This isn't Neverland
Philosopher, Ayn Rand, would be rolling in her grave given current global events. The past quarter has seen only painful continuation of European crisis meetings with no useful outcome, more mediocre economic data and lots more whingeing. Suggestions that capitalism should be allowed to function as it was intended remain totally absent. Those likely to benefit from German benevolence remain vociferous in encouraging it while those benefiting from artificially low interest rates and government handouts remain firmly supportive of their continuation. Those providing the resources through paying taxes, earning profits and efficiently producing goods and services are either ignored or vilified. After all, why work when someone else can do it for you. Why resort to free market competition when you can lobby for assistance?
Unfortunately, decades of slowly increasing government intervention and Keynesian policies which allow government control of money and credit will not be permitted to recede easily. We must therefore ponder the potential actions of policymakers and the response these actions are likely to elicit from those impacted, as it is certain they will dominate the landscape for years to come.
Many would argue that much of this can be ignored and we should focus solely on bottom-up stock picking. We could think of nothing better. However this isn’t Neverland and I’m not Peter Pan. Almost every industry and business we can think of is impacted by intervention to varying degrees, either here or offshore. Industries such as steel and aluminium are suffering from Chinese policies which encourage new capacity to be built until profits disappear totally. They are proving successful in this profit elimination. Banking thrives on volume growth dictated by the extent to which central banks make credit available. Airlines are subsidised and manipulated the world over in the name of tourism. Regulators set prices for utilities and telecommunications companies while governments allow toll roads to shut and prevent alternate routes to allow high tolls and upfront payments to governments. Land prices are influenced by government regulation on land release and house prices are distorted by credit availability and negative gearing policies. We’ve got carbon tax policies making us uncompetitive versus countries without them and handouts back to those impacted by them. All sounds pretty free market to me.
So how should we invest in an environment of such intervention? Probably the first step is to ascertain where intervention has caused prices to divorce most significantly from fundamentals. There is little doubt that bond markets should be the centre of attention in this regard. We have Basel and other regulatory reforms forcing banks and insurers to become buyers of sovereign bonds, central banks using their own balance sheets in an effort to manipulate prices and Europeans desperately trying to create artificial buyers of government bonds to salvage insolvent governments. Virtually all fundamental buyers have disappeared, crowding instead into the corporate bond market. Fortunately, additional supply in this area, as corporates seek to disintermediate banks and secure longer term funding, has prevented prices from reaching the ridiculous levels seen in sovereign bond markets. Equity markets on the other hand, having been devoid of government support and expected to happily contribute additional funding to ensure banks are not subject to actual losses on dud loans, are faring less well. Investors, quite rationally, are responding to a consistently reinforced message that they will not be offered the same protection as bondholders. Consistent outflows are the order of the day, and when any pool of assets sees the pool of money seeking to buy them contract, they fall. So where do we go from here?
This is where clarity begins to abate. In our minds, we believe that many of the Ponzi schemes perpetrated by governments around the world cannot be sustained. Elected officials representing those that have behaved more responsibly will act to preserve their jobs and the wealth created through production and saving rather than making endless donations to the less frugal. Those aiming to prolong the circus through further deception will eventually be exposed. Those with unsustainable budget positions will suffer the same fate as insolvent companies or insolvent individuals. The only choice is whether they go broke through default or through money printing and devaluation.
It is at this point we must make a confession. During the quarter, for the first time in many years, we purchased a gold stock, Newcrest Mining. Having pilloried gold companies in these reports for some time, we owe an explanation. Valuing gold is almost impossible. It has value only in so far as others accept as it having value in exchange. In this function it is obviously similar to money. By deduction, valuing a company which sells gold doesn’t become progressively easier, or more scientific. Our rationale for purchasing exposure to it lies in the uncertainty over how investors will react in the event that the enormous pool of assets known as the bond market can no longer be artificially sustained. If investors lose faith in the ability for wealth to be sustained in these ‘risk free’ assets, they will seek refuge elsewhere. Gold may be one of these ‘elsewheres’. In addition, the gold price reflected in the value of many gold equities has retreated sharply over the past year, such that valuations of stocks such as Newcrest Mining can be justified on gold prices well below current levels. We continue to have a strong preference for businesses selling goods and services with greater utility, however, with ‘tail risk’ at undoubtedly elevated levels, we can see value in buying some sensibly priced insurance.
