Real world pitfalls could derail darlings

In its bid for Dulux this month, Nippon Paint offered yet another example of the ability for differing perspectives to provide divergent outcomes when it comes to the subtle art of company valuation. Dulux is an exceptionally well run company with powerful brands commanding a vastly disproportionate share of profitability in the domestic paint industry. These dynamics create a double-edged sword; when the company is already run efficiently and the industry offers minimal scope for rapid volume growth, profit growth is tough. 

On the positive front, life as a competitor to Dulux ain’t much fun and even the Dalai Lama’s patience would have been tested waiting for the slip ups which may have offered the prospect of market share and profit transfer to the list of international players such as PPG and Sherwin Williams who have seen opportunity in competing against Dulux in what appears a cosy market. Nippon Paint are realistic. Their $4.2bn takeover offer is not premised on spurious operational improvements, or a slide presentation with pro-forma synergies straight out of the investment banker preliminary handbook in fraud and deceit. It seems merely a differential in the future returns deemed acceptable by the buyers relative to the sellers. Nippon is paying a little over 18 times EBIT (earnings before interest and tax). Assuming earnings are held relatively stable in the longer run (history has been better than this), Nippon will earn an ungeared return of a little over 5%. This is somewhat lower than the return of 7% or so which Dulux investors could have anticipated the previous day (which explains the 30%+ share price gain). So are the Japanese buyers irrational? Is this another Toll Holdings or Lion Nathan? We’re not so sure.

As the available returns on most assets continue to descend, much of the developed world is being offered some perspective on the thinking of investors who have operated in an environment where government bonds and cash have offered no perceptible return for the best part of two decades. It’s probably fair to say the risks of sharply higher interest rates and hyperinflation have not been their primary concerns. Toll Holdings was a poor investment because the earnings proved unsustainable. Paying an elevated multiple exacerbated the problem, but the former caused disproportionate damage. 

Getting caught up in asset beta, optimal gearing levels, equity risk premia and most of the rest of theoretical tripe that gets trotted out in finance theory misses the point. These are overcomplicated ways of trying to answer the question of what return on investment is considered reasonable given the risk involved. Creating a good quality, durable business is hard. These durable earnings are the true scarce resource. These are the income streams supporting our debt and asset values globally. They have grown at nothing like the rate of asset prices and debt levels. Lower interest rates and financial leverage have done this work and engendered the massive wealth transfers and wealth inequality which plague most nations. As the illusion of wealth creation (it should more correctly be labelled wealth transfer) perpetrated by ever lower interest rates is exhausted – given the proximity of interest rates to zero in most nations – we believe the focus should logically shift away from leverage and financial engineering to the genuine value in sustainable earnings. 

As returns from large pools of the world’s capital in areas such as government bonds evaporate, we expect the returns investors are prepared to accept may continue to surprise us.

Given an expectation that our failure to accurately dimension sustainable earnings will remain the primary source of our (long run) valuation errors, it is this issue which occupies a great deal of our thought. We must try and identify why and how a business has made money in the past, and how this will change in the future. While we may draw comfort from history, our risk emanates significantly from how this may change. High growth and high profit margins are the holy grail for investors. They are invariably seen as the definition of what constitutes a good quality business and particularly in current market conditions, it is these attributes which give rise to ebullient valuations. The counter factual rarely garners similar attention: ie that in the absence of extremely high barriers to entry, it is these high margins and returns which should be the threat to sustainability and offer the greatest potential for earnings reversion. Charging the highest prices possible, whether it be for blood plasma products, real estate advertising, wine, iron ore or infant formula, is roundly considered a laudable attribute, not a source of risk. Sustainability, like valuation, seems to vary depending on your perspective.

We also understand that sustainability encompasses more than earnings, and that it’s an emotive term at present. Everyone wants to be sustainable but virtually no-one can agree on what it means. Some examples are obvious and highly charged. Take the Adani coal mine. No bank wants to fund it, no investor wants to touch it. While the wave of new funds seeking to ride the ESG enthusiasm is obvious, I haven’t noticed a large number of High Carbon Emission funds being launched of late. But is it the right thing to ensure the project is stopped or to ensure fossil fuel industries are starved of equity capital, debt funding and insurance cover? We are sceptical. 

As Australian investors, it is probably not within our remit to dictate how China, India or other nations meet their energy needs. However, given coal will be required for some time to come, it does seem logical that we should seek to supply the necessary tonnes of coal to feed these plants from mines with the lowest strip ratios and highest energy content possible such that we burn the coal with the lowest possible emissions while countries solve the problem of delivering base load power from more sustainable sources. Adani may possibly fit into this picture, as it is almost certainly cleaner than a significant proportion of Chinese, Indonesian and other Asian-based coal. Evaluating and explaining the situation to a broad spectrum of well-meaning Australians who want to feel they are making a difference to climate change is unlikely to deliver a long-term career at present. As with all aspects of sensible long-term investing, we believe it is important to take a holistic and considered approach to sustainability, rather than reacting emotionally to currently topical issues.

Our questioning over long-run sustainable profits rather than short-term direction has in many cases come at short-term cost to our clients. Whether it is regular and large ongoing revisions to long-term sustainable profits driving the performance of tech market darlings such as Afterpay (+22.2%), Altium (+4.6%), Appen (+13.6%), Wisetech (-3.2%) and Xero (+11.9%) or just FOMO (I think it’s fair to say we expect the latter), it is clear that our scepticism over levels of sustainable profitability has at least left us with the ‘missing out’ bit of FOMO. Similarly, other extremely high margin businesses with relatively short histories and not known for low pricing relative to peers such as Magellan (+22.5%) and A2 Milk (+17.2%) continue to reach new highs.

On the positive side, some of the businesses we believe offer durable earnings at still attractive prices, such as Crown (+15.5%), Lend Lease (+7.4%) and James Hardie (+6.3%) provided some insulation to missing out on dancing with the darlings. Dancing has never been our forte anyway!

Outlook

Creating money and credit at much faster rates than economies have created businesses and earnings has been the fashion for many years. With the world remaining awash with capital searching for an acceptable yield, and central banks determined to underpin the asset and debt piles they have spent years erecting, it seems likely the supply demand imbalance between sustainable earnings streams and investors looking for them, should remain favourable.

The market darling sectors look to us to offer almost universally asymmetric payoffs.

If businesses grow at truly exceptional rates, sustain margins vastly higher than the remainder of the economy and can then stabilise and avoid any decline, shareholders may receive a reasonable return on their investment. Should they be subject to some of the potential pitfalls of the real world, such as new market entrants, price competition or disruption, the vast amounts of market capitalisation which have been added over recent years without commensurate earnings, will prove a mirage.

Similarly, the traditionally stable earnings streams, particularly those which investors have happily defined as ‘asset classes’, such as REITs and infrastructure, have continued to have future returns depressed by ever-rising share prices. Sandwiched between these extremes, sectors commanding much of the economy’s profit, such as mining, construction materials, banking and telecommunications, offering less exciting prospects for the high growth, high margin and minimal capital employed, yet far more appealing earnings yields than their ‘asset class’ counterparts, in our eyes, offer far superior returns.

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