Chapter 8

Buying What You Know

IN THIS CHAPTER

Appreciating ordinary shares

Choosing specialised stocks

Joining the ETF revolution

Choosing the share to buy

If you want to buy shares, you’re not starved for choice. About 2,200 shares are available on the Australian sharemarket and more are being added every month (of course, companies occasionally get delisted, too). These companies cover virtually every activity that can legitimately be conducted for profit. The ASX presents a dazzling array of opportunities. You can’t help but be impressed by the ingenuity and potential on display.

However, you can’t own everything, so don’t try to stretch a portfolio too far. If you own 20 stocks, you own too many. Diversification is great, but has its limits. A share portfolio becomes difficult to monitor properly when it grows beyond 15 stocks. That means if you’re taking charge of your own sharemarket investments, you have to narrow your sights compared to an institutional investor who may hold 50 or more stocks. In this chapter, I tell you all about the different types of sharemarket sectors and stocks, and show you how to choose what goes in your portfolio.

Acquiring Ordinary Shares

Ordinary shares, those tiny building blocks of a company’s equity, can be anything but ordinary in their performance. Most activity on the sharemarket centres on ordinary shares, or what the Americans call common stock.

Each ordinary share entitles the owner to:

• A proportional share of the company’s profit after expenses
• A proportional share of the company’s assets after the liabilities have been met in the event of liquidation of the company
• A vote for the board of directors in the company

The ordinary share is one of the great inventions of the financial world. It may be ordinary, it may be common, but an ordinary share is a fabulous opening to the wealth created in the economy.

Buying blue chips

Named after the highest-value chip in poker, blue chips are the sharemarket’s elite stocks. Blue chips have an established track record over many years of consistently rising profits and fully franked dividends.

The blue chips have large market capitalisations, which guarantees plenty of liquidity in the market. They boast well-established businesses, high-quality assets and — usually — good management. Blue chips typically have high dividend yields, in the range of 4 to 7 per cent (except biotech CSL, which is more of a capital-growth stock than a yield generator). Over time, blue chips prove to be reliable wealth generators.

Blue chips sometimes fall from grace. At various times, companies considered blue chips, such as Westpac, BHP and AMP, have all turned in billion-dollar losses and lost their blue chip status. As if a 20-year litany of poor investment performance, strategic blunders, poor acquisitions, write-offs and at least one botched takeover wasn’t enough, AMP’s diabolical testimony in the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in 2018 (refer to Chapter 4) left its credibility shattered. AMP was officially an ex-blue chip — finally proving to investors that a household-name brand does not a blue chip make. From a peak of $45 on its first day of trading on the ASX in 1998, AMP has slid all the way to $1.48.

QBE Insurance also cashed-in its blue chip, with its share price spending the 2010s sliding backwards. The big four banks — ANZ Banking Group, Commonwealth Bank, National Australia Bank and Westpac — are beloved of investors for their high dividend yields, but in May 2020, they were all showing a negative total return over the last five years. That’s not a blue chip stock. A commodity price slump in 2015 took BHP and Rio Tinto down badly, hurting their status.

The 177-year-old newspaper giant Fairfax Media — publisher of The Age, the Sydney Morning Herald and The Australian Financial Review — was once considered an unassailable blue chip because of the reliable earnings from the ‘rivers of gold’, its newspapers’ classified advertising revenue. But the company was not able to react quickly enough when three internet-based start-up businesses stole the lion’s share of the rivers of gold out from under its nose — jobs website seek.com.au (ASX code: SEK), real estate sales website realestate.com.au (owned by REA Group, code REA), and auto sales website carsales.com (CAR). As a final humiliation, when Fairfax merged with Nine Entertainment Company in December 2018, its market value, at $1.45 billion, was outweighed more than 12 times by the combined value of the three companies that had disrupted and fatally weakened it.

Telstra has been Australia’s largest and most profitable telco and a solid dividend payer but, despite this, Telstra’s shares have been disappointing performers since the company was floated on the ASX following an offer of shares from the federal government in 1997 at the $3.30 level (and subsequent sales at $7.40 in 1999, and $3.60 in 2006). A series of disastrous expansions — including a failed move into Asia that lost the company $3 billion — conspired to cut the market value of Telstra in half. Intense competition, new technologies and the government’s decision to build the NBN have all affected the sector and Telstra — particularly over the last decade.

Adding to the NBN challenge, the announcement in 2017 of TPG’s ambitious plans to become Australia’s fourth mobile network provider also weighed heavily on Telstra’s share price. Telstra has had to take huge amounts of costs — mainly in the form of employee numbers — out of the business. Telstra has positioned itself as market leader in the rollout of 5G technology, and its roll out of this network will boost its earnings, but Telstra’s share price has done very little in recent years — especially for the long-suffering investors who bought into the ‘T2’ second-tranche float in 1999. In May 2020, it was showing a five-year total return of –7.4 per cent a year; and a three-year total return of –5.7 per cent a year. Blue-chip? I don’t think so.

The other thing that investors must remember about blue chips is that when the market is being routed across the board as it was in 2008, and in early 2020, even the bluest of chips are not immune. The sharemarket is the most volatile of the asset markets — and the blue chips, as the highest profile and most liquid stocks, can be most affected by this volatility. Indeed, because the expectations are higher on blue chips, they can be savagely treated in the short term if they disappoint the market. If you expect a blue chip share only to rise and never to fall in value, you’ve got another thought coming.

Blue chip stocks are exposed to the same systemic risk as any other stock on the market. The blue chips usually lead the market higher, but when the market suffers a correction, the blue chip stocks plunge, too. You can do poorly in blue chips if you buy and sell them at the wrong time, so you need to watch these stocks as closely as your other stocks.

In terms of popularity, the investing public certainly appears to believe that Telstra, AMP and the big banks are still blue chips. According to the most recent company annual reports, Telstra is the most widely held Australian stock, with 1.3 million shareholders (610,000 of them with fewer than 1,000 shares), followed by Commonwealth Bank, with 830,300 shareholders (615,440 with fewer than 1,000 shares), and AMP, with 723,390 shareholders (489,000 with fewer than 1,000 shares). Westpac, NAB and ANZ Bank are next, and after them come BHP, Wesfarmers and Woolworths.

In contrast, the sharemarket’s bluest chip, CSL, has a relatively small share register, with 167,800 shareholders, of which 140,270 own fewer than 1,000 shares. Despite its stunning record of capital appreciation, CSL is not a big dividend source, and its dividend is unfranked — which goes a long way to explaining its relative unpopularity.

Looking at Industrial and Resources companies

Traditionally, the main kinds of companies listed on the stock exchange have been divided into Industrials and Resources. Resources companies are easy to identify; they include mining and petroleum companies that drill, find, extract, process and sell Australia’s mineral commodities. Any company engaged in these activities is a resource company; one that isn’t engaged in these activities is an industrial company.

Choosing Industrials

The industrial part of the sharemarket is the largest by value and by number of companies. These companies are involved in a vast array of activities — not only manufacturing products but also developing drugs and diagnostic devices, banking, making wine, processing waste, setting up telecommunication networks, farming fish, selling software, collecting financial receivables, building power plants and operating ferries. The more you investigate the Australian stock market — especially the world beneath the top 200 — the more the variety of what listed companies do will amaze you. You want a feel of the different types of companies that make up the stock market? It’s time to examine the Global Industry Classification Standard (GICS) sectors of the S&P/ASX 200 index.

FINANCIALS: BANKS AND FINANCIAL SERVICES

At the top, the dominant GICS sector is Financials, which accounts for about 26.4 per cent of the S&P/ASX 200 index, down from 41 per cent in 2016.

The Financials sector includes 279 companies, coming from three industry groups — banks, insurance companies and ‘diversified financials’, which covers diversified financial services companies, asset managers and consumer finance companies.

Naturally, the Financials sector heavyweights are the big four banks — Commonwealth Bank, Westpac, NAB and ANZ, in order of size — as well as Australia’s home-grown investment bank Macquarie Group. (An investment bank doesn’t take deposits and make loans; instead, an investment bank trades on its own account, delivers corporate advice and financial services packages, and manages investment opportunities.)

The sector also contains the operator of the stock exchange, ASX, which is listed on itself; the big insurers Insurance Australia Group, Suncorp Group, QBE Insurance and Steadfast Group; health insurers Medibank Private and NIB; funds management companies Magellan Financial Group, Platinum Asset Management, Pendal Group and Janus Henderson; financial services companies AMP and Challenger; the smaller banks, Bendigo & Adelaide Bank and Bank of Queensland; and the big listed investment companies (LICs), Australian Foundation Investment Company (AFIC), Argo Investments and Milton Corporation. The 212 ETFs are in here as well, which bulks up the sector’s numbers, and a variety of smaller financial services businesses round out this part of the sector.

Banks receive and pay the prevailing price of money in the form of interest. A rise in interest rates means added revenue on the asset side of the bank balance sheet and extra cost on the liability side. Banks can lend more than they borrow because they can create credit. Bankers generally don’t like high interest rates because they raise the cost of borrowing and lending money. However, depending on the liability costs, a bank can do well in a rising interest rate environment. For example, if a bank has a high proportion of its liabilities in savings and cheque accounts paying a low interest rate, an interest rate rise will increase the bank’s profits.

Banks also have non-interest income — revenue generated not from borrowing and lending but from their fees and charges. However, this income has declined markedly as a proportion of total revenue, under intense competition and greater consumer awareness, and the banks have reverted to greater reliance on interest income — non-interest income accounts for about 23 per cent of the major banks’ revenue, down from 41 per cent in 2006.

The insurance influence on the sharemarket grew in the 1990s with the demutualisation of several large mutually owned life insurance offices. These companies changed their status from mutually owned societies to companies limited by shares; shares were then offered free to their policyholders pro rata according to the policies held. In this way, AMP, AXA Asia–Pacific (formerly National Mutual) and Insurance Australia Group (formerly NRMA Insurance) migrated to the sharemarket, bringing millions of first-time investors with them. In March 2011, AXA Asia–Pacific merged its Australian businesses with AMP and sold its Asian businesses to its French parent company, AXA.

MATERIALS

The Materials sector accounts for 19.1 per cent of the S&P/ASX 200 index. The Materials sector is a biggie, with 667 companies, but it’s something of a grab bag, covering Metals and Mining, the Chemicals industry, Construction Materials suppliers, the Container and Packaging industry, and the Paper and Forest Products industry for forestry plantation, paper and timber companies.

The mining industry provides the largest materials stocks, with the big global miner BHP (producing iron ore, thermal (electricity) and metallurgical (steelmaking) coal, copper, nickel, and oil and gas) the largest stock in the sector. BHP is followed by iron ore heavyweight Fortescue Metals Group, global operator Rio Tinto (which produces iron ore, copper, bauxite (aluminium ore) and aluminium, diamonds, and industrial minerals (borates, titanium dioxide and salt)). Big gold miners Newcrest Mining, Northern Star and Evolution Mining are also in the top ten, as is South32, which was spun-off by BHP in 2015 — it produces aluminium/alumina, manganese, nickel, silver, lead, coking coal (another term for steelmaking coal) and thermal coal. Rounding out the Materials top ten are global packaging giant Amcor and Orica, the world’s biggest supplier of explosives and blasting systems to the resources and construction markets.

Gold producers Saracen, Regis Resources, St Barbara, Silver Lake Resources, Gold Road Resources, Perseus Mining, Resolute Resources and Alkane Resources are in this sector as well, as is Alumina, which owns 40 per cent of the Alcoa World Alumina & Chemicals (AWAC), the world’s largest alumina (aluminium oxide) and bauxite business. Also included are copper/gold producer Oz Minerals, nickel/copper/gold miner IGO, iron ore/lithium producer Mineral Resources, nickel producer Western Areas, mineral sands producer Iluka Resources, copper/gold miner Sandfire Resources and copper/zinc/lead producer Consolidated Tin Mines. Argentina-based lithium producer Orocobre, Zimbabwe-based platinum producer Zimplats, manganese miner Jupiter Mines, manganese miner and processor OM Holdings, lithium/tantalite ore miner Pilbara Minerals, tin miner Metals X, graphite (in Mozambique) and battery anode material (in USA) producer Syrah Resources are also all in the Materials sector, as are a host of junior gold producers and explorers.

