Flood of liquidity or water torture?

Water torture always seemed to me a fanciful way of inducing insanity. Constant dripping might be annoying; however, inducing insanity is another matter altogether. Watching yet another month pass where yet more illusory market value is created courtesy of abundant liquidity and storytelling, while earnings become increasingly irrelevant, I’m becoming less sure.

If I watch another video clip of a fund manager telling me how their rigorous investment process allowed them to identify a technology or ‘platform’ company which became a 10 bagger, I’m going to puke. ‘Luck’ and the elevatory properties of liquidity rarely get a mention. A tiny proportion of the companies delivering exceptional gains of recent years have been dominantly propelled by earnings. Investing has become a game of trying to predict where money will flow and valuations expand. Contrarian investors and hedge funds trying to profit through shorting overvalued companies continue to be steamrolled by liquidity and momentum. Policies such as granting APRA power to ban underperforming superannuation funds from accepting new members appear set to further encourage lemming behaviour, pile ever more investors into index funds and ensure there is no reward for anti-consensus thinking or sensible price formation. 

Against this backdrop, confidence in valuation discipline will never again work as an investment strategy has become dominant, valuation dispersion is historically high, and longer-term fund manager returns have rarely been more skewed by outsized differentials of recent years.

Making free money even more so

The key conundrum for the coming decade of investing is whether the elevatory powers of liquidity support ever have limits. Alongside this assessment, even if we assume liquidity can continue to levitate asset prices, we need to determine whether it necessarily supports the same winners as the past.

Stories need an ending. We are further along the path to free money than we ever thought feasible. It would be remiss of us not to consider the implications of this action progressing further. Interest rates are virtually zero. This has not prevented many in powerful positions suggesting you should pay others to take your money (and I thought I was insane). Having established a precedent justifying the acquisition of any financial asset they desire at any price, it is feasible central banks believe it reasonable to continue inexorably along this path, regardless of effectiveness or side effects. As ANZ CEO Shayne Elliot commented in the recent full year result; 

“We don’t need more liquidity. We’ve got more than enough.” “Money is essentially free today and making it even more free doesn’t really change anything.” 

This seems obvious, yet it does not accord with central bank thinking.

Entrepreneurs with sound business ideas able to generate profits and create jobs have not been the dominant borrowers in Australia for many years. Nearly every major asset owner in Australia has struggled to rationalise aggressively investing in their business, as an insufficient capacity to meet demand remains a problem most businesses would like to have, but rarely exists. Yet again, as we see employment prospects crushed by COVID-19, the RBA would like us to believe money will flow somewhere other than further inflating prices of existing assets. Already accelerating house prices evidence subdued credit growth is almost solely in housing, while further gains in the more speculative end of equity markets suggest they’ll be wrong yet again on the expected destination of their easy money. Unfortunately, this doesn’t mean it won’t happen. It also doesn’t necessarily mean irrational pricing of sectors at the epicentre of equity market speculation prevails indefinitely.

Chasing the money flows

Whilst big picture rants such as that in the preceding paragraphs can tend to be overly emotional, the more nuanced reality of sector and individual stocks examples illustrates the extremes. Let’s take some of the businesses exposed to wealth management as an example.

HUB24 and Netwealth have both roughly tripled their market capitalisation since March lows, leaving valuations of $1.5bn and $4.1bn or around 13 and more than 30 times revenue respectively, with investors in these businesses looking like geniuses. AMP, with platform revenues five or six times that of this pair, together with a bank and the AMP Capital business was, until the recent entry of Ares Funds Management, valued not far above the market capitalisation of Netwealth.

While our assessment of the value of AMP is more conservative than that of Ares, we would acknowledge that $4bn–$5bn bought significant revenue and current earnings and pricing is far from crazy. 

Our concern was over earnings prospects, particularly in sub-scale banking operations (where scale peers trade around net asset backing) and platform technology and service. Core to our concern on platform valuation has been the assumption that the $2.5bn or so in revenue currently levied as fees to end customers for investment administration (that is, recording transactions and balances) is both unsustainable in quantum and potentially unnecessary over the longer term as traditional custody and transaction recording systems change.

As a comparison, the revenue of technology providers (dominantly Iress) to the financial planning industry, which currently supports client transaction and reporting for financial planners and their clients, is around 10% of this revenue pool. While the latter revenue stream has the decided disadvantage of having to charge planners, directly impacting their business profitability, rather than passing on fees to customers, the differential remains staggering. Iress still manages to produce margins above 20% on this revenue. Our conversations over the years with potential technology competitors in the platform segment found many were reluctant to enter the segment, as they believed revenue levels were unsustainable.

