Much is disconcerting in both the pace and extent to which value (or at least apparent value) can be both created and destroyed in asset markets globally. As markets shift higher, percentage gains seem innocuous, however, they are obviously translating into ever larger dollar gains. A better than anticipated sales and earnings result from Amazon in recent days saw the creation of some $80bn in additional market capitalisation. This was the entire market capitalisation of the business some 6 or 7 years ago. Closer to home A2 Milk added more than $1bn over the month, Wisetech Global not far short of $1bn and Blackmores more than $500m. In the case of A2 Milk and Wisetech these amounts are substantially more than their reported revenues for the 2017 year, and in the case of Blackmores very close. Rising asset values come with a catch. They either require perpetually recurring changes in profitability to keep previous return expectations intact or they necessarily compress future returns. In the case of Amazon, if we wish to justify our additional $80bn of value which took ebullient investors a few short hours to create, and want say a 10% return on our investment, we need to find $8bn of additional operating profit, forever! Even if we’re happy to settle for 5%, the number is $4bn. At Woolworths, tens of thousands of staff have worked hard each day for decades in building a business of 1000 supermarkets to sell about $40bn annually and make around half this amount. Price momentum and financial market asset value creation often make wealth creation seem easy; making the profits to support the paper wealth is hard. We remain somewhat sceptical in the ability of many of the Powerpoint slides and persuasive sales pitches which are currently being translated into extremely optimistic valuations, often in turn used to fund aggressive acquisition strategies, to deliver long run earnings to match the hype. As the old idiom goes, money talks, bulls..t walks.
Effervescent market environments and vertical share price charts incite emotional responses. Whilst a business may remain well managed, the analysis of it has a tendency to the cursory. From our perspective, A2 Milk is probably a case in point. Booming demand, significant price escalation and minimal required reinvestment are the equivalent of aphrodisiacs for analysts.
More likely long term scenarios and the potential for prices and demand to fall as well as rise, are ignored. In reality, most food manufacturing and consumer goods businesses make margins of closer to 10% than the 25% which A2 are currently reporting . Good ones may get to 20%, but staying there is incredibly difficult. If the $5.5bn valuation of the business is to be justified, we are going to need at least $400m or so in operating profit. At a 15% profit margin on a $30 tin of infant formula we’ll need to sell around 100m tins. Using some crude assumptions we might conclude that some 5% of the population in an average country might be under 3. In Australia, we might reasonably conclude we have a market of some 1m people buying perhaps 1 tin per week. $1500 per annum is no small investment for an average parent, however, this would still only leave a profit pool of $225m at our 15% margin. Our very rough assumptions therefore leave us needing A2 Milk to earn the entire profit pool (100% market share) of nearly 2 Australia’s to justify the current market valuation. Countries the size of China, at 50 times the Australian population, offer potential for weaving even wilder optimism around prospects (ignoring the small detail that the $1500 annual bill excludes a large element of the population). Our point is hopefully clear; valuing a business requires a realistic assessment around the prospects for making profits over the long term, and even when the future is highly uncertain, placing realistic probabilities around the prospects for success or failure. We do not deny the potential for A2 Milk to justify its current valuation, management have done an amazing job to date, however, we would suggest there is a far greater probability it will not. If the $5.5bn was your money and you could make only one investment, your investigations would be likely to run more deeply than an observation that there are a lot of babies in China, the stuff is flying off the shelves in Coles and Woolies (for resale in China) and recent sales through Chinese daigous have been solid. Conditions change and popularity sometimes fades. Sensible valuation also needs to think about the other side.
My learned colleague Mr Fleming wrote last month on the cultural challenges companies faced in growing, particularly when growing quickly. We find the efforts of companies such as Netflix in avoiding the inevitable pitfalls of growth both fascinating and admirable, however, the avoidance of bureaucracy and inflexibility accompanying the path towards increased company size will remain the exception. The more pertinent question for many of Australia’s large companies is how to dismantle the excessive bureaucracy and cost now in place.
Businesses such as Telstra are prime examples. A significant part of the challenge in dealing with the transition to NBN and increasing competition across most of the business is the necessity to lower its cost base to enable competition versus more nimble players. Despite efforts to deliver productivity gains, operating costs are not falling, ever. With labour costs of around 20% of sales (more than $5bn), the labour costs of the business are a greater percentage of revenue than any other telco in the region, despite far greater revenue and scale. TPG Telecom operates on 10% of Telstra’s revenue with 5% of its labour cost. Matching TPG’s labour costs would see Telstra save $2.5bn in labour cost and at multiple of 10 times operating profit, create $25bn in value. Recent bank results have shown broadly the same thematic; somewhere between the executive floor and the 30 or 40 thousand employees the productivity gains disappear. In our humble opinion, the only realistic way for savings to be achieved is to break the business into smaller pieces. South 32 remains a case in point. The process may be painful, however, the end result is lower costs, happier employees, happier shareholders. Excuses for not breaking up and refocusing businesses are wearing thin and we’d expect to both see and exert more pressure on a number of lumbering behemoths.
On the wrong side of the ledger this month, Fletcher Building (-12.1%) eroded half a billion or so, and Lend Lease (-9.5%) closer to a billion. As is all too commonly the case in development businesses, the lure of large contracts offered a methodology through which employees were kept busy during times when work was scarce, while shareholders would have been far better placed if they twiddled their thumbs. Fletcher Building has become a charitable works operation in NZ, as much of the profits of recent years in the building and interiors operations have been unwound in current year losses. In fairness, both companies have solid track records in many other elements of their operations and given the contribution to overall business value in both cases, reactions are probably disproportionate. Additionally, as we referred to earlier, history has provided ample evidence of the propensity for these outcomes to occur periodically. Our valuations both expect and incorporate these outcomes, however, it does not make the news more palatable when it arrives.
Grappling with financial asset values becoming ever more disconnected with economic reality is challenging. At one end of the spectrum is the scenario of mean reversion which would see the era of massive intervention and manipulation end with collapsing asset prices. At the other is a continuation of the increasingly popular Japanese business model in which perpetual government deficits are funded through ongoing debt issuance purchased primarily by the central bank. We like to think of this as a slightly more obtuse and disingenuous method of levying tax on the population which offers the government a powerful position in using this spending to appease voters and inject money directly in the name of economic growth. As Japan has recently accepted a continuation of this policy through its recent re-election of Prime Minister Abe, many long years after warnings of impending disaster from all corners of the globe, there is some precedent for its sustainability. That variations of this policy have been adopted almost everywhere shouldn’t go unnoticed.
We do not believe the strategy of positioning for Armageddon is sensible unless conditions are extreme. Whilst pockets of obvious excess and speculation are developing (many were amongst the strongest performers this month), much of the stock market offers returns which remain reasonable relative to asset values which remain elevated across the globe and across asset classes. Nevertheless, after extended periods of strong returns and levels of financial leverage which remain too high, those with any sanity should have a risk appetite lower than normal, not higher.