Capacity for poor returns
For the third year in a row, the equity market has sold off, beginning in mid to late April. On each occasion the correction has been more than 10% from the prior peak. May saw the full force of this retreat in equity prices with domestic cyclicals such as Bluescope Steel, Myer and Fairfax reaching all time low share prices, and BHP and Rio revisiting GFC levels.
Amidst the chatter, market tumult gives rise to pause for thought as to what we consider to be enduring truths. Our investment philosophy is premised upon equity valuations reflecting sustainable returns on capital, and arbitraging the differences between these valuations and security prices, which often better reflects spot returns on capital. Our process should hence be directed only to two ends; what the likely shape of the cashflow profile for a corporate is through a cycle and secondly, what is the right multiple to pay for that cashflow stream, given an assumed long run bond rate and our assessment of the specific fundamental risk attaching to that company.
All of the above seems pretty straightforward. Alas, the same factors that have caused instability in markets in recent years, and have been exaggerated in recent weeks, have also caused us to revisit some of these assumptions, at a macro level as well as an individual corporate one. Bonds, specific company risk factors, and forecast cashflows are all being priced as being in zugzwang – every contemporary move is a losing one. We have consistently written that we agree with this view – using monetary stimulus to attempt to remedy a debt crisis is doomed to fail. So long as this is the principal policy response, the compound effect of these influences naturally translates into market volatility.
The multiple we use to capitalise the cashflow stream for a corporate is based upon an assumed bond rate, inflated by a fundamental risk premium attaching to that company. Bond rates in Australia are currently at a record low of 2.8%, having rallied 1.3% through the past quarter, which is the largest rally (by a long way) in the developed world through that time. US 10 year rates are half of Australia’s, and also at record lows, and in May Germany and Switzerland issued negative coupon bonds. The justification for investing in a negative coupon bond is something we are more than open to hearing; the only logical explanation that occurs to us is the view that deflation is far more likely than inflation, which (because of excessive capacity additions in capital stock through the past cycle) is the view we have held and expressed for some time. In the meantime, we need to use a sustainable long run bond price assumption in determining the multiple we apply to earnings when constructing valuations. This assumption was 5.5%, and had been for many years; we changed it to 4% during the month, reflecting the sustained period of low growth in earnings we anticipate will accompany the nascent deleveraging besetting the developed world.
As we await the great deleveraging to truly commence – McKinsey recently updated their G10 debt to GDP analysis, and highlighted that only three member countries (South Korea, Australia and the US) had reduced this ratio since the GFC in 2008 – those resistant to this path unsurprisingly continue to garner political acclaim. The election of French President, Francois Hollande, on a platform opposing austerity – after all, why should the French pay their own way if the Germans remain happy to pick up the tab? – logically heralded the acceleration of market moves. This month sees further elections, and a good bet would be that self-interest continues to prevail. The inevitable call for further monetary intervention has arisen, but this is the economic equivalent of putting fuel onto a bonfire without a match, unless fundamental reform (such as recapitalising the European banking sector) accompanies it. The US used the euphoric market reaction to the introduction of Quantitative Easing to recapitalise their banking sector; in not doing so with their own system, the Europeans have wasted the same opportunity that was presented with the introduction of the LTRF programs of last December and February. Bond yields, consequently, remain subject to ongoing volatility and compression, and the greater implication for equities from this reduction in the risk free rate is not the implicit multiple boost, but rather the reduction in secular growth rates that can be expected in a deleveraging environment.
The assessment of fundamental risk attaching to equities – the risk of permanent impairment of capital – is also currently undergoing secular change. At a sector level, the aggressive addition of capacity to an industry without regard for appropriate return has been the hallmark of failures in the financial system, across borders, in recent years. Credit negligently extended to US homeowners, and more recently European sovereigns, has led to similar outcomes.