Industrial representatives in the Materials sector also include steel products manufacturer BlueScope Steel; construction materials companies James Hardie Industries, Boral, CSR, Brickworks, Adelaide Brighton and Fletcher Building; agricultural chemicals firms Nufarm and Incitec Pivot; metals recycler Sims; and packaging companies Orora and Pact Group.

Because the Materials sector is such an eclectic mix, many investors prefer to break out the resources sector by using the S&P/ASX 200 Resources index, which picks up miners and metal producers, as well as oil and gas companies involved in the oil and gas industry, and the production of other fuels, such as coal and uranium. Several ETFs track this index.

HEALTH CARE

The Health Care sector represents 13.4 per cent of the S&P/ASX 200 index, and contains 176 companies, made up of two industry groups — the Health Care Equipment & Services industry, covering health care equipment, supplies, providers, services and technology companies; and the ‘biotech’ industry, which is Pharmaceuticals, Biotechnology and Life Science. This is the industry that develops drugs and diagnostic compounds and devices.

At the top of the Health Care sector are big industrial companies such as CSL; New Zealand-based Fisher & Paykel Healthcare, which makes products used in respiratory care, acute care, surgery and the treatment of obstructive sleep apnoea; global hospital operator Ramsay Health Care; diagnostics and imaging company Sonic Healthcare; global hearing implant maker Cochlear; ResMed, a leading global maker of devices and software solutions that help treat and manage sleep apnoea, chronic obstructive pulmonary disease, and other respiratory conditions; global gloves and protective personal equipment (PPE) maker Ansell; Kiwi-based marketer, wholesaler and distributor of health care, medical and pharmaceutical products EBOS Group; diagnostic imaging technology company Pro Medicus; drug distributors/pharmacy chain operators Australian Pharmaceutical Industries and Sigma Healthcare; medical facility operator Healius; and aged care provider Regis Healthcare.

Then come the biotechs, which garner a lot of attention from speculative investors trying to emulate some of the Australian biotech industry’s success stories, such as Biota, which developed Relenza, an influenza vaccine; and Viralytics, which developed an immunotherapy called Cavatak from a common cold virus and aimed it at cancer. Viralytics was taken over by pharma giant Merck in 2018 — Merck’s bid was 160 per cent above the share price, and the $500 million deal is an example of the nirvana to which Australian biotechs aspire. Merck still has Cavatak in trials, but has shown that when used in combination with immune checkpoint therapies like Merck’s Keytruda, Cavatak can almost double the rate at which cancer is destroyed.

Investors love to speculate on what will be Australia’s next biotech success story.

In May 2020, the latest candidate was stem-cell therapy developer Mesoblast, which had reported success in trials of its potential treatment for critically ill COVID-19 patients — a bone marrow product called remestemcel-L, which is intravenously infused in patients suffering from acute respiratory distress syndrome (ARDS), the most common cause of death from COVID-19 infections. Under ‘emergency compassionate use’ protocols, patients at New York’s Mount Sinai hospital with ARDS were given remestemcel-L intravenously, and the results were much better than those seen in ventilator-dependent COVID-19 patients receiving standard-of-care treatment. On the back of these results, Mesoblast began enrolling patients in a Phase 2/3 clinical trial in more than 20 medical centres across the US to ‘rigorously confirm’ whether remestemcel-L provides a survival benefit in patients with moderate/severe acute respiratory distress syndrome (ARDS) due to COVID-19. (See the sidebar ‘Playing the long game’ for more on testing phases and trials.)

The biotech constituents of the Health Care sector contain dozens of interesting stories, such as those shown in Table 8-1.

Not many biotechs have actual earnings, and investors are in many cases relying on the approved drug or the device technology being picked up by larger partners (or even purchasers). Biotech can be a lucrative investment field, but one that is littered with the bleached bones of failed businesses. News flow is crucial to making share price gains, with many companies then finding sustaining and consolidating these share price gains very difficult. Smart investors follow the biotech companies’ announcements closely, and understand that the further companies move along the approval pathway, the probability of success, the value and the ability to do a deal with a partner all increase.

PLAYING THE LONG GAME

On the long path to commercialisation of drugs, diagnostics and medical devices, success in biotech investment requires patience. A pharmaceutical company is required to conduct extensive pre-clinical laboratory testing before testing a compound in humans can begin. Pre-clinical trials involve thorough testing of the compound in animals (for example, mice) to prove the compound appears to be safe, and possibly effective in mammals.

Pre-clinical testing usually takes three to four years and has a success rate of about 1 per cent. If successful, the company provides the relevant information to the US Food and Drug Administration (FDA), requesting approval to commence testing the drug in humans — known as an Investigational New Drug (IND) application. (Most companies apply for FDA approval, regardless of where they are based, because this is considered the ‘gold standard of approval’, and to gain access to the world’s largest pharmaceuticals market.) If the FDA approves the IND, the company is cleared to test the compound in human volunteers in Phase I clinical trials. These trials aim to determine how the drug acts in the human body, and to investigate any side effects that may occur as dosage levels are increased. Phase I usually lasts from several months to one year.

Once a drug has been shown to be safe in Phase I, Phase II trials aim to evaluate the efficacy — the clinical effect — of the new treatment, in a testing period that may last from several months to two years. Phase II trials determine the dosage and treatment schedules. Phase II is where most experimental drugs fail — approximately only 30 per cent of drug candidates successfully complete both Phase I and Phase II testing.

Phase III trials then seek to confirm the clinical benefits of the drug in large numbers of patients; this large-scale testing aims to provide a more thorough understanding of the drug’s effectiveness, benefits, and the range and severity of possible adverse side effects. Phase III trials usually take one to four years to complete.

Upon successful completion of Phase III, the pharmaceutical company submits the results of all the studies to the FDA so as to obtain a New Drug Application (NDA), which means that the drug can be sold to the public. The FDA has initiated a ‘fast-track’ approval process for new drugs seen to potentially satisfy a significant unmet therapeutic need.

TABLE 8-1 Biotech Companies in the Health Care Sector

Biotech Company	Area of Research and Development
Paradigm Biopharmaceuticals	Its Zilosul drug is under evaluation from the US Food and Drug Administration’s expanded access program and has FDA ‘orphan drug’ status — a status given to provide incentive to companies to develop medicines for rare conditions, which means only a small population of potential users — for using Zilosul in treating the rare metabolic disorder MPS-I.
Kazia Therapeutics	Its Cantrixil ovarian cancer drug is showing some success in Phase I trials, and the company is developing its licensed drug candidate GDC-0084 as a potential treatment for glioblastoma, the most common and most aggressive form of primary brain cancer.
Living Cell Technologies	Its proposed Parkinson’s Disease treatment NCELL is showing effectiveness in trials.
Immutep	Its lead product candidate, eftilagimod alpha (IMP321), has shown success in trials as a chemo-immunotherapy for metastatic breast cancer.
Prescient Therapeutics	Its cancer drug PTX-100 is progressing well through trials in patients with advanced cancers.
Opthea	Its lead compound, OPT-302, treats several eye diseases, including wet age-related macular degeneration (wet AMD), which results in vision loss and is the leading cause of blindness in people aged over 50 in the developed world. Opthea’s shares rose five times on the back of positive trial results in September 2019.
Nanosonics	Its infection prevention device trophon sterilises ultrasound probes without chemicals. Nanosonics — which has another major product in development — has 22,500 trophon units installed worldwide, in its major market, the US, as well as Asia–Pacific, Europe and the Middle East.
PolyNovo	Its NovoSorb bio-degradable polymer technology works as a wound dressing and burns treatment, and is being used in emergency, trauma and major-surgery applications in a substantial number of countries.
Medical Developments International	Its Penthrox product, also known as the ‘green whistle,’ is a fast-acting non-opioid pain relief product that is used everywhere from the sporting field to ambulances to hospital surgeries. It is used in about 30 countries worldwide, with approval submissions lodged in the US and China.
Starpharma Holdings	Its dendrimer-based DEP drug delivery technology is designed to deliver drugs more efficiently, ensuring the right amount of the drug is delivered to the right part of the body. Starpharma has tested its DEP irinotecan treatment against colorectal, breast, and pancreatic cancers and reported impressive results.
PharmAust	Its lead anti-cancer drug, monepantel, inhibits the mTOR pathway, a key driver of cancer. It is currently in veterinary clinical trials with dogs. The anti-cancer action may also be able to treat viral infections (including COVID-19), and is progressing to pre-clinical (laboratory) trials.
Cynata Therapeutics	It has mesenchymal stem cells (MSCs) from its stem-cell manufacturing platform Cymerus in three clinical trials, against osteo-arthritis, graft-versus-host disease and critical limb ischaemia, an advanced stage of peripheral artery disease. It was also approved in May 2020 for a clinical trial of its MSCs against COVID-19.
Genetic Signatures	This molecular diagnostics company has a proprietary platform technology, 3BaseT, from which it has developed and is selling tests for a range of respiratory diseases and sexually transmitted diseases (STDs). In April 2020 its test to identify the SARS-CoV-2 coronavirus strain, the virus that causes COVID-19, was approved for sale in Europe and Australia.
Alterity Therapeutics	Formerly Prana, Alterity develops therapies for neuro-degenerative diseases; its lead candidate, PBT 434, aimed at disorders related to Parkinson’s Disease, is in Phase I clinical trials, and has received ‘orphan drug’ status from the FDA.
Allegra Orthopaedics	This orthopaedic manufacturer has a global licence to the composite bio-compatible ceramic ‘synthetic bone’ material Sr-HT-gahnite, developed at the University of Sydney; its lead product is a 3D-printed spinal cage, which works to regenerate bone under spinal load conditions, and is completely resorbed by the body.
Rhythm Biosciences	This company is developing ColoSTAT, its low-cost blood test for the early detection of colorectal cancer, which could replace the global standard-of-care, the Faecal Immunochemical Test (FIT).
Bionomics	Although its BNC210 anti-anxiety drug appeared not to work against anxiety and post-traumatic stress disorder (PTSD), a change of dosing technique made a big difference, and in November 2019 Bionomics was granted FDA ‘fast track’ designation for BNC210 for the treatment of PTSD and other trauma- and stress-related disorders.
Imugene	This immune-oncology company has two cancer treatments in clinical trials in the US and Austria.
Clinuvel Pharmaceuticals	This company’s photo-protective drug SCENESSE strengthens blood vessels and reduces swelling, thus protecting patients against any light source and ultraviolet (UV) radiation. It has been approved by the FDA and the European Medicines Agency (EMA), and has been launched in China to treat erythropoietic protoporphyria (EPP), a rare genetic metabolic disorder.

Note: This is only a small selection of listed biotech companies; there are a number of others listed on the ASX.

The biotechs can surge on the back of good announcements and plummet on the back of not-so-good ones (refer to Chapter 4). Consider the case of infectious diseases specialist Biotron, which for years has been developing a therapy to treat viral infections, including HIV-1 and hepatitis C. In September–October 2018, Biotron shares rocketed from 2 cents to as high as 45 cents — a 2,150 per cent surge — in just three weeks. The trigger was Biotron announcing that its flagship drug candidate, BIT225, was ‘having a unique effect in patients, over and above viral suppression seen with current anti-retroviral drugs’ in patients suffering from HIV, in phase 2 trials.

However, Biotron shares slid over 2019 and early 2020 back to levels as low as 5 cents — before BIT225 achieved some more astounding results from a Phase II clinical trial in March 2020. The drug showed that it could ‘unmask’ hidden HIV cells in the body, allowing the immune system to attack the virus and kill it for good. Ordinarily, HIV-infected cells stay hidden in the body indefinitely, meaning patients need life-long treatment. This time, the share price reaction was far more muted — up just 13 per cent, as investors appeared more worried about the company running out of cash. Shareholders of Biotron — which is also testing its library of anti-viral compounds against SARS-CoV-2, the coronavirus that causes COVID-19 — appear to be hanging their hats on the inevitable partnership/takeover announcement.

