Quest for sustainable cash flows has a familiar ring

“I wish it need not have happened in my time,” said Frodo. “So do I”, said Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time that is given us.” JRR Tolkein in The Lord of the Rings perfectly captured the feelings of many in 2020. Social disruption, economic dislocation and market euphoria. A veritable cornucopia of conflict between each of these, with about as little in the way of a coherent narrative tying all three together as there is in a US presidential debate.

And so, on many fronts, we need to decide what to do with the time that is given to us. Market values, globally and on the ASX, have clearly shifted more strongly towards technology stocks in the past year than ever before. Yet to what extent have profits shifted accordingly, and to what extent are they likely to?

Bond rates have clearly gone below 1% in all developed countries. Yet to what extent should hurdle rates drop accordingly, and to how much should we expect profits to drop? Also, does this only affect firms requiring capital to grow?

A once-in-a-generation shift in market values

The change in market values in the past 12 months is a once-in-a-generation event. In percentage terms, it’s best represented by the differing performances of a few key indices. So, while the S&P/ASX 200 is down a touch, and the S&P/ASX 200 Resources index, led by iron ore and gold miners, is up a little, the MSCI World has posted gains in the mid teens, while the US S&P 500 is up 20%, led by technology stocks. Meanwhile, the NASDAQ is up 50%.

This continues the theme of the past decade. Since January 2009, many asset prices have enjoyed great gains – Australian bonds up 100%, the ASX 200 up 150%, and the S&P 500 more than double that. Yet the NASDAQ has dwarfed them all, returning nearly 700%.

Real economy indicators have materially lagged asset prices. Australian house prices are up 50%, and wages and CPI up half the house price gain, and on all measures Australia has done better than the US and EU. Commodity prices are flat over the decade, which is an interesting context for the recent rally in some metals.

And yet the shift in profits belies these trends. Goldman Sachs recently highlighted that while US IT, software and R&D spending recently reached a record 50% of US non-residential fixed investment, it has only just surpassed its 2009 level. In other words, while the long run trend is of course strong (it has more than tripled in the past 50 years), the growth in the past two years only mitigated a multi-year decline. A similar situation exists in Australia where whilst the proportion of R&D and computer software spend of private non-dwelling investment is at a record level (14%), this is only marginally higher than where it got to 20 years ago when it last peaked.

At an individual level, company profits and cashflows, especially in Australia, do nothing to belie these trends. The shift in corporate profits has not justified the multiple expansion we have seen over the past two years, and even a cursory glance of a longer history highlights the cyclical nature of profits in the sector. We have, of course, made the point previously that there is a large distinction to be made between the major US technology companies and their Australia peers. The US companies are highly profitable, with largely organic growth, little in the way of capitalised costs, and profits composed largely of free cashflow. In aggregate, their Australian equivalents do not exhibit these characteristics, notwithstanding some great companies like Xero in their midst.

True defensives show their stripes

Technology companies are not unique in having volatile earnings, as we saw across the market during the FY2020 results season. Resource stocks enjoyed buoyant prices, led by iron ore and gold, leading to the strongest earnings upgrades in a reporting season in 20 years. Industrials, in contrast, saw the biggest downgrades they had experienced over the same period. Of course, this is largely COVID-19 related – but not wholly. And possibly, within industrials, true defensives showed their stripes.

The waste companies – Cleanaway and Bingo, both of which are in our portfolio – produced robust revenues and good earnings and cash flow outcomes, despite not retrenching at all through the period of subdued activity. They are both very well managed companies, which was proven again through testing times.

Retailers were another standout exception to the poor industrials results. However, they were so tainted by the unique circumstances of the half – affecting revenues, wage costs, rents and inventory availability – that it may be that the current market tendency to capitalise current conditions for listed retailers across genres may prove fickle.

The other strongly performing sector within industrials, building materials, saw a variety of influences. James Hardie is benefiting from extremely strong demand in the US, plus new management making the most of every opportunity available to the company. Whereas Boral has recently outperformed following changes in the share register, governance and management, leading to renewed optimism that acceptable returns can be generated after more than a decade of mid-single-digit returns.

For financials and property, the worst is yet to come

The time that is currently given to us in financials and property is also vexed. Financials, led by the major banks, experienced their largest downgrades in the past decade as faltering volumes and prices driven by the inexorable decline in interest rates saw revenues crimped, and profits lowered further through rising costs and bad debts. The decline in profitability forecasts for the banks is now approaching the levels seen through the GFC and the worst is yet to come for bad debts, which will likely continue to rise through FY2021 and FY2022, albeit off extremely low levels.

In property, our analyst Daniel Peters has long highlighted the cyclical nature of property income reflecting the health of the tenants, a stark example being Sydney CBD office rents, which dropped nearly 70% in the last recession in Australia, when vacancies peaked at a touch more than 20%. Of course, a perfect storm had occurred: years of construction had seen a swag of new supply entering the market at the same time as demand fell, lead to a deterioration in both sides of the vacancy equation. Sydney is not an isolated example. We have seen similar situations emerge in Perth and Brisbane during the past decade, if less extreme.

Sydney has recently seen CBD office supply increase and a further splurge is due for completion through the next twelve months. The current implied cap rate for Dexus – a touch more than 6% on Daniel’s numbers – seems attractive, but Vicinity Centres at 8% highlights how far multiples can fall when demand and supply converge the wrong way. We have recently acquired some property exposure in the portfolio after a long period of not owning any, but in doing so we are aware of the cyclical nature of rents in both office and retail, and have spent significant amounts of time with tenants and landlords trying to measure the fall we expect in rents through the next several years (and thereafter).

The market outlook

Toto, we’re not in Kansas anymore. Low to no interest rates are causing large dislocations in the price of those Australian equities perceived to offer a secure income, on the one hand, or growth on the other, with a squeeze in the ugly centre where a downgrade pimple is rapidly priced as a derated mole, no matter the sector. Sustainability of earnings and, more importantly, cashflows, has never been more important, nor securities more harshly dealt with if expected levels of cashflow evaporate.

The better opportunities in the current market tend to be idiosyncratic, where cashflows are hit, albeit not by structural factors, and where derated multiples become attractive. Ensuring that such dislocations are transient, rather than structural, remains critical in assessing portfolio holdings and opportunities, as indeed has always been the case.

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