Welcome to the August edition of the Generate KiwiSaver Scheme Newsletter. July was another great month for your KiwiSaver scheme. Generate received some special mentions for strong performance in the latest Morningstar KiwiSaver Survey. In addition, the Conservative Fund and Focused Growth Fund topped their categories for one-year performance for the year to June ‘18. The Growth Fund came in a very credible third. For more see here. Pleasingly the strong performance continued in July despite some wobbles late in the month. More on this later.

Returns to 31 July, 2018 (after fees* and before tax).

*except the $3 per member per month fee.
**the funds opened on 16 April 2013
Note: Past performance is not necessarily an indicator of future performance.

July saw the funds deliver solid returns with the Focused Growth, Growth and Conservative Funds returning 1.48%, 1.10% and 0.25% respectively. We continue to hold elevated levels of cash with some markets being close to the year’s highs and we believe the volatility we have experienced year to date is likely to continue.

The best performing international investment was Google’s parent, Alphabet, with a return of 8.0%. Alphabet reported stronger than expected revenue and earnings late in the month. The stock had already had a strong month leading to its earnings and subsequently gained further momentum. We continue to like Alphabet’s prospects, whether it be its core digital advertising business or other facets of the business such as artificial intelligence and cloud storage. We recently read with interest that Hamish Douglass – the high profile Lead Portfolio Manager of the Magellan Global Fund – believes Alphabet is “at least 50% undervalued.”

The lowest returning international investment was Facebook, which was down 11.8% in July. Facebook has been a strong performer for the growth funds in previous months but gave up some of those gains in July after it reported earnings late in the month. Facebook actually reported second quarter earnings that were higher than the consensus expectation. What turned investors off was when the company projected a material reduction in longer term margins as well as slowing revenues in the second half of FY18. We note that Facebook has a strong history of beating its estimates and believe that is likely to continue in the years ahead.

The top-performing Property and Infrastructure stock in July was Vital Healthcare Property, which was up 5.2% over the month. Sentiment towards Vital has been weak in recent months. This was possibly exacerbated by the announcement that Vital entered into a derivative to acquire a material stake in Australia’s second largest private hospital operator-Healthscope. However, the market seemed to gain comfort with the deal given the stock rebounded strongly in July. 

Z Energy was the lowest returning Property and Infrastructure stock in July declining 5.1%. During the month the company revised down its earnings guidance by $30 million due to two key headwinds. First, there were delays in restarting Refining NZ’s Marsden Point refinery after a planned maintenance shut down. Second, high oil prices have translated to high prices at the pump, which is dampening demand. Both of these factors are one off in nature and so are not of great concern to us. The company also published its quarterly operating statistics, which showed a loss of market share. This is something we will be monitoring closely moving forward.

We have seen a number of assets experience bear markets this year. The more volatile and higher risk assets were the first cabs off the rank. For example, at the time of writing, Bitcoin has fallen some 66% since it peaked in late December last year (see our December 2017 newsletter here which talked about the risks of the Bitcoin bubble). Emerging market equities are currently on the cusp of entering a bear market (the definition of which is a 20% fall) in USD terms. Typically the riskier assets are the last to appreciate and join in the bull market but also the first ones to get punished in a bear market. From here the risk is the bear market spreads to higher quality assets such as developed equity markets. But this risk in the U.S., for example, has been lowered by the latest earnings season whereby the stock market has not kept pace with the strong earnings growth thereby decreasing the valuation of the market on a price/earnings ratio. Nevertheless, in our view, the risk of a material sell-off remains, therefore, we are holding more cash than usual. If indeed the storm clouds do arrive and stocks pull back substantially we can (to quote Warren Buffet) “rush outdoors carrying washtubs, not teaspoons.”

The month of July saw equity markets advance on the back of global growth remaining robust, subsiding trade tensions and a positive start to the earnings season. The MSCI All Country World Index returned 2.9% (in local currencies).

In the US, the S&P500 gained 3.6% over the month. The share market was buoyed by strong economic data and news that the US and the EU had defused trade tensions. However, disappointing earnings announcements from a number of tech titans took the shine off the share market’s performance. The most notable fall was Facebook, which saw almost 12% wiped off the value of the stock (see “Generate Fund Performance” for more detail as to why). Twitter, Netflix and Intel also disappointed the market and were duly punished.

On the other side of the coin Google’s parent, Alphabet, and Amazon posted earnings, which were well received by the market.

The industrial sector led from the front driven by improving trade sentiment and strong company earnings releases.
Eurozone equities had a positive month with the Bloomberg European 500 gaining 3.1%. Solid earnings and the agreement between the EU and US to work together to reduce tariffs related to non-auto industrial goods provided tail-winds for the share market.

