Damien Klassen

Focus on supply side when ‘D’ for demand is the issue…. “Fiscal cliff here we come!”

I wanted to talk about the Australian budget. I’m not seeing what the admirers are seeing. At first, I was worried that I’d missed something. But the dovish speech by Governor Lowe suggests the Reserve Bank are seeing exactly the same thing I am.

Four months ago, I wrote what good government stimulus would look like. This budget didn’t tick many boxes. Don’t get me wrong; the fiscal cannon is large enough to help. There is enough ammunition loaded into the cannon. But it has been pointed in the wrong direction. Which means it will likely need to be fired again within the next 12 months.

Supply side or demand side?

The budget has a huge focus on supply-side support. Supply is not the problem! Everyone has spare capacity. Demand is weak and needs help, not supply.

Giving money to companies to hire more workers when the existing workers are not at full capacity is not going to help. Giving companies tax credits to buy new equipment doesn’t help if the old equipment is running at 60% capacity.

We don’t manufacture in Australia anymore

So why do we want to give tax credits to companies to spend on capital? This expenditure will be heading directly offshore, helping other countries.

$30b on company tax incentives and another $1.5b on a Modern Manufacturing Strategy is a noble endeavour. But that money is going to buy Chinese, Japanese and US robots. I’m sure those countries will be grateful for the demand. Australian taxpayer-funded stimulus payments should really be targeted to support Australian jobs.

Isn’t an increase in capital expenditure going to reduce employment?

Some companies do have a good reason to spend on capital. The reason is to automate processes so that they can reduce staff.

This is not really what the government should be going for when staring down the barrel of the highest underemployment statistics of the past 90 years.

Australian budget fiscal cliff

The drop off in spending is really (really) large from Q3 to Q4. In Q3, government (and superannuation drawdown) support was over $100b. In Q4 it looks like being almost 70% lower. Q1 of 2021 will be 70% lower than Q4.

COVID is looking increasingly like a marathon. Australia came out of the gates sprinting; we’ve now dropped to slow to a walk. In three months, it will be a crawl.

The insolvencies haven’t happened yet. Another wave of infections is hitting Europe and the US. Demand has not recovered, even in largely virus-free countries. It is too early to congratulate ourselves on a job well done.

Where is the budget support for structural change?

The Australian economy was heavily reliant on education, tourism and population growth. None of those will return quickly.

So, you would think there are two choices:

1. Support the workers until those industries return
2. Help the workers get new jobs in other sectors.

I’m not sure which policies are designed to do either. There are some token amounts. But I’m not expecting the average (former) waiter or airline stewardess to transition seamlessly into a robotics role as part of a Modern Manufacturing Strategy.

The paradox of thrift

On one hand, the Australian budget takes away money from those on JobKeeper and JobSeeker who are most likely to spend the money.

On the other, it gives tax cuts to higher-income earners who are likely to save it.

I’m not going to argue the social case for or against. But the economic case is that already weak demand is about to be dealt another blow.

Net effect:

• Massive fiscal cannon, lots of ammo, aimed in the wrong direction.
• Expect the Reserve Bank to need to do more to make up for the misfire.
• A supply-side budget without precedent.
• Not Keynesian. Can’t call it Austrian. It isn’t MMT. It probably wants to be supply-side, but you would have to be an extreme trickle-down adherent to love it. The guiding economic principles are not clear at all.
• It will give a short-term sugar hit, followed by weak recovery, especially for wages.
• Expect corporate profits to be helped by lower tax rates but hindered by poor sales.
• Expect the government will need to do more. Hopefully, they will aim better next time.

By Damien Klassen, Australian wealth and superannuation manager

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Damien Klassen

The digital games and interactive media sector have captured investor interest during the COVID-19 pandemic, says Damien Klassen, Head of Investments of the superannuation and wealth manager Nucleus Wealth.

“The current high valuations these stocks are being accorded globally reflect strong market interest, although it remains a sector that’s under-appreciated by many investors.

“What’s also often not appreciated is the fact this sector was booming before COVID-19 with $US120 billion in earnings in 2019. To give that figure added meaning, one of the highest rating movies ever, Avengers: Endgame, grossed $US858 million in its opening weekend. By contrast, Grand Theft Auto V’s release earned $US1 billion in just over three days.

“Originally just a PC/console experience, ubiquitous smartphones are now raking in the cash. And, it’s important to note, the phone market appears to complement the PC/console experience, not compete with it.”

