Sustainability - the calibration of fundamental risk
Sustainability is the calibration of fundamental risk, especially those risks beyond the short term. The Australian equity market through May saw this (un)sustainability, writ large, expressed in returns, through all of cyclical risks, operational risks and social licence risks
The cornerstone for our process is simply valuing stocks by applying a multiple reflecting the likely duration of excess return to a sustainable ebit (earnings before interest and tax). Whilst much work is done on competitive return periods, the bigger determinant of returns is correctly calibrating sustainable ebit, which relies not just upon normalising cycles but also dimensioning the underlying structural growth and free cashflow for a company (as opposed to its most recent experience and the attendant hype or despair).
May saw the retracement of many stocks that have enjoyed cyclical buoyancy, especially those exposed to the domestic consumer. Whether or not Amazon is entering the market, domestic consumption has been boosted in recent years by strong employment and loose consumer credit policies. If a consumer cycle and the consequent operating leverage for retailers is the 2017 equivalent of the commodity price cyclical experience of 2014 through 2016, we are still yet to be confronted by a credit cycle, and yet normalising for this may yet be the most important calibration of all. Whilst cyclical factors drove some sectoral and stock performance in May, so did structural growth and free cashflow (or the lack thereof); this can often be masked through a roll up phase, as shareholders in some telco names ultimately found, to their cost.
The biggest adjustment to sustainable ebit, though, often comes about through social licence adjustments, often in the form of government interference in the market. In recent years, examples arise across sectors. The NBN rocked the Telco market; Aged care facilities (and GP’s and diagnostic providers) have felt the wrath of policy in the Healthcare sector; and when profits were at a cyclical peak, the Resource Super Profit Tax was mooted for the major miners. In May, whilst global equity markets rose, the Australian market index fell, largely because the Banking sector fell 9% in reaction to results where 1% earnings growth on 5% credit growth became the new norm, but moreso due to the Federal budget announcement of a $6b levy over four years imposed upon the four major banks and Macquarie.
The rationale for the levy has four sources, in our view; and one major consequence. A paperwork trail from “official sources” legitimising the economic basis for the levy given a quantification of the earnings benefit each of these five receive as a result of the implicit government guarantee; secondly, the behaviour of the banks in passing through out of cycle rate rises in the past two years, increasingly without an economic basis other than “because we can, and we need something to get this year’s profits above last year”; thirdly, the sheer quantum of profits made by the sector (pre tax profits of $60b), and finally, the fact that globally, special taxes, levies or penalties upon the banking sector are now the norm, and in not having them, Australia was the exception. It may well be bad policy, but the world is awash with it, just as it is structural deficits and desperate attempts to narrow them by Governments looking to tax any socially acceptable source, whether it is “foreigners” buying real estate or excess returns generated in industries benefiting from state subsidies.
The paperwork trail started in late May, 2016, when a press article quoted a Reserve Bank internal report which noted that the four major banks and Macquarie received two notches of rating grade support by Standard and Poors and Moodys because of “perceived government support”. It quantified this benefit at between 20 to 40 basis points, per annum, since 2000. The government’s response to the financial system inquiry, noted that steps should be taken to reduce the implicit guarantee provided to these five recipients. A year on from the article, and the Federal Budget announced a 6 basis point levy on wholesale liabilities for those five banks, in an endeavour to raise $6.2b in revenue over four years. The major banks have disclosed that they anticipate the levy will cost them less than $1b per annum; the likelihood, then, is that the levy will be increased in coming years, especially in the event of a change in government, towards the UK rate (21 bps) but hopefully as owners of bank equity, below France (50 bps).
