When the music stops…
With floods having ravaged Queensland and parts of Victoria, and riots breaking out in Egypt, investing has not been the epicentre of most Australian’s thinking this year. The continuation of tensions across many areas of the globe, highlight what we believe to be a crucial factor in investment thinking going forward: imbalances in the global environment are extreme and expectations for a smooth return to equilibrium are likely to be forlorn.
The Queensland floods have obviously devastated homes and infrastructure in the state and will necessitate a very significant rebuilding program. This rebuilding and the controversial levy to pay for it, on top of infrastructure which was already bursting at the seams, has provided some insights into the issues facing not only Australia, but most of the developed world. The first is the issue of infrastructure. A recent report by the McKinsey Global Institute* highlighted the extent to which fixed investment has been starved in developed nations over recent decades, contributing to the so-called ‘global savings glut’. Whilst the developing world has been investing in infrastructure and simultaneously saving, investment in the developed world has been in constant decline, resulting in a massive surplus of capital. As this surplus capital drove real interest rates lower, the developed world responded by using these surplus savings to fuel consumption and house prices, rather than in the replenishment of capital stock. As longer term growth is very much tied to the quality and quantity of this stock, this has led to an inevitable decline in growth rates, a decline which will continue into the future. Efforts to stimulate growth through short term stimulus and consumption may be successful in the short run, particularly given the enormous dependence of these economies on services and consumption, but they will not be sustainable. Whether the entity is a company or a country, its health will be materially impacted by the quality of its underlying asset base. Good companies re-invest sensibly in assets and people, and starving a business will extract a price at a later date. The path of the Australian government over recent decades very much fits the McKinsey model of declining investment, and without a reversal it will extract a price.
The second issue relates to savings and how we pay for it. When, as a country, you’re spending all of your earnings (plus a bit extra), and an unforseen event strikes, the pool of savings to dip into to fund the rebuilding is decidedly shallow. The fact that the pool is shallow despite a resource boom, resultant unprecedented terms of trade and decades of uninterrupted growth, shows just how much has been frittered away in house prices, consumption and increased government inefficiency. We’re living like Premier League footballers, so we better hope we don’t get relegated. Whilst the government determination to control spending is therefore necessary, it highlights the outcomes that will be necessary to replenish infrastructure. Capital spend would normally be exactly the sort of spending for which borrowing made sense, as it is likely to generate growth and payback in the future, however, when the proceeds from running down capital stock have already been spent, sacrificing current consumption (increasing tax) becomes the fallback position.
Further evidence of the inefficiency and ineptitude plaguing infrastructure renewal came in the form of a further provision of $250m by Downer EDI (-16.1%) against the proverbial train smash that is the Waratah rail project. As significant shareholders in the company, some may argue that we’re not likely to be objective. That’s probably right, but it’s not going to stop me! Given the history of losing money on just about every form of government contract, with projects mired in bureaucracy, variations and unreasonable terms and conditions, we are amazed that bidders actually turn up, let alone sign the invariably onerous contracts. The current contract disaster is not the fault of current management. It rests with a previous management team more concerned about announcing large contracts than making money from them. Proportionally reducing bonuses for every contract announcement, banning the release of information on the size of the order book and deferring every dollar of management compensation until project completion would be a start! Given the necessity for companies in the engineering and contracting sector to deliver the countless projects needed to replenish the country’s infrastructure, we remain hopeful that they will eventually appreciate the need to either mitigate the risk assumed or to deliver returns commensurate with the risk taken. The track record to date is reflected in a sector with employees in the hundreds of thousands, margins in the low to mid single digits and aggregate market capitalisation amounting to a few months revenue. Not exactly a success story. In case you hadn’t noticed, watching shareholders and taxpayers monies being flushed down the toilet in paper shuffling, legal fees and complex financing structures, rather than in building stuff is starting to upset me. Hold on while I reorganise my papers!
The reaction of investors to the clear attempts by Chinese authorities to address the unbalanced and unsustainable growth is, in our view, alarmingly mild. Popular wisdom continues to seek emerging market growth and commodities as avenues for return, despite an obvious inability of countries like China to deploy this capital profitably. These excessive and growing imbalances are the primary cause of our concern.
*McKinsey Global Institute - Farewell to cheap capital? The implications of long-term shifts in global investment and saving.
Whether it’s Chinese authorities grappling with unstable growth and inflation, US authorities giving away money to stimulate growth, or terms of trade, commodity prices and currency levels, whichever way we turn we find extremes. The fact that these extremes have prevailed for some time, does not suddenly validate them as sustainable levels. Iron ore and coking coal producers are currently making egregious profits selling raw materials to steel producers making no money, who in turn sell steel to automobile producers making no money and property developers building vacant buildings; hardly a balanced and sustainable system. Over time, unsustainable models collapse and equilibrium slowly returns.
The political instability which is evident across the world is perhaps symptomatic of a world characterised by lengthy periods of accumulated excess, where the unwinding process is meeting vast resistance. Paying back excesses is usually less fun than building them. The positive emerging from the process is that efficient, vibrant and strong businesses and economies are normally built in times of adversity, as competitiveness is restored and excesses are cleansed. It is for this reason that we believe some of the most attractive investments in the market at the present time are to be found in areas which have been dealing with adversity rather than artificial buoyancy. Whether it’s exposure to US housing, a depressed US economy, or currency pressures, these businesses have invariably been driving hard for productivity gain whilst their competitors in more buoyant environments, particularly commodities, have been strategising over powerpoint slides and maximising the release of exciting drilling results to over exuberant investors. Accepting the need for productivity improvement rather than focusing on lobbying the government to maintain the status quo is also an attribute we would embrace.
We expect the year to be eventful and returns unpredictable, and we are logically less enthusiastic on future returns than was the case when share prices were lower. Despite market levels which are no longer undervalued, there remain many businesses where an extrapolation of current conditions is unrealistically pessimistic and returns should be strong. There are similarly many for which the tide will recede and former waterfront land will prove to be toxic swamp.
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