Unravelling AFIC's share trades

With a market capitalisation of more than $7.5 billion, Australian Foundation Investment Company easily towers above other listed investment companies on the ASX.

I spoke with Managing Director Mark Freeman this month to ask him about the company’s latest half-year profit result, which was substantially higher than the previous corresponding period. AFIC’s investment team was busier than usual during the six months, taking advantage of opportunities to take part in share buybacks, rights issues, and to sell out of some major positions. It also bought into new ones.

As well as asking Freeman to walk through the results and key transactions, we also spoke about the consequences of a change to franking credits legislation under an ALP government. AFIC is actively campaigning against such a change.

Listen to the podcast, or read the full transcript below.

Hello, I'm Tony Kaye, I'm the editor of InvestSMART, and today I'm joined once again by the Managing Director of Australian Foundation Investment Company, Mark Freeman.  Mark, welcome back.

Thank you.  Thanks for having me. 

No problem, Mark.  Mark, you've recently announced your latest financial results for the six months to December 31.  It was a good result.  Profit to members was up 75.5% to $239.4 million.  That profit actually reflected some quite significant changes in the AFIC portfolio during the term, including quite a bit of selling activity and also some buying activity.  I've done some calculations and I've worked out that it was about $273 million in asset disposals in the half, and about $314 million in purchases.  Is that a high level of activity for AFIC under the normal conditions?

Yeah, look, it is probably a little bit higher than normal because obviously, the big one, there was a participation in the Rio buyback, which was significant.  I think you'll find there's probably over $100 million of that.  That's really the bulk of it.  There's obviously the de-merger of Wesfarmers went through in this result as well, which you could classify that as turnover or not.  But it comes through as an acquisition in the numbers, the Coles Group, where it said an acquisition of $73 million, well that was really just the split.  But Rio was the big one, and we also participated in the BHP buyback as well.  They were the most significant deals.  Probably the other big purchase was, Transurban, did a rights issue during the period, which was quite a big investment for us as well.

Yeah, so are you out of Rio and BHP, in particular?

No, we're not.  We actually had a very big holding in Rio.  It’s still, actually despite that, an overweight position in the portfolio and BHP is still substantial.  Between the two of them, it would be sort up to 9% of the portfolio in those two stocks.  We still have a significant weighting towards BHP and Rio, and as a longer-term investor, we’re still very comfortable with that because these are high-quality low-cost assets that always reduce our cash.  We're very happy with the way these businesses are being run at the moment where it's all about getting the best out of your high-quality assets, using those high-quality assets to get your marginal growth.  Keep focusing on those costs and efficiency gains, and hopefully any investing they do out of that is more counter-cyclical and that's sort of the message that both those companies have been giving. 

We don't mind that they look at assets every now and again, but this is a cyclical industry, and you have to be very disciplined and make sure you buy and away from your core assets, it's done in a very counter-cyclical manner.  In the meantime, if they're not there then, basically they pass through those profits and dividends to shareholders, which both companies are doing.  They're doing it in a way as we’ve seen, that if those people can benefit from franking credits, then those buybacks have been very interesting. 

We took a decision to have a bit of a participation in those, and I guess the outcome of those is that we generated a significant special dividend, and it is special.  We talked about proposed changes in franking credits, if there's a change in government, certainly, the best thing to do is to get them into the shareholder's hands in this financial year.

One of the things I wanted to ask you about was the sale of the QBE Insurance holding.  What was behind that?

Look, we've been a long-term investor in QBE, but it's more around industry structure.  I think the current management are doing a pretty good job.  I think they’ve steadied the ship but it cycles up and down, but it's a very large player in a very competitive industry.  We've seen globally some of these companies, they’ve struggled to get growth, and with those sort of challenges, we just felt that we would look elsewhere in the market but we'll keep it under review. 