Rather than seeing the initial press report as a warning sign (where did that report come from? Who commissioned the RBA to do that paper and why? Who alerted a publisher that such a paper existed and could be accessed under Freedom of Information, and why?), in the year between publication of the article and the announcement of the levy, the major banks put through out of cycle rate increases which amounted to billions of dollars of additional revenue. For context, their increases in the first quarter of this year amounted to $2.1b; the annual pre tax profits combined of Harvey Norman, JB Hi Fi, Myer and Premier combined, are slightly less than $1b. Little wonder that specialty retailers are now hurting, badly, given the increasing frequency and quantum of out of cycle rate rises in the past two years. In exercising pricing power in implementing these out of cycle rate rises, with little more economic justification than (1) because a small basis point change in points equals a lot of revenue in dollars, (2) which we need now to exceed last year’s profit, and (3) because we can, the Banks wrote the playbook for the introduction of the levy; the Government in imposing a small levy in points (1) raises a lot dollars, (2) needs the money (to be seen to be addressing the fiscal deficit), and (3) because they can, without resistance from any other political party or the general population. Karma can sting, and little wonder the Banks have accepted the levy without a meaningful yelp.
If they are the four sources of the levy, its major investment consequence is that sustainability should always remain front of mind. ESG always has been about much more than climate change and carbon, worthy as that issue is. Clearly, in taking out of cycle price rises in the past two years, the banks have compromised their social licence. In optimising short term profits, they have reduced corporate value. When it is considered that this is probably just the thin edge of the wedge, given globally operating risk penalties for the banking sector through the past decade have been far greater than credit losses (and in valuing the Australian banks we assume ongoing, net penalties greater than double what has been announced), the sector may be best served in radically changing its economic model. Perhaps (much) lower product prices in retail banking, with (much) lower cost structures, could lead to more sustainable returns, and a restoration of the eroded social licence. This consequence extends beyond the banks – any sector with significant state benefit and/or regulation of pricing, which is making excess returns, is prone to the same treatment, and the propensity and quantum of that treatment is proportional to Australia’s fiscal position. The more this deteriorates, the more the question becomes “Who’s next; and how much” rather than “Who could see that coming”. Apart from banking, another ASX sector that relies upon government funding/regulation, but which makes a large amount of dollars of profit and large excess returns, is healthcare, and there is no reason why this is a sector that is immune from government penalty upon excess return (as has been seen in recent years through changes in payments for GP’s, aged care providers, and diagnostic providers).
The Elliott Management proposal for BHP is pithy – “Fix BHP; End Chronic Underperformance”. Again, a drive at improving the sustainability of a business through understanding what it is that makes the business valuable today. As we wrote at the time of the South32 demerger, BHP shareholders would be well served by an annual instalment of a South spin off – South 33 (possibly petroleum), South34 (possibly copper), etc …, BHP has done an acceptable job at reducing costs through the past three years, but is now keen to invest again, replicating past behaviours which is highly likely to only replicate (poor) past returns. No value over volume to be seen here. The new BHP Chair has much work to do.
Finally, Fairfax received a takeover offer during the month, and soon thereafter a further bid, again from private equity, was announced. Both of the bidders have been asked to confirm to a Senate inquiry into public interest journalism their commitment to quality journalism. When Fairfax relisted in 1992, it was a top 20 company on the ASX. Today, if one was to aggregate the market caps of Realestate.com. Seek and Carsales, as well as Fairfax, that synthetic entity would again be an ASX20 company. Unfortunately, in defining itself as a publisher that hosted classifieds, rather than the other way around, more than a decade ago, and in using that definition to guide its investment priorities, the Fairfax board and management chose the unsustainable path.
Sustainability is the calibration of fundamental risk, especially those risks beyond the short term. The Australian equity market through May saw this (un)sustainability, writ large, expressed in returns, through all of cyclical risks, operational risks and social licence risks. It was tempting 18 months ago to think that many of those risks only lay with commodity exposed stocks – events are rapidly conspiring to prove that they are much broader, if asynchronous in nature, across many sectors in the equity market, and attending to their calibration will remain critically important in dictating returns. In a world awash with expensive assets, there is no pretending that equities listed on the ASX are any different. Within that context, though, we continue to believe better relative value can be found among major miners and those with offshore earnings streams, and our portfolios are positioned accordingly.
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