Finding the long shots

A year for the underdogs! The Western Bulldogs, the Cronulla Sharks, Leicester City, the Chicago Cubs, Donald Trump, Brexit; it was a good year for the bookies and tough for those backing favourites. The long shots also had a better year in equity markets. Domestically, infant formula, vitamins, aged care and fund managers gave way to coal, lithium, steel and aluminium. As always, we remain cynical of those professing an ability to identify the catalysts for these changes in fortune. Outlook commentaries at the outset of 2016 were noticeably devoid of cheerleaders for this year’s eventual winners, while prior year winners had plenty of fans. As the groundswell of opinion shifts, the army of cheerleaders will always swell in number. Being out on your own isn’t comfortable for most. As Adam Grant highlights in his book ‘Originals’, non-conformists are often the ones to change the world, however, they don’t get there without occasionally looking stupid. Steve Jobs’ inclination to believe the Segway (a two-wheeled, self-balancing personal transporter for those that don’t remember) was going to revolutionise transport may have been misplaced; a few of the other things he tried turned out OK!

We can’t help thinking that equity markets could use a few more non-conformists to upset the status quo. Beta, Sortino ratios, implied volatility and catalysts still seem to be dominating the simpler questions concerning how a business makes money, whether it is likely to make money durably and how much someone is being asked to pay for it, all questions not easily answered by reference to a share-price time series. Trying to make money smoothly every month is nice in theory; it’s just not how real businesses actually work. Even in a year in which our investment performance has fared well, we can’t help questioning whether resource stocks have improved for earnings momentum reasons associated with a more buoyant commodity price environment rather than the more fundamentally appealing (from our perspective) rationale, this being the realisation that these businesses, based on any rational long-term commodity-price outlook, had become ridiculously cheap versus counterparts with a more appealing short-term earnings trajectory or a perception of earnings stability. Similarly, despite the outcome, we’re not sure whether a Donald Trump victory in the US presidential election should change the underlying value of the average business.

As always, the year provided plenty of lessons on the importance of understanding the true life cycle of a business. Generic descriptions of ‘quality’ businesses as those earning high or stable returns, or those able to grow quickly, are platitudes borne of didactic slide presentations and belie the need to understand why and how a company makes money. There are plenty of ‘good’ businesses currently not making much money and many ordinary ones doing well. Economic value can be created gradually, quickly, smoothly or in cyclical bursts. It is the quantum in the long run and the amount we are asked to pay for this value creation that matters. A few we believe are worth thinking about are discussed below. 

On almost all measures, Sydney Airport (-14.1% over the December quarter) qualifies as a ‘good’ business, and undoubtedly a long-duration one. Since the purchase by the Southern Cross consortium in 2002, Sydney Airport has been a highly lucrative investment. Versus a $5.6 billion purchase price, the asset is now valued at more than $21 billion. Its return on capital is well into double digits despite having a large element of the asset base subject to regulation. Outside the quasi-regulated aeronautical asset base of about $4 billion, investors are paying nearly $17 billion for car parks and a shopping centre. (The build cost was a small fraction of this amount.) This value growth has been driven by a Sydney population augmented substantially by immigration, strong passenger growth, a monopoly position and resultant price increases, significant financial leverage (the airport now has more debt than its original purchase price) and a massive increase in the price investors have been prepared to pay for these cash flows as interest rates have fallen. Existing investors understandably have a strong preference for maintaining the status quo. However, the recent controversy surrounding the Western Sydney airport and the potential involvement of Sydney Airport in its development has left shareholders with a conundrum. Without government assistance, development carries traffic risk, project-cost-blowout risk and financial risk. It will almost certainly not earn significant returns in early years. However, if another party commits to build the airport, it will provide competition for Sydney and erode returns as traffic migrates to the new airport. Why though, should investors be willing to pay multiple times the build cost of the existing airport yet not be willing to invest at book value in the new one? The answer, in our eyes, is an unrealistic picture of the path of the return on capital. Valuations that assume the government will invest in infrastructure around the airport to allow ever-growing traffic volumes and that it will subsidise a new airport to ensure returns are never compromised by the need for new investment strike us as a tad unrealistic. Nearly all long-dated assets should periodically require investment, which dilutes short-term returns in order to earn a payback in the longer term. Sydney Airport will remain a good asset, however, in our experience, valuations premised on returns that rise inexorably without hiccup are almost always wrong. Adding financial leverage as returns rise further tends to exacerbate the problem when the eventual need for reinvestment arises. These principles apply to office buildings, retail shopping centres, pipelines and many similar assets, where the economic nature of the asset has been disguised through distributions that ignore depreciation, trust structures that avoid the payment of tax and an asset-price-inflation environment that has overshadowed the impact of asset ageing. It is why we incorporate an economic depreciation charge in our valuation of assets of this type and is a contributing factor in our struggle to find any valuation appeal in these highly sought assets. 

