Delaying Judgement day: the lure of short term returns
The surprise 'Brexit' vote result towards quarter end served as a stark reminder of increasingly tenuous linkage between the financial economy and the real economy. Politicians and those connected to the financial economy were almost universally in favour of remaining part of the EU. Warnings of the consequences of exiting were dire. Recession, collapsing currency and upheaval were only the beginning. Initial financial market reaction will prompt the "I told you so" response. The question of why membership or otherwise of the EU should have outrageously beneficial or catastrophic economic consequences (as distinct from financial market consequences) is more difficult to answer. Trends towards protectionism and increasing distrust of the political establishment are evident globally, with 'Brexit' merely being the most high profile and recent manifestation. Having happily enjoyed the benefits of 'globalisation' over past decades as manufacturing capability was shifted to developing countries allowing a myopic measure of inflation to justify ever lower interest rates and booming asset prices, the other side of this cycle is proving decidedly less popular. Keeping the public employed and happy is getting tougher.
As you may gather, the disconnect between financial markets and economic reality is confounding us. Market pundits talk of "risk on" and "risk off" as though investors are carefully reassessing the economic reality in response to new information. It seems more likely to us that ever larger sums of money are moving around on the basis of historic correlations, minimum volatility targeting and extrapolations than from any assessment of fundamental economic change and a reassessment of ongoing business profitability. 'Brexit' saw materials and energy companies temporarily savaged, whilst the usual defensive suspects (healthcare, REITs and utilities) were spared. Valuation levels continue to have almost no impact in the assessment of risk with ever rising multiple/lower discount rates for market darlings justified on the basis of lower interest rates and superior growth, whilst rates for the out of favour remain apparently unaffected. Even those with material revenue exposure to Britain and Europe (Ramsay Healthcare, CSL and Cochlear), saw almost no reaction, while BHP Billiton, Rio Tinto, Origin Energy and most other energy and materials stocks, all of whom sell almost nothing into Britain and sell almost solely in US dollars, saw panic. Gold stocks soared as traditional 'safe havens' were sought. Learned behaviour seems to have well and truly taken over from considered analysis. Days later, markets had recovered most of the losses, triggered no doubt by the soothing comments from central bankers, ready to inject whatever liquidity was necessary and to cut rates further in response to this largely undefined economic disaster known as 'Brexit', but the end result was the same; higher prices for defensives and little move in the rest.
This simplistic revulsion to 'beta', operating leverage, 'risk on', or any other of the cornucopia of terms financial markets have coined for things they expect to go up and down a lot, seems borne of a wildly disproportionate favouring of financial leverage over operating leverage. Our thinking on risk has always been based on the belief that the risk inherent in equity ownership stems from the combination of these two sources; operating leverage - the extent to which operating earnings are prone to rising and falling in response to changing business conditions, and financial leverage - the extent to which debt is used in an effort to amplify returns for equity holders. In general, in arriving at a sensible risk equilibrium, those with more stable earnings (utilities, REIT's) will employ more financial leverage than those with more substantial operating leverage (cyclical industrials and resource stocks). This is very much the case in the Australian market at present, with defensive stocks generally far more aggressively geared. This dynamic is what permitted REITs to perform abominably in the wake of the financial crisis whilst operating earnings were only minimally impacted. There has been no balance in these sources of risk of recent years. At the slightest hint of economic weakness, calls for further monetary stimulation are cacophonous. Each successive move hands further gains to financial leverage whilst punishing operating leverage as the weak stave off bankruptcy yet again. When investors become accustomed to financial leverage never having any negative consequences, whilst any earnings downturn is savaged, 'beta' revulsion is unsurprising.
To reward punting on houses and stocks with excessive financial leverage far more than hard work as a wage earner will be disastrous for long run economic growth, which is why we believe the recognition of the limits of monetary policy are being increasingly recognised.
John Kay and Mervyn King (former Bank of England governor), in their recent books, 'Other People's Money' and 'The End of Alchemy' both eloquently highlight the need for change. Their ideas are worth reading. Unfortunately, current central bank governors are longer on rhetoric and shorter on gumption. Appetite for change may be improving, but gradually.
Despite much in the way of stock price gyrations over the quarter, the net result was less than exciting, with the exception of sharp gains for gold stocks. Nonetheless, the allure of acquisitions as a substitute for organic growth and restructuring to take advantage of the aforementioned multiple disparity remain key themes. Mayne Pharma rose sharply at quarter end after the acquisition of a portfolio of generic drugs from Teva Pharmaceuticals whipped investors into a frenzy. The short duration nature of most of these earnings streams and the substitution of drug acquisition for research and development does not change the economics. While our valuation increased due to the low acquisition price paid, the market is assuming that acquired earnings are all additive, and no research and development investment is required to maintain earnings. This will become evident in 2017 when earnings from Doryx, another low priced acquisition, face competition from Mylan. In a similar vein, Crown sought to bridge an apparent undervaluation in the business through a plan to separate the domestic casinos, transfer a number of hotels into a REIT and create a new holding vehicle for its international assets. Whilst we broadly agree with management views on valuation and the appeal of directing more of the cashflow from domestic assets back to shareholders rather than endless offshore casino capacity expansion, we have always struggled to embrace deals which incur fees, additional operating costs and do nothing to augment operating cashflow. They are all too frequent at present. The culture of illusory value creation remains alive and well in the listed market.
2016 has shown some early signs of interest rates, financial leverage and short term earnings momentum abating as the sole driver of stock performance. As we have raised previously, the longevity of reliance on interest rates as the (unsuccessful) salvation for economic growth has left stocks perceived as most sensitive to this driver at multiples which have never before presaged strong long term returns. Eventually, investors will realise that paying indefensibly high multiples for businesses necessarily impacts longer term returns. Whilst weight of money and central bank assistance continues to drive multiples of defensive and 'growth' stocks higher, the lure of short term returns continues to delay judgement day. Different risks doesn't mean lower risk. In the case of defensive stocks, low operating leverage, high financial leverage and stratospheric multiples do not add up to low risk. It is merely the dormancy of the latter two that has created this illusion. In the case of many 'growth' stocks, we expect the combination of negligible capital employed, stratospheric multiples and growth fuelled by debt funded acquisitions and a perception of business duration which is, in most cases, absent, will eventually burst this bubble for all but a few.
On the positive side, bubbles invariably leave valuations for non-participants at levels highly conducive to good long term returns. Although the universe of cyclical industrials and resource stocks is now dwarfed by defensive and 'growth' counterparts, valuations remain highly attractive. Economic reality and rationality can often take longer than anticipated to reassert itself, however, it always does.
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