08 May April Market Commentary
Changes in the indices representing the asset classes depicted below were very minor for the most part and as a result here have been comparatively modest moves in the assessed valuations for all three of the equity asset classes. An exception to this however was Listed Property which has continued to rally since December 2013. This stronger performance has actually moved the asset class valuation from Fair Value to the lower end of what we assess to be Fair Value.
With the benefit of hindsight, a deal between internet company AOL and media company Time Warner has come to be known as the death knell for the technology led market boom that ended in early 2000. At the time it was reported: “In a stunning development, America Online Inc. announced plans to acquire Time Warner Inc. for roughly $182 billion in stock and debt Monday, creating a digital media powerhouse with the potential to reach every American in one form or another.”1 It was at the time the largest deal in history, and what was significant was that the acquirer AOL had only just become profitable, but nonetheless would represent 55% of the combined company shares despite the fact that Time Warner would contribute 70% of the combined company’s profits.
Many of you will have seen this chart in recent presentations, for those that haven’t it shows companies that have listed in the US for the first time via an Initial Public Offering or IPO. What it actually shows is the proportion of those companies that have not yet become profitable. Late last year this measure showed that 74% of companies that undertook an IPO had negative earnings. The peak for this measure was in 2000, around the time of the AOL Time Warner merger.
Last week there were two headlines, “The Megadeal Makes a Comeback” in the Wall Street Journal and “Megadeals Drive Takeover Activity Past $1 Trillion Mark for 2014” in Bloomberg. Not yet included in that trillion dollar figure is, amongst others, a proposed deal between pharmaceuticals companies Pfizer and AstraZeneca, in which the former would acquire the latter for US$100 billion. The market value of AstraZeneca is right now sitting at US$99 billion as the share price has run up from US$47 mid last year to US$79, or in other words AstraZeneca is now worth about US$40 billion more than in June 2013.
Only time will tell if indeed Pfizer is getting value, or if in fact some of the purchase price will in due course need to be written down. What suggests that at least some of the purchase price will indeed be wasted is the increasing prevalence of using inflated stock prices to make acquisitions by issuing more shares rather than using cash. As the WSJ article notes,
cash only deals, by dollar volume, fell to 48% year to date, the lowest percentage since 2001.
There is mounting anecdotal evidence to confirm the quote, in the long term there will be no lessons learnt by most investors from the last financial crisis, or indeed earlier crises such as the technology led equities market bubble that popped in early 2000. Following these exploits vicariously will be interesting, perhaps even exciting at times, but as a wise person once said: if investing is exciting, you’re doing it wrong.
We are a couple of weeks away from seeing the detail of the first federal budget handed down by Treasurer Joe Hockey, but as has become the norm in recent years we are well into the ‘ground softening’ period of leaking key details of the expected policy measures. These have been extensively covered, including increases to the qualifying age for eligibility to the age pension, a temporary levy / tax on higher income earners to address the budget deficit, and some sales of publicly owned assets. The long term plan is to return the budget to a surplus equivalent to 1% of GDP within a decade, a significant task from the current position in which the budget deficit is equivalent to 3% of GDP.
With the caveat that we should hold off on forming conclusions until the detail is available, economists have pointed out that this greater fiscal tightening has the potential to hold back our economic growth, which continues to be slightly below long term trend growth rates. Estimates2 are that the deficit reduction levy could raise as much as $6 billion in 2014/15 which would represent a drag of around 0.4% on GDP, and that the levy may be in place for up to four years. Growth in the Australian economy had been expected to accelerate beyond 3% over the remainder of the current year and into 2015, though sub trend growth may persist for longer if this policy tightening is enacted.
In simple terms, and no matter whether it is called a levy or a tax, the effect of such policy will be to remove money from the economy that otherwise would have gone to either spending or savings. Any changes in the latter option is one that will be worth following closely in coming years, as the rate of household savings in Australia has remained relatively high following the financial crisis.
