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Finding the long shots

Martin Conlon  |  13 Jan 2017Text size  Decrease  Increase  |  

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Durability of earnings and returns will become increasingly important as the tailwind from interest-rate reductions dissipates, Schroders head of Australian equities Martin Conlon says.


A year for the underdogs! The Western Bulldogs, the Cronulla Sharks, Leicester City, the Chicago Cubs, Donald Trump, Brexit; it was a good year for the bookies and tough for those backing favourites.

The long shots also had a better year in equity markets. Domestically, infant formula, vitamins, aged care, and fund managers gave way to coal, lithium, steel, and aluminium.

As always, we remain cynical of those professing an ability to identify the catalysts for these changes in fortune. Outlook commentaries at the outset of 2016 were noticeably devoid of cheerleaders for this year's eventual winners, while prior year winners had plenty of fans.

As the groundswell of opinion shifts, the army of cheerleaders will always swell in number. Being out on your own isn't comfortable for most. As Adam Grant highlights in his book Originals, non-conformists are often the ones to change the world, however, they don't get there without occasionally looking stupid.

Steve Jobs' inclination to believe the Segway (a two-wheeled, self-balancing personal transporter for those that don't remember) was going to revolutionise transport may have been misplaced; a few of the other things he tried turned out okay!

We can't help thinking that equity markets could use a few more non-conformists to upset the status quo.

Beta, Sortino ratios, implied volatility and catalysts still seem to be dominating the simpler questions concerning how a business makes money, whether it is likely to make money durably and how much someone is being asked to pay for it, all questions not easily answered by reference to a share-price time series.

Trying to make money smoothly every month is nice in theory; it's just not how real businesses actually work.

Even in a year in which our investment performance has fared well, we can't help questioning whether resource stocks have improved for earnings momentum reasons associated with a more buoyant commodity price environment rather than the more fundamentally appealing (from our perspective) rationale, this being the realisation that these businesses, based on any rational long-term commodity-price outlook, had become ridiculously cheap versus counterparts with a more appealing short-term earnings trajectory or a perception of earnings stability.

Similarly, despite the outcome, we're not sure whether a Donald Trump victory in the US presidential election should change the underlying value of the average business.

As always, the year provided plenty of lessons on the importance of understanding the true lifecycle of a business. Generic descriptions of "quality" businesses as those earning high or stable returns, or those able to grow quickly, are platitudes borne of didactic slide presentations and belie the need to understand why and how a company makes money.

There are plenty of "good" businesses currently not making much money and many ordinary ones doing well. Economic value can be created gradually, quickly, smoothly or in cyclical bursts. It is the quantum in the long run and the amount we are asked to pay for this value creation that matters.

A few we believe are worth thinking about are discussed below.

On almost all measures, Sydney Airport (ASX: SYD) (-14.1 per cent over the December quarter) qualifies as a "good" business, and undoubtedly a long-duration one. Since the purchase by the Southern Cross consortium in 2002, Sydney Airport has been a highly lucrative investment.

Versus a $5.6-billion purchase price, the asset is now valued at more than $21 billion. Its return on capital is well into double digits despite having a large element of the asset base subject to regulation.

Outside the quasi-regulated aeronautical asset base of about $4 billion, investors are paying nearly $17 billion for car parks and a shopping centre. (The build cost was a small fraction of this amount.)

This value growth has been driven by a Sydney population augmented substantially by immigration, strong passenger growth, a monopoly position and resultant price increases, significant financial leverage (the airport now has more debt than its original purchase price) and a massive increase in the price investors have been prepared to pay for these cash flows as interest rates have fallen.

Existing investors understandably have a strong preference for maintaining the status quo. However, the recent controversy surrounding the Western Sydney airport and the potential involvement of Sydney Airport in its development has left shareholders with a conundrum.

Without government assistance, development carries traffic risk, project-cost-blowout risk, and financial risk. It will almost certainly not earn significant returns in early years. However, if another party commits to build the airport, it will provide competition for Sydney and erode returns as traffic migrates to the new airport.

Why though, should investors be willing to pay multiple times the build cost of the existing airport yet not be willing to invest at book value in the new one? The answer, in our eyes, is an unrealistic picture of the path of the return on capital.

Valuations that assume the government will invest in infrastructure around the airport to allow ever-growing traffic volumes and that it will subsidise a new airport to ensure returns are never compromised by the need for new investment strike us as a tad unrealistic.

