is that newly demerged companies tend to struggle on the market for the first six months or so because of the supply overhang, before finding a level that attracts fresh buyers.

Bottom line – Coles is a sell.

There may be a case for owning it in an income-focused portfolio, but at a more attractive price.

What is the future for Wesfarmers?

Under MD Rob Scott, Wesfarmers has been employing the old “shrink to greatness” strategy. Since taking over, he has divested their disastrous investment in Homebase, the chain of UK home improvement stores that Wesfarmers tried to “Bunningsise” and failed so dismally. He has completed the demerger of Coles, exited coal mining with the sale of the Curragh mine and a 40% interest in the Bengalla JV thermal coal mine, sold the Kmart Tyre and Autoservice business and disposed of a 13.2% indirect interest in Quadrant Energy.

To be fair to Scott, this has been about repositioning the conglomerate for the future so that it is focused on higher growth, higher returning businesses. The balance sheet has been considerably strengthened and on the whole, the market has welcomed the sales.

But he hasn’t yet created a single dollar of new revenue. The absurdity of the share price going up to almost $53.00 on the news that Coles was being demerged and completion of other corporate actions has been laid bare by the post-demerger aggregated share price today of $44.71 (Coles of $12.75 and Wesfarmers of $31.96). A fall of 15.3%.

In terms of the existing Wesfarmers businesses, Bunnings seems to go from strength to strength. However. a challenged housing market could impact sales growth. Kmart is on fire, while Target continues to struggle. Officeworks has probably been squeezed as hard as it can (Wesfarmers tried to IPO this but failed), and measured growth is the best that can be expected from the industrials and safety division.

The bottom line is that the jury is out on Wesfarmers. According to FN Arena, of the 8 major broking firms that cover the stock, 5 have neutral recommendations, 1 rates it as a sell and two firms have no rating. Like the market, they want to see what Scott is going to do with Wesfarmers. Selling assets was the easy part – the hard work, to build and develop new revenue streams, awaits.

Wesfarmers is a hold.

 

Your Questions Answered

Monday, November 19, 2018

Question 1: I note in the BHP buy-back information that part of the arrangement is “a fully franked deemed dividend.” From the ATO website, they say “DEEMED” means the dividend is from the company accumulated franking credits. Does this mean shareholders will receive all the dividend money as a franking credit, which can be claimed from the ATO in due course?

Click here to take a free 30-day trial to the Switzer Report and read the full answer.

 

Shorten slugs hybrids

Thursday, November 15, 2018

Investors in hybrid securities issues, such as CommBank’s PERLS XI Capital Notes or the new issue announced by Westpac on Monday, Westpac Capital Notes 6, should consider carefully the impact of Bill Shorten’s proposed changes to franking credits. While there has been widespread  discussion about the potential impact on widely held bank shares and high dividend payers like Telstra, the hybrid securities market hasn’t rated much of a mention.

A fully franked distribution is critical to the return from a hybrid security, because the actual cash distribution component is adjusted down for this benefit. Westpac’s new hybrid, which looks likely to be priced at a margin of 3.7% over the 90-day bank bill rate, is set to pay a cash distribution for its first 90 days at a rate of just 4% pa. This is calculated by adding the margin of 3.7% to the current 90-day bank bill rate of 2% and then multiplying the sum by 0.7 (an adjustment factor derived from the company tax rate).

This distribution will be fully franked, so for self-funded retires drawing a pension from their SMSF, the  return is currently 5.7% pa when the franking credits are refunded. Take away the refunding, the 4% looks interesting but not particularly compelling. Better than a term deposit earning 2.5%, although much higher risk, but a lot less than the dividends on bank ordinary shares, which in some cases are yielding over 7%. Also, less than the distribution yield on some relatively lower volatility securities such as property trusts, Transurban and Sydney Airport.

This is one of the reasons that I advised caution on the CBA PERLS XI issue (see http://www.switzer.com.au/the-experts/paul-rickard/is-commbanks-new-hybrid-a-real-pearler/).

Of course, only some types of investors will be impacted by the change and as it is almost impossible to estimate just how many there are, the toll on the ASX-listed hybrid securities market is but a guess. My guess is that as a retail oriented market ideally suited to income investors, particularly SMSFs, the impact could be considerable. I am also assuming that the ALP  wins Government and that when presented as legislation to the Senate, it passes through the Senate crossbench without amendment. Still big assumptions.

