Delivering to the rhetoric
The great re-rate in equity markets continued apace through January, with a new year following old habits. Earnings down, but share prices up, the #1 hit song in financial markets through 2012, kept spinning. It appears the principle behind quantitative easing – central bank buying of bonds in conjunction with a zero interest rate policy leads to investors buying shares, and the resulting increase in equity prices leads to investment and consumption, elevating growth – is working, to the extent that Europeans and the Japanese are now enthusiastically (re) embracing the US led strategy. Investors are becoming more enthusiastic about equities the higher prices go. Last year saw all major equity markets produce very strong returns, and weekly equity inflows have increasingly improved such that for the last week in January they were the third largest on record.
The only issue with all the above is that everything after “increased share prices” isn’t happening. Investment and consumption continue at anaemic levels, probably because revenues are hard to come by. In fact, earnings went backwards through most major markets as share prices rallied through the past six months, and nowhere was this more pronounced than here in Australia. As we have maintained for some time, lower growth levels will be an enduring part of the corporate environment and hence management teams need to either make the price in the goods and services that they sell and/or lead on productivity in order to generate excess returns. As Mike Kane, appointed as Boral CEO four months ago, has discovered, hitting these two prompts can quickly turn a “dog” into a “star”; the difficulty is always in sustainably delivering to the rhetoric, not just announcing the intention.
In the US, for example, median household income continues to fall and is 8% below its 2007 peak. In turn, the oft referred to deleveraging has only occurred in the mortgage market, and the resulting US$1 trillion decline (purely foreclosures and write downs) has been offset by declining incomes to the extent that debt to income ratios have not moved. Consumer indebtedness has hit an all time high. A bit hard to delever when your income is dropping! Governments have the same dilemma, with G7 gross government debt at 100% of GDP, double the levels of twenty years ago, and still rising even though it is now at levels only previously seen during global war.
Hence, the issue of excess leverage in the government and household sectors doesn’t just remain, but is in fact being exaggerated by current policy. Debt default by a major economy through this year remains a non- trivial prospect. Weakening bond yields in anticipation of this risk, as we have seen through recent months even as equity markets have rallied, will ultimately see equity prices decline, especially in an environment of weakening earnings. Equity investors are being paid for these risks, for sure, especially relative to bond investors, but the risks remain.
What have we been doing in response to this market environment through recent months? As can be seen from the foregoing, our expectation for future returns has not increased as equity markets have risen, nor has our assessment of these fundamental risks confronting investors abated. Further, and as always, volatility in share prices has been greater than volatility in our assumptions of mid cycle earnings. Hence those better performing stocks in the portfolio become relatively less attractive, leading us to trim Boral and Fletcher Building as they have rallied in the market’s hope that a (good) new manager will overwhelm the history of (poor) returns from the industry and those specific companies, and CSL as the bellwether of operational excellence in the ASX200 continues to be bid up. Conversely, we have added to the major miners and some energy stocks, and selected industrials and financials such as AGL, News, Computershare, Macquarie, QBE and NAB, following their underperformance of the market, and especially where our mid cycle earnings assumptions remain largely unchanged.
After an annus horribilis in 2012, approximately their tenth in a row, NAB’s senior executives went on leave in January and made no market announcements at all, seeing the stock outperform its (more) major bank peers by the largest monthly amount in several years. With NAB, clearly no news is sensational news. Given it retains a larger asset base than CBA, and yet is capitalised at almost $40b less than its more major peer, there is little argument as to the size of the management discount. Maybe longer holidays, more often, for the senior executives could be a winning strategy for shareholders, in the absence of the group changing tack and deciding to adopt a more sensible strategy such as leading the industry on price or productivity, and undertaking mergers and acquisitions (M&A) on a counter cyclical rather than pro cyclical basis.
Of course, the pro cyclical nature of M&A amongst management is a broad spread affliction. The major resource stocks, BHP and Rio, and the chemical stocks, Orica and Incitec Pivot, are interesting case studies of stocks that have definitely added increasing amounts of capacity through the past decade as demand (largely commodity volume driven) increased. Last drinks have been called all round. Management speculation has accompanied BHP aggressively pulling back on its capex and opex budgets from this year; and management change has accompanied Rio announcing the same strategy. To give some context, BHP’s capex in 2004 was slightly more than US$2b, and this year it will peak at almost US$20b. Guidance has this halving within the next three years. In each case, lower capex and higher productivity should see higher cashflows than are being priced in currently accrue to shareholders.
The chemical stocks are similar. A new CEO at Orica has announced a focus upon services and improving the return on assets as opposed to the most recent strategy of building another US$1bn plant to generate additional profits (on the promise of an 18% return on net assets, which in reality has not and will not be achieved on investment made since 2004). The renewed focus upon return on assets, rather than asset growth, is eminently sensible, and ultimately will yield the best returns for shareholders. The path, however, may be painful as the sheer amount of profit available in providing services to the mining sector is not large relative to that available through the construction of another large plant. Worley is a global services leader, built over 30 years, now employing 35,000 people, and this year will make approximately $380m profit, or $10,000 per employee. For Orica to make a meaningful services contribution on a starting EBIT base of $1b, within the next couple of years is not a trick that should be tried at home. The strategy is correct, and ultimately value creating, but the path may not meet current earnings expectations. Incitec is a similar story, with the announcement late last year of the deferral of a proposal to build a $1b ammonium nitrate plant at Kooragang Island in NSW a strong signal of the (re)emergence of capital discipline and focus upon cashflow. Like their major customers, both Orica and Incitec have performed best through their listed history when cashflows have been strongest, which is usually when returns on assets are rising through a focus upon managing price and productivity rather than adding supply.
The major themes affecting the Australian markets of too much debt, albeit concentrated in the financial and household sectors, aging demographics, and commodity prices continuing to trade at levels well above what we consider long term sustainable prices, all remain on foot. Our portfolio is positioned accordingly, with a bias to industrials with earnings exposure to economies where we believe upside to mid cycle exists more than can be said to be the case in Australia, or with exposure to domestic industries where cyclical debasing has already occurred. Whilst demand for financial assets may ultimately see them bid above fair value, it would be imprudent for us to ignore what we see as the ongoing risks detailed above, which only become amplified the longer they remain unaddressed. This balancing act has dominated the past four years and will continue to dictate our assessment of not just future likely returns, but also risks, in the portfolio.
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