Weekly Impressions

In another turbulent week for global stock markets, the S&P500 moved sharply lower overnight, shedding over 3%, apparently on continued concerns about China's future growth prospects following the weaker than expected manufacturing survey mid-week and renewed volatility in the Shanghai Composite Index.

The key question for investors is whether US stocks at current levels, represent good value now.  Despite the correction in recent months, the stock market still doesn't look particularly cheap, with the 12 month forward PE on the S&P500 of 15.7x still higher than historical norms (see chart).  The headwinds facing US stock investors stem from the stagnation in expected profitability over the past 12 months.  This follows a rapid recovery in profitability from 2009 to 2011, followed by more modest upgrades from 2011 to mid-2014.  Since then, growth prospects have remained broadly unchanged, in part reflecting the appreciation of the US dollar.  An effective tightening of monetary policy - thanks to the end of QE and imminent end to the Fed's policy of forward guidance - probably has been another headwind facing corporate America. 

The ASX200 fell by around 5% during the week to its lowest level since December 2014.  The start of the year now seems a very long time ago, when synchronised monetary easings by over 20 central banks - including the RBA - over the course of a month - helped to propel stocks higher.  Analysts have marginally downgrade future growth prospects for the ASX200 companies in aggregate year to date, which means that the 12 month forward PE of 14.5x is little changed from the end of 2014 and in line with historical norms.

Future growth prospects of the ASX200 have now stagnated for almost five years, so episodes of multiple expansion and contraction have driven market volatility over this time.  Since mid-2013, the 12 month forward PE has hovered in a narrow range of 13x to 16x, so the current PE is at the mid-point of the range, making the market look neither cheap or expensive at current levels (see chart).

Beyond the cycles of multiple expansion and contraction, a pick-up in earnings growth is the necessary ingredient to drive the market sustainable higher.  But while the Australian economy remains stuck in a nominal funk, revenue headwinds will remain persistent.  Margin expansion can only drive profitability so far.  Since global commodity prices peaked in mid-2011, growth in nominal GDP has been even more anaemic than the early recession of the early 1990s.  In previous posts, I have suggested - contrary to conventional wisdom - that the RBA has been too slow to respond the negative terms of trade shock, which have declined by over 50% from the peak.  The central bank has been more concerned about the composition of growth - hoping that net exports and non-mining capital spending would drive growth - than overall growth in nominal GDP. 

Evidente has also previously highlighted that the five year long stagnation in growth prospects for the ASX200 is testimony to the resilience of corporate Australia, considering the stiff revenue headwinds that companies have faced.  Companies have trimmed costs aggressively, undertaken restructuring, sold off underperforming and non-core assets, and deferred capex where feasible.  Some analysts have taken a glass half empty view of the weakness in business investment, interpreting this as evidence of under-investment in future growth.  But most investors have rightly taken a glass half full perspective, and ascribed tremendous value to companies that have foregone investment opportunities that do not meet their cost of capital requirements, and returned capital to shareholders, predominantly in the form of higher dividends.

At a time when the terms of trade has shed 50% and future earnings growth prospects have stagnated, it is remarkable that analysts' dividend forecasts are one third higher than five years ago (see chart).

At the stock level, even small earnings misses continue to be punished by the market, notably Seek and Dick Smith Holdings.  Given the stellar rise of Seek over the past decade as the dominant online platform for job ads, the 10% fall on the result garnered plenty of news flow, namely comments from the CEO that investors remain subject to short termism, and exhibit little patience for Seek's plans for global expansion.  There might well be an element of truth, but Seek is not being singled out by investors.  After all, the equity risk premium has increased in recent years, as investors have lost trust in CEOs to undertake value accretive investments and acquisitions.  But the adverse reaction to SEK's results reflects the fact that analysts' growth expectations had become excessively optimistic.  Not only did analysts' earnings upgrades for the stock start to slow in early 2015, but have started to downgrade the company's growth prospects in recent months (see chart). 

Other high growth stocks that have been subject to growth stalls or downgrades in recent months include REA and Carsales (see chart).  Domino's Pizza has bucked the trend, with analysts continuing to upgrade the company's future growth strongly in the past year.

For high growth stocks trading on rich multiples, even small earnings misses can lead investors to re-assess the company's longer term growth prospects.  Consequently, investors have de-rated SEK, REA and CAR (see chart).  Given the top-down headwinds that have buffeted corporate Australia cited above, the aggregate supply of growth has been scarce over the past five years.  In hindsight, those few stocks that offered strong growth prospects were strongly bid up by investors.  For Domino's, the risk it that its strong growth profile has become even more scarce in an environment where the growth prospects of other market darlings have stalled.

