Searching for a musical analogue for current financial market conditions I'd probably go with the XTC classic ‘Senses Working Overtime'. “I’ve got one, two, three, four, five senses working overtime, trying to take this all in”. Trying to assimilate the myriad of macro and micro-economic variables into a coherent framework is no easy task. Central bankers have continued dramatic levels of intervention in the name of economic rescue and arbitrary inflation levels. Outcomes remain inflationary for asset prices but deflationary for most other prices as financial capital floods the world in search of return and unprofitable enterprises are kept afloat. Challenging demographics and increasing wealth inequality are driving the disgruntled majority to demand increasing political intervention and greater transfer payments to offset inequality while governments try to plug the holes with bank levies. The common theme is the ongoing tendency toward extremes. Asset prices, debt levels and profit margins remain unusually high whilst interest rates, growth and volatility remain low. The beliefs of mean reversion advocates are being sorely tested. Whilst reticent to position ourselves firmly in the mean reversion camp, we’d acknowledge our tendencies are more in this direction than in extrapolation. On the bright side, the recovery in both commodity prices and many of the associated businesses over the past year has offered some respite for those believing cycles may still exist. Still depressed oil prices, stratospheric technology stock valuations and central bankers that despite their rhetoric, are really not that keen to see how the world fares without their ‘guiding hand’, suggest those of the mean reversion persuasion are still kicking into a reasonable wind.
At a company level, the challenges of aggressively priced equity markets are compounded by exceedingly divergent multiples. The reflexive nature of rationalising share price movements and the lack of success of mean reversion dictates the incorporation of a more malleable belief set for those seeking to reconcile prevailing valuations. Put simply, as multiples rise and fall for sectors with strong price momentum, valuations can be most easily rationalised using the ‘house next door’ strategy. Exponential growth or decline enabled through now pervasive talk of technological disruption or the ‘Amazon effect’ readily serve as incremental excuses for not touching the out of favour and embracing the popular.
The theories behind these excuses warrant some examination, particularly in light of the recent price moves accompanying the perceived and actual impact of Amazon's entry or potential entry into successive sectors and its recent US$13.7 billion acquisition of Whole Foods, a ‘bricks and mortar’ retailer of organic foods at prices which have earned it the moniker ‘Whole Paycheck’. Amazon has accomplished a great deal. Its brand is ubiquitous, its revenues have grown significantly (profits less so), its use of customer behavioural data is phenomenal and initiatives such as Amazon Web Services is industry changing. However, while its sales may be growing, its market shares are far from dominant (generally well under 10%) despite having operated for many years now. Its share of US appliance retail, a category which seems suited to a retailer without a ‘bricks and mortar’ presence is less than 1%. Amazon’s sales growth in the category last year was around $20 million and its sales growth rate about the same as Lowes (despite Lowes having around 25 times the sales base). It is less than clear from the data that we are all likely to be spending our days sitting at home watching Netflix waiting for our new toaster to arrive while every shopping mall is re-purposed as a distribution warehouse. Additionally, whilst not burdened with retail stores it is not obvious that the model of (very efficiently) picking, packing and delivering direct to customers is necessarily more profitable or lower cost than traditional retailing in all categories, particularly if one assumes that rents of warehouses versus retail stores normalise over time to reflect relative demand (i.e. if retail sales shift from local stores to centralised warehouses, local store rents will fall and warehouse rents rise). Whilst Amazon shareholders may be prepared to tolerate lower profit margins than other retailers, in our experience this tolerance is greater when combined with a rising share price.
We usually find unbundling a value chain and simplifying a business helps in understanding what you’re buying. In assessing the Amazon threat to a business like Woolworths, we must think about how one could operate the business differently. Supermarkets are large boxes which put goods on shelves into which customers are drawn to pick and pay for goods. Costs are dominantly in the cost of goods sold, rent, labour and the logistics of getting the goods to store. If we all choose to have our groceries delivered (an option which the perceptive amongst you will note is already available), we must question how this lowers total costs in the supply chain. It is difficult to see how goods suppliers can be the source of much gain (their business doesn’t change much). The change will come in altering the current logistics chain. While running very large warehouses and delivering direct sounds appealing versus running 1,000 supermarkets, it ignores a major positive in the existing model. Customers make their own way to the store and provide their labour for free in picking goods. Even a highly efficient logistics operation will not necessarily lower costs. One might also observe that despite an undoubted increase in the proportion of goods being delivered direct to customer, evidence of exponentially growing profitability amongst logistics providers is limited. Just ask the lucky Japanese owners of Toll! In short, lowering profit margins is easy, particularly when you have tolerant shareholders, making more profit is hard.
