Welcome to the June edition of the Generate KiwiSaver Scheme Newsletter.

The clock is ticking! Have you checked that you qualify for this year’s $521.43 Government contribution to your KiwiSaver account? The last day for contributions is Friday 28th June. Each year between the 1st of July and the 30th of June, for every $1 you put in (up to $1,042.86) the Government will put in $0.50c.  Make sure the rest of your family gets their 'freebie' too. Anyone aged between 18 and 65 is eligible, regardless of whether they are working or not. See www.generatekiwisaver.co.nz/gc to check if you have contributed enough and for full eligibility details.

How likely would you be to recommend Generate KiwiSaver to others?

1         2         3         4         5         6         7         8         9          10

(Not At All Likely)                                               (Extremely Likely)

Returns to 31 May 2019 (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.

The prediction contained in the last edition of the newsletter was all too accurate with global share markets enduring a solid pullback in May. To put this into perspective though the Funds are all positive over the second quarter to date (this includes returns from April and May), and the calendar year to date returns are still impressive: the Focused Growth, Growth and Conservative Funds are up 9.9%, 8.5% and 4.7% respectively.

Early in the month, the optimism of an imminent announcement of a US-China trade deal was shattered by a series of tweets from President Trump. As trade tensions reignited between the two nations share markets came under increasing pressure; by the end of the month, the MSCI World Index in local currency was down -5.5%. The two growth funds were not immune to the sell-off in global equities with the Focused Growth and Growth funds declining -3.6% and -1.9% in May respectively. The Conservative Fund managed a creditable flat performance (0.0%) given the difficult market environment.

The strongest performing international equities holding in May was the Jupiter European Opportunities Trust. The Trust generated a positive return of 4.6%, which was 8% above its European shares benchmark when measured in Jupiter’s active currency (GBP). A number of the Trust’s holdings contributed to this strong result. More specifically, just nine of the Trust’s twenty-three holdings had a negative month. The highlight of the month was, ALK a producer of immunisations for allergies. ALK reported a strong set of first quarter results and upgraded full-year guidance pushing the stock up 40%. The Trusts largest holding, Wirecard, continued to recover after being accused of fraud by the Financial Times. Finally, the discount to Net Asset Value that the Trust’s shares trade at closed during the month (2.4% to 0.2%), which contributed to the strong performance.

Alibaba was a victim of the break down in the US-China trade talks. The company released its fourth-quarter results, which were ahead of analyst expectations at both the sales and earnings level. It also provided encouraging 2020 revenue guidance of CNY500 billion plus. While the results were enough to secure a positive day for Alibaba’s share price, investors’ focus rapidly reverted to macro concerns and the downside in Alibaba’s share price resumed. The trade tensions between the US and China is of particular concern for Alibaba investors because the strong growth in the Chinese middle class has been one of the factors contributing to Alibaba’s exceptional growth rate. A slowdown in Chinese economic growth could slow this growth. These concerns saw the share price drop 19.6% in May, making it the weakest performing international equity holding for the month. The dramatic fall needs to be put into perspective though, as in the calendar year to the end of May Alibaba was still up 9%. 

Contact Energy generated a 9.8% return in May making it the strongest performing Property and Infrastructure (P&I) holding for the month. The RBNZ cut its overnight cash rate to 1.50% from 1.75% in early May, which catalysed a rally in NZ yield stocks. Contact also benefited from strong inflows into its Clutha catchment which pushed up storage by 12% over the month to 126% of the historical average. This is particularly important for Contact because they have yet to re-contract gas supplies for their gas-powered combined cycle generation units.

Once again, a retirement operator has the dubious honour of being the weakest P&I holding. Metlifecare’s share price suffered a 9.7% decline in May. There was no company-specific news released during the month, but the REINZ housing data did nothing to buoy sentiment. This data showed that house sales volumes in April were weak. Given the timing of Easter, which made for a great excuse to take an extended break, we think the May stats will be more useful. Metlifecare is now trading at a 35% discount to its book value. We feel that this level of discount is unwarranted and have taken the opportunity to add to this position.

At the start of May a trade deal between the US and China seemed almost like a foregone conclusion. Both parties had expressed optimism based on the then claimed significant progress that had been made.

This wisdom looked increasingly questionable as Trump then made a series of tweets complaining about the lack of progress and threatening additional tariffs if an agreement was not reached by the end of the week. The news at the end of the week was not good, an agreement was not reached, and the US was increasing tariffs on Chinese imports.

The impact of this setback was compounded by news that the US was taking action against China’s flagship technology company, Huawei. The US Commerce Department announced that it had added Huawei to the Entity List, which effectively prohibits US companies supplying Huawei with US technology without prior approval. This move chokes off vital access to semiconductors and Google’s Android operating system for its mobile phones. The Chinese interpreted this as an escalation in the trade war.

Speculation that China would retaliate by banning rare earth exports to the US was sparked by a visit by President Xi Jinping to a rare earth producer. State-linked media then emphasised this is a very useful source of leverage. The US Commerce Department confirmed the widespread impact of a ban in a paper discussing potential solutions.

Rare earths are used in the production of everything from consumer electronics to household appliances as well as military hardware. China controls over 70% of the supply and an even larger proportion of the refining capacity.

At the end of the month, Trump tweeted threats of new tariffs on Mexico if they did not take steps to reduce illegal immigration. This was the first time that tariffs have been used by President Trump with a non-trade objective, which was a concerning development. Fortunately, Trump has recently backed down from these threats which has provided a tail-wind to markets in June.

It is worth noting that while the dollar amount of Chinese exports to the US impacted by tariffs sounds large, the direct impact of this trade spat is modest when compared with the size of the US and Chinese economies. The risk is that the uncertainty causes firms to delay their investment decisions and that this acts as a drag on global growth.