Klassen identifies five trends driving this sector. They are:

• The emergence of eSports: The global eSports audience grew to $US450 million worldwide in 2019, up 15% year on year. And this was before Coronavirus forced half the world indoors. Those under 20 are more likely to watch eSports than live sports.
• The move to mobile. Historically, digital games were the preserve of PCs and then consoles. Today, mobile games generate almost twice the revenue of PCs and consoles combined.
• Broadening demographics: There’s a stereotype that video games are the sole preserve of adolescent boys. The move to Smartphone gaming has seen games such as Candy Crush and Words with Friends effectively raise the average user age to about 35. Additionally, women now make up almost 50% of overall gamers.
• Evolution of the business model: Initially, game designers pursued a traditional software purchase model with dollars paid upfront. Now games have no upfront costs but use in-game purchases to generate revenue. These so-called ‘Micro-transactions’ accounted for four out of every five dollars spent on digital games in 2019.
• Geographic trends: More than two-thirds of digital gaming revenue is generated in Asia. The increasing affluence in China and emerging markets is another key driver of growth.

For investors, Klassen says there are a dearth of investment options in this space in Australia, with the only real candidate being Aristocrat (ASX: ALL) if micro-caps below a market capitalisation of $50 million are excluded.

“Aristocrat provides entertainment from casino-themed games such as Vegas Penny Slots or adventure games such as RAID: Shadow Legends. These are free to play but make money through in-app purchases. This shift to digital games now generates around 40% of its revenue, with recent comment by Aristocrat indicating revenue is up 20% due to COVID restrictions.

“For the brave-hearted, there are four micro-cap options (see Appendix A). But remember, they are mostly early stage and capital hungry. They should be regarded as venture capital stage opportunities, not dissimilar to listed bio-techs, where the risk to capital is high because you are more exposed to the success or failure of an individual game than the industry’s growth.

“There’s also the option of investing offshore, with US-listed video game companies such as Activision Blizzard, Take-Two Interactive providing a pure play, or, for a more diversified exposure, via a Sony, Google, Apple and Microsoft, with all four having significant exposure to the growth of gaming.

“For a more targeted Asian focus investors could target some of the big Chinese stocks such as Tencent Holdings. But buyer beware. There is political risk in these stocks as the situation currently unfolding with TikTok highlights.”

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Damien Klassen

ESG (Environmental, Social and Governance) is one of the fastest growing trends in investing globally. It has become part of the funds management zeitgeist, aided, in part, by research pointing to better performance by fund managers that favour companies with good ESG policies and practices.

The recent decision by the Trump administration to restrict the ability of US pension funds to invest in companies espousing ESG principles has thrown a spotlight on the issue once again.

Unabashedly progressive fund manager, Damien Klassen, head of superannuation and wealth manager Nucleus Wealth, and fund manager who predicted the COVID-19 crash in March – and took his clients out of the equity market beforehand – has a special interest in ESG.

His firm gives individual investors and SMSF trustees the option of filtering investment portfolios to avoid investing in more than 30 ESG categories, including tobacco, armaments, fossil fuels, gaming, fast food and even genetically modified food

“We recognise ESG is not a one-size-fits-all notion.

“One investor may have a disdain for tobacco companies and be happy to own gaming company stocks, while another may not care about either but have a strong view about not investing in fossil fuels or armaments manufacturers. Nucleus Wealth is a rare fund manager that allows a totally bespoke and individual approach to ESG.

“With funds of $US9 trillion ($13 trillion) under its control, the US Department of Labor says that fund managers acting on behalf of American workers should only follow ‘objective risk criteria’ when buying stocks and bonds,” notes Klassen.

“The language of the proposed policy reaffirms the standard interpretation of fiduciary guidelines that only financial risks and returns can be considered in the management of US employer-provided pension funds; ‘non-pecuniary goals,’ for example relating to political or public policy, should not guide pension investments.

“Rarely if ever do I agree with Donald Trump but there are strong arguments that the ‘E’ and the ‘S’ are factors better suited  to other actions by investors, such as making a donation to a cause, lobbying government on an issue or not taking up new capital raising.

“Not buying a firm’s shares on the secondary market has virtually no impact on a company. Boycott a company product by all means – but company management cares much more about product sales that who buys their shares. For instance, groups like Mad F—–g Witches and Sleeping Giants in Australia are said to have played a role in the decision by Nine Radio and Alan Jones to part company due to consumer boycotts they promoted on his show’s sponsors.

“Further, our review of the growing body of research data shows that’s its G – Governance – is the key variable of performance

“On the issue of climate change, activists would, I believe, be better advised lobbying governments to join the list below than avoiding buying the shares of a fossil fuel producing company.

