Same song still on repeat
Investment strategy of recent years has been somewhat monotonous. Martin Conlon, Head of Australian Equities, discusses one the most frequent asked questions we face is: What is the catalyst for these trends to change?
Investment strategy of recent years has been somewhat monotonous. The sequence can be roughly described as follows: 1) Buy every safe haven asset one can think of; 2) Wait for another piece of disappointing economic news; 3) Cue another promise of further monetary stimulus; 4) Await further elevation in the value of aforementioned safe haven assets driven by ever lower discount rates; 5) Repeat. Like all well learned routines, behaviour becomes ingrained. Investors have grown accustomed to risk assets underperforming regardless of valuation, and vice versa in the case of defensive assets. Incentives to invest in long dated capital investments subject to free market pressures have all but disappeared. When no-one is underwriting the returns on these investments and on the other side of the ledger, financial assets are providing assured gains underwritten by central banks and offering vastly superior liquidity, one should probably not be surprised as to where the money has gone. In this environment, it is equally unsurprising that one the most frequent asked questions we face is: What is the catalyst for these trends to change? Our answer: We don’t know.
Nevertheless, we remain convinced the monotony will break. The fact that something has happened does not always improve the probability of it continuing to happen. We are more inclined to side with Isaac Newton in believing “For every action, there is an equal and opposite reaction” than believing in the existence of a ‘free lunch’ and the magical ability of economists to create prosperity out of thin air. The massive imbalances in the size of the financial economy relative to the real economy to which we have referred in previous months are the outcome of many repetitions of the above sequence. Every action has been at the expense of the real economy and in particular, those investing tangible capital, and in support of the financial. As investors are forced to contemplate the implications of the latest chapter in the policymaker handbook for global distortion; negative interest rates, assessing a development able to detrimentally impact financial profits rather than augment them, doubtless came as a shock. The share prices of banks globally suffered as their ability to pass on the costs of these nonsensical policies to the real economy was questioned. When hiding money under the mattress starts to deliver better returns than your cash management account and regulators are countenancing ways of reducing and removing physical cash, it’s fairly clear they are getting desperate. Little wonder the gold bugs saw more than a few rays of light in the past month or so.
Several of the anchors carrying the weight of the monotonous routine referred to above are increasingly weakening in our view, throwing into question an investment strategy entirely premised on buying bonds, REITs or equities that look as much like bonds as possible. While the simple questions of deteriorating central banker credibility, collapsing global trade in the face of increasingly protectionist behaviours and ever ballooning debts are important, the dysfunction and its manifestation is perhaps better examined by looking at a range of earnings results across market sectors.
The resource and energy sectors, amongst the largest investors of fixed capital in the economy, were perhaps the least surprising. Returns for shareholders are almost universally low to mid single digit or totally non-existent. The majority featured write-downs of both ill-considered merger and acquisition activity and/or over capitalisation of projects now facing a dire outlook. Whilst reactions ranged from the self-help of redoubled efforts to further reduce costs and control industry overcapacity to the reduction of dividends to both preserve cash and optimise the ability to take advantage of acquisition opportunities, share price reactions were telling. Alumina (+30.0%), South32 (+28.2%) and Iluka Resources (+23.9%) were firmly in the self-help camp. Rio Tinto (+6.7%) is perhaps trying to keep a foot in both camps, with a strong focus on costs yet a determination to keep the dinosaurs focused on production growth (despite having no relationship with economic value growth) placated, whilst BHP Billiton (+1.4%) opted for the savage dividend cut, relatively weaker cost focus and sought support for preserving firepower to pursue acquisition activity. Forgive our cynicism, but having extinguished sufficient value over the years in deals such as the Billiton merger and US shale investments to bankrupt virtually any other Australian company, we would prefer to be leaving Donald Trump in charge of US immigration policy than leave the BHP board in charge of capital allocation. The energy sector displayed similar dynamics. Origin Energy (+10.5%) and Santos (+6.4%) remain buried under the weights of excessive debts supporting projects now likely to deliver abysmal returns, with share price gains merely reflecting the derisory amounts of market capitalisation now left supporting these massive projects, leaving investors necessarily subject to extreme sensitivities in the value of residual equity. In connecting these results back to expectations of an ongoing deflationary environment supporting negligible interest rates indefinitely, we would suggest there is very limited scope for significant further price falls in these areas. As losses or unacceptably low returns permeate almost the entire industry and capital expenditure continues to be savaged, sustained further price falls (removing further value from the real economy) are not becoming increasingly likely. Additionally, if further deterioration occurs, it will inevitably require pain to be shared by debtholders, as equity buffers are negligible. We believe the vast majority of deflation is in the rear vision mirror, not through the windscreen.
