19 February 2023
Cash and bank hybrid securities safer place to be as interest rates continue to rise and bear down on shares but there are exceptions.
This newsletter should be read in conjunction with my previous one available at grahammiddleton.com
CSL May Be an Exception
Australian listed pharmaceutical business CSL has developed into a global giant with a strong array of pharmaceutical products and a huge pipeline of new products at various stages of testing as they move toward approval by the US Food and Drug Administration (FDA). The FDA is the critical approving authority. With huge global sales, a recovery in blood serum collections post Covid and the inclusion of the Vifor business, CSL has resumed its growth curve. Unlike businesses which will be hit hard by reduced consumer spending CSL’s pharmaceutical products are resistant to economic slow-down.
CSL’s 20 Year Success Story
At a recent price of $304, CSL has grown at a compound rate of 23.3 percent over 20 years! While CSL dividends are modest the capital growth over a long period has been astonishing with a slight pause to ingest the major purchase of Vifor. The market interpreted CSL’s half year results positively.
We have long owned CSL in our family superannuation fund, becoming overweight with its growth and regard it as a long-term hold.
It is strongly advised that potential investors look up CSL’s yearly and half yearly accounts over a number of years, as well as its periodic update on pharmaceutical products in the various stages of development and testing. Dial up CSL via one of the Australian Stock Exchange (ASX) lists. If advised to sell some or all CSL challenge your adviser to justify sale recommendation and identify why another stock is a better long term investment.
I very much prefer it to hospital stocks which have staffing problems and exploding costs.
Bank Hybrid Yields
Margins above BBSW (bank bill swaps) mean that yields on bank hybrids are now well above 6 percent grossed up with franking credits. This is below long-term share market returns, but is likely to prove to be above the coming year overall market return as interest rates drive down share prices and property. As interest rates rise the BBSW rate will follow. We have spread our hybrids among several issued by each of the big five banks including Macquarie with a range of reset dates for each bank’s hybrids to diversify what we view as minimal hybrid risk. There is a slight risk in hybrids which rank after bank deposits but ahead of bank ordinary shares. In my opinion the risk is very small.
The above is general advice and it is important that when investing you take the trouble to understand the proposed investments and take advice as necessary.
Anti-Inflation Strategy: Interest Rates and Other Central Bank Actions Drain Money out of the Economy
The break-out of inflation will be extremely destructive to the economy if not checked. The evidence for its impact can be found in the high inflation of the 1980s and early 1990s which led to the infamous ‘recession we had to have’ as described by then treasurer Paul Keating, accompanied by high unemployment and shock waves of business failures. It is vital to stop inflation getting out of hand. There are two ways of tackling inflation:
1. By federal and state governments reducing spending and balancing their budgets. This is known as fiscal policy. Its weakness is that politicians find it nigh on impossible to restrict spending. When in opposition they constantly criticize governments for not spending more and when in government they blame the previous government for having overspent.
2. By central bank actions which are known as monetary policy. When politicians fail to maintain effective fiscal policy central banks are forced to take monetary action. They do this in two ways.
Firstly, they force up interest rates by increasing the rates at which they lend to banks and by reducing their stock of government bonds. Instead of rolling over bonds as they mature they take back the money on maturity. This forces governments to pay higher interest rates to attract money from investors which reduces liquidity in the financial system.
Secondly, by forcing up the rate at which they lend to banks they in turn have to charge more to borrowers. As home buyers and business borrowers have to pay higher interest rates they are forced to reduce borrowings and this is a reason why housing prices fall and capital equipment purchases by small businesses are deferred. This in turn reduces the money multiplier inherent in the banking system. The overall impact is less spending money in the population reducing demand and creating downward pressure on prices. i.e. reducing inflation. The overall process is referred to by economists as quantitative tightening (QT). This is the opposite of the quantitative easing (QE) which occurred during the Covid pandemic when interest rates were reduced and government bonds were purchased by central banks with very low yields; effectively printing money for government which is beneficial to stem a temporary crisis but leads to a break out of inflation and a need to reverse policy.
Politicians Huge Conflict of Interest!