INDUSTRIALS

The Industrials sector accounts for 8.2 per cent of the S&P/ASX 200 index. It features 149 companies, across three main industry groups: Capital Goods, which covers construction and engineering, machinery, aerospace, building products, electrical engineering and industrial conglomerates; Commercial and Professional Services; and Transportation.

The biggest industrial stock by market value is Transurban Group, one of the world’s largest toll road operators. This is followed by Brambles, the global logistics business that operates the world’s largest pool of reusable pallets and containers. Sydney Airport and its dual-listed Kiwi counterpart, Auckland International Airport, are sector heavyweights, as are Australia’s largest rail freight operator, Aurizon, international engineering contractor CIMIC Group (the former Leighton Holdings), employment websites operator Seek, international toll road operator Atlas Arteria and plumbing supplies group Reece.

Australia’s global airline, Qantas, and its New Zealand counterpart, the dual-listed Air New Zealand, are prominent industrials — while they hope for a resumption of aviation post-COVID-19 — as are media group Seven Group, port logistics company Qube Logistics, waste management operators Cleanaway Waste Management and Bingo Industries, plumbing fixture manufacturer Reliance Worldwide Corporation, shipbuilder Austal, infrastructure specialists Downer and Cardno, and intellectual property services firm IPH.

In this sector are also the engineering, equipment and services groups that assist the resources industry, including Monadelphous, ALS, Lycopodium, Emeco, Primero, Decmil, MACA, NRW Holdings and Acrow Formwork and Construction Services. You’ll also find childcare provider G8 Education, automotive parts and pumps business GUD Holdings, car fleet group SG Fleet and regional airline Regional Express here. It’s a very eclectic group.

CONSUMER STAPLES

At 72 companies strong, the Consumer Staples sector makes up 6.8 per cent of the S&P/ASX 200 index. This sector represents the companies that make or sell the things that people need to buy all the time — making it, in theory at least, a highly defensive sector.

The sector is made up of three industry groups: Food, Beverage and Tobacco, which contains packaged foods, agricultural products, brewers, distillers, soft drinks and tobacco companies; the Household and Personal Products industry, which hosts the companies producing products like toiletries, vitamins, supplements and other health and household products; and Food and Drug retailers.

The largest stocks are supermarket arch rivals Woolworths and Coles; global wine company Treasury Wine Estates; Coca-Cola Amatil, which bottles The Coca-Cola Company’s range of beverages in much of the Asia–Pacific region; Australia’s biggest vitamin and supplements company, Blackmores; New-Zealand-based specialised dairy producer A2 Milk Company and its specialist milk supplier, fellow Kiwi stock Synlait Milk; groceries, liquor and hardware wholesaler and distributor Metcash; rural merchandising and essential agricultural services provider Elders; poultry and fodder supplier and producer Inghams; and food and beverage company Freedom Foods.

In this sector you’ll also find Australia’s largest horticultural company, Costa Group; international malt supplier United Malt; food group Bega Cheese; almond grower and processor Select Harvests; Australia’s largest cattle company, the 196-year-old Australian Agricultural Company (it has only been listed since 2001); Australia’s largest listed grain handler — and also the ASX’s biggest listed agribusiness — GrainCorp; rice farmers’ co-operative SunRice (listed under the name Ricegrowers); Tasmanian fish farmers Tassal and Huon Aquaculture Group; hygiene, personal care and tissue products maker Asaleo Care; and Bubs Australia, a specialist manufacturer of infant milk formula made from goat’s milk. For a tipple, you can also find Australia’s only remaining listed brewer, Gage Road Brewing and Tasmania-based Lark Distilling.

REAL ESTATE

The Real Estate sector represents 6.6 per cent of the S&P/ASX 200 index. Bulked-up by the presence of the 49 A-REITS — the real estate investment trusts — this sector has 84 companies.

REITs are unit trusts that own property and are traded on the sharemarket. REITs give individual investors the chance to share ownership in property assets, such as city office blocks, shopping centres, industrial parks and tourism properties, which they couldn’t afford to invest in as individuals. REITs own about two-thirds of the institutional-grade property in Australia.

The REITs offer property investment, but with all the advantages of a stock exchange listing. All or part of the property holding can be sold instantly rather than having to sell the actual properties.

REITs are considered a reliable source of high yields because they’re required to distribute all of their taxable profit to unit-holders. Most REITs usually pay out about 90 to 95 per cent of their profit as distribution, compared to about 75 to 80 per cent of the major listed industrial companies’ profit going out as dividends. (And this figure will come under pressure from the COVID-19-induced slowdown.)

Over the past 20 years, the average yield from the S&P ASX 200 A-REIT index has run at 6.3 per cent, compared to 4.3 per cent for the S&P ASX 200 index. However, REITs do not boast the tax advantages of a fully franked share dividend so this outperformance is not as good as it looks. The REITs’ distribution has a tax-advantaged component, which comes from the trust’s building depreciation allowance — income-tax free — and a tax-deferred component, which reflects other taxation deductions available to the trust during the period. However, these components are not as effective in reducing an investor’s tax liability as fully franked dividends from shares.

REITs do offer another advantage. A lease contract usually entitles the landlord to apply annual rent increases, either fixed or linked to CPI — meaning that REITs have inflation protection built-in.

While the REITs have usually been seen as a defensive sector in the sharemarket — apart from a dalliance with entrepreneurialism in the 2000s, when many of them geared-up and took on activities such as property development, syndication, management and property services to add earnings streams other than mere rent collection — they are seen as vulnerable in the wake of the COVID-19 pandemic. This is due to their higher exposure to the retail sector than is typical among their global peers.

In mid-2020, the likelihood of the Australian economy going into recession is seen as very high, so A-REIT distributions will be pressured because of difficult business conditions and the fact that some of their tenants cannot carry on normal operations for long periods. The valuations of shopping centres and office towers have come down to reflect changes in consumer behaviour and the re-assessment of space needs on the back of the ‘work-from-home’ response to COVID-19 of many companies. While the pandemic will alter demand and pricing factors, by what extent remains to be seen.

The REITs were among the worst-hit sectors during the COVID-19 market falls as investors feared for rental returns, distributions and valuations. But in the post-2008 recovery from the GFC, the A-REITs were among the shining stars of the ASX, outperforming in 7 of 12 years, including significant outperformance in 2011, 2012, 2014, 2015 and 2018.

The big fish of the REIT world are the sector’s heavyweights. Logistics property giant Goodman Group is by far the largest stock, at $27 billion, with the second-largest, shopping centre heavyweight Scentre Group (which operates the Westfield chain of shopping centres) less than half that size, at $11.7 billion. Then come Dexus, Australia’s largest office landlord; office, residential, retail and industrial property owner Mirvac Group; and retail, office, and logistics landlord GPT Group. Multinational construction, property and infrastructure company LendLease is next, followed by diversified trust Stockland (one of Australia’s largest retail landlords). Then come retail REIT Vicinity Centres (co-owner of Australia’s largest shopping centre, Chadstone in Melbourne); office, retail and industrial owner Charter Hall Group; and Woolworths’ landlord SCA Property Group (which was spun-off from Woolworths in 2012). The remnant of Westfield is also here, in the form of the merged Unibail-Rodamco (in 2018, Westfield Group was taken over by European property group Unibail-Rodamco), which owns and operates 90 shopping centres, including 55 flagships in Europe and the US.

Specialist REITs are also listed in this sector, such as the BWP Trust, which mostly holds large-format retailing properties — in particular, the Bunnings Warehouses operated by home products and hardware retailer Bunnings Group. These also include self-storage centre portfolio, National Storage REIT; retirement living and budget tourism REIT, Ingenia Communities Group; Aventus Group, which owns 20 ‘large-format’ retail centres, hosting tenants including Nick Scali, Harvey Norman, Bunnings Warehouse, and Baby Bunting; industrial property trust Centuria Industrial REIT and its office property stablemate Centuria Office REIT; commercial property trust Cromwell Property; APN Industria REIT, which mainly owns industrial, warehouse and business park properties, and stablemate APN Convenience Retail REIT, which owns service stations and their attached convenience stores; and the similar Waypoint REIT, Australia’s largest owner of service stations and convenience stores.

Arena REIT specialises in childcare, health care, education and government-tenanted properties. Three pub REITs are also listed — the ALE Property Group (spun-off by Foster’s Group in November 2003), Hotel Property Investments and Redcape Hotel Group. And rural REIT Rural Funds Group is a way to play Australian agriculture as a landlord — its portfolio is based around almond orchards, vineyards, cattle, cotton and macadamia assets.

CONSUMER DISCRETIONARY

The Consumer Discretionary sector accounts for 6.6 per cent of the S&P/ASX 200 index. This sector includes 131 companies, selling us things and experiences that we don’t actually need — thus, the sector was hammered by the COVID-19 pandemic and resultant crash, with many stores closing because their likely customers were staying at home, and foot traffic melted away. The sector slumped 45 per cent in the COVID-19 crash, compared to the 36 per cent fall of the market index.

Wesfarmers, the Perth-based conglomerate that owns home products and hardware chain Bunnings, department store chain Kmart and office products chain Officeworks — in addition to its chemicals, energy, gas and fertilisers businesses, among others — is top dog in the Consumer Discretionary sector. This company is followed by global gaming machine giant Aristocrat Leisure; gambling and entertainment company Tabcorp (created from the December 2017 merger between Australian gambling giants Tabcorp Holdings and Tatts Group); casino and hotel operator Crown Resorts, which owns the Crown casinos in Melbourne and Perth (with Crown Sydney, at Barangaroo on Darling Harbour, scheduled to be opened in 2021); Australia’s largest pizza chain, Domino’s Pizza (also the world’s biggest franchisee for the Domino’s Pizza brand, holding the rights for Australia, New Zealand, Belgium, France, The Netherlands, Japan, and Germany); and international education organisation IDP Education.

Next are home entertainment retail chain JB Hi-Fi; retailer Harvey Norman; global household appliance marketer Breville Group; and Star Entertainment — operator of the original Sydney casino, The Star (also on Darling Harbour) as well as The Star Gold Coast (formerly the Jupiters hotels and casinos on Queensland’s Gold Coast), and The Treasury hotel and casino in Brisbane. Then come retail group Premier Investments, owner of the Smiggle stationery chain, and the clothing retailers Just Jeans, Jay Jays, Jacqui E, Portmans, Dotti and sleepwear brand Peter Alexander; travel agency chains Flight Centre and Helloworld; automotive aftermarket parts, service and accessories business Bapcor; and funeral companies InvoCare and Propel Funeral Partners.

A host of retailers of all kinds are in this sector, such as fallen department store icon Myer, baby goods specialist Baby Bunting, Super Retail Group (which owns BCF Boating Camping Fishing, Macpac, Rebel Sport and Supercheap Auto), AP Eagers (the country’s biggest car dealership group), online retailer Kogan.com, online lottery seller Jumbo Interactive, women’s fashion chain City Chic Collective, manchester and homewares specialist retailer Adairs, costume jewellery specialist chain Lovisa, lighting store group Beacon Lighting, discount chain The Reject Shop, furniture retailer Nick Scali, motorbike dealerships chain MotorCycle Holdings, Collins Foods (which operates restaurant chains KFC and Sizzler in Australia and parts of Asia) and Restaurant Brands New Zealand (which operates and owns the master franchising rights for the Carl’s Jr., KFC, Pizza Hut, and Taco Bell brands in New Zealand).

ENERGY

The Energy sector accounts for 4.3 per cent of the S&P/ASX 200 index. It’s made up of two industries — the Oil, Gas and Consumable Fuel producers, and the Energy Equipment and Services industry, which covers oil and gas drilling, equipment and services companies.

