Are we living a ‘Truman Show’ reality?
Even ugly ducklings can grow up to be swans someday and we have started to observe a number of fallen stocks recover and perform well this year as either management teams change (vis APN) or new owners perceive value where the stockmarket didn’t (Wotif.com). That is a good segue into the dramatic reemergence of M&A both locally and globally. This shouldn’t be a surprise really. We are in a situation of record low interest rates, relatively high equities valuations, low organic growth, strong balance sheets and most dangerously of all, board confidence.
Dealogic, an organization which tracks global M&A deals, reported that Global M&A volume reached U$1.83tn in H1 2014, up 41% on the previous year and the highest level since the first half of 2007. During July, Australian small caps saw one major deal as Expedia bid for online travel agent Wotif.com in which we were a shareholder. Frustratingly, over our holding period we did not make money on this position as we had owned it much earlier and our entry price was above the Expedia’s takeover level. The Wotif.com deal is an interesting one, however, in that it demonstrates the need in our job to constantly reconsider how we look at things. Viewed from one angle, Wotif.com looked like a stale online business with a high but mature market share gradually being circled by larger and more aggressive global competitors looking to make a meal of it. Viewed from a different angle however, and clearly the one Expedia saw, taking over Wotif.com was an opportunity to consolidate the Australian OTA (online travel agency) market, cut costs (since Expedia has already developed its own technology it can simply re-deploy this into Wotif.com) and ultimately raise commission levels by several hundred basis points. Wotif.com charged the lowest hotel commission rates in the country and in spite of raising its commission levels to 12% of sales, was still 3-4% below comparable rates that Hotels.com and Expedia charged. Thus a takeover at around 10x EBIT with cost savings, topline synergies and an industry structure improvement behind it makes it look like a staggeringly good deal for Expedia even at a 25% premium to its closing price.
There was more talk of takeovers in July as the press debated the ROC Oil / Horizon merger, the Woolworths (South Africa) bid for Country Road and David Jones and in larger cap territory KKR’s bid for Treasury Wine Estates. So, we are firmly back in the bankers dream scenario. What does this tell us about the market? Very often capital market interest peaks at close to market peaks. Investors tend to act pro-cyclically – in other words they provide capital when everyone else is and shun investments when everyone else is shunning them. This rarely leads to great investment outcomes. The hubris spreads and companies get drawn into bidding for other companies, usually destroying significant amounts of shareholder wealth in the process.
Investors in equities should heed the actions of some the great long term equity players like Buffett and Baupost’s Seth Klarman. Buffett’s Berkshire is currently sitting on $50bn of cash, the largest cash holding he’s ever had. Klarman’s fund was sitting on 40% cash at the end of 2013 and he returned a whopping $4.0bn of cash to his investors. Klarman has likened the current market environment to the Truman Show. The Truman Show was a 1998 film starring Jim Carrey who lived in a Plexiglas Dome bubble where everything was completely manipulated unbeknownst to Carrey’s character. His life was broadcast to the outside world and all the people in Carrey’s life were actors. Klarman continues “but there is one fly in the ointment: in Bernanke’s production, all the Trumans – the economists, fund managers, traders, market pundits – know at some level that the environment in which they operate is not what it seems on the surface”. We suspect the “Trumans” will be mad as hell when the production brought to you by Central Banker Brothers Inc draws to a close and the ‘Dome’ comes down.
So, should you go to cash? How and when do you best invest? Charlie Munger reminds us to “Look for more value in terms of discounted future cashflow than you’re paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favour”. Let’s consider cash for a moment then. On face value cash is a pretty dumb investment. The entire return on cash is income. This means you pay your top marginal tax rate on the returns. At present, if you are a higher income earner, after paying close to 50% tax on your interest rate of 3% odd you are barely keeping up with inflation. By the way, 3% cash return is pretty good in a global sense nowadays. The UK, US and EU all offer cash rates well under 1%. So, if you are extremely risk averse, whilst being in cash may make you feel safe, it’s going to make you poor in the long run. Why do some of the best investors then like to hold cash? There are several answers but the most colourful belongs to Buffett ; "If you are trying to shoot rare, fast moving elephants it always pays to carry a loaded gun". Translation - cash gives you the liquidity when you need it to move quickly into a better mispriced investment. Cash is an open ended call option to invest back into an undervalued investment – normally when the other “Trumans” are heading for the exits wearing significant losses on their breathless overpriced investments.
You can probably tell from the above text that we are not bullish at the moment. There are more signs each day that we are heading toward a market top. We should clarify that we love equities long term and enjoy picking up and investing in great businesses run by highly capable people. We don’t like overpaying for this privilege however, and increasingly the jewels are not lying around in the rough where we like to find them they have been exalted and are being held on high by a cheering crowd of Trumans.
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