Though investors crave certainty and specific guidance, the strong behavioural factors involved in asset pricing mean skewing probability in our favour is the best we can hope for.
Rising interest rates and stubbornly high inflation suggest unsettled weather ahead. A wise weather forecaster would suggest carrying an umbrella.
Weather forecasters get a hard time. Despite vastly improved timeliness and accuracy of forecasts through time, experts in the profession will never be able to forecast with certainty and will always deal in probabilities. When the forecast 50% chance of rain at 2pm passes in blazing sunshine, human nature will tend towards branding weather forecasters as clueless. Michael Lewis’ ‘Against the Rules’ podcast series explores these themes as he has done entertainingly over the years in books such as Moneyball and Liar’s Poker. Much as investors crave certainty and reassurance, asset valuation is unfortunately about probability and akin to forecasting the weather.
The combination of underlying earnings/cashflow and multiples/discount rates which form the basic building blocks for any asset valuation dictate high levels of uncertainty. While those of us involved in asset valuation will tend to emphasise the sophistication in this process, behaviour and emotion are crucial drivers, particularly when it comes to multiples. On the revenue, earnings and cashflow axis, much of our role is in cleaning the data, i.e. ensuring the reported earnings derived from the asset or business are supported by cash and earned without compromising the sustainability of the asset or business.
Arriving at multiples/discount rates is where life gets far more subjective. Credit spreads, risk premia, long-term growth assumptions and asset betas are terms that add credibility and precision around the number by which we multiply an asset’s cashflow or a company’s earnings to arrive at our estimate of value. Real life suggests these numbers are fairly arbitrary. To the technical list of justifications for multiples, one could add FOMO, panic, greed and momentum. Multiples have a decided tendency towards pro-cyclicality.
Mind the gap
Our expectation on higher interest rates dampening the appetite for the more speculative and highly-priced end of the investment spectrum was based on very straightforward probability. The gap between the most expensive and cheapest stocks in the equity market had widened immensely in the era of free money and was close to or beyond historic extremes. The return of inflation and the removal of free money afforded investors the opportunity to again earn a return without being forced into speculation or undue risk. The most probable losers were logically the non-earning and high multiple (assumed long duration and high growth) most advantaged by zero cost money. While this reversion did eventuate in the period to December 2022 our expectation of continued reversion has proven wholly incorrect in the first half of 2023. The gap stabilised and has begun to grow again, albeit mildly.
The tug-of-war between fundamentals and behaviour in the first half of 2023 has been a perplexing one, and observations on potential drivers of behaviour influencing multiples are necessarily subjective. While rising mortgage rates and expiring fixed-rate loans are pressuring elements of the housing market, the top end is continuing to elevate from already ludicrous levels. Office property and traditional REITs are under pressure from debt costs and vacancies, yet industrial property remains buoyant and data centres as popular as Taylor Swift tickets. Traditional commodities and commodity stocks have rolled over hard whilst unbridled optimism on battery metals remains pervasive. Bifurcation is the order of the day and the learned behaviour encouraging speculation across a broad range of assets ingrained over long periods is proving difficult to quash.
The need for AI (Average Intelligence)
Artificial intelligence has been instrumental in providing fuel for the renewed speculative fire. While the extremely sophisticated statistical probability algorithms which underly artificial intelligence models offer amazing and diverse applications, forecasts on winners & losers, revenue and profit are largely guesswork at present. The mandatory hockey stick forecasts have already emerged, however, these are nothing more than (mildly) educated guesses. As is evidenced by the history in areas such as IT spending, if massive markets ($1trn+) are to develop, something else will need to give way, as the envelope of global revenue in major sectors/economies is grounded in reality and cannot grow at double-digit rates for long.
One element of AI which we believe is interesting and important is the ongoing and expanding necessity for data cleaning. AI algorithms can be amazingly powerful if the data on which they are based is reliable and comprehensive. If not, results will always be compromised. Whether data relates to company financial statements, emissions, roads and obstacles for autonomous vehicles or plagiarised text for university essays, utility is inextricably linked to data quality. The old ‘garbage in, garbage out’ phrase seems as true as ever to us. In areas such as emissions where data and measurement processes are in their infancy, offer dubious accuracy and incredible complexity, placing great store on output will likely prove extremely unwise. Data cleaning requires understanding, as it is only with context that data becomes useful. While the temptation, as has been the case in financial markets for some time, to forsake understanding for pattern identification will remain, our bias remains towards thinking a bit.