Nearly all long-dated assets should periodically require investment, which dilutes short-term returns in order to earn a payback in the longer term.

Sydney Airport will remain a good asset, however, in our experience, valuations premised on returns that rise inexorably without hiccup are almost always wrong. Adding financial leverage as returns rise further tends to exacerbate the problem when the eventual need for reinvestment arises.

These principles apply to office buildings, retail shopping centres, pipelines, and many similar assets, where the economic nature of the asset has been disguised through distributions that ignore depreciation, trust structures that avoid the payment of tax and an asset-price-inflation environment that has overshadowed the impact of asset ageing.

It is why we incorporate an economic depreciation charge in our valuation of assets of this type and is a contributing factor in our struggle to find any valuation appeal in these highly-sought assets.

South32 (ASX: S32) (+14.1 per cent) highlighted the ability to add value through a different path. This time last year, coal prices were languishing at levels permitting few in the industry to make any profit. Manganese producers were in a similar predicament.

The value of the entire business was about $5 billion, half tangible asset value and probably the equivalent of a few storeys in the Sydney Airport car park.

Skyrocketing prices for coal and manganese and stronger prices for other commodities will allow the business to make well above $2 billion in operating profit should current prices prevail for another six months.

The business also has no debt, such that the risk that shareholders take in embracing a relatively volatile earnings stream should never be terminal.

The returns delivered by the business last year were mediocre at best, however, it always retained the optionality of earning extremely strong returns in a more buoyant price environment.

Every year in which the business can deliver return on capital of 20 per cent to 30 per cent pays for a number of years in which returns are in the mid-single digits, while still delivering solid value growth over time.

Lastly, there are obvious lessons in the tumultuous experience of some of the quarter's laggards, Sirtex Medical (ASX: SRX) (-55.1 per cent), Bellamy's (ASX: BAL) (-48.7 per cent, though yet to re-trade) and Vocus Communications (ASX: VOC) (-37.9 per cent).

We would characterise all of these as being of questionable duration. Returns may be high, however, the trade-off is they have potential to evaporate quickly. Post vaporisation, shareholders are often found questioning what they actually own.

Biotechnology stocks in particular have extremely polarised payoffs. Investment in research and development must result in a product that is effective, then drug authorities must be convinced of its cost versus benefits and then an army of sales and marketing staff need to convince doctors to use it.

(It is instructive that the 2016 sales and marketing investment by Sirtex was nearly double the cumulative investment in R&D over the past five years).

Subsequently, products run the risk of being made obsolete by new, more effective, or lower-cost treatments. Unsurprisingly, the losers greatly outnumber the winners.

The same could probably be said for businesses such as Bellamy's and Vocus. If consumers turn their attention elsewhere, shareholder equity can often be left mainly on advertising billboards. This risk is rarely captured in the slide presentations praising the exceptional returns from "capital-light" businesses.

We are in no way dismissive of all such businesses, however, we often observe the cursory attention paid to the role of duration in deciding how much to pay for a business.


Alumina (ASX: AWC) (o/w, +25.3 per cent). Bauxite, alumina, and aluminium have been tough places to make money for many years. Even lower-cost operations such as those of Alumina (through its 40 per cent share of Alcoa World Alumina and Chemicals) have struggled to make acceptable profits as Chinese capacity additions have pressured the market.

The absence of competitive advantage and lack of profitability evident in China and the still low valuations (on a per tonne basis) of the lower-cost operations in the Alumina portfolio leave us optimistic on the ability of the business to deliver stronger returns in a profitability and share-price context.

Rio Tinto (ASX: RIO) (o/w, +16.1 per cent). The mantra of "value over volume" adopted by new CEO Jean Sebastien Jacques is highly appealing in an industry that has inverted these words for much of history.

Actions taken to date are largely positive from our perspective and we believe the prospect of strong cash generation even in a far more challenging commodity price environment than evident should leave Rio Tinto as a conservatively geared business able to deliver solid returns in all but the most challenging operating conditions. Valuation remains attractive.

Orica (ASX: ORI) (o/w, +16.3 per cent). Having digested significant pressure on price from a mining sector looking for further cost reductions, productivity improvement has gone some way to ameliorating this impact for Orica.

Although profitability remains well below peak levels and returns far lower than levels achieved in past years given the artful combination of ill-considered reinvestment with merger and acquisition disasters, we believe valuation is attractive with only minimal improvement from current levels.

