Oh Mr Magoo you’ve done it again
As Mark Twain said, “If you tell the truth you don’t have to remember anything”. The truth of the past year is that we could detail our successes on the back of a postage stamp with a crayon. In almost every instance, valuations which we thought were excessive have become more excessive and those we thought cheap have become cheaper. Although February saw some recovery in a number of the laggards in which we see good long term value, namely the larger resource stocks such as BHP Billiton and Rio Tinto, the broad thematic trends favouring defensive yield (or at least the perception of it) at almost any price, remain intact. We are unashamedly frustrated. If Mr Magoo was a fund manager, he would have loved the past year. Near sightedness has led to wonderful outcomes. Trying to put businesses and the economy into a broader and longer term context has been wholly unrewarding. We have lost none of our faith in the fact that valuations always matter in the long run or that the powerful momentum engineered by globally negligent monetary and government policy will transpire to be myopic and damaging.
Like many, we have been analysing our recent mistakes (amongst many) in failing to predict the recent ructions in oil markets in an effort to avoid their repetition. As is almost always the case, mistakes with such a significant impact tend to be in the large and simple category, rather than small and obscure. The supply demand imbalance exacerbated by large supply increments from the US and the increasing reliance on Middle Eastern suppliers happily shedding market share to higher cost new entrants in order to maintain an artificially high price should have highlighted disproportionate price risk in one direction; down. In this instance we, and most operating in the oil industry, suffered from myopia aided by the prevalence of an artificially high price for a lengthy period. Supply and demand is a simple but crucial concept. Imbalances almost always create larger than anticipated effects.
We feel exactly the same way at an overall economic level. The problems are large and simple. Economists would have you believe that the economy is a complex beast, only understandable through a morass of charts and formulae which justify government and central bank manipulation in order to arrive at a better outcome than through focusing on the simple. The problems are not complex.
For starters, there has been wholesale and long lasting ignorance of the difference between money and wealth. Money is merely the way the apportionment of wealth throughout the economy is counted. Society cannot be made better off through changing the quantity of money in the economy. However, if you don’t change the quantity of money in the economy, you can’t get nominal GDP growth, and if GDP growth is your North Star, you inadvertently switch focus from trying to ensure wealth is created to ensuring money is created. This is the source of much of the distortion plaguing the world, and the reason, as my learned colleague pointed out last month, financials are now dominating both the stock market (being at their highest weight in history) and the economy, through profits which now dwarf businesses in the real economy. As the channel through which money enters the economy, banks fulfil a vital role. Sensibly managed and controlled, they should facilitate productive investment through matching savings with those with a need for productive borrowing. They can do this without needing a perpetually rising money supply. Unfortunately, when central bankers desperately want to inject growth (money), banks are also their channel. They make money cheaper (cut interest rates) and banks oblige by trying to push it out the door, usually badly. Recently released bank results provided yet another snapshot of what is actually happening. Credit, although growing at relatively slower rates than the crazed levels of recent decades, continues to outpace both the growth in incomes of wage earners and revenues of real businesses. Banks are reporting revenue growth of mid to high single digits with almost no compression of net interest margins. Results season showed almost no other company matching this organic growth level, save a number of healthcare businesses also relying on the government to divert more of the income towards them rather than competing for it in a free market (I’m still not sure why my son should pay for the healthcare of the elderly while they don’t pay for his car insurance). What should also be obvious is the fact that the financial system’s increasing size relative to the revenue of the remainder of the economy can only exist in an environment of widening income inequality. If, as banks and mortgage insurers assure us, people were saving more and getting ahead on their housing loans, credit should be falling, it is not. Population growth of 1.5% (mostly through immigration) does not equate to 6% housing credit growth unless someone is growing their debt balance. If savings are rising at the same rate (in dollars) as loans, then it is almost certainly because some people are becoming more indebted and others are saving more (inequality is rising). Efforts to stimulate economies around the world have consistently seen this outcome. Debt has risen from already excessive levels, asset prices have risen further and real economies have withered. Only beneficiaries of rising inequality are thriving. Banks (making a margin on gross loans and savings) are happy, asset managers and superannuation industry participants are just fine, and businesses catering to the ultra rich (VIP casino gambling) are booming. Results season saw a broad continuation of these trends. The parallels with oil markets are clear. Central banks continue to add more supply (money) through ever lower interest rates, yet demand (like oil) for credit with productive use is relatively inelastic. In central bank land they no doubt believe a raft of small businesses are just waiting to start up. They are only waiting for borrowing to get just that little bit cheaper before committing. Mr Magoo funds management continues to profit from the assumption that the same problems will continue to be treated with the same cures. More money, no more productive uses = rising asset prices and rising inequality. “Oh Magoo, you’ve done it again”.
The real economy businesses doing better were almost universally driven by solid cost cutting performances (Rio Tinto (+11.9%), BHP Billiton (+15.0%)) or have won market share in categories with fairly anaemic overall growth (Domino’s Pizza (+34.1%). Market share losers are struggling as even the most ardent cost saving programs struggle to move nominal costs backwards for long. Woolworths (-3.4%) has been a case in point. We have maintained a significant position in the portfolio as valuation remains very attractive, however, the mindset of continually rolling out stores and assuming the revenue opportunity will mimic that of recent decades, worries us greatly. They are not the only ones with this mindset. Alternatively, as was the case for Toll Holdings (+44.4%), finding a buyer (Japan Post) prepared to pay a multiple vastly higher than anyone thought feasible, because money is free where they come from and you may as well own a trucking business which at least makes some profit over holding a Japanese bond which doesn’t make any, works also.
Wisdom is generally acquired by those that want to learn. If you produce the same chart pack for the same meeting and refer to the same inputs, you’re probably going to arrive at the same conclusions. Unsurprisingly, weak data since the last interest rate cut has lent voice to a chorus of economists calling for the need for further cuts. This should go well. The housing market could use some more juice! Perhaps I’m too cynical. This could be the time when banks finally stop just lending more against housing and claim that loan quality is deteriorating rather than improving (nothing like perpetually falling interest rates and rising asset prices to wallpaper over problems).
We have made far too many errors over the past year and we continue to review the inputs we are using in an effort to prevent their recurrence. Regardless of the angle of approach, we cannot rationalise the current divergence in valuations. Pricing relatively passive assets like toll roads, shopping centres and pipelines at more than double the multiple of retailers, raw material producers and transport companies suggests the latter can comprise a far lower share of the economy in the longer term (despite being far larger employers), without compromising the ability of these passive income streams to grow ever larger as a share of the economy. The maths may work for Mr Magoo, but not for us. The more housing loans are permitted to grow (already around 100% of the country’s annual revenue) faster than the underlying businesses in the economy, the greater the economic cost of the eventual adjustment. Mathematically, it will already be almost impossible for the real economy to absorb the costs (the entire manufacturing sector in Australia currently generates revenues equivalent to about 1 year’s housing loans). Whilst it is easier to ignore these facts and focus on share price charts with soothing upwardly sloping paths and invest accordingly, we will not. Mr Magoo will eventually trip over.
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