Weekly Impressions

The 5% devaluation of China's currency dominated financial markets in this past week.  The China bears seem to garner most of the headlines these days, and so it was again: according to the pessimists, the devaluation confirms that the economy is in dire straits and that the government is desperate to boost net exports and so ameliorate the ongoing weakness in consumption and business investment.  To many commentators, China's devaluation represents the latest chapter in the ongoing saga of 'currency wars' waged amongst the world's central banks.

Devaluation yes, but after many years of appreciation

What seems to have gone under the radar in much of the press and commentary is that the Chinese Yuan (CNY) has undergone a significant appreciation in recent years.  Because it has been broadly pegged to the US dollar, the CNY effectively had appreciated by 25% against a basket of its major trading partners.  As a result, the devaluation only returns the CNY's trade weighted index back to levels that prevailed as recently as November 2014 (see chart). 

The bears are right to argue that the devaluation is a signal that the authorities remain concerned about China's future growth prospects. But they have good reason to: manufacturing and industrial production remain in a funk, disinflation is widespread (with pockets of deflation), the recent sharp fall in Chinese stocks has rattled confidence, and many residential and commercial property markets are suffering from a glut of inventory.  Against the backdrop of a weakening economy in recent years, the CNY would likely have depreciated if it had been a floating currency.  The PBOC has not put up the white flag; it is right to seek to re-align the currency with the economy's fundamentals.

In fact, the devaluation of the CNY - together with the recent relaxation of reserve requirements, cut to official interest rates, and (at times clumsy) efforts to support the stock market - has brought the PBOC in line with other central banks, that have eased monetary policies which has been designed to address the global shortfall in aggregate demand.  When the ECB and BOJ adopted more aggressive monetary stimulus at various stages in the past year, financial markets welcomed those moves. 

Yet the PBOC is derided as irresponsible when it seeks to also address the classic symptoms of a domestic cyclical downturn.  This is not to deny China's many structural challenges, including much needed reform of the financial system and re-balancing of growth towards consumption.  Such structural reforms are necessary to help China achieve sustainable growth over the medium term.  But China - along with most other economies - is currently suffering from deficient demand and the best solution is more aggressive monetary stimulus.

Record low wage growth in Australia a signal that labour demand remains weak

In Australia, the clearest sign of an economy that is also suffering from a shortfall in aggregate demand was continued absence of wage pressures.  The private sector wage rate (excluding bonuses) is 2.2% higher than a year ago, which represents the slowest annual growth since the inception of the wage price index in the late 1990s (see chart).  In a speech delivered during the week, the RBA's Christopher Kent confirmed that record low wages growth reflects weak demand for labour, and this is consistent with animal spirits remaining dormant in the corporate sector.

The much anticipated handover from mining capex to non-mining capex remains elusive and continues to be a source of frustration to the RBA.  In another speech from the central bank delivered during the week, Mr Phillip Lowe acknowledged that while this transition continues to drag on, it is appropriate that the household saving rate decline further; that is, it is reasonable to expect consumption to grow faster than disposable income to support growth at time when the corporate sector was showing little appetite for taking on investment projects. 

As long as the 'economy is expected to operate with a degree of spare capacity for some time' (in the RBA's own words), institutional investors should have an overweight in some of the richly valued defensives that have strong earnings predictability.  Based on Evidente's proprietary earnings predictability scores, stocks that have ranked highly on this measure have outperformed significantly since 2011, coinciding with the peak in global commodity prices (see chart).  Other stocks that rank strongly on Evidente's earnings predictability measure include: ASX, Ramsey Healthcare, AGL, Amcor and Coca Cola Amatil.

Investors have now digested the major banks' capital raisings, but expect EPSg to revert to low single digits

At the sector level, banks continued to dominate the reporting season, with CBA being the last major to announce a capital raise (a rights issue of $5 billion).  Certainly significant considering that they reported a full year after tax net profit of $9 billion.  Encouragingly, the lift in bad & doubtful debts announced by ANZ in the prior week (citing renewed risks in agriculture and mining) does not seem to have been shared by either NAB or CBA. 

Given that the bad & doubtful debt cycle is likely to have troughed, EPS growth for the sector is likely to revert to low single digits, consistent with growth in nominal GDP.  This was reflected in CBA's growth of 5% in NPAT for the full year.  Balance sheets across corporate Australia in aggregate, remain in excellent shape.  But pockets of stress pose risks to the majors, particularly low and declining yields for commercial property, which continue to be characterised by rising vacancy rates, particularly in Perth and Brisbane. 

Upside to EPS growth is limited and the sector is trading on multiples that are at the high end of historical norms, suggesting limited scope for valuation expansion.  Nonetheless, I continue to recommend that investors have a small overweight position in the sector due to sustainably high payout ratios and strong predictability of earnings.  Higher capital requirements will dilute their ROEs but the banks have the flexibility to eke out more efficiency gains and drive their already low cost to income ratios even lower.  Stronger capital buffers will also help the banks to better cope with adverse exogenous shocks, such as renewed weakness in property markets.

Macro-prudential measures to curb credit growth to housing investors - Avoid REA

The ongoing strength in residential property markets in Sydney and Melbourne helped Realestate.com (REA) to report a 24% lift in NPAT for the full year.  The CEO's presentation slides highlighted the penetration of premium listing products, investment in high growth markets and boasted the size and engagement of its audience.  The CEO also devoted no less than three slides to that old chestnut, innovation.

But there was no mention of the two key macro drivers of the stock: turnover of the housing stock (which governs listings) and new lending commitments (the two are strongly correlated).   House lending has been on an upward trend for the past three years, lifting from 14% to 18% of the stock of housing credit, underpinned by lending to investors, while lending to owner-occupiers has stagnated (see chart). 

The key risk going forward is that lending to investors slows as the lift in investor lending rates and more stringent LVR restrictions take effect.  The RBA and APRA are clearly determined to engineer a moderation in credit growth to this segment to sub-10%.  Lending to owner-occupiers is likely to pick up the slack only if the majors loosen their LVR restrictions to this segment (unlikely) or the RBA eases policy again (likely, but not for a while).  In the meantime, expect growth in total lending commitments to slow and turnover in the housing stock to plateau or decline.  To achieve growth in listings in these conditions, REA will need to win market share from Domain, which could spark renewed price competition.  Investors should avoid REA while this dynamic plays out. 

Ansell: The dark side of global diversification

The earnings torpedo delivered by rubber glove and condom manufacturer Ansell last week highlights the dark side of global diversification.  Investors - who marked down the stock by 16% on the day of the result - clearly didn't believe the CEO, who cited adverse currency moves, currency hedging gone wrong and disappointing economic performances in many key developed and emerging markets.  The Chanticleer column in the Australian Financial Review wrote an excellent piece this week on the poor performance of a number of complex, multi-national businesses, with assets located in multiple jurisdictions, including Ansell, Orica, QBE and NAB.  The poor returns from ASX listed global conglomerates demonstrate just how difficult these businesses are to manage for Australian based CEOs. 

Evidente has updated its model of firm complexity, based on five factors, including product diversity and geographical dispersion.   According to the model, the most complex stocks include: Seek.com, Qantas, Worley Parsons, AMP and Computershare (Ansell ranks in the top quartile of complexity).  If history is any guide, the risk is that these stocks can invariably deliver earnings torpedos, particularly for those that have poor quality management and weak governance structures in place. 

Dear Banker, Please do not mess with Mr Stevens

During the reporting season, Evidente will be providing regular updates of the key themes emerging from company announcements, as well as communications from the government and central bank.

In a busy week for macro news flow, the RBA decided to leave its policy rate unchanged, as was widely expected. In the statement accompanying the decision and the recently released quarterly Statement of Monetary Policy, the RBA confirms that headwinds facing the outlook are likely to persist and that the economy is expected to operate with a degree of spare capacity for some time yet. 

Of course, those monitoring the macro data flow would know that the economy has been operating at well below full capacity for some time already.  The fact that underlying inflation remains at the bottom end of the RBA's target range of 2-3% (and is probably undershooting the target by a long way when upside measurement bias in the CPI is taken into account) and private sector wages are growing at their most sluggish rate since the late 1990s confirms that the economy continues to suffer from a shortfall in aggregate demand.

It should therefore come as little surprise that sectors offering a high earnings certainty and sustainably high payout ratios have delivered above market returns over the past three years.  Consequently, the infrastructure, healthcare, telecommunications and bank sectors are trading on high multiples by historical standards, despite low growth prospects (except for healthcare).

If Mr Stevens is correct that aggregate demand will continue to be deficient (which I think he is), from a portfolio construction perspective, there is little reason to be underweight these sectors despite their rich valuations.  

