Low interest rates and the rise of the zombies
Low interest rates have kept poorly managed businesses — ones that can’t manage their debt through cashflow — shuffling along like the walking dead. For these entities, even small changes to the financial landscape can have profound impacts.
Progress in data analysis and artificial intelligence has done little to alleviate the propensity of people to gravitate towards euphoria and panic together. October saw a fair amount of euphoria give way. Commentators will invariably insert the requisite ‘catalysts’ to explain recent markets falls, aided a little by hindsight. We are a little more sceptical as to the ability to discern in advance the reasons why investors may decide to stop buying and start selling, even if the increments in each direction are small.
Rather than building concerns on trade wars or increased US treasury yields, their answers may be more in line with that of Charlie Skinner in the first episode of one of my all-time favourite shows, The Newsroom: “we just decided to”. Part of the reason ‘they decided to’ was the influence of others on their behaviour. Emotions are likely to remain difficult inputs for financial models.
More than 80% of the S&P/ASX300 registered falls during October. Among the residual about a quarter were gold stocks and a few were the subject of private equity bids: MYOB (+13.7%) from KKR, Navitas (+13.4%) and Healthscope (+0.5%) from BGH Capital. Ben Gray and AustralianSuper are obviously in the early stages of privatising the entire listed equity market, so that at least should provide some support!
Correlations amongst the winners and losers were high, and for the most part, reactions were largely an output of the learned behaviour from previous episodes. A brief synopsis would read: sell cyclical and speculative stocks; buy REITs, defensives and gold. While there are elements of this synopsis that may be logical, we believe the overall picture is more nuanced.
One of the reasons is the cumulative risk from decades of pursuing artificial stability. The aforementioned reaction from investors is a learned behaviour. Any threat of downturn (whether it be an economic or financial market concern) equals more financial accommodation, asset price rises and further rewards to financial leverage. We have long believed that each attempt to stave off any downturn through progressively greater intervention must result in greater accumulated risk. Platitudes on the improved resilience of the financial system in the face of objective data which evidences ever greater leverage are, in our view, misleading.
Paul Volcker recently wrote a brief article on Bloomberg in advance of his just released book, Keeping At It: The Quest for Sound Money and Good Government. He talks more common sense in a couple of pages than I’ve heard from most central bankers in the past two decades.
In brief, he believes the role of engendering price stability has given way to a preoccupation with the dangers of deflation, and the false precision of an imprecise and invalid inflation target, inadvertently creating the real danger of encouraging rising inflation and extreme speculation. Comments on the slow productivity gain in services business such as healthcare and education relative to the production of goods are also interesting in light of an equity market that is becoming increasingly services based, yet relies on inflation being controlled by goods prices for its low interest rate fuel.
The elevated importance of credit conditions
The most important ramification of these views on financial system risks is our more circumspect view of financial leverage and the elevated importance of credit conditions. The odds of declining interest rates and central bank intervention engendering ever-higher asset prices and ongoing gains to those employing financial leverage are not improving. This is not an independent probability like a coin toss. As the system becomes more leveraged and dependent on speculative gain and interest rates closer to zero, the risks versus potential gains from financial leverage are skewing ever more unfavourably.
Interestingly, recent research by the Bank for International Settlements also highlighted the long-term rise in zombie firms (those unable to cover debt servicing costs from current profits) and the detrimental impact this has on productivity and the performance of ‘non-zombie’ companies. Unsurprisingly, their research suggests low interest rates, particularly since the GFC, appear to be a significant contributor.
The effects are readily observable in the results of domestic companies and their heightened sensitivity to relatively small changes in credit conditions. Discretionary retailers are always at the forefront given continuing escalation in non-discretionary costs (healthcare, education, utilities, tolls and mortgage payments) forces disproportionate adjustments in residual consumer spending. Flight Centre (-12.7%), Lovisa (-25.6%), Reject Shop (-53.4%) and Nick Scali (-16.5%) all highlighted incrementally tougher conditions, while the automotive sector is facing similar headwinds evidenced in businesses such as AHG (-18.3%) and Suparetail (-18.6%), where new vehicle sales volumes have already fallen markedly. This impact has been wrought by miniscule changes in credit conditions and still fairly high levels of credit growth. Given banks have been pilloried for their profligate lending behaviour it is difficult to suggest tightening credit conditions are anything other than a necessary path to sustainability.
