Pouring Fuel on the Fire

“I got chills, they’re multiplying and I’m losing control; Cause the power, you’re supplying, it’s electrifying”. I’m not sure Philip Lowe conjures the same sort of image as John Travolta, but for the central bank doves in command around the world, ‘You’re the one that I want’ may well have been the theme song of bond investors for the past decade.  Whether central banks really are ‘losing control’ is now pivotal, as monetary manipulation has undoubtedly been the electrifying force behind asset prices. Observing the importance of bond markets and the inflation outlook for equity markets is straightforward, however, as the RBA pours petrol on an out of control property market fire whilst talking about ‘output gaps’, a desperate need for inflation and the role of monetary policy in creating jobs, one can’t help wondering whether the credibility earned over many decades is close to breaking point. It is perhaps unsurprising that equity markets have mimicked the pattern of ever greater enthusiasm in bringing forward tomorrow’s returns. While policymakers try and hold together the specious narrative around easy money creating ‘jobs and growth’ rather than just shifting wealth around, equity investors justifying ludicrous valuations for businesses promising revenue growth and profits in the distant future have hitched their horses to the same wagon. The recent sharp sell-off in bonds, has been and will doubtless continue to be met by ever greater intervention, removing any remote possibility of central bank balance sheets ever normalising. It will also ensure price distortion remains the order of the day, spreading further out the yield curve and infecting all other assets which have traditionally relied on bonds as a benchmark against which to price. Importantly, losing credibility and trust tend to have important ramifications when they are the basis for the financial system. Increasingly wild fluctuations in just about all assets highlight the scale of the challenge in operating a global price fixing scheme. Days gone by where Amcor and Visy executives met in the pub to hold up the prices of cardboard boxes will be child’s play in comparison.

As corks in the manipulated financial market ocean, banks have recently drifted in the right direction. Results were solid, spurred by net interest margins beginning to recover and an evaporation in COVID driven bad debt charges. Share prices duly followed the earnings trajectory, with most recording solid gains, albeit with CBA relinquishing some of its strong share price performance advantage over more accident-prone peers. Our consternation over how current conditions can prove sustainable has driven very cautious positioning in the sector. In attempting objectivity across all sectors from a sustainability standpoint, we have no idea why pumping another $100bn of additional lending each year almost solely into unproductive house price gains to foster increasing inequality should be considered differently to fossil fuel usage.  Our thinking and valuations have always been premised on the assumption the periodic losses which banks suffer as a result of making poor loans are the primary deterrent to poor lending behaviour. Removing the losses removes the deterrent. Bank share prices have become ever more dependent on house price direction given the heightening proportion of loans deployed against the sector. Rising house prices equals safer loans. Depositors, via the RBA, are effectively being forced to provide free capital to enable borrowers to purchase some of the world’s most expensive houses on the basis ridiculously low mortgage rates will permit them to service them, with resale offering the only realistic prospect of repayment. That valuation should be premised on extrapolating current circumstances in perpetuity seems unwise. As a strategy for sustainable policymaking this seems to resemble the abandonment of renewable energy in favour of large-scale coal fired power stations. The recent New Zealand government requirement for the Reserve Bank to consider house prices in setting interest rates suggests not everyone believes the ‘three wise monkeys’ approach to policy setting is sustainable.

In this environment the reaction to the sale of ME Bank by its industry fund owners to Bank of Queensland was interesting. Our learned bank expert expected investors to look no further than the claimed earnings accretion despite the fact the business had been acquired in an auction process at a price above NTA and, like nearly all smaller banks (including BOQ), had struggled to make anything more than mediocre returns for some years despite benign bad debts. More cynical observers thought investors might perhaps be sceptical of claimed synergies arising from the familiar path of provisions created via acquisition accounting and delivered only on presentation slides combined with ongoing adherence to a business model which involved being a relatively high cost provider of commodity housing loans via mortgage brokers, no new products and mediocre technology.  Learned expert 1; Cynical fund manager 0.

Elsewhere in earnings results, the task of separating the durable from the transient remained challenging. Earnings outcomes were for the most part solid, however, with extensive JobKeeper payments being channelled directly from taxpayers to shareholder dividends (hard to believe the average nurse is pleased to be making a charitable contribution to the Solomon Lew retirement fund!), and revenue growth rates substantially distorted, using the 2021 financial year as base from which to forecast will likely be unrewarding. These distortions should provide greater than average levels of opportunity in the coming months and years as those focused on earnings momentum investment are thrown a much higher than average percentage of curve balls. Snippets from results and management meetings which gave us some food for thought included:

• Santos and carbon capture – having just finished the Bill Gates book on avoiding climate disaster, the scale of technology (not the BNPL or online gaming kind) and infrastructure investment necessary is clear. Santos has a couple of unusual advantages on the path to zero carbon. The Cooper Basin is a significantly depleted gas field with potentially vast amounts of CO₂ storage available. Secondly, as Cooper Basin gas has high levels of CO₂, Santos have significant CO₂ extraction facilities in place. This combination potentially positions the company as a very low-cost player in carbon capture and has allowed them to commit to net-zero emissions by 2040. Whether traditional energy companies are the primary villains, or a significant part of the solution depends very much on your perspective.

