Show me the incentive, I’ll show you the outcome

“Show me the incentive and I’ll show you the outcome”.  Charlie Munger’s quip is typically insightful and relevant to many of the ructions currently facing the domestic economy and a number of the key sectors within it. Structuring incentives which engender desirable behaviour is often more complex than it appears, whilst misguided incentives almost always have unintended consequences.

The domestic housing sector, and particularly the bubbles which have well and truly formed in the Sydney and Melbourne markets, are one of the more obvious examples of incentives gone awry.  While debate will continue to rage on the relative contributions of capital gains tax discounts, negative gearing, profligate bank lending, land supply, immigration and lenient foreign investment policies, there is one overriding observation;  all of these incentives are acting in concert to exacerbate the problem rather than resolve it.  In isolation, policies such as CGT which allow for income on speculative gains to be tax advantaged over wage and salary income seem like madness, not to mention mortgage risk weightings and levels of profitability which make the residual operations of the major banks look like not for profit organisations, however, it is the cumulative impact of these factors and absence of any incentives to improve affordability which should leave us unsurprised at the outcome.  Insane ideas such as allowing superannuation to be accessed by first home buyers are probably to be expected from political parties reticent to take action which might trigger the only possible resolution to the problem, falling house prices. Recent CoreLogic data highlights dwelling prices in Sydney and Melbourne have risen 107.3% and 92.2% respectively since January 2009 (post global financial crisis) whilst Perth and regional prices have risen 5.5% and 4.3% respectively over the same period.  We suspect the ‘Armageddon’ scenarios which banks assume in the thorough modelling undertaken prior to handing out another interest only mortgage to someone comfortably able to afford repayments as long as household expenses don’t move above $100 a week would see only a part of this cavernous price performance differential unwound.

Somewhat unfairly, we believe the side effects of these perverted incentives which have created an increasingly fragile domestic economy are likely to be borne far more significantly by the consumer discretionary segment of the economy.  Retail sales are already showing signs of slowing with profit warnings from The Reject Shop (-48.7%), RCG Corp (-23.9%) and Coca Cola Amatil (-13.4%) symptomatic of a discretionary income environment sandwiched between non-discretionary elements such as health and education which are relatively devoid of productivity gain but not of price increases and levels of debt which leave even modest ‘out of cycle’ interest rate increases from the banks removing reasonable chunks of disposable income.  The discretionary income segment will share a disproportionate amount of pain.  This is further exacerbated by demographics.  The intergenerational wealth transfers driven by skyrocketing house prices have transferred spending power away from those with a high propensity to consume (under 55’s) and towards those unlikely to spend more, whilst the voting power of the older generation make changes to any of the abovementioned housing bubble incentives or politically unpalatable territory such as asking the elderly to bear a fairer share of the healthcare spend they incur, a minefield on which no-one will dare walk.  The high representation of consumer spending in the listed equity market, particularly at the smaller end, will make market share gains almost essential in driving improved profitability, while the losers are likely to find financial distress uncomfortably close.

Divergent incentives also saw the telecommunications sector bear its share of upheaval during the month.  TPG Telecom (-13.8%) paid $1.26bn to acquire 700Mhz mobile spectrum and announced plans to spend $600m constructing a 4^th mobile network covering 80% of the population.  This spend is almost concurrent with a similar strategy in Singapore where TPG has acquired spectrum and is constructing a 4^th mobile network.  From a TPG perspective, they have no existing mobile business to protect, possess reasonable synergies (at least in Australia) in already owning a fixed line network, are unarguably a low cost organisation and see existing mobile pricing from incumbents as high (ditto in Singapore).  Existing mobile market players were firmly incentivised to maintain the status quo, sustain relatively high pricing and handsome levels of profitability. The price reaction of Telstra (-9.4%), extinguishing some $5bn in value, highlighted both the materiality of the mobile business within its valuation (in the $25bn- $35bn range for most) and the sensitivity which all businesses demonstrating strong levels of profitability (which tend to be extrapolated in valuations) have to changing industry structure.  Life will get tougher even though customer propositions will bear little similarity.  On the TPG side, we would suggest the reasons for the price reaction are somewhat different.  High levels of investment without commensurate profitability in the short to medium term will lead to earnings downgrades.  Despite its role in providing equity capital for long term investment, most investors have a predilection for businesses able to deliver high levels of profitability with almost no investment (the unfortunate corollary being that these businesses don’t need to be listed) and an alarmingly low tolerance for earnings heading in the wrong direction.  In this instance we are equivocating to a degree on the longer term merits of the investment.  Whilst we are universally supportive of investing at book value rather than via acquisition, a significant proportion of the investment is in a highly priced mobile spectrum licence expiring in December 2029.  Additionally, evidence of 4^th entrants successfully garnering significant market share and profitability is limited.  We are more than happy to make long dated organic investments, however, this one undoubtedly entails a fair degree of risk.  The option to fund the investment largely through debt also heightens risk.  We would maintain that early stage investments are far more logically funded through equity.

