That turgid mid ground
by Andrew Fleming, Deputy Head of Australian Equities
18 months ago, we outlined six fundamental views which shaped our Australian equity portfolio. Of the original list below, only one tenet has changed:
We have written in previous monthly commentaries on the first three themes. There is no need to labour the point, lest we be accused of “Grumpy Old White Man Syndrome” (One client observed recently that many Asians are more optimistic than Westerners, especially older Westerners, and this is reflected in their respective economic performance).
Having said that, in needing to raise $750m recently, Arrium was a classic case study in how each of these factors can parlay aggressively into stock performance, with the share price underperforming by 48% during the past quarter and 75% over the past year. Lower global growth and over capacity has continued to see manufacturing processors without intellectual property, such as steel makers, produce low returns; this is the story of Arrium’s steel making business, with its iron ore mining operations providing the vast bulk of its earnings in recent years. With the iron ore price falling to US$77 through recent months, its lowest level since the GFC, even with the Australian dollar falling as well, higher cost iron ore producers such as Arrium have seen their operating earnings drop by large percentages.
If asked “What is the catalyst ?”, we can only respond with the truth; we don’t know, and rarely can a catalyst for major market moves in almost any tradable security be identified with precision, even in retrospect. What was the catalyst for the GFC? How about the Tech bubble? And, in each case, the recovery in asset prices that ensued? Even now, it is hard to know. All that is clear is that the pre-conditions for those exaggerated moves had been increasingly in place for some time, by reference to valuations. Current conditions for Arrium continue to read lower growth for longer, over supply, absence of pricing power, not being a low cost producer and having high levels of financial leverage; this is ultimately a Molotov cocktail for investors, even if through the past quarter “the catalyst” for Arrium’s performance, and the decline in the iron ore price, remains as elusive as ever.
Mining services is another example of the peril in extrapolation. One of our team has just circulated a November 2011 article highlighting how “Mining service providers have been a bright spot in the float market in the past two years. Titan Energy Services wants to continue that trend…”. That stock is now down 82% relative to the S&P/ASX200 through the past year, and an extremely poor relative performance is common to mining service companies in the three years since the article. What sector of the listed market, today, has characteristics which to us seem eerily similar to the fads of cycles past? Without question, in our opinion, it’s Education. As always, the vendors are being rational in coming to market, but just as the mining services boom to bust has occurred within three years, we suspect the report card in three years’ time for many of the Education companies listing today may feature more F’s than A’s.
One final example where we still see risk arising from undue extrapolation of the past rests with the retail sector. Consumer Discretionary is the most shorted sector in Australia relative to market capitalisation, by half as much again as any other sector. Reflecting a secularly lower sales growth environment and a mix shift in channel towards online, US shopping centre floor space growth has been less than 0.5% per annum for each of the past five years. Retailers are rationalising store numbers as leases mature, and traffic to malls is declining by low single digits per annum. Retailers are continuing to focus upon maintaining sales by growing online; for example each of Nordstrom and Macy’s have grown online sales at more than 30% per annum through the past several years.
Finally, the ability to exert pricing power and a productivity focus sounds trite, but they are often the only weapons left open to management in a low growth world. We are often happiest when it is obvious that pricing power remains latent. For example, a small listed New Zealand company, Metro Glass, is run by a former senior manager from James Hardie. We have previously highlighted James Hardie as an exemplar of both pricing power and productivity, and those disciplines have been parlayed into the operating metrics for Metro, which has invested to ensure a position as the lowest cost glass producer and distributor in its local markets, by a material margin. Because of their 20% higher cost bases, and current operating losses, Metro’s next largest competitors need to continue to raise prices just to become profitable, let alone start to garner an acceptable return. The industry is acting rationally in (gently) raising prices, but because of their relative positions on the cost curve Metro retains significant latent pricing power which is likely to be quickly matched by competitors should it ever be exercised. Management are wise to keep that card up their sleeve.
A productivity focus is important, but can take two forms. Capital productivity is often just as important as operational productivity. Capex to sales ratios for ASX industrial companies have halved since peaking above 10% in 1990, with no discernible retardation to growth. We are unaware of large scale investment, which is valuable, not being made because of an absence of capital, especially in Australia. Good projects in Australia can definitely and readily be financed, by equity and debt. As an investment proposition, where companies come to the completion of large investment programs, which is a characteristic of the large miners and many energy and utility stocks through the next two years, the ensuing free cashflow generation can prove highly valuable to shareholders; our portfolio remains positioned accordingly to capture what we forecast to be a capital productivity dividend.
The six principles we spoke to in setting the scene for our market outlook at the beginning of this commentary are prima facie headwinds for both multiples and earnings. They remain afoot even with the market’s poor performance through September. A fair starting multiple, management intent and capacity to generate good returns on investment, even in the face of challenging conditions, remain a shareholder’s single biggest lever for outperformance through markets prone to correction.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice.