Pitcher Partners Sydney - Summer Wealth Update 2022-23

Wealth Update Summer 2022 23

Summer 2022-23

Welcome to our latest Wealth Management Update.

This edition covers the following topics:

• Reporting season update International equities

• ESG The what, why and how?

• Danger Zone The dangers of investing based on return on equity

Reporting season update

International Equity Portfolio

Note: All figures in USD unless otherwise stated. Results referring to percentage changes (increases/decreases) relate to the previous corresponding period (pcp) e.g. Q4 FY22 results are compared to those of Q4 FY21.

Apple Inc (AAPL: US)1

Share price 29/11/22: US$141.17 Result Q4 FY22 Revenue US$90.146 billion, up 8.1% on the pcp Underlying EPS US$1.29, up 4.4% on the pcp

• A strong revenue result was led by growth in its Mac laptop computers where sales of $11.5 billion far exceeded consensus forecasts for $9.36 billion thanks to the launch of new Macbook Air and Macbook Pro designs

• iPhone sales of $42.6 billion by contrast showed some signs of weakness (consensus: $43.2 billion) but still recorded a record sales result in the September quarter.

• Revenue of $90.1 billion and earnings per share of $1.29 exceeded consensus forecasts of $88.9 billion and $1.27 per share respectively

Key

points

• As with other US based firms mentioned below, currency was a major headwind to the value of overseas sales with the trade weighted DXY index (a measure of the value of the US dollar against a basket of currencies) rising 7.1% over the quarter, a substantial drop in the value of any overseas profits. Part of this headwind may reverse in this quarter with the DXY index declining 4.5% on the back of speculation that the US would halt further interest hikes.

• The slowing global economy did see certain segments struggle with services revenue falling almost $1 billion short of consensus at $19.2 billion (consensus: $20.1 billion) due to weakness in digital advertising (businesses selling fewer ads) and gaming. Apple continues to expand its user base with a reported 900 million paying subscribers, up from 860 million in the June quarter.

Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFSL number 336950.

Our comments

• The quality of Apple’s hardware and services franchise remains undiminished in our view. Upcoming iPhone 14 launch could serve as a meaningful catalyst for stronger revenue growth in line with the company’s outlook.

• Strong dollar will impact earnings but may be nearing its peak with growth in the December 2022 quarter to date seeing a sharp reversal.

• Apple has remained a safe haven for investors this past year notwithstanding the macro backdrop. This has supported the share price but leaves the valuation more challenged notwithstanding the quality of the business. The development of ancillary business lines such as services and advertising are playing an important role in continued top line growth, justifying its more premium valuation relative to history.

Key points

• Abbott upgraded guidance for 2022 to $5.17 $5.23 adjusted earnings per share which included $0.5 billion in COVID 19 testing sales and excluded certain one off costs such as the voluntary recall of its baby formula products.

• This amounted to a further 8.3% upgrade on its June quarter update guidance of $4.70 to $4.90 per share.

• Key drivers were strong demand for its medical devices and diagnostics products with the launch of its latest generation glucose monitoring device (to manage diabetes) being well received.

• The resumption of infant formula production was also positive and should eventually help restore sales in this space which were depressed following the factory shutdown earlier this year on product quality concerns. The presence of new entrants in the wake of the shutdown production such as A2 Milk may weaken the medium term outlook by introducing additional competition in this segment.

• COVID 19 testing sales are rapidly declining as a source of revenue and earnings with an increasing expectation that these are immaterial from next year. Earnings will fall in 2023 as a result (this reflects current market consensus) before gradually exceeding 2022 results in 2025 as a result of growth in other segments eventually catching up to the temporary earnings boost from COVID 19.

Our comments

• The company declared its 395th consecutive quarterly dividend and has increased its dividend for 50 consecutive years, highlighting its growth over time and the quality of its operations to continue paying dividends through several recessions over that period.

• Despite challenges in the form of losing COVID 19 diagnostic sales, the business remains well positioned for strong growth over time and investors will benefit from both this and a regular, increasing dividend presenting an attractive total return versus the broader market in our view.

Adobe (ADBE: US)1

Share price 29/11/22: US$326.78

Result Q3 FY22

Revenue $4.433 billion, up 12.7% on the pcp

Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFSL number 336950.

