2019 and the decade ended strongly for equity market returns nearly everywhere, and Australia was no exception. Profits were not the fuel, remaining anaemic. There will be no shortage of commentary from brokers and fund managers on the in-depth fundamental analysis and diligent company visits which allowed them to identify exceptional opportunities in Xero, Afterpay, Pro Medicus and a raft of others which allowed investors to double their money in a year. A day does not go by without an email justifying another upward move in the discounted cashflow valuation of these market darlings to ensure price targets remains slightly ahead of rampaging share prices.

Slightly less attention will be paid to the role of the central banks in facilitating these extraordinary gains and the type of environment in which the dominant characteristic of market winners is absence of profit. In the period since the global financial crisis, the strong performance of companies with zero or negative tangible capital has been pervasive across the globe. Nearly every list of admired or ‘quality’ businesses is replete with ‘platform’ or technology companies with virtually no capital employed. Exxon Mobil or Rio Tinto, not so much!

Cheap money, innovation and the power of incentives

The cause of this transition and its sustainability remains a perplexing question. Popular wisdom (and the claims of nearly all senior management with whom we engage) dictates that disruption is a bigger issue than has been the case in the past. Given technology has been a pervasive influence on business for many years (the previous tech bubble was 20 years ago now) and the tangible capital trend has been more confined to the post-GFC ‘cheap money’ era, we remain sceptical of the popular wisdom.

Ultra-cheap money has created peculiar incentives, and incentives are vital. Safi Bahcall’s book Loonshots offers some illuminating insights and examples of ideas which changed the world, and the structures and incentives which helped to bring them about. Stories such as how Vannevar Bush created and structured the Office of Science Research and Development, facilitating the development of radar, aiding victory in World War 2 and how Akira Endo painstakingly screened fungi to develop statins, only to have it rejected by superiors and passed to a competitor, are fascinating. However, it is the importance of systems, structure and incentives which are the essence.

Structures and systems which foster innovation differ wildly from those which sustain an existing franchise, and it is these structures and systems which define a company. Bahcall references the hierarchies and associated remuneration differentials evident in nearly all companies and the tendency to which these incentivise employees to expend most of their effort attempting to further their position in the organisation, rather than innovating or furthering the needs of customers. Controlling these hierarchies as businesses grow is a problem afflicting a vast number of listed companies, not to mention governments.

‘Culture’ is the outcome of good or bad systems and incentives, it is not the input. When Royal Commissions are blaming ‘culture’ for problems in banking, superannuation and financial advice, they would do well to keep this in mind. Similarly, it is the incentives created by low-interest rates and free money that worry us the most. Focusing on the outcome, ‘economic growth’, jobs or a myriad of similar measures misses the point. Perhaps it is a coincidence that we have more companies than ever commanding stratospheric valuations without commensurate profits at a time in which cheap money, central bank intervention and index and ETF investing are at unprecedented levels. Perhaps not.

Bank valuations diverge as headwinds continue

Although all sectors were in positive territory for the year, banks took the title of class dunces, with low single-digit returns looking decidedly dismal versus more than 20% for the broader market and more than 40% for market leaders such as healthcare (again!). Headwinds facing the banking sector are obvious; evaporating credit growth, financial repression pressuring margins and regulation gone mad (fix the incentives!). Simultaneously, banks are battling the management hierarchy problem identified by Bahcall in spades. They have more levels than the Burj Khalifa.

Combined with challengers without profit motive in the payments sector, and free-riders such as Afterpay able to sidestep costly identity checks and transaction account operating costs, the debated overvaluation and the future of bank sector profits is complex. Nevertheless, the extent to which the valuation of banks with very similar profiles have diverged has surprised us. Westpac and CBA both have about $700bn in total loans and about $500bn in housing loans. CBA has marginally more in deposits ($650bn versus $570bn), while the CBA’s Net Tangible Assets are a little higher ($62bn versus $54bn). These similarities notwithstanding, the recent travails of Westpac have seen its market value fall to $88bn while CBA tips the scales at $143bn. 

Given the future growth of both banks is unlikely to be highly material versus their current asset base, it would appear investors are expecting CBA to earn vastly higher profits than Westpac on a similar asset base for a very long time.