The members of House of Representatives and Senate economics committees, made up of members of government, opposition and minor parties, who grilled the Governor of the Reserve Bank on interest rate settings collectively own 41 rental properties, all or most of which are financed with bank borrowings! That is some conflict of interest!
Higher Interest Rates are Bad for the Following
· Stock market demand for start-ups dry up. Hence very few new ASX listings.
· Tech stocks are reeling and displacing staff with further pain to come.
· The draining of money from global economies via central bank actions will be destructive to crypto, which does not merit being described as an investment class. Crypto failures are likely to accelerate as scarcity of money cause people to withdraw.
· Commercial property is suffering multiple hits from increasing interest rates, work from home lowering demand for office space and increased long term bond rates forcing valuations to fall. Commercial property valuation formulae factors in a risk margin above expected 10-year government bond yields.
· High yield corporate debt/junk bonds risk is rising and on sale values falling.
· High yield equities are likely to fall in value.
· Buy now pay later businesses will struggle to survive in an environment where their cost of borrowing is much higher and there is greater risk of bad debts, mostly a myriad of small debts, which are not cost effective to recover. Recent failure in this sector is likely to be a harbinger of more to come as well as greater sector regulation.
All of the above are at severe risk in an environment of central banks forcing up interest rates and keeping rates higher for longer.
Worried about high fees for superannuation administration and advice packages? Is your adviser worth what you pay? What is the market cost of a quality superannuation fund administration and advisory services?
In recent years, with substantial improvements in software packages there are specialized superannuation fund administrators who don’t insist on coupling administration to advice as a package. I personally use Heffron, a specialist superannuation administrator, and have a long-term relationship with Campbell Thompson (telephone 0407 839 229) and his assistant Simone Shelton (0402 085 892) dating back to E. L. & C Ballieu which have been absorbed into Ord Minnett. In both cases I am under no financial obligation to recommend either and will receive no financial reward for doing so. They are the services with which I am familiar. Many retired couples with large super funds can engage Heffron and Ord Minnett separately and save large amounts of fees or if they are comfortable making their own investment decisions, simply use Heffron as a quality superannuation fund administrator or as a basis of comparison with other administration services. I am aware of SMSF couples who have been paying large amounts based on historical formulas which are now outdated or who no longer find that the advisory component of their super fund administration and advice package is worth the cost to them. They can obtain quotes from the above and compare fees with what they are paying.
Debt Free ARB Has Long Outperformed Bapcor
While ARB share price soared above expectations then corrected its compound annual share price, movement over the past 5 years has been 9.47 percent—much better than Bapcor, to which it is often compared, with a compound share price movement over the past 5 years of 1.55 percent. I am puzzled when I hear of advisers telling clients to sell/lighten ARB and buy Bapcor! While Bapcor has debt, ARB has zero net debt and a strong balance sheet. Readers should dial up each via the ASX200 and trawl back to their respective annual reports and examine their balance sheets closely. I wonder whether advisers advising a switch from ARB to Bapcor have examined their balance sheets and long- term performance. ARB has been listed for much longer and its share price performance over 20 years (measured to 18/02/2023) has been a compound annual growth rate of 15 percent to which should be added its half yearly fully franked dividends over that period.
In the coming period of higher interest rates well managed businesses with strong balance sheets are in a relatively strong position.
Industry Superannuation Funds Property and Infrastructure Valuation Gaps and Risks Increase as Interest Rates Rise
As the interest yield at which 10-year Australian treasury bonds has increased significantly, both commercial property and infrastructure investment investments owned by Industry Superannuation funds are now seriously overvalued which has been reported on extensively in the financial press. Both the US Federal Reserve and the RBA are indicating further interest increases are likely. Rates are most unlikely to correct back to the extremely low rate they reached prior to the first increase in the current cycle. 10-year bond yields will be higher for longer. Hence infrastructure and property values which are priced on their yields being set at a margin above bond yields will continue to weaken and may take several years or longer to recover to their current inflated values in industry superannuation funds. Recently the Australian Financial Review has written of the substantial valuation risks in outdated valuation of commercial property and infrastructure assets by industry superannuation funds. Because of lengthy lags in valuation, industry superannuation funds value of these assets is presented as having substantially appreciated whereas similarly classified assets listed on the stock market have declined sharply in value as interest rates have increased. This is great for fund members withdrawing from industry superannuation funds while these assets remain overvalued but unjust to recent members whose account balances risk a hefty fall when inevitably valuations correct asset values to market.