That said, let’s make the assumptions and see who could be impacted.

Who is impacted?

Bill Shorten’s plan is to abolish the refunding in cash of excess franking credits. Only recipients of a government benefit (including a part aged pension) will be exempted.

Franking credits will still be applied as a tax offset and available to reduce tax, but they won’t be refundable. This means only some taxpayers are impacted.

Let’s take a couple of examples to show who is impacted. We will start with Mary, an individual paying tax at the highest rate of 47% (includes 2% Medicare Levy). Assume that the distribution on the hybrid  security is $70, and the attached (non-cash) franking credits are $30. Both the distribution in cash ($70) and the franking credits ($30) are taxable, so Mary’s taxable income is $100. At a rate of 47%, this means tax of $47 is payable. Next, the franking credits are applied for a second time, this time as a tax offset of $30. So, Mary’s net tax bill is reduced to $17.

Once Mary has paid tax, she is left with $53 in cash (the distribution of $70 less net tax of $17). As the franking credits have been used as a tax offset, there is no cash refund from the ATO.

Under Shorten, Mary is not impacted.

Next Jane, who’s paying tax at 34.5%. Assume the same distribution of $70, attached franking credits of $30, taxable income of $100. At a rate of 34.5%, she pays $34.50 in tax. Against this, she applies her franking credits as a tax offset of $30, leaving net tax to pay of $4.50. After paying this, she is left with $65.50 in cash. Again, as the franking credits have been used as a tax offset, there is no cash refund. Under Shorten, she is not impacted.

Let’s go to the other end of the tax scale and take Bob & Sally’s SMSF, which is fully in pension mode and has that fantastic tax rate of 0%. Assume the same cash distribution of $70, attached franking credits of $30 and taxable income of $100. At a rate of 0%, Bob & Sally’s SMSF pays $0.00 in tax. But the franking credits are still available to be used as a tax offset, and as there is no tax to pay, they are refunded in full by the ATO. Bob & Sally’s SMSF total return is $100, the $70 cash distribution and the $30 cash refund.

Under Shorten, the cash refund goes. The return to the SMSF drops from $100 to $70.

Other 0% taxpayers, such as a non-working spouse whose taxable income is less than $18,2000, would be similarly impacted.

Finally, the tricky example –  Fred & Grace’s SMSF in accumulation mode paying tax at 15%. Whether it will be impacted or not will depend on the fund’s asset mix.

Let’s assume  the same distribution of $70, franking credits of $30 and taxable income $100, and make a further assumption that all assets of the SMSF are fully franked shares or hybrid securities. Tax of $15 is assessed against the hybrid security (tax rate 15%), and against this, a tax offset of $30 is available. After application of the tax offset, no tax is payable, and there is an excess offset of $15 that could be refunded in cash. Potentially,  a return of $85 (the $70 cash distribution and $15 tax refund). 

As Fred & Grace’s SMSF is fully invested in franked shares, there won’t be any net tax to pay, so  excess tax offsets are refundable in cash by the ATO. Under Shorten’s plan where refunds will cease,  the return on the hybrid security will fall from $85 to $70.

If on the other hand, Fred & Grace’s SMSF had assets that don’t pay franked distributions, such as international shares, term deposits, property or cash, then they may not be in receipt of a cash refund. This is because the excess tax offsets from the hybrid security are being applied to reduce the tax payable on the income from those other assets. This won’t change under Bill Shorten’s proposal.

So, impacted are SMSFs in pension phase and other 0% rate taxpayers. Some SMSFs in accumulation phase will be impacted, while others won’t. High rate individual taxpayers won’t be impacted, nor will foreign investors and most Australian institutional investors.

But my sense is that SMSFs in both pension phase and accumulation phase are big investors in hybrid securities, and under Shorten, they won’t look particularly attractive investments.

If you are impacted, what can you do about it?

The answer is not a lot. Although the ALP softened its original position to provide an exemption for persons who are in receipt of a government benefit and an SMSF where at least one member was receiving a government benefit, in the case of an SMSF, it is not prospective (the SMSF had to be in this position prior to 28 March 2018). So, if your SMSF is already in pension mode, you can’t take any action.