Underlying EPS $3.4, an increase of 9.3% on the pcp

• Adobe saw 13% revenue growth in its digital media segment, 11% in its Creative revenue and 23% in its Document Cloud offering.

• The business continued to build annualised recurring revenue (ARR), a measure of repeat business, with $449 million added for the quarter in net terms to its Digital Media division after allowing for customer churn.

• The firm is targeting another $550 million in net ARR for the December quarter

Key points

• It left its 2022 full year guidance unchanged at $13.50 adjusted earning per share even allowing for headwinds from a stronger US dollar which is being offset by a seasonal uptick in demand for Adobe products.

• The company also gave more colour on its acquisition of Figma for $20 billion (half cash, half in shares) which it identified as having a $16.5 billion market opportunity, a strong margin profile (gross margins at 90%) as well as growth prospects that would allow Adobe to accelerate its product strategy particularly in delivering Creative Cloud solutions online

• While the derating in the first half of 2022 was painful the core Adobe business continues to execute well in our eyes.

• Its breadth of tools makes it well suited to the rise of new or more popular forms of media for creatives and the building ARR book suggest it retains stickiness amongst users.

• In summary, the core business is continuing to execute well in balancing profitability while spending for growth and should be able to compound earnings growth above the broader market in the medium term.

Our comments

• However, the price paid for Figma was extremely high relative to what it is adding to Adobe in the immediate term. Figma has recently been reported as generating $400 million in ARR implying a multiple of 50x ARR and a doubling of the $10 billion valuation Figma was given in its last capital raising as a private business in 2021.

• Figma undoubtedly has strategic value as a cloud native solution (i.e. it was designed for an online world from the beginning versus existing software businesses). This gave it an advantage for functionality with other open source providers and made it a potential longer term threat to Adobe by building a “good enough” solution that would enable users to circumvent the Adobe ecosystem.

• This transaction negates that potential threat and has value in that regard. Purely as a business acquisition we will not know if or by how much Adobe overpaid until several years into the future when we can properly assess the success of integrating Figma and growing it and its associated offerings under the Adobe umbrella

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Our comments

• YouTube ad sales for example declined to $7.07 billion, down 2% from a year ago.

• The weaker global economy and higher inflation has seen business ad spending decline particularly for areas such as insurance, loans and mortgages with higher rates slowing new mortgage loan originations for example.

• Currency remained a notable drag with growth to September slowing to 6% compared to 11% growth in constant currency terms. The weaker US dollar performance in the December quarter so far will be a meaningful tailwind assuming it persists.

• Google Cloud performance was a slight positive with revenue of $6.9 billion versus consensus of $6.69 billion Operating losses also narrowed to 10.2% of sales compared to 12.9%, a year ago.

• The Alphabet group has shown signs of sensitivity to global economic conditions which is unsurprising given the elevated growth since the pandemic began due to lockdown initiatives driving increased online activity

• Google Cloud remains a source of longer term revenue growth (accelerating slightly to be up 37.6% for the September quarter year on year) and operating losses are continuing to shrink.

• The quality of the franchise particularly its core Search business remains intact with no meaningful competitor solutions of its scale and quality.

• Cost management remains a point of concern however with management still guiding to new employee additions in the December quarter despite the slowing growth profile. There are material levers to pull in this regard however with the company showing a willingness to cut staff during the global financial crisis and the substantial losses in its Other Bets division a natural target to improve profitability as well.

Key points

• Strong demand for cancer drug Darzalex continued to drive sales for its Pharmaceutical division with above market performance driven by increased market share to Darzalex as well as strong demand for its immunology offerings such as Stelara.

• A stronger US dollar dragged on international business performance, similar to other American multinationals

• Plans to spin off its Consumer Health division as a new company are continuing to progress with final separation expected in 2023. One rationale behind the spinoff would be improved flexibility for the core JNJ business with Consumer Health being less material than its Medical Devices and Pharmaceutical divisions.

• JNJ strengthened its overall guidance slightly by tightening its average expectation for underlying EPS from $10.70 per share to $10.725 per share citing stronger underlying business as offsetting negative currency pressures.

• On 1 November 2022, JNJ also announced the acquisition of Abiomed, a leading provider of cardiovascular medical devices, for $16.6 billion. The deal is expected to be slightly negative to flat for 2023 earnings before increasingly adding to profitability from 2024 onwards.

