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Breaking Up

In late September Commonwealth Bank announced both the sale of its life insurance business and that they were looking at floating the bank’s funds management business Colonial First State GAM on the share market. Based on the strong performance of recent spin-offs investors are likely to have a close look at any initial public offering (IPO) of Colonial First State GAM. In this week’s piece we are going to look at the rationale behind spinning off assets to form a new company, and we will review the performance of recent company spin-offs from large companies such as BHP, Orica and Amcor.

What is a spin-off?

A spin-off occurs when a listed company parent separates a portion of their existing company into a second listed company and allots shares in the new company to existing shareholders based on their holdings in the parent company. In some situations, the parent company will also simultaneously issue new shares to new investors to broaden the shareholder base and allow the new spun-off company to begin life with a healthy financial position. In a spin-off, the newly created company takes a portion of the parent company’s assets, employees, intellectual property and debt. For example, in 2012 Woolworths’ spun-off 69 Australian and New Zealand shopping centres into a $1.4-billion listed property trust called SCA Property. Woolworths shareholders then received one unit in SCA Property Group for every five Woolworths shares held.

The ignored child gets a new lease on life

The most common reason cited for a company demerging or “spinning off” a division into a separately listed vehicle is that the smaller new firm will now be run by management totally focused on it. The theory goes that as a result of this increased love and focus and not having to compete with other larger divisions for management attention and capital, the demerged division begins to prosper.

Recent examples of this can be seen in BHP’s 2015 spin-off of South32, Woolworth’s spin-off in 2012 of a portfolio of shopping centers into SCA Property Group, and Amcor’s demerger of its Australian packaging business Orora. These three spin-offs have proved to be very successful with South32 giving shareholders a total return (share price gain plus distributions) of +35% vs BHP’s gain of +16%. Similarly, SCA Property has returned +103% since it was spun out of Woolworths in 2012, against a total return to Woolworths shareholders of 8%. Since listing, Orora (which was viewed by the market as low growth compared to the dynamic world of global packaging) has returned to investors an impressive +198%: a healthy premium compared to Amcor’s still strong +68%.

From meeting with the new management teams of following their demergers, it was clear to me that they exhibited a great deal of pride in the results of their own smaller companies. Furthermore, as stand-alone companies they were able to make acquisitions to grow their businesses or buy back their stock on market. Such moves probably would not have been approved if they were still competing with Woolworths and BHP’s much larger Australian grocery and global mining business for capital.

Sum of parts worth more than the whole

In many cases the value of the two separate businesses is greater than the old combined business, even after accounting for additional costs such as a separate ASX listing and board. This is a benefit for shareholders of the parent company, as the more attractive “core” business is now re-rated upwards by the market and valued on a higher multiple. The sum of the two parts becomes greater than the original whole.

Looking at Commonwealth Bank and its fund manager Colonial First State GAM, the bank as a whole is currently being valued at 13.6 times the profits that it generated in 2017. Here the market is valuing the funds management earnings as if they were bank earnings, despite their higher margin. However, the market values stand-alone fund managers such as BT Investment Management (trading on 22 times earnings) and Janus-Henderson (trading on 15 times earnings) on higher multiples, reflecting the higher profit margins and low capital requirements for fund managers.  Using a mid-point of these valuations, Colonial First State GAM would be valued at $4.5 billion, an uplift from the $3 billion that their profits from 2017 are currently being valued as part of Commonwealth Bank.

Spinning off a management headache?

Whilst the above more recent spin-offs have all outperformed their parents, it would be wrong to see that all spin-offs from large companies make great investments. In some situations, a spin-off can be prompted by management foreseeing that a division of their business is likely to face issues in the future, that may spill over and impact their core business.

Arrium

BHP has previously spun off divisions in the past that they deemed less desirable. In 2000 BHP demerged their long steel division (Arrium née OneSteel), and in 2002 their flat steel division BlueScope. This was motivated by the view (which proved to be correct) that greater returns could be made from digging ore out of the ground and directly shipping it to China, compared to manufacturing commodity steel in Australia. Furthermore, BHP was able to “spin-off” the industrial relations headaches that are a feature of the heavily unionised steel manufacturing sector.

From listing up until 2008, BHP was criticised for letting go of their steel manufacturing businesses. It might face similar opposition to spinning-off South32, however often the genius behind this course of action does not become apparent for several years. Arrium was delisted in 2016 after a well-publicised insolvency. Whilst BlueScope has performed well over the last few years it still remains 74% below the issue price courtesy of dilutive capital raisings in 2011, and in 2009 required  to keep the wolves from breaking down the steelmaker’s doors.