The sector hosts 166 companies. Top of the Energy food chain are the petroleum heavyweights Woodside Petroleum, Santos, and the Papua New Guinea-focused Oil Search. Electricity and gas supplier Origin Energy is there, as is fuel supplier Ampol (the former Caltex Australia) and Worley, the global engineering and consulting group that specialises in the resources and energy sectors. Washington H Soul Pattinson also appears here — despite the fact that it operates the Soul Pattinson chemist chain and has major investments in building materials, finance and telecommunications — because it owns 50 per cent of coal producer New Hope, which is itself a constituent of the sector, along with fellow coal producers Whitehaven Coal, Yancoal Australia and Stanmore Coal.

Australia’s largest onshore oil producer, Beach Energy, is also there, as are fellow producers Cooper Energy, Senex Energy, Karoon Energy and Carnarvon Petroleum, and uranium producers Energy Resources of Australia (ERA) and Paladin Energy. The dual-listed Z Energy, a New Zealand fuel importer, distributor and seller, is a feature, as are hydrocarbons industry service providers MMA Offshore and Matrix Composites & Engineering. Beyond that, a large group of petroleum explorers is also included.

COMMUNICATION SERVICES

The Communication Services sector accounts for 3.7 per cent of the S&P/ASX 200 index. It holds 78 companies, made up of two industry groups — Media & Entertainment, which includes companies involved in advertising, broadcasting, publishing, movies, entertainment, interactive media and services, and Telecommunication Services, covering companies involved in mobile and integrated communications services.

The latter industry group provides the sector heavyweight, Telstra. (Prior to the float of the first portion of Telstra shares in November 1997, the Telecommunications sector didn’t exist on the ASX.) Property websites operator REA Group is next in size, followed by the dual-listed Spark New Zealand, which supplies telecommunications and internet services in New Zealand. Telecommunications supplier TPG Telecom is next, and then comes the big employment and auto sales websites operators, Seek and Carsales.com respectively.

Dual-listed New Zealand telecoms infrastructure operator Chorus is next, and then media and television group Nine Entertainment, with property websites operator Domain Holdings and telecoms provider Hutchison Telecommunications (which runs the Vodafone brand in Australia).

At time of writing, TPG Telecom and Hutchison Telecommunications had just announced a merger, under which TPG would split-off its Singaporean business and list it as a separate entity on the ASX, while the much larger Australian business would merge with Vodafone to form Australia’s third-biggest telecom firm.

INFORMATION TECHNOLOGY

The Information Technology sector comprises just 2.9 per cent of the S&P/ASX 200 index, but is the third-largest by population, holding 204 companies. It’s where you’ll find the heavyweights of the new S&P/ASX All Tech index, and that index’s heavyweights are also the leaders of the IT sector. Such ‘heavyweights’ include buy-now, pay-later fintech Afterpay, cloud-based accounting software provider Xero, global share registry and financial infrastructure provider Computershare, cloud-based logistics software provider WiseTech Global, data centre operator NEXT DC, electronic printed circuit board (PCB) design software company Altium and machine learning and artificial intelligence dataset developer Appen.

As investors would expect, the sector is a hive of serious ‘tech’ cred, but also a lot of companies that are striving to turn amazing products into revenue, cash flow and profits.

UTILITIES

The smallest sector, Utilities, accounts for just 2 per cent of the S&P/ASX 200 index, and has 28 constituents. Five industries are present:

• The Electric utilities industry, which includes electricity generator, retailer and metering providers
• The Gas utilities industry, which includes gas transmission, storage, processing, compression and gas-powered generation companies
• The Multi-utilities industry, which includes companies offering a wide range of utility services
• The Water utilities industry, which includes companies involved in water supply and water and wastewater technology
• The Independent power and renewable energy producers industry, which features independent companies that produce energy through renewable and non-renewable sources.

The Utilities sector has a strong trans-Tasman flavour, hosting quite a few dual-listed companies from New Zealand. Leading the sector is gas pipeline and processing and storage facility operator APA Group. This company is followed by AGL Energy, a large generator and retailer of electricity and gas for residential and commercial use; AusNet Services, which owns and operates the Victorian electricity transmission network, one of five electricity distribution networks, and a gas distribution network in Victoria; and infrastructure fund Spark Infrastructure Group, which invests in regulated utility infrastructure, including electricity and gas distribution and transmission, regulated water and sewerage assets, both within Australia and overseas.

The Kiwi contingent is led by New Zealand electricity generator and retailer Mercury NZ; New Zealand’s largest renewable energy power company, Meridian Energy; infrastructure, utility, airport and social infrastructure investor Infratil; New Zealand’s largest electricity and gas generator and retailers, Genesis Energy and Contact Energy; and renewable electricity generation company, Tilt Renewables.

Also in the sector are specialist off-grid power generator to the resources industry, Zenith Energy; wind power generator Infigen Energy; renewable energy generator Genex Power; and water investment company Duxton Water (D2O), the only pure water exposure on the ASX.

CLEANTECH

The latest technological wave to grab the attention of investors is cleantech. This term is used to describe companies involved in renewable energy, carbon dioxide emissions control, biofuels, energy efficiency, water purification technology, salinity, carbon sequestration projects, alternative engine technology, electrical switching devices, clean coal technologies and new materials.

The Australian market has many stocks that qualify as cleantech candidates. The grouping is similar to Biotech in that many of the stocks involved are yet to commercialise their technologies. But profitable companies such as waste handling and recycling companies Cleanaway and Bingo Industries are showing that cleantech operations are no barrier to strong financial performance.

Exploring Resources

The GICS sectors of Energy and Materials contain the Australian stock market’s Resources stocks. Because of Australia’s mineral wealth, the sharemarket is renowned overseas as a Resources market. Some international investors still appear to regard Australia as little more than a gigantic mine to be invested in only when commodity prices are rising. These overseas investors hope to get a double benefit if share prices and the Australian dollar are rising.

In the mid-1980s, the Resources sector represented about two-thirds of the Australian sharemarket’s capitalisation; now it accounts for about 16 per cent. Although Resources activity has grown tremendously, the difference is better explained by the fact that far more of the depth and breadth of the Australian economy has moved on to the sharemarket, and the industrial side of the market has swelled.

The Australian resources sector is a huge contributor to the economy. In 2018–19, it accounted for 8.5 per cent of gross domestic product (GDP), and 35 per cent of GDP growth. It is also a massive source of export earnings. In 2018–19, Australia exported $77 billion worth of iron ore, up from $4.1 billion 25 years earlier. Indeed, it is the largest exporter of iron ore in the world, with 53 per cent of total exports, more than twice the proportion of its nearest competitor, Brazil. Of Australia’s total iron ore, 81 per cent goes to China.

Australia also exported $44 billion worth of coking (steelmaking) coal and $26 billion worth of thermal (electricity) coal in 2018–19, compared to $10.3 billion worth of coal 25 years ago. The country is the world’s largest exporter of steelmaking coal, accounting for 53 per cent of total exports, and is the second-largest exporter of thermal coal (behind Indonesia).

Gold exports rose over the period from $7 billion to $19 billion, and Australia has the potential to become the world’s largest gold producer by the mid-2020s. Liquefied natural gas (LNG) has risen from a $1.8 billion export market in 1994–95 to almost $50 billion. Australia is second only to Qatar as an LNG exporter.

Copper has gone from $1.2 billion worth of exports to $9.7 billion; crude oil from $2.6 billion to $9.1 billion; lithium from nothing to $1.7 billion; and uranium (where Australia is the third-largest producer, and has almost one-third of the world’s proven reserves) went from $281 million to $730 million.

Mining and petroleum drilling companies extract, process and sell Australia’s minerals, oil and gas. Australia possesses virtually the full set of mineral commodities, making for one colossal industry.

The main reason investors invest in resources is to capture the upside of the global economic cycle, and to have commodity price exposure in the portfolio for diversification purposes. Australia’s resource companies have enjoyed several years in the sun, powered by the rise in commodity prices, driven mainly by the massive industrial expansion in China. With China looking to power-up its economy to recover from the COVID-19-induced slowdown, commodity prices appear to have strong support.

Mining companies have a stable cost of production and can usually predict their operating costs. These companies measure profits by sales income minus operating costs, so fluctuations in the prices of the commodities they mine — and in the A$/US$ exchange rate — are the key to their profitability, although they can drive costs lower to help their margins, too. After all, their costs are only one of their profitability parameters that they can realistically control.

The main issue for the investor contemplating the Resources sector is whether to take the lower risk route — investing in the large-cap diversified miners, such as BHP and Rio Tinto, or iron ore heavyweight Fortescue Metals — or to invest in the pure-play companies, such as Iluka, Western Areas and Alumina, where you’re taking a view on their specific commodities (mineral sands, nickel and aluminium, respectively). The risk is higher with those companies, but you can receive greater earnings leverage at times. Even riskier are the highly speculative junior explorers, where the investor is looking for a strong capital gain related to specific projects that the company has. Alternatively, you can buy a resources-focused ETF and so hold a diversified portfolio of resources stocks.

The prices of resource shares generally anticipate movements in commodity prices. Resource shares are attractive to buyers when the Australian currency is weak because the supply contracts of the miners are written mostly in US$, while they report their profits in A$. The Resources sector is even more attractive in times of economic expansion, because world economic growth translates to growth in global industrial production, and Australian mineral commodity producers supply a great deal of the global industrial production.

EXPLORING FOR RESOURCES

Since the beginnings of the stock exchange in Australia (refer to Chapter 2) the Resources sector has given the market a lot of its romance, in the tradition of the exploration company hitting paydirt with a drilling hole, resulting in a share price surge. In particular, the names of nickel explorers Poseidon and Tasminex live on as synonyms for instant riches — and the inevitable bust (refer to Chapter 3). It’s history that Poseidon — which actually did mine nickel at Windarra — eventually went into receivership in 1976 (although an unconnected company, Poseidon Nickel, owns and operates the multi-mine Windarra project) and that Tasminex never mined nickel at Mount Venn. (Mount Venn is now owned by a company called Great Boulder Resources, but it is a very long way from being mined.)

The excesses of the 1969–70 nickel boom prompted the first serious look at corporate governance in Australia. These days, the veracity of stock exchange announcements — and the qualifications of the geologists who sign them — are strictly enforced. A rigid system is in place — the Joint Ore Reserve Committee (JORC) Code for Reporting Mineral Resources and Reserves, which defines the criteria for publicly reporting resources and reserves.

Under the JORC code, a company proceeds from resource to reserve, where an ore reserve is considered to be the economically mineable part of a measured or indicated mineral resource. Ore reserves are subdivided into probable reserves and proved reserves. Announcements must be signed off by a ‘competent person’, which means a member of either the Australian Institute of Mining and Metallurgy or the Australian Institute of Geoscientists.

Despite the tighter regulation of announcements and the claims made in them, some tricks of the trade remain. Prime among these are nearology and flexibility. An outbreak of nearology occurs when one spectacular drilling result sparks a flurry of announcements from any company with ground that shares the same postcode. For example, after Sandfire Resources’ breakthrough world-class copper–gold discovery at De Grussa in Western Australia’s Bryah Basin in May 2009, the share prices of more than 20 junior companies with exploration projects in the region pricked up. The reasoning of speculators was that if Sandfire had done it — and its shares had rocketed from 7 cents to $2.15 in just a few months — so could its neighbours. Investors poured millions into the ground searching for another company-making DeGrussa-style deposit in the region. But so far, no-one other than Sandfire has succeeded in that region.

It was the same story for Sirius (refer to Chapter 3) when it found the world-class Nova nickel deposit in the Fraser Range area of Western Australia in 2012. After the shares went to the stratosphere, from 5 cents to $5.00, more than 40 ‘nearology’ plays flooded the region, sinking millions of investor dollars into exploration to find the next Nova — only to be disappointed. (In fact, the only company to benefit from ‘nearology’ was Sirius itself, when it found the nearby Bollinger deposit, hitting the jackpot twice. Similarly, the only meaningful discovery near DeGrussa so far has been the small but high-grade Monty deposit, which Sandfire found in 2015 in a joint venture with Talisman Mining.)

In late 2018, BHP reported a big iron oxide–copper–gold find 65 kilometres to the south-east of its Olympic Dam mine in South Australia. In one day, the share prices of the Big Australian’s neighbours in that area, Aeris Resources, Argonaut Resources and Cohiba Minerals, spiked 27 per cent, 41 per cent and 100 per cent respectively. All received ‘please explain’ notices from the ASX, concerned about continuous disclosure requirements — but there was nothing to see, it was nearology again.

