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The market seems to react to a new development in the US-China trade war with every day that passes. Trump and Xi have swung forward and backward in their attempt to agree on a deal, retaliating back and forth with tariffs in the process. The latest has been China’s announcement that they will increase tariffs on US$60 billion worth of goods from June 1. This came in response to Trump’s decision to increase 10 per cent tariffs on $200 billion worth of Chinese imports to 25 per cent which itself was a kneejerk reaction to Xi backtracking on supposedly agreed upon trade deal terms. 

Of course, both China and America will be hurt by the growing tariffs, with costs incurred on both sides by importing businesses and consumers. However, Trump appears to misunderstand the impact on American citizens, and particularly voters in Republican states.

America buys more Chinese products than China buys from America. As such, Trump believes that China will suffer more than America, and ultimately need to give in to his demands to force a trade deal. Axios’ Jonathan Swan asked several current and former administration officials who Trump believes is paying his tariffs. The consensus is that he believes China is incurring all the costs, not American importers and consumers, as Trump believes in tariffs “like theology.”

Unfortunately for Trump, this trade war is not simply theoretical. While China is undoubtedly being hurt, Americans are also feeling the pain of increased cost of living and doing business. Axios has designed a map that tracks the impact of the trade war once China’s threatened retaliation takes effect. The map is separated into federal election counties, darker segments having a greater concentration of industries being affected by the increased cost of Chinese trade.

Clearly, Republican seats make up the majority of the darkened segments of the map. Moreover, many of these segments are in rural areas of the country, where businesses are far more exposed to sudden movements in the global economy. This potentially affects hundreds of workers in each small rural industry.

Trump believes he can hold out Xi by continually increasing tariffs to force him into a trade deal. He also believes in his tough stance on China as a key pillar to win the 2020 election. On the other hand, Xi removed the two-term limit on Chinese presidency last year, allowing him to remain in power for life. Trump knows that a new president in 2020, especially a Democrat, is unlikely to maintain the same show of strength against China as he has imposed.

Trump’s political agenda appears to be at odds with itself, and unless he can get a deal across the line before the 2020 election he could be doing more harm than good to his own voters. The added pressure of time may yet swing this trade war into an even more volatile state than it is already in.

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In the world of active equity management, investment managers – ourselves included – seek to “outperform” the broader equity market index. This outperformance is typically referred to as “alpha” in the industry jargon. Of course, alpha can be both positive – when a manager outperforms; and negative – when a manager underperforms.

One thing to keep in mind about active management is that, by definition, the generation of alpha is a zero-sum game. That is, one manager can generate alpha if, and only if, there are other managers out there generating negative alpha. The returns of the global equity peer set below appear to be roughly consistent with this concept: over the last (nearly) four years, approximately half the major global equity managers in Australia outperformed the global equity market; while approximately half underperformed.

Enter the “paradox of skill”. This paradox states that in activities (such as active equity investing) where both skill and luck contribute to outcomes, luck will play a larger role in determining results as skill levels increase.

Have you noticed that, over shorter periods of time, the alpha generation of even skilled investment managers appears somewhat random? This is not because investment managers are not as good as they used to be – indeed, it’s the opposite. The skill level of investors today has increased so much that equity prices do a better job of reflecting relevant information – though mispricings do still emerge from time to time.

If you would like to learn more about the interaction between skill and luck, I would recommend a book written by your author’s former Professor at Columbia University, Michael Mauboussin, called The Success Equation. In addition, Annie Duke’s Thinking in Bets is another must-read to think about decision making in the context of imperfect information combined with luck.

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Australia’s four major banks have now reported their interim results. Common to all of them were three key themes, which are presenting both challenges and opportunities.

Generating any revenue growth is becoming increasingly challenging

Once one-off remediation and profits on sale of businesses are stripped out, revenue growth for Australia New Zealand Bankng Group (ASX:ANZ), National Australia Bank (ASX:NAB) and Westpac Banking Corp (ASX:WBC) was almost non-existent and down for Commonwealth Bank of Australia (ASX:CBA). Slowing growth in the average loan book was offset by continued net interest margin contraction.

*CBA March quarter data

Source: Companies

Net interest margin compression, combined with fee reductions in wealth (WBC) and banking were combined with poor loss outcomes in general insurance for ANZ, CBA and WBC. This more than offset growth, albeit slowing growth, in loans books.

