In search of sustainability
A trend which could well become more powerful within equity markets showed the early signs of emergence during April… the search for yield. This trend is an outcome of financial repression, as central banks pursue policies which transfer wealth away from the prudent, in an effort to rescue the less prudent and the intermediaries (primarily banks) which facilitated them. This trend is simultaneously logical and worrying. Financial repression through manipulation of interest rates and financial markets is no different to increasing taxation. It is merely an alternative form of subterfuge. Just as tax is rarely paid willingly, investors don’t have to willingly provide funding to governments at an unfairly low cost. Would you lend money to the Spanish government at 6% or the Japanese government at 1% when they almost certainly can’t repay it? The search for alternative sources of income is eminently logical. The worry stems from the pervasive insistence of policymakers on intervention in free markets. The possibility that accumulated intervention may be a cause of the problem, rather than the solution, remains disregarded.
How this search for yield manifests itself, and which sources prove to be reliable rather than ephemeral, is a more difficult question. The trends to date have been haphazard. A number of traditionally defensive sectors with strong yield support have performed exceptionally well. Telecom New Zealand and Telstra continued to build on strong gains over the past year, while REITs such as Westfield, Mirvac and CFS Retail saw support which has, to date, been more elusive. Supermarket retailers such as Woolworths and Wesfarmers remain ignored. We continue to focus on two factors, the sustainability of, and the price being paid for the ungeared cashflows. Yield must be funded by cashflow in the longer run and leverage significantly increases risk. Our concern with REITs remains one of valuation. The absence of tax and depreciation combined with high payout ratios renders yield a distorted measure when compared with traditional businesses. These factors will not matter to some in the short run, they will in the longer run.
The abovementioned questions of intervention and sustainability were also at the forefront of our minds on a recent trip to China. Years of bludgeoning by commentators assuring us that urbanisation and industrialisation guarantee China many more years/decades of strong growth have not wearied us. We are paid to challenge assumptions, not blindly accept them. Unsurprisingly, the property market was the subject of much attention. It is important for many reasons. With local governments deriving around 50% of their revenue from land sales, and those land sales driven in turn by the profitability of developers, flat to falling property prices are a concern. That was exactly the message the developers gave us: affordability is rotten in most areas, credit is not as plentiful as it was, and social housing makes no sense for developers as it’s not profitable. The other dimension is supply, and it is in this area that we disagree more vehemently with the popular wisdom. Let’s look at some rough numbers (they’re the only kind available in China!). On official numbers China completed some 1 billion m2 of residential housing space in the past year. Given units are on average 70-80 m2, this equates to housing starts of some 12-14 million. To put this in context, the US is currently developing around 600,000, UK around 200,000 and Australia around 140,000. Housing starts per head of population for developed economies are therefore somewhere around 0.2% to 0.6%, whilst China sits at about 1%. So what does this mean? Relative to starts in mature economies with superior demographics, starts per head in China are well beyond these levels. The difference can obviously be attributed to urbanisation. Assuming 1.5% of the population move into cities every year, 20 million people may therefore require perhaps 7 million more housing units. Additively, assuming starts in a mature economy at a level of around 0.4 to 0.5% of the population and an assumption of urbanisation at a relatively aggressive 1.5% per annum only leaves required housing starts at or around current levels. Once the urbanisation process matures, the number will need to fall sharply. An assumption that starts, a key driver of commodity usage, can grow significantly from current levels, is in our view, illogical. This does not sit comfortably with an assumption of consistently increasing steel production and iron ore demand. Whilst acknowledging our limited insight on the propensity of local and central governments to persist with white elephant projects to bolster short term demand, we feel confident that the laws of supply and demand will eventually assert themselves. As Herbert Stein said, “If something is unsustainable, it will stop”.
The combination of domestic economic weakness, rotten weather and ongoing currency strength saw earnings continue to move in the wrong direction during April, aiding the trend towards safety and yield. Downgrades from Boral, Bradken, JB Hifi and Seven West Media are indicative of margins and returns across most domestic businesses which are above normal levels and are being driven back towards equilibrium. We would expect this process to continue for some time yet, and as it does, there is little doubt that perceived safety will become substantially over-priced and perceived risk substantially under-priced.
From a stock perspective, we find the current outlook quite perplexing. Despite an extremely cautious view on longer term growth, the anticipation of an extended period of deleveraging and a roundly sceptical view on the sustainability of Chinese growth, our valuations (which are always based on longer term sustainable earnings) are already pointing us towards industrials, banks and large resource businesses as offering far superior prospective returns than REITs, infrastructure stocks and the similarly defensive cashflow streams which investors would normally be seeking out in such an environment. As always, there is a risk that we are still suffering from over optimism in our earnings forecasts on more cyclical businesses, however, we are doing our utmost to ensure these are grounded in reality.
Most importantly, in this environment, we are seeking businesses in which management are realistic about the structural changes and challenges that are confronting their businesses. Most industries have excess capacity and the environment we envisage will not call for more. Remembering fondly the days of 15% credit growth, double digit sales growth and waiting for their return isn’t going to cut it. The more these challenges are acknowledged and profits are redeployed in providing better income returns to shareholders rather than investing in “growth” and new capacity, the better we feel. The large resource companies arguably have most to gain from this change in direction. The increasingly scarce businesses which have genuine growth prospects (not through acquisition) and pricing power should also become increasingly valuable. They are the equivalent of long duration bonds. In an increasingly scarce environment for yield, we are very confident they will produce sharply better returns than their short duration counterparts.
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