Andrew Fleming talks about how two bubbles that emerged two years ago are reversing.
Two years ago, two price bubbles emerged on the ASX and we progressively positioned the Fund against both of them. Bonds yields were at unsustainable lows, driven only by unconventional policy, and in turn were distorting equity market pricing for yield sensitives. The emerging bubble was in commodity prices, which kept plumbing new lows. Price-to-book metrics for both genres were hitting decade long extremes, albeit at opposite ends of the multiple spectrum. A year ago, both stretched factors went even further away from us, with book multiples for affected stocks hitting levels hitherto unseen on the ASX; it is only in the past few months that both have started to revert, and our portfolio has benefited commensurately. Returns have started to accord to fundamental risk, albeit we are nascent in this unwind.
Investment in equity is always and everywhere about arbitraging risk-adjusted returns. Risk in itself is embedded in all equity investments, and at least as much time should be spent analysing where the risk lies as in analysing where the opportunity for return lies, because real risk often has more influence upon realised returns than is envisaged at the initial time of investment. Real risk is not an arithmetic contortion with correlation; it is fundamental, the risk of permanently losing capital, and for an equity holder it is embedded in operating leverage and financial leverage, and the multiple paid for the expected cashflow path, and more importantly yet less considered, normalised level.
Whilst return from earnings growth remains scarce – even after no eps growth on the ASX for four of the past five years, market earnings expectations are still prone to downgrade – reflecting the impact of low bond yields, the equity market itself has performed well through recent years, driven purely by rerating. Telstra is a classic case in point at a stock level. When David Thodey assumed the role of CEO of Telstra in 2009, revenues were $25 billion and ebit was a little more than $5.5 billion. The share price almost doubled during his tenure to 2015, adding $30 billion in market value, although revenue and ebit were almost identical from beginning to end.
Risk as an equity market investor has increasingly been dominated by macro factors through recent years as unconventional monetary policy amped up, in geographic breadth as well as monetary depth. Citi has calculated that circa 80% of global equity market returns have been driven by market factors through the last year; this is almost triple the proportion of a decade ago, before the great global monetary push.
Boards and management have had a decision to make in this context. When debt is plentiful and cheap, and becoming more so on each front, and asset prices are rising (even if revenues and profits aren’t), should gearing increase at a faster rate than income? If so, should protection from any reversion in interest rates and/or liquidity be purchased by taking out longer duration debt or otherwise hedging this risk? The answer is clear. All of Sydney Airport, APA, Transurban and Amcor now have significantly higher debt relative to their asset base than a decade ago. Two years ago, we would have thought the risk of this position overwhelmed the benefit for equity holders, and for most months since then this view would have been a losing one. Only in the last quarter has it started to look like this view may have merit, and on our long-run assumptions, we are still nascent in this unwind. Some of the stocks in the list spoken to above have almost tripled relative to the market since GFC lows; they have given up one quarter of these gains in the past few months but are still only back to the relative levels of late last year.
The second bubble has also changed course this year. After four successive years of tumult in prices, commodity prices bottomed in February this year, and have since rebounded aggressively, especially through the past quarter. Our overweight position in low-cost, long-life minerals stocks for the past two years has been predicated upon a conviction in the underlying cashflow strength arising as both opex and capex continue to decline through this and next year, even at lower commodity prices. In most cases, prices early this year were in line with our long-run price assumptions, and prices now are well above our long-run expectations. The rebound in commodity prices has not been expected by us (and clearly many others), and has disproportionately benefited geared, and higher cost producers, more than those resource stocks in our portfolio, where we mostly still believe the multiples are unreasonably low given the quality of their assets and the resulting duration of the cashflows they can be expected to produce.
So why did prices change course in February? This matters to returns for our portfolio, and given the index weight of resource stocks, to overall market returns. This buoyancy in commodities is often attributed to Chinese stimulus, which we doubt. Industrial production growth, especially as it pertains to infrastructure, remains well lower than it has been for most of the past decade, as is commercial credit growth. Further, corporate bond defaults in China this year have escalated dramatically, and have emanated largely from commodity producers and users (steel and coal). As with most major turning points in free markets through the past 20 years, catalysts remain elusive, even in retrospect. All we know is we continue to maintain stable long-run price assumptions with metals, very close to what we have had for most of the past decade and benchmarked to the 90th percentile on the cost curve; and that especially for those producers with long mine lifes and low or no levels of debt, they continue to represent stark value as against the remainder of the ASX 200.
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