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Our comments

• The Abiomed acquisition is costly with the price equating to an almost 79 times current year earnings (65 times current year operating cashflow). It represents a strategic choice to emphasise medical devices within the JNJ business which should be able to accelerate the distribution of Abiomed products and realise value from its extensive product development to date. To recreate an Abiomed from scratch would be a costly exercise. The acquisition while costly can be rationalised as necessary to buy a capability in cardiovascular disease that JNJ lacked. In addition, it represents a less significant percentage of JNJ’s total market value compared to Figma relative to Adobe, hence the more muted share price reaction to the news.

• The business has shown the benefits of its diversified operations in being able to navigate a difficult macroeconomic backdrop and eke out earnings growth.

• Our opinion on JNJ as a mature but growing business at a reasonable valuation remains intact. The ability to reprice its pharmaceutical products also highlights the quality of the brands within its stable. Extending its medical device franchise should improve recurring revenue over time as products such as the Abiomed suite are needed to monitor heart health for example.

Microsoft Corporation (MSFT: US)1

Share price 29/11/22: US$240.33

Result Q1 FY23

Revenue $50.12 billion, up 10.6% on the pcp

Underlying EPS $2.35, an increase of 3.5%

• We saw signs of US dollar strength challenges with Azure growth slipping to 35% for the year to September (consensus: 36.5%) and Microsoft projecting a further slowdown for the December quarter

Key points

• Microsoft guided to cloud revenues of $21.25 billion to $21.55 billion, slightly below consensus estimates of $22.01 billion

• Elsewhere in the business, personal computing was impacted by a slowdown in consumer spending with projected sales of $14.5 billion to $14.9 billion versus estimates of $16.96 billion for the December quarter highlighting continued weakness is anticipated.

• Microsoft is still performing strongly in underlying terms particularly with its cloud business. It has, however, begun to show signs of sensitivity to the broader economy with segments such as personal computing struggling in recent quarters.

Our comments

• US dollar strength has also posed a headwind to the business although this is likely abating in the near term given the selloff in the US dollar in the current quarter to date.

• The bid for US gaming giant Activision continues apace and if it proceeds should open up more revenue opportunities for the Gaming division given the depth of intellectual property being acquired.

• Our overall thesis on the business remains intact with the shift to cloud offering a path to continued earnings growth and returns on capital at a premium to the broader market and a reasonable valuation in our view.

Nestle S.A. (NESN: CH)1

Share price 29/11/22: CHF 111.26

Result Q3 FY22

Revenue CHF 23.55b, up 9.4% on the pcp

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Key points

• Nestle saw organic sales growth of 8.5% for the nine months to September split between 1% of real internal growth (RIG, a volume measure) and 7.5% of pricing growth

• Organic growth or the nine months to September was broad based at 7.4% for developed markets (58% of group sales) and 10.2% for emerging markets (42% of group sales).

• On an underlying volume basis, the result was more subdued at 0.1% for developed markets contrasting to a more robust 2.5% growth in emerging markets.

• The company upgraded its FY22 guidance with an expected organic sales growth rate of “around 8%” up from the previous target of 7 8% and confirmed an underlying operating profit margin of ~17%.

• The business announced the acquisition of the Seattle’s Best Coffee business from Starbucks, bolstering its coffee franchise.

• Nestle continues to exert strong pricing power, leveraging the power of its brands to maintain positive volume growth.

• The business has performed well, given its global scope, in containing inflationary pressures in its cost base and also passing on increases to end consumers.

Our comments

• The resilience of organic growth is being tested with developed markets weak on a volume basis. The concern is whether consumers is the wake of higher inflation and interest rates globally will continue to tolerate higher prices or pivot into substitute goods.

• Emerging markets remain a growth segment with notable volume growth (2.5%) even in the face of sizeable pricing increases (7.8%) highlighting the inelastic demand for Nestle goods.

• Overall, the business remains well placed to continue generating high single digit earnings growth without being overly troubled by inflationary challenges and returning capital back to shareholders in the form of dividends and buybacks.

• UMG saw top line revenue rise 13.3% year on year in constant currency terms driven by growth in all segments.

• At a segment level, Recorded Music saw 10.1% revenue growth, Music Publishing 6.9% and Merchandising & Other was up 101.1% (in constant currency terms)

• Recorded music was bolstered by strong demand for subscription and streaming offering with 7.7% growth for the year, supported by continued growth in music subscribers both in premium and ad supported offerings.

