In theory there is no difference between theory and practice. In practice there is.
As interest rates approach zero in much of the western world, the linear relationship which economists expect from their monetary intervention isn’t quite going to plan. Rather than igniting animal spirits and spurring spending, declining rates are creating insatiable demand and stratospheric prices for safe haven assets whilst doing nothing for the velocity of money and economic activity.
"In theory there is no difference between theory and practice. In practice there is”. Yogi Berra’s (purported) quote seems an apt description of the current state of global markets and economies. The past financial year, particularly in Australia, has been dominated by interest rates as 10-year bond yields collapsed 150 basis points between October and June. The theory of human behaviour embraced by economists dictated that monetary accommodation would aid economic growth as lower rates spurred consumption and investment. As interest rates approach zero in much of the western world, it appears the convenient linear relationship which economists expect from their monetary intervention isn’t quite going to plan. Rather than igniting animal spirits and spurring spending, the expectation of ever declining rates is creating insatiable demand and stratospheric prices for safe haven assets whilst doing nothing for the velocity of money and economic activity. Private sector credit across the western world is not growing to any significant extent in response to lower rates.
Given Australia does not share many of the demographic challenges of Europe and Japan, maintains high levels of immigration, continues to enjoy relatively buoyant commodity prices, particularly in iron ore which is by the far the most material to our economic wellbeing, and has the dubious honour of having one of the highest levels of consumer indebtedness, it has surprised many (including us), that policymakers and commentators have embraced the need for significantly lower interest rates despite limited evidence of benefits and substantial side effects. When reading yet another spurious justification for interest rate action we would acknowledge the understandable difficulty in announcing that rates are being reduced due to widespread discontent arising from an absence of speculative capital gains from residential property. As the dominant driver of equity market activity and returns, it has been both frustrating for us and painful for our investors that the returns of most portfolios are being determined exogenously with so little justification. Whilst current year equity market returns have obviously been strong as the valuation of businesses (dominantly those generating passive income and employing few people) moved markedly higher, these returns are obviously borrowing from the future as running yields on these assets move ever lower.
Having just returned from China, we observe some stark parallels. Whilst the necessary rebalancing in China may desire more consumption and lower reliance on investment and much of the Western world is battling over-reliance on consumption, both are battling the side effects of too much easy credit going into the wrong places. Much has been written over the years on the scale of construction, not to mention the difficulty in rationalising how China can sustainably consume more than half the world’s steel and cement. Perhaps anachronistically, we remain of the view that supply and demand imbalances, wherever they occur, and particularly when borne of artificial stimulation (e.g. ridiculously easy credit), become increasingly difficult to sustain. It was therefore interesting to find a number of sources in China acknowledging buyers are becoming more difficult to find, developers are extending credit terms, the price caps which are used to control property pricing in many cities are increasingly unnecessary, property completions are significantly lagging starts (starts generate the cash for developers as buyers pay up front while completions utilise the cash) and most developers have a materially reduced appetite for land acquisition. The potential diagnosis; vastly too many buyers have been purchasing apartments on the expectation of price gains rather than for the more mundane purpose of living in them. An excerpt from one of our meetings: “previously people got rich by buying a house, now you need to be rich to buy a house”. When comparing prices paid for apartments to average incomes in various Chinese cities, it is hard to conclude they are sustainable, particularly given the stark differentials in building costs versus our levels, meaning Chinese buyers are already paying away a large proportion of the purchase price to the government (in the form of land prices) given construction costs are far lower than western levels. In China, materials costs are generally 60-70% of project costs, in Australia it is labour that is 60-70% of costs. If wages moved anywhere near Australian levels over time, implied cost escalation would be enormous if land acquisition prices (government revenues) were maintained. Controlling the human appetite for speculative gain over the drudgery of wage and salary income appears not to be a peculiarly Australian problem.
In other thematics to emerge, there is little doubt as to the government appetite for the reduction of coal as a fuel source, however, subsidies remain essential in driving this outcome. Relative to the convoluted subsidy schemes invented by western countries, the Chinese options are refreshingly simple. If they want more wind power in a particular region they pay generators more, if they want less they reduce the price. Similarly, in electric vehicles, one would not get carried away with the desire of consumers to single-handedly make a difference to the environment. Sales respond to subsidies and have fallen away sharply without them. Given the election outcomes in Australia and the feedback we receive from Australian energy retailing businesses on the appetite for consumers to actually pay the higher costs of renewable power, the message to Kevin Costner in Field of Dreams may need to be re-worked: “if you subsidise it, they will come”.
