Living in Cloud Cuckoo Land
In the metaphorical market equivalent of a couple of Panadol and a good lie down, the best panacea for a resoundingly bleak outlook and seemingly insurmountable economic disasters is a couple of quarters of solid investment returns. 2012 ends having delivered strong returns in most global equity markets, Australia included, and on cue, confidence in future returns is recovering. Ben Bernanke must be pleased. Stage one in the meandering path of convoluted logic dictating that the artificial inflation of investment markets should eventually result in improved consumer confidence, increased borrowing and job creation, appears well on track. That is, if you ignore the fact that as yet there has been no increase in borrowing by anyone other than governments, and no job creation.
Whilst it is easy to be cynical and admonish policymakers for undoubted errors, mistakes will always be a fundamental part of the human condition. Our frustration stems far more significantly from the proclivity for dishonesty and deception and the lack of acknowledgement of these errors. An honest and frank admission that some mistakes have been made, would appear a prerequisite for progress. The debt situation confronting the western world is not a result of decades of sensible financial management. Slavish adherence to the belief that one has never made an error, despite incontrovertible evidence to the contrary creates less than promising prospects for improvement. Our starting position in investing your capital is one of acknowledging that our continual improvement will rely on identifying our (all too regular) flawed assumptions and challenging them. At present, life is a little more uncomfortable for investors, as some of the assumptions which are potentially subject to challenge are those that have formed the bedrock of investor education over recent decades.
The first is the simple issue of how we determine whether the market (or an individual company for that matter) is cheap or expensive. Our thinking, like that of most market participants has been shaped by the belief that government bonds represent our best estimate of the ‘risk free rate’ that investors accept in return for eschewing current consumption or alternative investments in favour of lending the government their capital. All other assets have traditionally been thought of as graduating up the risk spectrum from government bonds (by varying degrees). Working out which assets are the best value stems largely from identifying the level of risk in the cashflows and determining whether the current price offers sufficient compensation for the extra risk. This premise is being challenged on a number of fronts. As governments prove increasingly inept financial managers (possibly not such a recent occurrence) and the potential for default on a relatively large scale increases in probability, the position of sovereign debt at the pinnacle of the safety pyramid has become questionable. Further, as sovereign bond prices are manipulated by central banks, it is clear that this rate is no longer a true free market rate at which a government can raise capital to meet its funding needs. Lastly, as the ‘risk free rate’ gets progressively lower, the ‘risk premium’ or extra compensation that holders of riskier assets have traditionally sought, has become much larger relative to the absolute bond yield (e.g. an equity risk premium of 5% is far more material versus a bond yield of 2.5% than it was versus a bond yield of 10%). The aggregation of these assumptions into what we call a discount rate (or invert and call an earnings multiple) matters a lot. If we accept that all other assumptions remain unchanged (a state of affairs prevalent only in Cloud Cuckoo Land), and assume that the risk free rate is permanently lower, or that investors should accept lower risk premia, a stream of cashflows which was previously discounted at a rate of 10% might now be justifiably discounted at 8% (increasing their value by 25% even assuming no financial leverage whatsoever). The interactions above are largely behind the strong performance of equity markets in the past year. The cashflows we bought last year are assumed to be of largely unchanged quantum and the returns we’re prepared to accept on them have lowered (driving prices higher). For a range of reasons, including demographics and likely deleveraging, we have a reasonable degree of sympathy for some structural lowering of discount rates, however, this does not extend to factoring in current government bond yields as sustainable.
On the matter of Cloud Cuckoo Land and the likelihood of cashflow forecasts being unchanged as discount rates fall, we are less pliable. Assumptions should be internally consistent. If you accept that sustainably low growth and inflation can justify a 3% government bond yield, you cannot then expect the average company to grow revenue at 5%. The dynamics of a sector such as REIT’s are a case in point. If discount rates (cap rates) fall in line with bonds, this does not magically make every building in Australia worth more. Logically, the rates at which rents can grow should fall at approximately the same rate as the discount rate, neutralising the impact of the lower discount rate. This unfortunate reality can be problematic for analysts with a penchant for magically inflating valuations by assuming that growth rates apply to revenue but not to costs or the capital base. As a result, despite spreadsheets with more detail than the tax legislation and plentiful CFA qualifications, valuations have a decided tendency to be lagging indicators of stock price movements and make weather forecasters look like Nostradamus.
