Time for the crazy ones
Think Different. The slogan behind the reinvention of Apple paid homage to ‘the crazy ones’; those who’d changed the world. Invariably they challenged the popular wisdom. The ‘crazy ones’ are not currently working in financial markets. Focus remains firmly on the minutiae of short-term inflation rates and how far and how fast interest rates will rise in the coming year. Central banks, and the RBA more than most, having seen almost nothing behave according to their models of the economy over recent years, face a conundrum: whether to follow their models in the other direction.
Years of cutting interest rates didn’t spur inflation or business investment. It did spur rampant speculation, asset price gains and leverage against existing assets. Now they have inflation, they need to decide whether to use higher interest rates to try and stop it. The Federal Reserve has made its call. Whether or not their actions will curb inflation is uncertain. That their actions will disturb financial markets and the inexorable financialisation trends of recent decades is becoming increasingly obvious. Should inflation not fall quickly, particularly as higher wage demands in tight labour markets take hold, the sceptics among us might wonder whether the tolerance for collapsing capital markets and asset prices will prove quite as durable as it was on the ride up.
Economics, after all, is just about choices and the results for society. If the policies employed over the past decade or so, both monetary and fiscal, aren’t creating the type of behaviour and societal outcomes we’re after, we should try different ones. While it might be time to think a little differently, finding Albert Einstein, Martin Luther King or Mahatma Gandhi of monetary policy remains a little tough. The hegemony of the financial over the real has created some powerful companies and individuals, ably assisted by some powerful lobbyists. While the groundswell of discontent over unaffordable housing, wealth disparity, and inaction on climate change may be well underway, expecting change without a fight really would be crazy.
If central bankers worship at the altar of inflation targeting, the investment equivalent has to be the return on capital. An investment process targeting an assortment of poorly managed companies achieving low returns on capital is rarer than a central banker advocating sharply higher interest rates. ‘Quality’ is where it’s at.
Whether it be the global technology juggernauts, healthcare businesses with exceptional margins, or more recently, exploding margins and profits for commodity producers benefiting from higher prices, high and increasing return on capital is the holy grail.
The ‘how’ in achieving this outcome receives a little less attention. High return on capital can and should be an admirable objective, however, like inflation, when measuring the outcome becomes more important than understanding it, things go awry.
Big technology firms seem a case in point. Equity portfolios full of Microsoft, Alphabet, Apple, Visa and MasterCard see greatness in wide competitive moats, pricing power and growth. While good products, scale economies, and innovation play a part, capital markets have also facilitated and supported countless transactions which stifle competition (try announcing a global ban on merger and acquisition activity and see whether you get a few more changes in market structure). The business model of many start-ups is as much about getting bought as it is about genuinely challenging incumbents in search of profit. Similarly, the high returns and margins for healthcare companies seem inextricably linked to high prices for drugs and medical devices funded by taxpayers and supported by an army of lobbyists.
How one views these high returns depends on your perspective. If you’re an investor who’s enjoyed the extraordinary returns provided by the march to dominance, you’re cheering it on and hoping it continues. If you’re a small business in a competitive sector seeing profits disappear as payments to Google, or a big business that’s transitioned technology to the cloud and wondering why the promised SAAS benefits haven’t appeared and what you’re going to do when Microsoft and Amazon put up the price every year without improving the service (not sure too many have thought about it yet!), then you might be wishing there was a little more competition. If you’re a government wondering why healthcare outlays are out of control and why the productivity gains which should accompany increased volumes and progress never seem to eventuate, you might not see outrageous margins and high returns quite as positively.
Viewing a business through the lens of those buying the products and paying the bills (increasingly the government via the taxpayer) will often provide a different perspective. Where a Tabcorp (ASX:TAH) investor sees a lottery licence as a wonderfully lucrative right to extract large and growing profits from the millions of poor and hopeful, one can also see governments which have sold taxpayers down the river by receiving pitiful compensation for mortgaging the future. Lotteries, tollroads and airports are amongst the countless examples. Selling the assets is one thing. Enshrining protection from future competition is another.
Quality should be a term reserved for businesses generating strong and sustainable returns through running a business well. While many of the current domestic and global leaders started this way, ever lower interest rates have been instrumental in skewing the playing field towards acquisitions, financial engineering (debt and buybacks) and away from genuine innovation and organic investment. It is also why we feel the time spent understanding the ‘why’ of high return on capital is far more important than observing the quantum.
When it comes to understanding the return on capital drivers for commodity producers, life is fairly simple. While resource quality and location are important, commodity prices overshadow everything. Battery minerals are in the sweetest of sweet spots. Claims of perpetual supply/demand deficits (impossible, but never mind) and the obviously attractive demand picture from electric vehicle and broader battery growth have created the perfect environment to whip investors into a frenzy. While cost curves for lithium production are rubbery, complicated by the alternative production paths of brine and hard rock, current lithium prices bear no resemblance to any cost curve.
Although little production is being sold at current spot prices, lithium carbonate prices of above US$70,000/tonne are in the vicinity of six or seven times the costs of even high-cost producers. Using iron ore as a benchmark, this would be the equivalent of iron ore prices of $US500+ versus the current (also elevated) prices of US$140.