Of these sectors, the one that continues to polarise opinion amongst portfolio managers is the banks, particularly following the past week in which the sector has shed 7%.  But I expect the renewed price weakness following ANZ's capital raising to be short lived.  The release of APRA's discussion paper a month ago - suggesting that the majors should add around 200 basis points of CET1 capital from their June 2014 levels - was timely and the majors have been astute in being proactive in getting ahead of the curve. 

The pessimists argue that being forced to use more equity in their liability mix will dilute banks' ROEs and undermine their ability to maintain high payout ratios.  However, higher capital buffers reduce the risk profile of the banks, and previous work I have done shows that conservative capital structures encourage banks to have higher payout ratios (see chart below and Evidente's blog post from November 12th 2014). 

Without the ongoing tailwind of lower bad & doubtful debt charges, the strong out-performance of recent years is unlikely to continue.  But I recommend having a small overweight bet in the majors due to the sector's strong dividend sustainability and ability for the banks to surprise the market on cost control.  For those unconvinced, any further price weakness on the back of what I consider to be misplaced concerns about higher capital requirements should be viewed as a buying opportunity.

Global investors have largely missed out on the bank sector's outperformance of recent years, based on their view that Australia's major banks are trading on rich book multiples relative to their global peers.  But those high book multiples persist thanks to high risk adjusted ROEs.  Moreover, based on proprietary work, I estimate that the majors have managed to hold onto the market share gained from the shadow banking sector during the financial crisis.  In contrast, shadow banks in other countries have regained the market share they ceded in the crisis.

Don't mess with Mr Stevens

Indeed, two developments in the past week ought to provide a cautionary tale for investors in shadow banks listed on the ASX.  First, Westpac announced that they would no longer provide funding to payday lenders, including Cash Converters (CCV) and Money3 (MNY).  Second, the outgoing Suncorp CEO acknowledged that when he commenced his role in 2009, Mr Glenn Stevens told him in no uncertain terms how he expected Suncorp to behave (presumably in terms of lending practices and risk taking activities more broadly).

A key lesson stemming from the financial crisis was that prudential regulators need to more carefully monitor the size and activities of shadow banks.  In order to check growth in non-regulated financial institutions, the RBA and APRA are likely to put pressure on the major banks to limit their funding of shadow banks.  Those shadow banks will have little choice but to tap investors for additional equity capital.  This process could potentially end in tears for shareholders, particularly as the regulators are determined to ensure that the aggregate market share of shadow banks in Australia does not recover to pre-crisis levels.  Evidente will shortly be releasing a detailed report on the outlook for ASX listed shadow banks.

The less cautious consumer: Good news for discretionary retailers

The only domestic cyclical sector that I continue to recommend an overweight position in is discretionary retailers, due to their exposure to a less cautious consumer (see Evidente's blog post from May 29th 2015). 

The June retail trade release confirmed that low interest rates and the wealth effect from rising house values are encouraging households to lift spending, particularly in light of the 2.2% lift in spending on household goods.  The modest decline in department store sales suggests that this sector remains structurally challenged, with David Jones and Myers responding with the announcement of strategic and workplace changes designed to adapt their offering to evolving consumer tastes.  The renewed depreciation in the Australian dollar could be a godsend to Myers, as it might encourage some of the global department store chains which opened stores in Australia at a time when the Australian dollar was significantly higher - including Zara and H&M - to exit the country in due course. 

RIO - Don't throw the baby out with the bathwater

Finally, RIO's interim result was well received by the market.  I remain comfortable maintaining an overweight in the stock, despite the prospect of renewed weakness in iron ore prices (Evidente's research report on 10th July contains more detail: Iron ore - Don't throw the baby out with the bath water).  Previous episodes of stagnant commodity prices have been associated with strong market returns from RIO, suggesting that at present, the market continues to under-estimate the company's ability to control operating costs, reduce capex and lift dividends (see chart). 

Monetary policy no villain

There is a widespread view among financial market participants that attributes much of the world economy's ills to irresponsibly loose monetary policy.  Many central banks have reached their zero lower bound and been there for a while, and pursued unconventional policies such as quantitative easing and forward guidance, designed to kick-start the psychology of risk taking.  But the headwinds facing the global economy have been far stronger and persistent than many had anticipated.

The RBA has not had to resort to such measures and although the cash rate of 2% is anchored at multi-decade lows, it remains among the highest official interest rates across advanced economies.  The interbank futures market assigns a probability of less than 10% that the RBA will cut the cash rate at the August board meeting.  In recent communications, RBA Governor, Mr Glenn Stevens, has highlighted his view that financial conditions remain accommodative and that the central bank will continue to monitor the effects of interest rate cuts in February and May.

