The inevitability of cycles
Forecasting doesn’t seem to be getting any easier - just ask Joe Hockey. After forecasts of US$60 iron ore in the mid-year budget update (following much higher forecast numbers in prior years), falling prices saw him warn of $35. Days later, prices were rebounding. Resorting to fundamentals to explain recent fluctuations in iron ore prices, exchange rates, the reasons behind the sudden boom in the Chinese stock market or the rationale for negative yields on German bonds is becoming increasingly difficult. Soothing words from central bankers and politicians on the outlook should perhaps be taken with a grain of salt. As the financial system becomes more manipulated, complex and ever larger versus the underlying economy, there are many reasons to suggest that economists and policymakers are wildly over-estimating both their input and control over the broader economic system. As mathematicians like Benoit Mandelbrot and astrophysicists like John Gribbin have explored, economists like reality to accord with their models and are disinclined to explore alternative views on the reasons for financial turbulence. When reading views like these, which approach the financial system from a different angle, aside from realising my decided intellectual disadvantage, it does give cause to reflect on the risks to the heuristics we often use in modelling (and valuing) the economics of businesses through time. When observing the role of human behaviour in markets such as the Sydney property market, we are inclined to believe that rationality may have a lesser role in price formation, at least in the short term, than we had perhaps imagined. What is obvious, is that long term stability and ever rising asset prices are not getting any easier to engineer and the potential for small changes to give rise to a far larger impact in either direction is growing. As Gribbin observes, phenomena such as traffic jams where minor incidents or increases in traffic can often instigate severe traffic jams yet clear inexplicably, highlight the sensitivity of many complex systems to small changes. Similarly, minor earthquakes are extremely regular and barely noticed, whilst severe ones are far less regular, unpredictable, and catastrophic. We do, however, know they will occur. Economists and bankers prefer to ignore them.
Our investment process expects and relies on a degree of mean reversion in a myriad of underlying cycles, whether they are commodity prices, exchange rates, interest rates or supply shortages. We understand this approach has pitfalls, but relative to extrapolation of prevailing conditions, it remains vastly superior. We aim to look through these cycles, do our best to determine how much a business can earn in an average year, and use this as the basis for determining its worth. When free markets are allowed to function, these cycles and basic economic theory seem to work OK. Much as the short term gyrations in iron ore or oil prices might surprise us (and Joe Hockey), they are symptomatic of allowing prices to adjust to the prevailing supply/demand balance. As Atlas Iron (-7.7%) abandons production due to the inability to compete and Fortescue Metals (+10.7%) calls for lower cost producers to abandon capacity expansion, the harsh reality that cycles must have lows as well as highs becomes evident. Perversely, this gives us greater confidence in our views on valuation. Having used mid cycle iron ore prices in the mid US$60 range even when the prevailing price was US$150, the likelihood of spending some time below US$50 should not present greater surprise. Imbalances cannot exert only upwards price pressure. Furthermore, when we are accustomed to cycles, they are far less likely to be catastrophic. US$50 iron ore and US$50 oil are causing significant ructions around the world, but producers are adjusting.
Dimensioning the length and amplitudes of the cycle impacting a number of other sectors, and consequently, arriving at valuations for the businesses therein, presents us with far greater headaches. Banking is possibly foremost in this category. If resources had a super cycle, banks have had a tsunami cycle. Iron ore prices are now back to levels of 2006. CBA profits in 2006 were a little under $4bn on net interest income of $6.5bn and average loans of some $275bn. 2014 saw the numbers at $8.6bn profit, net interest income of $15bn and average loans of some $700bn. $6bn of operating expenses has grown to $9.5bn whilst claiming significant productivity gain. Bad debts are largely non-existent. This cycle has been made possible through ever lower interest rates. How should we dimension it? We feel sure that without the aid of ever lower interest rates, the cycle would have had some ups and downs. One does not need to be an astrophysicist to ascertain that if interest rates were 8% tomorrow, it may induce a few house price falls and the odd bad debt. So whilst there may be some scope to reduce interest rates further, induce further loans and stymie bad debts in the short term, it would seem wise to assume that the position of the banking system in the cycle is more akin to when iron ore was US$150 and oil US$110. Valuations suggest otherwise. At higher than normal multiples on current earnings, policymakers have ingrained the belief that banking and asset prices will have no cycle. This is always when cycles can wreak the greatest havoc. This pessimism and euphoria which always accompanies cycles occupies our thinking in every sector, however, the disproportionate importance of banking and financials to the Australian stock market and the vastly extended cycle in which they are operating elevate our concern on this particular cycle.
The same principles are constantly evident across the spectrum of ASX listed businesses. Qantas (+8.7%) has benefited from the concurrence of oil prices heading down, the return to duopoly conditions and resultant price rises domestically. This improvement in cyclical conditions has seen the share price move around 180% higher in the past year. Whilst we believe management have done an excellent job managing the tough conditions of past years and short term earnings will undoubtedly be exceptionally strong, 3 times net tangible assets is now reflecting an assumption of good times for a long time. The cyclical pattern of airline industry earnings would suggest some heroism in this assumption. Domestic general insurers Suncorp (-2.9%) and IAG (-4.8%), are enduring both higher claims and increased competition after a period of benign weather and exceptional margins. Having seen buoyant conditions for some years, the psyche of investors is different. An immediate return to the good times is favoured over a period in the doldrums. As always, we feel the best course of action is to dimension the cycle relative to a longer term view. This would suggest valuations are not nearly as attractive as they appear.
The same psyche permeates in current merger and acquisition activity. The takeover battle between M2 Group (+8.3%) and TPG (-1.9%) over iinet (+12.6%) is a case in point. Market share gains for nearly all challenger brands have been the way of the world as regulators have ensured favourable access to Telstra’s network through regulation. Extremely healthy margins with minimal capital investment have been the order of the day. Extrapolation of these conditions, together with synergy benefits from cost savings and earnings accretion through the ever lower debt costs funding acquisitions have proven a potent share price cocktail. As always, we remain wary that the dynamics of a relatively mature industry with already high pricing are likely to require a medium term adjustment in cyclical conditions which is not evident in expectations.
A belief in the inevitability of cycles creates a necessary conundrum at present. As economists and policymakers redouble efforts to ensure asset prices remain perpetually elevated, the cycles impacting the underlying businesses in the real economy are experiencing their usual ups and downs. Arguably, many have been extended on the downside as ever cheaper capital provides artificial support for the weak. The stock market dominance of financials over the real economy is the objective evidence of this process. Whilst this gives us great long term confidence in the better valuation support offered by businesses where cycles are both visible and anticipated in valuations, materials and energy being the prime examples, we are left wondering how policymakers will address the increasing burden of trying to suppress cycles and which sectors will bear the brunt of their inadvertent ‘reverse Robin Hood’ behaviour.
Hypersensitivity of prices to small changes in either fundamentals or behaviour, dictate the possibility of significant moves in either direction. Just as the Sydney property market develops a ‘head of steam’ which seems difficult to control, equity markets and bond markets will retain this propensity whilst their size and complexity grows at a rate beyond the underlying economy. We will continue to favour the view that policymakers are wildly overestimating their input and control and there is no guarantee that future earthquakes will be at the lower end of the Richter scale. As such, we will prefer businesses which offer the coincidence of free markets having a dominant role in determining profits, and valuations which acknowledge and incorporate cyclical ups and downs. They are not becoming more plentiful.
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