PaperlinX

In 2000 Amcor spun off PaperlinX (now called Spicers) their stodgy printing papers division. However by 2003, Amcor was being criticised in the press after PaperlinX’s share price had risen from $3.17 at listing to $5.40. Concurrently, the PaperlinX was expanding globally after paying $1 billion to buy Europe’s largest fine paper merchant and became the world’s largest paper merchant.

The following decade was particularly unkind to PaperlinX investors as the paper business consistently shrank globally with the growth of electronic communication and document transfer technologies. Currently the company’s share price sits at 3.2 cents and one could make the case that Amcor’s management team, in spinning off a low-growth declining business, removed a division that would have consumed both shareholder capital and management attention. These negative factors ultimately would have arrested Amcor’s share price growth over the past ten years had they held on to their paper business.

Our Take

Whilst the above suggests that spin-offs can unlock hidden value for shareholders, there are downsides. Two separately listed companies result in the additional costs of maintaining two separate listings on the ASX such as two separate boards and management teams. We are likely to have a close look at any initial public offering (IPO) of Colonial First State GAM, especially on price weakness if a number of shareholders sell their entitlements just after listing. Unlike steel making or printing paper, funds management in Australia is a robust business and Colonial is a significant player with a powerful brand.

 

Monthly Newsletter September 2017

  • The S&P/ASX 200 A-REIT index posted a small 0.5% gain over the month of September, slightly ahead of the wider ASX200 which was unchanged, as commodity prices and the AUD were weaker.
  • The Fund gained had a solid month gaining +1.6%, outperforming the index as our strategy of preferring recurring rent collectors over developers was successful.
  • Additionally, the bulk of the options sold last quarter ultimately expired worthless at the end of September. This strategy added value, as it converted uncertain future gains (which ultimately did not occur) into certain income.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in September and the fund’s strategy

Why Institutional Investors avoid Residential Property

One of the misconceptions investors have is that the $123 billion dollar listed property index is primarily exposed to residential real estate. In fact, residential property comprises a small part of the index, with only 4% of the value of the index coming from trusts exposed to residential property. Further, this exposure primarily comes from developers selling finished apartments or home and land packages, not from actually owning housing real estate that is rented out.


 

 

 

 

 

 

 

Last month Mirvac announced they will be bringing Australia’s first major build-to-rent apartment development to market in a move that could potentially address housing affordability issues. In this week’s piece, we will look at why institutional investors have shied away from investing in residential developments, unlike in the US and the UK where this sector is a growing part of the Listed Property indices.

Residential property has attracted little interest from institutional investors as it is an area where retail investors have an investment edge. In the below chart, the grey bars show that exposure to residential real estate comprised 4% of the S&P/ASX 200 A-REIT index in September 2017, or $4.7 billion. This is dwarfed by the value of the discretionary retail ($59 billion), industrial ($25 billion), and office ($22 billion) real estate assets listed on the ASX. In comparison in the US, the residential sector accounts for around 25% of the $US2 trillion in institutional property investment, placing the sector just behind office.

 

Whilst the smaller transaction size of buying a two-bedroom apartment is attractive to retail investors (compared to an industrial warehouse or an office tower which may be valued in the tens to hundreds of millions), there are three structural reasons why retail investors dominate residential property investment.

Capital gains tax “crowds out” corporate investors

Although the domestic rental sector exists  in LPTs in the US and Europe, in Australia the tax-free status of capital gains for owner-occupiers selling their primary dwelling has had the effect of bidding up the purchase prices of residential real estate. For example, when a company generates a $500,000 capital gain from selling an apartment, they would approximately be liable to pay approximately $108,000 in capital gains tax, whereas the owner-occupier pays no tax on the capital gains made on a similar investment. This discrepancy in the tax treatment allows the owner-occupier to pay more for the same real estate assets, and thus has contributed to the low yields mentioned below.

Negative gearing

Similarly, individual retail investors benefit from the generous tax treatment in Australia that allows them to negatively gear properties. There are three types of gearing depending on the income earned from an investment property: positive, neutral and negative. A property is negatively geared when the rental return is less than the interest repayments and outgoings, placing the investor in a position of losing income on an annual basis. However, under Australian tax law, investors can offset the cost of owning the property (including the interest paid on a loan) against other assessable income. This incentivises individual high-taxpaying investors to buy a property at a price where it is cash flow negative in order to maximise their near-term tax returns and bet on capital gains. Whilst companies and property trusts can also access taxation benefits from borrowing to buy real estate assets, a rich doctor on a top marginal tax rate of 47% has a stronger incentive to raise their paddle at an auction.

