Where the best future returns will be found (and where they won’t)

Forecasting is a tough business. With Russian aggression in Ukraine coming hot on the heels of a one in a hundred-year pandemic, followed by the fourth or fifth one in a hundred-year flood in the past couple of decades, it’s easy to conclude that either you don’t know much about probability or you’re 400 years old. Fantasies promising uninterrupted good times and prosperity requiring nothing more than a little easy money are becoming ever harder to perpetuate. In this note, I discuss the trends observed in February reporting, why Mike Cannon-Brookes’ bid for AGL offers more questions than answers, as well as my outlook for the Australian market. 
Martin Conlon


Forecasting is a tough business. With Russian aggression in Ukraine coming hot on the heels of a one in a hundred-year pandemic, followed by the fourth or fifth one in a hundred-year flood in the past couple of decades, it’s easy to conclude that either you don’t know much about probability or you’re 400 years old.

Fantasies promising uninterrupted good times and prosperity requiring nothing more than a little easy money are becoming ever harder to perpetuate. Sanctions against Russia which appear lame perhaps highlight the fragility of western economies lacking energy and raw material self-sufficiency and relying on China for manufactured goods. Even restricting access to SWIFT is problematic, as the potential impact of destabilising the financial system applies equally to non-Russian economies more dependent on financialisation. A snapshot of stock market capitalisation in most developed markets reveals the extent to which financial intermediation and low capital intensity businesses have come to dominate the landscape.

Easy money at every turn

If you are after a buy now, pay later option, some streamed entertainment content, an online shopping interface with Chinese goods or a hastily approved mortgage, western economies have got you covered. Large scale investments to provide energy, materials and food; not so much. Globalisation has allowed the premise that an economy cannot, in the long run, consume more than it produces to be suspended. Pandemic stimulus further exacerbated these conditions as consumption intensive economies added fuel to these imbalances, stressing supply chains and stoking inflation. As believers in equilibrium and sustainability, we feel the path for these economies is the same as for a company that has milked its assets and used leverage to buy back stock at ridiculous prices.

Tougher times will follow. While Australia obviously fares much better on these measures, courtesy of an efficient and productive mining and agriculture sector, supporting financial intermediation with easy money at every turn has also left some glaring weaknesses.

Inflation begins to bite

While results were generally solid, most sensible companies are acknowledging that an environment featuring a tight labour market, pandemic hangovers, broad-based inflation, and resultant handbrakes on monetary madness, makes forecasting precise earnings a touch unwise. Cost inflation was a theme across virtually every company. Results for miners were incredibly strong, buoyed by commodity price strength, but the waterfall charts of BHP, Rio Tinto, Fortescue, South 32 and others all featured cost inflation on the negative side.

Fortunately, it remains under control in Martin Place and well compensated through 0% interest rates. Nevertheless, price strength across metal and energy markets amplified by concerns over Russian supply impact saw mining and energy stocks dominate the positive side of the ledger in February. Characteristics around share price weakness were similarly uniform; outrageous multiples and an absence of profit and cashflow were suddenly less highly sought after than in recent years. Questions over how rivers of red ink in online retailing, sports betting and payments would eventually transform into the rivers of gold assumed in valuations suddenly became more relevant.

As is so often the case, for all the talk of catalysts and identifying market inflection points, they are less obvious in real time and not even clear in retrospect. 

Collapsing liquidity as more investment is entrusted to machines only serves to heighten the emotional response of real investors as they question the logic behind why the valuation of multi-billion-dollar companies should regularly rise and fall by 10 or 20% in a day.

Cashflow is impacted

Inflation also challenged the cashflow of many companies. Escalating costs impacted inventory levels and the enthusiasm for ‘just in time’ gave way to a little more ‘just in case’. Brambles reported rising profits but collapsing cashflows as choked supply chains drove pallet shortages at a time when timber costs made new ones expensive, forcing investors to determine whether this is good or bad news for the future. Distinguishing judicious investment from wasted money and artificially inflated earnings is not always obvious.

As patient (and frustrated) long-term Brambles investors, cashflow has been an ongoing issue. When your assets are pallets, and retailers and pallet recyclers are inclined to indifference (or they even benefit from treating your assets less carefully than you’d like) looking after your assets is crucially important to profitability and the attractions of pooling over ‘white’ pallets; far more so than enthusiastic capex in adding more pallets. GPS chips to locate pallets are perhaps less important than providing greater incentive for care and disincentives for misuse.

A matter of perspective

Woolworths and Coles created a similar conundrum. While Coles constrained CODB (cost of doing business) to around $100m higher than the same period last year, Woolworths saw an increase of $500m. Offsetting this, Woolworths are garnering a greater share of ecommerce sales and have undoubted passion in delivering great service to customers. Whether to applaud admirable cost control or support investment and aggression in ecommerce (which risks turning traditional high value customers into lower margin customers and damaging the economics of stores where customers have traditionally provided the transport and labour), depends on your perspective.

The battleground of logistics is similarly troubling. Vast investments in warehouse automation promise (as technology always does) massive efficiency gains. A sceptic would point out the last round of logistics investments promised similar gains, however, costs never saw the benefit. Given many companies called out inflation in technology labour, it is more than possible companies are merely swapping costs rather than saving them.

More questions than answers

Given our views on energy costs, and the strong belief in viable renewable energy requiring higher prices, we can’t let the Brookfield and Mike Cannon-Brookes bid for AGL go through to the keeper. It is easy to observe the bid was long on media attention and a little shorter on substance.

Surprisingly, there seemed to be little questioning on why Brookfield and Cannon-Brookes needed to buy AGL if they wanted to tip billions into renewable energy. Given AGL essentially comprises a bunch of retail customers who want the lights to turn on and for whom the service is connection, meter reading and billing, together with a wholesale electricity generation business of dominantly coal-fired power, it is neither immediately obvious why this is an essential asset for someone wanting to build renewable generation, nor what is preventing such renewable investment without owning AGL.

Closing coal-fired generation earlier would remove cashflow from AGL earlier and bring forward closure costs, reducing the value of the business, unless of course, one expected the closure of coal to result in sharply higher energy prices. While the shake-up of an inefficient behemoth such as AGL may be desirable, and the clean energy ambitions of Cannon-Brookes admirable, we were left with plenty more questions than answers.


Our discomfort with stratospheric valuations lies precisely in the uncertainty of forecasting. Low discount rates do not improve certainty on the future, which is a major reason we believe this rationale for embracing outrageous multiples is flawed. While results from the likes of Cochlear and CSL may have been solid, and the companies unarguably good, we continue to find them unappealing investments for a simple reason; current valuations require the path of future profits to be very good for a very long time. This path is possible but not probable. 

Many of the other companies which have seen stratospheric appreciation in recent years do not share the attributes of CSL and Cochlear; they don’t make any money and the businesses aren’t any good. While many have retraced significantly from their highs, in nearly all cases we believe sensibly priced, proven and sustainable businesses remain vastly more attractive.

Long periods in which interest rates, house prices, equity markets and geopolitical stability have been broadly unidirectional, have led to firmly ingrained beliefs. The past couple of years have thrown a few curve balls in the shape of the pandemic and the recent intensifying conflict. History says countries, together with the companies and economies which underpin them, do not have the smooth consistently growing pattern which these ingrained beliefs imply. We believe efforts to eliminate cyclicality and encourage ridiculous leverage will prove unsuccessful and unwise, with market capitalisation in many equity markets still conveying an unbalanced and unsustainable picture. By far the best future returns will be found in embracing cyclicality and avoiding excessive leverage.

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Martin Conlon
Head of Australian Equities

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,...

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