The traditional valuation of these types of assets is closely related to the yield on the 10-year government bonds. Investors demand a margin above the 10-year bond rate to reflect a risk margin. As interest rates increase bond yields grow and the resale value of bond prices fall as does the price at which commercial property REITs and Infrastructure trade at. This is elementary corporate finance modelling. The successive RBA interest rate increases have led to a significant increase in 10-year bond yields but Industry super funds have been reluctant to revalue these assets.
Members of Industry super funds can protect themselves by selecting cash options until it is clear that their funds property and infrastructure investments have been properly valued to market.
The Big Question?
As the problem has been highlighted in the Australian Financial Review it would be interesting to note whether industry super fund executives and board members have switched their own investment choices within these funds as the valuation disparity has emerged?
Are Potential Dental Practice Purchasers Getting Good Advice from Accountants?
Prior to my retirement I had spent 33 years advising dentists. When faced with a dentist contemplating purchase of a practice it was important to avoid perfect becoming the enemy of a possible practice purchase at a slightly above value but still offering a worthwhile opportunity to the purchaser.
Very few accountants are skilled at business valuation. Those that are have concentrated on building expertise with respect to particular types of businesses or professional practices. Only having a substantial client list of a particular business type and developing deep knowledge of that business equips an individual to value accurately. In my case I concentrated on dental practices and veterinary practices but refused invitations to value types of business of which I had little knowledge. I advised a huge number of dental and veterinary practice owners including benchmarking of annual practice financial performance, advising practice purchase and sales including veterinary partnership and dental associateship transactions and measuring and advising on their overall wealth creation through many years of practice.
Too often accountants seeking to impress a potential new client but not having a substantial dental client list or in some cases zero dental clients tend to tell the potential practice buyer what they want to hear. This has a heavy bias toward telling them the practice is overpriced. Often the result is that the dentist forgoes a critical career and wealth creating opportunity.
On many occasions where a dentist had an opportunity to buy a practice but the price was a little above valuation, I advised the dentist to buy if it was evident that they could easily cover the extra interest cost, the practice had good fundamentals including suitable premises and suitable handover conditions.
Vital to Ascertain an Accountant’s Dental Practice Knowledge
Before accepting advice as to practice value from an accountant it is vital to ascertain precisely how many dentists the accountant actually does annual accounts for and for how many years. If the accountant has few if any dental practice owning clients or is evasive their advice needs to be put aside. Some young dentists pass up opportunities only to later see a colleague thriving in a practice that they later wish that they had purchased. The accountant who gave them ill-informed advice which had a huge detrimental impact on their career and long-term financial outcome is never held to account. The best way to ascertain the experience of the accountant is to ask a number of questions about dental practice profitability and operation to which you already know the answers. For lots more information read my book Financial Success as a Dentist.
Don’t confuse accounting qualifications with specialized business knowledge.
Please Pass On
If you like these newsletters, please pass them on to colleagues. Past newsletters and articles in Australasian Dental magazine on business issues are at grahammiddleton.com. I can be contacted directly at graham.george.middleton@gmail.com
Independence And Disclosure
I am not a representative of any accounting practice, financial planning firm, business or marketing consultancy. I spent 33 years as a business and financial adviser to mainly dental, medical and veterinary specialist and general practitioners. Since I retired as a director of a financial services group, of which I had been a founder, on 30 June 2020, I am no longer licensed as an investment adviser. Readers should treat the above as general advice and take professional advice as required.
General Advice
I sold my interest in a financial services and accounting group on 30 June 2020 and have no intention of starting another financial services business. I own, via my family superannuation fund and investment portfolio, some of the stocks mentioned in this newsletter. My website is now available at grahammiddleton.com.
Those who find my newsletters of value to them are asked to consider making a donation to the Delany Foundation, a registered charity which assists schools in Papua New Guinea, Ghana and Kenya. Delany Foundation c/- Holy Cross College, 517 Victoria Road Ryde NSW 2112.
Best wishes to all readers
Graham Middleton