You can see why speculators often try to join the dots quickly — the nearology theory is often based on not only geographic adjacency, but also sound geological reasons. One company might have tenements consisting of the identical rock type in which the other company’s discovery was made. But, sadly, it rarely works that easily.

Another trap for rookies in the resources area is ‘flexibility” which occurs when a particular commodity is running hot, and deposits can be re-packaged to take advantage. For example, if nickel is running, gold projects can be re-presented as nickel projects. Or the projects could be copper projects under the right circumstances, but the drilling data can also be re-interpreted as highly prospective for diamonds.

Certainly, the potential for excitement in the explorers never goes away. Investors have to beware of the way that announcements are presented because the Australian stock market hosts explorers looking for virtually everything that can be mined.

The explorers — whether looking for minerals or hydrocarbons — are highly speculative. In fact, you’re not investing when you play in this market, you’re punting. The risk is higher because no financial fundamentals exist at all. Rather, you’re looking for a strong capital gain related to the company’s specific drilling programs or projects. This sharemarket participation mode is very announcement-driven and fits the day-trader mentality of trading momentum to a tee. But Australian resources investors have shown that they can be very patient; for example, Oil Search began looking for oil and gas in Papua New Guinea in 1931. The first revenues from this venture came in 1991, and the first dividend to shareholders followed a year later.

BUYING GOLD: A SPECIAL CASE

Australia has a long history with gold investing, which was the genesis of the country’s informal sharemarket beginnings back in the 1850s. While investors often participate in gold through gold stocks — which at times can give great leverage to gold prices — the ASX has two vehicles that enable retail investors to buy gold in its own right. The first of these products, Gold Bullion Securities (ASX code: GOLD) was launched in March 2003. Each GOLD security gives the investor ownership of one-tenth of an ounce of gold bullion, held in the London vaults of custodian bank HSBC Bank USA. GOLD securities may be sold at any time on the ASX, or (subject to certain conditions and fees applying) holders may redeem them at any time for cash or in exchange for gold bars. The price of a GOLD security is one-tenth of the A$ gold price.

Later in 2003, GOLDs were joined on the ASX by the Perth Mint Gold Quoted Product, or PMG (ASX code: PMGOLD), which is a security (technically a warrant) that gives you the right to own one-hundredth of an ounce of gold. That right may be bought and sold on the stock exchange. The gold is held in Perth as bar or coin, and guaranteed by the Western Australian Government.

Both products enable investors to trade in gold as if the investors owned physical bullion. This type of investing is a very clean and efficient way of ‘playing’ the gold price; instead of buying the corporate risk attached to a gold miner, an investor buying either GOLDs or PMGs is only ‘buying’ the gold price. No company-specific factors such as mine life, resource security or hedging activity complicate matters. The stocks simply track the A$ gold price very closely, and may be sold at any time on the ASX. Brokerage is charged on the purchase or sale, and the management expense ratio (MER) of the investment is 0.40 per cent a year for GOLD, and 0.15 per cent a year for PMGOLD.

Gold is also tradeable on the ASX through a range of exchange-traded products (ETPs), which offer exposure, through a listed stock, to the price changes of physical gold. ETPs also offer an investment in physical silver, platinum, palladium, and a basket of the three, plus gold.

Finding Specialised Stocks

Some of the stocks in your portfolio fulfil specialised roles. For example, those in listed investment companies widen your investment in the market dramatically. If you feel you don’t know enough about the market and lack confidence, managed funds may be the way to go. Other types of investment also exist that can offer you specific tax advantages.

Looking at listed investment companies (LICs)

Unit trusts (managed funds) are professionally managed and follow a diversification and asset allocation strategy that’s available only to the most sophisticated sharemarket investors. Two types of trusts exist — trusts that are listed on the sharemarket and trusts that are not. Listed investment companies (LICs) own a portfolio of other listed shares; in effect, these companies operate as a share that invests in other shares. Like their unlisted cousins, listed investment companies offer built-in diversification and professional management at a cheaper rate for investors.

Non-listed equity trusts are very popular, but the industry often comes under fire for the high fees it charges investors. LICs are more competitive because the brokerage fee on the purchase of a LIC is usually about half the entry fee of an equity trust. The annual management fee for a listed trust is even smaller.

The share price of a LIC tends to fluctuate around (but mostly under) its asset backing or the value of its net tangible assets (NTA). The NTA is the market value of that company’s share portfolio divided by the number of shares on issue. Sometimes the share price of a LIC can fall below NTA, and investors may buy an interest in the portfolio for less than the cost of establishing that portfolio. This means that two individual investors’ performance could be very different in the same LIC, depending on the discount/premium when they first invest.

For example, over the five years to May 2020, the largest LIC, Australian Foundation Investment Company (AFIC), traded at a discount to NTA of up to 4 per cent and a premium to its worth of as much as 9.1 per cent. The second-largest LIC, Argo Investments, traded at a discount to NTA of up to 4.2 per cent and a premium of as much as 10.8 per cent. The third-largest LIC, Milton Corporation, moved between a discount of 5.9 per cent and a premium of 7.6 per cent. These three LICs combined have a market capitalisation of about $16 billion, which accounts for around 35 per cent of the total sector.

An unlisted equity trust is open-ended, and the NTA determines the value of the underlying units in an equity trust. An investor in an equity trust buys the units by paying the NTA plus fees. LICs are closed-end investment vehicles because, after the initial capital raising, the shares trade at a price set by the market. (No new money comes into the fund unless new shares are issued or through a dividend reinvestment plan.) As with any other stock, supply and demand as well as the health of the sharemarket affects the share price.

Historically, during stronger market phases, the investment companies are at a premium to NTA. Buying at a premium to NTA works against the investor because the trading opportunity lies in riding the move from discount to premium. Longer-term investors can have an investment that tracks the market. Long-term investors who buy investment companies at deep discounts to asset backing are rewarded because their original investment keeps working for them over the years.

LICs are the tortoises of the sharemarket. They never pick up speed but, over time, generally achieve returns in line with the market average. Selecting a LIC on the basis of discount to NTA may not be the best strategy — the better-performing LICs trade at a premium, and the poor performers often trade at a discount — although in strong markets, even very large LIC portfolios can move into discount temporarily. Medium-cap/small-cap specialist LIC WAM Capital, for example, has never traded at a discount — but over the ten years to May 2020, it has increased its NTA by an average of 6.5 per cent a year, and the share price has appreciated by an average of 10.3 per cent a year. The most important criterion in evaluating a LIC is its track record.

LICs are permitted to report NTA figures before and after provision for unrealised capital gains. Some of the investment companies aim to make a profit and pay a dividend purely from the dividend flow in their portfolio. Others aim to add to profit by trading the portfolio. Most LICs distribute income in the form of fully franked dividends. For LICs with a dividend reinvestment plan, investors can choose to increase their investment exposure rather than receiving cash.

The better-performing LICs have outperformed the equity market accumulation indices (which count dividends as reinvested) over quite long periods.

For example, in the 20 years to 30 June 2019, Argo Investments earned its shareholders a total return of 10.9 per cent a year (including franking credits), compared to a return of 8.7 per cent a year for the S&P/ASX 200 Accumulation index. Over the ten years to April 2020, fellow LIC heavyweight AFIC reported total return plus franking credits of 7.7 per cent a year, versus 7.5 per cent a year for the S&P/ASX 200 Accumulation index.

A more recent innovation has been the listed investment trust (LIT). The main difference between these two structures is in the tax treatment — as companies, LICs pay tax on their earnings and pay dividends to their investors (which are usually taxable to them but include franking credits). As trusts, LITs are structured to pay no tax directly, but instead must distribute their taxable income to investors, who then pay tax on it at their own tax rates. These distributions usually do not include significant franking or other tax credits.

Since 2018, eight LITs have floated on the ASX, all in the credit sector, offering investors access to a portfolio of corporate loans, or other private debt instruments, mostly provided by non-bank lenders. These funds offered much higher yields than cash, and found a ready audience — income-oriented investors who had been badly hit by falling yield returns from cash and fixed interest, but were worried about buying stocks for dividends given the potential for capital loss.

This group features the KKR Credit Income Fund, Partners Global Income Fund, Perpetual Credit Income Trust, NB Global Corporate Income Trust, Qualitas Real Estate Income Fund, Gryphon Capital Income Trust, MCP Master Income Trust and the MCP Income Opportunities Trust. However, the COVID-19 crash was not kind to the LIT share prices. As closed-end vehicles, most of the credit LITs fell well below their reported NTA values — to discounts of 20 per cent to 50 per cent — as the market struggled to price their underlying assets accurately. As with the LICs, however, this dislocation opened up the opportunity for new buyers to augment their returns by riding the process (however long it took) of returning to trade closer to NTAs. As well, assuming the distributions remain the same, investors who buy at the lower price stand to benefit from an increased yield based on the lower entry price. Just as in many other types of stock, the COVID-19 crash showed that LITs — because the ‘L’ stands for ‘listed’ — are always susceptible to human behaviour and market fluctuations.

THE LIC MARKET

The LIC market in Australia is relatively small — about $44 billion, compared to $595 billion in unlisted Australian equity trusts — and is dominated by longstanding companies like Australian Foundation Investment Company (AFIC) at $7 billion and Argo Investments at $5.3 billion in size. AFIC was founded in 1928 and was closely aligned with the JBWere stockbroking group, while Argo Investments was founded in 1946 in Adelaide by a group of stockbrokers that included the world’s greatest cricketer, Sir Donald Bradman. Milton Corporation was established in 1938 and listed on the Sydney Stock Exchange in 1958.

Of the 65 LICs listed on the ASX, most invest in Australian shares. Those with a large-capitalisation Australian stocks focus include AFIC, Argo, Australian United Investments (AUI), Milton Corporation, Carlton Investments and AFIC’s stablemate Djerriwarrh Investments (which specialises in the buy-and-write options strategy). Those with a small-capitalisation Australian stocks focus include Mirrabooka Investments, WAM Capital, QV Equities and Ophir High Conviction Fund.

Globally-focused LICs include Magellan Global Trust ($2.1 billion), MFF Capital Investments ($1.5 billion) and Magellan High Conviction Trust ($870 million), as well as smaller companies like WAM Global, Templeton Global Growth, Platinum Capital, PM Capital Global Opportunities, Pengana International Equities, Tribeca Global Natural Resources and Evans & Partners Global Disruption.

Other LICs with a specific focus include Argo Global Listed Infrastructure, Platinum Asia Investments, Hearts & Minds Investment (a global high-conviction investor); WAM Microcap, Spheria Emerging Companies, NAOS Emerging Opportunities Company, NAOS Small Cap Opportunities Company and Acorn Capital Investment Fund, which mainly target Australian ‘microcap’ stocks; and Plato Income Maximiser, an income-focused LIC. ‘Long–short’ funds are also available, which can short-sell stocks (sell them without owning them by borrowing the stock, hoping to profit from a price fall). Domestic specialists in this group include Australian Leaders Fund and Absolute Equity Performance, while globally-focused long-short LICs include L1 Long Short Fund, VGI Partners Global Investments, Antipodes Global Investment and Regal Investment Fund.

Engaging with exchange-traded funds (ETFs)

Exchange-traded funds (ETFs) are one of the fastest-growing investment products in the world. An ETF is effectively a stock that represents a portfolio. For example, the StreetTracks S&P/ASX 200 Fund (issued by State Street Global Advisors; ASX code: STW) is designed to closely track the performance of the S&P/ASX 200 index, because it comprises all of the companies in the index. By buying that ETF, with one transaction, no matter what amount invested, the investor will receive a return that matches, before fees and expenses, the return of the S&P/ASX 200 index.