What was interesting was the slowing of not only mortgage book growth, but also business lending outside of lending to large institutional clients.

Source: Companies, UBS estimates

Net interest margins fell despite the out of cycle standard variable mortgage increases put through by three of the four majors early in the period. More importantly, the outlook for net interest margins wasn’t as positive as expected with the banks flagging that the benefit from the recent contraction in the Bank Bill Swap Rate (BBSW) to Overnight Index Swap (OIS) spread will be offset by ongoing pressure on front book mortgage rates as banks focus on gaining market share to offset the impact of slowing system growth.

Non-interest income remains under pressure, with fee revenue generally falling, while trading performance was mixed across the banks. WBC and CBA faced a further headwind in an elevated claims cost period due to more storm costs than normal. This should be expected to mean revert in future periods.

Overall, the results highlighted the difficulties the banks face going forward in growing revenue.

Cost reductions are becoming the last option for earnings growth

Three of the four major banks managed to reduce their absolute amount of operating costs before remediation, divestments, and other one-off items in the period relative to the previous reporting period. CBA was the exception, increasing its underlying operating costs by 2 per cent on an annualised basis.

*CBA March quarter data

Source: Companies

Similarly, two of the banks managed to reduce their underlying cost to income ratio despite the weak revenue growth with the exceptions being CBA and WBC.

*CBA March quarter data

Source: Companies

Despite what was a reasonably good operating cost performance, operating profits before bad debt charges based on underlying continuing business revenue and operating costs were essentially flat to down. The only bank producing meaningful underlying operating profit growth was NAB.

*CBA March quarter data

Source: Companies

This highlights how hard it will be for the banks to generate material profit growth purely through operating cost reductions. Revenue growth will need to re-emerge, but it is difficult to see where this will come from given the high level of debt in the household sector, which will limit loan book growth, the banks that are more exposed to mortgages, combined with the competitive pressure on front book rates.

Bad debt provisions remained low but the underlying credit trends are deteriorating at an accelerating rate

While net bad debt provisions had a continued benign impact on earnings growth, the trends below the surface continue to deteriorate.

The increase in charges relative to underlying operating profits were small, and for WBC, the charge actually reduced relative to 2H18.

*CBA March quarter data

Source: Companies

While the increase in charges was fairly benign for earnings growth, 90+ delinquencies in the Australian mortgage books not only continued to rise, but they appear to have jumped more significantly in the latest period.

*CBA March quarter data in 2H19

Source: Companies

A large component of the increase continues to be the WA property markets, but the increase in NSW during the latest period was noticeable as well. NSW and the ACT have had much lower levels of delinquencies than the other states. But NSW delinquencies have increased in the last 6 months such that they are now inline or slightly above VIC.

Delinquencies do not necessarily turn into impaired loans, but they do act as an early indicator of potential future problems and building stress in the system.

Overall the results showed the headwinds that face the banks at present, and the challenges to their ability to generate earnings growth in the medium term.

The Montgomery Funds own shares in Westpac and National Australia Bank.  This article was prepared 15 May with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.

With the banks recently reporting their results, Stuart takes a closer look at three key themes which were present during the results.
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The Reserve Bank of Australia recently opted to leave interest rates on hold. But with key parts of the economy in decline, it may be just a matter of time before it has to cut again.  The question is: how effective will a rate cut be?

It’s generally folly to predict whether the RBA will raise, cut or hold rates steady.  And fortunately, we’ve not needed to predict economic data to know that we should be avoiding some sectors. Deteriorating individual company economics in some sectors and virtually insane valuations in others have both been sufficient to warn us, for example, to stay away from consumer facing stocks, and especially those demonstrating strong overseas growth priced for indefinite continuity. And our bias has had a lot to do with the outlook for the housing construction and retail sectors, which you might appreciate are the third and second largest employment sectors in Australia respectively.

So, what do we know?

