Twain, Louis Vuitton, and the problems with valuations
The markets continue to look like Louis Vuitton – where the glamorous and sparkly are eye-wateringly priced compared to the ordinary. Wealth inequality means an increasing percentage of the population will baulk at the ridiculous price of anything, and the same should apply to stock prices.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”.
Sage advice from Mark Twain, as always. Many of the assumptions underlying finance and economic theory which economists ‘know for sure’ are intuitively appealing — free markets and supply/demand among them. When there is too much supply of something and insufficient demand, prices should go down. This either removes supply (some producers stop producing because they can’t make money), or stimulates demand (lower prices causes buyers to increase demand). Prices therefore contain a great deal of information. Whether they be share prices, house prices, interest rates (the price of money), electricity prices, the price of a mobile phone plan or the price of a bottle of Treasury Wines’ Grange Hermitage.
Whilst generalisations are dangerous, we’d observe many prices are tending towards extremes. Theory would suggest this shouldn’t happen in free markets. The prices of houses, shares and other assets are close to extreme highs by historic standards. The price of money is extremely low. The price of luxury goods such as Grange Hermitage has moved ever higher, while the price of most mass market goods and services (cars, T-shirts, TV’s) has moved ever lower in real terms. These shifts have accompanied shifting wealth inequality. As wealth bifurcates, the prices of the objects of desire of the wealthy bifurcate accordingly. The sting in the tail is the commensurate narrowing of the market. If you need to sell your $10m house or your $700 bottle of Grange to someone on average weekly earnings, the spread between the bid and offer is likely to disappoint. More accustomed to the $10 shiraz, they’re not likely to part with $50 (let alone $700) for a bottle of wine, even if it is full-bodied with hints of blackberry and a beautifully long finish.
The same principles apply to the equity market. Prices are set best when markets are wide and deep, with buyers and sellers making decisions based on underlying fundamentals. In an overly financialised world where ballooning asset values continue to drag human resources from less lucrative pursuits (that’s what high prices do), the price setting mechanism is becoming less healthy. The rich data set which share prices provide for analysis and the rich potential rewards means machine learning and data analysis are finding some of their most lucrative outlets in financial markets. As users of Netflix, Amazon or Facebook can attest, many companies are perfecting the art of not only predicting behaviour, but inducing it. Concurrently, the increasing pool of passive investment is narrowing further the pool of investors setting prices (passive investment by definition relies on the price setting efforts of others) and increasing the ability to shift prices to extreme levels. Many fundamental investors unknowingly assimilate these induced behaviours (where prices themselves become the primary driver) and further reinforce them. Valuations formerly seen as ridiculous (because they are!) become justifiable as the lure of favourable momentum becomes intoxicating. These are the times when things we thought we knew for sure on how business valuations should be derived, and how free markets should work, are challenged.
Almost all sectors sit at historic extremes in terms of price earnings ratios versus history. If historic relationships hold true, there will be strong returns to be made as things normalise. Globally, investors with strong valuation disciplines have been challenged for some years and are roundly the class dunces at present. The facts, therefore, seem to point strongly towards positioning for a reversion in these extremes. In taking Mark Twain’s advice though, we need to think through whether this expectation of reversion may be flawed. For the most part, we conclude these extremes will be transitory. Profit and cash flow fundamentals will always rule in the end and the pushing of valuations to ludicrous extremes has happened many times before. Eventually, if real cash profits (not the accounting fictions which are currently popular) do not follow valuations, gravity will unwind the artificial market value creation.
It is on the profit side of the equation where we harbour a few more concerns. As we’ve alluded to above, true free markets allow prices to fluctuate freely. These have become notably more absent of recent years. You can’t just have free markets when and where it suits you. When you manipulate interest rates (one of the most significant and important prices) you have permanently interfered with free markets and the flow on impact of intervention at this scale will be colossal. To start blaming trade wars (a different, but not necessarily more sinister form of price manipulation) for potential global ructions is the absolute height of hypocrisy.
Having emphasised the importance of prices and how they’re set, industries and businesses in which we believe prices are markedly too high (usually because they’re not set in free markets) our valuation methodology requires us to adjust our views of sustainable profitability to reflect more realistic prices (the alternative is to assume artificial prices in perpetuity). Our expectation is that forces will eventually drive these prices down to more normal levels. This lower level of sustainable profitability will in turn drive a lower view on valuation than that derived by those more inclined to extrapolate the status quo. Adding insult to injury, in an environment which eschews any expectation of reversion, businesses enjoying these egregious prices are generally the ones boosting short-term profits and therefore accorded the most generous multiples.
Taking healthcare as an example, Fisher and Paykel Healthcare (+11.8%), CSL (+23.9%), Cochlear (+10.2%) and Resmed (+14.5%) all report margins and returns on capital stratospherically higher than the broader market. None sell their products into free markets. Customers generally don’t pay the bill, taxpayers or insurers do. We continue to expect that governments will seek to reduce the excessive prices charged by these companies in an effort to deliver better value for the taxpayer. We have generally been wrong. The only losers, when governments fail to keep the prices in check are taxpayers, as the residual disposable income available to purchase goods and services reduces accordingly. In general, the companies are happy (they earn egregious profits), the patients are happy (they receive excellent but exceptionally expensive products and perceive them as nearly free), and intermediaries such as health insurers or governments are generally able to pass on the costs to the general public as higher premiums or taxes. The unintended side effect is the progressive squeezing which this places on free market businesses trying to sell goods and services to consumers who are progressively relieved of more of their disposable income. Each of the businesses above trades at multiples far above the market average. Given this multiple is effectively the discounting of expected future profits, investors are expecting these egregious profits will grow far more quickly than the broader market, necessarily taking them to ever more excessive levels.
The recipe is somewhat similar for toll roads, airports and utilities. Almost every investor globally is looking for long-term guaranteed earnings streams where pricing is not subject to the vagaries of free markets. Governments are generally obliging by selling rights to fleece consumers well into the distant future in return for up-front payments. They are oblivious to the incremental pressures which this fleecing is foisting on businesses competing for what’s left of disposable income.
At the other end of the spectrum is telecommunications as we found out at the Telstra Strategy Day; three words which should strike fear into the hearts of Telstra (-16.6%) shareholders. Competition is working just fine. Whilst the volume outlook for the industry’s products remains robust, consumers continue to expect (and receive) rapidly improving products without paying any more. At the same time, carriers are investing heavily in new network, seeing returns come under increasing pressure. Free market competition, and hence prices, will always ebb and flow. We do not believe investors should fear it, nor panic on long-term valuation merely because it happens to be intense at a point in time. It is difficult not to see the irony versus industries such as electricity which are demanding certainty prior to committing to any investment. Maybe it’s just me, but I don’t see anyone providing Telstra, Woolworths or Rio Tinto with a guarantee on the future, yet they still seem to be investing.
Overriding free markets sets dangerous precedents. Unfortunately it doesn’t seem to be receding as a factor in determining the prospects and value of a business.
The lure of the fast buck remains as powerful as ever. As we have raised many times, the overly financialised world in which we operate has elevated asset price speculation far above the tedium of saving wage and salary income, one of the side effects of manipulating interest rates and driving wealth inequality. It is perhaps unsurprising that the equity market echoes these ‘Louis Vuitton’ characteristics, where the glittering and glamorous command prices far in excess of the bland and mainstream. Expectations that these conditions will prevail into the distant future may be possible, however, our analysis of the facts and history suggest it is improbable. Sometimes the things you know for sure just ain’t so.
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