“Getting your country on this list or reducing the time to phase out will have far more effect than convincing a fund manager not to buy the stock.

“Don’t get me wrong. I want investors to avoid buying shares in companies where they don’t agree with the ethics. But if they truly want to make an impact, don’t stop there. And if they are avoiding buying solely for performance reasons, the primary spot to focus on, we believe should be ‘G’ – governance,” says Klassen.

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Damien Klassen

Diversity issues have exploded into the global zeitgeist over the past few months as Black Lives Matter protests have rocked cities around the world.

Locally, AMP’s decision to appoint and executive with a (verbal) sexual harassment transgression on his file to a CEO position has focussed attention on the group’s lack of females on its board (one) and management committee (one).

“Increasingly, we are finding that for some clients a lack of diversity in companies is important and consequently we have added ‘diversity’ as an ethical exclusion, says Damien Klassen, head of the Melbourne-based superannuation and wealth manager Nucleus Wealth.

“This gives investors the option to strike companies from their portfolio that don’t have enough gender diversity in their board and management team.

“In an investment climate where diversity, specifically gender and race, are front of mind issues in the community generally two questions are suddenly more prominent.

“Does diversity improve financial performance? And, how can I, as an individual investor, express a preference for companies with diverse boards and management?” says Klassen.

Klassen notes that from an investment perspective, diversity is an interesting concept.

“There have been a lot of studies into the diversity of gender and race on company performance with, yes, diverse results. It still appears to be a good, but far from infallible, indicator of more innovative companies.

“On the positive side, group diversity increases networks, resources, creativity, and, importantly, innovation. On the negative side, more diversity can lead to less communication, increase group conflict, lower satisfaction and increased staff turnover.

“From a quantitative perspective, corporate governance is a factor that outperforms, that is, companies with good corporate governance tend to perform better than those with weak corporate governance.

“For governance scores however, we use them as a negative screen rather than a positive one. That is, bad governance can make a quality score worse and therefore the company needs to be cheaper before we buy it.

“But we are not choosing to buy a company with 42% gender diversity over the one with 39% on that measure alone. Many of the governance scores are like that – there is a definite ‘bad’ option, but we believe there is little sense trying to rate the difference between two good options.”

“As for how individual investors can express preferences for companies with diverse boards and management, Nucleus Wealth is one of a small number of fund managers that allows investors a deep, bespoke approach to ESG and that now extends to one of its subsets, namely ‘diversity’,” says Klassen.

Nucleus manages stocks within the domain of the 1600-company MSCI World Index, a common investing benchmark containing only very large companies.

Every investor’s stocks are held in a separately managed account (SMA), meaning they can filter investments for major all ESG metrics including, now, diversity.

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Damien Klassen

One of the most significant global trends in investing at all levels, from mum and dad investors to the largest institutional organisation such as major super funds and hedge funds is restricting the commitment of funds to companies that have passed an ESG filter test.

The shorthand term is ‘ethical investing’.

Environmental, Social and Governance is defined by Investopedia as:

“Environmental criteria look at how a company performs as a steward of the natural environment. Social criteria examines how a company manages relationships with its employees, suppliers, customers and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits and internal controls, and shareholder rights.”

Why is ESG investing on such a roll?

According to Damien Klassen, the CEO of wealth and superannuation manager Nucleus Wealth, one of the few fund managers that provides investors with the option to personalise their ESG preferences, there are two main drivers.

“First is the logical reason that an increasing number of people worldwide don’t want to financially support companies whose activities they may disagree with, or at least do not actively support. For instance, gambling, weapons manufacturing, cigarette and tobacco production and distribution, petroleum, coal mining and so on,” says Klassen.

“Second, is that there is a body of research promoted by various ethically investing organisations, such as the Responsible Investing Association of Australia (RIAA), that purport to show that investment returns are greater for ethically operating companies, that is, with a positive ESG rating.

“But a word of caution: ESG is no ‘magic pudding’: it is possible for ethical funds to perform better, but it still requires investors to do their due diligence.

“There are 1,600 stocks in the MSCI World Index – a common investing benchmark containing only very large companies. If you give fund manager A the ability to invest in any stock and fund manager B the ability only to invest in 800 of the better ethical stocks, then you are asking fund manager B to beat fund manager A with one hand tied behind his back.

“The good news? Reducing the opportunity set that a fund manager has doesn’t affect performance too much – especially if you are only cutting out a few sectors. There are plenty periods where fund manager B will outperform.

