Why the best, reinvest

Reinvestment is a vexing issue for investors. At one extreme, where physical capital is not a barrier to entry, global best practice sees aggressive investment in order to attempt to sustain competitive advantage.

At another extreme, where physical capital has proven the anchor for returns to be generated for generations, investors are now rewarding management that are restricting investment, best enunciated by RIO as a strategy of value over volume.

Getting that investment balance right is critical for management in ensuring the durability of their businesses and investors in valuing those businesses. This is especially so as growth stocks in Australia have never been more prized.

Small revenue bases and limited investment have not proved impediments to multiple benchmarks for ASX names, in line with global leaders. The FAANG stocks – Facebook, Apple, Amazon, Netflix and Google (Alphabet), which account for half of the US market gain year to date — now trade at a little less than 7 times revenue, but with global dominance in their domains, they still reinvest aggressively. The past four years, for example, have seen less than 20% of their aggregate revenue growth flow through to EBIT. On the basis that these are well run companies, which despite pricing power are focused upon optimising market value through increasing business duration through aggressive investment back into their franchises, they are a benchmark against which to assess ASX listed peers (of sorts).

In contrast, some of the ASX listed stocks with greatest market gains through the past year are trading on far higher multiples than 10 times revenues, and are reinvesting far less than 85% of sales growth into improving their offer. In some cases, this may be because they believe such spend could be wasteful; Netwealth and Hub24, for example, would point to user surveys as testament to a strong product and service despite spending far lower amounts than established competitors. Maintaining that dynamic as the business matures through multiple product release may prove another dynamic altogether, as evidenced by the reinvestment rate of the FAANG cohort. Australian IT stocks are trading at 20 year highs, and whilst many are great businesses, we suspect most will need to increase their reinvestment rate, to the detriment of reported margins, as they continue to grow.

The reason ASX investors are paying such high multiples where they perceive long-run growth may prove to be is that Australian market earnings growth is tepid, with industrial stocks about to report their fifth consecutive year of earnings per share (EPS) growth less than 6%. The world is painting a very different picture. Albeit aided by tax cuts, in the US EPS growth is 25% year-on-year, with all sectors ex REITS doing 10%+. Overall revenue growth in the market is 10%, multiples of what is being recorded in Australia on a like for like basis (normalising for sectors, especially commodity prices). Even in Europe, sales growth is 8% and ex energy (which has been materially boosted by the strong YTD performance of the oil price), earnings have grown at 6%. Japanese earnings growth is stronger still; Australia is the laggard of the developed world. The miracle economy, in EPS terms, is running out of puff.

At the other end of the perceived growth spectrum, Jean Sebastian Jacques hasn’t missed a beat since assuming the role as RIO CEO. Value over volume has been the corporate strategy, and whilst defying history RIO has been true to this label through the past several years, as indeed has the mining sector, at the very time that the global M&A cycle is reaching all-time highs. At over US$2trillion year-to-date, global M&A in value has now exceeded the prior highs set in (of course) 2007 (US$2tr) and 2000 (US$1.7tr). For JS to now pronounce that most M&A destroys value, and that RIO is happy to wait years if need be to acquire at prices which stack the odds of the deal being in the favour of the buyer and not the seller, is comforting for RIO’s shareholders and at odds with the corporate strategy of others. The major M&A transactions which have created value on the ASX through the past decade tended to occur when assets were valued cheaply, and where goodwill levels were low. ANZ, CBA, Macquarie and Amcor all did large deals which satisfied these criteria; RIO’s acquisitions of Alcan and Riversdale most certainly did not.

The RIO acquisition of Alcan spawned the transaction whereby certain Alcan packaging assets were in turn sold to Amcor for $1.9b, with four years after the appointment of Ken MacKenzie as CEO. The Amcor share price was then $4 and has since quadrupled, largely on the back of this acquisition, which almost doubled the then asset base of Amcor, featured a negligible goodwill amount and has since dwarfed in economic value anything else acquired by Amcor since, and certainly any of the 25 acquisitions made through the past several years. The Bemis acquisition is the culmination of a progressive dilution in M&A metrics for Amcor. What was a 20% return on investment by year three has become a 15% return; and this transaction targets 10%+ within three years. The story of Amcor is not atypical; it is why M&A volumes are this year at cyclical highs, at the same time as asset prices are at all-time highs.

Apart from M&A, two other factors are suggesting we are at or near cyclical peaks in the Australian equity market. Notwithstanding tepid earnings growth, ASX listed industrial stocks are trading at their highest multiples through the past 30 years, transcending the prior peaks seen in 2007 (immediately pre the GFC) and 2000 (preceding the end of the TMT bubble). In contrast, resource names continue to trade at multiples close to long-run averages, albeit with earnings and cashflows which are currently above mid-cycle levels thanks to elevated commodity prices, and banks are also trading at multiples close to long-run averages. It is squarely with industrial stocks where multiple extremes currently reside.

Indeed, to take it a step further, even within industrials there are extremes, with IT being at a 20 year multiple high and healthcare not being far off that level, whilst Telcos and Financials are at 20-year lows. Telstra and AMP are priced for plenty to (continue) to go wrong. Any purchase of the equity in these companies has been a poor purchase for quite some time; however it is not hard to make a fundamental case that each now represent value. The same argument can readily be made for the banks, notwithstanding the fact that so long as an Inquiry into misconduct continues, little good conduct is likely to feature in daily news cycles, and plenty of misconduct will continue to be found. Five years from now, though, we suspect CBA will still have more retail deposits and Australian home loan customers than any other bank, and will make an underlying profit not a long way short of current levels.

Outlook

In the past year, sources of return have been more varied by stock and sector than has been the case for several years prior. In points contribution to a relatively flat ASX index return; for example, BHP and RIO have been among the best contributors, and Fortescue the worst. There are only three thematic drivers we can point to that are material and prone to reversion; Healthcare and mid- to small-cap industrials with the perception of growth have been bid up to record and we now believe unsustainable multiples, whilst major Banks have been among the worst performers and now represent relatively good value, even in the face of falling earnings.

Further insights

You can read more analysis from the team at Schroders here