Same issues, same result
Same issues, same result. The Australian equity market continues to trade at high multiples, albeit with an extreme spread between the highest multiples, which are at dangerous levels, and the lowest, attributable to material stocks of all sorts, whether they are miners or suppliers to miners. Earnings growth also remains muted across the board, with revenue growth almost always less than volume growth, even in industries where volume growth is strong, such as building materials.
An absence of pricing power and low growth rates are in line with the way we thought economies may progress, but we did not envisage a successively narrow market leadership, driven by ever more expensive industrial stocks, already earning higher than sustainable margins. Banks and property related stocks doing well; material stocks, especially those commodity related, faring worse. Same issues, same result.
One of our portfolio holdings, Macquarie Group, has been the best performer among major stocks on the ASX through the past quarter (other than Toll, boosted by the benevolent Japan Post bid). Since the GFC, Macquarie has been re-invented; its group earnings are now dominated by its fund management business. Whilst its most recent strong performance may have been driven by a US$4b acquisition of an aircraft operating lease portfolio, Macquarie Asset Management is now half the group profit and more than half the group valuation. As asset prices have risen, and fund management companies have been rerated as earnings have risen (to well above mid cycle levels), the Macquarie share price has risen accordingly. Whilst front page headlines still focus on the capital markets part of Macquarie, combined the Capital and Securities segments are now worth a fraction of the Funds Management business unit, and it is hard to see a path where that reverses. Our position in Macquarie when it was aggressively growing its mortgage book and the Funds Management business was large and profitable but undervalued, was easy to justify whilst it traded at a material price to net tangible asset discount to the major banks; given its outperformance through the past year, that is now far less the case.
For five years now, there have only been two drivers to trading bank profit growth in Australia – loan volumes and falling bad debt charges. In its last annual report, for example, the Commonwealth Bank of Australia (CBA) showed a five year summary of their financials. Margins have been flat, and non interest income has grown at less than 1% compound through that time. All revenue growth has been driven by loan growth, and almost all loan growth has been mortgage related. Similarly, CBA have grown share most aggressively in personal lending through recent years. CBA management have contended to us that in a downturn they will always outperform; given the high starting multiple, and the aggression with which asset growth has been pursued in recent years, this will be interesting to watch as this cycle unfolds. Paying out more than the cash they generate in dividends means that on a yield basis the banks look ever more relatively tempting as cash and bond yields fall, but fully dimensioning the downside as bad debts escalate has proven elusive to model for the 18 countries in the G20 that have endured recessionary conditions through the past decade. Au contraire, no country has had a bad debt experience less than that modelled. Capitalising current dividends for the banks in Australia may prove optimistic. Capital invested poorly ultimately has a price, even if it is not always obvious at the time; same issues, same result.
What transpires as optimism, of course, is never evident when conditions are strong. Ask all those singing “Stronger for Longer”, not just late at night, for several years until twelve months ago. Yet with an iron ore price now below US$50, and in turn the Australian dollar taken with it to now trade at .76 USD, the 99% fall in the share prices of second and third tier iron miners through the past twelve months may not yet be the end of it. Being overweight RIO and BHP, and in other commodities Iluka and Alumina, all low cost and lowly geared, has been the right place to be within the commodity stock spectrum. Holding any commodity stocks, though, has been exactly the wrong thing to do through this time in the context of the broader ASX200, which has been one of our grave errors. We still believe in the validity of our long held long run iron ore price of US$65 (the 90th percentile on the cost curve), and currency assumptions (.75 USD), and both BHP and RIO make high returns on capital at these prices. We are pensive, though, about how much time will be spent “under the curve” as demand continues to equivocate, even as the iron ore price wilts.
