May you live in interesting times
When someone – purportedly Chinese – offered the proverb “May you live in interesting times” they were clearly referring to the current investment climate faced by Australian small cap managers. Whilst I say this with more than a hint of tongue in cheek I think the times certainly are interesting. Over the past month we’ve seen a strong reversal in the fortunes of the Australian dollar, a massive increase in the forecast budget deficit, a bounce in deep cyclicals and surprise, surprise we’ve learned that a prism isn’t just a glass used to refract light into the colours of the rainbow its also a clandestine mass electronic surveillance data mining program (PRISM). Being humble fund managers we just spend our time pondering stock valuations and looking for investment opportunities.
One of the things we consider on our clients’ behalf is where and how value is captured by an industry. If you had been told, for instance, that mankind would invent a means of placing you inside an aluminium transport tube, move you at close to the speed of sound, arrive safely 99.999% of the time and yet cost less than an equivalent car trip’s petrol costs you would have concluded that this was a supreme achievement. Given that this business is also cyclical, capital consumptive and logistically complicated you might conclude few competitors would enter the field and that the operators could make vast fortunes. Unfortunately that assumption would have been completely wrong. We are talking of the airline industry of course which has only made money on a global basis in 7 of the past 14 years according to the International Air Transport Association. In aggregate the industry is running at substantial accumulated losses. On the other hand, different parts of the transport value chain capture and retain far greater amounts of value – especially in relation to risk and capital employed. Online booking agents exemplified by companies such as Webjet, Expedia, and TripAdvisor and even real world travel agents like Corporate Travel and Flight Centre capture and retain decent parts of the travel ticket value. Similar logic applies with the accommodation industry where again the more capital consumptive and therefore lower return segments of the industry, ie the hotels, are substantially less valuable than the agencies and booking machines supplying it. Captivating and then capturing the customers therefore generally appears to be more valuable than supplying the actual service in many cases. Whilst taking all factors into consideration when looking for our clients’ investments, knowing which part of the value chain and why value accretes have tended to yield better results over time.
On the note of captivating consumers we have spoken in previous commentaries about innovation and the power of disruptive business models. Whilst we respect the power of innovation we are also cognisant of the fact that the speed of evolution in a technology laden world is becoming more rapid. The potential half lives of businesses are shorter. Visualise the impact tablet and mobile computing is having on PCs and the fallout being suffered by Microsoft and Intel. Whilst online business models are rapidly growing they are also prone to their own disruption via new superior models. Many of the larger US tech names with which we are all familiar, Facebook, Yahoo and Google for instance, are consistently looking for upstart companies that could take down their own citadels. The analytical community gasped when Facebook paid US$1.0bn for Instagram a year ago. Instagram was a start-up making no money which had only been founded two years prior. Similarly, Google paid US$1.65bn for YouTube when it was yet to make a profit. Both Instagram and YouTube had captivated consumers and were providing something which solved a simple problem for hundreds of millions worldwide – one simplified photo sharing, the other videos. When analysing internet opportunities in Australia we keep in mind the possible model changes that could be evolving in someone’s garage right now – technology models that are most likely making use of the social side of the internet as a tool of disruption.
The Australian dollar has been the other interesting mover during the month. Forecasting this whippet is like trying to control an angry child – and prone to just as much frustration! The once in a decade forces that had propelled the dollar to record highs against the rest of the world are now pretty well understood. Less understood has been Australia’s stance and relative position in the global competition to devalue. It is here I run the risk of stepping into unknown territory. Although we have an educated guess as to the path of the AUD we confess its short term movements are, relatively speaking, guess work. On a longer term timeframe, however, we believe in normalising global forces and the ultimate power of purchasing power parity to bring this unwieldy beast back into line. As such all our modelling assumes a long term AUD of around 75c to the USD… although we hadn’t expected that this apparently bearish forecast would start looking so realistic so quickly. One thing that has often occurred during periods of correction however is that the dollar over corrects on the way to its long run average. In the small cap space there are a few names in the portfolio with some reasonable international earnings. The Australian dollar decline will help mitigate our rapidly slowing resources industry and reduce the attractiveness of industries heavily reliant on importing. Sectors like retailing, international outbound tourism and autos are likely to see pressure on prices and margins but conversely domestic and international inbound tourism and education are likely to receive a welcome shot in the arm.
Our job as fund managers is never dull. Mark Twain wrote “history never repeats itself but it does rhyme” and this is true of the Australian business environment and investment opportunities as they constantly evolve. With interest rates at record lows, we suspect the market may continue to get driven higher in the near future. . The next 6 months is likely to see a re-awakening of the IPO markets in Australia and New Zealand as better market sentiment and higher valuations encourage asset transactions. We will selectively participate in these when we think the investment cases have merit.
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