The final crucial assumption in completing the picture is that of risk. Should recent market strength be easing our concerns on the future? It is here we must take aim at one of our long term favourites, volatility. For some unfathomable reason, many investors continue to clutch tightly to the belief that it should provide a reliable indicator of risk. In our humble opinion, this belief is horribly misguided. Having seen solid gains in the market over the past year and some cashflow and confidence return to the equity market, volatility has eased and we can now all sit back in the knowledge that we’re past the worst. Volatility and the perceived riskiness in listed equity markets stems from a couple of simple issues. Firstly, as price is measured extremely regularly, the data points available for analysis and interpretation are plentiful. Measuring something more regularly has nought to do with underlying risk. Secondly, as a highly liquid, deep market with rapid settlement, equities are the way in which investors raise cash quickly. It’s not so easy selling a Pitt Street office block or an airport in T+3 without moving the market a bit! As superannuation funds and other investors crowd into infrastructure, property and similarly illiquid assets in the name of long term liability matching, equities are not only becoming a smaller proportion of overall portfolios, they are becoming the liquid tail which gets whipped around when liquidity crises arise. The more the tail gets whipped around, the riskier it becomes and more crowded the illiquid assets become as volatility is used as an input for portfolio risk. Gotta love that thought process!
Obvious sector trends during the December quarter were more difficult to discern than the strong yield bias that has dominated for much of the past year. As yet rejected acquisition attempts for Graincorp and Arrium saw rejuvenated interest in a number of out of favour businesses including Bluescope, CSR and Macquarie Group, although the desperate and dateless ball was not sufficient to see Billabong secure a steady dance partner. A significant rebound in the iron ore price also saw significant gains from Fortescue Metals, Atlas Iron and more subdued gains from the lower cost players Rio Tinto and BHP Billiton. Despite some dalliance with the dogs, yield remained in high demand, with major banks, particularly CBA, performing well, although less major banks, NAB, struggled to keep pace. CBA cracked the magic $100bn market cap mark, whilst NAB languished at the post-Christmas sale level of less than $60bn. REIT’s also maintained strong interest, with Goodman Group again amongst the leaders. After raising $400m in new equity in November and seeing China Investment Corporation sell more than $500m in stock during the quarter, the cynics amongst us might suggest there is some indication that the ducks are beginning to quack rather loudly in the sector.
From our perspective, the gradual shift of interest rates towards zero and the inflation in the value of other investments as investors search for return, must be gradually additive to risk. Call us illogical, but the addition of further borrowing to an already highly leveraged system and the provision of capital at progressively lower rates of return for progressively lower quality uses, is unlikely to result in a less risky investment environment. This does not mean that we believe equities are a poor avenue for deploying capital relative to other assets, it means that we will not react to increasingly aggressive valuations with increasing confidence. We remain of the view that sustaining strong and acceptable levels of profitability is far more likely to be an issue for investors than undue focus on the multiple which is being accorded, as the re-rating which has benefited equity valuations remains immaterial versus that applied to bonds over recent decades. None of this avoids the issue that significant capital has been misused and destroyed over an extended period, and papering over cracks with intervention and artificially low interest rates will not fix the house. Nevertheless, we must invest in the environment which exists, rather than an alternate reality which we might desire. We remain of the view that progressively less productive intervention and an inability to indefinitely borrow more from tomorrow to prop up today, will eventually undermine the profitability of companies accustomed to artificial tailwinds and unwilling to position their business for tougher times (it will undermine some governments too). Pricing power, sensible leverage and a proactive approach to cost will remain the order of the day. We’ll aim to minimise dalliances with the dogs, though unlike many central bankers, we are human!
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