One potential strategy for those approaching pension age is to invest outside super to maximise the tax-free income threshold of $18,200), while ensuring that you qualify for the age pension. To get under the assets test limit and qualify for a part pension, you may have to invest in the family home or spend (not gift) some of your funds. Seek the appropriate advice before contemplating this strategy – it could have some downsides.

 

Your questions answered

Monday, November 12, 2018

Question: With the likely election of a Labor federal government next year, I believe we are heading for a disaster for self-managed superannuation funds. Labor will destroy franking credits, and individuals signing petitions will only open the floodgates for tax audits. Looking at the Switzer business, a Labor win will not be a good result. The party will also change negative-gearing policies, which will hurt many property investors. In relation to the above, what does the Switzer Report recommend for investments? I back a total pull-out of all banking shares and Telstra and investing overseas, especially as the Australian dollar will be US60c by Christmas 2019.

To read the answer, click here and sign up for a free 21-day trial to the Switzer Report.

 

Is Commbank’s new hybrid a real pearler?

Thursday, November 08, 2018

Last Thursday, the Commonwealth Bank announced the launch of its latest ASX-listed hybrid security – CommBank PERLS XI Capital Notes. Set to pay a fixed margin of 3.7% over the 90-day bank bill rate and have an offer size in excess of $750m, the final terms of the issue will be announced tomorrow after a bookbuild today.

And while I am a fan of hybrid securities for investors who understand the product and the risks, like all markets, there can be times when it pays to just sit out and keep the powder dry. With the recent movement higher in bank ordinary share yields, plus the uncertainty over the ALP’s policy changes to dividend imputation, I think the hybrid market is at this point.

I don’t dislike the issue  – I just don’t think it is a real bargain. I will come back to this a little later, but firstly, details of the offer.

CommBank PERLS XI

CommBank PERLS XI Capital Notes will pay a quarterly, fully franked distribution. This is calculated at a fixed margin of 3.7% over the then 90-day bank bill rate, and then adjusted by the company tax rate (to take into account the benefit of the franking credits). The distribution is re-calculated each quarter.

With the 90-day bank bill rate currently at 1.95%, this implies a gross distribution rate of 5.65% pa for the first 3 months (1.95% plus 3.70%). The actual distribution in cash, which is fully franked, would then be 3.96% (5.65% x 0.70 = 3.96%).

Distributions are discretionary and subject to distribution payment conditions. If a distribution is not paid, it doesn’t accrue and won’t subsequently be paid. To protect holders from this discretion being mis-applied, Commonwealth Bank is then restricted from paying a dividend on its ordinary shares. 

Exchange into CBA shares or Early Repayment

PERLS XI are perpetual and have no term. However, CBA must (subject to a test) exchange the PERLS XI Capital Notes into CBA ordinary shares on 26 April 2026 (in about 7.5 years’ time). If exchange occurs, holders are issued $101.01 of CBA ordinary shares for every PERLS XI Note of $100 face value (which effectively means that they are issued CBA shares at a 1% discount to the then market price). The test for the exchange is the price of CBA ordinary shares at the time – provided they are higher than approximately $38.84, exchange occurs – otherwise, it is retested on the next and subsequent distribution date(s) until the test is met.

To qualify as regulatory capital for CBA, two further events cause mandatory exchange - a ‘capital trigger event’ and a ‘non-viability trigger event’. Under these tests, the Australian Prudential Regulatory Authority (APRA) can require CBA to immediately exchange PERLS XI into ordinary shares if CBA’s Common Equity Tier 1 Capital Ratio falls below 5.125% (the ratio was 10.0% on 30/9/18), or if it believes CBA needs an injection of capital to remain viable. In these distressed circumstances, exchange would most likely result in a holder receiving considerably less than $100 of CBA ordinary shares as there is a cap on the maximum number of shares that can be issued.

CBA also has an option to redeem the PERLS XI Notes early on 26 April 2024 (in approximately 5.5 years’ time) by paying holders $100 per PERLS XI Capital Note.  

Details of the issue are as follows:

CBA is also conducting a re-investment offer for holders of PERLS VI (ASX Code CBAPC). PERLS VI, which pay interest at a fixed margin of 3.8%, will be called (redeemed at the $100 face value) if investors do not elect to re-invest in PERLS XI. Payment will be made on 17 December.