• The removal of coronavirus restrictions bolstered demand for live touring with the License and Other revenue segment growing 30.2% for the year.

• Music Publishing was impacted by a change in accounting practices. Excluding this growth was 12.3% instead of 6.9% quoted above Digital continued to perform well, up 17%, thanks to the growth of streaming and subscription offerings

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Our comments

• Finally Merchandising and Other benefitted from the rebound in touring related merchandising (for live events and the like) following a COVID 19 related slowdown in touring during 2021.

• Our thesis of Universal Music as a diversified record label able to extract value from different facets of the music industry ranging from live events to streaming (e.g. Spotify) offerings as it benefits from its extensive catalogue of music rights

• Currency impacts helped cushion results on a reported basis due to the relative weakness of the Euro this year. In a stronger period of European economic growth, the reverse may hold should the Euro appreciate.

• Universal Music will continue to be capital intensive to an extent as it needs to find and develop new artists to bolster its music catalogue. We would also expect some royalty acquisitions over time where the company sees the value in being opportunistic in adding new music royalties as part of its stable.

• Operating revenue growth was driven by a combination of volume growth, core pricing increases and higher fuel surcharge revenue (surcharge passed on to customers).

• Importantly business volume growth remained positive, up 3% over the same period.

• This result belied substantial challenges in the form of strong inflation via high fuel and wage costs.

• The company downgraded guidance with volumes now targeting 3% growth (down from 4 5%) and a full year operating ratio of 60% (up from 58%) implying weaker profit margins to close out 2022.

• Our overall view on the business remains intact

• Arguably more than some other businesses it has seen meaningful challenges from supply chain disruptions, higher labour costs and energy prices.

• It has however demonstrated the quality of its moat with pricing power a key lever in countering these impacts and passing them on to the end customer instead of absorbing through lower profit margins. This has been tested more recently but we expect over time that productivity initiatives and the easing of supply chain challenges will support business results going forward.

• We continue to see Union Pacific as an inflation protected annuity stream that supports our portfolio with its defensive nature.

Visa Inc. (V: US)1

Share price 29/11/22: US$209.06

Result Q4 FY22

Revenue $7.79 billion, up 18.7% on the pcp

Underlying EPS $1.93, an increase of 19.4% on the pcp

Key points

• Visa saw a strong result ahead of consensus estimates in the September quarter with EPS of $1.93 (consensus: $1.86).

• Key drivers included the resilience of consumer spending to date and increased travel demand in the Northern hemisphere, notably the US as consumers took advantage of the stronger US dollar to travel overseas

• The payments processor saw payment volumes rise strongly by 10%, boosted by a 36% surge in cross border volumes (card spending outside the country of issue). This suggest that spending is not just inflation-related but also supported by underlying demand, a near term positive for Visa which profits from this upswing in activity.

• The board approved an increase to its quarterly cash dividend by 20% to $0.45 per share and also authorised a new $12 billion share buyback program which should bolster share price growth in the near term.

• Visa continues to play a role in global commerce as a key payments processor with its duopoly with Mastercard remaining intact.

• Travel volumes are a notable boost to overall sales and as travel demand continues to recover it remains a useful upside catalyst in the near term notwithstanding the challenges that higher energy prices and interest rates pose to consumer spending.

• The business has maintained margins and seen earnings recover in line with the boost to consumer spending, justifying our position as a high-quality exposure to global commerce.

By Cameron Curko, Head of Macroeconomics & Strategy |

Pitcher Partners Sydney Wealth Management +61 2 9228 2415 cameron.curko@pitcher.com.au

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Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty

Our comments

ESG – The what, why and how?

What do we mean by the term ESG?

In investing circles, ESG refers to investments that consider Environmental, Social and Governance issues as part of their process. For example, a fund might exclude companies with poor environmental credentials such as fossil fuels polluting the environment or tobacco and gambling businesses that profit from the legal but harmful products and services that they provide to the public.

Why would you invest in ESG products?

Investors have multiple reasons for choosing ESG products. It could be:

• Aligning with ethical or moral concerns such as avoiding companies that employ child labour in developing countries, profit from fossil fuels or environmental damage as an example.

• Aligning with religious beliefs

• Trying to make a direct impact by funding businesses or projects that “make a difference” e.g. green bonds that fund projects with a positive environmental impact2 such as encouraging households to purchase solar panels.