Lastly, on commodity prices, and iron ore specifically, the supply demand squeeze is obvious. Steel mills are seeking any avenue of alternative supply as the Vale induced disruptions continue to reverberate through markets. Whilst prices at the current US$110+ level are obviously not sustainable in anything other than the fairly short term, finding product to keep blast furnaces running is the primary focus and concern over further price rises is palpable. Discerning what this means for valuation of iron ore exposed businesses is more challenging given gains for Rio Tinto (+6.0%), and BHP (+6.9%) continue to be dwarfed in percentage terms by Fortescue (+35.9%), as investors seek exposure to earnings momentum and operating leverage. Whilst the excess cashflow which all players will earn from this period of pricing (now all time highs in $A terms) is enormous ($50/t or so of additional profit on around 700mt of iron ore exports per annum) and will possibly justify a significant proportion of market value increments, it is just as certainly not durable.
The challenge in determining sustainable earnings levels and in turn business value, is becoming more difficult as the operating environment becomes ever more manipulated. This may be part of the reason as to why so many have reverted to simplistically chasing recent earnings momentum. Whilst reaction to ‘trade wars’ has been vociferous, we see this as no different to manipulation of interest rates and currencies, and far less material. Manoeuvring to achieve relative advantage takes many forms, some more explicit than others. Whilst world trade is obviously beneficial if countries are focusing on areas in which they have competitive advantage it is more than possible that historic distortions have significantly aided trade growth in the past with some proportion of this growth unsupported by true competitive advantage. As with all things (and share prices), there is no law that dictates world trade should always grow. The simple observation that western countries are vastly skewed to consumption and others skewed to production suggests an imbalance may exist.
As my learned colleague Andrew Fleming raised last month, in addition to the conundrum of determining sustainable earnings in this environment, the larger problem in recent times has been an apparently haphazard approach of transmitting lower interest rates into equity market valuations. The June quarter was replete with examples, many of which are tough to rationalise. Whilst perceived stable and long duration income streams featured prominently, including Goodman Group (+13.7%), Transurban (+13.9%), Charter Hall (+11.4%) and Stockland Group (+11.9%) , the speculative end of the market received at least as much attention, with Nearmap (+34.5%), Appen (+25.6%), Xero (+23.2%), Afterpay (+19.7%) and Wisetech (+19.9%) at their increasingly familiar position at the top of performance tables. Announcements from Visa on their intentions to match the Afterpay product present little more than minor speed bumps for investors on a speculative mission. Little time is spent observing the proliferation of entrants in many of these segments nor of the underlying role of capital markets in businesses which require almost no capital. It is difficult to believe the buyers of these two market extremes are from the same cohort. It seems more likely that those seeking yield are being dragged less willingly into the equity market by evaporating yields elsewhere, while rampant speculation at the other is given licence through exactly the asymmetric rationale which policymakers apply to residential property. We’re OK with ups, just not the downs. The obvious losers have been the large bulk of traditional businesses in the middle which employ all the people and generate all the revenue.
Bingo Industries (o/w, +47.7%) Having endured a significant collapse in value after Bingo downgraded its earnings earlier this year, the reality of what we believe is a well-run, well positioned business has driven significant recovery. Given the business is now far more in control of its destiny, given operations across collection, recycling and landfill, we are strong believers in its long term value. Given the obvious economic value in improving recycling performance as waste becomes a greater issue, innovative providers should have significant growth prospects.
Aurizon (o/w, +18.7%) The haphazard and often unfathomable approach to regulation in Australia has wrought some havoc on the valuation of Aurizon. Management have worked hard in mitigating these challenges directly with customers given regulators in Australia can generally be relied on to miss the forest for the trees. Whilst the prospects for thermal coal in the long run are likely to be challenged, coking coal volumes will remain cost competitive and underpin operations. In an environment in which businesses with stable and sustainable earnings remain highly sought, Aurizon’s valuation remains far more attractive than most of its peers in our view.