ETFs emerged out of the ‘index fund’ movement, which started in the US in the early 1970s, with the first index fund having an investment objective of approximating the performance of the Dow Jones Industrial Stock Average. The first actual ETF was listed in March 1990 on the Toronto Stock Exchange, known as the Toronto 35 Index Participation Fund, or ‘TIPs’. That ETF, now owned by BlackRock, still exists today and is now known as the iShares S&P/TSX 60 index ETF, with assets of C$7.81 billion (A$8.5 billion).

The market really got going with the launch in January 1993 of the Standard & Poor’s Depositary Receipt — the SPDR, or ‘Spider’ — which trades on the New York Stock Exchange Arca market, under the ticker ‘SPY’. It remains the largest ETF in the world, with a market capitalisation of US$263.9 billion (A$406 billion), and average daily volume of US$36.4 billion (A$56 billion).

From US$1 billion in market size in 1995, ETFs have grown to a US$6 trillion (A$9.2 trillion) market around the world (US$4.4 trillion of that in the US), with almost 8,000 ETFs trading worldwide. In total, ETFs account for about 37 per cent of US trading value.

Like their counterparts abroad, Australian investors have embraced the ETF revolution. From a humble beginning in August 2001, when State Street Global Advisors launched two ETFs on the ASX, worth $48 million in total, ETFs have grown to the point where the ASX Monthly Funds Report for April 2020 listed 212 ETFs in the Australian market, with a total market capitalisation of $60.7 billion, from a total of 25 issuers.

The largest ETF on the ASX is the Vanguard Australian Shares Index ETF, which is capitalised at $4.8 billion, followed by the SPDR S&P/ASX 200 Fund (one of the first two listed in 2001), which is valued at $3.4 billion. The largest international equity ETF is the iShares S&P 500 ETF, with a capitalisation of $3.1 billion.

Australia’s ETF listings cover Australian shares, global shares, infrastructure, property securities, bonds (government to corporate), cash, mixed assets, currency and commodities (precious metals, industrial metals, crude oil and agricultural commodities).

ETFs offer an individual investor a simple means of gaining exposure to a broader portfolio — they are structured to provide, in one stock, exposure to the ‘beta’ (market performance) of the stock portfolio. The approach is similar to that considered in the active-versus-passive debate described in Chapter 5 — in deciding to use an ETF, you accept that you’re giving up the chance to benefit from any ‘alpha’, or out-performance of the index that an active manager may be able to achieve; instead, you investor simply want to gain the performance of that relevant index. (Although active ETFs do exist — see the section ‘Active ETFs’, later in this chapter, for more.)

An equity ETF holds the shares on behalf of its investors, so all dividends from the underlying companies are paid directly to the ETF. The ETF then collates any income the assets generate — including dividends, interest, capital returns, capital gains — and pays this to investors through regular distributions, rather than immediately as the dividends are received. This timing could range from monthly to annually. Many investors find one payment with one statement attractive, compared to receiving multiple dividends from multiple holdings. As with shares, ETFs are traded on the ASX, and settled through the CHESS clearing system. The Chi-X exchange also trades a range of ETFs.

The appeal of ETFs is the instant diversification and versatility that they can offer to investors. They can provide core exposure to various asset classes within an investment portfolio — investors can gain access to a variety of asset classes at a relatively low cost, and ETFs can be used as the building blocks of multi-asset portfolios. For example, you could buy a broad Australian-market ETF to serve as your ‘core’ holding of Australian shares in your portfolio, around which other selected diversifier holdings can be established, such as US shares, or a broad global shares ETF. Buying a global share ETF is an instant, cost-effective way to add international exposure to a portfolio, and hold it long-term, to reduce the concentration risk of Australian stocks.

The ETF menu also offers funds tracking sector-specific indices, such as resources, or ones that carve out different sharemarket ‘factors’, such as high dividend yield or ‘quality’ (including companies that have strong balance sheets, encouraging growth prospects, relatively high return on equity (ROE) and which show consistent improvements in their earnings).

ETFs share three main characteristics:

• They are open-end rather than closed-end funds. This means that the number of units on issue and available to be traded on the stock exchange will fluctuate, according to demand.
• They are involved in a simultaneous primary market (for ongoing unit creation and redemption) and secondary market, which is traded on the exchange.
• They are designed to ensure that the unit price on the secondary market does not diverge too far from the net asset value (NAV) of the units.

Although most ETFs are quintessentially passive investments — simply replicating an index — they can be used tactically, to take a short-term trading view. ETFs also suit the ‘core/satellite’ strategy, where investors use ETFs as core asset-allocation holdings to pick up market ‘beta’, and then choose active managers and/or direct shareholdings to add ‘alpha’.

ETFs are the cheapest way that an individual investor can ‘buy’ the overall market in a particular asset class. Because ETFs can be used to establish instant investment in a range of asset classes — Australian shares, overseas shares, Australian bonds, overseas bonds, property, infrastructure, commodities, foreign currency — they can make it easy to do the job of asset allocation. Asset allocation is the biggest long-term determinant of portfolio performance, but can often be a difficult task. However, virtually your entire asset allocation process can be completed using ASX-listed ETFs or ETPs. The ETFs that invest in international shares will either be currency-hedged or unhedged, with investors deciding whether they wish to take currency risk (refer to Chapter 5).

In Australia, ETFs usually account for about 4 per cent of total ASX trades, but in the COVID-19 Crash, this proportion rose to about 10 per cent of total trades, as investors sought the perceived safety of precious metals such as gold or broad-based market ETFs. The number of transactions and volume and value figures reached all-time highs. In March 2020, the ASX ETF sector transacted on average about $770 million worth of trades a day, nearly four times higher than the previous peak. The 748,000 transactions for March were about two-and-a-half times higher than the previous month. A lot more people seemed to be more active in the market, because the versatility of ETF uses allowed them to do what they wanted to do.

Themed ETFs

ETF issuers have put a lot of effort into developing ‘thematic’ ETFs that aim to capitalise on emerging trends. Examples include biotech, environmental change, demographic shifts and technology EFTs — and within technology, ‘hot’ areas such as artificial intelligence and robotics, and cyber-security are also covered.

For example, on the ASX investors can use:

• BetaShares Australian Sustainability Leaders ETF (ASX code: FAIR): This ETF tracks an index that includes Australian companies that are ‘sustainability’ leaders, in that they score highly on socially responsible investment considerations, and excludes companies with direct or significant exposure to fossil fuels.
• BetaShares Global Cybersecurity ETF (ASX code: HACK): This ETF offers a simple and cost-effective way to gain exposure to the world’s leading cybersecurity companies in a single ASX transaction.
• BetaShares Global Healthcare ETF (Currency Hedged) (ASX code: DRUG): An ETF that offers a simple and cost-effective way to gain exposure to a diversified portfolio of the world’s leading health care companies in a single ASX transaction.
• BetaShares S&P/ASX Australian Technology ETF (ASX code: ATEC): An ETF that aims to track the performance of the new (2020) S&P/ASX All Technology index.
• ETF Securities Global Core Infrastructure ETF (ASX code: CORE): This ETF aims to provide investors with a return that tracks the performance of the Solactive Global Core Infrastructure Low Volatility Index, an index comprising the 75 least volatile listed infrastructure companies, chosen from global developed-market stock exchanges.
• ETFS S&P Biotech ETF (ASX code: CURE): An ETF that seeks to track the performance of the S&P Biotechnology Select Industry index, an index that carves out US life sciences companies from the broader pharmaceutical/health care sector. (It is an equal-weighted index.) This ETF picks up leaders in a variety of biotech fields, including COVID-19, cancer, cystic fibrosis and rare genetic disease therapies.
• ETFS FANG+ ETF (ASX code: FANG): This ETF tracks the performance of the NYSE’s FANG+ index, an index that captures the high-growth technology companies and global innovation leaders listed on the US stock exchanges. (It is also an equally-weighted index.)
• VanEck Vectors China New Economy ETF (ASX code: CNEW): An ETF designed to track the CSI MarketGrader China New Economy Index, which aims to choose the 120 companies in China with the best ‘growth at a reasonable price’ (GARP) attributes, selected only from the technology, health care, consumer staples and consumer discretionary sectors.
• VanEck Vectors Morningstar Wide Moat ETF (ASX code: MOAT): An ETF designed to follow the Morningstar Wide Moat Focus index, which is an index that focuses on US companies with sustainable competitive advantages, as chosen by Morningstar’s equity research team. In Morningstar’s methodology, companies with a ‘wide moat’ are companies with strengths that are difficult for competitors to replicate easily; for example, strong intangible assets, a network effect, cost advantage, and efficient scale. (A ‘network effect’ is where a company’s product increases in value the more people use it. Great examples are Carsales.com.au [operated by Carsales.com], seek.com.au [operated by Seek] and realestate.com.au [operated by REA Group]. These websites are more useful to users precisely because they are the market leaders — that’s the network effect.)

These ETFs that track custom-made indices cost more than those that follow broad-based indices such as the S&P 500 index or the MSCI World index, but plenty of investors want these kinds of specifically targeted exposures.

ETFs COME THROUGH THE CRASH

The spectacular market slump and price dislocation experienced over February–March 2020 put all of the sharemarkets under stress; however, the ETF sector was perhaps more closely watched than others. Of course, broad index-based ETFs gave their investors the fall — and the rebound — of their underlying indices, because that is what those ETFs are designed to do, and what their investors expect those ETFs to do.

ETFs did exhibit volatility in pricing during the COVID-19 crash — but only in line with the volatility or the structural setup of the underlying assets and indices. This volatility was more pronounced in some asset classes. In the heightened volatility of the global market crash, the spreads on many ETFs were wider than usual, which reflected the extreme market movements in underlying exposures.

ETFs have ‘market makers’, which are firms paid to provide buying and selling quotes (bids and offers) on the ETFs throughout the trading day — the market makers play an important role in ensuring that buyers and sellers of the ETF can transact at prices close to the net asset value (NAV). They provide liquidity through the trading day and frequently update their quotes to reflect changes in the NAV of the ETF.

During the COVID-19 crash, buy–sell (bid–offer) spreads were quite volatile. For any stock, the buy–sell spread is the difference between what a seller is asking for the stock, and what a buyer is willing to pay, generally calculated off the highest bid offer. As for any managed fund, the buy–sell spread is the invisible cost of investing, paid each time an investor enters or exits the fund, and covering the costs incurred by the market maker or fund provider.

As the ETF market has grown over the past decade, the average bid–offer spread has fallen from 75 basis points (0.75 per cent) to 29 basis points. For many of the largest and most liquid ETFs, average bid–offer spreads are typically 5 basis points to 11 basis points (0.05 per cent to 0.11 per cent). And the ‘tighter’ the spread, the easier it is for the market makers to trade in the market.

But in March 2020, a month of significant volatility on global financial markets, the average bid–offer spread for Australian ETFs blew out to 85 basis points (0.85 per cent). Even in April 2020, as markets calmed down slightly, the average only returned to 51 basis points (0.51 per cent). Even the $3.1 billion iShares S&P 500 ETF, the largest global shares ETF in the Australian market, saw its average bid–offer spread move from 4 basis points in February 2020 to 15 basis points in March.

This reflected the fact that during the Australian trading day, market makers are pricing the global shares ETFs on the basis of the US stock index futures contracts, which are trading outside US sharemarket trading hours. (Stock index futures trade virtually 24 hours a day, with a rise or fall in index futures outside normal market hours often used as an indication of whether the sharemarket will open higher or lower the next day.)

But several times in March during the Australian trading day, US stock index futures stopped trading because the futures went ‘limit-down,’ meaning they fell by more than 5 per cent, and thus trading was temporarily suspended. This gave rise to ‘gapping risk’, in which nobody is quite sure what price to quote until trading resumes. However, the market makers maintained pricing on the ETFs, using their modelling techniques and other methods to try to reflect the prices accurately. By taking that risk on to their balance sheet, they were able to give investors the ability to buy or sell on the ASX.

This situation was repeated in many ETF sectors and asset classes during the COVID-19 crash, when price discovery was made suddenly very difficult. In some of the fixed-income sectors — corporate bonds and high-yield bonds, for example — market makers also had to take balance-sheet risk to maintain a buy–sell spread as prices gapped, and this pushed spreads wider.

