I thought love would last forever: I was wrong
Both diversification and return are tough to find. Years of watching central bank super heroes forcibly inflate the prices of fixed income securities everywhere has left mere mortals scavenging amongst the leftovers. In an equity market context, this has left real estate, infrastructure, healthcare and anything else that can masquerade as a bond being carried along in the super hero slipstream. Unwittingly, investors have been left with their highest ever weighting in bond-like equities at the time of their highest ever prices. Added to bond portfolios which have rarely been larger or more ludicrously valued, it is difficult to envisage a time where investors have carried less inflation protection. When the prevailing wisdom is so dominated by fear of deflation, this is probably unsurprising. We have been reticent to bow to theories suggesting the cash flows from running a hospital can somehow be twice as valuable as those from running a mine. Additionally, our reluctance to sacrifice what we believed were the only remaining sources of diversity (cyclical stocks which couldn't impersonate bonds) has been costly. We struggled to comprehend how an absolute weighting of less than 20% of the total portfolio in resource stocks across a broad range of commodities, which should not all themselves be correlated, was foolish relative to far higher absolute weightings in interest rate sensitive sectors on the other side of the ledger. Whilst a month or two of recovery in resource stocks is a refreshing change, we believe the overarching picture remains decidedly unbalanced, with the valuation equation remaining sharply in favour of cyclical stocks and bond-sensitive valuations universally elevated. If Mario Draghi and Janet Yellen’s super powers do not transpire to be those of Superman and Wonderwoman, the slipstream could well result in some turbulence for which few are prepared.
Alongside the justifications for ever rising divergence in the valuation differentials between defensive and cyclical stocks, have been arguments supporting more elevated valuations for 'growth' stocks as ‘growth’ becomes harder to find. We would contend that the absence of 'growth' in the economy more generally is purely a function of excessive leverage and a resultant limitation on adding more. We can find little evidence suggesting the economy has reduced potential for productivity gain. Technology and innovation are providing as much productivity impetus as ever. Justifying historically high multiples based on this supposed scarcity is merely a confusion of the impact of ever increasing financial leverage over the past few decades with growth.
The significant percentage gains in a number of resource stocks over the past few months necessitate some perspective. Share price gains for BHP and Rio Tinto since the beginning of December are around 10%. Very few resource stocks have yet regained the share price levels of June last year. Since the beginning of December, iron ore prices have risen more than 60% and coking coal prices nearly 40%. We believe much of the commentary on these stocks and the sustainability or otherwise of these prices are meaningless, as it almost always confuses the direction of commodity prices with the underlying value of the business. This is a symptom of investment markets which have become driven by momentum rather than fundamentals. Our valuation of Rio Tinto will not change tomorrow based on whether the iron price trades higher or lower. It is highly likely that share prices will.
Put simply, the operating earnings of Rio Tinto's iron ore business will depend on roughly the same variables as most other businesses: the volume it sells, the price at which the volume is sold and the costs of production. The direction of the prices of the products it sells or the share price itself in the very short-term are unlikely to hold much long term information value, which is why research should involve greater depth than a commodity price or share price chart with a line of best fit through it.
Despite the aforementioned recovery in many resource stocks, it was not accompanied by any significant weakness in defensive and ‘growth’ counterparts. Stocks such as Domino’s Pizza (+7.9%), Aconex (+6.4%), Ramsay Healthcare (+5.9%), Scentre Group (+5.6%) and Cochlear (+5.6%) added to already stratospheric gains over recent years. These stocks, which fall firmly into the ‘growth’ stock category on which we commented earlier, offer far greater cause for concern in our eyes than bank stocks which have added incrementally to capital over the past year and are a greater focus for punitive treatment from investors.
The vast majority of defensive equities have remained both underpinned by and highly correlated with bonds. To borrow from W H Auden, we’d suggest the loving relationship of these equities to bonds will remain "my North, my South, my East, my West, my working week and my Sunday rest". Suggesting these valuations are attractive without being simultaneously comfortable with bond valuations is irrational. Arguments supporting bond valuations at current levels rest largely on the prospect of deflation and/or a financial crisis in which bond values are protected whilst other assets are not. Whilst we acknowledge the probability of either of these outcomes is not insignificant, there is not a dissimilar probability that after years of inflating the global balance sheet (asset values and liabilities) policy makers will turn their attention to the profit and loss statement which supports this balance sheet. It is from here that fiscal policy, deficit spending and 'helicopter money' discussions emanate. This is also the only other avenue which will allow deleveraging. This eventuality would almost certainly prove anathema for the equity market conditions that have prevailed over recent years. We firmly believe portfolio structure should remain cognisant of these risks. Betting the house on ongoing low interest rates, no inflation and stability is unwise. As Auden highlighted; "I thought that love would last forever: I was wrong".
We believe expectations of ongoing deflationary conditions (which are spurious in any case, as they depend on the particular prices on which one chooses to focus) are, like the prevailing investment methodologies, anchored in extrapolation rather than logic. As prices fall further and operating conditions become more challenging for most businesses not exposed to asset prices, the probability of these prices continuing to fall should abate. The alternative is a decimation of profits and a rapid elevation in financial distress. This would present a new set of challenges to policymakers determined to support asset values and would certainly not be confined to cyclical stocks! Additionally, as profits and return on capital for industries subjected to free market forces reach exceptionally low levels, the profit leverage to rising prices becomes substantial. The slight recovery in valuations of many of these businesses has done little to erode our views on valuation attraction in these areas relative to defensive counterparts. In addition to the diversification benefit which we believe has been all too readily shed by those chasing the super heroes; this landscape leaves us very comfortable with current portfolio positioning.
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