This chart3 from the RBA shows a steady decline in the savings ratio for households had continued for the better part of two decades, before ending abruptly when the financial crisis beset economies and financial markets in late 2008 and early 2009.
One possible scenario is that households in time are able to maintain spending levels by offsetting the impact of any increased taxes with a reduction in savings. In the short term however that appears unlikely and recent data confirms that consumer confidence has reacted to this uncertainty with a sharp fall in April, suggesting savings will be at least maintained amid the short term uncertainty.
As with many things, it will be important not to react to short term moves, but rather to keep our focus on a longer term horizon.
We start our United States discussion in a somewhat unusual manner, and will focus initially on a single company known to all of us, Apple Inc. The maker of the iPod, iPhone and iPad has grown to become the largest technology company in the world and is valued at just over half a trillion US dollars. To give some context to this number, Apple has a market capitalisation that is just about equal to the combined value of BHP Billiton and all four of our major banks. Another illustration of the scale of this business is that the cash alone it holds of US$151 billion is worth far in excess of any one of those four major banks, and is in fact not far shy of the total market cap of BHP Billiton which stands at approx. US$180 billion.
Perhaps not surprisingly given this pile of cash, the company has of late come under pressure from some activist minded shareholders to either deploy it by making investments or acquisitions, or return it to investors via dividends. What Apple has in fact decided to do is to buy back their own shares and they will spend up to US$90 billion doing so. This is a perfectly valid course of action if in the opinion of Apple management there are no alternative investment opportunities that would provide a superior return to shareholders, and we have seen historically high levels of share buybacks being carried out over a wide range of business and industries in the last few years.
What is interesting in this case however is that Apple isn’t using its US$151 billion of cash to complete the buybacks, instead they are issuing debt in the form of corporate bonds at very cheap interest rates. The reason is simple, most of the cash that Apple holds (about 88%) is held offshore from the United States, and as the incoming Chief Financial Officer said recently: “To repatriate our foreign cash under current U.S. tax law, we would incur significant tax consequences and we don’t believe this would be in the best interests of shareholders.”
Technology companies in particular have been able to exploit the global nature of their operations in recent years by shifting income to lower taxing locations. JP Morgan estimates “that US$1.7 trillion in foreign earnings is being held overseas by more than 1,000 firms, yet to be taxed by the [US] federal government.”4 To provide another example, a US Senate investigative committee “found that from 2009 to 2011, Microsoft was able to shift offshore almost half of its net revenue from US retail sales, or roughly $21 billion, by transferring intellectual-property rights to a Puerto Rican subsidiary. As a result, the subcommittee found that Microsoft saved up to US$4.5 billion in taxes on products sold in [America].”4
Returning to Apple, what stands out about the bond issuance is how cheaply they have been able to issue the debt, because investors are scrambling to earn income in an environment where official interest rates are effectively 0%. We have spoken recently about the pendulum of value between investors buying bonds and companies issuing them being very much in favour of the issuing companies. Whilst thankfully it is occurring to a much lesser extent in Australia, we do however reiterate our views that the prices being paid right now, and hence the rate of income that will be generated, are not wholly representative of the risks being assumed by investing in corporate bonds and other fixed income investments.
The metaphor of a pendulum is one we use frequently, and one that works well when we look at investments and markets with a long term time frame. In time more favourable valuations and better future performance will become available as the pendulum swings back to investors.
1. Tom Johnson. That’s AOL Folks. CNN Money. 10-Jan-00.
2. ANZ Research. Australian Economics Update. 29-Apr-14.
3. Reserve Bank of Australia, Chart Pack. Released 2-Apr-14.
4. JL Yang, Post analysis of Dow 30 firms shows declining tax burden as a share of profits. Washington Post. 27-Mar-13.
DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management Pty Ltd (ABN 76 821 231 362 Corporate Authorised Representative of Paragem Pty Ltd AFSL 297276) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial planning) for suitability in respect of their unique circumstances.
About Reuben Zelwer
Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.