Iluka Resources (ASX: ILU) (o/w, +16.0 per cent). Mineral sands has exhibited some of the characteristics of coal, with recent years having been somewhat devoid of profitability for most industry players, Iluka included.

The lucrative royalty stream for Mining Area C has assuaged some of this pain, however, price increases are necessary to restore any semblance of acceptable profitability for the industry.

Iluka has recently concluded the acquisition of Sierra Rutile in further strengthening its mineral sands position and we remain optimistic of the potential for better shareholder returns ahead.


Regis Resources (ASX: RRL) (o/w, -23.1 per cent). Rationalising investment in gold stocks is not easy and valuing them involves at least as much art as science.

Our approach has been to see them as an insurance policy against a fiat monetary system with more than a few cracks, however, we will always attempt to ensure the cost of this insurance by reference to a long-term sustainable gold price is sensible.

Regis is ungeared and operates in a low-risk environment with relatively low sustaining costs. Like all gold stocks, however, the propensity of investors to shelter some of their wealth in real or virtual gold bars will drive vicissitudes in the gold price that normally overwhelm fundamentals in determining the share price.

Flight Centre Travel (ASX: FLT) (o/w, -14.0 per cent). Flight Centre has an enviable track record in a highly competitive industry. The exceptional growth evident to anyone not living under a rock is testament to the passion and drive of the founders and staff in the business.

While not without significant risk, the global expansion which is currently delivering minimal profitability offers significant potential value.

Crown Resorts (ASX: CWN) (o/w, -11.7 per cent). The sale of a significant proportion of the Melco Crown shareholding and the retreat from aggressive global expansion of the VIP business have significantly altered the investment proposition for Crown shareholders.

From our perspective, this is unarguably positive. Large-scale investments premised on a small number of gamblers losing large amounts in a globally competitive environment are significantly less appealing than the domestic business, which has invested large amounts of capital developing high-quality venues driven by local clientele.

We are also supportive of a more conservative approach to financial leverage.

Commonwealth Bank (ASX: CBA) (u/w, +13.8 per cent). While we view the Australian banks as offering reasonable investment prospects based on our expectations of a future of lower credit growth and higher bad debt charges, CBA remains the most aggressively valued bank given its greater exposure to the more lucrative mortgage and personal lending operations deliver the highest levels of profitability among the major banks.


While the stark divergence in the valuations of mining and energy businesses relative to businesses with perceived defensive characteristics has unwound to a degree, driven by a slight unwind in the multi-decade bond bull market, the broader valuation picture remains largely unchanged.

Valuations of nearly all assets (equities included) are aggressive versus history and premised on a tenuous and hyper-sensitive balance between a financial system that is excessively large versus the underlying economy and history, requiring an unduly low interest rate to support it.

This hyper-sensitivity can work in both directions, allowing the possibility of significant gains and losses as small changes in discount rates are amplified.

These risks have been evident for some time, but cannot abate without imparting pain to those asset values that are not supported by sound underlying cash flow and returns, a process which remains anathema to policymakers everywhere.

The credit-creation process remains the heart of the matter. While the dangers of excessive credit-fuelled demand in China are obvious and well publicised, it remains unclear to us why the credit-fuelled consumer demand boom evident in many Western countries (including Australia) is more benign. Ever-higher levels of credit are not the solution to greater financial stability.

Our rationale in dealing with this investment environment is straightforward. We believe durability of earnings and returns will become increasingly important as the tailwind from interest-rate reductions dissipates.

Secondly, excessive financial leverage is becoming an unpalatable game of Russian roulette as global discontent grows over financial stimulus that has been squandered in outsized gains on passive assets and delivered limited real economic benefit.

Low- to mid-single-digit ungeared returns on real estate and infrastructure assets, which set aside nothing for reinvestment and replenishment, remain generally unappealing, while materials stocks still offer reasonable value based on earnings levels that allow for lower commodity prices and the substantial reinvestment level which their depreciation charges imply.

We remain particularly cautious on businesses earning substantial excess returns courtesy of egregious pricing where governments rather than consumers pay the bill and free market forces are nowhere to be seen. Areas of healthcare are prime candidates in this regard.

More from Morningstar

• Opportunities in quality credit, specialty finance and mortgages

• Asia valuations cheap relative to western markets


Martin Conlon is head of Australian equities at Schroders. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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