In our view, Netwealth and HUB24 have (cleverly) entered the industry with contemporary products which mildly undercut exorbitant fees to higher balance clients (as fees were levied on balances), effectively cherry picking the most profitable customers of existing platforms. The lower margins of more mature platforms are inextricably linked to the much lower levels of profitability available from lower balance, lower fee clients. Real life dictates the low fee cohort tend to wildly outnumber the exorbitant fee variety. Invariably, forecasts for contemporary entrants to an industry assume they will never be afflicted by the diseconomies and bloated cost structures of established players, and the nice profitable customers early in the business life cycle will never turn into the tougher lower margin ones which necessarily accompany continuing growth.

In short, even before considering significant disruptive threats to the longer-term future of the industry, we’d expect a significantly shrinking revenue pool and margins which are closer to the 20% level. 

If industry revenues fell to $2bn (extremely optimistic in our view) and margins were 20%, this would leave operating profits for the industry at $400m. Assuming profits were sustainable forever at this level, we’d probably be able to find $6bn of value (at 15 times EBIT). As such, Netwealth and HUB24 could be around fair value if they controlled the entire industry profit pool between them rather than the <10% they control currently.

Hopefully, this provides context as to why we believe the valuations are nonsense. In the short run, while that’s where the money flows, the ledger records this as the fair value for the company and our clients endure the poor relative returns that come from not chasing money flow. Iress, with a diverse technology business across geographies, financial markets and wealth management, multiples of the revenue and conservative accounting, is valued at less than $2bn because it doesn’t have revenue growth.

Have I mentioned how much I enjoy water torture?

When basic maths doesn’t add up

On countless occasions we find this sort of basic analysis leaves us scratching our heads as to how our picture of industry profitability over time and the unit economics of a customer vary so wildly from the numbers assumed by others (perhaps assuming they actually use numbers is my first mistake). Whether it’s Xero and the small business customers which provide their revenue, energy customers for AGL and Origin, or telecommunications customers for Telstra, it is hard to divorce the economics of the business from that of an individual customer.

If a Xero small business customer pays $400 a year in revenue and Xero makes a 20% or 30% margin, the $100 or so profit they make might make them worth $1500 each (using our 15 times EBIT) if you keep them for a long time. When you’re paying $16bn upfront for the business, you’re assuming this profitability for more than 10 million small businesses, or about four times the current customer base. Either that or small businesses pay far higher prices than they are currently. That is a lot of success in order to receive an average market return if it eventuates.

Dragging forward ever more forecast future growth into current valuations, much of which is likely to be an illusion, cannot create durable market value. Interestingly, the profitability per customer and value for more mature businesses like energy and telecommunications do accord far more closely with the back of the envelope mathematics. When a customer makes you $100 or so in profit every year, they get valued at $1000–$1500 each. Plenty of opportunities exist offering sensible pricing for businesses,assuming sensible revenues and profit margins. It’s just not where the money is flowing.

The infatuation with platform companies and the potential for very high margins is understandable, given the remarkable performance of US behemoths and the lure of similar gains. Even these companies make margins not dissimilar to those we described above. Anchoring in reasonable assumptions remains an exceedingly painful way to invest at present. Applying any common sense to the valuation of businesses delivering the greatest short-term gains suggests paying current prices will eventually be more painful.

Beyond the hype, neglected opportunities

As I write, the RBA have obligingly cut cash rates to 0.1%, committed to keeping 3 year bond yields at the same level and announced $100bn of bond buying. Perhaps we’ll be surprised that doubling and tripling down on the policies which have failed to engineer anything other than asset price bubbles will suddenly morph into highly effective strategies to create businesses and jobs, with the obvious problem in stimulating productive demand for credit all this time being it wasn’t cheap enough. Seriously!

Nevertheless, trillions of dollars of debt instruments across the world are becoming long-duration, zero-yield assets being purchased by unelected bureaucrats in uncontrolled quantities. Previous owners of these bonds or government spending with the proceeds will dictate the outcome. Given there seems little prospect of productively deploying this capital at anything like the same pace, it is anyone’s guess where this money flows and which prices it inflates.

We have been surprised and wrong that in equity markets it would seek a home to a greater extent in businesses without current profits and long on promises or in market darlings at multiples never seen in history. Given prices and multiples across a raft of long duration businesses across resources, materials, telecommunications, insurance are available at multiples at or around historical average levels, we continue to be amazed these see little attention. We may not be able to make videos on how our untapped genius identified an undiscovered 10 bagger, but we should at least have profits and dividends.

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