Finding sustainable returns in the Afterpay economy
Finding sustainable returns in the Afterpay economy
Genuine sustainability requires the avoidance of actions that are likely to defer costs or have adverse consequences in the future. Identifying unsustainable actions and practices is generally a little tougher in advance than in retrospect, with climate change probably the most topical example. It did not appear illogical in decades past to produce energy (the lifeblood of every economy) at the lowest cost from the most readily available sources. The costs and consequences of rectifying these decisions are now becoming apparent.
One of the most problematic issues with sustainability is that improving it generally has a cost to the present. One might observe this to be in direct opposition to a government and central bank that prefers growth and equity market investors (or at least the computers behind them) to savage the valuations of anything not ‘growing’. Worshipping ‘growth’ makes it tough to embrace sustainability. In Afterpay parlance, we have a decided preference for buy now pay later (BNPL) versus pay now buy later (PNBL).
Passing credit on unwilling borrowers
As a barometer on where both the overall economy and the banks themselves are positioned in the BNPL versus PNBL trade-off, the ANZ result was informative. Management expect loan growth of close to zero and margins to remain under pressure. No revenue growth and costs which aren’t going down means earnings are. Given competitive intensity is obviously increasing (that’s why margins are falling) and bad debts appear virtually non-existent, it seems highly illogical to assume that banks are not prepared to make loans to creditworthy borrowers. Return on equity, still in double digits (just), means bank profit levels are still solid, albeit propped up (as is just about every business), by customer inertia in the back book.
On the other side of this equation we have a Treasurer urging banks to waive responsible lending standards for small businesses and a central bank governor telling us: “At low interest rates, many investments that didn't make sense at higher interest rates should now make sense”. House prices have begun to rise again, particularly in those epicentres of price sanity, Sydney and Melbourne, and the Reserve Bank is contemplating QE, given insufficient asset price support is such an obvious diagnosis of our economic problems. In looking for a climate change analogy to their attitude to credit growth, Josh Frydenberg is cutting the ribbon on a new brown coal power plant and Phil Lowe is shovelling coal (he just looks a little less menacing than John Setka).
Objective data the world over, now reflecting many years of such intervention, offers little support for these urgings and policy settings. Large central bank holdings of securities have only driven asset prices, consumer price inflation has remained largely unaffected, although Brexit seems to have had some impact on UK inflation! Banks the world over are willing to lend, their problem is lack of demand. Lower interest rates have generally correlated with higher hoarding of cash, even when rates move negative (Switzerland, Denmark) and gold prices have risen consistently. Credit has been almost universally successful in driving house prices, and suppression of financial stress and market volatility has not flowed through into higher confidence. Finding sustainability through continuation or acceleration of these policies is as likely as me edging out Eliud Kipchoge for the marathon record. Like energy policy, the first step towards sustainability is to stop exacerbating the problem.
Exhortations for governments to spend aggressively to stimulate the economy also seem to hold little water. Relative to GDP over the past two decades, levels of government work to be done across utilities, transport and building remain at high levels. The major transport infrastructure construction pipeline produced by Macromonitor and included in Cimic’s result presentation does not suggest insufficient activity. Additional government spending is a BNPL scheme in the hands of bureaucrats rather than taxpayers. The record of surplus versus deficit positions for most governments would suggest their BNPL scheme should be called ‘Neverpay’ rather than Afterpay. Misallocation of capital is already a pervasive problem given the extended period of exchange rate and interest rate manipulation globally; it will not be cured through increasing the scale of misallocation.
The elevating effects of a fat cheque book
Company level evidence of the problem is also plentiful. My learned colleague Mr Fleming touched on the WeWork fiasco last month. While Adam Neumann and his mission to ‘elevate the world’s consciousness’ might be at the extreme end, the number of listed loss-making companies is an historically reliable sign of excess. Adam Neumann is not Robinson Crusoe at present. Levels are worrying relative to history and unlisted markets are probably worse. A strategy of aggressive acquisition activity woven around a persuasive story of global domination and scale economies has been popular in times of easy money since the South Sea Bubble.
The war of words which erupted between WiseTech Global and the hedge fund J Capital Research during the month was along these lines. Real rates of organic revenue growth, product quality and the calibre of the 33 acquisitions on which Wisetech has spent $400m since 2016 were among the topics. Unsurprisingly, the debate ended with WiseTech concerned over self-serving and misleading claims and the ability for a short seller to disrupt the market, a test which few seem as concerned about when they are positively biased research reports from those assisting in the capital raising process.