While NVIDIA and other direct short-term beneficiaries of AI excitement and vast market capitalisation addition are perhaps understandable (albeit astonishing in quantum), few tech companies have seen improving earnings estimates to accompany share price gains. Many are suffering from the excessive cost and bloat which often accompanies size, growth and increasing maturity. Rationalising the tangential relationship of Australian technology stocks and their sharp outperformance is similarly tough.
As the code and user interfaces that underly all technology companies become easier and faster to manipulate, this would seem to challenge the duration of competitive advantage assumed in most valuations. The Link loss of the HESTA administration contract to GROW perhaps highlights some of the real-world issues. Listed in 2015 on the back of the synergies and market position afforded by merging the failed Super Partners technology project, it would seem some customers believe there are now superior technology options available. Combining these business and earnings durability concerns with aggressive financial leverage (borne of dubious M&A activity) is likely to create more than a few headaches. Operating leverage works both ways and the margin expansion which analysts assume and capitalise in perpetuity when revenues rise can unwind quickly as it’s lost.
When homes become ‘investments’
Perhaps less surprising over recent months is the extent to which the domestic housing market has dominated headlines. I read with interest a recent Robert Armstrong article in the Financial Times and it’s reference to Edward Leamer’s 2007 paper, ‘Housing IS the business cycle’. While a little dated in our opinion, the basic argument is that housing starts and the change in housing starts are by far the best forward indicators of the economic cycle. Given real estate is akin to Australia’s national sport, basic intuition would suggest Australian sensitivity to housing market fluctuations would be even greater than the US. Housing IS the Australian economy and banking system.
We absolutely agree on the importance of housing starts. Sustainable and improving supply/demand dynamics will always be important to pricing power and profits. It is also one of the reasons we are generally favourably disposed towards building materials companies. Though highlighted by COVID, there is a litany of subtle but important economic and behavioural changes that are also closely interwoven with demographics. For many years ongoing falls in the number of people per household drove additional housing demand.
On a population of 26m living in around 10.8m houses (including 1m vacant ones), the fall in people per house from 2.9 to 2.5 creates demand for nearly 1.5m additional houses (a lot for a country generally building 150-200k houses a year). This durable but artificially high demand contributed to the industry developing excess supply and ceding pricing power. An extended period in which supply addition has been restrained, demand fundamentals have become more durable and much better pricing power signs have emerged leaves us positive on prospects for the sector. The fairly significant fall in people per household since COVID arguably exacerbated already strong demand fundamentals, while migration levels unaccompanied by infrastructure and housing investment are skewing supply-demand imbalances further.
Alongside these trends, many are scratching their heads as to why property listings are so low and schemes such as land tax over stamp duty are being floated in the hope everyone will suddenly move to smaller properties and relieve housing demand pressure. These hopes seem at odds with trends toward lower mobility between homes and around the country evidenced in the US. Mobility has been declining for decades and older people aren’t keen to move a lot.
Interestingly, despite the large influx of migrants over the past year, job vacancies remain high and housing completions have struggled to close the gap with approvals. The backlog remains significant and apartment approvals have rebounded. Whatever way you cut it, while Australia has a major house price problem, on the quantity side demand fundamentals remain solid with data also seemingly pointing to durability of labour and cost pressures.
As build-to-rent models and similar schemes emerge in an attempt to find ways to add affordable supply, we prefer to keep it simple. Yields in the vicinity of 2% (multiples of 50x) create a highly unfavourable probability for future gains. Earnings yields and multiples closer to 10 for the businesses supplying the raw materials offer a far more appealing probability of gain from our perspective. When it comes to housing we remain far more comfortable being exposed to quantity rather than price. Many of these exposures including Boral, Fletcher Building and James Hardie contributed strongly over the quarter.
Vacant homes, full planes
Another slow-moving wave that looks likely to create some challenges is the impact on the labour force of early retirement. While good data is still sparse, it seems likely this has contributed to both labour shortages, booming travel demand and changing consumption patterns. Expectations of durable levels of higher demand in areas such as travel remain uncertain, however, the ability to propel ongoing consumption in categories that naturally fall with age looks challenging. These drivers are important, given the tendency of forecasts to anchor to the recent past. Where operating leverage is high and forecasts expect smooth improvement, we remain exceedingly cautious.