The interconnection with other segments of the economy was also evident. It transpires that Aurizon (+13.4%) does actually require solvent coal and iron ore companies to support the value of its rail and rolling stock assets. Who would have thought! The dismal state of global trade and the shipping industry is beginning to impact the port business of Asciano (+1.1%), building materials businesses like Boral (+6.3%) and Fletcher Building (+4.6%) delivered modest returns despite a buoyant construction environment, and insurers such as QBE (-2.9%) and the commercial insurance businesses within Suncorp (-1.0%) and IAG (+2.5%) continued to struggle under the weight of surplus capital globally. All these observations cause us to question the expectation of ongoing deflation and its use in the justification of egregiously low interest rates. The intense pressure which these businesses are already under necessarily limits their ability to make ongoing future profit donations to support the financial asset Ponzi scheme and to contribute to the expectation of ongoing price deflation.
At the other end of the spectrum, companies enjoying the benefits of ‘capital light’ structures, which invariably means using the capital of others, are living the dream. It is ironic to say the least, to see infant formula producers making out like bandits while the producers of milk powder are being decimated by collapsing prices. Management of one company assured us that capital employed is no longer a relevant measure and that brand value and intangibles invalidate the relevance of measures such as price to book and support an acquisition based strategy with very healthy doses of intangible asset value. Forgive us for thinking it may not be ‘different this time’.
We do not pretend to understand where every risk lies, however, our sense is that the real economy is not positioned to be the perpetually disproportionate loser which current valuations suggest. There just isn’t enough profit left in it. Observations in results season only left us more convinced of the inability of ports, railroads, pipelines, shopping centres, airports and office towers to thrive without acceptable returns also accruing to those taking disproportionately greater risk. With a far greater percentage than normal of the world’s investment capital crammed into richly priced defensive assets and a pervasive belief in the inevitability of ongoing deflation in the real economy and underwritten stability in financial assets, the pool of candidates awaiting admission to this party may be dwindling. Should these conditions change slightly, the next tune playing at the party might be that of Martha and the Vandellas, introduced by Robin Williams in ‘Good Morning Vietnam’; “Nowhere to run to baby, nowhere to hide”.
The future path seems to us more likely to bifurcate. Either a methodology will be found to inject money into the real economy such that prices and activity begin to outpace the wild escalation in financial asset values, allowing egregious debt levels to ameliorate, or the financial asset values will need to retrace to match the ability of the real economy to pay. The obvious signal in following policies such as negative interest rates is that the rubber band attaching the value of financial assets to the economy which actually does something to generate the income for these assets, is stretched very tightly. The problem with this bifurcation is that the paths go in very different directions. In the former case, the profits of the real economy could be expected to benefit disproportionately, whilst the latter raises the spectre of which financial asset owners are decimated to restore balance. Our attempts to look through cycles still suggest that many of the businesses across energy, materials, industrial and consumer sectors, offer attractive long term value. Given the risks associated with the above bifurcation, we far prefer those with very conservative financial leverage. When we combine these with self-help efforts to lower costs and improve productivity, such is the case with aforementioned businesses like Alumina, Iluka Resources and South32, we are particularly comfortable.
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