27 April 2021
Follow the Money
I wonder at the long-term future of “buy now, pay later” businesses Afterpay and Zip. In July last year, Afterpay founders Anthony Eisen and Nick Molnar sold $270.6 million worth of shares at a time when it was raising $786 million of new share capital, and this year it raised a further $1.5 billion but Eisen and Molnar sold a further $121 million of shares. Meanwhile, the Commonwealth Bank has introduced its own plain vanilla “buy now pay later” product. This appears to be an attempt to force greater regulation on the sector and diminish its short-term momentum. The stratospheric share price rise of Afterpay looks to me like a bubble. Windfall share issues to staff of its US office following the announcement of its intention to list on a US stock market look extraordinarily generous.
Owning bank shares
Currently shares of our four major banks have been trading on what are—by historical standards— very high price-to-earnings ratios, reflecting a market belief that the worst of the Hayne Report findings are behind them. This comes as the government, backed by federal treasury, has made it clear that regulatory zeal had gone too far interfering with lending which is necessary for economic and employment growth. The Reserve Bank has signalled its intention to keep interest rates low. This in turn means that the four major banks are able to borrow at negligible interest rates and while interest rates charged to households are the lowest in our memory, there is still a healthy margin for banks between their cost of funds and their loan rates.
The Magic Bank Money Multiplier
Banks lend out a huge multiple of their shareholder capital which explains why their dividend payments to investors in their shares and hybrid investments, which are classified by the banking regulator APRA as Tier One capital, are substantially above the interest rate charged on home loans. As banks lend to borrowers to buy assets and the sellers of those assets create new bank deposits which can be loaned out in turn, the banks create money supply, and the amount each bank can lend is a huge multiple of tier one capital—the requirement of which is set by the regulator. If a bank creates losses through bad loans, this creates a multiple reduction in lending capacity. Housing loans are given a beneficial weighting allowing banks to lend a greater multiple of tier one capital.
Having previously substantially reduced our super funds holding of bank shares, we bought back ANZ, CBA and NAB shares during the COVID recovery. I note that while their shares have recovered, all four of the major banks are trading below their ten year high, which was on 31 March 2015.
AMP’s Downward Spiral Continues
Following its demutualisation in 1997, AMP’s debut on the stock market was dramatic. On its first day some stockbroker’s computer system got stuck and sales were recorded at up to $36 per share. These sales were cancelled following quick notification to the ASX and selling brokers, but the share price traded in the $20 plus dollar range. A while later the NAB made a takeover offer to the AMP board of $21 per share, but the AMP board unwisely rebuffed the approach. Since that time AMP has been on a semi continuous slide and has had a succession of CEOs and chairs. Recently AMP traded down to $1.11. Attempts to sell part of its investment arm, AMP Capital, have inevitably been gamed as potential buyers smell blood in the water and figure that the price will fall or that more investment mandates will be lost. I cannot imagine why any investor would be keen to buy AMP shares. It seems that AMP is on a continuing downward spiral. The demerger of AMP’s private markets and AMP capital business, after negotiations with Ares came to nought, are an outcome of organisational weakness. What will be left of AMP after the demerger will likely be a near friendless small rump of a once huge organisation.
The Shortcomings of Managed Funds: Own the Manager, not its Funds.
Managed funds mostly underperform the market, and those with the highest management expense ratios generally perform worst. Facts don’t lie and it is apparent that an array of fund managers all hinting that they have some particular way to beat the market cannot all do so, nor can they collectively add sufficient value to cover their expense ratios unless their MERs are very skinny indeed. Funds managed by Hamish Douglas/Magellan Financial group have been criticised recently for drab performance, but they have high MERs meaning that they pay substantial fees to the manager. In 2020 Financial Year the funds managed by the group paid it $591.6 million in management and service fees and $81 million in performance fees for total payments of $672.6 million. That suggests that investors should consider buying shares in Magellan Financial Group rather than investing in any of its investment trusts.
It is of course important to do thorough research and start by going to ASX 200, selecting MFG, and then converting its share chart to 10 years. Then look back through its annual reports and take whatever additional professional advice is necessary. My comments are general advice only.