Contributors
James Hardie (Overweight) (+24.9%)
The battle between interest rate rises being used to quell demand and, like Australia, strong ongoing demand for more and better housing stock, is creating an interesting environment for pricing of building materials businesses. We take comfort in the high probability that any fall in building activity will revert to higher levels given the aforementioned demand fundamentals also prevailing in the US. In the case of James Hardie, the ongoing US fibre cement market share gains against inferior products and its dominant position in the category have fuelled both strong margins and earnings growth together with higher-than-average multiples given the expectation this will continue. Our assessment of risks and prospects sees us a little more circumspect than in years gone by.
Aurizon (Overweight) (+16.7%)
Emotions run high in any business with coal exposure. In the case of Aurizon, coal (mainly metallurgical) fills much of its rolling stock and travels on its largely regulated below rail infrastructure. Emotion around the future has also pressured multiples and valuation to levels we believe reflect a far more pessimistic future than is likely.
Fletcher Building (Overweight) (+22.9%)
Conglomerates and success are not often synonymous. Fletcher Building is not the exception to the rule. Our attraction to the concrete and building products operations and a solid but tangential distribution business are offset by the ongoing commitment to development and construction operations which combine the appeal of low returns and high risk. The excessive corporate overhead level which normally accompanies conglomerates offers additional potential for rationalisation. We are focused on the underlying asset appeal and the potential for the future rather than the extended history of mediocrity (I’m feeling generous).
Detractors
Ramsay Healthcare (-15.4%)
The attractions of a portfolio of high-quality Australian hospitals with steadily rising replacement cost and strong ongoing demand sit alongside currently challenging operating conditions and a historic acquisition strategy best characterised, in our opinion, as overpriced and unwise. Labour and cost inflation running ahead of negotiated revenue compensation from governments and health funds together with more volatile demand as COVID-induced behavioral changes from surgeons and patients are digested, leave management with plenty on their plate. High levels of debt from overpriced European acquisitions which seemed innocuous at lower interest rate levels are creating additional headaches.
South 32 (-14.0%)
A diverse commodity exposure, low and sensible levels of financial leverage and a management team with plenty of common sense leave us believing the longer-term prospects for the business are likely to be very positive. The preoccupation with short-term commodity price moves which tends to afflict nearly all commodity stocks strikes us as offering opportunity for those prepared to focus on solid business duration and the very high probability that the downs in commodity prices will eventually be replaced by ups and vice versa.
Alumina (-5.1%)
Alumina shareholders have seen the aforementioned confidence in the ups and downs of commodity pricing sorely tested. Downs have vastly outnumbered the ups. Underlying assets in the AWAC partnership between Alumina and Alcoa have rarely produced the earnings that their quality should dictate. We still believe the probability conditions will improve rather than deteriorate is incredibly favourable.
New nail, same hammer
Strength in equity markets in the face of rising interest rates has surprised us. The narrow and speculative source of this strength surprises us more. The seemingly logical assumption that equity investment will provide shelter from the ravages of inflation is possibly a factor in this strength. In an environment of wealth inequality, changing demographics and still high speculative appetites, we’d see reasonable odds the blunt tool of interest rates will drive significant unintended consequences. The logic of quelling demand with higher interest rates is sound when wealth and pain are spread fairly evenly. Having used, what is in our opinion, ridiculously low interest rates to foster wealth inequality and increase economic fragility through asset price booms balanced on high levels of debt, the path back looks fraught. If inflation is the new nail, central bankers are hitting it with the same hammer. Early retirement, travelling the world at the front of the plane and needing some imported labour to ensure the coffee machine keeps humming are sitting alongside unaffordable housing, and crushing cost of living increases for the mortgage belt. Exhortations to suppress wage demands so inflation can be kept under control may prove a tough sell.
Those of us tending more towards assuming reversion over a trajectory of bottom left to top right, see probabilities favouring caution. The extended experience of benign inflation weather has shifted and is permeating both goods and services. The extensive training which many investors have had in the reliability of speculative gains is proving tough to break. As we face multiples and earnings levels that remain high by historic standards a sensible weather forecaster would suggest the probabilities tilt towards the likelihood of unsettled weather. We feel a wise investor should at least be carrying an umbrella.