Whenever spreads widen, it’s because of the price discovery difficulty in the underlying assets. During the COVID-19 crash in some of the fixed-income ETFs, such as those investing in corporate bonds and high-yield bonds, problems arose from the fact that bonds do not trade on public exchanges (such as the ASX) as shares do. Instead, they are traded directly between institutions and rely on a core group of banks to do most of the trading. Amid the dislocation of the COVID-19 crash, no-one quite knew what the current prices of the underlying bonds were. The market makers — firms that are some of the biggest buyers and sellers of bonds in the world, and probably better placed than anyone to understand what the prices are of some of these fixed-interest products — took risk on their balance sheets to maintain a market as prices gapped and spreads widened.

In those cases, the ETFs actually provided a more accurate reflection of the pricing than the underlying market was providing at the time. However, some bond ETFs on the ASX did trade at prices well below their NAVs — discounts of up to 10 per cent were common — catching some investors who use bond ETFs by surprise.

Active ETFs

Not all ETFs are structured solely to follow an index. Some ETFs are actively managed (refer to Chapter 5), where the fund manager chooses its own portfolio and constantly researches it, deciding what to buy, hold and sell, and in what proportions. The manager will actively manage weightings of the stocks depending on stock valuations, industry trends and views on likely macroeconomics and geopolitical developments. They can also hold cash to manage the overall risk of the portfolio and to take advantage of opportunities when markets move. The manager of an actively managed ETF will try to beat the performance of the relevant benchmark index, while also trying to avoid (or lessen) a fall in the benchmark index.

If that sounds similar to what an unlisted managed fund does, that’s because an active ETF is really more accurately described as a listed managed fund — and in the Australian market, they are called exchange-traded managed funds (ETMFs), or Quoted Managed Funds (QMFs), which is the term under which they trade on the Chi-X exchange. They function like managed funds, but are traded like shares that can be bought and sold during the trading day on the stock exchange. This means, although ETMFs operate in a similar way to traditional managed funds, they have the added benefit of transparent, live intra-day pricing on the ASX, and market-making ability that ensures liquidity for investors.

Active ETFs were only introduced into Australia in March 2015, when funds management group Magellan listed its Magellan Global Equities (MGE), which closely resembles the firm’s unlisted Magellan Global fund. In 2020, 47 active ETFs were trading on the ASX, with a total capitalisation of $6.2 billion (10.2 per cent of the value of the entire ETF cohort). MGE is by far the largest, holding more than one-quarter of the active ETF dollars, at $1.7 billion.

Active ETFs usually cost more than passive ETFs because of the involvement of portfolio managers and researchers; you are paying for the team’s skill. In the Australian marketplace, the MERs of active ETFs range between 0.35 per cent and 2.05 per cent a year — but, in general, active ETFs’ annual fees are between 0.5 per cent and 1.0 per cent.

Protection ETFs

Several of the active ETFs issued by ETF provider BetaShares are ‘inverse’ ETFs, designed to generate a return that is negatively correlated to the return of either the Australian or the US sharemarket; in other words, they are structured to rise when a sharemarket index falls. Because of this, these ETFs can be used for short-term trading, to ‘short-sell’ the index — that is, to profit from a fall — but they can also be used to protect a share portfolio to some extent.

Two of the BetaShares inverse ETFs (known as ‘bear funds’) are geared (leveraged) so as to potentially magnify the profit from the ‘short’ strategy. The simplest of the bear funds, being ungeared, is the BEAR fund (that is the ASX code), which simply targets a return that is negatively correlated with the return of the Australian sharemarket, in a roughly one-to-one relationship. In effect, if the fund’s benchmark index — the S&P/ASX 200 Accumulation index, which includes dividends — falls by 1 per cent, the fund should rise in the range of 0.9 per cent to 1.1 per cent. (The reverse is also true — if the S&P/ASX 200 Accumulation Index rises by 1 per cent, the BEAR fund should fall by 0.9 per cent to 1.1 per cent.)

The other Australian bear fund, the BBOZ (ASX code) fund, is also designed to be negatively correlated with the return of the S&P/ASX 200 Accumulation index, but in a magnified way — it uses internal leverage (that is, BetaShares borrows money to put on a larger position) to try to achieve a return of 2 per cent to 2.75 per cent for every 1 per cent fall in the S&P/ASX 200 Accumulation index. And, of course, the opposite reaction in the event of a 1 per cent rise in the index.

The third product, the US Equities Strong Bear Hedge Fund – Currency Hedged (ASX code: BBUS) is designed to generate magnified positive returns when the US market (as represented by the S&P 500 Total Return index, which includes dividends) goes down, and vice versa. BBUS is structured to deliver a 2 per cent to 2.75 per cent increase in the value of the fund’s units for every 1 per cent fall in the benchmark index (and vice versa).

In the COVID-19 crash, all three funds did what investors expected them to do. The BEAR fund gained 16.9 per cent in March 2020, compared to a fall of 20.7 per cent in the S&P/ASX 200. For the March 2020 quarter, BEAR was up by 20.1 per cent, compared to a 23.1 per cent slump in the index.

As investors would also expect, BBOZ, the geared Australian short fund, did even better. It appreciated by 33 per cent in March 2020, compared to the 20.7 per cent fall in the S&P/ASX 200 and, for the March 2020 quarter, BBOZ rose by 40.6 per cent, against the 23.1 per cent fall in the index.

BBUS, the leveraged US fund, surged by 22.6 per cent in March 2020, compared to a 12.4 per cent fall in its benchmark index, the S&P 500 Total Return index. For the March 2020 quarter, BBUS gained 47.8 per cent, versus a fall of 19.7 per cent for the index.

Visiting the Hybrid Part of the ASX Zoo

The ASX also hosts a $41.1 billion sector of ‘hybrid’ securities, so named because they combine features of debt and equity securities — the debt features being that investors are paid an interest ‘coupon’, and the equity features being that the securities have no maturity date, or very long maturities.

Hybrid securities have been popular with retail investors in recent years because they are mainly issued by banks, and offer high yields; however, they also involve higher risk than traditional fixed-income investments. Hybrid securities typically promise to pay regular interest, at a defined margin above the bank-bill rate (that is, a floating rate). However, unlike a bond, the amount (and timing) of interest payments are not as certain. Because hybrids can be exchanged for shares of the underlying company’s shares (they have a fixed date for optional repayment or conversion to shares), they are much more like equity, and do not provide the same level of protection as bonds in a market downturn.

In the corporate capital structure, hybrids generally sit between equity and debt, and as with debt, they are ranked ahead of equity in the event the company is wound up. Most hybrids are issued by banks and insurers, and have historically had around one-quarter to one-half the risk of shares, but higher volatility than investment-grade floating-rate notes. If the hybrids do not have a set date when they’re called in (or repaid), most modern (or so-called Basel 3) hybrids automatically convert to equity at around ten years. Alternatively, the prudential regulator of banks and insurance companies, the Australian Prudential Regulation Authority (APRA) can demand that they be converted into ordinary shares if the issuer is in distress. If the hybrid issuer suspends distributions, penalties normally apply — if they don’t pay the income or interest on their hybrids, the issuer is not allowed to pay dividends on their equity, either.

Hybrids are broadly split into three varieties:

• Convertible/converting debt securities (that convert into ordinary equity securities at some stage)
• Preference shares (equity securities with debt-like features)
• Capital notes (debt securities with equity features) which may be perpetual (no maturity), subordinated bonds and securities where the issuer can redeem the securities under certain conditions

Investors choose to invest in hybrid securities for a number of reasons, including the income, the diversification, and the better liquidity and price transparency than provided by corporate bonds. Coupons are both optional and variable, and the timing of the maturity payment is the choice of the issuer — or the issuer can convert the security into equity. Since the cash flows in a hybrid are relatively unknown, investors look at the ‘running yield’ — the ratio of the expected yearly distribution relative to the current market price of the hybrid.

Considering exchange-traded bonds

The ASX also hosts exchange-traded bonds (XTBs), with the range of XTBs including underlying bonds from Australia’s largest companies. Currently, about 50 XTBs are available on the ASX, issued by 30 companies, and all major names from the S&P/ASX 200 index — for example, AGL Energy, APA Group, Bank of Queensland, Dexus, GPT, Mirvac, National Australia Bank, Qantas, Telstra and Westpac.

Each XTB represents a fraction of a corporate bond, which is traded on ASX. Investors buy and sell XTB units on the ASX with minimum amounts starting from $500. All XTBs have a face value of $100, meaning investors receive $100 per unit at maturity. The performance of the XTB should reflect the underlying performance of the corporate bond.

The XTBs have the same coupon rate and maturity date as their underlying bond. They effectively mirror the cash flows of individual corporate bonds issued in the wholesale market. They combine the predictable income and capital stability of corporate bonds, with the ASX market’s transparency and liquidity. Investors can choose fixed or floating-rate coupons (interest payments) across a range of sectors.

The XTBs have made it easier than ever before to incorporate the diversification benefits and the regular, predictable cash flows of corporate bonds into a portfolio. In the wholesale bond market, institutional investors are typically required to buy bonds in large amounts ($500,000 or more), but XTBs over corporate bonds offer participation for as little as $500.

Since XTBs began trading on the ASX in May 2015, 33 XTBs have matured, with $130 million returned to XTB investors in face value payments at maturity, and $46.2 million paid in coupon (income) payments to XTB investors.

In a similar manner, Australian Government Treasury Bonds are also traded on the ASX, in the form of exchange-traded Treasury Bonds, or eTBs. This is also done through fractional ownership, where a one-unit holding of an eTB provides beneficial ownership of $100 of face value of the Treasury Bond over which it has been issued.

An eTB Holder has beneficial ownership of the bonds in the form of CHESS Depositary Instruments (CDIs), which means that the eTB holder has all of the economic benefits (including coupon and principal payments) attached to legal ownership of the Treasury Bonds over which the eTBs have been issued.

Exchange-traded treasury indexed bonds (ETIBs) are also available, and these work the same way as eTBs, except the value of ETIBs is adjusted with the consumer price index (CPI) — that is, inflation — meaning the interest received can fluctuate.

Moving with the mFunds market

In 2014 the ASX introduced the mFund platform, allowing investors to buy and sell unlisted managed funds through their broker in the same way that they trade shares. This eliminates the traditional paper-based processes for investing in managed funds, and uses the same CHESS electronic system used for settling ASX stock transactions.

When you buy units in an mFund, your holdings may be electronically linked to your Holder Identification Number (HIN) through the ASX, which means they can be tracked along with other investments such as shares and ETFs in the one spot, such as via an online broker.

Several costs are associated with investing in mFunds including brokerage fees, management fees, the minimum investment and price per unit. For example:

• Brokerage fees: These are charged by the broker or online share trading platform for any settled trades. Each time you want to buy additional units in the fund, you’ll need to pay this fee, which tends to range from $30 to $40.
• Management expense ratio (MER): These are the annual fees charged by the fund issuer, which range from around 0.2 per cent to 1.9 per cent.

The ASX lists 234 mFunds — all actively managed funds — from 70 fund managers. Most mFunds offer much lower minimum investment amounts than required when investing directly in the equivalent funds through the fund manager or an investment adviser.

Unlike ETFs, mFunds are not actually listed on the ASX (they are listed on the ASX’s mFunds platform,), which means investors aren’t buying or selling mFund units from or to other investors. However, mFunds are settled by the ASX’s mFund service, so the ASX is responsible for transferring ownership of units to buyers after payments have been processed.

Deciding What to Buy

With the market divided into specific sectors, you can get a feel for the sectors with which you’re most comfortable. Some sectors need a bit more research and effort in order to make successful investments; resources and some of the telecommunications companies operate in a complex environment. As with all share investment, the more you know about the companies that you invest in, the sounder your investment.

Buying what you know

If you use a company’s goods or services, you know that company well, and you understand what makes them attractive to consumers. You can see where the revenue is coming from to pay you, as a shareholder, your earnings stream and dividend wage.

One of the annoying (because it’s true) clichés of the sharemarket is that if you can’t explain to someone sitting next to you at a dinner party what one of your stocks actually does, you shouldn’t own that stock.

