Three issues confronting Australian stocks
This time of the year brings forth a multitude of “year ahead” prognostications. Almost without exception, they predict an exaggeration of most recent trends; we are yet to see a prediction that in 2017 Australian bond yields will breach the 1.8% lows seen in August 2016, nor that commodity prices will next year reverse more than this year’s gains (although commodity prices falling is a consensus view and one we agree with). Early this year, though, we came across a well-considered, non-consensus and yet prescient “year ahead” piece. In the March commentary, we referred to Larry Summer’s article “The Age of Secular Stagnation,”, and his views that “international coordination is thus necessary to avoid an excessive and self-defeating reliance on monetary policy and achieve a mutually rewarding reliance on fiscal policy … Secular stagnation and the slow growth and financial instability associated with it have political as well as economic consequences.”
This year, Summers’ musings have been to economists what Michael Moore has been to psephologists, with the policy intent shifting from monetary towards fiscal stimulus in the US, and the election of President Donald Trump. While many have dubbed the observable effects of the past month – rising bond yields and outperformance of banks and miners globally, which in turn in Australia has seen the top-20 outperform – the Trump effect, the truth is that these trends were months in the making. Indeed, the economists from Deutsche Bank have been highlighting that tightness in the US labour market is approaching 2007 levels for some time. For the bigger drivers in the Australian equity market, commodity prices and interest rates, performance in November was no different in direction to September and October.
The issue now for Australian investors is threefold. Firstly, what are “neutral” interest rates; and are we there yet? This matters massively for Australian equity portfolios driven by valuation. Using a bond rate of 3% (spot 2.8%) instead of 2% (as Australian bond yields were, or lower, between April and September) sees our Westfield, Scentre and Sydney Airport valuations drop 25% and our Transurban valuation fall 15%. Bond-sensitive stocks dominated Australian equity market performance for the four years to mid-2016 as bonds rallied, and their underperformance in recent months has only followed bonds changing course and in many cases this only brings equity prices back to levels of 18 months ago. It’s easy to forget what you learned, while you’re waiting for the thrill to return.
The second material issue for Australian equity investors to form a view on is one that we expect to be a defining issue for market performance in 2017; what happens to the Australian fiscal deficit in the face of a sovereign ratings downgrade ? Will taxes rise; and if so in what areas (consumption, personal, levies to fund health); or alternatively will spending be cut, and again if so in which areas (healthcare) ? Sudden changes in regulation have disrupted the expected returns in many sectors in recent years (telcoms, gaming, energy, education, parts of Healthcare) and we expect this trend will exaggerate, not dissipate as fiscal pressures increase. More astute management teams are already highlighting this risk and what it may mean to returns (to wit Medibank’s announcements ever since Craig Drummond has become CEO). But as always, we suspect the market will only fully react when the changes take effect, when the finger of blame turns upon itself. Suffice to say, we assume lower sustainable returns than those made currently for any company where returns are subject to regulation and where excess returns are being made now. We see material potential downside for equity values where those higher than sustainable current returns, are also being priced on high multiples. As the shareholders in Estia, Japara and Regis can attest, just as those in Bellamy’s Australia and Blackmores can, unsustainably high earnings on a high multiple, is usually an awful starting position for returns. Few of those arguing the investment merits for these stocks 12 months ago are doing so today – after they have halved.
A third critical assumption when valuing stocks within the Australian equity market are long-run commodity prices, and their impact upon valuation for mining stocks. We did not foresee the commodity price rally through 2016, and our forecasts continue to be predicated upon long-run prices similar to the spot prices of 12 months ago, being benchmarked to a cost curve and largely stable for a decade. Of course, mining stocks have enjoyed a great year of performance as commodity prices have rallied in 2016, just as the two prior years had been like trying to catch a deluge in a paper cup as commodity prices collapsed. The emotive argument that mining companies secularly destroy shareholder value appears less pervasive as these companies respond explicitly to the criticism; for example, Rio Tinto’s new strategy is titled “Value over volume”. While we still see material valuation support for Alumina and Iluka, the strong relative performance of recent months has seen the valuation case for BHP Billiton, Rio Tinto and South 32 diluted, albeit in every case we still have some upside to valuation.
Finally, with the breakdown in the patterns of serial correlation through the past few months, we are starting to see opportunities to broaden the portfolio exposures, albeit still to less of an extent than we would wish, due to the extreme divergence in starting position valuations, and company actions in themselves. Boral is a good case in point. The US$2.6 billion acquisition of Headwater by Boral was met with a $700 million market cap write-off, or about one-quarter of the goodwill paid. Mike Kane, the Boral CEO, could not have been clearer through the past several years; while the non-residential construction market in Australia had strong volume prospects, tensions on returns meant that the cashflow leverage is not as great as some in the market might wish were the case, and hence the future for the group lay in expanding further into the US market. He proved true to his word. Headwater’s earnings appear high relative to its asset base, and many acquisitions have been made in recent times to generate these earnings. Large acquisitions relative to the acquirer’s size, at a high book multiple for higher than peer margins, without a clear reason for sustainability, has seen Transfield Services (2010 acquisition of Easternwell for $575 million) and ALS (acquisition of Reservoir for US$533 million) lose all of the value paid for those acquisitions, within two years. Boral, too, has paid a high multiple for high margins, with almost 80% of the consideration passed for Headwater being goodwill. Hence, for Boral, the possessions are causing us suspicion, but (as yet) there’s no proof. Relative to the market Boral has only been lower than current levels for a few months in the past decade, and hence the starting multiple is now attractively low after shareholders have reacted to the transaction, and yet the risk attaching to the cashflows Headwater will produce remains high.
In terms of the outlook, not just because of direction, but also because of a break from the serial correlation that had characterised market movements through the prior three years, we prefer an investment environment such as we have seen through the past six months. We remain overweight metals stocks on valuation grounds, and yet we continue to think many commodity prices are well above sustainable levels; we remain underweight interest-rate sensitive stocks on valuation grounds and yet our long-run bond rate of 3% is very close to spot. As always, valuation is the driver for portfolio positioning, not a view as to the next directional change in macro trends. Nonetheless, pretending those same macro trends have not had a large impact upon portfolio performance through recent years, bad and then more recently good, is disingenuous, even if we wish dearly that were not the case. As we now approach more neutral settings and valuations are less bifurcated, we are enjoying the prospect of restoring more uncorrelated drivers of return and risk to the portfolio, and are doing so and expect to do more of it.
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