But I think it's a different company to what it was 20 years ago.  In the early days of Frank O’Halloran, it was a much smaller company and they had a good track record of finding these sorts of niche insurance businesses that they felt they could run better.  But, as they became more and more acquisitive, the acquisitions got bigger and bigger, and more reliant on debt funded acquisitions and some of them really turned out to be quite poor.  It's a big business now, and as I said, the industry structure, just makes us balk at it, and it is one of those businesses too, you hear from time to time with a person, it’s often difficult to get behind what's really going on in these large insurers.  We’ll keep it under review as we go along.

Okay.  Now, I did want to come back to the franking issue.  Because, some of the activity which you did in the half, obviously, partly relates to that, I imagine.  Is that an ongoing strategy of AFIC’s now to get those franking credits back into the hands of members before something does happen?

Well, look it’s something we talk about, when you look at it we run the company for shareholders.  If there's something we can do to benefit shareholders, we obviously, if it’s something, there’s a lot of discussion and then under the proposal that’s been put forward by the opposition, from the 1^st of July, things are different.  And those shareholders are getting a franking credit refund, which is a return of tax that’s already being paid on their behalf by the company.  If they’re not going to get that anymore, then that's really a game changer for a lot of our investees.  Certainly, if we can help them out by getting things like the participation in the Rio and BHP buybacks, get those proceeds back to shareholders, then, that’s obviously what we've done in this result. 

I suspect that other companies would probably would have to be thinking about this.  Because they are of significant value and I guess you can’t underestimate how many particularly retirees are out there who are investing in shares and these franking credits will form, in many cases, a significant part of their income.

Are you looking to do some changes to your portfolio of holdings, specifically around the franking credits proposal?

No, not really.  At the end of the day, we're a long-term investor in companies.  But I think those companies, we're not looking to trade before some event as such.  But, say those companies we have investments in, we’ll be looking to them to really think about can they get those franking credits back to shareholders?  Do they have the balance sheet?  Obviously, you don’t want them to do it, and take on a whole lot of debt to do it.  But franking credits, you have franking credits because you've earned profits and you just haven't paid them out to shareholders.  So, best you could do is say, well, let's get them out to the shareholders in this year in case there is a change in the current policy.

Now, some LICs have spoken about actually converting to a unit trust type structure to change that taxation position.  Is that something that AFIC’s looking at?

No.  We’ll look at anything but I think one of the big issues will be there is a potential capital gains tax event around that change and you certainly wouldn't want to incur that because we've got significant unrealised capital gains in the portfolio.  It's very important because it's just part of long-term investing but being tax aware.  You stick with your stocks.  Every time you pay tax, it just goes to counter, and means you've got less money to reinvest into the market and we certainly wouldn't want to do that for our shareholders.  So, we'll look at things but I suspect if it stands, we’ll continue on with it as is, but everything's always up for review.

Let's move on to your view on what's happening with markets.  You alluded to expectations around volatility and a lot of portfolio managers are saying that.  Is that something that you see is going to be the overriding factor during 2019?

Look I’ve been in this business long enough to say, I've got no idea what's going to happen in 2019.  We can't pick those sort of one-year views on markets.  I don't know anyone who can, and there’s been a long slew of people who try and do it.  But we can have a general sense of where value is, and again, even that’s very hard to do.  But certainly, that pull back we had in markets, when you look at any long-term valuations to the market, when we got back to 5,500, it was exhibiting something that looked around fair value on any multiples.

You look at the market which may have looked a little bit high on price to sales and I think there’s still good margins being generated, particularly in the US market, at the moment.  That's where the biggest concern in the US market is by those still bearish, is the fact that US businesses, when you look at margin trend over 10 years it’s been climbing up, and up, and up.  If there’s any reassessment of that, that will be a catalyst for more market volatility, I guess.

People are watching that very closely.  But I think broadly, when you looked at the Australian market, we thought it was of fair value.  When I looked at the market, we were starting to see a number of stocks that I would say I’d be happy to buy some stocks in that sector, and some stocks here, and that gave me more a sense that we were certainly at around a fairer save to your pocket.  The pull back from the highest, I guess, wasn’t a great surprise.

