The more things change
When I was growing up I remember being taught that it was a good thing to live on less than you earned and to save, invest and try to get ahead that way. Whilst we know that central banks are attempting to restore growth to the global economy, it is paradoxical to say the least, that you are now paid (at least if you are a government) to borrow money rather than save it. (Never mind the small irony that central banks are an extension of the very governments themselves whose debt is being bought back). We now have a strange situation globally where something in the order of $5-7 trillion dollars’ worth of debt is trading on a negative yield. What does this mean for smaller cap investors? We have argued before that we see the Australian and indeed the global economy heading for a lower growth period. Furthermore, risks appear to be growing with volatility rising, geopolitical pressures emerging (Russia, Middle East) all at a time when valuations are relatively full. As equity investors we also need to remember that the discount rates used in our valuations are a derivative of other factors and other markets namely the bond and debt markets. The normally free market forces dictating discount rates are unusually distorted at present due to the massive and continued intervention by central banks and as such an additional level of caution is warranted.
You will be relieved to know that I don’t intend to delve deeply into central bank arcana nor to examine all the complex economic and financial links in the global economy. Rather, I want to point out the need to be aware how these large forces are potentially playing out in the equity arena and in particular our patch of interest, the smaller companies' field. We have always held the belief that businesses earning good cashflows, trading at reasonable valuations with modest financial gearing are a good place to start investing. As risk increases, despite current trends and momentum tempting one the other way, we continue to remain grounded to these underlying beliefs. In other words, the more things change, the more things stay the same for us.
Valuations in small cap land continue to elongate in some popular sectors with the less popular sectors seeing the corresponding slack. In particular, the small cap resources sector, a previous market darling has performed appallingly since its 2011 peak. Although we are fully cognisant of the negatives surrounding resources, we are becoming increasingly aware of some of the more recent positive forces starting to work their way into the equation. These are firstly valuations. On most measures small resource stocks are looking good value, particularly against their more favoured industrial counterparts. Secondly, cost bases which had blown out are now shrinking due to the shift in bargaining power returning to companies and some aggressive declines in energy costs. Whilst we generally remain wary of investing in mining contractors, they have been a quick source of renegotiated savings for many mining companies and have been forced to pass on reductions of up to 20% in mining costs. Capital goods prices are also falling, once again thanks to less global competition for new machinery and the available supply of good second hand components and machines. Finally, the Australian dollar has, at last, started to crack. With most small cap mining stocks domiciled in Australia, the benefits are immediate now that foreign exchange and commodity price hedging is largely a thing of the past.
From a bottom up perspective the earnings growth in resources stocks is also forecast to materially outperform the industrials as earnings rebound from low’ish levels in 2014. Given the generally underweight positions of most small cap fund managers to resources it should be little surprise then that stock performance table for January is dominated by the smaller gold and resource stocks. At the other end of the ledger are the smaller oil companies still reeling from the aggressive sell off in oil prices and a number of mining service stocks including Bradken. Bradken is a mining services company that produces mining consumables (things like wear plates on crushing machines, grinding media (basically large ball bearings), and GET or ‘teeth’ that go on mining buckets). Bradken was the subject of an unsolicited bid from Private Equity in December last year. During the due diligence period the shares traded at a large discount to the bid price which suggested, a little like the situation which transpired at Transfield, some healthy scepticism around the eventual success of the bid. After their due diligence process, the private equity teams walked away claiming they could not get the backing of their financiers for a highly levered take over deal.
With record low interest rates, some additional M&A would appear a likely outcome over the course of 2015. Whether the M&A is driven by industrial logic (viz Programmed Maintenance’s merger bid for Skilled Engineering) or some fancy spreadsheet calculations by a private equity analyst remains to be seen – but I know where my money lies!.
As we head into reporting season we expect some degree of earnings disappointment. Broking analysts tend to be an optimistic bunch whose forecasts aren’t overly tempered by actual market experience. Unfortunately, we are unlikely to be completely immune from all result downgrades despite our continued focus on the fundamentals I mentioned earlier in this report – valuations, cashflow and modest gearing. If we have properly adhered to our bedrocks however the damage is likely to be manageable and an increase in volatility may present some opportunities for us to add to new or existing positions.
February is one of our two annual “moments of truth” where equity investors get to witness some of the limitations of Excel spreadsheet modelling. It is where the non-linear world collides with the linear - with the former prevailing. It would be a mathematical miracle if we didn’t see some degree of earnings revision downwards over the course of the next month and whiler the helium- effect of the central banks continues to exert an upward lift on longer duration assets, we expect some form of equal and opposite effect in due course.
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