The Australian equity market continues to trade at mildly high multiples, albeit with an extreme spread between the highest multiples, which are at dangerous levels, and the lowest, attributable to material stocks of all sorts, whether they are miners or suppliers to miners. Earnings growth also remains muted, with revenue growth almost always less than volume growth, even in industries where volume growth is strong, such as building materials.
An absence of pricing power and low growth rates are in line with the way we thought economies may progress, but we did not envisage a successively narrow market leadership, driven by ever more expensive industrial stocks, already earning higher than sustainable margins. To make sense of this we have needed to resort to the eternal wisdoms contained in the classics, especially five sage insights from Niccolò Machiavelli’s “The Prince”.
“All courses of action are risky, so prudence is not in avoiding danger (it's impossible), but calculating risk and acting decisively. Develop the strength to do bold things, not the strength to suffer”.
Well, Mike Kane from Boral certainly took this advice. Since assuming the role of CEO in October, 2012, he has disposed of the plasterboard business into a joint venture (JV) with the global product leaders, USG, formed another JV in bricks with CSR, sold its concrete masonry business to Brickworks, outsourced IT and shed 1,400 jobs and more than 50 sites across the organisation. Of the senior executive team in place at the time Mike assumed the CEO role, fewer than 20% remain in place. Having said that, structural pressures on earnings remain immense – even with housing starts at 1,000,000 in the USA and 200,000 in Australia this year, EBIT will still be lower than any year between 2002 and 2009, and yet Boral’s market capitalisation is higher than almost any period through that time. Boral, as with Fletcher Building, is decisively managed, but now needs to execute very well to achieve market expectations.
In contrast, Cameron Clyne retires as NAB CEO having undertaken no M&A of note since assuming the role in 2008 (thanks to the Federal government blocking the crazed attempt to purchase AXA), and with an executive team largely intact. As is the performance record – the third successive NAB CEO to come fourth in a race of four. In assuming the CEO role at NAB, Andrew Thorburn may need to read “The Prince” for a host of reasons, and we hope he follows Mike Kane’s example and “acts decisively”. NAB remains the biggest bank by assets and the smallest by market capitalisation, because it earns the lowest return on assets of the peer group. Contrary to myth, this does not reflect underlying industry returns for retail banking in the UK (which are stronger than in Australia last year), but rather poor execution, across several divisions in the NAB group. Our overweight position in NAB remains, and our patience remains eternal.
Government intervention remains a high risk for equity holders across many industries. “He who seeks to deceive will always find someone who will allow himself to be deceived” is not just an appropriate axiom for those looking to sponsor initial public offerings, but applies just as strongly to those investing aggressively into heavily regulated industries. Ask the Chorus shareholders. Or, for that matter, Telstra’s of several years ago. Or the casino operators in New South Wales and Queensland, or regulated utilities. None of these industries enjoy a more favourable return environment than they did several years ago. The exception, of course, are the miners, who didn’t play nicely, but left a legacy of no Resources Super Profits Tax (RSPT), and an absence of political will to float the potential for one anytime soon. The tradition of regulatory interference is now continuing, albeit in the form of increasing taxation on foreign operations, a slightly different guise. Amidst a profit upgrade released through March, Macquarie Group also noted that this year their tax rate will be about 38%, well above the nominal corporate tax rate. Through the past several years, this rate has been far lower; below 20% in 2007 when profits were at cyclical highs. Macquarie expect their tax rate to remain high for many years to come, as northern hemisphere governments, especially, look to balance fiscal budgets. Even the more prosperous are taxing the foreigners. Hong Kong is applying a 15% stamp duty on foreign purchases of property and doubling stamp duty for all but resident first home owners. David Murray remarked once that the traditional path faced by governments seeking revenue is to tax foreigners (they don’t vote), and fixed assets (that can’t be moved). That playbook remains fully afoot.
Finally, “where the willingness is great, the difficulties cannot be great”. Many doubted that the major miners could focus on free cashflow, let alone well exceed their targets of a year ago. Au contraire; they have executed this well. It is a course now open to the energy stocks as they mature their CSG investment programs. In turn, we are overweight both sectors, and as they have struggled with relative performance that position has only increased. To be fair, many of the better performing industrial stocks – Carsales, Seek, Flight Centre and REA Group, for example – have also produced strong cash flow, albeit they are now priced for perfection, with no scope for slippage on operational excellence. James Hardie remains the operational excellence exemplar in the portfolio, albeit with its large outperformance through the past year we have reduced our position, as is the case with Macquarie.
“Of mankind we may say in general they are fickle, hypocritical, and greedy of gain”. Many of the traits which characterised the market boom of 2006 through 2008, before the GFC, are again in force. Who would have thought a property trust would be cheered for using debt to buy 20% of a property developer, as Stockland has done with Australand during March, only six years later. Equity markets have risen apace for several years now, at a much faster rate than earnings growth. One to two years ago, given low bond yields and the prospect of them going lower, and low multiples for equities, we thought buying equities was a credible investment strategy. That is now subject to some caveats. High multiple stocks, which on the ASX are almost wholly industrial stocks with a technology tinge, are now at multiples so high they have never before presaged gains for investors. Whilst materials stocks remain reasonable value, due to the cocktail of better than expected outcomes for volumes and prices, and capital and operating costs dropping dramatically, they are yet to outperform. Price momentum has been king; the best predictor of next month’s outperformers has been last month’s outperformers, increasingly, through the past year. This cannot last, as the 2006 and 2007 markets reminded us, “This is a common failing of mankind, never to anticipate a storm when the sea is calm”.
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