Short term-growth and long-term dilemmas

Working out what’s important isn’t easy. Perhaps because Bill Gates is much smarter than most, he makes it look easier than most. His recent comments highlighted that COVID-19–induced austerity, including virtual cessation of air travel and vast reductions in car traffic, had only managed to reduce global emissions by around 8%. This is perhaps understandable given transportation only accounts for about 16% of global emissions, however it highlights the scale of the climate change challenge.

Given the vast economic cost in lives and jobs of this forced reduction, using the economic impact of COVID-19 as a measure of the cost of carbon derived a figure around 30-50 times greater (estimated by Rhodium Group) than the $100/tonne estimate often used by economists. The message was straightforward; fighting climate change by reducing energy demand could inflict catastrophic economic pain resembling a pandemic such asCOVID-19.

We are not going to solve it through austerity and reduced usage, nor just through solar and wind power. It requires breakthroughs in production methods for food and goods and methods. It requires the promotion of electricity usage whilst decarbonising its production and investing heavily in its transmission. There is great opportunity for productive investment.

Having delivered inadequate returns for clients over recent years, we are rightly challenged over whether we have insufficiently embraced technology, innovation and elements of the market offering ‘growth’. 

While the scoreboard remains technology dominated, with the breadth of market leadership across nearly all markets narrowing dangerously in its favour, we cannot help feeling investors are missing what’s important.

August, like most other months in recent years, saw returns monopolised by the usual suspects: Afterpay, Zip, Wisetech Global, Altium, Megaport, Netwealth, Xero and Kogan, to name a selection. We would debate whether any of the moves were justified by result fundamentals, and even more strongly debate the quantum. To the longer-term list you could add advertising businesses such as Carsales and REA, and branding businesses such as A2 Milk.

Perhaps we are underestimating the vast economic benefits of a one-off opportunity to bring forward a few weeks spending or the social harmony gains should Pointsbet successfully induce swathes of the USA to extinguish their wages gambling online (a hope which seems to us vastly less likely than the wastage of vast amounts of shareholder’s money on NBC advertising), but few of these companies seem likely to make a significant contribution to solving some of the issues identified by Bill Gates.

Investments that truly matter

At the other extreme, the energy sector, the lifeblood of all economic activity, has fallen from 16% of the S&P500 in 2008 to barely more than 2%. The Australian market has followed suit. 

The market capitalisation of Afterpay would buy AGL and Origin Energy with about $7bn change, a reality we find demoralising. 

While AGL and Origin Energy may not be investing enough in decarbonising energy, they are at least investing something, while concurrently delivering most of the country’s electricity and gas. Portfolio holdings such as Bingo Industries and Cleanaway Waste are both investing significantly in recycling and better management of waste. Dollars of productive investment are crucial to generating future returns and solving what’s important.

While most investors mean well, we are concerned that initiatives such as measuring and minimising emissions on an investment portfolio risk being highly counterproductive. The flow of money is already pushing the prices of perceived ESG-friendly companies into the stratosphere, lowering future returns, driving crazy merger and acquisition activity, and removing much of the imperative for profit. Swimming against this tide are the energy, resource and industrial companies best positioned to invest in technology and infrastructure to solve the important issues. Capital starvation and a rising cost of capital are increasingly compromising this process. 

As the likes of Apple and Tesla add phenomenal amounts of market value through highly productive activities such as stock splits, investor attention and the behaviour of companies often seems more focused on the creation of illusory market value.

The past decade has seen no increase in the number of listed companies in Australia, minimal increase in the amount of capital raised and no sign of increased productive investment with this capital. Monetary policy is proving effective at propping up asset prices and little else. Unadulterated nonsense such as claims the ‘trickle-down effect’ will foster economic growth and happiness for all, rather than fostering wealth inequality, are still given credence. The US may be further down this path; it does not mean Australia and others should follow. This has left us questioning whether we are at the cusp of change in the macroeconomic landscape.

Retail therapy for an ailing economy

Questioning long-held beliefs does not come comfortably. Stephanie Kelton’s The Deficit Myth and its explanations of Modern Monetary Theory (MMT) are anathema to those, like me, whose economics education was along traditional lines. It is for this reason I read it. While there are reasonably obvious holes in the theory, given its effective reliance on the gradual erosion of currency value as the variable in transferring resources around the economy and the significant role of government in deciding where resources should be directed, it also offers numerous ideas with potential for superior outcomes to those being employed currently. Vilifying the entirety of MMT while not accepting that at least part of the current theory is as nonsensical as anything MMT offers, seems extreme.

The initial experiments with fiscal policy in response to COVID-19 offer some interesting insights in this regard. Superannuation withdrawals, JobKeeper and JobSeeker payments have both supported those who have lost income and transferred funds into the hands of people not used to having it. We would hazard a guess superannuation withdrawals have not come dominantly from over 55s. Perhaps unsurprisingly, they spent it.

Strength across a broad range of retail categories, particularly furniture, homewares, hardware and supermarkets left a large number of retailers far better off. Bunnings, JB Hifi, Harvey Norman, Adairs, Baby Bunting and a raft of others delivered very strong results, with valuations generally well above levels of a year ago. While there are obvious question marks over the sustainability of government-sponsored wealth transfers and the usefulness of the spending, together with the extent to which sharp reductions in travel and entertainment spending transferred into other categories, evidence suggests they have proven far more effective in sustaining economic activity in highly challenging conditions than anything the Reserve Bank has managed in the past decade. Those owning assets and used to their inexorable rise may not like it, as they are the transferor for a change. However, they’ve probably had the better side of the last 30 years. Methinks they doth protest too much.

