Capital flood puts returns under water

One of the hardest aspects of creating an income-focused securities portfolio from the Australian listed securities market is the dearth of paper that has been created with a fair yield.

There may be numerous reasons for the lack of opportunity but there is one reason in particular that sticks out, and frankly it annoys an old fund manager like me.

To lay the foundation for my comments that will flow shortly, let me remind you of the evidence that I presented last week to show that Australian companies are currently achieving “recession type” returns on equity. Further, they are doing so in a period that is not a recession.

The current low levels of return on equity resulted from the massive capital raising spree undertaken by listed companies from 2006 through to 2010. All up, some $300 billion was raised and the incremental return on that equity has been absolutely poor. In the main the capital raised merely retired debt and therefore the returns are equivalent to interest rates.

My real concern is with the appalling lack of initiative or common sense exhibited by the large capital providers in this country. Why large equity fund managers provided plain basic equity funding, with no conditions, to a range of mediocre companies at the heights of the GFC, remains an unanswered question. Then again no-one has actually posed the question – have they?

My answer is simple. The managers responsible were, and continue to be, disconnected from the funds they manage. They do not think like capital owners but merely act as pawns to the large investment banks. In my view this disconnect started with the destruction of our large “mutuals”, whom were the providers of stable long-term capital prior to the mid-1990s. From their destruction we have seen that the provision of capital has moved from a process of “creating value based on risk” to a process of merely “discounting price”.

To emphasise my point I want readers to reflect on three great deals undertaken since 2008 by the best owner managers of capital in the world – Berkshire Hathaway’s Buffett and Munger. 

First, there was their deal of September 2008 when Berkshire purchased $5 billion of Goldman Sachs’ preference shares that were negotiated to pay a 10% dividend and were redeemable early for a 10% premium above cost. Berkshire also received warrants granting it the right to buy $5 billion of Goldman Sachs’ common stock at $115 per share (or 43.5 million shares) through to October 1, 2013.

Goldman Sachs called the preferred stock for redemption in April 2011 at a premium of 10% over par value, plus accrued and unpaid dividends. As a result, Berkshire Hathaway earned approximately $1.75 billion ($1.25 billion in dividends plus a redemption premium of $500 million) in 2½ years on its investment of $5 billion. This represented a return of 35% over this time period from the preferred stock alone. As for the warrants, remember Berkshire had the right to buy 43.5 million Goldman Sachs common shares for $115 apiece. Under a further deal announced by the companies this year, Berkshire will get Goldman Sachs’ stock equal to the difference between the average closing price during the 10 trading days before early October and the exercise price, multiplied by 43.5 million. Goldman stock is now priced at about $160, and Berkshire has a $2 billion further profit.

Second, there was a similar deal struck in October 2008 with General Electric (GE) where Berkshire subscribed for $3 billion of preferred shares yielding a 10% dividend. Berkshire’s stake is callable after three years at a 10% premium and it received warrants to buy $3 billion of common stock with a strike price of $22.25 a share for five years.

Recently GE and Berkshire agreed to unwind their deal at a 10% premium and the settlement of the warrants with a net share settlement. This time the warrants are barely in the money, and so Berkshire will not have the Goldman type windfall.

Finally, in 2011 Berkshire undertook a $5 billion preferred perpetual share investment in Bank of America, with attaching 10-year warrants. The yield was just 6% with a buyback premium of 5%, but today the warrants are in the money by over $3 billion, because the share price is now over $12 with the warrant being struck at $7.14.

From the above you can consistently see that Berkshire offered its capital to major corporations on highly attractive terms. It did not rely on an intermediary to create the deal because the intermediary is paid by, and represents, the issuer.

So, in my view, Australian institutional equity managers provided too much capital to too many companies, without a requirement to generate a sufficient return for the risk. They have let their clients down, and their clients are the broader population of average superannuation members. The let-down is measured by the poor medium-term returns of most equity funds emanating from the rotten returns from the Australian market over the last seven years.

Australian Foundation Limited Notes (AFIG)

While not absolutely comparable to a Berkshire type preference share, I do believe that the listed AFIC notes are worthy of consideration for my income portfolio. Indeed their structure does offer equity upside coupled with a protected downside and a solid, sustainable yield (running yield currently 5.5%). Separately, also see James Kirby interview AFIC Managing Director Ross Barker on video today on energy opportunities in the Australian market.

The terms of the issue can briefly be summarised as:

• Face value of $100 per redeemable convertible note;
• Yield 6.25% (fixed) paid half yearly in arrears on February 28 and August 31;
• Interest payments are not deferrable by AFIC, nor are they discretionary;
• Convertible into AFI shares or redeemable for $100 cash on 28 February 2017 (if not already redeemed or converted) at the option of the holder.

Analysis

AFIG are convertible to ordinary shares on any of the interest payment dates (twice a year) at the discretion of the noteholder. According to the AFIC Note PDS: “Upon conversion each AFIC Note will convert into a number of Ordinary Shares determined by dividing the Face Value by the Conversion Price”.

The number of ordinary shares was determined by dividing the face value ($100) by the “conversion price”, which upon listing of AFIG was set at $5.0864. That is 19.66 shares. Therefore, potential equity upside exists should the underlying AFI security appreciate during the five-year maturity period.

On the flipside, the noteholder is protected from excessive downside as the opportunity to redeem at face value of $100 in 2017 also exists. Perhaps this is best further explored by considering three scenarios, noting the current market prices of AFI and AFIG of $5.32 and $113.81 respectively.

1. Worst Case Scenario – ‘Downside protection’

In this scenario, the market recedes over the coming years and thus the share price of AFI falls below the ‘conversion price’ of $5.0864. The note holder redeems the face value of $100 cash at maturity in 2017, after receiving $25.00 of interest accrued between today and maturity. Hence note holders face a worst-case total return of $125 by 2017. This equates to an annualised return of about 2.4% over the next four years, given today’s entry price of $113.81.

2. Base Case Scenario – ‘Some equity upside’

Over the past decade, the share price of AFI has appreciated by about 5% per annum, having moved from $3.27 in June 2003 to $5.32 today. If AFI continues to appreciate by 5% per annum through to 2017, the price at maturity would be $6.47. When multiplied by the number of shares (19.66), the dollar value of AFI shares realised upon conversion equates to $127.20. This capital gain, coupled with the $25 of interest garnered from this point to the 2017 maturity, drives a total return of about 7.5% per annum over the next four years.

3. Bull Case Scenario – ‘More equity upside’

If the bull market was to come roaring back, delivering annualised share price gains for AFI in the region of 10% per annum, the capital gain realised upon conversion coupled with interest payments to maturity drives a higher return still; nearly 12% per annum.

Conclusion

So in summary, AFIG offers some equity upside, some downside protection and a solid running yield.

In my view, when we aggregate these factors and consider the risk/reward profile of the notes, AFIG presents as a solid opportunity for the more risk averse, income-focused investor. I have a buy on the note at about $112 for the income portfolio.

John Abernethy is the Chief investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au

Clime Income Portfolio Statistics

Return since June 30, 2012: 25.97%

Returns since Inception (April 24, 2012): 24.70%

Average Yield: 7.59%

Start Value: $118,757.19

Current Value: $149,595.03

Dividends accrued since December 31, 2012: $4,491.75