This movement towards ESG based investments is now one of the fastest areas of growth in the asset management business. PwC is forecasting that ESG oriented assets under management (AUM) will more than double from US$4.5 trillion in 2021 to US$10.5 trillion in 2026 while in the Asia Pacific it is expected to triple off a lower base to reach $3.3 trillion in 20263 In their base case it will be taking an increasing share of total investments as shown below with private markets (private equity, venture capital and the like) expected to lag public markets for stocks and bonds given its relatively smaller size

Figure 1: ESG growth forecast by asset type and region (2015 2026)

2 S. Freestone, ‘Green bonds reach new highs in Australia’ , PRObono Australia, 2022 (accessed 28 November 2022) https://probonoaustralia.com.au/news/2022/08/sustainability and green bonds in australia/#:~:text=Green%20bonds%20are%20%E2%80%9Cbonds%20that,(TCV)%2C%20William%20Whitf ord

3 ‘Asset and wealth management revolution 2022: Exponential expectations for ESG’ , PwC, 2022, (accessed 29 November 2022) https://www.pwc.com/gx/en/financial services/assets/pdf/pwc awm revolution 2022.pdf

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How would you invest?

As climate change and social issues have become more charged in recent years, we have seen a material shift with investors highlighted above with growing demand for products with an ESG focus. In some cases, these may “just” be aligned to environmental goals and in others, more broad based e.g. factoring in broader social ambitions and targets

Today the typical Australian investor has a range of options before them. These usually fall in one of two camps:

1. Negative screening

2. Impact investing

Negative screening is the process of removing potential investments due to ESG concerns. For example, take a benchmark index such as the S&P/ASX 200 and remove businesses that are involved in gambling or alcohol sales. A fund manager following this index would then exclude companies such as Endeavour Group (owner of Dan Murphys and a range of pubs across the country) or Tabcorp (gambling operator with brands including TAB and Keno) from the portfolio.

The goal here is twofold;

• by avoiding these businesses investors know they have limited exposure to damaging business practices; and

• by reducing demand for these stocks enough they will tend to trade at more depressed valuations versus the broader market making it more difficult for them to raise capital and grow in the future. The second point is seemingly indirect, what does a depressed valuation matter if you’re still making money? It can be a powerful deterrent to expanding operations however as it makes more ambitious projects that require equity injections from shareholders increasingly expensive and at times prohibitively so. If broader society buys into the approach, e.g. bank lenders with ESG targets then in some cases an entire industry can become increasingly sidelined.

This has arguably become the case with the domestic coal sector with a range of operators increasingly isolated from equity and debt markets as a source of capital in recent years. Just this year we saw Commonwealth Bank promise to no longer finance new thermal coal mines and reduce its existing lending to zero by 20304. Mine operators in this scenario will have to increasingly rely on the few lenders left (at potentially higher rates) or self fund their operations and expansion if they even can do so.

These negative screening solutions tend to be more “benchmark like” in nature and are commonly offered to clients as a benchmark index such as the S&P/ASX 200 less a range of unsatisfactory businesses in an ETF (listed index fund) or managed fund structure.

Impact investing is more direct and “hands on” with managers actively looking to engage and promote stronger ESG outcomes in their investments. Examples include;

• investor activism to encourage divesting environmentally damaging business divisions e.g. a conglomerate that also owns an oil field;

• encourage investing in the business itself to achieve net zero greenhouse gas emissions; or

• private markets (private equity, property etc) funds aiming to deliver social goods such as affordable childcare or housing.

These tend to be less benchmark aware approaches as they are targeting a specific set of outcomes in listed equity markets or bond markets for instance. They tend to be more suitable for investors with concrete ESG goals that have a higher risk tolerance and ability to handle returns deviating materially from traditional benchmarks such as the S&P/ASX 200 or the S&P 500 indices.

Conclusion

ESG investing is now a powerful movement across the asset management industry and is only expected to grow more important over time. Its influence has already started to impact the broader economy with certain business practices becoming increasingly uninvestable such as thermal coal. There are a range of investment

4 Australia’s big four banks face shareholder ire over funding fossil fuels, Guardian Australia, 2022 (accessed 22 November 2022) https://www.theguardian.com/australia news/2022/oct/11/australias big four banks face shareholder ire over funding fossil fuels

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options available to meet investor preferences and a particular choice will depend on the strength of their ESG preferences and ability to handle potentially higher levels of risk.

