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The manifestations of leverage

David Wanis  |  30 Nov 2012Text size  Decrease  Increase  |  

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David Wanis is a senior portfolio manager at Schroders.


One of the big picture themes currently dominating the investment landscape is the financial repression brought about by central bank policy aimed at transferring wealth from savers to borrowers in order to deleverage the economy from currently unprecedented levels. Within small caps, we are seeing the effects of this in a number of ways.


Compression of yields

The pursuit of yield has resulted in anything with a dividend greater than that available from a term deposit being bid up significantly. As term deposit rates follow cash rates downwards, we should probably expect a continued bid for securities with this characteristic.

However, we continue to believe this is an artificial distortion of security prices brought about by central bank policy. This has most likely brought forward future returns in these stocks, making them less prospectively attractive as an investment than 12 months ago.

Compression of security yields tend to be the first symptom of financial repression, as the frictional cost of buying securities is relatively low. We have observed this first phase of yield compression in the small-cap market through the outperformance of traditional yield-driven securities - property trusts, infrastructure, utilities and telecommunication stocks.

All of the more significant small-cap property trusts, or REITs (real estate investment trusts) as they are now known - Charter Hall Retail (CQR), BWP Trust (BWP), Charter Hall Group (CHC) and Challenger Diversified Property Group (CDI) - have outperformed the Small Ordinaries Index, as have the larger telcos, Telecom New Zealand (TEL), Chorus (CNU), Singapore Telecommunications (SGT) and TPG Telecom (TPM).

The infrastructure and utilities names have not only outperformed the small-cap index, but have in the space of 12 months largely exited the small-cap universe either through performance and migration into the S&P/ASX 100 Index - SP AusNet (SPN) - or through being the target of takeover activity - Hastings Diversified Utilities Fund (HDF), Australian Infrastructure Fund (AIX).

Although now of limited relevance to small-cap investors, given the few investment opportunities that remain in infrastructure and utilities, we would observe that these equities are not without risk as the confidence in the operating cash flow has been offset by a matching amount of financial leverage.

This means equity holders may still be exposed to unexpected changes in the rate of asset returns that may come about from a change in the regulatory framework in the case of regulated utilities.


Debt-fuelled M&A

As the repression continues, bank lending standards are relaxed (availability of credit) and lending spreads decline (price of credit).

This continues until eventually the fiscal conservatism taken to heart by company directors - "never again!" - is overwhelmed by the lure of cheap credit funding mergers and acquisitions (M&A) that is both strategically attractive and now financially saleable to shareholders. Just think of all that EPS (earnings per share) accretion!

The latest quarterly Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices released on 31 October 2012 shows exactly these trends in the US market - with standards for commercial and industrial and commercial real estate loans continuing to ease and spreads over bank funding costs continuing to decline.

Although demand for commercial and industrial loans has yet to rise to the bait, there is no such hesitation in the commercial real estate sector where demand is notably increasing.