Market love and unfaithfulness

The ASX rallied sharply in July on expectations central banks would lose their nerve on rate hikes, pivoting to lower rates in 2023 in the face of weakening economies and flagging financial markets. But central bankers from around the world met in Jackson Hole late August and quickly snuffed out such optimism; they presented a united front in their fight against global inflation, brandishing the only weapon they have, higher interest rates.

As a result,the September quarter ended with the market still confronting further rate rises in the US and elsewhere. The escalation of interest rates saw US 10-year government bonds brushing 4% in late September – the highest level in more than a decade – and the ASX 200 unwinding its gains from July to finish the quarter essentially flat after adjusting for dividends. In all of this, there has been a greater level of scrutiny around stock valuations and fundamentals, though in our view there is plenty of room for more, after many years of stock market exuberance (briefly interrupted by COVID-19).

Unflattering light

One segment of the market that has come under the spotlight is that of high-growth stocks which generate no profits, no cash flow, and certainly no dividends. In a world of zero interest rates, the lack of conventional sound business metrics was deemed a minor flaw, as investors were lured by the promise of exponential revenue growth and high profit margins at the end of the growth rainbow. Who needs profits, cash flows and dividends anyway, when there is a vast TAM (total addressable market) to conquer?

As it turns out, some investors do – and more so now than 12 months ago. The cohort of cash-burning stocks in the ASX have significantly underperformed the broader market year-to-date, and gains made in the false dawn of July have been relinquished.

Source: Datastream and Schroder Research

Cash burners such as Zip, Life360 and PointsBet have pursued growth at just about any cost, and management teams have been, arguably, unfaithful in managing the small amount of shareholder funds entrusted to them, to chase large TAMs.

In looking at the history of some of the more successful companies in Australia, it is striking that the likes of CSL and REA did not have to incur many years of large losses and equity injections in their early days to achieve their strong growth and high returns (and dominant market positions):

• Based on Bloomberg figures, CSL, a year after listing in June 1994, made a net profit of US$18m in FY95, with US$7.4m of free cash flow. Growth from there only continued, and the rest is history (including US$2.3bn of profit and US$1.6bn of free cash flow in the last financial year from its leading position in global blood plasma products)
• REA incurred just over $18m of losses in the 3 years after its listing in 1999, with cumulative free cash flow of negative $8m – cash flows that were more than recouped in the subsequent 3 years. It recently made about $400m profit in FY22 and $480m in free cash flow and now dominates residential property listings in Australia.
• In contrast, Buy-Now-Pay-Later provider Zip was founded in 2013 and has regularly incurred losses which have grown to more than $1.7bn in the last two years (FY21 and FY22), with negative free cash flows of more than $700m. Life360 and PointsBet have similar profiles of regular and increasing net losses and negative free cash flows.

An own goal

Another company that has, in our view, been unfaithful in the small things is ANZ, when it agreed to buy Suncorp Bank in July this year. ‘Small’ here is relative; it is a $4.9bn transaction, after all – but with ANZ’s market cap of around $65bn the transaction represents less than 8% of the ANZ’s value. Which is just as well for ANZ shareholders. The acquisition price equates to about 1.3x Price / Net Tangible Assets, a significant premium to ANZ’s own shares trading at 1.1x, and comparable regional banks such as BOQ and Bendigo at 0.8-0.9x Price / Net Tangible Assets. While ANZ has directed investors’ attention to potential synergies, there is every likelihood that the assimilation of a small company into big bank bureaucracy will more than wipe out any such theoretical benefits – more so as ANZ is already grappling with its own challenging technology overhaul and has struggled recently with its mortgage origination processes.

This highlights a common problem in much of corporate thinking: that a company would be better if it were bigger. Hence value-destroying acquisitions and expansion into new and risky markets and geographies (often followed by write-downs and retreats). But if a company is not faithful in the little it already has, it is unlikely to be faithful when bigger.

When the past catches up

In a similar vein, it was private hospital operator Ramsay Health Care’s (RHC’s) global growth aspirations which led to a series of overseas acquisitions, culminating in the company’s 52.5% stake in French listed entity Ramsay Générale de Santé – a stake which proved to a be a stumbling block in KKR’s now failed takeover proposal for RHC. If anything, the bid highlighted the value RHC’s Australian business, which will eventually bounce back from COVID-19 interruptions on elective surgeries and is supported by a valuable portfolio of land and property. But the inability for KKR to conduct due diligence on Ramsay Générale de Santé (which represented approximately 10% of RHC’s value), and RHC shareholders not wanting to be left with a stub of illiquid French shares, were sticking points in negotiations. As these negotiations dragged on, the tide of interest rates rose and KKR’s price indications sank – ultimately leading to KKR’s withdrawal.

The root of all evil

They say that the love of money is the root of all evil. But the above examples (and countless others) indicate that, at least in relation to companies and economic management, it is perhaps the love of growth that is the root of all evil, including corporate losses, lousy cash flows and inflation.

The tail end of the September quarter saw the new UK government announce sweeping tax cuts alongside spending initiatives such as energy price caps. Finance Minister (or more precisely, the Chancellor of the Exchequer) Kwasi Kwarteng said the UK needed ‘a new approach for a new era focused on growth…’ Never mind that it was the desire for growth that led to ridiculously low interest rates and rampant government spending – which in turn led to ridiculous asset prices and rampant speculation on everything from tech start-ups to crypto currencies to NFTs. And just a bit of inflation.

The temerity of the UK government was too much even for financial markets, which have generally welcomed government and central bank largesse. Chastised by a falling currency and bond and stock markets, the government has partially reversed its stance, abandoning plans to abolish the top rate of income tax. A small and immaterial gesture in the scheme things, to be sure, and it remains to be seen where the government draws the line on fiscal responsibility versus growth at all costs.

This is not to say that growth is bad. Far from it. But there is a vast difference between growth founded on sound business principles and competitive advantages, and growth based on corporate acquisitions, reckless expansion and profligate government spending. The difference may not always be apparent in the short term, but Judgement Day eventually comes to all.

Market outlook

Monetary policy always comes with a lag. While financial markets attempt to immediately price in any interest rate changes, it often takes many more months before such changes fully impact the real economy. Meanwhile, household spending remains resilient in the face of both higher interest rates and cost-of-living inflation, no doubt aided by post-COVID-19 revenge spending on travel, entertainment, dining out and other little luxuries. But with Australian households being some of the most indebted in the world, it is likely that spending will have to eventually be curtailed – which is ultimately the point of hiking interest rates to dampen inflation in the first place.

The RBA were clearly conscious of both Australian household leverage and the lagged effects of monetary policy when they hiked interest rates by a less-than-expected 25bps in October. While the ASX took this very positively, there is always the risk of unintended consequences; slowing interest rate hikes relative to the US risks a weaker Australian dollar, which in turn would raise the price of imports and domestic goods which have export price linkages, and hence inflation. Being too dovish now risks higher rates in the longer term.

Australian companies will be grappling with higher interest costs on their own debt, while dealing with input cost inflation and selling into a more frugal consumer environment. That is not an easy juggling act, and we expect equity market returns to remain under pressure in the near term.

Originally published by Joseph Koh, Portfolio Manager, Schroders