A notable feature of the recent trading on the Australian stock market has been the dramatic drop in daily turnover. Whether this is important or not for the market or for us as investors, is subject to much debate. The turnover is low compared to what? Were previous periods normal? Does mindless turnover really matter and if you are not a seller should you care?
Obviously for those businesses and individuals that rely on turnover to generate commission or revenue, the drop in volumes is confronting. A recent report in the Sydney Morning Herald noted suburban pockets of rising unemployment. These job losses appeared to be flowing from the financial services industry with commercial and investment banks reducing staff. The rise in unemployment was observed to be dampening down the prices of residences in high-income areas. The effects of the GFC and the European debt crisis were hitting home.
It is our observation that the effects of a poorly performing equity market is affecting the ability of many advisors to generate an adequate return for their clients. This should have had an effect long before now but time and poor performance are now converging. So what is causing this and how bad is it?
To answer these questions we note the following observations drawn from the ASX website:
- The ASX 200 Index is currently 4350 points with a total market capitalisation of $1.26 trillion.
- The ASX 200 Index was also 4412 at the end of October 2005 with a then market capitalisation of $1.026 trillion.
- Net new equity raised in the market (that is, primary issues) over the six years approximates $230 billion.
- New floats over six years amount to about $66 billion.
While we note that there have been some companies taken from the market, it is observable that the market capitalisation today approximates the market capitalisation of October 2005 after new capital raisings are added. All this has occurred in an economy which over six years has grown from $1.16 trillion (GDP 2004/05) to $1.31 trillion (2010/11) or about 13 per cent.
From the above we can see that:
- The Australian Equity market as a whole has generated no capital gain for index investors in six years.
- Worse still the market has achieved no gain or revaluation from the capital raised or from the new companies that have been floated.
- Importantly, the suppliers of capital or the gate keepers (the fund managers) have supplied capital to companies who have not converted it to value creation.
- Finally and crucially the managers of the capital, the CEOs and their teams, have been paid huge salaries and bonuses to achieve incredibly mediocre returns.
The whole of Australia has grown at about 2.2 per cent per annum compound over the last six years but this economic growth barely matches inflation. With population growth of 1.5 per cent per annum, the low GDP growth suggests an anaemic level of improvement in productivity.
Worse still – when the economic growth from the resources sector is subtracted, it leads us to conclude that the rest of Australia’s productivity must actually be going backwards. So what is the rest of Australia? Well ignoring the production generated by agriculture it is dominated by service industries such as financial, tourism, health, education and public service. The fastest growing sector of the last ten years has been the financial sector.
Clearly something is wrong and frankly the rewards being received by our top executives are not being translated into wealth creation for the broader population. There is no dramatic productivity improvement under their management and the returns on employed equity are not rising. So on what basis are these people being remunerated and is there any evidence to suggest that extra pay actually translates into a higher level of performance?
Thus, questions must be asked as to why we as a community are paying so much for such mediocre results. Further, are not the actions of these people directly responsible for the poor returns of equity markets in a period of sustained economic growth? Why have the returns on the over $300 billion of new equity that has been invested in companies not produced an adequate return to justify a lift in value of the market? Are we actually sure that the new capital that is invested into companies is going to those that can achieve the best returns on equity?
As an aside, what the above does show is that the investment phenomena known as indexing, has turned into an economic disaster. Have we allowed consultants and experts to stupefy our capital markets (through pushing indexing) to the point where the markets are no longer proxies for growth? Individual companies are growing (and that is Clime’s focus) but indices aren’t and so maybe we are observing the downfall of indexing as a legitimate investment process – if indeed it ever was! Investment managers who do think and can value companies will add value for their investors so long as they are not stopped from plying their trade.
Thus, the observation that so many financial service employees are losing their jobs may not be solely because turnover is falling. Rather it is a symptom of poor business leadership at the very top of Australia’s management tree. If companies are not improving their economic performance then ultimately the market will reassess their value. Those advisors who cannot properly value companies cannot foresee the likely ramifications on the investment returns of their client portfolios. Possibly clients on mass are realising that their advisors and brokers cannot offer value in a market where the ability to value a company is paramount.
So much for advisors, but the above analysis shows why shareholders are rightly looking at highly paid executives. Importantly they should focus on of five- and 10-year returns and if they do they will conclude that very few executives have added value and thus they are excessively remunerated.