Our bigger issue is whether the world is better off with a lot of wealthy founders as WiseTech recycles ultra-cheap equity capital into buying 33 businesses that would be happily operating as small businesses if WiseTech hadn’t turned up with a fat cheque book. Alternative reasons as to why they would suddenly want to be part of an Australian business they hadn’t heard of a couple of years ago are difficult to fathom. Perhaps they just wanted to ‘elevate their consciousness’.
Why build when you can buy?
The principle is simple. When the price of money is too cheap it prioritises leveraging of existing assets over the formation of new capital stock by companies able to generate reasonable returns. In simple terms, why bother building a new airport, road or building when you can borrow cheap money, buy an existing one and generate most of the gain without the hard work. One only needs to observe REIT and infrastructure asset markets to notice that, like housing, most of the capital growth emanates from existing assets, while the amount of new activity remains largely unaffected.
Sydney Airport provides a useful illustration. Alan Joyce’s exasperated claims that airports were abusing their monopoly position proved wasted breath as the Productivity Commission concluded there was nothing to see here. While the Productivity Commission believes prices are fair (they obviously don’t fly much), the $27bn in enterprise value (debt and equity) for a balance sheet that shows net property plant and equipment of less than $4bn offers a rough guide as to size of the gap between what the assets cost to build and how much investors are prepared to pay. Every incremental interest rate move has widened the gap, but when it came to investing new capital to develop a second Sydney airport, the returns just weren’t sufficiently attractive. It is far more appealing to sit back and revel in the gains as taxpayers shoulder the burden of building surrounding roads and the government obliges by running population growth policies that funnel in customers while taxi drivers wait in a 2 hour queue and passengers drink $5 bottled water.
Costa Group and the perils of oversupply
In an effort to remain balanced and raise a sustainability issue we hadn’t thought about well enough, we should also mention the travails of Costa Group, a portfolio holding. As a major producer of berries, citrus, tomatoes and mushrooms, Costa has encountered its fair share of issues in the past year – raspberries which crumble, declining berry and mushroom prices and drought among them. The attraction of a business (and a number of its agricultural counterparts) integral to the sustainable food supply domestically and the increasing demand for quality produce throughout Asia is obvious. Balanced against this is the perishable nature of produce and the ability for prices to collapse quickly when markets are oversupplied (you either sell it or throw it out). Costa has undoubtedly been a contributor to oversupply given its aggressive capacity addition (no problem with insufficient investment here) and has been at least slightly delusional in its expectation of achieving a price premium when product isn’t scarce.
The escalating cost of water, although not a massive issue for Costa, highlighted it as an issue on which we probably hadn’t thought sufficiently. On a sustainable basis, Australia almost certainly doesn’t have enough water to supply current water rights holders (likely an understatement). We are also likely to be farming an area of land far above that which is sustainable based on soil quality and available water. Although products such as citrus, in which Costa is a large player, probably make sense if strong prices can be achieved in markets such as China, we are not likely to be a low cost player if water is priced properly. We need to be assessing agricultural profits on the back of sustainable water prices as historic levels are far too low. Again, we have deferred costs which are now coming home to roost.
Lessons on what sustainability really means remain plentiful. Healthcare, pension schemes and a long list of others are arguably even more material.
Equities outlook: high beta businesses help insure against fragile markets
The lengthy period in which equity markets have become increasingly correlated with debt markets has caused us much consternation. Recent ructions in US repo markets were interesting in the terms of the sell-off in bond sensitive/’growth’ stocks and the rotation into ‘value’ which accompanied them. From our perspective, this serves to highlight the fragility and reliance on cheap funding which has come to characterise markets. On the positive side, it underscores the extent to which traditional cyclical ‘high beta’ businesses have become the antithesis of this trend and therefore the most logical way to insure against the increasing fragility of markets. For the time being, the hegemony of healthcare, infrastructure, REITs and various other ways of participating in the global carry trade, remains in place.
Calling the end to ever escalating multiples on defensive and ‘growth’ assets has been a ‘widowmaker’ trade reminiscent of calling the end to the Japanese bond ‘bubble’. As believers in sustainability, we remain optimistic in the eventual application of Stein’s law: “if something cannot go on forever, it will stop”. The valuation and financial leverage of assets in sectors such as construction, mining and a range of cyclical sectors, remain highly attractive versus defensive peers, and in most cases are being run on a more sustainable basis as the issues are visible rather than suppressed. As always, we believe the most painful risks are likely to be those which haven’t yet garnered much attention rather than those in plain sight.
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