Building castles in the air
What to make of the current environment? If one’s field of vision is restricted to the stock market, the world’s problems are a distant memory. The fundamental economy in most regions remains a less rosy picture. Why the dichotomy? In part it comes back to an understanding of what drives markets. The answer, in the short run, is confidence and money. Though some, often wearing corduroy jackets with suede elbow patches, remain of the view that the stock market epitomises efficiency, rapidly assimilating all available earnings information into stock prices, those who occasionally venture off campus are generally less convinced. By definition, markets are places where buyers and sellers meet. For a market to rise, the value of buying must outweigh the value of selling, however, the overall amount by which the market rises need not bear any relationship to the value of this excess buying. In simple terms, the value of stocks owned by all those who choose to sit on their hands and neither sell nor buy today will be impacted by the enthusiasm or otherwise of those that do choose to trade. In this way, it is possible for a few hundred million flowing into the market to create billions in additional market capitalisation, and vice versa. We are firmly of the view that it is always wise to keep this in mind, as markets are inherently fragile, and as policymakers play the game of injecting more liquidity they will become more so. Markets in stocks, real estate and bonds are vastly larger than they were a couple of decades ago, and keeping the size of the flow proportional to the value of the stock is becoming increasingly difficult.
We would also make a few observations which we believe are interesting on the trends in both earnings in the economy and stock market performance over recent months. The first is the exceptionally strong performance of the financial sector relative to the real economy. Since central banks have made clear their intention to prop up dodgy assets and zombie banks at any cost, huge amounts of money have gone into the system. Most of it has remained firmly stuck in the financial system and has not permeated significantly into the real economy. It has ensured that banks borrowing costs have fallen significantly as yields on debt instruments have rallied sharply and driven significant earnings gains as interest margins widen and bad debts evaporate (or at least get shunted down the road). In combination with an investing public desperate for yield, the cocktail has been potent. Of the $1.24trn in market capitalisation in the S&P/ASX200, the financials account for 43%, about 6% higher than the same time 5 years ago. Within it, banks have risen from 19% to 29% over the same time frame. Although we understand the role the financial sector plays in the economy (it does pay us after all), we cannot change the fact that it is designed to facilitate the real economy, not take over it. When we look further at the incentives for bank lending and find that capital requirements and available profit margins dictate a strong preference for lending against housing, not exactly the use of funds likely to most enhance long term productivity, you get some idea of why we remain concerned about the end game. Economies such as Germany are healthier than those of Spain because they are built on sound foundations rather than castles in the air. Australia will be subject to the same rules in the long run.
Businesses seeking to deploy the capital channelled (or supposed to be channelled) through our financial intermediaries continue to enjoy far less rosy conditions. Resource and energy projects remain dogged by ludicrous blowouts in capital expenditure (I suspect “Gorgon” is becoming an expletive in the hallowed halls of Chevron’s head office), whilst finding customers for the end products is proving a little harder than planned. Despite the need for spending on new infrastructure, the combination of labour rates and productivity which are making Australia one of the world’s most expensive countries, a government so mired in bureaucracy that nothing gets off the ground and traffic forecasters that couldn’t lie straight in bed, is ensuring that conditions remain challenging. Hopefully we will wake up at some stage and realise that while sound financial institutions are important, the way we use the money they channel is more important.
A second trend of interest is the increasing enthusiasm with which investors are greeting profit improvement driven by price increases. Eclipsing even the banks in terms of profitability are the domestic insurance companies. Both IAG and Suncorp added to already exceptional gains over the past year on the back of continuing price increases in response to a period of extended catastrophe activity. The fact that much of the cost of catastrophes is borne by reinsurers, and their rates have not risen nearly as far as feared, together with more benign catastrophe activity in the short run, is allowing insurers to aggressively expand margins. Similar action on pricing is supporting the expansion of already high margins in online businesses such as Seek, REA. REA are enjoying significant success in convincing punters to pay extra for an attractive red border around their property ad (obviously likely to attract the browser that can’t resist an impulse purchase of a $2m house)! Whilst these strategies create undoubted value in the form of near term profits, we almost universally treat them with a high degree of trepidation. Why? As we’ve repeated on numerous occasions, one of the most valuable attributes for a business in our minds is duration. Equities are priced largely as perpetuity cashflow streams. The question of whether the cashflows are sustainable in the long-term is almost always more important than their quantum in the current year. Whilst it is crucial that companies seek to earn the best returns possible on their capital employed, how they do it is equally important. The best companies in the world are constantly reinvesting to maintain and grow their market position and reduce their costs versus competitors. It is also why we will almost universally prefer businesses which have latent pricing power but tend to leave it unused and reinvest in strengthening market position over those that fully exercise it in the short run. The results of businesses such as Brambles pleased us for exactly that reason.
And finally, succumbing to our (almost) monthly tendency to twist the knife in the back of mergers and acquisition activity, we must draw attention to a few more candidates supporting our notion that serial acquisition based growth strategies remain one of the surest ways to drive value destruction. SAI Global, Sonic Healthcare, QBE Insurance and Computershare are all businesses which we believe have fundamentally sound operations, and in many cases, a number of the acquisitions made over the years have been very sound. However, like the blackjack table, the odds are always stacked against you and if you don’t walk away, you won’t win. These businesses are at various stages of pain and recovery from playing at the table too long. The ramifications of failed acquisitions are rarely thought about at the time. As JFK famously said, “victory has a thousand fathers, defeat is an orphan”. The departure of Marius Kloppers as the CEO of BHP Billiton during the month was a salutary reminder. Marius undoubtedly accomplished a great deal during his tenure at the company, and his initiatives in improving the pricing mechanisms in commodities such as iron ore will create enduring value, however, a misstep in the M&A arena proved fatal. As always, the accomplices to the misstep generally seek to move into the shadows at the back of the room.
Our curmudgeonly instincts dictate that we will always spend a disproportionate amount of time worrying about what may go wrong rather than what could go right. At the current point in time we find ourselves struggling for reasons for fundamental optimism. Undoubtedly, there is significant potential for markets to rise further. This rests almost solely on the issues raised earlier surrounding the flow of money and the race for yield. Reading the newspaper daily will provide an endless stream of individuals prepared to provide a forecast for returns during the next quarter or year. We will leave commentary on the short term to them, as our crystal ball remains permanently clouded no matter how much we rub it. Our focus will remain on the structure and foundations of the economy and the businesses within it. The path forward seems to us to depend on a couple of major factors. The first is whether banks choose to loosen the purse strings again once balance sheets have been rebuilt through the benevolence of central banks. If lending does accelerate, the more problematic issue will be their ability to find productive ways to deploy lending. As infrastructure around the world crumbles, and real investment struggles to earn even mediocre returns, the outlet for new lending seems more likely to be a further inflation in the price of the existing housing stock and financial assets. If this is the case, we can guarantee it won’t end well. The more positive outcome will depend on some effort being directed into fixing the mistakes of the past rather than repeating them. Many companies are on a sensible path in this regard, acknowledging the need for productivity gains in both labour and capital. We feel relatively certain that this is more likely to hold the secret for future success than cheap money, bloated financial intermediaries and a government sector that would currently struggle to operate a successful chook raffle.
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