Further, the flow through cost of these lithium prices to electric vehicle costs is material. Battery costs, some 30-40% of the vehicle cost, are up markedly with raw material costs more than offsetting scale and technology improvements. While US$8 or $10k of batteries may not deter wealthy Tesla buyers, it will certainly be an issue for EV demand in less developed countries. The annualised cost of battery replacement, while not an issue in the early stage of market development, will become a major deterrent if prices do not fall materially (used cars won’t be worth much if they need new batteries). Current pricing will also accelerate the push for new technologies such as DLE (direct lithium extraction), given the need to address issues such as vast water consumption in arid areas. While most commodity producers are enjoying a waterfall of cash at present, and those with current lithium production are under Niagara Falls, current conditions are extraordinary. Valuations in the current market can change rapidly, given the ability to generate the equivalent of 10 or 20 years of normal cashflow in a single year. Those of you able to remember all the way back to 2019 when the demand outlook was similarly positive, but prices at the opposite extreme, will be well aware of the dangers in extrapolation. Conditions seem very bubbly from our angle.
Barbarians through the gate
If we needed more evidence that the Barbarians have come through the gate and are now wandering around the paddock, Ramsay Healthcare (ASX:RHC) provided the latest exhibit. Given an obvious bias to listed markets and the benefits of free market pricing, fractional ownership and liquidity, we won’t claim to be objective, however, when the higher entry prices as private equity and large superannuation funds pry assets from the clutches of listed equity markets are added to management teams likely to remain fairly unchanged and co-owners with a stronger track record in eliminating staff over hiring more, we’re not totally sure why the bid is likely to be good for patients and members. Should a more likely scenario eventuate, in which the assets remain largely the same, the service the patients receive remains largely the same and the profits don’t, therefore, experience much change, things may be simpler.
A higher price paid will equal a lower return received.
We like the Ramsay business. It has not sold hospitals into a REIT structure to improve returns through smoke and mirrors. It attracted doctors and patients through offering high quality facilities and equipment and a good patient experience. The profit impact of lost utilisation during COVID-19 was obviously transitory and therefore relatively unimportant to business value. It might annoy management that some question the merits of the fairly highly priced global expansion steps, which seem to have added little, however, having to justify actions to a myriad of owners can also be construed as accountability.
Adopting a short-term focus, we could merely accept the benefit which a takeover offers for our clients’ performance and move on. There remain many options to redeploy proceeds with better return prospects. It is the most likely outcome. This approach also leaves us unsatisfied. Accepting unadulterated nonsense is not our bag. Believing ever larger superannuation funds not subjected to sufficient price discovery/validation can purchase the same pool of underlying assets at higher prices and out the other side will emerge an asset pool with better returns, lower fees and lower risk/volatility sounds nice. It’s wrong.
Denial is not a river in Egypt
That interest rates should not be where they are currently is obvious to nearly everyone that isn’t a large, long-necked bird inclined to bury its head. Even if inflation was 2 or 3%, an interest rate near zero makes no sense. Whilst there is every possibility that the economic environment in Australia and the US is unusually overheated due to excessive COVID-19 stimulus versus other regions and may unwind, longer term perspective suggests the ‘Think Different’ slogan should have been forced on central bankers many years ago. The ‘how’ matters.
The level of inflation and employment, like return on capital, are headline indicators, not idols to be worshipped.
Creating jobs skewed towards intermediation and asset flipping is not the same as creating productive assets and infrastructure. The path back to some degree of normality looks treacherous, given the usual enthusiasm with which free money was deployed in additional leverage and speculation. The extent to which many believe we have already endured substantial corrections in the frothy areas of the market serves to illustrate how significantly enduring excess can dull the senses. Whilst moves in bond markets indicate the susceptibility of markets accustomed to artificial pricing, history suggests the bubbly areas of equity market valuation have some way to retrace.
Common sense remains uncommon
Policy choices which encourage the productive over the speculative have not started, and if schemes such as the Labor proposal for ‘shared equity’ stakes in houses are any indication, the ‘crazy ones’ we’re after haven’t arrived yet. Truly insane would be a more apt description. Try taxing unearned capital gains at the same or higher rates than wage income, and removing negative gearing, significant investor visas and foreign ownership of residential housing. The unavoidable levels of volatility which accompany valuations propelled to unsustainable levels by ill-considered policies are likely to test the resolve of investors when bouts of panic replace the euphoria which has dominated recent years. We’d expect enterprise value to sales, total addressable market, lifetime value of subscribers and many other terms which have entered the investment lexicon over recent times may abate further in popularity. While we remain sceptical on the appetite to remove the excesses encouraged by mispriced money, even small steps toward more normal conditions can be powerful. We’d expect thinking a little differently to the past decade and buying genuine cash profits, business models which make sense and sensible valuations will prove more lucrative than crazily valued pipe dreams, profitless growth and financial engineering.
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Martin is the Head of Australian Equities, and leads the portfolio construction process for Australian Equity portfolios, while also retaining analytical responsibilities for a variety of sectors including Diversified Financials, Gaming,...