Tremors cause tsunamis
The results season just past was a popularity contest the likes we have not witnessed since the halcyon days prior to the GFC, and for many with longer memories somewhat reminiscent of the go-go dot com era. If history doesn’t exactly repeat, the script is certainly reading in the same vein with greed, excess liquidity and over exuberance unsustainably inflating valuations. We have little doubt the bubble will burst with a sharp adjustment in the pricing of riskier assets with the small and micro end of the sharemarket likely to suffer more pronounced downturns than the larger companies. The many smaller companies that are trading on ultra-high multiples may seem safe but ultimately this faith is likely misplaced. The infallibility of their earnings forecasts likely more vulnerable to a general economic malaise than is currently contemplated – spreadsheets or the users of spreadsheets simply can’t handle the non-linear. Whilst running with the herd can be reassuring in the good times, in the bad times the perception of safety can evaporate quite rapidly.
Call me a bear; however I think I sit in the pragmatic camp as there have been times, perhaps infrequent, when I have been exceedingly bullish. However, this reporting season, like no other had me shaking my head to the point where my neck is still hurting. Too many reporting companies offered platitudes and promises and were duly met with a frenzy of buyers. A small beat of guidance somehow became a reason to re-rate a company’s valuation astronomically. If the result was missed or of poor quality, just increasing the dividend and providing some inkling that the first six weeks of the year had shown signs of a pickup was enough. Acquisition driven growth was the ‘bees knees’ and anyone that ‘gouged’ customers to beat forecasts was rewarded despite the unsustainability of such a strategy. Meanwhile, the unpopular companies and sectors generally continued to mark time and in some cases de-rate further. The cry of ‘strong forever’ a distant memory for the resource sector and its derivatives, those ‘fair weather’ fans having since switched allegiances to any high PE stock that has price momentum. As we all know humans have a natural inclination to ‘gild the lily’ but numbers generally tell some modicum of truth. The cash flow statement is usually the key test of whether a result is good or not with free cash flow. Combined with tax paid and interest paid measures these are becoming increasingly important indicators of the health of a business and quality of earnings, particularly over longer time frames. Some of the more popular companies in small cap land apparently don’t pay much in the way of tax with legal firms the obvious perpetrator. There has been many a contractor which at balance date seemed to be sitting on a pile of cash but when you back solve debt levels based on interest paid you quickly surmise the cash must go out the door soon after balance date. Scepticism is clearly warranted at this point of the cycle and I suspect many of the popular companies will come unstuck in the next few years as flimsy financial figures disintegrate with the advance of time.
My parents taught me to pay back my debts as they did in their day. If you took on a mortgage it was with the aim of paying it back. In their day, debt was a necessary evil but if you worked hard you would hopefully clear that mortgage and then move into a saving phase and accrue for your retirement. Those less fortunate by retirement age would generally go on to the pension but still their aim was to be self-sufficient. Perhaps I am altruistic but it feels like today the objective is to gear up to the hilt into a number of investments and hope that asset prices appreciate such that you flip the assets for a higher price to a person greedier or more stupid than yourself. Paying back the mortgage is an afterthought and debt is a good thing. Fortunately, the central banks have been very accommodating of this attitude/strategy over many years and even more so now such that liquidity required to fund this is readily available. Given a good chunk of society is engaged in this type of behaviour it has become accepted wisdom. However, this is not isolated to home ownership but also reflected in many sharemarket manifestations of the finance bubble. There is no end of ‘tinpot’ finance companies that have risen from obscurity in the last few years from the ashes of the GFC. Instead of reviled they are revered as their share prices are promoted by the part of society that believe that debt is good. The death knell for this overinflated bubble would appear to be the re-emergence of a bad debt cycle. If you happen to venture from some of our cities’ wealthier suburbs towards suburbia you might be a little surprised to learn how tough life has actually become despite record low interest rates. Unemployment is on an upward trajectory and has been for some time now despite the RBA’s effort. Tremors cause tsunamis and when it hits it will have ramifications for all finance providers and society at large. We aim to stay clear of the worst that an economic downturn may bring – the damage to overpriced valuations could be severe.
Clearly, I remain ensconced in the bearish camp. Nevertheless, we continue to manage the Fund from a bottom up fundamental perspective, with the macro risks also guiding our exposure from certain sectors and stocks. As always though, opportunities will arise whether the market is frothy or not.
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