Think like a private equity fund

The private equity world is simply putting a higher price on assured cash flow streams. The common theme in all public-to-private equity transactions has been an assured cash flow stream from an established company. That established company usually operates in a tight industry structure, with very high barriers to entry.

Industry structure plays a very big role in deciding the volatility of cash flow, as it does in deciding long-term return on equity, long-term EBIT (earnings before interest and tax) margins, and long-term dividend yield.

The private equity world is simply more tolerant of risk, and particularly more tolerant of gearing, than the public markets. They don't have the short-term performance pressures of the public market, and they don't have the same transparency requirements of the public market.

Private equity funds are trying to work out the sustainable free cash flow yield of a given company, to calculate the economically appropriate long-term gearing level for that sustainable cash flow stream. This isn't about price/earnings (P/E) multiples and earnings per share (EPS) growth, and that is why the prices paid will always surprise the public market that set their "valuations" off short-term EPS.

It's been my long-held view that corporate Australia is under-geared. The pressure from the public market has led to the vast bulk of Australian companies carrying sub-optimal gearing relative to the stability of their cash flows. The public market puts pressure on boards for short-term rewards such as buybacks and special dividends, and seems to endlessly want their capital back.

That's one thing I just can't understand: why does a market that is awash with capital want its capital back?

Capital management = lower P/E?

BHP Billiton (BHP) has been buying back shares at an ever-increasing rate, yet its P/E has been contracting at an ever-increasing rate. It has never been more active in returning capital, yet the market has the stock on the lowest prospective P/E in a decade. The MBA textbook never said this would be the outcome of large-scale capital management, and I often wonder what BHP's P/E would have been if they had simply done no capital management and had deployed their excess capital into further large-scale acquisitions. The same can be said for Rio Tinto (RIO), which has experienced a similar P/E de-rating despite large-scale capital management programs.

The "resource bears" justify their negative view on the P/E compression currently occurring in BHP and Rio Tinto as being representative of the peak cycle for commodities. However, the "overpriced" resource stock fallacy is exposed by the capital management initiatives of both companies. Obviously the BHP and Rio management (and they are better placed than analysts) believe their respective share prices are so undervalued, the most efficient way to enhance shareholder value is to implement a share buyback.

The "bears" then argue their negative view is supported by the lack of growth options for resource companies, considering they are implementing share buybacks instead of acquisitions. You simply can't have it both ways. The clear message here is that resource company management is showing a new financial discipline that will result in rising return on equity figures supporting better EPS growth, and eventually, higher P/Es. The other side of the financial discipline equation will be higher for longer commodity prices and earnings, as the supply side-response is constantly delayed.

Investors tell these companies they will reward efficient management of capital, but in reality, they are yet to do so. They re-rated property trusts instead.

It's now reached the almost unbelievable stage where both BHP and Rio due to their low prospective P/Es, very low gearing, and very high free cash flow yields, are now possible private equity targets. I don't think in reality they will ever be private equity targets, but the investment arithmetic is undeniable. If you had the proverbial "balls of steel", and were prepared to gear BHP's cashflows to 100%, you could end up owning this irreplaceable set of long-duration assets in just under 10 years.

But it’s not just the public markets short-termism and lack of appreciation of cash flow that is attracting foreign private equity interest. It's also changes to the Australian capital gains tax systems.

No tax here

On Wednesday, legislation passed through the Senate, with bi-partisan support, that capital gains tax no longer applies to foreign investors. This is big news, and has big ramifications for our equity market. Foreigners can now buy and sell most Australian assets without having to worry about capital gains tax. Talk about hanging the "for sale" sign on the country! This actually disadvantages Australian investors and I think you will see many Australian private investors reincorporate their private companies in foreign domiciles to take advantage of the capital gains tax advantage.

In its infancy

I've written before how well-placed contacts tell me we are only witnessing the infancy of foreign private equity and corporate interest in Australia. I reckon that is correct, yet the equity market believes this is the peak of private equity and corporate interest in Australian assets. I believe that is a huge strategic mistake.

On that belief I continue to focus our equity strategy on highly cash-generative businesses operating in tight industry structures. The trend to re-gear stable cash flow assets began a decade ago with Macquarie Bank re-gearing infrastructure assets. Now the MBL re-gearing model has advanced from airports to airlines (Qantas) and that shows this move to re-gearing cash flow has moved to higher-risk industries, but still industries with tight industry structures.

I think the threat of private equity buyouts has been the cattle prod corporate Australia needed. Lazy balance sheets will become a thing of the past, and we will see optimal economic gearing become more prevalent.

Use it or lose it

And now it seems the public market is starting to reward boards who "use it". IAG has clearly been rewarded for buying foreign assets funded by tapping the compulsory superannuation pool; it’s a very interesting development for a company that has previously been out of favour in the market's eyes. Exporting investment capital is necessary, and sensible deployment of that capital will be rewarded.