  • We know that residential approvals fell off a cliff late last year and earlier this year.Dwelling approvals have fallen from circa 280,000 dwellings at the peak to less than 170,000 dwellings. That’s a fall of 40 per cent.
  • We know that approvals must lead construction activity, so at some point in the next six months housing construction activity is going to collapse.
  • We know that the construction industry employs 9.6 per cent of the workforce and 37 per cent of those people are employed directly in residential construction. That’s 3.5 per cent of the workforce employed in residential construction which is about to decline 40 per cent.
  • That means income growth for these workers (tradies etc.) is about to turn negative.
  • Having spoken to several of Australia’s and NSW’s largest privately-owned house and land (H&L) package developers, we know that their pipeline is already down 50 per cent. Without a circuit-breaker (rate cut and looser credit availability) they will be laying off staff by Christmas. As an aside we also know that national vehicle sales have collapsed and listed car dealers such as AHG have downgraded. A dealer principal I have spoken to is laying off staff already.
  •  We know that the listed H&L developer Villaworld reported a greater-than-50 per cent decline in unit sales volume half-on-half earlier this year and we know that the listed AV Jennings reported a 90 per cent decline in profits (albeit unadjusted). More recently, Villaworld provided its 3Q19 update which underlined a continuation of weak conditions. In the four months to 30 April 2018, the company generated 266 sales or an average of 66 per month. To put this in perspective, in 2018, the company was selling 149 per month.The current run rate is the lowest since FY13.
  • We can safely conclude that without said circuit breaker, already-anemic national wage growth will slow further and national unemployment will rise.
  • As Figure 1. shows, the April employment index dropped from 6 in March to -1 in April. Given the points above, this should not come as a surprise. It is the weakest reading since January 2016 and the sharpest one-month fall since the GFC.
  • The Reserve Bank of Australia (RBA) has excused its neutral stance by pointing to ongoing strength in the labor market.

More recently, the RBA has acknowledged that rates need to be lowered if unemployment increases.

Figure 1. A strong signal for the RBA to cut rates

  • It’s worth thinking about how a sharper-than-currently-expected slowdown in the Australian economy may affect the growth of businesses in your portfolio as well as their price multiples. Remember, sell side analysts tend to be slow in downgrading expectations, preferring to wait for company guidance. It’s also worth considering how effective a rate cut, combined with a reduction in APRA’s 7.25 per cent stressed mortgage assessment rate might be at re-stimulating lending, house prices and construction activity.
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Much has been written about Uber recently, with the company having recently made its stock market debut. The business is polarising, with bulls and bears both making interesting arguments for and against the company as an investment.

One aspect of the bull case for Uber involves the presence of network effects that suggest a level of defensibility for the business, as well as optionality around new revenue opportunities in the future. But do these network effects exist, and if so, how strong are they?

If we start with the definition of network effects, it refers to a situation where as a network gains users, that network becomes more valuable to all users. A well-referenced example of a network is that of the telephone. The very first telephone had basically no utility until a second telephone came into existence –that way a call could be made. As telephones proliferated, all users had more options of people they were able to contact, and the value of the network increased.

One theory is that network effects follow Metcalfe’s law, whereby the network effects are proportional to the square of the number of users in that network, n2. The below chart shows that as users are added to the platform, the value of the platform grows.

Source: Medium

In the case of Uber, the network is comprised of riders (demand) and drivers (supply). The question I would pose to readers is the following: Does Uber benefit from network effects and follow Metcalfes law?

A follow up post will provide further thoughts around this topic.

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Last week the New York Times published an opinion essay penned by Facebook co-founder Chris Hughes, who calls for the breakup of the social media giant. Hughes, who left Facebook over a decade ago, levels a range of criticisms at the company and Mark Zuckerberg – chief amongst them the overwhelming power that Zuckerberg wields, but also his cavalier attitude towards privacy in the quest for “domination” and Facebook’s stifling of innovation and competition.

Setting aside the sensationalist slant and self-serving nature of the essay, it highlights the dangers and difficulty of blanket calls for regulation.

Firstly, it needs to be said that Hughes’ concerns are not without justification, and similar arguments can and have been levelled against the other usual suspects – Google, Amazon and even Apple. Yet an Elizabeth Warren-esque approach to regulation (“break ‘em up!”) is unlikely to be an appropriate remedy to the perceived market power of these companies.

Yes, these companies are big, and it is difficult for anyone to play down their market power with a straight face. But absolute size is not a trigger for regulation. And what is “market power” in the context of free consumer services? US anti-trust theory adheres closely to price abuse and is yet to evolve to address cheaper or free services. European anti-trust focuses more on anti-competitive behaviour which is easier to make a case for, but that has not prevented the EU from implementing well-intentioned regulations with unintended consequences (see our discussion of the GDPR here).