*Source: Company reports

• Low CO₂ content in Oil Search LNG production and low CO₂ emissions across the AWAC alumina production portfolio for Alumina seem underappreciated attributes. In a world where commodities are seen as uniform, emissions and resultant environmental damage should be seen as differentiators in the same way as grades of iron ore. In the Alumina example, at around half the emissions per tonne of major alumina producers and already attractive positions on the cost curve, the business seems extremely well positioned in a world which should eventually seek incentives through higher premiums for green products and higher explicit costs for emissions. Emergence of green premiums has the potential to significantly change cost curves and profitability across a range of industries and products. Given the business has delivered solid margins, earnings and dividends despite a challenging alumina price environment we continue to believe the business is more than reasonably priced if prices and margins don’t improve and extremely cheap if they do.

*Source: Company reports

• Hiccups in the results of market darlings such as A2 Milk and Appen served as salutary reminders of the implicit dangers in pricing unwarranted certainty on the distant future. Whether driven by unpredicted Chinese tariffs across a range of industries or demand predictions which just transpired to be horribly optimistic, forecasting the future as an unbroken path to riches is wrong far more often than it’s right. Businesses which have been kind to investors over many years such as Cochlear, CSL and James Hardie delivered solid results again, making it emotionally easy to justify to ourselves the wonderful quality of these companies. We share these emotions. However, in nearly every case, the price being paid for the future is higher than just about any time in history. The temptation to drag ever more of the distant future in today’s multiples and valuations is not an affliction confined to bureaucrats and politicians.
• Consumer behaviour during the pandemic has resulted in demand for services declining and demand for goods strengthening. JB HiFi, Bunnings, Eagers Automotive, Premier Investments, Harvey Norman, Domino’s Pizza, Nick Scali; the list of companies delivering record or near record results was long. Most are intermediaries between consumers and goods manufactured in Asia. Sharply rising shipping costs and inventory issues were cited by many. Most casual observers outside Martin Place would note inflation in the price of goods is largely out of our hands as we produce very few outside difficult to transport products such as building materials. Manufacturing is a small part of the economy. Inflation in these products depends on energy cost inputs, Chinese policy, global demand, transportation costs and currency levels. Complacency on inflation has largely been driven by exporting manufacturing to lower cost nations, mainly China. Whether the inflation picture changes in the future is likely to be driven by them not us. The illusion of control can be dangerous.

We could write a much longer list of observations which we are thinking through in terms of how they should influence (if at all) our assessments of long term value; Telstra continuing to win market share in a sector with great long-term growth fundamentals and duration plagued by competitors with no strategy other than price competition, revenue forecasts for supermarkets which don’t seem to take account of the extent to which 2020 was abnormally strong, the extent to which COVID is being blamed for earnings and cashflow impacts which simply don’t add up, capitalisation policies manipulated to satisfy investors who read the presentation slides but never get to the bottom of financial accounts and departing chief executives which vary from highly capable and effective through to those that are out of their depth in a car park puddle and leave the companies they touch in a crumpled mess in the corner of the car park.

Outlook

The ever greater doses of manipulation which will be justified in holding together a financial system which has lost most connection with the real economy (the bit that actually matters) seem likely to create ongoing, not to mention potentially violent, mood swings. It is always useful to remember that ongoing RBA bond purchases are just turning the bonds someone used to own into cash. In turn, this cash floods the banking system and is mostly redeployed into investment assets across equities, property, etc., not taken down to Bunnings. Seeing a rise in bank deposits doesn’t always mean hard working wage earners have tucked away more of their salary. The inflation these actions create still seems to us to be far more likely to be of the asset price variety as making cash an ever more painful investment just pushes holders into other avenues. This is incredibly damaging to the extent it drives vast wealth transfers and perverted incentives without anything like the fairness and accountability of the tax system, however, it seems unlikely to drive much higher goods prices or wages. The already vast scale of these experiments mean it is virtually impossible to determine the scale of the bubbles which emerge, although it seems likely the price fixers are creating an ever more challenging game of ‘whack a mole’ in keeping things under control. Ludicrous valuations for loss making technology businesses and Bitcoin are examples of the sort of ‘investment’ which these policies foster. The temptation of the government to take advantage of this free money and run ever growing deficits seems far more likely to stoke the inflation fire. We don’t know but we’re watching closely.

Whilst we may not relish the artificiality of the environment, the nonsensical overconfidence which some investors are implicitly placing in their ability to forecast the distant future (necessarily accompanying ‘valuing companies’ on revenue multiples, TAM (total addressable market) and the like) and the obviously frothy environment in searching for a fast buck, means more mundane businesses continue to trade at normal (but generally not depressed multiples). Many investors, large and small, are succumbing to the frustrations of missing out and the discomfort of maintaining discipline. This is unfortunately the anatomy of bubbles. As ever more investors join Australia’s version of John Travolta on the dance floor, the best opportunities aren’t right under the disco ball. ‘Stayin Alive’ may be more important in the future!