Band-aids to the rescue
February saw a return to relative calm in financial markets. The LTRO (Long Term Refinancing Operation) in Europe has allayed concerns over a liquidity crisis and allowed Spanish and Italian banks to borrow funds from the ECB at negligible interest rates and reinvest the proceeds in their respective countries’ government bonds. Distressed government bonds in these jurisdictions have thus rallied, improving funding costs for governments and carry trades are improving the apparent profitability of suspect banks. Everyone’s happy. Those professing the ‘muddle through’ prognosis can claim success for the minute (despite having offered no explanation of how a ‘muddle through’ thesis might manifest itself) and rallying markets have provided policymakers some breathing space. So how comfortable should we feel?
Risk, from our perspective, remains elevated and is becoming increasingly so. The possible scenarios and outcomes are numerous; however, those which appear genuinely good for investors are elusive (other than for the ‘muddle through’ proponents where ignorance and lack of thought remove the need for concern). Will the quantitative easing and near zero interest rate policies prevalent across much of the world cause an inflationary spiral? Will the liquidity be retained by banks to erode the cost of bad loans and therefore not facilitate new lending? Is there demand for new lending from an ageing population anyway? Will aggrieved capital providers rebel against disguised theft and precipitate renewed financial crises? I certainly fall miserably short of the levels of wisdom necessary to answer these questions, however, I would suggest that those professing greater clarity are even less wise. Mark Twain, as always, captures the issues better than most: “When I was fourteen, my father was so ignorant I could hardly stand to have him around. When I got to be twenty-one, I was astonished at how much he had learned in seven years”. Policymakers, having operated in a calm and reassuring environment for an extended period, pronounced the death of inflation, forecast endless strong growth, low inflation and an end to economic cycles. Reality has shown them up as cocky teenagers with a whole lot to learn!
The remedy of ultra-low interest rates and quantitative easing concerns us greatly and is a major reason we remain wary. The list of potential problems is long, however, a number are now readily observable, both in investor and company behaviour. Low rates encourage demand to be brought forward and discourage savings. They also spur asset price inflation and apparent wealth, fuelling an increased risk appetite for financial leverage. As capital searches for return, they incite currency wars, distort exchange rates and risk the wastage of vast amounts of capital. As these distortions occur, most are welcomed by investors as signs of renewed economic growth and returning market activity. Company level examples of such activity were plentiful during February. Billabong was the leading performer as prospective private equity bids at progressively higher prices propelled the share price, while Pacific Brands also saw an unsolicited approach. Takeover speculation drove Echo Entertainment as Crown accumulated a 10% holding and sought regulatory permission to move higher, and Goodman Fielder rose courtesy of Wilmar International accumulating a 10% stake. Fortescue Metals was also buoyed on speculation that cashed up global miners would prefer to overpay for existing mines than through the hard work of growing organically. Not a lot of jobs or new assets are likely to be created by any of these transactions, but they’ll put a bit of cheap debt to work. Companies will claim to be targeting 15% returns through such deals, however, the temptation of cheap debt and earnings accretion means they’re likely to settle for far less.
The potentially greater mischief in ultra-low rates lies in the longer term. Despite the fact that policymakers are experimenting in unknown territory, theories applied to investment remain largely unaltered. We continue to use and calculate terms such as WACC (weighted average cost of capital), net present value, equity risk premia and risk free rates as though nothing much has changed. Most of this theory rests on the presumption that future value will be worth far less than today’s value, meaning that long duration assets and liabilities are vastly reduced when discounted to today. We are less than sure that these traditional assumptions will prove well founded. The recent decade’s experience of rising asset prices and subdued consumer prices could well be inverted. Challenging these assumptions has profound implications. Businesses with excellent duration, pricing power and low gearing could become worth far more. Companies and governments with shorter dated cashflows with less pricing lower and large liabilities (particularly pensions) could be worth far less, as time fails to erode the value of these liabilities. We have not even come close to solving these problems from an investment standpoint, but we’re fairly sure that blindly following accepted wisdom will prove debilitating from a wealth perspective.
Results season proved relatively unsurprising, with far more of the more substantial price moves driven by corporate activity prospects rather than mundane factors such as earnings and cashflow. Mining services providers generally fared well, with buoyant activity flowing through to exceptional activity levels and expanding margins for many. Although many businesses have done an excellent job capitalising on the resource sector’s desperation for volume growth, we are less than convinced that many have suddenly become excellent long-term investments. Share prices of NRW Holdings, Boart Longyear, Macmahon and Campbell Brothers would indicate that many do not share our longer term caution. The other side of the ledger was generally characterised by a significant number of slightly disappointing results, rather than a raft of disasters.
The concernsaired above should largely explain why the somewhat stronger performance of equity markets over the past couple of months has not imbued us with a newfound sense of optimism or risk appetite. This in no way reflects an inability to find businesses that we believe will be very sound long term investments, but more an overarching landscape which remains devoid of appetite for trying to resolve longer term problems and instead focuses on applying band-aids to deep wounds. The band-aids may be justifiable, but co-incident efforts need to be made to address the root cause of the problems.
Our views on the types of businesses which will thrive in a challenging global environment remain largely unchanged. Despite muted reactions to results, meetings with companies such as Brambles, CSL and Cochlear gave us great confidence that there remain many companies that are genuinely managing their businesses to sustain their duration and grow value in the long term rather than purely optimising short-term earnings and pay packets. If, as we expect, duration and quality become more important themes going forward, these efforts will undoubtedly pay off.
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