If this article has sparked an interest in ESG investments, we encourage you to reach out to your adviser and express your interest. Not only do they have access to extensive external research, but they also have the broader investment team to draw upon and we are confident that we can find solutions to meet your ESG ambitions.

By Cameron Curko, Head of Macroeconomics & Strategy |

Pitcher Partners Sydney Wealth Management +61 2 9228 2415

cameron.curko@pitcher.com.au

This view is general advice only and does not take into account your personal circumstances or finances. If you have further questions, we encourage you to consult with your adviser.

Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFSL number 336950.

Danger Zone: Making investment decisions based on return on equity

Investment decisions have always been about assessing the level of risk against the relative return. Over the past decade when interest rates were at record lows, the concept of risk often took a back seat in favour of chasing returns. With inflation soaring and interest rates rising, it is timely to revisit the concept of risk and the pitfalls of making investment decisions based on return on equity alone.

Why volatility is a poor predictor of risk

In investment parlance, the concept of risk is often coined around the volatility of returns. Put simply an investment is seen as riskier if the variance of returns around the mean is high. Over the last 12 months we have seen extreme volatility in both equity and bond markets, but this does not necessarily mean they are inherently riskier than investments in unlisted markets. In fact, the whole concept of risk is inherently flawed as the rapid adjustment in price of bonds and equities is also a function of their liquidity rather than risk alone Just because an asset rapidly rises or falls in price does not mean that the underlying business is necessarily risky, or the balance sheet is stressed.

It makes no sense that a listed property assets has fallen 30% when the unit price of an unlisted property asset holding a similar type of underlying properties (in terms of type, quality and leverage) has barely moved. Unlisted assets typically have much lower liquidity and therefore the concept of price discovery is slower meaning unit prices take much longer to adjust. This is why we believe volatility alone is a poor predictor of risk.

Return of equity

In similar terms, we equally believe that another common mechanism to predict future shareholder returns, the metric known as return on equity, is similarly flawed. Indeed, a common strategy by private equity players and investment bankers to add shareholder value is to simply increase return on equity by the use of debt without sufficient regard to the associated risks.

How does it work?

The concept of increasing return on equity by the use of debt is best shown by an example:

Example 1

XYZ Corporation Limited has $200 worth of assets and a $50 worth of debt. It has one shareholder. The net assets or equity held by that shareholder is therefore said to be $150. XZY Corporation makes a profit after tax each year of $20.

Return on equity = profit/equity = $20/150 = 13.3%

XYZ decides to buy back shares by increasing debt. This changes its mix of debt and equity such that it now has $50 more debt but $50 less equity. Its overall profitability remains unchanged but the return on equity to shareholders increases appreciably from 13.3% to 20%.

Return on equity = profit/equity = $20/$100 = 20%

By simply changing the financing structure (mix of debt and equity), all other things being equal, shareholder returns can improve. As many executives are measured on total shareholder return, it is not surprising that the bias towards debt is commonplace. The attraction was compounded by the low interest rate environment experience over the last decade debt was cheap and easily sourced.

The other supposed benefit of more debt

The other key benefit of debt is a reduction in what is known as the weighted average cost of debt. It is the weighted average cost of debt (plus equity) that determines the discount rate that is used for valuing assets under the discounted cashflow methodology. This all sounds reasonable enough except the problem lies in that it is calculated using a model known as the capital asset pricing model. Like most models, it's not without its shortcomings and so rigid adherence to the outcomes can prove disastrous. Again, it is perhaps best shown by an example:

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Example 2

XYZ has $200 of assets, $50 of debt and $150 of equity. Its overall profitability remains unchanged at $20.

Weighted average cost of capital (WACC): = cost of debt x (% of debt to total assets) + cost of equity x (% of equity to total assets)

Where;

Cost of debt = borrowing interest rate x (1 tax company tax rate)

Cost of equity = risk free rate + (Beta x market risk premium)

Assume;

Borrowing interest rate = 9%

Risk free rate (10-year government bond rate) = 5%

Market risk premium = 6%

Beta = 1 (stock specific risk where market average equals 1)

Therefore;

Cost of debt = 9% x (1 0.30) = 6.3%

Cost of equity = 5% + 6% = 11 %

Therefore;

Weighted average cost of capital = 6.3% x 25% + 11 % x 75% = 9.825%.