“The bad news? If fund manager A and B have the same skill, you must expect the ethical one, in the long run, to have the worst performance. However, it can play out differently in the real world.

“For example, over the past few years, the oil price fell from $100 + to less than $20 and stock prices of oil companies plummeted. Energy is generally negative in ethical screens and so managers who couldn’t invest in oil stocks (the ethical managers) outperformed those who could (everyone else).

“In the other direction, there are funds that exclude only tobacco, and these funds over the past 10 years have generally underperformed the world index as tobacco stocks rocketed up,” says Klassen. (Chart below)

You know it makes sense!

According to Klassen, if there is a cause an investor is passionate about and wants to support companies in that area, there are four options, in order of the most helpful to least helpful:

1. Make a donation. Are you trying to help or are you trying to make money? If it is the first then by donating you can feel good straight away, you get a tax deduction up front (rather than waiting to book a capital loss when you sell shares!). Donating directly to companies is not generally tax deductible – but if your cause is ethical then there likely will be industry bodies that are tax deductible.
2. Buy the product yourself. Most companies want more customers rather than more shareholders – and the ones that don’t you shouldn’t be investing in.
3. Buy shares from the company in a capital raising. That way your money will actually go to funding the company expand or its research and development.
4. Buy shares on the market. This is the least helpful way of helping the company. All you have done is transfer money to another investor.

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Damien Klassen

Nucleus Wealth, the Melbourne-based wealth and superannuation manager that predicted the ‘Covid-19 Crash’ and took all clients’ money out of risk assets before world markets fell dramatically in late February, says market and business conditions are ripe for a global depression.

Head of Investment Damien Klassen says Nucleus was on alert for any event that might end the current economic growth cycle – one of the longest on record – so when news of COVIS-19 broke we did an in-depth study of issues relating to the pandemic, creating a database of cases where the disease was contracted, not diagnosed.

“Based on this evidence, we got an insight into the rapid growth in cases caught outside of China because the number of cases exported from China fell (after travel bans), offsetting and hiding the rapid growth in home-grown cases. On this evidence we made the call to dramatically de-risk client portfolios.

“Today we remain deeply pessimistic about the outlook for markets and the global economy with no plans to rush back into equities or risk assets. The Covid-19 situation is severe, deep and disarming, but the overlay of other factors on top of the pandemic is why we are adopting a wait-and-see attitude.

“Elements of that pessimistic overlay include the fact that corporate debt is at record highs (see chart). When corporate debt peaks there is almost always a recession. And central banks have just about run out of conventional monetary policy.

“Many companies run ‘just-in-time’ inventory and have very little slack in the supply chain. Now there is a supply shock for companies from shutdowns and quarantines, as well as a demand shock from closures and quarantines.

“There has been a massive hit to consumer confidence – it was poor before Covid-19 and has now fallen off a cliff – as well as business investment from this uncertainty.

“We expect the de-globalisation of supply chains and trade will have echoes of the reduced trade during The Great Depression (see 1929-1933 trade graphic).

“All of these factors lead to dramatically higher unemployment rates. Unemployment does not bounce back quickly – hiring takes months, especially at larger companies. The rise in unemployment by 10 million people in the US in a matter of weeks is unprecedented.

“Our forecasts mean we don’t expect The Great Depression 2.0 to be as prolonged as the original, but current indications are that unemployment will be similar, possibly worse.”

Klassen remains wary of lifting tough social restrictions too early. “Singapore and Japan are going back to extreme measures, despite early success, because this virus is so pernicious and the fact that people without symptoms carry it and pass it on with ease, without either side of the ‘virus transaction’ being aware of what’s happening.

“Until there is a vaccine, or at least an anti-viral agent where people who have the virus can be treated, we are in dangerous territory.

“The implications for managing our clients’ money is that we will continue to be defensive, accumulating quality stocks at opportune times. Our focus will be on preserving clients’ capital within the parameters our clients signed on to which is only investing in blue-chip liquid assets.”

Nucleus has more than $100 million in separately managed accounts for individuals, SMSFs, private companies and in regular SG superannuation accounts. In March, performance for the Nucleus Tactical funds ranged between +0.1% to -1.4% verses stock markets down more than 20% (see chart).

A suite of portfolio options is offered to superannuation and non-superannuation clients, with Nucleus placing a premium on risk control, investing only in blue-chip liquid assets (cash, government bonds, the top 80 ASX stocks and the top 1600 global stocks) in separately managed accounts. Clients can customise their portfolios to meet ethical, risk and income needs.

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