The broader conundrum we encounter in attempting to understand divergence in multiples and the inherently superior profit growth and/or business duration necessary to justify those at the high end, is the currently popular theme of disruption (of which Amazon might be considered a subset). On whether disruption is forcing change at a greater rate than in the past, we feel the evidence is mixed. Although evidence of more rapid adoption of new technologies is strong and outcomes for newspapers alongside businesses such as REA (+11.9%) provide ample evidence of the winners and losers from disruptive impacts, it is not clear that the apportionment of consumer spending (the revenue pool for most companies) or the market share shifts underneath this spend, are more rapid than has historically been the case. More importantly, if business life cycles are shortening, this would be an argument in favour of lower multiples, and unless disruption applies to some sectors and not others, should apply to all sectors equally. When we assess the threats of disruption, it is easy to observe the vulnerability of coal producers or newspapers. These businesses generally trade at very low multiples as a result. However, we can find few reasons why very high multiples in sectors such as healthcare, or individual market darlings such as Aristocrat (+26.4%) or Magellan (+22.0%), are somehow less vulnerable to disruption. Lastly, if technology is the primary source of disruption, it seems highly illogical to assume the technology businesses themselves are not highly vulnerable. Whilst an increasingly electronic and data driven equity market may be inclined to equate the greatest multiples with superior short term earnings direction, disruption seems like an unevenly applied and convenient short term excuse. If I were to describe Aristocrat as a purveyor of large sized boxes housing TV screens with relatively rudimentary games used solely to extract significant elements of the disposable income of the less well-off, not to mention operating in an industry generally losing share to other forms of gambling and not growing revenue, multiples in the high 20’s accompanied by 30% EBIT margins and a $14 billion valuation would perhaps seem aggressive. Perhaps it’s disruption proof?
If determining the outlook for the fundamentals of earnings and valuation were not sufficiently difficult, the propensity for evolving technologies and product structures to impact markets and investment behaviours complicates the outlook yet further. We have little doubt that increasing shifts to passive (or other rules based) investment strategies, the increasing usage of data driven investment techniques, artificial intelligence and various other technologies aiming to replicate traditional human responses more quickly, are introducing risks which will prove unpredictable and difficult to contain. Whilst contentious, it emanates from a belief in resilience being borne from diversity, or antifragility as Nassim Taleb would more eloquently phrase it. As financial markets grow ever larger relative to the underlying economy, the promotion of strategies likely to encourage herd behaviour rather than stem it, seems ill-considered.
Wishing for an environment less driven by government and central bank intervention is fanciful. Recent years have seen any signs of weakness met with action. Inaction is anathema to those with a belief in their ability to control outcomes. Despite the well-publicised ‘path to normalisation’ (raising interest rates and reducing the size of central bank balance sheets) which would logically see wealth transferred back to those with a more conservative approach to leverage and risk (given the rewards accruing to risk taking and leverage on the way up), we feel this normalisation is more than likely to be abandoned at any sign of pain. Maintaining any semblance of credibility in their plans to ever ‘normalise’ will become increasingly difficult in this environment. It is ludicrous to assume a high degree of predictability in such an environment, however, when most variables are at extremes, the payoffs to moving further along these extremes (lower interest rates, more financial leverage, even higher asset prices), seem limited. As such, we view a portfolio with as much diversity as possible, financial leverage at low or at least manageable levels, and multiples and earnings levels which are not materially higher than historic levels, to be the most palatable method of dealing with conditions which are discomforting for those of us with some memory of when mean reversion occasionally worked.
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