That turgid mid ground
A change in physical seasons is noticeable as the days lengthen and temperatures dial up. Defying the thermometer, the equity market cooled in Australia in September, with a significant fall in the S&P/ASX200 (down 5%) and the currency (down 6%) seeing one of the worst months on the ASX in US dollar terms in twenty years. Given market outperformance in recent years has been mostly attributable to a QE inspired rerating, with earnings being no greater than had been anticipated through this time (and cashflows being lower than had been forecast), equity market volatility is unsurprising. If 2012 to the downside, and 2007 to the upside, saw multiples at extreme levels, we are now in that turgid mid ground, albeit with this headline level still masking extremes at a sectoral level, with financials the beneficiaries and energy and materials (major miners especially) the laggards.
18 months ago, we outlined six fundamental views which shaped our Australian equity portfolio. Of the original list below, only one tenet has changed:
- lower (global growth) for longer, driven by overcapacity and demographics;
- an ongoing need for deleveraging by the government, financial and household sectors, albeit deferred (but ultimately exacerbated) by political realities;
- there is no long term monetary solution to indebtedness; although this is now becoming an increasing craze for central bankers;
- in line with unemployment rates, the Australian economy is still above mid cycle (with unemployment rates at 6.2%) whereas most other developed world economies remain below;
- business plans extrapolating prior cycles are folly; and
- the two golden rules for corporate success in this low volume environment remain the ability to exert pricing power and a productivity focus.
We have written in previous monthly commentaries on the first three themes. There is no need to labour the point, lest we be accused of “Grumpy Old White Man Syndrome” (One client observed recently that many Asians are more optimistic than Westerners, especially older Westerners, and this is reflected in their respective economic performance).
Having said that, in needing to raise $750m recently, Arrium was a classic case study in how each of these factors can parlay aggressively into stock performance, with the share price underperforming by 48% during the past quarter and 75% over the past year. Lower global growth and over capacity has continued to see manufacturing processors without intellectual property, such as steel makers, produce low returns; this is the story of Arrium’s steel making business, with its iron ore mining operations providing the vast bulk of its earnings in recent years. With the iron ore price falling to US$77 through recent months, its lowest level since the GFC, even with the Australian dollar falling as well, higher cost iron ore producers such as Arrium have seen their operating earnings drop by large percentages. Our assumed long run iron ore price, and that we believe is used by the major iron ore producers in Australia, reflects the 90th percentile on the cost curve for the commodity, and is much closer to current levels than the higher levels seen through much of the past five years. Finally, even after the equity raising Arrium remains with a debt level we consider to be well above prudent levels. Extrapolating the high prices of the past several years for Arrium, or any other higher cost mining operation as a standalone investment, remains prone to ongoing downward revision.
If asked “What is the catalyst ?”, we can only respond with the truth; we don’t know, and rarely can a catalyst for major market moves in almost any tradable security be identified with precision, even in retrospect. What was the catalyst for the GFC? How about the Tech bubble? And, in each case, the recovery in asset prices that ensued? Even now, it is hard to know. All that is clear is that the preconditions for those exaggerated moves had been increasingly in place for some time, by reference to valuations. Current conditions for Arrium continue to read lower growth for longer, over supply, absence of pricing power, not being a low cost producer and having high levels of financial leverage; this is ultimately a Molotov cocktail for investors, even if through the past quarter “the catalyst” for Arrium’s performance, and the decline in the iron ore price, remains as elusive as ever.
Mining services is another example of the peril in extrapolation. One of our team has just circulated a November 2011 article highlighting how “Mining service providers have been a bright spot in the float market in the past two years. Titan Energy Services wants to continue that trend…”. That stock is now down 82% relative to the S&P/ASX200 through the past year, and an extremely poor relative performance is common to mining service companies in the three years since the article. What sector of the listed market, today, has characteristics which to us seem eerily similar to the fads of cycles past? Without question, in our opinion, it’s Education. As always, the vendors are being rational in coming to market, but just as the mining services boom to bust has occurred within three years, we suspect the report card in three years’ time for many of the Education companies listing today may feature more F’s than A’s.
One final example where we still see risk arising from undue extrapolation of the past rests with the retail sector. Consumer Discretionary is the most shorted sector in Australia relative to market capitalisation, by half as much again as any other sector. Reflecting a secularly lower sales growth environment and a mix shift in channel towards online, US shopping centre floor space growth has been less than 0.5% per annum for each of the past five years. Retailers are rationalising store numbers as leases mature, and traffic to malls is declining by low single digits per annum. Retailers are continuing to focus upon maintaining sales by growing online; for example each of Nordstrom and Macy’s have grown online sales at more than 30% per annum through the past several years. In contrast, floor space growth in Australian shopping centres continues apace, with last year at 2.5%, and online sales as a proportion of total sales for Australian retailers is still minimal (for example Myer 3%, JB HiFi 2%, both beaten by that bastion of creative destruction, Pacific Brands, at 4%). Perhaps the shorts are onto something. Even with unemployment increasing through the past year to 6.1%, we are still a fair way below long term trend numbers and hence domestic demand may continue to fall short of expectations.
Finally, the ability to exert pricing power and a productivity focus sounds trite, but they are often the only weapons left open to management in a low growth world. We are often happiest when it is obvious that pricing power remains latent. For example, a small listed New Zealand company, Metro Glass, is run by a former senior manager from James Hardie. We have previously highlighted James Hardie as an exemplar of both pricing power and productivity, and those disciplines have been parlayed into the operating metrics for Metro, which has invested to ensure a position as the lowest cost glass producer and distributor in its local markets, by a material margin. Because of their 20% higher cost bases, and current operating losses, Metro’s next largest competitors need to continue to raise prices just to become profitable, let alone start to garner an acceptable return. The industry is acting rationally in (gently) raising prices, but because of their relative positions on the cost curve Metro retains significant latent pricing power which is likely to be quickly matched by competitors should it ever be exercised. Management are wise to keep that card up their sleeve.
A productivity focus is important, but can take two forms. Capital productivity is often just as important as operational productivity. Capex to sales ratios for ASX industrial companies have halved since peaking above 10% in 1990, with no discernible retardation to growth. We are unaware of large scale investment, which is valuable, not being made because of an absence of capital, especially in Australia. Good projects in Australia can definitely and readily be financed, by equity and debt. As an investment proposition, where companies come to the completion of large investment programs, which is a characteristic of the large miners and many energy and utility stocks through the next two years, the ensuing free cashflow generation can prove highly valuable to shareholders; our portfolio remains positioned accordingly to capture what we forecast to be a capital productivity dividend.
The six principles we spoke to in setting the scene for our market outlook at the beginning of this commentary are prima facie headwinds for both multiples and earnings. They remain afoot even with the market’s poor performance through September. A fair starting multiple, management intent and capacity to generate good returns on investment, even in the face of challenging conditions, remain a shareholder’s single biggest lever for outperformance through markets prone to correction.
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