An infatuation with growth
Infatuation with the stimulation of growth at any cost remained the theme of 2013. Checking the dials from 30,000 feet, central bankers remain convinced that the anaemic levels of growth evident on traditional economic measures are justification for keeping the taps wide open. All we need is time to ensure that economic recovery becomes well established. As such, the ‘pilots’ seem assured that the plane is heading in the right direction. Back in the cabin, the ‘flight attendants’ of the corporations charged with making the trip more comfortable for passengers, are similarly confident of the inevitability of a return to smooth flying conditions. They too, believe that ‘growth’ is the holy grail for their corporations and that they must seek the grail whatever the cost. The passengers, having been repeatedly reassured by the flight crew that things are on track, assume that nothing is amiss. The question that is almost never asked is what this idyllic destination called ‘growth’ actually looks like, and why we should all want to go there.
Increasingly, we believe that ‘growth’ is becoming one of the more perfidious terms in the financial lexicon. Despite having positive connotations, in an economic and corporate sense the mischief is in the definition and calculation. Policymakers are determined to engineer a GDP growth figure that meets the economists’ definition of nirvana. China, the envy of the Western world has delivered high single or double digit growth rates for a couple of decades. The US is using every tool in their arsenal to ensure growth moves back into the low single digits, while Europe and Japan are the class dunces, unable to engineer even modest rates of growth. These all important ‘growth’ figures are purportedly vital to our collective wellbeing. So why are we cynical? These GDP growth figures are the accumulated results of attempting to accurately record the revenue of the entire economy. We have sufficient trouble verifying the veracity of an individual company’s revenue figures, yet these are subject to the scrutiny of auditors and based on generally accepted accounting principles. Nonetheless, we are expected to accept that this measure of the revenue of the entire economy is flawless. Furthermore, given that we count GDP in nominal dollars and then discount by a spurious deflator based on a manufactured view of what’s happening to prices in the broader economy (this is sounding more reliable by the minute isn’t it?) to arrive at ‘real’ GDP growth, by far the dominant variable in determining whether the revenue number will be higher is the amount of nominal dollars in the economy for us all to swap around. As such, economists are happiest when governments, individuals or corporates (or all of the above) are borrowing money, allowing the quantity of money in the economy to rise and facilitating a larger pool of dollars to be shared around and recorded as potential revenue. What is less clear is how a constant increase in the quantity of money, facilitating strong published growth rates, improves the living standards and employment prospects of a country’s citizens. We would suggest the answer is not much. The response by investors to ‘better than expected’ growth rates and ‘positive surprise’ in economic data seems more about habit and training rather than an understanding of how wealth is actually created.
At the corporate level, ‘growth’ remains the raison d’etre for most management teams. Earnings per share growth, TSR (total shareholder return) and an assortment of other measures are combined in suitably convoluted measures to ensure remuneration reports are sufficiently voluminous and cumbersome that readers are overwhelmed by confusion and boredom while executives are magically delivered their targeted short and long term incentive awards. What is clear from their behaviour is that increasing the size of the company through acquisition and driving earnings growth through financial engineering is far more prevalent than the tough slog of building new plant and equipment, growing customers and revenue organically and driving cost efficiency. The results are perhaps best observed by examining the extent to which intangibles have grown as a percentage of the equity base of Australian companies. Based on Worldscope data, this figure was around 16% in 1989 and has grown to nearly 35% today. In nominal dollars, these numbers are more disconcerting, with $88bn of equity and $14bn in intangibles in 1989 dwarfed by today’s $773bn in equity and $264bn in intangibles. The lure of acquiring ancillary businesses and promising synergy benefits (usually getting rid of staff) would seem to have won the day. Our problem with this strategy, as is often the case, is one of sustainability. Unless returns on tangible capital can rise inexorably, indefinitely adding intangibles must be significantly dilutionary to long term return on capital, and we firmly believe that return on capital will be the dominant driver of shareholder returns. Cursory analysis of a number of recent deals and announcements can illustrate the problem.
During the quarter, IAG purchased Wesfarmers insurance underwriting operations for $1.85bn. The acquisition was announced with typical fanfare and claimed synergies and earnings accretion. As always, there are integration costs ($120m) recognised as exceptional items, while synergy benefits involve squeezing suppliers (reinsurers) and rationalising staff, provide much of the justification. The complicating factor is that IAG paid about 5 times tangible assets, thereby giving rise to about $1.5bn in intangibles. Despite the fact that IAG are undoubtedly a more than competent insurance company, this level of goodwill necessitates the maintenance of loss ratios and costs far below those of competitors in order to sustain returns at adequate levels. Why? Well if another insurer could write the same level of premium using a similar amount of capital as that of the existing Wesfarmers operations, say $400m of capital to write $1.6bn of premium, they would need to deliver $40m of profit to make a 10% return. Given IAG have employed an extra $1.5bn of intangibles to accelerate the acquisition of this amount of premium, they will need to deliver more than $180m of profit to make the same return (plus a bit extra to cover the one-off costs) and then maintain this level of profitability in perpetuity. While the current buoyant operating environment for domestic insurers make it likely that this level of profitability (and an acceptable return on the purchase price) will be achieved in the short run, we suspect time will not make it look better.