How to invest

The offer is due to open tomorrow (Friday). Several brokers and financial planners are involved in the issue, including CommSec, Morgans, Morgan Stanley, Bell Potter, Macquarie and Ord Minnett. If you are investing via a broker or financial planner, many are receiving a placement fee of 0.75% and in some cases, may be willing to share some or all of this with potential investors.

CBA shareholders and holders of PERLS VI, VII, VIII, IX and X can also access PERLS XI Notes directly through a Securityholder offer at www.commsec.com.au (you don’t need to be a CommSec client).

My view

While this issue is reasonably priced compared to existing secondary market yields, I am not a huge fan for three reasons.

Firstly, it is priced on the lower side of the margins that CBA has previously paid for PERLS issues. Listed below is a table of previous issues, showing that the fixed margin has ranged from a high of 5.2% to a low of 2.8%.

History is not always the best guide and there are reasons why margins should be lower now including the very strong capital position of the major banks, lower issuance, and comparable margins in wholesale markets. This particular issue also has a relatively short term to the mandatory exchange and expected call date.

But this is an issue directed at retail investors and while 3.7% looks interesting, it is not riveting.

Compared to the yields available on bank ordinary shares, PERLS XI stacks up poorly. While they are very different securities, they do carry some of the same underlying risks. Whenever there has been a sell-off in bank shares (as there has been over the last couple of months), hybrid securities trading on the ASX have fallen in price and their effective trading yields have increased.  

Here is the comparison on a cash and gross (post franking) basis between CommBank’s PERLS XI and the closing yield on bank ordinary shares yesterday (1 year forecast from FN Arena).

* Closing price 7/11/18, forecasts from FN Arena for FY19 dividends. PERLS XI using current bank bill rate of 1.95%

Thirdly, hybrid securities will be impacted if the ALP’s policy to deny the re-funding of excess imputation credits in cash becomes law. My guess is that the big holders of hybrids are SMSFs, particularly those in pension phase. While there has been a lot of commentary about the potential impact of this change on bank shares and Telstra, the hybrid market hasn’t rated much of a mention. I doubt this is yet factored in.

 

My view on ANZ

Thursday, November 01, 2018

When describing ANZ’s full year profit result yesterday as “solid”, CEO Shayne Elliott made it clear that actions to simplify the business, reduce cost and rebalance capital had put the Bank in a good position to meet the challenges facing the industry. But with no revenue growth and a strained franking account position, the Bank will be relying on further share buybacks to maintain earnings per share and put a floor under the share price.

Fortunately, ANZ is in a very strong capital position due to the divestment of its Asian and wealth management businesses and organic capital generation. After completing its current on-market share buyback (it has around $1.1bn remaining from its original $3bn program) and already announced divestments, its capital ratio on September 30 (on pro-forma basis) was 11.83%. This is well in excess of APRA “unquestionably strong” target ratio of 10.5%.

Because franking credits are strained, “off-market” share buybacks are off the agenda. Also,  while the annual dividend of 160c per share (fully franked) is now secure, it won’t be going up. This leaves on-market share buybacks as the preferred method for returning capital.

ANZ will also “neutralise” its dividend re-investment plan (DRP), which means  buying on market an equivalent number of shares to that it issues  through the DRP. Along with share buybacks, this will support ANZ’s reported earnings per share.

Full year cash profit from continuing operations of $6.5bn was down 4.7% on the previous year, but $0.3bn better than analysts’ forecasts. It included “large and notable items” totalling almost $700m, of which $295 was for customer remediation costs arising from the Royal Commission and $206m for accelerated software amortisation.

Highlights included:

  • Strong performances in Institutional and in New Zealand. The former grew second half cash profit before provisions by 7% compared to the first half. In New Zealand, cash profit before provisions grew year on year by 7%. Interestingly, cash profit in   NZ has grown by almost 300% since 2010, and in 2018 , total expenses (in actual Kiwi dollars) were less than those incurred in 2010;
  • Bad debt provisions were at record lows. The Bank booked a cost of just $688m in FY18, down from $1,199m in the previous year. The second half loss rate was just 9bp. Importantly, the forward indicators are positive and show no signs of  mortgage or other financial stress;
  • Total expenses (excluding large and notable items) fell by 1.5%. Excluding Asian Retail, ANZ shed 2,710 positions, with Australian Retail losing 1,000 jobs (7%). ANZ said that most of these positions went in the second half, giving ANZ a trajectory for lower costs in the next half; and.
  • Tier 1 capital of 11.44% at 30 September (11.83% on a proforma basis).

