Thinking straight in the spaghetti economy
‘Think straight, talk straight’: the motto of Arthur Andersen. The unflinchingly high standards which built the company from early in the 20th century gradually gave way, culminating in Enron and collapse. Maintaining high standards and discipline is tough. The erosion of straight talking and thinking is evident everywhere, though perhaps more obvious in POTUS tweets. Through our equity market biased lens this erosion has us worried more than ever about the process of price formation, the collapse of free markets and the fading linkage between the real economy and valuation of both debt and the companies in which we invest. Exploding central bank balance sheets, oil and commodity markets in which financial investment dwarfs genuine usage and wildly gyrating equity markets raise plenty of questions as to how perilous this erosion of standards has become.
Significant rallies across equity markets helpfully coincided with massive central bank intervention in debt markets. As always, commentary will look for fundamental linkages to explain market moves, whether they exist or not. While there is obvious justification for intervention in the real economy at present to ensure money flows to those who need it, intervention in financial markets is a more complex matter. The lack of symmetry in intervention over time is obvious; like government debt, recent decades have seen lots of the growing bit in central bank balance sheets, but not the shrinking bit.
When it comes to not talking straight, using the excuse of needing to provide liquidity to markets (as Philip Lowe did recently) is a pretty clear example. Liquidity in all markets is inextricably linked to price. When a price is artificial and high, it makes sense that buyers disappear. I would quite like to sell my house for $20m, however, liquidity at this price is probably not great (if anyone at the RBA is interested, give me a call!)
Maintaining liquidity or propping up overpriced assets?
Governments are spending aggressively at present. Recent decades show no evidence of governments repaying debt or living within their means. As a lender to the government, this would suggest you should be demanding a better return to compensate for the risk of not being repaid, which must be rising. After all, there are two eventual options when it comes to debt reduction: pay it off or write it off.
Instead of rising rates, every major central bank has stepped in as a buyer, suppressing yields and allowing governments to spend while asset owners can pretend their asset values are unaffected. After the RBA announced that they’d like the 3 year bond yield to be priced at 0.25% and they’d be a buyer of as much volume as necessary to set this price, amazingly enough, liquidity improved and the price got there. No sh.t Sherlock!
Claiming there is no direct price manipulation because bonds are not bought directly from the government is yet another exercise in deception. Intermediaries such as banks will always be prepared to stand between the government and the central bank for a fee. High frequency trading fills the same role in equity markets, creating the illusion of volume and liquidity, though never intending to be an actual owner. This artificial volume, together with a far greater percentage of passive ownership, is contributing to a far more questionable price setting in equity markets. To be fair, the RBA are only recent entrants to rigged markets and have only been a buyer of government bonds. Simultaneously, the US Federal Reserve and European Central Bank (ECB) have been buying just about anything they feel like at whatever price they feel like. The dislocation in markets which they seek to address is code for them not liking the price buyers were happy to pay because asset owners would incur losses and highly leveraged entities would be threatened. You wouldn’t believe it - liquidity improved after they started buying!
Much has been written about the impact of this price distortion on economies. Economies are horribly intertwined bowls of spaghetti. If assets aren’t allowed to fall in price you incentivise everyone to borrow and bet on ever rising prices. When you don’t let companies go broke, you suppress prices because overcapacity in industries is never withdrawn and inefficiency is never weeded out. Without adequate profit prospects, the incentive to invest in new assets collapses and governments take over, investing in projects that never make money and can’t repay debt. The list goes on. Price distortion (whether through interest rate manipulation, asset purchases or price controls) has been progressively increasing for many years now and the bowl of spaghetti is global.
Banks facing a low-growth future
The reason we have such intense debate over banks and how we should value them is the unenviable position they occupy in this environment. As NAB, Westpac and ANZ have all recently released results, opined on bad debts and, in the case of NAB, asked investors for another $3.5bn, it is worth touching on how we attempt to think through the path forward for banks. Banks inherently rely on finding a stream of creditworthy borrowers to productively use the funds of depositors and other funding providers. History suggests they are periodically over-enthusiastic in this endeavour and find less than creditworthy borrowers. In the distorted price environment described above, losses which would have been crystallised in normal cycles have been progressively delayed and accumulated, meaning the probability of future losses is higher than normal, as is their severity. At present, this is combined with an expectation they will play their part for Team Australia and provide further accommodation to borrowers that in many cases are already stressed. We expect bank shareholders to wear a significant cost for this accommodation, particularly given Australia’s unhealthy reliance on immigration to support house prices and consumption. We assume bad debt losses will consume much of the next few years’ profits and that shareholder returns will be in the high single digits at best on a longer-term perspective.
The margin for error in these assumptions is significant, and the cost of errors in highly leveraged entities is large. This still leaves valuations looking reasonable given, they are currently below or around tangible asset valuations for banks other than CBA. However, we temper this with an expectation that future credit growth of anything other than very low levels is constrained by near zero interest rates. Banks are likely to be very low growth businesses for the foreseeable future. We are also alive to European and Japanese banks which are far further down the road to becoming zombies protected only by intervention, explaining why they trade well below tangible asset backing.