Indeed, it seems that the concerns of politicians, consumers, regulators and other stakeholders are nebulous (and change with the latest scandal), which is usually an impediment to writing effective regulation. As Chris Hughes’ essay demonstrates, the debate around Facebook alone touches on privacy, free speech, harmful/hateful content, anti-competitive behaviour, data interoperability and M&A – several of which are mutually incompatible regulatory objectives.

What exactly does “breaking up” Facebook by spinning off Instagram and WhatsApp achieve? Two or three people now have unchecked control over the social fabric of 2.4 billion people instead of one, but it does nothing to address privacy concerns or the spread of harmful content across the platforms. Zuckerberg’s recent privacy manifesto and Facebook’s pivot towards encrypted messaging addresses users’ privacy concerns but inhibits the company’s ability to moderate harmful content across its messaging platforms. The FCC made a gigantic blunder by greenlighting Facebook’s acquisition of Instagram, but separating the two now is not going to fix the (lack of) competitive landscape – the difficulty of building a social network is not in attracting users, but in effectively monetising those users so as to create a sustainable business (see Snap Inc.’s travails as an example). Separating Instagram will cripple its ability to monetise and thus its ability to compete with Facebook core. WhatsApp has substantially no monetisation to speak of.

Similar regulatory stumbling blocks arise for the other large internet and consumer companies as well. Some may be easier to overcome, but others have been erected long ago on the foundation of a naïve belief that the internet would only bring out the best in humanity and suppress its worst instincts. Momentum is clearly gathering for “something” to be done, but no one really knows what or how it should be done. Attention-grabbing articles like Hughes’ essay serve to fan the flames but offer little in the way of elegant solutions.

The Montgomery Global Funds own shares in Facebook, Alphabet, and Apple. This article was prepared 15 May with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Avita Medical you should seek financial advice.

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ROGER MONTGOMERY by Roger Montgomery - 5d ago

In this interview on Money News, Roger discusses the recent downgrades for companies leveraged to the housing market. For those companies doing well, success is more than reflected in their share prices – leaving very little for value investors. Although which companies should you keep an eye on?

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The contrasting fortunes of fleet management businesses, Smart Group and Eclipx, highlight yet again the importance of making good corporate acquisitions.

The major players in the Australian fleet management sector comprising McMillan Shakespeare (ASX: MMS), Smart Group (ASX: SIQ), SG Fleet (ASX: SGF) and Eclipx (ASX: ECX) certainly have contrasting trajectories. On May 9, Smart Group had their AGM and on Monday the Eclipx CEO, Doc Klotz, resigned effective immediately.

First to Smart Group. The highly regarded Michael Carapiet is the Chairman, and in his address the company recorded improved 2018 results (normalised Net Profit after Tax up 22 per cent to $78 million on an 18 per cent boost in Revenue to $242 million; earnings per share (EPS) of 59.5 cents; dividend per share (DPS) of 40.5 cents) which was attributable to “innovation, customer service and integration of our previous acquisitions.

“Due to our diversification, we can now offer a broad range of products and services which we anticipate will improve their experience and deepen our relations with them.” Smart Group services 343,000 salary packaging customers (+6 per cent), has 62,500 novated leases under management (+4 per cent) and 695 full-time equivalent staff (-4 per cent).

Smart Group has a good track record of acquisitions and Fleet West, purchased in January 2018, added 2,800 to the fleet vehicle under management, or 12 per cent of the total 22,900. In early May 2019, Smart Group paid $9.1 million for the two small acquisitions and these are expected to deliver $0.7 million of EBITDA in 2019 (for eight months), inclusive of $0.7 million of integration costs. In 2020, they are expected to deliver $3.0 million of EBITDA.

By contrast
Eclipx have reshuffled the management deck chairs. Garry McLennan, CFO for the past five years, has recently resigned and CEO Doc Klotz is being replaced by UBS Australia banker Julian Russell. Total statutory remuneration for McLennan and Klotz over the two years to 30 September 2018 was $6.8 million. Meanwhile, Bevan Guest was promoted from MD, Fleet Australia to the newly created position of Chief Commercial Officer.