Negatives included:

  • A weak result for the Australian Retail Bank, ANZ’s biggest division, where a slowing housing market and constraints on investor lending took their toll. Cash profit before provisions and excluding large and notable items for the second half was down 2% on the first half. Year on year, it rose by only 2%; 
  • Volumes were also weak – with year on year housing growth of 3% and deposit growth of 1% below system. The second half was even weaker, with housing growth slipping to 0.3% and deposits going marginally backwards. Shayne Elliott admitted that the tight control of expenses might have had some impact on volumes, implying that ANZ might have gone “too hard, too fast”; and
  • Net interest margin (NIM) declined from 193bp in the first half to 182bp. Some of this was due to customer remediation and other one off factors, while a change in the asset mix played its part as ANZ focussed on (lower margin) owner occupied home loans and customers switched out of higher margin interest only loans to lower margin principal and interest loans. On the flipside, ANZ’s recent increase to the variable mortgage rate was yet to fully flow through and looking ahead, the immediate outlook for NIM was more stable.

The brokers and the market

The market’s initial reaction to the result was positive, with the shares up 1.05% yesterday.  The analysts were on the whole a little more subdued. While noting it as a “beat”, UBS thought it was a little “messy”. Macquarie thought the result “credible”. Others were concerned about the deterioration in NIM and whether ongoing switching in the home loan market and regulator action on front book/back book pricing would put further pressure on revenue.

Overall, the major brokers remain reasonably positive about ANZ, with 5 buy recommendations and 3 neutral recommendations (no sell recommendations). The current consensus target price is $29.35, 13.2% higher than Wednesday’s closing price of $25.93. At this price, ANZ is yielding 6.17% (fully franked).

My view

Macquarie got it right in labelling it a “credible” result. I continue to believe that the major banks are “cheap” and ANZ’s result has done nothing to shake my confidence. While It is going to remain “revenue challenged”, the dividend is secure, capital position is strong and it is the most advanced of the major banks in simplifying its business and products to cut costs. Sentiment on the banking sector remains negative, so you can afford to be patient and buy on market dips.

 

4 money lessons your kids should know

Thursday, October 25, 2018

Being a “non-cool old man” (hell, I’m not even 60 yet!), some might say it’s a bit rich for me to be lecturing millennials less than half my age about how to save and invest. So this appeal is through you – their elder siblings, parents, or perhaps even grandparents – to share these tips about how they can spend, save or invest “smarter”. And also, a couple of things they shouldn’t do.

1. Spending

Firstly, I’m not going to labour the point about doing a budget (which sounds incredibly boring). It goes without saying that this is a good idea. By working out that you spend $12 a day on those three take away cappuccinos and if you cut back to just two per day how much that would improve your bank balance over a month – that is the power of a budget. Peter Switzer called doing a budget “exciting” as “it gives you the money firepower to turbo charge your wealth-building” (see here).

But I do want to address how you pay for things. Using Afterpay (which for the non-millennials is electronic lay-buy) is OK, provided you are really disciplined about your payments. Remember, you will pay 4 equal instalments due every 2 weeks by direct debit to your debit or credit card. Miss one instalment on an item under $40 and you pay a late fee of $10 (a simple interest rate of 25% - the effective per annum rate could be in the 100’s of percent), and on larger items, a simple interest rate of 25% capped at $68. Could it happen to you? Possibly. While only 5% of instalments incur a late fee, Afterpay says 22% of customers have paid late fees.

Debit or credit card? Debit cards are fine. If you get a credit card, and there are sound reasons to do so including establishing a credit history with a bank, keep it simple. Low or no fee, low interest rate, no reward or loyalty points.

Loyalty points are great for people who always pay their credit card balance off in full by the due date, but for everyone else, they are a waste of time. They are the classic marketing illusion – they look and feel valuable, but in reality, they aren’t worth that much. In most loyalty schemes, one point is worth on average half of one cent. That means 100 points, which you get when you spend $100, is worth 50 cents. 1,000 points is worth $5, 10,000 points is worth $50 and 100,000 points is worth $500. That’s right – you have to spend $100,000 to earn $500!