Qantas monopoly unlikely to emerge
The alternative to artificial price support is currently being explored in domestic aviation, with the government leaving the market to determine an outcome. Unsurprisingly in our view, placing Virgin into the hands of the administrators has seen plenty of interested parties throw their hats into the ring.
Fears of Qantas emerging as a monopoly are likely to prove unwarranted. Our suspicion is that in the longer term this may prove a challenge rather than a benefit to Qantas, as a new owner with a potential entry cost below book value, a willing and able work-force and already developed infrastructure should prove viable in a large and lucrative domestic aviation market. We expect equity and debt investors will lose a fair amount of money, which was how capitalism was supposed to work; however, we also acknowledge their entitlement to feel aggrieved as the decision on who loses and who gets bailed out becomes ever more arbitrary (just ask Lehman Brothers).
Capital raisings – the good, the bad and the ugly
The relative ease and speed with which Australian companies have been able to raise $16bn plus is testament to how efficiently capital markets can operate in Australia. The fairness of this process is more questionable. In this day and age, we find no reason why the process of capital raising could not be done through an online auction process which require price and quantity, cleared the same way as the daily market close. Large gains which have been registered by some stocks after concluding the capital raising process should not be a measure of success. They are handing out money to some investors at the expense of others. Nevertheless, ready and relatively cheap access to capital should be one of the key benefits of listing, and on that front, the Australian market is performing well.
Our approach in capital raisings (and valuation more broadly) is always to focus first on the value of the enterprise before we worry about the optimal split between debt and equity. Most companies have a propensity for too much debt (unsurprising after an extended period in which interest rates fall and asset prices rise). Our participation has therefore been selective. While we acknowledge the quality of businesses such as Cochlear, IDP Education and Megaport, aggressive valuations meant we chose not to participate. Short term price moves suggest this decision was unwise, however, as the Arthur Andersen lesson goes, when you start abandoning your disciplines, the slope is slippery; what seemed like investing quickly morphs into gambling.
Similarly, it is undeniably positive that businesses such as Webjet and Flight Centre have been able to access funds to recapitalise; however, our view of their prospects did not see them offering attractive returns versus the obvious risks involved. Like so many businesses these days in a world where the price of capital has been eroded to virtually zero, they employ almost none; their value depends totally on a judgement of whether they can make sustainable profits and how much they will choose to leave shareholders versus employees.
For Webjet, a raft of business acquisitions (an attribute we like about as much as Superman likes kryptonite), complicate the picture. In the case of Flight Centre, the tug of war between high rents, supporting the outrageous property values we’ve come to know and love, and a business struggling to make enough profit to pay them, is front and centre. Given REITs have been among the hardest hit in recent equity market moves, this assessment of how far rents are likely to fall in reaching a more sustainable equilibrium has also occupied our time recently, and we do believe prospects for reasonably good returns are available in some.
Recent events and the likelihood they will change the path of both the economy and the financial system of the future significantly, have made ‘thinking straight’ challenging. Where past equity market downturns have seen valuations of high flyers return to earth, the good fortune in largely avoiding the epicentre of Coronavirus impact has seen investors double down on already high-flying valuations in tech and healthcare.
As I write, Tencent’s announcement of its 5% shareholding in Afterpay will undoubtedly see the share price resume its climb up the Matterhorn. Given the business is already valued at $8bn and makes no money on revenues still under $0.5bn, this valuation necessitates much optimism. As US tech juggernauts move above 20% of US equity market value and Asian counterparts like Tencent replicate their path, while regulation has proven inept at controlling their dominance, the source of this optimism is clear.
Our enthusiasm for companies across the real economy in areas such as building materials, chemicals, commodities, and waste, at valuations bearing no resemblance to the high flyers, has proven a tough way to make money in recent years. The Afterpay valuation would allow you to buy all the equity in Boral and Incitec Pivot, controlling billions in hard assets, generating about $10bn in revenues and delivering operating profits which, while volatile, have a long history of being significantly higher than the revenue of Afterpay. Given research and valuations (I use this term loosely) have become firmly tied to share prices, despite prices being set in increasingly opaque markets, we have little doubt most will find reasons to stay optimistic on Afterpay and pessimistic on those we perceive to be highly attractive investments.
The erosion of ‘straight talking and straight thinking’ might give us much cause for concern, and in the evaluation of many investments, there is little doubt that careful analysis of financial statements and data has given way to ‘the vibe’ as Dennis Denuto would call it. The erosion of free markets and the principles of expecting competition and business effectiveness to drive return on capital outcomes is undoubtedly key in why there are so many question marks over ‘value investing’, or as we would put it, caring about the price you pay for an investment. When the choice is to either stick with trying to maintain disciplines and standards or follow the path of least resistance, we are trying to stay glued to the principles that Arthur Andersen espoused in the early days rather than those that took hold in the days of Enron.
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