Interest rate common sense? No thanks

They have seen the whites of the enemy’s eyes and beat a hasty retreat. Given the correlation of equity markets with the progression of quantitative easing, the prospect of tighter monetary conditions, particularly in the US, sent shivers through markets in the final quarter of 2018. The appetite for ‘normalisation’ faded rapidly. Bond markets rallied nearly everywhere with Australia amongst the leaders. Fresh from a Royal Commission in which banks had been chastised for profligate lending and insufficient scrutiny of income and expenditure levels, by early 2019 the RBA had become concerned that credit conditions had tightened too significantly, with many now wagering that the next move in official interest rates will be down. I can’t help feeling it would be a little galling to have stepped off the stand having been torn to shreds by Rowena Orr only to be told a few months later the RBA are worried your standards are too strict! As Wayne Byres, APRA chairman, was quick to point out; “As we have said on many occasions, sound lending standards need to be applied through the cycle, regardless of whether housing prices are rising, falling or moving sideways”. It would appear a caveat should be added to the end of this statement: ‘unless it makes you unpopular’.

The message is clear. Having filled the world full of easy credit for decades, no developed world economy seems interested in constraining credit in the slightest. Any free market inclination towards higher interest rates seems likely to be firmly resisted by central bankers believing they know better. Whilst Mr Trump may be alone in overtly tweeting his role in supporting markets, others are less vociferous but equally asymmetric in their passion for rising over falling asset prices. The first two months of 2019 should leave them pleased.

Exceptionally low interest rates and bond yields engender valuation headaches for equity investors given the sensitivity they create in valuation multiples. As government bond yields provide the yardstick against which we can readily compare ungeared earnings yields, every 1% change in the bond yield theoretically justifies significantly higher multiples, if one assumes growth rates are unaffected. Although this is a big if and difficult to justify, a yield drought in fixed income makes a continuing search for yield in equity markets likely. A couple of popular yield proxies provide useful illustrations. After a strong first half, Goodman Group (+9.8%) is expected to deliver full year EBIT (earnings before interest and tax) of a little over $1bn. This includes significant performance fees (which probably shouldn’t be capitalised) and virtually no depreciation and tax (given its trust structure). Goodman carries minimal debt. Current valuation sees investors paying around 25x EBIT for the business, meaning they are happy to accept a 4% yield on the business. If this yield was to fall a further 1%, to a seemingly innocuous 3% yield, the company value could rise another third. In the case of Transurban (+2.5%), which adds some financial leverage to a perceived stable earnings stream, declining yields are even more powerful. Trading at around 20x EBIT, Transurban investors are demanding a yield of around 5% on their untaxed earnings; however, Transurban adds around $13bn of debt to the mix to ‘enhance’ returns to equity holders. If it were to trade on a 3% yield, the share price would double. These potentially significant moves are tempting, particularly given the dramatic success of this investment strategy in a period of declining interest rates. Of interest to us, however, is the lack of global precedent for valuations of interest rate sensitive stocks much above domestic levels. Even in Japan, where yields have hovered around zero for some time, valuations are not markedly higher. In our view, evidence suggests the love affair domestic investors have with defensive yield proxies is highly mature and even if the RBA cut rates, future gains may be limited.

Of similar interest during results season was the continued infatuation with applying stratospheric multiples and imputing extremely long duration on businesses with strong short-term growth. The easiest stage of the company lifecycle to sustain this excitement is early (as revenue and earnings numbers are tiny and ‘expectations’ can be beaten by capitalising a bit more software, making a few more acquisitions or convincing eager investors you need to invest a little more now as the long-term prospects are just so good). However, it is difficult not to maintain a touch of cynicism when each six-monthly reporting period sees sharp share price volatility as these apparently long-term investors sharply re-assess long-term prospects for these businesses based on some decidedly short-term results. Multiples as high as 25 times revenue are seen as justifiable (primarily through use of the ‘house next door methodology’, which means ridiculous levels are OK as long as other businesses are ridiculous with you), mean small revenue and profit increments can create alarming market value increments. Technology remains the epicentre of this game. Appen (+49.5%) and Altium (+39%) saw market capitalisation additions in the hundreds of millions despite revenue and earnings levels which ‘beat expectations’ by numbers in single digit millions. Whilst in no way belittling what are often strong results from very competent management teams, being small and high growth is proving wildly more lucrative than having high levels of profit and lower growth. IDP Education (+31.3%) versus Navitas (+0.2%) is a case in point. The businesses have significant similarities and operate in largely the same landscape. IDP management has excelled in growing the business, however, their superior profit trajectory sees the business valued at almost double that of Navitas despite the latter having significantly more revenue and slightly more earnings. As the saying goes, “to travel hopefully is a better thing than to arrive”. Reaching maturity or even the perception of its arrival drives punishing changes in rating. As growth becomes more elusive, its prospect is an ever more powerful aphrodisiac.

On the positive side, the fund’s investments in resources have continued to pay dividends, in every sense of the word, with much of the sector providing the polar opposite exposure to that of technology. While investments in the latter provide virtually no current rewards relative to their valuations and require faith in the distant future, the former are showering shareholders in cash and dividends as strong commodity prices and balance sheets with no debt provide an embarrassment of riches. As a biased Alumina (+13.1%) shareholder, we could point out that the full-year dividend was markedly higher than the annual revenue of either Wisetech Global and Xero despite a market capitalisation which isn’t materially higher. Rio Tinto (+10.5%) pointed out they’d generated US$46bn in operating cashflow and asset sales between 2016 and 2018. This was the entire market capitalisation of the business at its nadir. We have sympathy for arguments that question the valuation attributes of businesses in structural decline; however, in businesses such as Alumina and Rio Tinto we believe there is no evidence of any such structural concerns, and valuation gaps between businesses with superior short-term growth but far lower degrees of certainty in the more distant future are cavernous. In a world that appears increasingly likely to debauch the value of financial assets we can see only merit in maintaining a reasonable portfolio holding in businesses that provide valuable resources to a diverse range of global customers at valuations which remain below those of most listed businesses. The fact that unfortunate incidents such as the tailings dam collapse in Brazil and stringent opposition to most new mine developments should ensure far more muted supply addition in most commodities into the future provides further impetus, as we remain of the view that the vast bulk of value which shareholders derive in most businesses is driven by the trajectory of price, not volume. Tech and healthcare shareholders may believe in a future of rapid volume expansion and minimal competition. We believe this will remain the exception rather than the rule.

Outlook

Exceptionally low interest rates and manipulated bond yields look to be with us for the foreseeable future. While this policymaker overreach gives no guarantee stability can be maintained (just ask the Bank of England how they went against George Soros), the experiment with peering over the edge and allowing markets to set interest rates seems unlikely to resurface soon. The kneejerk reaction to this reality is to return to the land of milk and honey in real estate, infrastructure and utilities which has showered largesse on investors for many years. We do not believe this has the scope to deliver anything but mediocre returns given the starting point of valuations.

While significant share price gains in many materials stocks over recent years have lessened the appeal of what were (in retrospect) exceptional investment opportunities, we continue to believe they offer far more appealing prospects than defensive counterparts. More challenging operating conditions, particularly in Australia, as effervescent housing markets and an over-extended consumer return to more normal levels will provide earnings headwinds; however, we believe these conditions are predominantly cyclical rather than structural, and where businesses are not carrying ill-considered debt levels, many represent reasonable value. In an environment in which buying a business facing short-term earnings decline is about as popular as Tony Abbott at an environmental rally, we believe there are attractive opportunities (and likely to be more) for those willing to define long-term as a period beyond six months.