It’s not just in the financial system where capacity additions have led to poor returns. Steel is a poster child of these phenomena. A decade ago, global steel production was 600m tonnes, of which China accounted for 5%. Today, apart from China, capacity remains at 600 m tonnes; unfortunately for global industry returns, China has added more than 600m tonnes of capacity itself through that time. The results are predictable. The China Iron and Steel Association (‘CISA’) announced that year to date profitability in the industry had dropped 96% on a year ago, to US$180 million. Helpfully, CISA postulated that poor profitability reflected “… increased steel output in China combined with slower growth of demand …”. These principles seem to work across borders, industries, time and political philosophies!
The aggressive addition of supply in products is clearly a concern to us when calibrating long run return assumptions for an industry and the companies that operate within it. We highlighted steel above; although logistically more problematic, cement may yet suffer the same fate, from the same source. Globally, the telecommunications industry has been beset by poor returns caused by supply additions ahead of demand through the past decade. Finally, but less obviously, retail industry returns, especially in Australia, have suffered from increasing competition from online channels. One of our portfolio managers recently returned from a global trip which included meeting with Nordstrom, the US department store, which observed that Australia is their third largest geographic market, after the US and Canada, even though they hadn’t advertised in Australia! For Myer and David Jones, this new source of supply of competing product is a less obvious but just as potent form of capacity addition in the industry; and the impact upon returns has been just as savage. As we noted upfront, both Myer and Bluescope Steel hit all time lows recently because of these secular changes in their operating environments.
By way of contrast, the best management teams have adapted to the environment around them. We rate James Hardie management as highly as any management team, given their ability to grow the business – the US is 90% of James Hardie’s business, housing starts in that market peaked five years ago and have since dropped 75% and yet the EBIT per US housing start that Hardies generates has almost doubled since that time – whilst maintaining very high (that is, greater than 50%) returns on investment. Just as importantly has been capacity management. James Hardie management have shut or mothballed plants ahead of falling levels of demand, and reduced capital expenditure savagely – last year the amount spent was the lowest level in a decade. The two major competitors in the US market for fibre cement are losing material amounts trying to compete with James Hardie. James Hardie has been a strong performer through the past year, unlike the other building material related stocks in the market (CSR, Boral and Fletcher Building), and its ability to set the price in its markets for the products it sells, and to maintain a position as the lowest cost producer in its markets, are the differentiating characteristics which have led to its relatively strong performance.
The Managing Director of Boral, Mark Selway, left his post during the month, after a tumultuous two and a half years in the role. Undoubtedly, Boral paid too much for acquisitions during this tenure, although the Chairman has confirmed to us that all of these transactions had unanimous board support with respect to both the assets themselves and the prices paid. If this was the negative, it appeared to us that the positive attaching to Mr Selway’s tenure was his focus upon operating returns and accountability. For example, Boral has led the way in reducing industry capacity through the past year, albeit at a short term cost; also key management personnel benefits paid, halved during Mr Selway’s tenure. Net, given a stretched balance sheet meant that no further acquisitions were possible (or being contemplated), we found the decision a curious one, albeit possibly an insight into the escalating pressures boards as well as management are facing as the domestic economy slows. Another poor performer was Hastie, which was placed into administration during the month. Incorporating a roll up of unrelated businesses, cashflows which rarely matched reported profits, an acquisition agenda instead of a strategy, fraud and an effectively open ended guarantee given to Middle Eastern counter parties which saw little reason to pay for work completed, we clearly made many errors when assessing Hastie. Any value that arises from this investment experience now is in how we adjust our behaviours and analysis. Rest assured we are acting accordingly.
Portfolio outlook & strategy
What does well as equity investments in Australia in this context? It’s hard to go past price makers and management teams showing an ability to generate productivity gains as a good start. As the RBA has noted, human nature means that productivity gains usually lag a poorer economic environment, and hence Australia has a currently poor productivity environment. By definition, then, many of the companies we can nominate as doing a good job on this front – James Hardie, Brambles, Amcor, CSL – have significant operations in the Northern Hemisphere. Many domestic industrial stocks, such as manufacturers, telcos and retailers have started down the productivity path. Banks are in a nascent (and currently fumbling) stage. Resource stocks have only through recent weeks started to concern themselves with such boring matters, given the ongoing lure of high prices. Our relative portfolio positions reflect this progression.
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