Animal spirits and quantum physics
The basic tenets to any fundamental investment philosophy in equity should refer to the determinants of return and risk. They should apply equally to a security in a company, listed or not, and irrespective of the industry the company operates in. Core beliefs as to the drivers of return and risk should endure; ideally, for an investor professing a long term approach, they should be consistent in the absence of structural change. These tenets should also be most useful during times of market dislocation, when raw instincts can overwhelm the recitation of a mechanistic “process” if it does not reflect the primal investment beliefs of the manager, and especially so when performance is challenged.
Right now, we are pressured on all fronts. Markets are stressed, but more in ways we did not see coming – an energy price collapse – than that we anticipated, the prick of the asset price bubble in financial assets, created by the global symphony of monetary weapons . In turn, our performance is pressured. Time to take stock, to reconsider core beliefs, to check the application of those to the investment units – companies – in front of us.
Our return assumptions are based on a simple premise – an equity investor also has the option of investing in debt. Nothing else though – as much as financial horse whisperers have conjured up exciting alternatives through the past decade, these remain the only two ways to finance an asset. The beauty for debt investors is that their return is fixed, especially in an age where the mere concept of “bail in” bonds presupposes that debt holders should not bear any risk that their capital investment is impaired (for reasons which will forever escape us). The coupons for a debt holder, expressed as a yield, have compressed markedly since the advent of quantitative easing. This year, government bond yields fell to all-time lows in Japan, most of Europe (Germany, France, Spain, Italy, Ireland, Portugal, Sweden, Switzerland and other EC member states), and Korea (and Australia is very close to an all-time low). More than 80% of the world’s equity market capitalisation is in countries with zero interest rate policies, and 50% of all government bonds in the world currently yield 1% or less.
So, given all of this, where are we now? Bonds in Australia are now offering a coupon of 3%. A lower yield than this has only ever been offered through the GFC. Bonds were offering nearly 7% in 2007. Cash rates in Australia, now at 2.5%, are lower than during the GFC, and will head lower as unemployment keeps rising. Clearly and universally, yields from debt instruments for investors are low. Equity markets have followed this trend, seeing equity markets rise in unison with this compression of yields, and those offering income and the perception of surety in that income, namely health care, telcos and property trusts, do best, and resources and energy, in particular, do worst. This bifurcation has been strong through the past year, but even stronger through the past quarter.
If 3% is the risk free debt yield, what premium are you paid as a debt investor in the credit market to buy corporate debt now? The lowest spreads are attaching to the bank debt, where premiums of circa 45 bps are being paid; and risky credits, like Alumina, offer a premium of 265 bps. On a simplified 10 year basis, corporate debt is mostly priced between 3.5% and 5.65% in the Australian market. Interestingly, before we leave this, most property is priced at the riskier end of this spectrum in debt markets.
For an equity investor, the equivalent to this debt coupon for equity investors is the earnings before interest and tax, or EBIT, expressed as a return upon the market value of the asset base purchased (market capitalisation and net debt), which together make up the enterprise value for the company. Of course, risks – especially operating leverage and financial leverage – mean that the cashflow stream in prospect for an equity investor has a possible return path far more divergent than that facing the debt investor for the same
company. This, we contend, is the fundamental basis for the equity risk premium; the fair compensation paid to the equity investor for the broader possible path of likely returns. Nonetheless, if the yield available to a credit investor is 3.5% to 5.65%; what is the appropriate equity range? And would you expect a similar tiering of sectors. That is, would you expect the highest multiple and outperforming sectors in the equity market in the past year, to also be the highest multiple / tightest yield debt sectors?
The short answer is the range for equity investors is 3% through 30%; with the equity market now tiering far more widely than the debt market, and the tiering of sectors is very different, with property being the stand out. Of course, a good investment for a debt investor may be a poor one for an equity investor (regional banks may be a good case in point), but generally we would expect some correlation. After all, what risks could confront a debt investor that should not concern an equity investor? Alternatively, are the debt investors looking at risk more broadly than equity investors (for example, are debt investors more concerned by leverage through a cycle, rather than just at crisis points, than equity investors)? We suspect it’s the latter, which is leading management and boards to gear as much as they can, again.
For example, let’s compare Scentre Group and Telstra, two equities that have done well as the yield theme has permeated through the equity market, against Woolworths and BHP, which have both been recent equity market underperformers as concerns as to their operating leverage (some of which may be overstated) bite. The credit margin for each of those entities is, respectively, 141bps, 72bps, 55bps and 73bps. That is, the most risky is Scentre Group and the least Woolworths. Using our mid cycle return estimates, equity market yields, in contrast, are respectively 4.0%, 8.5%, 9.7% and 8.3%. Scentre Group offers the lowest returns and Woolworths the highest, precisely the opposite order of debt markets. This is not just because of our mid cycle adjustments; using spot numbers we come up with the same order.
Portfolio outlook & strategy
Equity markets are always more prone to emotional swings in multiples, and what prompts the opening and closing of these swings is more in the realm of animal spirits than quantum physics. When a sample of four mature, large and stable stocks from across the market spectrum sees the equity market tiering of return being the opposite of debt markets, we suspect that emotion in equity prices is approaching extreme levels. It reflects current and very recent operating conditions, as the commodity cycle has normalised, but as the domestic economic cycle also starts to normalise through the next year it may be that many sectors outside of resources, including those to date heavily subsidised by an increasingly indebted government sector, start to be hit by those same cyclical forces. At that time sector rotation towards those with increasing levels of free cashflow, as opposed to just the augmentation of recent trends which has increasingly occurred through the past year, may occur.
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