Yields on residential property too low

At current prices, the yield that residential property offers are not very attractive for listed vehicles. At the moment, the ASX 200 A-REIT index offers an average yield of 5%. This compares very favourably with the yields from investing in residential property. SQM Research reported recently that the implied gross rental yield for a 3-bedroom house in Sydney of 3% with a 2-bedroom apartment yielding  4% in July 2017. After borrowing costs, council rates, insurance, and maintenance capex, the net yield is estimated to average around 1%. With listed property investors focused on yield receiving on average ~ 5% from property trusts investing in office towers and shopping centres, such a low yield would only be accepted if it was offset by high and certain capital gains.
Mirvac’s new “build to rent” fund

In August Mirvac announced their intention to develop a build to rent fund with assets based initially in Sydney. This fund is likely to be targeted at institutional investor, rather than retail investors, who generally already have a significant exposure to residential real estate. This looks to be an opportunity for Mirvac to access both development profit (profit margin +25% in FY17) and also an ongoing funds management fee on the completed assets. However, we would be surprised to see much of Mirvac’s own capital invested in the fund. In 2017 Mirvac generated a 18% return on the $1.8 billion of capital invested in its residential development business (ROIC). Mathematically it is hard to see how investing in their own finished product will generate returns higher than the trust’s average cost of capital.

Our take

Whilst the residential sector is a large part of the overall stock of Australian real estate assets, without significant taxation concessions it is hard to see this sector garnering much interest from institutional investors, especially for income-focused investors such as Atlas Funds Management. The Atlas High Income Property Fund’s strategy of populating the portfolio with higher quality domestic rent collectors combined with a derivative overlay strategy to enhance income should continue outperform in a property market that is trading sideways. We see that the majority of returns over the next 12 months will come from distributions and income from writing call options over existing holdings, rather than spectacular capital gains.

 

Meetings with Management

A key part of our investment process is meeting with the management teams of companies at least once every six months or when we are in the process of adding a position to get an understanding of the quality of the management team with whom we are entrusting our investors capital. Generally, we seek to meet with management teams just after they have released their semi-annual profit results, and at other times during the year when we have specific issues or concerns that we feel need to be addressed.

As reporting season finished last week, we have been very busy over the month meeting with management teams from various companies and property trusts. In this piece, we are looking to shed some light on the role that these meetings play in the investment process.

The content and tone of management meetings vary widely depending on the nature of the company and how far the results delivered by the management team deviate from our or the market’s expectations. As such, the meetings can vary from being quite convivial discussions running through dividend policy and debt maturities, to downright hostile conversations about poor acquisitions, asset write-offs or recapitalisations.

Why Meet with Management Teams?

The efficient market hypothesis developed by Fama in 1970[1] states that it is impossible to “beat the market” because stock market efficiency causes existing share prices always to incorporate and reflect all relevant information.

If we believed this to be true, investors should simply invest in an index fund, because   it would be a waste of time for anyone in the market to meet with management, as we could learn nothing that was not already incorporated into every company’s current share price.  Whilst this theory sounds elegant, in practice markets are inefficient due to the influence of human emotions and robotic trading algorithms trading off price momentum.  Ironically, the current trend we are seeing of flows into index funds should deliver a long-term benefit to active management, as they cause market inefficiency by directing an increasing proportion of inflows into higher priced over-valued companies.  After almost twenty years in the market it seems to me that the increasingly short-term focus of investors is creating more inefficiencies.

Further, I have previously worked at a fund’s management firm that had a fund with a strategy of deliberately avoiding meeting with management teams. This approach is based on the view that meeting management, cultivating a relationship, and understanding the business would distract from their investment strategy of profiting from the short-term price movements in a large number of companies. In my opinion, the weakness in this approach is that a company is more than a collection of cash flows, assets and liabilities contained in the financial accounts. The future direction of any company and its share price is determined by the skill and motivations of the individuals managing these assets. Also, management teams have incentives to present their financial results in the most favourable light and in some situations, this results in misleading financial accounts.  Fund managers running index and quantitatively managed funds are unlikely to be able to detect these issues.

Selective briefings?