When it announces its interim results for the six months to March 2019 on 24 May, Eclipx is expected to recognise an impairment charge of between $110 million and $130 million. This relates to the underperformance of Grays and Right2Drive and is subject to audit. In 2016 and 2017 Eclipx spent a combined $246 million acquiring these two businesses. Both businesses are now being prepared for sale and the company also intends selling its Australian Commercial Equipment Financing business. Julian Russell, who has been an adviser to the company since 2014, said “the divestment of non-core businesses… will result in a resized cost base to reflect a simpler business model.”

The graph below shows the relative share price performance of Smart Group and Eclipx over the past three years.

With a current market capitalisation of $307 million (320 million shares x $0.92), Eclipx may represent good value if their core businesses of “Australian Commercial” and “New Zealand Commercial” remain intact, as they historically have had an ability to earn a normalised $50 million of profit or 15.5 cents per share.

Smart Group and Eclipx share price  16 May 2016 – 13 May 2019 

Source: Bloomberg

You can read part 1 of this blog here.

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I’m pretty sure most voters aren’t aware of the Australian Labor Party’s parent visa policy.  But investors should be. Because, if Labor wins the upcoming election, this policy could benefit many healthcare companies.

The proposal I am talking about is the “Labor’s Fairer Long Stay Parent Visa” which is aimed at making it easier for Australian families to secure long term visas for their parents. This table shows the main points of the proposal:

Basically, the idea is to uncap the number of visas and to make it significantly cheaper, which from a humanitarian standpoint is very appealing.

From a societal economic viewpoint, it does though not look as appealing as:

  • The parents are unlikely to still be working and hence are not going to give rise to any tax revenues
  • Parents are by definition older and more likely to have health problems putting a strain on the healthcare system and moving the average age of the population upwards
  • They will collocate with their children and as more than 80 per cent of the last 10 years immigrants are living in Sydney or Melbourne, this will put further strain on the infrastructure of these cities.

The Productivity Commission in its migrant intake report from 2016 cuts off its estimate of the net present value of lifetime fiscal impact depending on the age of arrival at the age of 60 but given the steepness of the curve, it is easy to draw the conclusion that  each arrival over the age of 60 is likely to have a negative impact of at least $300,000 on the economy if they stay permanently.

Whether this negative impact on the economy is something that is worth it, is up to the population to decide in the election, but given at the moment Labor is favoured to win, I think it is worth it to try and assess the impact on the companies involved in the healthcare sector as they are the ones most likely to be impacted if this proposal is implemented.

Private hospitals

Given that the parents will be required to take out private health insurance, they will have the option to seek treatment at private hospitals. The private hospital operators are therefore likely to see increased volumes as a result and it should hence be a positive for them.

Primary care providers

Primary care providers are also likely to see increased volumes as a result and this proposal would be positive for them.

Pathology/medical imaging providers

As with the private hospitals and primary care providers, pathology and medical imaging companies are also likely to see increased volumes and it should be a positive for them as well as they are essentially volume businesses with fixed revenue per test and some economies of scale.

Private health insurance providers

The outcome for private health insurance providers is a bit harder to predict as it depends on if Labor will also implement its policy of capping private health insurance premium price increases to 2 per cent, per year. Insurance is a risk and cost sharing system and if you add a large number of people who are likely to be heavy users of the insurance, the cost of providing such insurance will by necessity go up. If you are able to compensate for this by increasing prices, it is not an issue and it might even be a positive as you get increased scale and might benefit from some economies of scale but if you are not able to increase prices to compensate, you will suffer margin pressure. This is therefore potentially quite negative for private health insurance providers.

Aged care providers

The impact on aged care providers is also hard to judge as it depends on if the parents will eventually return to their home country once the visa expires or not. If they manage to convert to permanent residents and have enough means, it could be a positive for the aged care providers.

The exact impact for all of the types of companies mentioned above is hard to exactly estimate as a lot of details about Labor’s proposal is still unclear and it is hard to estimate how many additional immigrants this could result in; but directionally, the effects should be as mentioned above.  

Will Labor’s proposed parent visa policy be beneficial for the healthcare sector? Are your parents looking for a visa to Australia? Andreas takes a closer look.
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In this week’s video insight Tim takes a closer look at the recent developments relating to the TPG-Vodafone merger. Last week the ACCC announced that it has decided to block the merger. Will they still proceed with attempting to build a network?

The Montgomery Funds own shares in Telstra. This video was prepared 13 May 2019 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Telstra  you should seek financial advice.

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