We own a modest holding of Magellan Financial Group in our family superannuation fund.
When should being overweight in an investment be of concern?
It depends on an investor’s overall financial position and years to retirement, as well as analysis of the particular investments. Consider:
Example One.
Ron, a successful dentist aged 45, and spouse have three stocks in their superannuation fund which have performed strongly over many years and now constitute 14 percent, 12 percent and 10 percent of their fund respectively with the overall fund balance being $2,500,000. An adviser says the fund is overweight and should sell each of these down to 7 percent of the fund. Ron is unhappy with advice to sell down the best three investments in the fund, all being companies with a history of good performance, and seeks alternative advice. The second adviser asks about the value of his home ($2 million plus), his practice (probably $1 million plus), his practice premises ($1,200,000 plus), and a few miscellaneous assets and minimal business-only debt. He notes that Ron and his wife are making surplus income to lifestyle needs and are making healthy superannuation contributions. Overall net assets are $6 million and the three assets the first adviser said were overweight represent 5.8 percent, 5 percent and 4.2 percent of the total respectively. Ron and his wife can accept that markets will fluctuate because they already have more assets than are probably necessary for their long-term retirement. Ron decides to hang onto those three successful investments but may consider using new contributions to diversify the fund’s investment bit by bit. The first adviser did not consider Ron’s overall position and ability to accept some risk in order to achieve long term results.
Example Two.
Jo and Harry are entering retirement. They have a modest home and a modest superannuation fund. They too have three well performed stocks which constitute 14, 12 and 10 percent of their fund. Their fund is not large enough to recover fully from a market correction while paying their superannuation pensions. They decide to trim a little off their largest investments and hold cash in their fund sufficient to pay their superannuation pensions for the following 18 months, and to periodically restore their funds cash holding to lock in their pension payments for the following period. They may also convert part of their fund to a more conservative investment mix and accept the probability of lower returns.
The Example of ARB
It is necessary to take a careful look at the performance of a company if you are told that you are overweight and whether prevailing economic conditions are favourable to its operations. An example is that COVID restrictions on air travel significantly favoured ARB Corporation as people added accessories to off road vehicles, while the sale of rugged 4WD vehicles and caravans accelerated widening ARB’s market. Those who were advised to sell down holdings in, say, July 2020 for around $19 would have wrung their hands as the profit in the half year to 31 December was up by 113.5 percent compared to the corresponding period in the previous year and ARB’s share price increased substantially. We own ARB Corporation shares in our family superannuation fund and investment portfolio. It has long been one of our best investments.
Acceptance of Risk Differs with Wealth
The biggest investors on the planet have substantial variations in their net wealth with changing economic and business conditions but understand that markets fluctuate and are adapted to it. Those with modest assets, particularly those in or approaching retirement are necessarily more risk averse. Those in retirement with substantial assets accept that being invested in the share market carries greater risk but offers better long-term rewards than being invested in cash.
Rollback of ASIC Red Tape Concerning Advice: The Hidden Cost of Overregulation.
I retired on 30 June 2020, having qualified at the financial adviser’s exam which meant that I was covered until 1 January 2026 subject to continuing online study requirements. I had met various new study requirements over the years as rules changed. To remain in business beyond 1 January 2026, I would have had to gain another tertiary qualification as my MBA, which was loaded with finance, accounting and economics electives, was deemed to be achieved too far in the past. As I was approaching my 75th birthday it was an appropriate time to sell up my interest in a business. I had gained far more from the experience of advising a large number of mainly professional and business clients and in dealing in financial markets over many years, including studying company reports, than from any of the material thrown at me by changing regulatory requirements. Much of the online testing of subject matter had little to do with the advice required to meet client needs. Periodically I sat new sets of exams dreamed up by regulators and by those providing training. Most of the content was unrelated to clients’ needs. It is likely that those setting the exams and training material had never successfully advised anyone and neither would have the regulators.