The press sometimes characterises the additional access to management that institutional investors have over casual mum and dad investors as being unfair or bordering on inside information. In practice, these management meetings don’t provide us with inside information, but rather are used by the fund manager as additional pieces to build up a mosaic of information to determine the underlying value of a company and its prospects for the future.

In the past, some of the most useful information on a company has been obtained not from management itself, but rather from meetings with that company’s direct competitors and clients. Often a company may be a little coy when asked the more difficult questions about issues facing their business, but that same company may enthusiastically discuss problems facing their listed competitors. Relevant issues include lost contracts or aggressive accounting measures being used to boost profits (that the company being interviewed inevitably no longer uses).

Two years ago, RIO and BHP were discussing their plans to cut significantly their cost base by reducing their reliance on contractors and indeed renegotiate existing contracts.  At the same results season the contractors were confident that margins and contracts would be maintained despite falling commodity prices hurting their customers. Coming out of these meetings it was clear that there was a disconnect between the guidance being given by the suppliers (Downer, United Group and Leighton) and their customers (BHP and RIO).

See the Colour of their Eyes

Before investing in a company, it is a critical part of the Atlas process to meet with the company’s management team. When meeting with management teams you are also looking to gauge management’s response and interpret body language when they are answering difficult questions. These can range from refinancing debt to achieving stated profit guidance targets which look excessively optimistic.

By purchasing securities listed on the ASX we are effectively entrusting our clients’ capital to the management teams of various companies and must therefore trust that these management teams are going to act in the best interests of our clients.

For example, a number of years ago we met with management of Lihir Gold (now part of Newcrest) to question them about their meagre dividend payout policy, despite ounces of gold finally starting to flow out of the mine on Lihir Island in Papua New Guinea. Management (former engineers) said that returns for shareholders would not increase, but rather they were going to invest the profits in building a new mine in war-torn Côte d’Ivoire, which would require building a 100km rail line through the jungle.  From this meeting, it was clear that management’s primary instincts as former engineers were to build beautiful mines, rather than reward the owners of the company. We took the view that our clients’ interests would be served better by receiving dividends now, rather than vesting that cash flow in a new, quite risky development; hence the position was sold shortly after the meeting.

Similarly, we left a meeting with a company’s CFO last year with the view that there was a disconnect between the profits outlook presented to us and the structural headwinds from deteriorating conditions in the company’s industry. As a result, we sold the position shortly after.  Whilst the stock price had been drifting downwards prior to our selling, it fell sharply 4 months later on a large profit downgrade.

Not a one-way street

It would be wrong to think that these meetings are mostly adversarial competitions for information between fund managers and company management. From the perspective of the company,  these meetings can be a forum for the CEO to gauge large sophisticated investors’ appetite to back potential acquisitions, changes in strategy, or capital management initiatives The advantage of doing this behind closed doors is that a company can avoid the potential embarrassment or loss of goodwill that comes with presenting an acquisition with a dilutive equity raising to a hostile group of institutional shareholders, some of whom may decline to support it.

Over the last month we met with a smaller company that was performing well, yet had only attracted research coverage from two investment banks. As their management’s focus was on running their assets efficiently and bedding down a large acquisition, they were uncertain about how to engage with the research departments of investment banks to encourage them to research their company. As the Fund is invested in this company, we are incentivised to assist the company in this area to increase research coverage that may assist in pushing its share price closer towards our valuation.

Our take

One of the benefits of having your portfolio managed professionally is that it is constructed and managed by individuals whose sole focus is to select and blend listed companies into a portfolio designed to deliver higher returns with lower volatility. To execute this strategy effectively, professionals prioritize meeting with management teams and going through their financial results in detail.  Another advantage for investors of institutional management is that fund manager tends to have access and opportunities to ask questions of senior management in investee companies that are unavailable to most retail investors.  

[1] Malkiel, Burton G., and Eugene F. Fama. “Efficient capital markets: A review of theory and empirical work.” The journal of Finance 25.2 (1970): 383-417.

 

Monthly Performance August 2017

  • The Fund gained +0.1%. lagging index over the month due to our strategy of favouring trusts with a high percentage of recurring earnings over those whose earnings are currently being bolstered by development profits.
  • The Fund had a very pleasing reporting season and on average the trusts held by the Fund delivered profit growth +6%, compared with the underlying property index which grew profits by +3.4% over 2016.  In the words of Ben Graham “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
  • In August 2017, 4 of the 12 trusts held in the Fund announced buy-backs which will should provide share price support over the next year.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in August and the fund’s strategy