South32 (+14.1%) highlighted the ability to add value through a different path. This time last year, coal prices were languishing at levels permitting few in the industry to make any profit. Manganese producers were in a similar predicament. The value of the entire business was about $5 billion, half tangible asset value and probably the equivalent of a few storeys in the Sydney Airport car park. Skyrocketing prices for coal and manganese and stronger prices for other commodities will allow the business to make well above $2 billion in operating profit should current prices prevail for another six months. The business also has no debt, such that the risk that shareholders take in embracing a relatively volatile earnings stream should never be terminal. The returns delivered by the business last year were mediocre at best, however, it always retained the optionality of earning extremely strong returns in a more buoyant price environment. Every year in which the business can deliver return on capital of 20% to 30% pays for a number of years in which returns are in the mid-single digits, while still delivering solid value growth over time. 

Lastly, there are obvious lessons in the tumultuous experience of some of the quarter’s laggards, Sirtex Medical (-55.1%), Bellamy’s (-48.7%, though yet to re-trade) and Vocus Communications (-37.9%). We would characterise all of these as being of questionable duration. Returns may be high, however, the trade-off is that they have potential to evaporate quickly. Post vaporisation, shareholders are often found questioning what they actually own. Biotechnology stocks, in particular, have extremely polarised payoffs. Investment in research and development must result in a product that is effective, then drug authorities must be convinced of its cost versus benefits and then an army of sales and marketing staff need to convince doctors to use it. (It is instructive that the 2016 sales and marketing investment by Sirtex was nearly double the cumulative investment in R&D over the past five years). Subsequently, products run the risk of being made obsolete by new, more effective or lower-cost treatments. Unsurprisingly, the losers greatly outnumber the winners. The same could probably be said for businesses such as Bellamy’s and Vocus. If consumers turn their attention elsewhere, shareholder equity can often be left mainly on advertising billboards. This risk is rarely captured in the slide presentations praising the exceptional returns from ‘capital light’ businesses. We are in no way dismissive of all such businesses, however, we often observe the cursory attention paid to the role of duration in deciding how much to pay for a business.

Outlook

While the stark divergence in the valuations of mining and energy businesses relative to businesses with perceived defensive characteristics has unwound to a degree, driven by a slight unwind in the multi-decade bond bull market, the broader valuation picture remains largely unchanged. Valuations of nearly all assets (equities included) are aggressive versus history and premised on a tenuous and hyper-sensitive balance between a financial system that is excessively large versus the underlying economy and history, requiring an unduly low interest rate to support it. This hyper-sensitivity can work in both directions, allowing the possibility of significant gains and losses as small changes in discount rates are amplified. These risks have been evident for some time, but cannot abate without imparting pain to those asset values that are not supported by sound underlying cash flow and returns, a process which remains anathema to policymakers everywhere. The credit-creation process remains the heart of the matter. While the dangers of excessive credit fuelled demand in China are obvious and well publicised, it remains unclear to us why the credit-fuelled consumer demand boom evident in many Western countries (including Australia) is more benign. Ever-higher levels of credit are not the solution to greater financial stability.

Our rationale in dealing with this investment environment is straightforward. We believe durability of earnings and returns will become increasingly important as the tailwind from interest-rate reductions dissipates. Secondly, excessive financial leverage is becoming an unpalatable game of Russian roulette as global discontent grows over financial stimulus that has been squandered in outsized gains on passive assets and delivered limited real economic benefit. Low-to-mid-single-digit ungeared returns on real estate and infrastructure assets, which set aside nothing for reinvestment and replenishment, remain generally unappealing, while materials stocks still offer reasonable value based on earnings levels that allow for lower commodity prices and the substantial reinvestment level which their depreciation charges imply. We remain particularly cautious on businesses earning substantial excess returns courtesy of egregious pricing where governments rather than consumers pay the bill and free market forces are nowhere to be seen. Areas of healthcare are prime candidates in this regard.