At the stock level, many assert that corporate balance sheets are under geared and in rude health. If this is the case, it is somewhat surprising that the quarter saw far more activity in capital raisings than in new buybacks. Brambles raised $450m after the sale of Recall failed to meet expectations, Billabong raised $225m after rejecting a private equity approach only months ago and Metcash raised $375m to shore up its balance sheet. We continue to view buybacks in the current environment with extreme scepticism. Whilst companies with very limited gearing, ongoing strong cashflow and valuations which don’t appear elevated, for example, News Corporation, may be justified in executing buybacks, many others seem lured by apparently cheap debt and positive EPS (earnings per share) outcomes. Engineering a positive EPS outcome at artificially low interest rates is like beating your grandmother in an arm wrestle. The hurdle might need to be set a touch higher! REIT’s in particular, are benefiting from an army of cheerleaders quick to observe that debt costs have moved so low that cap rates on properties now offer positive carry. It would appear they have learned little from the lessons of a few years ago. Gearing up at a time when rates are at generational lows and property prices are substantially reliant on the abovementioned intervention would seem to us to be a strategy which could politely be termed unwise. Nevertheless, perceived defensives, whether highly geared or otherwise won the day by a large margin this quarter. Cyclicals and resource stocks were roundly trounced.
Another outcome of tougher economic times which is causing us some consternation is that of strategy and remuneration in the face of mediocre operating performance. Job losses are always unfortunate, however, in our minds, shareholders cannot be seen as a charity through which to fund employees. When businesses generate unacceptably low returns on capital for extended periods, management and employees must take steps to improve inadequate performance. Similarly, we will not agree to resetting remuneration hurdles for highly paid management personnel that have cost shareholders large amounts of money through ill-considered acquisitions. When shareholder losses are permanent, financial costs for those responsible should not be fleeting. This may seem Ayn Rand’ish to some, but as intermediaries employed to deliver the best possible returns for investors we feel an important part of our role is to hold boards and management accountable for the use (and misuse) of shareholder capital. It is also a key reason for our advocacy of active management over passive. As tougher economic times prevail, we do not expect the number of acrimonious encounters with management to abate.
A buoyant environment in many areas of domestic construction activity, particularly mining, has not translated into profitability for Leighton, as the Airport Link and Victorian desalination plant contracts have lost vast sums of money. Management change last year has yet to translate into improved performance and the risk management processes of the company still require significant improvement. We continue to believe that the earnings power of the franchise should be materially higher although market frustration with the continued missteps remains high.
To date, equity investors have seen intervention in the form of monetary policy and stimulus as the panacea for improving market performance. The half-life of this announcement impact has faded substantially. As Mitt Romney noted in a CBS interview in relation to US stimulus, it “did not put Americans back to work, did not raise our home values, did not bring jobs back to this country or encourage small businesses to open their doors”. Perversely, we are strongly of the view that improving equity returns will require the very long term tailwind offered to bond investors by policymakers to run out of puff and intervention to fail. As noted above, central bankers have been the staunch allies of bond investors, rescuing them from every poor risk assessment and associated loss with interest rate reductions, stability funds, quantitative easing and numerous other underhanded and deceptive tactics designed to put ‘lipstick on the PIIG’s’ for want of a better term. When bond investors are faced with a similar price to pay for poor risk selection as their equity counterparts, capital should hopefully once again see returns commensurate with the risk.
In the interim, we shall continue to seek businesses which are positioned and managed to sustain the best possible returns in the environment and use financial leverage judiciously. Consistent outflows have seen equity markets move into cheap territory on most traditional measures, however, this is only one piece of the puzzle. There will undoubtedly be many opportunities to buy good quality businesses cheaply as panic surrounding riskier assets prevails, however, it is equally important that the custodians of these businesses are disciplined and realistic about the environment and do not disregard the interests of shareholders as the going gets tougher.
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