It's also interesting to see Wesfarmers (WES) shares start recovering as they deploy capital into a series of acquisitions. Wesfarmers has phenomenal cash flow, and the business can handle higher levels of gearing. It was only a few months ago that other brokers were saying that Wesfarmers had run out of growth options. I'd back chief executive Richard Goyder and finance director Gene Tilbrook to deploy capital every day of the week, and it seems the market is slowly starting to work this out too. I see Wesfarmers as a listed private equity company.

Similarly, Toll Holdings (TOL) has moved to new highs after bedding down the Patrick Corporation acquisition. Toll is an example of a company that has always run optimal economic gearing levels, and to the best of my knowledge have never returned capital to shareholders other than in the form of a small dividend yield. Every time their gearing drops to a sub-optimal level they embark on another complementary acquisition. Transport/logistics is supposed to be cyclical, but Toll has built a huge barrier-to-entry business via continually leveraging its cash flow.

Focus on sustainable cashflow

The point of all this is that you must focus on companies with sustainable cash flow and high barriers to entry, and consider whether they could handle higher gearing.

Many investors might regard this as dangerous and just another form of ill-conceived financial engineering that will end in tears. Such caution might be well-placed, but you will not know you are right for a very long time. This re-gearing of assets won't blow up tomorrow, and if anything, the trend will see more and more companies re-gear via acquisition, or being acquired and re-geared by their new owners.

Remember the great quote of John Maynard Keynes: "Markets can remain irrational for longer than you can remain solvent." I am of the view that most of this re-gearing of Australian high cash flow yield assets is rational, yet we will clearly see some "irrational", extremely risky, deals as we move forward.

Even if you think this is all nonsense, just remember you will not be proven right immediately. Perhaps all we are seeing is the corporate world adopt a less conservative approach to gearing, similar to what we have seen in the domestic household sector.

If you don't believe in all this you can still make money via buying under-geared, high free cash flow assets, and waiting for a "re-gearer" to take you out.

Down under on top

Anyone fortunate enough to see the CNBC business show on Foxtel yesterday (Thursday) would have witnessed some truly great theatre. The anchor was interviewing a fund manager and enquired about the fund's best performing stock for the year. Interestingly, the manager nominated Zinifex (ZFX). The anchor seemed bewildered that an Australian mining company '” a zinc stock! '” could be such a strong performer. The fund manager even had to explain to the anchor what zinc was used for!

The interviewer then asked the manager for his next-best recommendation. The answer, Macquarie Infrastructure Group, left the interviewer stunned: "What is going on down there in Australia?” and "You don't like US stocks?" In response the fund manager replied that the majority of Australian stocks offered more than twice the yield of US stocks and better growth prospects. Your witness.

The real message here is the power of fully franked dividend yield, and virtuous circle of mandated super contributions, within the tax-effective superannuation structure. We think this supports our view that investors seeking higher after tax returns through superior grossed-up dividend yield underpin the Australian market. We think the only valid comparison of comparative returns is on an after-tax basis, and for this reason Australian equities will continue to command a premium to global markets.

In addition, it also supports our view that there is very little value-add to compare Australian banks to overseas banks on the basis of P/Es alone. Australian banks are priced by local investors for their superior after-tax returns based on grossed-up dividend yield. It is interesting to witness the current round of bank downgrades by the big US investment banks because they appear expensive relative to foreign banks. I think any bank trading correction, driven by this myopic P/E view, will prove to be a great buying opportunity. Australian banks will not seriously underperform until dividend yields are cut significantly, and that isn't going to happen any time soon.

Banks: the clear view

If you focus on return on invested capital you will get the direction of dividend yield right. That is all that matters when looking at Australian banks. This P/E analysis of banks is absolute rubbish. St George Bank (SGB) has been consistently described by analysts as "expensive" for the past 10 years. It's expensive because it’s got the highest return on invested capital. That's what drives the P/E, so in theory you should buy the most expensive banks on P/Es because they have the most efficient capital base. That's why I recommend SGB and Commonwealth Bank, because their diversified income streams drive the highest return on invested capital.

Those income streams reduce overall asset risk, and you can see that reflected in higher credit ratings from the ratings agencies. I recommend the banks with the highest percentages of non-interest income, and these two banks command the highest basic P/Es because they are lower-risk and generating the highest return on economic capital.

If you believe nothing else I write, believe me when I say that looking at Australian banks from a basic P/E perspective is a big mistake. Australian banks will always command a premium to global banks, and you'll most likely do best buying the most "expensive" Australian banks because they are generating the highest economic returns on capital.

Christmas rush

This looks like being the busiest-ever December in Australian equities. While hedge funds and traders have wound down their activity, the private equity and corporate world has stepped right up.

Just when you thought it was safe to go for a long lunch '¦