While IAG were spending money on acquiring intangibles, John Neal at QBE was busy cleaning up the mess from past acquisitions. Announcing an expected net loss of $250m for 2013 due to further claims provisioning and intangible and goodwill write downs in North America, the impact of tougher operating conditions on poorly timed and overpriced acquisitions was starkly illustrated. Given the intangible numbers quoted earlier exclude the damage to shareholders wrought by already written down goodwill from acquisitions, you can begin to understand the scepticism with which we greet acquisition intensive ‘growth’ strategies.
On the financial engineering front, the Lowy family embraced the more ebullient market conditions in announcing a traditionally complex deal which involved shuffling the same assets and cashflows, adding more debt to the Australian business, buying back some shares at a price materially higher than that which prevailed in the market at the time and paying fees and costs of $120m. The share prices of both existing Westfield entities duly rose, courtesy of the earnings and distribution impact which, if investors were logical, should have been offset by the increased risk which equity investors assumed as their risk profile was increased, courtesy of increased financial leverage. As the details sunk in, both Westfield Group and Westfield Retail Trust gave up most of the gains, restoring some hope that the wool can’t always be pulled over investors’ eyes. Given that the September quarter also saw the successful sale of a raft of assets (dominantly by private equity) at very full prices, we’d be reluctant to get too carried away with the evidence that investors are learning from past mistakes. Dick Smith, Pact, Nine Entertainment and Cover-more all closed below issue price as the flood of supply overwhelmed demand.
On the earnings front, news remained fairly bleak. The earlier airline analogy was perhaps less than well chosen, as the news from the airline industry during the quarter gave little cause for optimism. Qantas announced a significant downgrade, with a forecast loss of $250-$300m for the December half. Accompanying the downgrade was a continuing war of words between Qantas and Virgin as the former complained of a competitive environment in which foreign airlines continue to fund Virgin’s capacity expansion in the domestic market (Virgin announced a $350m entitlement offer in November). Whilst feeling less than envious of Alan Joyce’s challenge of trying to make money in a sector in which profits have an uncanny ability of doing more landing than taking off, we’d observe that irrational competition from foreign airlines is not exactly a recent phenomenon. After nearly two decades of operation as a listed company, the Qantas share price closed at $1.10, some way below its initial listing price of $1.90, suggesting that investors should possibly be heeding Warren Buffet’s advice from way back. “I have an 800 number now that I call if I get the urge to buy an airline stock. I call at 2 in the morning and I say: “My name is Warren, and I’m an aeroholic.” And then they talk me down”.
Although we have no doubt that much of the commentary over the coming year will remain focused on whether the ‘growth’ outlook is improving or deteriorating (not to mention a healthy dose of ‘tapering’ rubbish), it is unlikely that much attention will turn to the question of why we are chasing it and how we should measure and define it. When you don’t ask the right questions you won’t get the right answers. We feel confident in predicting that 2014 will not be the year in which the Government decides to produce a properly audited profit & loss, balance sheet and cashflow statement, rather than the current cash based system in which asset sales are put in the P&L and future liabilities are ignored altogether. Nor will it be the year in which companies acknowledge that acquisition led growth at inflated prices is a bad idea and the remuneration should be fundamentally refocused towards growing tangible capital.
Most of 2013 has been about money illusion and what always dominates markets, supply and demand. As more money has been pushed into the system and investors have directed a greater proportion towards stocks, prices have risen. In response to these rising prices, owners of unlisted assets and companies keen to ‘grow’ through buying already existing assets at higher prices have created more supply. Like every other year, we suspect 2014 returns will again be driven by supply and demand. This equation will remain highly unpredictable as the tireless efforts of policymakers in ensuring that poor investments are propped up with artificially cheap finance have left the world with an increasingly large face value of financial assets and increasingly low returns on them. Added to this, they are determined to add further to this pool through fostering incremental borrowing. Small shifts in allocation in such a massive pool can dictate large shifts in price. Adding further debt to a system already delivering low returns will eventually push more businesses into loss and make bad debts inevitable.
The abovementioned problems with measurement and the misdirection of effort and resources which they engender, makes it all the more important in our minds to find and support companies that are striving to achieve genuine, value creating growth rather than those busy purchasing intangibles and fostering a short term growth illusion. Trying to predict whether money flow into equities will remain positive and maintain a surplus of demand over supply, thus driving prices higher and favouring those with greater financial leverage and speculative appeal, is a hard way to win sustainably. Focusing on those that keep it simple and try to grow tangible capital by earnings, real profits and reasonable returns will, in our eyes, always remain a far more sustainable way of growing wealth.
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