Yeah, are you seeing value emerging in the Australian market at the moment?  Or is there still a way to go? 

No, I think there has been and particularly as I said with that pullback we had. The market’s had a decent recovery off that low point.  We're sort of around 5,875.  But certainly, there were selective stocks that were getting caught in the back draft and we're starting to see it.  There’s a few stocks here we could definitely buy.  But with the little bounce we've had, I guess some of the stocks we were focusing on have had a good bounce back, I guess, in this environment.  So, we're probably just a little bit neutral at the moment and we've obviously got reporting season starting very soon.  I think we'll wait and see what comes out of that.

Now, Mark, last time we spoke, you mentioned that AFIC was looking potentially at an international share fund.  Is that something that's still on the agenda?

Look, I think what I've always said is, we'll look at anything.  We get asked a lot by our shareholders but that’s probably still a little way off.  At the moment, I guess we have to consider about whether we have a competitive advantage or not.  I think in listing overseas, you've got to have a pretty strong commitment to it, to do it.  One of the advantages we have here is we get pretty good regular contact with management.  I guess the feature we would bring to one if we did it, we would do it with the intention of being I guess a lower cost product than the peers in the market.  But yeah, we're still a fair way off looking at that at this point.  I mean, ultimately, one day perhaps but, never say never.  But certainly not in the next 12 months. 

The other thing, obviously, I guess the feature of this result was we're trying to keep investors informed of the franking credit issue because, we still believe it's not well understood by everyone in that market and there's a lot of investors out there that will get a bit of a shock if there’s a change in policy.  We're still getting a lot of our shareholders, they’re going to get quite hurt by this change, many who have sort of quite small balances in the stock and in a super fund.

They don't earn high incomes and are going to have a significant reduction in their income over the year, and it's going to be quite hurtful to a lot of people that have worked hard, and saved hard, to build up and save for their own retirement and they’ve done it in good faith with the current system and they are quite distressed by it.  We'll continue to sort of work hard to try and get this proposal re-looked at. 

Yeah.  It's certainly causing a lot of consternation amongst investors and it really needs to be clarified.

I think so because it's basically a blanket approach.  And I think, from everything here, there's some concerns over those that have very large self-managed superfunds, in terms of getting franking credit returns.  Yeah, that's an issue, I don't disagree needs to be looked at.  Now, if you've got someone who’s got $900,000 in a superfund and it's all in Australian equities, you might be earning $36,000 and might be earning an extra $10,000 from franking credits and that is not a high income by any stretch.

I think the minimum wage and the pension is a about $38,000.  That's if you’ve got it all in Australian equities.  Now, what's being said is that you need to diversify away from Australian equities.  But, if you go into overseas assets, your yield is probably more like 2 to 3%.  Not the sort of 4% frank you get from our market and would have a significant reduction in income and people just can't live off that. 

I think a whole lot of people are being captured in this net, who are just really call them “Aussie Battlers”.  They're people who have worked hard to build up.  They want to be self-sufficient and they don't understand why they're being, I guess, targeted for a significant reduction in income that they're earning.  We do really feel for them.  We’re sort of advocating really strongly that, I think all politicians, both sides of the politics, these are people that need to come out and speak to the people and hear the stories of the people who are going to be impacted.

Because I’ve heard a lot of it and it's really quite distressing because you're capturing all people who participate in self-managed super and, a lot of them are confused as to why a pooled fund can still use the franking credits, but a self-managed super fund is going to have to worry about it.  We're still sort of saying that their voice, and there are some groups out there, needs to be heard.  It's a part of the market, you know, elderly, retired people, they don't have a strong voice.  I just don't think they're being listened to and heard.

Well, Mark, I'm sure we're going to be talking about this a lot more and I'm happy to talk to you about it again.  So, that's for joining me again today.

Yeah, okay, a pleasure.

Thank you.