Gravity will overwhelm in the end
As continuous disclosure rules now ensure that reporting season is short on surprises, focus is firmly on outlook commentary. Analysts await guidance with bated breath, as it provides two key benefits; firstly, it obviates the need for any thought, as one only needs to ensure that forecasts line up with company expectations and secondly, it ensures that fault for any deviation from company expectations over the coming year can be laid firmly at the feet of company management. Quality of management becomes synonymous with their ability to meet or beat guidance. Given that businesses have wildly differing degrees of predictability and that prudently managing a business with a long-term focus can often mean sacrificing the short-term, many of these measures of success seem to us, misguided. In any case, those businesses that adhered to an optimistic outlook tended to perform better than those that took a more sombre approach. As always, time will tell.
Recent years have been a somewhat perplexing time for investors advocating an adherence to any degree of mean reversion investing. To some extent, we would put ourselves in this category, as we believe that return on invested capital should act as a long term anchor for the average business. Whilst it will always be possible for some businesses to defy the odds, and due to exceptional market positions, pricing power, skilful management, earn excess returns (for want of a better term) for extended periods, the average business is more likely to find its path being driven towards the average. Like the residents of Lake Wobegon in ‘A Prairie Home Companion’, “where all the women are strong, all the men are good looking and all the children are above average” the majority of CEOs see their businesses as performing well above their peers, and invariably have an extensive slide pack to prove it. However, once you’ve adjusted for write-downs, abnormal items, restructuring charges and dubious accounting, Lake Wobegon moves further into the distance. Despite this powerful gravitational force, many of the standout performers in the stockmarket have seemingly torn free of these shackles. Internet based businesses such as Carsales, REA Group, Webjet and service businesses such as Flight Centre, McMillan Shakespeare and Super Retail Group feature prominently at the top end of performance tables over extended time periods, whilst their more capital intensive peers in more traditional industries have done little to enhance shareholder wealth. Bluescope Steel, Qantas, Alumina, Boral and the like have been good ways for superannuants to ensure a longer working career. As an economic rationalist, I find myself asking the question of Professor Julius Sumner Miller, “Why is it so?”
Although any attempt to rationalise some of these trends will be guilty of oversimplification, there are a number that we believe are important. The overwhelming trend, and one to which we have referred many times, has been the increasing dominance of the financial and insurance sector relative to the real economy. Whereas post war economic growth was driven by productivity and innovation, growth in recent decades has relied disproportionately on credit, housing and consumption. Wealth creation is measured by gains in stockmarket capitalisation and house price appreciation rather than productivity. TSR (total shareholder return) is now a common method of remuneration despite having nought to do with value creation. Despite relatively regular warnings in the form of financial crises, stockmarket and housing bubbles, each crisis has been met with further accommodation to allow the financial sector to resume its inexorable rise without the consequences that capitalism would normally inflict. A number of the other trends that we have observed in industry performance over an extended period are arguably ancillary impacts of this process. Whether it is the suppression of returns on manufacturing and most forms of fixed capital, the sharp transfer of power towards distribution and away from capital providers (Flight Centre now commands a market capitalisation about 60% higher than Qantas), or the increasing dominance of regulation in determining corporate outcomes, most have their root in an economic belief system which requires growth at all costs, and an almost unilateral reliance on monetary policy to drive this growth.
As with any long running process, this has created a legacy of distortions which are problematic and uncomfortable to unwind. At a granular level, there are always reasons as to why now is not the time to let free markets work. Take last month’s example of McMillan Shakespeare (MMS) and the novated car leasing business. It exists due to FBT legislation which artificially creates demand for new cars. Take away the tax incentive and demand collapses, as do car sales. Standing back from it, there is no valid argument for providing this artificial support. However, when car manufacturers, dealers and service providers such as MMS have been accustomed to artificial support, there is nothing surer than the outrage that will stem from any attempts to restore normality. Jobs will be lost, plants will be shut and the world will be torn asunder for those at the coalface. As a result, the path of least resistance is invariably to restore the intervention. The path is well trodden. At a granular level, there are always arguments for sustaining intervention. When one observes the outcome from 10,000 feet, the totality is far more insidious. In the name of financial stability and growth, we are now decades into a phase of economic development which most regard as normality. The outcomes are observable. Leverage has exploded; the simple reason as to why bank assets have moved from under 90% of GDP in the early 1990’s to around 200% today.
As sceptics of the ability for all Australian and global residents to move to Lake Wobegon, determining normality is only becoming more difficult as distortions become more enduring. When people become sufficiently accustomed to house prices which don’t fall, or are convinced that our dire shortage of land for development (despite having more land per capita than almost any country on earth) is the reason why our house prices are sustainable, fiction becomes fact. Examples such as McMillan Shakespeare only make us more adamant on our long held beliefs. Intervention and distortion can distort normality for extended periods, potentially decades, however, as they did for Professor Sumner Miller, physics will overwhelm in the end. The greater the extent to which a business is reliant on, or has benefited from distortion, the greater the eventual risk from gravity.
As a result, our interpretation of company results did not always coincide with that implied by post result share price moves. Results such as Woolworths and Brambles only reinforced our confidence in businesses that earn their profits in free markets and manage the business focused on the long run. Those of businesses such as Carsales and REA Group, where profits are being driven by maturing franchises looking to aggressively exploit price, created far less enthusiasm.
In time honoured Australian fashion, easier monetary policy is inducing far more ebullience in the residential property market than in the real economy. Although this could well translate into more positive sentiment and increased consumption activity in the short run, it will only make us less sanguine in the longer term. We are not sure what possible benefits can be expected from a post-election environment, although the prospect of a conclusion to the campaign is, in itself, grounds for some optimism. When the lucky winner emerges, we suspect that the reality of a deep cyclical economy living significantly beyond its means will provide a more sombre backdrop.
In our minds, the economic path being forged by policymakers globally is almost guaranteed to be rocky. Having presided over an explosion in the size of the financial system relative to the real economy, we feel sure that gravitational forces will be working powerfully in favour of driving them closer despite concerted efforts to drive an ever widening gulf. Sharp moves in gold stocks (as was seen in August) and bond yields are symptomatic of the increasing difficulty in sustaining distortions which have become accepted as normality. We will do our best to focus your investment in businesses that do not rely on artificially supplied oxygen to thrive and can withstand the weight of gravity.
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