The Festival of Dangerous Ideas
September in Sydney ended with the production of “The Festival of Dangerous Ideas”. It’s a talkfest, but could well be the title for global markets and politics in recent years. September saw the same trends as in recent months, just exacerbated. Sovereign bonds mostly rallied, except for those PIIGS (Italy is a new member) nations where leverage and poor productivity have combined to see asset values exposed. Equity risk premiums around the world continue to increase, now to record levels, as the paradigm of bonds being lower risk than equity has been replaced by an investor experience of bonds being no risk, and (net) equities being no gain. Policymakers have been the greatest ally of bondholders, as their propensity to use taxpayers money to prevent bond holders experiencing any loss whatsoever has been boundless, whilst equity holders have been afforded no such protection. Short term rallies in markets occur, usually, in response to a “We will do whatever it takes” comment, but soon peter out as the triumph of rhetoric over action has a decreasing half life in financial markets.
Deleveraging is painful, for investors and corporates, as Australia is currently experiencing, albeit in a very mild form relative to that being experienced by the Northern Hemisphere citizenry. We think this theme of deleveraging, along with another theme of productivity, will both prove long run drivers of investment returns. This will impact the Australian market, as we have discussed previously, through both operational leverage and financial leverage.
Among industrial stocks, the downside of operational leverage has been most felt by retailers. To give some context, though, household debt to disposable income ratios at 160% in Australia is four times what it was in 1990. This is the highest ratio, now, in the Western world, and well ahead of the US at 120%. Whilst the path is obscure, an end point of continuing to borrow more to consume was always likely. Unemployment is still at markedly low levels in Australia, even though consumer confidence is low and savings rates have improved, hence retailers may be in for further pain. Landlords to retailers need to be careful in assuming their current revenues are robust, and that the multiples paid for their properties will continue at the mid teen levels experienced through the past decade.
The other major victims of a reversion of operating leverage to longer term norms are resource stocks. Throughout September, as commodity prices faltered from their all time highs of the prior month, share prices moved markedly. Many of the worst performers in the poor overall market were the high cost, short mine life producers and/or explorers, which is a natural reaction to their stellar performance of prior years as commodity prices rallied. Our long run assumption for all commodities continues to be the 90th percentile of the cost curve; giving us a suite of commodity price assumptions still well below current levels for all but aluminium. Energy and materials were the worst performing sectors for the month and quarter ended September. We continue to be underweight these sectors, albeit we selectively see value in the lower cost, longer life producers.
We believe that companies that will perform best through a deleveraging cycle will be those with two characteristics, namely pricing power and a sustainable balance sheet. Pricing power is oft talked about, but rare; it is the ability to set the price in the market you operate in without losing material share. A good example is retail banking in Australia. As a group, the major banks set the price in Australia, having repriced through the past two years, and gained share (pre GFC banks wrote 75% of owner occupied mortgages in Australia, now it’s 95%). Banks are often spoken about as obvious losers in a deleveraging environment, however this ability to set the consumer price is not shared by their peers in many other countries, especially the US. The capital, liquidity and regulatory imposts facing the Australian banks both before and immediately after the GFC have largely eased, and whilst they will always remain highly leveraged to the value of assets they finance and hence prone to large write offs through a cycle, the market is now pricing in worse returns than we feel is likely. Financial leverage has hurt, and will continue to hurt, those without pricing power more than it will the major Australian banks.
Executive compensation is back on the agenda. There is little doubt that executive compensation in Australia is excessive; the more important issue is that it is misaligned. Incentives should not be a contrary indicator to the investor experience. We recently made a submission to Treasury on our ideal model for executive compensation, advocating all incentive payments be determined by reference to net tangible assets per share growth through time, and settled in unvested shares that vest progressively through a medium to long term. Meg Whitman recently accepted the role of CEO of Hewlett Packard and has a base salary of $1. Steve Ballmer, CEO of Microsoft, has a base pay of $650,000, and a bonus last year of the same amount. For the Head of Human Resources at one of our major companies to receive $5m this year highlights the discrepancies in Australia. Boards need to address the issue, and the two strikes rule may bring it to a head at AGMs in 2012.
Finally, the passing of Steve Jobs has just been announced. Capitalism is best served by those who create intangible value; in other words, durable earnings streams spawned from genius and not just balance sheets representing the accumulated industry of prior generations. The commercial and consumer world benefits in two ways from such true entrepreneurs; not just in the form of products created through their endeavours but also by the creation of a benchmark for what can be done, to which all can aspire should they dare. For example, we believe one of the best managed companies in our universe to be James Hardie. Even with US housing starts at 50 year lows, and 75% below the peak of five years ago, James Hardie generates returns on operating capital in the top quintile of stocks in our universe. We asked James Hardie some time ago which companies they benchmark to, as no other construction materials or building products company in the world gets close to their operating returns. Their reply was “Apple”, because everything consumers see is the result of strong organisational disciplines; meetings start and end on time, with clear purpose and accountabilities, and capital (including time and effort) is applied in a rational and focused way. The Pixar principals’ said Jobs’ only ever had one suggestion for them; “Make it great”. The best outcomes for all of us. as investors, consumers and citizens, is when more companies and governments act in the same manner. This may well qualify as a thought for the next Festival of Dangerous Ideas.
Outlook & strategy
Our fundamental outlook remains largely unchanged. The reality is that large price moves now far better reflect the economic challenges we have consistently spoken to and still see as confronting and unresolved. Globally, both the US and now the EC have seen economies and markets assailed through too much debt and inflated asset prices, still to be written down to fair levels. It may be because of concerns that such a path may yet lay in front of them, that the Chinese are not keen to use their own stores of liquidity to recapitalise Europe. The same major themes are affecting the Australian markets, augmented by commodity prices continuing to trade at levels well above what we consider long term sustainable prices. Our portfolio is positioned accordingly, with a bias to industrials with earnings exposure to economies where we believe upside to mid cycle exists more than can be said to be the case in Australia, or with exposure to domestic industries where cyclical debasing has already occurred, such as pathology. These ongoing risks have indeed become amplified the longer they remain unaddressed, and this will continue. This balancing act has dominated out thinking in constructing the portfolio through the past three years, and continues to dominate our assessment of future likely returns, which have of course increased as market prices have fallen, but also risks, which are yet to materially abate.
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