Sustainability should be in the DNA
Sustainability should be in the DNA of all businesses, however, given the behavioural training on cheap money provided over recent decades, a move towards sustainability may make getting rid of coal fired power look like a walk in the park. As Paul Volcker highlights, if we genuinely want price stability and faith in the value of money, financial conditions can’t always get easier. In tightening credit conditions, speculation and aggressive acquisition strategies tend to be exposed; companies believing they were sensibly geared often find the process of paying down debt from cash flow a little more difficult than assumed, whilst the behaviour of customers who are highly geared themselves means profits head more rapidly in the wrong direction at the least opportune time.
This month’s hedge fund-driven controversy on Corporate Travel Management (-34.3%) highlights a few of the pitfalls of acquisition-fuelled growth. Whist guilt may not be proven, the fragilities of such strategies are clear and part of the reason we remain vocal opponents of intangible intensive acquisition strategies. Few good businesses have been built by rolling up large numbers of disparate businesses at high prices in the name of revenue and EPS growth. Companies such as Google, Apple, Intuit and Xero, which have products that people actually like and usually work, have tiny amounts of their asset base in acquired intangibles. IBM, Sage, Oracle and SAP, which have balance sheets replete with intangibles, rely more on overcharging gullible corporate customers for products that often elicit streams of profanities from users. Corporate Travel may not fall squarely in the latter category, however, our starting point in attempting to validate sustainable margins twice that of peers in a highly competitive industry is one of scepticism. Ascertaining what is actually going on in companies making rapid-fire acquisitions is tough. While the path to inducing over-excitement in investors usually involves explaining why scale advantages and superior systems facilitate higher margins than peers, the margins often disappear when the dust clears.
The perils of complexity
Looking for recent lessons on why to avoid becoming a complex unwieldy organisation, AMP (-22.6%) fits the bill. No one is talking about AMP’s scale advantages! Its issues with life insurance also possibly reflect some of the above issues raised by the BIS on ‘zombie’ companies.
In disposing of residual life insurance and wealth protection businesses well below embedded value, much to the ire of investors who’d assumed higher values, management referred to global competitors benefiting from a lower cost of capital. This is an erudite way of saying global competitors are prepared to earn far lower profits than AMP for doing the same thing. Life insurance has become a progressively harder way to make money in the face of a flood of cheap money. Large global players, often from jurisdictions like Japan, happily accept returns which domestic investors find derisory. They have purchased numerous offshore businesses and rarely improved either operating or financial metrics materially. They may not all be the ‘walking dead’ yet, but they’re on the road. The relative winners have been those that sold businesses to these zombies earliest. Arguably, AMP’s mistake was being late. We have complained previously of the side effects of cheap money and the high cost of encouraging mediocrity, and while many of AMPs problems have been self made (acquiring AXA being a big one), the current environment is doing them no favours. High returns on capital are increasingly becoming isolated to those not requiring any capital or those more able to subvert effective competition (don’t get us started on medical device and pharmaceutical companies).
It is increasingly difficult to discern whether financial and asset markets drive the economy or whether the economy drives asset markets. As financial markets are now multiple times the size of the real economy, it seems logical to believe that economies might be the boat and financial markets the ocean. The cost of unbridled financialisation is that ships are navigating in open ocean, and not lakes. Many of the ship captains around the world may be wildly overestimating their navigational ability and seaworthiness. For the same reason, while it appeals to our desire for control to believe that company valuations are responding rationally to our careful financial analysis, we are more likely to need to deal with valuations which depart sharply (in both directions) from those we believed feasible. Apparently small changes in discount rates are unleashing large changes in equity value, exacerbated further when high levels of financial leverage are involved. In an era in which ‘high conviction’ and ‘high alpha’ have become popular buzzwords, we believe there is a fair danger these terms may be synonymous with overconfidence.
In buying a business, common sense dictates that one should retain a healthy degree of scepticism on value far into the future when that future is highly uncertain. Terminal value in a financial valuation is the capitalisation into perpetuity of this distant future. Many businesses with more predictable paths in the future, not to mention current profits, continue to be valued at levels that appear to us to offer far superior value to those with more uncertain prospects. We continue to favour sensible valuation and low levels of financial leverage in favour of historically egregious valuations in some sectors and excessive financial leverage in others. The extreme speculation of which Paul Volcker warns has been amply rewarded in many areas of recent years. We’d expect most of these rewards are in the past.
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