When the going gets tough, call your accountant

Results season provided more food for thought than usual, as the challenge of separating artificially supportive from artificially depressed operating conditions, changes to lease accounting and government support meant meaningful analysis took some time. While we can claim little certainty on the path forward, post-result meetings with shopping centre owners such as Scentre Group and Vicinity, and with operators across the retail spectrum, raised serious questions about the extent to which shifts to online purchasing would be structural, whether online retail is actually lower cost than bricks and mortar, and what levels of rent might be sustainable.

From our perspective, we are still struggling for persuasive evidence that online retail operations in most sub-sectors delivering better margins than traditional retail, yet the revenues attract exceedingly differing valuations.

Perhaps more time consuming was the reconciliation of statutory earnings with the unrelated numbers used in company slide presentations. ‘Non-cash’ earnings adjustments (which should really be translated as ‘previously wasted cash’), EBITDA, and management earnings featured in countless results. The insane multiples attributed to the darlings at the epicentre of speculation central, their generally small dollar revenues and often non-existent profit lines, mean incentives for subtle accounting changes are unusually large. ‘Growth’ must be achieved at any cost and when the going gets tough, the tough turn to their accountants. Increasing capitalised R&D, excluding share-based payments (wages), adding back ‘non-cash amortisation’ and some of the more subjective measures such as loss ratios in lending operations are all part of massaging numbers in the right direction.

Wisetech Global managed to enthuse investors into adding a few billion extra to market value by trumpeting 23% revenue growth and 17% EBITDA growth. Flat operating profit and significantly increased capitalised R&D received less attention. 

Afterpay made that look like child’s play adding $8bn or so after upgrading EBITDA by $20m (to $44m) as a few more customers than expected repaid them. The irrelevance of this change to a company valued at more than $20bn should be obvious; however, in these adrenalin-fuelled sectors you need to keep the shots coming. 

The pattern of ill-disciplined analysts adjusting forecasts for the next few years down while becoming ever more optimistic on the distant future continued, as the alternative of offering more realistic valuations, downgraded recommendations and standing in front of the momentum freight train, proved less appealing.

Sustainability needs investment, however you account for it

Virtually every company on the planet needs to reinvest to sustain a future. Whether this investment is captured on the balance sheet and then amortised or taken through profits as incurred should be irrelevant for company value if investors think through life cycles and business economics. It is perhaps more relevant for share prices when algorithms are looking to react as quickly as possible to ‘meets’, ‘beats’ and ‘misses’ (I can barely stomach typing those foul words!).

Early in their life cycles, most companies will be spending well above the rate at which any existing assets are deteriorating (depreciation and amortisation) to grow revenues. 

As a business matures and revenue grows, this will normally stabilise, albeit often unevenly rather than in equal annual instalments. In others, such as Telstra, where the business is changing shape, the charge against earnings for depreciation and amortisation can be significantly higher than the costs of sustaining the business after it passes fixed line operations to NBN. Our job is to ascertain how much we think it really costs to sustain revenues and margins and how much extra a company might need to spend if it seeks to continue growing them.

Investors in businesses such as CSL often claim R&D is undervalued as it is expensed and should be added back. We would beg to differ. If one removes the R&D expenditure and values it separately, it is wholly unrealistic to assume all the existing products, often old and being challenged by competitors, can grow revenue and sustain margins in perpetuity. Already high margins might be driven higher if they chose to stop investing. After a while, a price would be paid and revenue and margins would decay to repay the lack of investment. CSL could not sustain its business without R&D and its management are unlikely to try, as they are smart and capable.

The numbers which accountants use to convey the reality of a business may not be exciting – however, they are important and usually the most reliable indicator of reality. Relying on the slide presentation from management with a vested interest in sending a share price to the moon and a lot of stock to sell is unwise. To borrow an old slogan from one of our holdings, with clean accounting and a management team doing an admirable job attempting to resolve the myriad of issues facing the healthcare industry: ‘I feel better now’.

Our portfolio position

We cannot pretend to have a huge insight into the outlook for the coming months. Central banks at present seem to have no problem sponsoring financial assets in a large-scale sports betting operation where all losing bets are refunded, such that an ever-increasing proportion of the population sees opportunity in gambling with house money. Crowds locked out of AFL instead cheer stock splits, acquisitions and contract announcements, diverting attention from the task of creating productive assets that might benefit the whole population rather than the winning punters. 

Those unfortunate enough not to have a sports betting account are increasingly reliant on government support, with this support likely to decline significantly, as superannuation balances have already been tapped significantly and other payments are scaled back. We expect this will precipitate a significant reversal in the good fortune experienced by many retailers, as the happy coincidence of elevated sales, low or no rent and government sponsored labour abates, while those hit most severely in sectors such as tourism and hospitality will need further support.

Financial intermediaries such as banks and insurers, particularly the former, seem likely to remain in unenviable positions. This is because lending money to those unlikely to be able to repay it, just because the central bank wants to keep credit flowing, does not make a wonderful proposition for shareholders. 

As Bill Gates has eloquently highlighted, there is a great opportunity for investment, with both social, climate and financial returns. However, much of it is long dated and will not provide a short-term sugar hit. 

We remain confident of prospects across the real economy in resources, energy and industrial businesses, many of which remain at reasonable valuations courtesy of the extremely narrow market leadership. At the more speculative end, we have no idea when ludicrous valuations will find their limit. But comparisons across most of history suggest there will be a lot to pay later if you buy now. 

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