Brand power

An extension of the ‘buying what you know’ policy is brand power. The types of companies that have become trusted blue chips of long standing are companies with a trusted brand name that has been around for a long time. Brands don’t get to be household names without earning the trust of investors as well as consumers.

Beware a brand that has had huge expenditure put into it and looks established, while the company behind it has not yet made a profit, or has profits that are unreliable. And watching AMP’s slow slide from $45 on the day of its float in 1998, or department store ‘icon’ Myer’s similar dismal track from their $4.10 issue price when floated in November 2009 to 14 cents in April 2020, should also be enough to convince you that the renown of a company’s brand has nothing to do with how well it will do on the sharemarket.

However, brand reputation is a major part of how appliance marketer Breville has become a ten-bagger during the period of Myer’s slide, from $2.25 to $24.37 before the COVID-19 crash.

Companies that dominate

Competition benefits consumers but not investors. If the competition is hot, margins remain down and also earnings — and that’s not good. The sharemarket may be the seat of capitalism, but it likes a monopoly best. What the sharemarket wants most are reliable and predictable earnings. A company that dominates its market delivers stability.

The big four Australian banks enjoy enormous size and scale, plus they’re considered to have implicit government protection — which is enshrined in the ‘four pillars policy’ that prevents them from merging, their ‘too big to fail’ status and the fact that they’re allowed by the Australian Prudential Regulation Authority (APRA) to apply lower risk weightings to their home loan assets than the regional banks, because they’re ‘systemically’ more important, and thus considered to be under more intense regulatory supervision. Commonwealth Bank, Westpac, ANZ and NAB thus collectively enjoy a competitive advantage.

Research firm Morningstar sums up a companies’ competitive advantage in its concept of the ‘moat’ — the combination of attributes such as a strong brand; a cost advantage; a product that is good enough to dissuade customers from changing brands and thereby incur the pain of ‘switching costs’; a ‘network effect’, whereby an increase in the users of a product or service results in a corresponding increase in mutual benefits for both old and new users; and efficient scale, which occurs when a market is effectively served by a small number of producers or sellers.

Morningstar says the best moats on the ASX are:

• ASX: The largest securities exchange in Australia, with a monopoly in listing, trading, clearing and settlement of Australian cash equities, debt securities, investment funds and derivatives.
• Cochlear: A very strong market position as a global hearing implant maker, with 60 per cent of the market, plus the trust of the ear, nose and throat (ENT) surgeons that install hearing implants.
• Transurban: High-quality, well-situated global toll road operator.
• Wesfarmers: Strong market position in consumer spending.
• InvoCare: The largest funeral, cemetery and crematorium operator in Australia, New Zealand and Singapore.
• Auckland International Airport: Monopolistic status as the largest airport in, and international gateway to, New Zealand.
• Brambles: The global leader in supply chain equipment solutions for the consumer staples sector.
• Commonwealth Bank, ANZ Banking Group, National Australia Bank, Westpac: Sustainable structural traits that guarantee high returns on equity. Together the four lenders control more than 80 per cent of the business and consumer lending markets, plus the vast majority of bank deposits.

CSL has been recognised by investors globally for its size and manufacturing scale, giving it a cost advantage over competitors in a market where demand for blood plasma continues to grow.

Other health care companies such as ResMed, Ramsay Health Care. Pro Medicus and Ansell have strong competitive advantages. So too does international student placement provider IDP Education, through its one-third ownership of the crucial International English Language Testing System (IELTS). Technology stars Altium and Appen have major competitive advantages — even Afterpay, with a first-mover advantage (particularly in the US market) that gives it an edge despite its core product being easy to emulate. Many companies have surprisingly strong versions of competitive advantage — although for many, the shock of the COVID-19-induced economic downturn may have lessened these advantages, at least temporarily. Seeing whether some advantages considered to be set in stone actually survive is likely to be fascinating.

Top management

Effective management is absolutely vital to the financial health of a company and to your investment. Good management positions your company at the forefront of its market. If the managers fail, so do your investments.

You can follow the track record of the management teams that run the companies in which you’re investing. If you don’t have confidence in their abilities, don’t wait until the board shares your opinion. Fire them first by selling the shares.

Assessing management is difficult and made more so by the publicity that some chief executive officers (CEOs) attract. The financial media can fall in love with high-profile CEOs, especially if they’re good with a quote, while a seeming Midas touch can bedazzle stock market analysts. In the late 1990s, it was Peter Smedley (former CEO of Colonial, then Mayne) who was a market favourite. Then in the early 2000s, it was AMP’s extrovert American chief executive George Trumbull, who was larger than life while taking AMP on an acquisition binge that later went awry.

Former Telstra CEO Ziggy Switkowski was another whose love affair with the media and market ended acrimoniously when he agreed in 2004 to step down two years early. His departure followed a series of disastrous expansions — including a failed move into Asia that lost the company $3 billion — that cut the market value of Telstra in half. Switkowski was followed by American Sol Trujillo, whose high-profile time in the top seat at Telstra was marked by an adversarial relationship with the federal government, the Australian Competition and Consumer Commission (ACCC), employees and customers — not to mention a 25 per cent slide in the share price.

Then came the boom of the mid-2000s, in which the luminaries of the debt boom such as Eddy Groves of ABC Learning Centres, Phil Green of Babcock & Brown, David Coe of Allco Finance Group, John Kinghorn of RAMS Home Loans and Michael King of MFS were all over the media, not only in the finance pages but in the lifestyle pages, too. Their high profiles could not prevent the credit crunch and GFC exposing their companies as unsound once the debt taps were turned off.

In contrast, not many investors would have heard of the likes of Cameron McIntyre, CEO of Carsales.com, Peter Wilson, CEO of Reece, Andrew Bassat, chief executive of Seek, Paul Perreault, chief executive of CSL, Shemara Wikramanayake, chief executive of Macquarie Group, Dominic Stevens, CEO of ASX, Elizabeth Gaines, CEO of Fortescue Metals Group, Rob Newman, CEO of Nearmap, Steve Vamos, CEO of Xero, and Dig Howitt, CEO of Cochlear. Relatively unknown they may be to the wider public, but they all lead management teams doing an excellent job of creating value for shareholders.

Retreating behind defensive stocks

Defensive stocks, considered safe in troubled times, are the most liquid shares in the top 50. A true bear market depresses share prices across the board, and designing a portfolio that performs well in such a market is difficult. In this situation, professional investors sell many of their shares to increase their cash holding.

In the extreme case of a recession, bank shares, high-yielding property trusts and patronage assets (refer to the earlier section ‘Choosing industrials’) are the best defensive havens because interest and rental income are fairly constant. In the worst cases, you can also move the rest of your portfolio to cash. Defensive stocks are non-cyclical because they experience solid profits regardless of the motions of the broader economy. Even if their prices fall in a bear market, they should not fall by as much as other stocks.

The food retailers are usually viewed as safe havens. For example, the supermarket stocks, Woolworths and Coles, are usually considered premier defensive stocks, as is Telstra — just as people need to eat no matter how bad the economic circumstances are, they also need and want to use their mobile phones and internet for work and pleasure. CSL and Ramsay Health Care are also considered defensive, backed by global cash flows and the growing demand for health care as the population ages.

Utilities are sound defensive performers because people still need electricity and gas, and energy stock AGL Energy, gas pipeline operator APA Group and electricity distributor Spark Infrastructure are good examples of defensive utilities. Sadly — for the human frailty it speaks of — gambling is also a robust defensive exposure, in the form of stocks such as Tabcorp.

Other defensive stocks are those with dominant market positions. A good example of that in the Australian market is Computershare, the world’s largest share registry business, and ASX in Australian financial markets (although this pair depends heavily on the activity of financial markets buzzing along nicely). Australian banks also proved to be sound defensive holdings during the GFC — although their profits suffered as their bad debt provisions mounted, and they were susceptible to movements in credit markets, the fact that they had very little exposure to US housing or to the European debt problem held them in good stead.

Will the banks behave in the same manner in the wake of the COVID-19-inspired economic slump? Bad-debt provisions will see the big banks take massive write-downs, and the threats to bank earnings and dividends are huge, as business and personal customers struggle to repay their loans. In 2020, the market is expecting the banks’ bad debts to balloon, judging by sharp falls in bank share prices this year. Less clear is what will happen if a meltdown in commercial property valuations eventuates, as more companies cannot pay rent or seek large rent reductions. Bank losses could worsen if areas of the economy are shut down for longer than expected, or unemployment rises more than expected, and the economic recovery from the COVID-19 downturn takes longer than expected.

Defensive stocks will not help your portfolio avoid a broad-based fall in the market, and the nature of a defensive stock ultimately boils down to the price you pay.

Cycling your way to recovery

Cyclical stocks are shares with sales and earnings that are affected most by the economic or industry cycle. When the local economy seems to have bottomed or come out of recession, the usual strategy is to sell your defensive stocks, such as the banks, and buy cyclical stocks, such as building materials, media and resources, to ride the recovery.

Cyclical industries include resources, energy, financial services, real estate and discretionary retailers that benefit from consumers having more disposable income. The big mining and energy stocks — BHP, Rio Tinto, Fortescue Metals, Woodside, Oil Search and Santos — are typically high-beta (that is, they tend to move with the market index) because they are most leveraged to the world growth cycle.

Other cyclical stocks — which tend to move with business and economic cycles — include Qantas, IAG, Ampol, Steadfast, Corporate Travel Management, Qube and Suncorp. The building materials stocks — CSR, James Hardie, Adelaide Brighton and Boral — tend to be cyclical, as do the discretionary retailers such as Myer, JB Hi-Fi and Harvey Norman.

Other stocks considered cyclicals are jobs websites operator Seek, car sales website operator Carsales.com and real estate websites operator REA Group, and the stocks that are attached to the automotive industry, such as ARB, AMA Group, Bapcor and AP Eagers.

Scooping the small-caps

Small-cap stocks are those with a small capitalisation or market value. However, if you’re a large fund manager, small capitalisation may be any share valued at less than $1 billion on the stock exchange, or it could be those outside the top 50 by market capitalisation, or the top 100.

Picking successful smaller companies is harder than picking good big companies because generally, you have to do your own research. Find out as much as possible about the company; reading its announcements to the ASX provides a lot of information on the company’s performance, along with its most recent annual report from its website.

Small-cap stocks are difficult to research. However, because most investors are concentrating on the larger stocks, you may be able to find an overlooked company that is already making a profit. When the rest of the market finds your stock, you can sell at a profit. That’s the theory, anyway! Many small companies don’t ever get picked up. If you have an eye for a good product with growing earnings and dividend streams and a sound balance sheet, buying small can be rewarding.

Punting on speculative stocks

Speculative stocks are those with the most risk but which offer potentially the highest returns. They have no track record and offer only the excitement of a good blue-sky story — the prospect of riches.

Because the Australian sharemarket relied on the Resources sector for such a long time, investors have a history of backing speculative companies. Mineral exploration companies are often in the middle of a boom-and-bust speculative investment. The Poseidon incident in 1969 is one of the most famous speculative debacles. From 1999 through 2000, investors bought speculative stocks (in this case, technology stocks) that were doubling, tripling and quadrupling in a matter of days. The fundamentals of investment such as profit, dividend and interest cover were irrelevant. When the companies didn’t produce earnings, technology shares tumbled. In the 2000s, the speculators favoured any stock drilling for copper or uranium, or working in drug development. Technology was back in favour in the second half of the 2010s.

The Australian sharemarket is full of speculative situations — the resources explorers can still soar on good drilling results, and they have been joined by many technology and biotechnology stocks that have a similar leverage to good news. Good drug trial results and announcements of tie-ups with big global pharmaceutical companies usually have the same effect on a biotech company’s share price that spectacular drilling results have on a resources explorer’s.

While it is risky, investing in speculative shares, if done with a small percentage (5 or 10 per cent) of funds that you’re prepared to lose, can be lucrative and fun. Stocks do double, triple and quadruple in value; ‘ten-baggers’ — even ‘20-baggers’ — do come along, but not often.