The Chinese stock market managed to recover some of its steep losses from the preceding month with the Shanghai Stock Exchange Composite up 1.0% in July. This was despite tariffs from the US being enacted early in the month and economic data remaining soft. The Chinese Yuan – which fell to a one year low against the USD - seemed to take the brunt of the bad news.

Emerging markets (EM) as a whole managed to buck the trend of the previous 2 months by posting positive returns in July. The MSCI Emerging Markets Index returned 1.2%. Encouraging economic data and healthy corporate earnings offered some much needed respite for EM equities. Latin America was the best performing region.

Over the ditch, the ASX200 Accumulation Index continued its winning streak by notching up a 1.4% return. During the month, the Big 4 Australian bank’s share prices continued to recover after being hit by the Royal Commission of Inquiry, which revealed widespread malpractice by Australian banks.

The local share market took a breather in July with the NZX50 Gross Index (NZX50G) easing 0.2%. Market darling A2 Milk gave up some of its recent gains after providing a trading update to the market. Although its new revenue guidance for FY18 was at the top end of its previous range, commentary around FY19 suggested cost growth is expected to accelerate faster than what investors had previously thought.

After 50 years at the helm of Berkshire Hathaway (which is currently one of the largest investments for both of our growth funds), Warren Buffett has become widely regarded as one of the world’s greatest investors. In his annual letters to shareholders, and in various interviews he has given, he has shared many of the lessons he has learned during his career. This month:

"Charlie and I believe in operating with many redundant layers of liquidity, and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100.”

Here Buffett makes it clear that he would never risk the long-term financial security of Berkshire Hathaway in order to enhance short-term returns for shareholders. Having ample liquidity (or access to cash) has the added benefit of being able to buy companies cheap when they don’t heed Buffett’s advice and get into financial difficulty.

Risk versus Return – the Trade Off

The link between risk and return is the most fundamental rule of investing. Low levels of uncertainty (low risk) are associated with stable and low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential – albeit far less predictable - returns.

Because of the risk-return trade off, you should be aware of your personal risk tolerance when making investments and fully understand the inherent riskiness of a particular investment.

Risk can have a negative meaning for some people. But it is not necessarily a bad thing - as long as the degree of risk is well understood.

If an investor has a long-term investment horizon (which is usually the case with KiwiSaver) the risk tolerance will typically be higher as a longer time period gives the investor the ability to “ride out” a downturn in markets.

The goal is to find an appropriate balance - one that generates a satisfactory return in the medium to long term, but still allows you to sleep at night!

Please log in to your account to see your full portfolio breakdown.

Tilt Renewables

Tilt Renewables is a renewable energy company with eight wind farms located in Australia and New Zealand. These wind farms generate enough electricity to power 285,000 households in a typical year.

One of the key attractions of an investment in Tilt is that it is part of the solution to Climate Change. Over the next few decades, reducing carbon emissions will require significant changes to the way energy is generated and used. The Paris Agreement targeted keeping global warming below 2 degrees and as close to 1.5 degrees as possible. To achieve this target Australia agreed to reduce its emissions to 26-28% below its 2005 levels by 2030, which implies a 50% reduction on a per capita basis.

While a high proportion of electricity generation is from renewable resources in New Zealand, the same cannot be said for Australia. We are not alone in thinking that for Australia to meet its Paris Agreement commitments it needs to dramatically increase the proportion of energy generated from renewable resources. Tilt is well positioned to exploit this theme. It has a pipeline 5 times as big as its current electricity generation portfolio. The majority of this potential future generation capacity is consented, and so signing off-take agreements is the key focus for the company.

It is also worth highlighting the relatively low-risk nature of Tilt. The price Tilt receives for its electricity is already locked in for the majority of its wind farms. This means that swings in the price of electricity have limited impact on the company’s earnings. The key swing factor for earnings is the amount of wind at Tilt’s wind farms. In low wind years earnings will be lower because they do not have as much electricity to sell as a typical year and vice versa.

As we were finalising the newsletter Infratil and Mercury announced that they intended to make a takeover offer for Tilt. Infratil is aiming to increase its ownership to 80% of the company with Mercury continuing to hold the remaining 20%. The sell-side analysts are arguing that at $2:30 the takeover price is fair, which implies that not only is the considerable development portfolio of little value (i.e. none of the sites will generate a return in excess of the cost of capital!) but that Infratil doesn’t need to pay a material control premium. There is a reasonable probability that the takeover will be successful at (what we believe to be) a very attractive buying price, even though it is at a premium to the price our funds paid for their shareholdings in Tilt. While this is slightly disappointing our significant holding in Infratil means that the portfolios will continue to benefit from Tilt’s combination of a low-risk base and good growth prospects.

Next month:

Mercury