The politicians have been alerted to the fact that regulatory requirements have become so burdensome that the vast majority of the population cannot afford the cost of advice. The requirement that advisers provide Statements of Advice (of which the requirements on the adviser are huge) mean that they can only afford to provide services to a very small, comparatively well-to-do percentage of the population. The irony is that clients, confronted with a huge document, ignore most of it, flip to the recommendations, and make their financial decisions based on their assessment of their adviser.
What Lots of Clients Seeking Advice Don’t Know!
Many advisers filled in a client fact sheet and send it off to a “factory”, which produces a regulatory standard statement of advice for the adviser’s signature—an approach which I personally thought was less than honest, and hence I laboured on the advice I gave personally. Curiously, experts on regulatory requirements advised me to make only passing comment on the performance benchmark-related decisions of dental and veterinary practice owners, even though their practices were the engine rooms generating the income necessary to fund home loan repayments and superannuation contributions!
A training industry has evolved which assists advisers to meet regulatory requirements, but which has scant knowledge as to what successful advisers actually do. Regulatory process triumphs over substance.
Where Do Most Get Their Financial Advice?
Much of the population get financial advice informally from family and friends and from discussions in pubs, clubs, men’s sheds and luncheon groups—none of which can be regulated effectively.
Nobody knows what percentage of ‘statements of advice’ are factory written in India or elsewhere without client knowledge?
Adviser Ethics
Much has been written about advisers doing ethics exams, but the question should be asked: what is achieved? The greatest con artists would cheerfully undertake ethics training if it was a requirement to get a qualification enabling them to extract money from their prey. Ethics is something people have or don’t have, typically as a result of their upbringing.
I remember demonstrably unsound investment schemes involving sale of pine and eucalypt plantations being sold by large numbers of chartered accountants and certified practicing accountants, the professional bodies of which had imposed ethical codes of conduct which were ignored, in the quest for huge commissions. I learned of the shortcoming of investment in tree lots about 34 years ago, but they continued to be sold for many years. I listed them among investments to be avoided in a book I wrote for health professionals in 1995 and in various dental and veterinary newsletters. I recall being told by a director of a practice selling timber lots that I had rendered further sales to dentists impossible! Eventually the companies growing the timber collapsed and vast numbers of investors suffered huge losses.
Sales commissions amounted to 6 percent and increased up to 9 or 10 percent including volume bonus as the plantations became desperate to receive more cash and provided extraordinary rich pickings for accountants able to persuade clients to borrow to invest several hundred thousand dollars! I recall a medical specialist being referred to me by his solicitor who sensed a problem. In our initial meeting I learned that his accountant, a prominent figure among the accounting profession, had sold him $700,000 of pine trees in one year and $500,000 the following year for tax deferral purposes assisted by a loan package arranged by the accountant. Buried at the back of the documentation was an innocuous disclosure that 6 percent commission had been paid, which amounted to $72,000 over two years. That was a significant sum 25 years ago! The medical specialist thought his accountant charged him reasonable fees until I pointed out the enormous commissions he was also receiving! In the later years the accountants selling timber lots to their clients were assisted by an in-house financial adviser to meet regulatory requirements.
In recent years, salesmen searching for investors in high rise apartment projects were approaching accountants and advisers with offers of $10,000 if they could introduce buyers. Some probably paid more. I received such an approach, which I ignored, as did others. The commission payable to the salesman must have been huge per sale if they were prepared to pay that much. This suggested that many apartment buyers who bought off the plan, because their accountants said it was a good idea, were unaware of the conflict of interest.
Thankfully there are many ethical investment advisers, including stockbrokers.
Consider Changing Accountants
If your accountant has sold you pine or eucalypt investments, shares in an olive grove or encouraged you to buy high rise residential units off the plan you should seriously consider taking your accounting elsewhere.
About Graham Middleton
Having sold my equity in an accounting and financial services group on 30 June 2020, I am no longer a representative of a financial services licence holder. This newsletter contains general advice only and those contemplating taking action should do additional research and take professional advice as necessary. Those who gain significant benefit from my newsletters can, if they wish, make a donation to the Delany Foundation, a registered charity, which contributes to schools in Ghana, Kenya and Papua New Guinea.
Best wishes,
Graham Middleton