Example 3

Now if XYZ changes its mix of debt to equity such that debt and equity are equal, the weighted average cost of capital becomes lower:

Weighted average cost of capital = 6.3% x 50% 11 % x 50% = 8.65%

Now, the final point that needs to be made is how this discount rate (WACC) then impacts upon a valuation. Without going into too much detail, the value of a shareholder’s interest can be determined by the present value of the future income streams. Again, this is best shown by an example,

Example 4

Using the assumptions in example 2, the income stream is the net profit of $20 per annum. Let's assume this is constant over time (perpetual). The value of a perpetuity equates to the income stream divided by the discount rate or:

Value of shareholder interest = Net profit / discount rate = 20 / 0.09825 = $203

Example 5

Using the assumptions in example 3;

Value of shareholder interest = Net profit / discount rate = 20 / 0.0865 = $231

In summary, the lower the weighted average cost of capital, the greater the shareholder value. More debt and less equity can suddenly unlock tremendous shareholder value.

What can go wrong?

The problems with the capital asset pricing model in reality are not necessarily in the theory, but in the practical application. The two main problems are as follows:

1. The cost of equity CAPM refers to an opportunity cost of equity, in effect the value a shareholder requires to be adequately compensated for the risk undertaken. This equates to the income (the proxy being the risk free bond rate as this is what the shareholder would otherwise be able to receive

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from a risk free investment) plus any capital gains made (the market risk premium). In theory, this means the cost of equity is almost always more expensive that debt. This may be so, but from an ACTUAL cashflow perspective the cost to a company is the cost of the dividend payments made. While dividends can sometimes be marginally more expensive than interest on debt, this is ignoring a key issue there is no compulsion to make dividend payments. Capital can be preserved should the company have encountered a difficult year. In other words, the cost to the company in such circumstances is effectively nil. They don't have to pay shareholders anything. While this would affect the share price, the net asset position could be preserved. This is extremely important as with debt, no such flexibility generally exists. Failure to make debt repayments generally provides the borrower with some type of immediate recourse, which can lead to receivership or liquidation. So, while debt generally appears cheaper than equity based on the CAPM equation, in reality it can be much more expensive.

2. This brings us to the next deficiency of the model. The concept of risk. While risk is introduced into the CAPM model (via the Greek symbol for beta), the concept is very subjective and therefore difficult to value. What we mean by this, is that in reality, companies with very high debt levels are riskier but the equations do not adequately reflect this. In other words, the model's outcomes typically reward debt over equity without sufficient justification. Just ask the CEO of any company that has collapsed because of being over indebted

In summary, return on equity forecasts need to be interpreted with caution as they do not adequately take into account any measure of associated risks. While debt can be effective when used in moderation, excess exposure can prove disastrous. In the words of the world's most famous investor, Warren Buffett, " to finish first, you must first finish".

By Martin Fowler, Partner | Pitcher Partners Sydney Wealth Management +61 2 8236 7776 c martin.fowler@pitcher.com.au

This view is general advice only and does not take into account your personal circumstances or finances. If you have further questions, we encourage you to consult with your adviser

336950.

Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFSL number

Making business personal

Authors

Martin Fowler

Partner | Pitcher Partners Sydney Wealth Management +61 2 8236 7776 martin.fowler@pitcher.com.au

Cameron Curko

Head of Macroeconomics & Strategy | Pitcher Partners Sydney Wealth Management +61 2 9228 9173 cameron.curko@pitcher.com.au

Charlie Viola

Partner | Managing Director Pitcher Partners Sydney Wealth Management +61 2 8236 7798 charlie.viola@pitcher.com.au

Jordan Kennedy

Partner | Pitcher Partners Sydney Wealth Management +61 2 9228 2423 jordan.kennedy@pitcher.com.au

Andrew Wilson

Principal | Pitcher Partners Sydney Wealth Management +61 2 9228 2455 a.wilson@pitcher.com.au

Adelaide Brisbane Melbourne Newcastle Perth Sydney

Copyright © 2022. Any advice included in this newsletter is general only and has been prepared without taking into account your objectives, financial situations or needs. Before acting on the advice you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs. You should also obtain a copy of and consider the Product Disclosure Statement for any financial product mentioned before making any decisions. Past performance is not a reliable indicator of future performance. Advisers at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFSL number 336950

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