Consider for example a CEO wrestling with the decision of where they should locate new manufacturing facilities. Should they add to their manufacturing footprint in China or locate its manufacturing in another country? A long drawn out trade dispute with abrupt twists and turns makes this type of decision very difficult, encouraging firms to delay investment decisions. This will in time act as a drag on economic growth.

The longer this uncertainty lasts the larger the impact on global growth. The Federal Reserve and other Central banks are, of course, very aware of the risks and have signalled that they will make monetary policy even more stimulatory if necessary.

We have built up considerable cash levels as a buffer for share market volatility and to provide the capacity to take advantage of sharemarket weakness. For instance, at the end of May Focused Growth had 14% invested in cash and fixed interest compared to its 1% long term target. We have not reduced share market investments further than this because the abrupt twists and turns of the trade spat make building conviction difficult and supportive central banks provide some optimism that investors with a sufficient time horizon will be rewarded for remaining invested.

Global share markets had their first negative month in 2019. Mirroring April when the US share market enjoyed the strongest performance of the year, in May the US share market endured the largest decline.

The reporting season for US companies was largely wrapped up in April and so investor focus moved to future earnings growth and back to macro issues, which have been covered in detail above. Interestingly, the difficult macro environment does not seem to be the catalyst for minor downgrades to second quarter earnings estimates. More specifically, Factset data shows that negative earnings revisions by analysts for the S&P500 index were less than average (2.1%, 15 year average = 3.1%). The -6.4% decline in the Standard & Poors 500 in May suggests that investors were more focused on the macroeconomic uncertainty and longer-term earnings growth.

European share markets were also dragged down by the macroeconomic risks, but the decline was not as severe as the US and China. European shares declined -5.0% in May when measured by the Bloomberg European 500 index.

The highlight of the month from our perspective was Siemens’s second quarter earnings release and strategy update. The company reported a robust set of results, modestly bettering analysts expectations across a broad spectrum of its businesses at both the revenue and earnings lines. Importantly the company provided a strategy update at its capital markets day. A new streamlined structure was announced, which will see the troublesome power division spun-out. Management also announced a cost out programme that should see a staggering €2.2 billion of cost savings in FY23.

Emerging Markets equities were also hit by an abrupt shift in the optimism surrounding US-Chinese trade negotiations. These more volatile markets declined -6.9% as measured by the MSCI Emerging Markets Index. Perhaps not surprisingly, it was China and its Asian neighbours that were the main detractors over the month.

Over the ditch, Australian equities enjoyed a standout month, notching up a positive 1.9% return. The surprise win by the Coalition government led by Scott Morrison was undoubtedly a significant driver. The Labour Party was widely expected to win and had promised to end cash refunds for franking credits which would have reduced the value of dividend payments to retirees. The removal of this overhang and the Coalition’s promise of tax cuts was enough to drive the Australian share market higher.  As one would expect, the banks and other large dividend payers were particularly strong in May.

Back home, the NZX50 Index ended the month up a very credible 1.0%, supported by a cut to the Overnight Cash Rate by the RBNZ. In a reversal of April, growth stocks (eg A2 Milk, F&P Healthcare and Ryman) featured as significant detractors and the solid dividend payers (eg Auckland Airport, Contact and Spark) drove the market higher.

After 50 years at the helm of Berkshire Hathaway (which is currently one of the largest growth investments for all three of our 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:

“Home ownership is a wonderful thing. My family and I have enjoyed my present home for 50 years, with more to come. But enjoyment and utility should be the primary motives for purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser."

Buffett made this comment in Berkshire’s 2008 annual letter to shareholders and had his advice been widely heeded the Global Financial Crisis may well never have happened.

Knowledge Builder - Short selling

Short selling (also known as shorting or going short) is the practice of selling an asset that you don’t actually own, in the hope that the price will decline, and you can buy it back in the future at a lower level. You can then keep the difference between the price at which you sold the asset and the lower price you paid to buy it back.

When taking a short position in shares, for example, the shares are borrowed from a third party – usually a broker – and then sold. The short seller may have to pay a fee to borrow the securities and have to reimburse the lender for cash returns the lender would have received had the securities not been loaned out. When the securities are repurchased, they are then returned to the lender.

Some of the Underlying Funds we invest into have the ability to short stocks. This can be helpful as, if executed wisely, it can limit or even reverse negative returns in falling markets.

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Berkshire Hathaway

Led by famed value investor Warren Buffett, Berkshire Hathaway's success has been built on the firm's record of acquiring and managing a portfolio of businesses with enduring competitive advantages.

Whether through direct ownership of individual companies or via significant shareholdings, Buffett has typically looked to invest in firms that have consistent earnings power, generate above average returns on capital, have little to no debt, and have solid management teams. Once purchased, these businesses tend to remain in Berkshire's portfolio, with sales seldom occurring.

In the early part of his career at Berkshire, Buffett focused on long-term investments in publicly quoted stocks, but more recently he has turned to buying whole companies. Berkshire now owns a diverse range of businesses including insurance, confectionery, railroad, real estate, jewellery, and several regional electric and gas utilities. Some of the companies that Berkshire has investments in include Apple, American Express and BNSF Railway.

Berkshire Hathaway has averaged an annual growth in net asset value of 20.5% for its shareholders from the end of 1964 to the end of 2018, which is more than twice the 9.7% return of the S&P 500 with dividends included for the same period. It is not surprising that Berkshire Hathaway is one of the very largest companies in the world given this exceptional track record. Whilst we do not expect this type of outperformance to continue in the future we know our money is with a “safe pair of hands.”

Next month:

Goodman Property Trust