'Oh, Inverted world'
Martin Conlon, Head of Australian Equities, gives an update on the effect of government policy on markets and unintended distortions for some industries, in particular business duration
‘Oh, Inverted World’ may be familiar to fans of indie music as the title of The Shins debut album, however, it is also a fair summation of our views on the world and investment markets. Fed officials are gathered at Jackson Hole determining what’s best for the US economy, the ECB is buying every corporate bond they can find at any price and the Australian Parliament is resuming, convinced they can be the engine of economic growth and stave off any downturn. None contemplate that they may be the source of low growth rather than the panacea for it. As focus heightens on the limits and unintended consequences of unconventional monetary policy, economists now believe the solution lies in more aggressive fiscal policy. History shows governments not to be the most effective spenders in the economy, so forgive us if we retain some cynicism on this course of action.
Insurance companies are front and centre when it comes to the impact of interest rate distortion, as they are obligated to invest in low risk assets to match insurance liabilities. The QBE Insurance (-7.7%) result typified the global environment. Insurance companies used to underwrite on the basis that the time lag between receiving premiums and paying claims would allow them to earn an investment return. As purveyors of financial capital, insurers now find the world awash with excess capital, resulting in ever greater risk for ever lower returns. Combined with virtually zero investment return, profitability is under intense pressure, even in a benign catastrophe environment.
As always, the government directed quagmire which is the healthcare industry led the way when it comes to economic distortions. It is clear the already high returns being earned by operators such as Ramsay are being extrapolated into the future given multiples of 20 times EBIT and more than 30 times earnings. We remain extremely wary of extrapolating ever higher returns for a business which already exhibits super profitability, earns virtually none of its profits in free markets and benefits from payers and governments convinced that constraining supply is the best way to control outlays, not to mention the aggressive use of financial leverage. We won’t even start on drug and medical device pricing, which again, results in outsized profitability and returns emanating from socialized pricing. When consumers believe a hepatitis C drug which costs $20,000 a dose actually costs $6, it shouldn’t come as an enormous surprise that demand is a little stronger than at the true cost.
Whilst we could cite other examples of ongoing and increasing distortion, it is perhaps worth touching on another glaring anomaly we see in market pricing; one prevalent far more in the mid and small cap end of the market. It is that of business duration. Discounted cash flow remains one of the weapons of mass destruction most readily available to financial analysts, due to the ease with which it facilitates a generic assumption that every business exists in perpetuity. Additionally, where recent experience has been favourable, this invariably provides the anchor for assuming this experience into perpetuity. A cursory examination of the facts would suggest the probability of businesses existing in perpetuity is neither high nor uniform. Perversely, as discount rates move ever lower, the importance of this duration continues to elevate. We often hear claims that scarcity of growth in the current environment should elevate the prices investors are prepared to pay for it. We feel the hiccups for stocks such as Blackmores (-21.5%), APN Outdoor (-34.9%) and Surfstitch (-33.3%) should be reminders of the importance of business durability to value in an environment in which infatuation with short term growth has become manic. They may be unfashionable, but long dated mine lives of businesses like Rio Tinto and BHP Billiton, or global pallet pooling businesses like Brambles with very high entry barriers might not have the short term growth of these ‘capital light’ peers, but evidence and analysis would suggest they are far more likely to be long duration assets than many of the ‘capital light’ peers in technology and consumer discretionary areas which are currently winning the popularity contest.
The aforementioned distortions which remain as prevalent as ever are amplifying the headwinds for some businesses and the tailwinds for others. This is likely to both enhance volatility and severely impact the usefulness of traditional valuation measures such as price earnings ratios, not to mention the discounted cash flow models used by those experts in the art of extrapolation. For those willing to look past current distortions and embrace duration rather than immediate earnings satisfaction, we believe opportunities are still relatively abundant despite market levels which remain artificially buoyant.
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