If one is after lessons on unintended consequences of misguided incentives, the domestic energy market is replete with them.  If energy company CEO’s wanted to leave their mark on the economy with large scale company changing projects, they have succeeded.  The mark is ugly. Overcapitalised and barely profitable LNG facilities are providing affordable energy to Asia, driving a shortage of gas on the East Coast of Australia and pressuring manufacturers with higher input costs.  Domestic reserving policies are now being countenanced as LNG facilities struggle to shore up long-term gas supply in the face of (often justifiable) environmental opposition. Electricity markets have seen over-investment in distribution networks, no investment in base-load power and subsidised investment in renewable energy.  Vertical integration in energy retailing is seeing higher electricity prices flow back as significant excess profits to owners of coal fired generation with almost no incentive to reinvest.  AGL Energy (+1.5%) has been a massive beneficiary, primarily through its ownership of coal fired power.  Assuming higher energy prices do not flow through to increased retail margins, given this will not see any increased distribution cost for retailers, most of the massive gains in market capitalisation over the past year are attributable to additional profits expected to flow from generation assets.  At its simplest level, one could argue investors have decided the Loy Yang and Macquarie coal fired plants (which generate the bulk of the group’s power) have risen massively in value.  As is often the case, the staunch opposition to supporting coal has abated a little with positive earnings momentum.  With no-one wanting to fund or countenance any reinvestment in newer and more efficient coal facilities, consumers and manufacturers are left paying excess profits to owners of dated facilities.  Sounds like Telstra all over again.  Another NBN fiasco for electricity and gas anyone?

At a company level, the proposal by Elliott Advisors to unlock value in BHP Billiton (-1.3%) raised yet more questions on incentives and outcomes.  We are dominantly focused on initiatives which will allow the business to become more efficient and deliver improved profitability. Those focused on delivering greater short term market capitalisation through listing businesses in jurisdictions currently paying more inflated prices for the same assets are of limited interest.  The Elliott Advisors proposals have a bit of both, however, their arguments are not without merit. On the activist investor front we see no harm in submitting a few large company Boards and management teams to the blow torch.  BHP’s dual listed structure is a vestige of the diabolical Billiton transaction whilst the US shale gas foray has been even more painful.  As is the case for many large companies, being big and being good are uncomfortable bedfellows. A century of free labour from BHP CEO’s would repay a small fraction of the eroded value.  Incentives need to stop aggressively pro-cyclical investment in advance. There is absolutely no doubt in our minds that the removal of any linkage between pay, company size and share prices would be a step in the right direction. 

Outlook

Equity values globally and domestically have continued to march higher.  As always, this does not make us more comfortable, as without commensurate improvement in business fundamentals we are merely lowering future returns.  Higher multiples (paying more for the underlying cash flows of a business) are responsible for a disproportionate amount of share price gains in recent years.  Companies both here and in the US are using debt funded buybacks to repurchase shares at exceedingly high prices.  This is madness.  AGL and CSL are both currently buying back stock at the highest share prices of all time.  Whilst the latter in particular is an exceptionally well run business, we struggle with a forecast outlook which justifies repurchasing stock at current prices.  Good companies can still do dumb things. Yet another reason to remove linkages to share prices from all management incentives.  We are yet to hear a good answer as to why it’s supposedly difficult to suitably incentivise listed company management without some reference to share price (TSR) when private companies seem to manage just fine.  Whether it’s the tax system, the energy market or executive remuneration, setting incentives to encourage the right behaviour will go a long way to improving outcomes.

At a stock and sector level, rotation back into the perceived safety of stable yet highly geared cash flows over the past quarter has seen the gap between these businesses and the more conservatively geared yet more volatile cash flows of resource and cyclical businesses widen again after closing to a degree in 2016. We continue to see little merit in forsaking far more appealing valuations for apparent stability when this stability is merely overvaluation and excessive financial leverage in disguise.