Transcript Five questions for the CIO September 2017

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Jade Khao (JK): Welcome to Five Questions with the CIO. I'm Jade Khao, UniSuper's Private Client Advisor in Sydney, and I'm here with John Pearce, our Chief Investment Officer. John, our Australian economy seems to be doing as well as other developed economies, but our share market continues to lag. Why is this?

John Pearce (JP): It's a fair observation, Jade. Consider these facts. Over the last 12 months alone, the Australian economy has added 280,000 new jobs. We've now hit a world record. We're now number one in terms of years without recession. But you're equally right, and the stock market does appear to be lagging. Every day we seem to hear of record highs being made on Wall Street, and yet our market tracks sideways. It's not unusual to see this disconnect between the stock market and the economy. And it happens for various reasons.

One of the primary drivers these days is the performance of our banks. And I'd like to refer you to a graph.

Net profit versus share price

Our biggest bank is the Commonwealth Bank. And if you have a look at the Commonwealth Bank's profitability, you can see a nice steady increase. Those green bars are the semi-annual profits. Now, you'd expect that with a bank, because banks are tied to economic growth. Now, have a look at the orange line. The orange line is the CBA share price. And pretty much for the last two years, we've seen a downward trend in the share price because the share price is factoring in expectations—negative expectations about the impact of the bank levy, increased regulation, and general fears of a housing bubble looming.

The CBA, of course, is beset by its own woes. I'm referring of course to the AUSTRAC issue. And the CBA is not only our largest bank, it's our largest company. So the CBA is dragging down the whole market. There is a silver line to this grey cloud. The dividend yields of the four major banks are now averaging over 8% on a gross level if you include franking credits. And historically, that's proved to be pretty good value, particularly if the economy remains in good shape.

JK: So since the banks are making up so much percentage of our share market, does that mean we're missing out on the tech boom?

JP: The Australian market certainly is, and the contrast between our market and the US market is pretty much illustrated here when you look at the difference in the top five holdings of both markets.

Three year total return

As we said, the Australian market is dominated by the four major banks. Look at the US market—all five are high-tech companies. And look at the performance over the last three years. Really, spectacular returns for these tech companies, whereas pretty ordinary performance of our top five.

Now, it's not all bad news for UniSuper members.

Our global growth portfolios are heavily weighted towards the tech sector. And indeed, our best-performing options in the recent past, our Global Environmental Opportunities and our Global Companies in Asia, they've both got pretty heavy weightings towards the tech sector.

JK: That's good to hear, John. I've heard some commentators draw comparisons between our current tech boom and the bubble of the late '90s. Could we potentially be in for another dot-com crash?

JP: I'll show you another graph. And you can see here, the blue line represents the index of US tech stocks. You can see here at the turn of the century, the whole dot-com bubble and subsequent crash.

Tech company share prices

Now, it's taken us a full 17 years for that index to reach those previous highs. And whenever an index reaches a high, it typically does ring alarm bells. And I must say, we're a little bit cautious ourselves and we have taken some profits on some of our tech holdings. Having said that, I do believe that this time is different. Now, they're dangerous words, but I have reason to believe that it's a far more solid base this time.

Have another look at this graph. The green line represents the profitability of these companies. And what do we see? Leading up to that bubble and bust in 2000, earnings or profitability was reasonably flat. Yet after that, we've had a very steady growth in profitability.

Supported by highrer profits

Companies like Apple and Google, these are massive companies and they're still growing their profits by well over 10% per annum. Think about this statistic, if you take the top 10 tech companies, their share prices or market valuation has grown by about 9% over the period that we've discussed, yet their underlying profitability has grown by about 350%.

So you can see how we're built on much more solid bases. Now, there is a bit of a disconnect appearing between share prices and profitability. To me, it's the basis for a correction, but not the basis for a crash.

JK: On the subject of tech bubbles, what are your thoughts on bitcoin?

JP: Well, apologies to bitcoin fans out there, but the term ‘bitcoin’ to me conjures up images of what it must have been like during the Dutch tulip mania of the 17th century. And this might interest you, but during that period, a particularly rare form of tulip could buy you the equivalent of a very expensive beach house. Of course, that didn't end very well. And now we have bitcoin. And consider this statistic, so $1,000 invested in bitcoin in July of 2010, seven years later was worth about $81 million. Does that seem like a bubble to you? It does to me.

BitCoin Bubble

Now, what is bitcoin? Well, bitcoin is a cryptocurrency. That means it is digitally generated by computers. It is not backed by a government nor is it backed by a central bank. And despite this lack of official backing, bitcoin’s actually used in legitimate transactions. It's also used in illegitimate transactions. And now it's widely used as an instrument of speculation.

We are led to believe, that the supply of bitcoins will always be capped at 21 million. And that's given rise to the speculation. We have now people punting that, with a limit of supply and increasing demand, the sky is the limit in terms of the price of bitcoins. But of course, I don't buy it. And I think it will fail for a few reasons.

Firstly, I think for this to succeed, it is going to eventually require some sort of official backing. I don't think the governments will support it because it represents a potential threat to sovereignty. And I don't believe that central banks will back it because it represents a potential threat to their control over the money supply. Now, some people will say, "well, I don't really trust governments anyway", but that might be the case, but do I believe that, on mass, people are going to trust some anonymous computer programmers building some fancy algorithms? I really don't think so.

And then, of course, we have the price of bitcoin itself. A rising price will actually render it useless for transactions. Would anyone seriously consider selling their house for a bunch of bitcoins? Once again, I don't think so. The rise in the price of a bitcoin will attract potential competitors.

And here's the point. There are already thousands of cryptocurrencies out there at the moment. In fact, in the next month alone, 140 new coin offerings are planned in the United States.

So there's nothing particularly special about bitcoin. I personally think it has all the hallmarks of a pyramid scheme. There’s going to be money loss, but UniSuper members can take comfort from the fact that we certainly won't be getting involved.

Jungle of cryptocurrencies

JK: I'd like to finish on a subject that I'm sure many of our members are concerned about, North Korea and the developments happening there. How do we manage this type of risk?

JP: It's very difficult, if not impossible, to actually manage this risk. To coin a phrase, there are simply too many unknown unknowns. Now, I think that's the reason why the market is seemingly taking this in its stride. The market just really doesn't know how to respond to this threat.

I've heard of experts wanting to put some sort of precise probability on the outbreak of war at 10% or 25%. This is pure guesswork and certainly not the basis for an investment thesis. Others would suggest that you have to have more cash, or government bonds, or gold in your portfolio. And I'm not one to advise people not to do this. You should always speak to one of our financial advisers. But I will say that these instruments are effective risk mitigators in a traditional crisis. We simply don't know how these things will perform in a nuclear situation.

The best we could hope for is sanity will prevail and a diplomatic solution is reached. Comparisons are being drawn with the Cuban Missile Crisis of 1962, when the world was at brink. Sanity prevailed then, and let's hope it prevails now.

JK: Thanks, John. If you have questions for John or feedback for us, please email us at Thank you for watching.

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