Medibank Private (o/w, +26.5%) Our rationale in owning Medibank Private dominantly involves the necessity to have efficient private operators providing some impetus to aid in controlling exploding health care costs. Additionally, we anticipate the logic of attempting to remove volume from high cost and customer unfriendly locations (hospitals) will build over time, requiring the facilitation of adept logistics operators willing to disrupt the current model. The opportunity for Medibank Private to feature prominently in this regard is significant. In the short run, the victory of the Coalition in the election and the fading of the spectre of extremely onerous price caps for the private health sector has vastly overshadowed any of the above thesis. Sometimes the cards fall your way.
[Core only] Iluka Resources (o/w, +19.7%) Whilst commodity pricing in mineral sands remains relatively tough and the supply demand picture in end markets such as Chinese tile production relatively challenging to piece together, the lucrative Mining Area C royalty stream has provided significant insulation given skyrocketing iron ore prices. Although reinvestment in the core business and Sierra Rutile has been questionable and has potentially diluted some of the value which would have been derived from iron ore royalties, we believe its valuation more than reflects this.
CYBG plc (o/w, -6.8%) UK financial regulation has become some of the most onerous globally, and penalties imposed on financial businesses have come at great cost to shareholders over recent times. In many cases the costs are substantially higher than historic profits. CYBG has eroded value through both mis-selling penalties and corporate activity, although the prospects for the Virgin Money business remain debatable given the combination of the CYB business with the new operations is in progress. We remain cautious on claimed cost synergies and expect market conditions in the UK to remain competitive and returns mediocre. Despite this, its valuation remains attractive given a multiple of book value which anticipates either further book value erosion or extremely poor returns in the future.
South 32 (o/w, -14.8%) Commodity prices in areas such as bauxite, alumina and manganese to which South 32 is exposed have offered nothing rivalling the excitement of iron ore, with many back to levels close to our expectations for longer run averages. Whilst this may dissuade those ravenous for earnings momentum, we continue to believe the value of businesses such as South 32 should never be based on spot prices. We believe the business is well managed and the absence of any significant financial leverage means it is well positioned to endure tougher times should they arise.
Alumina (o/w, -3.7%) As for South 32, weakness in prices of alumina and aluminium has seen enthusiasm wane whilst the appetite for businesses where commodity prices are soaring remains voracious. The supply demand and commodity price gyrations, which invariably impact businesses selling commodities into global markets, always drive a more volatile profit stream. Furthermore the solid returns available for businesses with attractive positions on the cost curve and sensible financial leverage, mean those willing to endure the share price gyrations should earn solid long run returns.
[Core only] Link Administration (o/w, -32.3%) Although only a small portfolio position, the value of the Link business has been savaged on the back of downgraded earnings, primarily from the UK business acquired from Capita. While Brexit and weak UK capital market activity have impacted to a degree, there is little doubt the quality of technology and systems in the acquired business was less than ideal, meaning the claimed cost synergies may morph into cost reinvestment to avoid market share loss. These challenges also impact the superannuation administration business domestically and merely reflect the reality of all technology businesses. Technology ages and competitors invariably enter the market with newer, superior systems pressuring incumbents. This is particularly the case when the technology comprises multiple platforms delivered through numerous acquisitions. The same issues will invariably afflict a number of current market darlings in the future.
It is tough to profess a focus on sustainability within the economy without questioning the sustainability of the financial system which supports it. Whilst we expected Australia would follow the path of monetary accommodation/manipulation that has pervaded the world, we have been surprised as to the pace and extent of interest rate evaporation, not to mention the rapidity with which this has been reflected in equity market valuations. Particularly in perceived defensive assets, an ever lower yield means the margin of safety continues to evaporate should the unthinkable happen and interest rates move in a direction other than that to which investors have become accustomed, or inflation find its way into the real economy rather than asset prices.
The vast majority of businesses in which we find valuation attraction remain outside the barbell which has formed around the passive/perceived stable asset category and the epicentre of speculation in which words and acronyms like disruption, first mover advantage, fin-tech, TAM and SAAS (total addressable market and software as a service for those not fluent in tech jargon) allow vast amounts of market capitalisation to be added without commensurate earnings. As the share prices of the bulk of the real economy between these two barbells continues to deliver far less exciting returns without much sign that sustainable revenues and profits are shifting with them, we believe the future returns must eventually normalise.
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