Opportunities for active investors as earnings momentum skews valuations

Ongoing market share gains by index and ETF competitors at the expense of active investors, together with the decay of fundamental analysis in favour of earnings momentum, continue to offer a raft of business valuations which seem to us to offer opportunity (both in buying undervalued businesses and avoiding overvalued). The time frame over which this opportunity (if we’re right) is realised is obviously uncertain, given the trends away from active management look unlikely to reverse soon – meaning incremental pricing of businesses will be dominated by computers and index constructors. Earnings momentum is easy to assimilate in quantitative models, context is a little tougher.

Businesses such as Jumbo Interactive, which fell meaningfully over the quarter, but remains more than 100% above the price from a year ago, is a case in point. The vast bulk of the business stems from the online sale of lottery tickets under an operating licence from Tabcorp which expires in 2022. These customers effectively pay a surcharge to purchase lottery tickets online, despite being able to purchase them online without a surcharge from Tabcorp. If Tabcorp terminates the agreement it is highly likely these customers will continue to buy lottery tickets and the Jumbo business would disappear. Optimism on the trajectory of lottery sales due to jackpot sequences and an ongoing shift to digital sales led to an expectation of rapidly growing earnings for Jumbo. Though revenues are relatively small ($67m in 2019), given the business is largely just a website, margins are high (operating income $38m). Infatuation with rapid growth and earnings momentum saw this business valued at more than $1.7bn in October, 25 times revenues and more than 40 times earnings for a business which exists almost solely due to a license which expires in 2 years, is in our view, not the right price. By a lot.

This is not an indictment of management efforts in running the business – they have run it extremely well. It is a comment on apparent lack of attention accorded to risks and business duration when focus turns almost solely to earnings momentum. We are biased observers and perhaps place undue emphasis on the importance of allocating capital where it can be used productively, rather than allowing it to inflate bubbles and transfer wealth unduly. However, as is the case with current crises in areas such as climate change, water policy and forest management, altering incentives to promote sensible behaviour in advance seems preferable to cleaning up after train wrecks.

Equities outlook

In 1929, Irving Fisher commented: “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as have predicted”. This forecast, along with approximately 50% of the remaining forecasts made by other economists in the last 100 years, did not go well.

The only honest answer on our expectations for returns in the coming year is that we don’t know. We can only observe that valuations of equity markets are high by historic standards and extreme in some sectors of the market. Aggressive valuation metrics by historical standards are a state of affairs shared by almost every major asset class on the planet, with monetary intervention the obvious reason. We remain of the view that engineering financial calm will become progressively more difficult as wealth inequality and discontent over political inertia make it more difficult to fool all of the people all of the time (there is no free lunch in altering the price and/or quantity of money). This does not change the conundrum for most investors: when you have capital to invest you must invest it all in something.

Given this backdrop, we continue to believe there are many businesses which offer more than adequate returns, particularly those with more volatile income streams, given the somewhat surprising coexistence of a high appetite for stable cashflows alongside rampant speculation in profitless businesses. Given bonds around the world have generally stabilised at very low yields, and the mad scientists running central banks are generally backing away from experiments with negative interest rates, we believe the impetus to valuations from lower discount rates and the benefits of borrowing free money to buy back equity are behind us. However, when a world of high asset prices (the numerator) is balanced on a very low discount rate (the denominator), simple maths dictate that we should not be surprised by relatively large moves in both directions. Low volatility is almost by definition artificial and manipulated.

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Stephen Moore

Absolutely brilliant. A voice of reason at a time when wisdom is no longer welcome. Please do keep this up

Justin Brooks

re your Jumbo Interactive comments "If Tabcorp terminates the agreement it is highly likely these customers will continue to buy lottery tickets and the Jumbo business would disappear......at more than $1.7bn in October, 25 times revenues and more than 40 times earnings for a business which exists almost solely due to a license which expires in 2 years, is in our view, not the right price. By a lot." Why would Tabcorp terminate the agreement when they own 12.5% of Jumbo Interactive? A $200m write off might be a tough sell to Tabcorp shareholders.

Will Hart

@Justin, if Jumbo's inherent value is centered on the license to re-distribute Tabcorp lottery tickets, owning 100% of that earnings stream (rather than a minority 12.5% stake + a license fee) is potentially a much better outcome for TAH shareholders. The key assumption to test would be this; "If Tabcorp terminates the agreement it is highly likely these customers will continue to buy lottery tickets"