Miss a credit card payment (or not pay the full amount) and you could be paying interest at over 20% pa, and you pay it from the statement date, not the date you miss the payment. The “interest free” period only applies when you pay the whole amount by the due date.

 An idea to help with budgeting and spending is to manage the timing of direct debits around when you get paid. For example, if you get paid monthly, see if you can get all your direct debits timed to occur on the day (perhaps the day after) you get paid. That way, you get all the regular payments out of the way – and know what you have left over for the month. If your landlord or utility won’t co-operate, open a second bank account to act as a holding account so you can set these funds aside.

2. Saving

I am a bit old fashioned when it comes to owning your own home – I think this should be the number one savings priority for younger Australians. While a case can be made that renting a home and buying an investment property can produce a better outcome, most people don’t buy “the worst house in the best street”. Further, the comfort of owning the roof over your head, let alone a tax system that biases home ownership through the absence of capital gains tax and latter on when it comes to eligibility for the government pension, speaks to making this a priority.

The Government’s new First Home Super Saver Scheme has changed the game for millennials saving for their first home. This is an absolute “no brainer” (see here). It is not the panacea to address the housing affordability challenge, but it will make it easier for those trying to breach the deposit gap.

The scheme allows savers to make voluntary contributions to super of up to $15,000 in any one year, and then up to a maximum of $30,000 over the duration of the scheme. This means that a couple can effectively save $60,000.

Critically, the contributions to super can be out of “pre-tax” dollars – just like salary sacrifice contributions - making them particularly tax effective.

Bottom line is that when withdrawn from super to purchase the first home, net of all taxes,  savers will have about 30% more on average than if they had saved the same amount in a bank term deposit.

Like any Government scheme, there are several rules that govern eligibility. 

You can participate in the scheme if you have never previously owned property (including an investment property). There is no age limit or minimum – but you must be at least 18 to make a withdrawal from the scheme. And you must intend to live in the property as soon as practicable, and for at least 6 months of the first 12 months you own the property. Further, the monies must be used for a home or home and land package – you just can’t use the funds to buy land.

Finally, eligibility is assessed individually, so while your partner might not qualify (because he/she owns an investment property), you can still qualify.

3. Investing

If you have already got the first home sorted, investing surplus cash in other growth assets should be a good strategy over the medium term. Putting extra money into  superannuation is probably not the smartest strategy because you won’t be able to access it for 30, 40 or possibly even 50 years. With retirement ages moving out and the Government capping how much you can have in super, millennials in this position will have lots of  time to build up their super nest egg.

The obvious investment assets are shares or property. The former have the advantage that you can start with as little as $500 per share (arguably, this is too small for the brokerage charges and a few thousand makes more sense), and shares can be readily liquidated so that they can be used as savings for your first home. If you don’t know what to buy, CommSec offers starter “share packs” (pre-blended portfolios of shares from $4,000). Alternatively, you could look at an index tracking exchange traded fund such as IOZ ; an actively managed fund such as SWTZ; or companies that you know and understand such as your bank or telco.

Buying an investment property is a bigger decision. The important thing to remember here is that your investment return will come from an appreciation in the price of the property. While the rental income should cover your operating expenses, it won’t usually cover your interest costs. If you negatively gear (best suited to those paying tax at a high marginal rate of tax such as 47%), by definition, you are losing money (outgoings, including interest costs, exceed income).

Not everyone is a great buyer of property, and with the market looking like it has further to pull back, this strategy should be carefully considered. The ALP’s proposed ban on negative gearing is another factor to consider. While this could be a negative in the medium term for property investors, as existing properties will be grandfathered, there is an argument that says to get in ahead of an expected ALP win.

4. Cancel

Finally, two things to cancel. Unless you have dependents or a mortgage, you probably don’t  need life insurance. While many super funds automatically deduct from your employer’s 9.5% super contribution a life insurance premium, it is your call whether you want this or not. Tell your super fund to cancel the deduction. Also, cancel any salary sacrifice contributions (outside those which can be put in to the First Home Super Saver Scheme) and invest these monies outside the super system.

 

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