Demand has been elastic with oil, however, as the price has fallen. Annual growth in demand is stronger than it has been for a decade (with the exception of the aftermath of the GFC), and whilst US supply has yet to correct (although rig counts are down 50%), global supply has dropped for two months in a row. As with the miners, stronger for longer craze gripped the energy stocks in Australia, and they splurged capital expenditure in synch with high prices, always a poor cocktail for long run returns. The test is now whether they can pare capex, and to a lesser extent operational expenditure as well, back as energy prices remain low; our assumption is that each major can do so to such an extent that they need not raise equity. If or when energy prices again rise, the operating leverage will at that time work strongly in favour of the energy stocks; as we have seen through the past six months with Incitec Pivot. All of the same arguments about needing to focus upon return on assets rather than just asset growth apply to Incitec, and in turn it had been a consistent underperformer for several years, until the violent reversion it has enjoyed through the past six months. Why? Prices for some of its key commodity drivers, especially DAP (Diammonium Phosphate), have improved, seeing earnings forecasts stabilise and multiples rapidly improve from the low base of six months ago. We are unaware of prescient forecasts of improving DAP price fundamentals six months ago, although backfilling reasons as to why this occurred is now a top 40 hit, and extrapolating spot and ongoing growth from spot has now become fashionable. Multiples tend to amplify rather than smooth earnings cycles, as spot conditions, good and bad, are extrapolated. We believe that the path to riches for an investor is leaning against these cycles, rather than trading in momentum with them. This philosophy has been singularly unrewarding through the past year, albeit more successful through the longer run.
Ian Smith leaving Orica was warmly received by the market. Of course the reported behaviour was inconsistent with the standards of behaviour required of a leader of an organisation of 12,500 people, and hence it is not possible to argue with the end outcome. The process, nonetheless, left much to be desired, as indeed has been the case with Orica’s governance for some time now. It is difficult to reconcile the Board’s view of a requirement for a “change agent”, the reported catalyst for the hiring of Mr Smith in 2012, with half of the senior executive team receiving more than 100% of “maximum short term incentive payments” the year before. The plethora of confusion sure to arise in asking how it is possible to pay more than 100% of a maximum, behoves us to put that topic to the side for the purposes of this commentary. Generally, though, the payment of 100% of a possible short term incentive is reflective of outstanding performance – hardly congruous with the co-incident need for a “change agent”, and a classic case of words colliding with actions. We did feel a “change agent” was and is needed at Orica, as it needs to continue to transition from an asset growth mindset to a return on assets mindset. Orica made $1b of earnings before interest and tax (“EBIT”) in 2007; this year it will make just more than $900m, despite almost $4b being spent on capital expenditure through that time, and EBIT staying within a 10% range from peak to trough. Mr Smith introduced a culture which sought to stem operational and capital expenditure, in an endeavour to capture a return on the “lost decade”, which the numbers highlight was and remains sorely needed. The “how” of Mr Smith’s approach was unproductive, but the “what” was and is right. As equity holders, at the current market value we are being paid a 10% return (EBIT / enterprise value) to hold Orica, which in a 2% cash rate and 2.5% bond environment will remain attractive even if earnings are downgraded by a further 20% (and we note no market forecasts have Orica earning below $900m EBIT in any prospective year). Capital invested poorly ultimately has a price, even if it is not always obvious at the time; same issues, same result.
Many of the traits which characterised the market boom of 2006 through 2008, before the GFC, are again in force. Equity markets have risen apace for several years now, at a much faster rate than earnings growth. Two to three years ago, given low bond yields and the prospect of them going lower, and low multiples for equities, we thought buying equities was a credible investment strategy. That is now subject to some caveats. High multiple stocks, which on the ASX are almost wholly industrial stocks with a technology and/or yield tinge, are now at multiples so high they have never before presaged gains for investors. Whilst materials stocks remain reasonable value, due to the cocktail of better than expected outcomes for volumes, and capital and operating costs dropping dramatically, they continue to underperform, following underlying commodity prices. Price momentum has been king; the best predictor of next month’s outperformers has been last month’s outperformers, increasingly, through the past year. This cannot last, as again the 2006 and 2007 markets reminded us, and the only defence from the unwinding of the momentum trade is valuation. Ignoring it because this time is different is a peril; it was ever thus. Capital invested poorly ultimately has a price, even if it is not always obvious at the time; same issues, same result.
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