Mr Stevens has speculated recently that Australia's growth speed limit might have declined due to slower population growth and that this might have also contributed to the stability in the unemployment rate.  Estimating potential growth or the structural unemployment rate is a notoriously difficult exercise.  But with private sector wages growing at their slowest rate since the late 1990s and underlying inflation anchored in the bottom half of the RBA's target range of 2-3%, it is hard to mount a case that the economy is hitting up against its speed limit.  Indeed, Mr Stevens himself has previously observed that the economy could do with more demand growth.  It is therefore reasonable to expect that there ought to be an easing bias, even if the RBA has not formally adopted one since cutting interest rates in May. 

For institutional investors, the outlook for monetary policy in Australia is likely to remain a sideshow to other macro themes, notably what the spill-over effects will be of the turmoil in China's stock markets, and the prospect of a lift in the US Federal Funds rate.  Nonetheless, investors will continue to field questions from those concerned that low interest rates in Australia run the risk of stoking speculative bubble in residential property markets, in high yielding stocks and encourage firms to lift payout ratios, thus under-investing for future growth.

Some of these concerns remain largely misplaced.  First, low interest rates have led to a lift in dwelling investment, which has been desirable given the mining and energy sector CAPEX cliffs.  But supply side constraints in the major cities - thanks to onerous regulatory restrictions on new high-rise developments - have also contributed to higher prices.

Second, high yielding stocks haven't actually out-performed.  Low beta stocks - many of which have strong earnings predictability - have delivered strong returns and are trading on higher multiples than historical norms.  But this has less to do with low interest rates and more to do with the fact that the risk premium has increased, as investors remain reluctant to take on too much risk.

Third, the sweep of the past 25 years shows that there the aggregate payout ratio is well within historical norms, despite the RBA official cash rate being at its lowest level over this period.  In fact, the chart below highlights five periods in the past 25 years where the aggregate payout ratio has peaked at levels above the current rate of 75% (see chart).  In previous blog posts, I attribute the rise in the payout ratio since the financial crisis to a loss of trust in CEOs' abilities to undertake value accretive growth projects and acquisitions.  Moreover, in a world awash with excess capacity and suffering from deficient demand, what incentive do CEOs have to undertake large growth projects?

Interbank futures are right to not expect the RBA to cut interest rates at the August board meeting.  But if the economy is still suffering from a shortfall in aggregate demand by year end (my expectation) there will be a growing chorus for further monetary stimulus.  APRA seems to be doing a good job of jawboning the banks to continue to lift the amount of equity capital in their liability mix, thus giving the RBA more scope to ease policy without stoking a property bubble.  The jawboning and other macro-prudential measures adopted by APRA have already led to a lift in lending rates for housing investors across the major banks in the past month.

A salute to corporate Australia

Many global investors have eschewed Australian stocks from their portfolios for a while now.  The high Australian dollar, sensitivity to the slowdown in China's growth and the attendant decline in commodity prices, the fact that the major banks continue to trade on higher multiples than their global peers and growing concerns of a bubble in Australia's residential property markets (particularly Sydney and Melbourne) have conspired to keep cautious global investors on the sidelines.

But the resilience of Australia's corporate sector has confounded most global investors.  Aggregate profitability has not declined over the past five years, despite the significant macro headwinds that have curtailed top-line growth.  Let's not gloss over just how severe the terms of trade shock has been; not only is the RBA's Commodity Price Index one third lower than five years ago, but the value of the Australian dollar relative to the US dollar has declined by only 10% over this time (see chart). 

Corporate Australia has responded admirably by  trimming costs aggressively, restructuring, divesting under-performing assets that have been peripheral to their core focus, and deferring capital spending where feasible.  No sector has remained untouched, including banks, mining, energy, telcos and retailing. Of course, the macroeconomic consequences of this belt tightening has led to a shortfall in aggregate demand, but that's a problem for the RBA to address, not corporate Australia.

Various measures of Australia wide corporate profitability show that there has been little change over the past five years, including the National Accounts measure of Gross Operating Surplus or forecast EPS for the ASX200 companies.  Consequently, forecast EPS remains one-quarter lower than the pre-crisis peak and has significantly lagged forecast EPS for the S&P500 companies, which is 20% higher than its pre-crisis peak.  But US companies have not had to deal with a large terms of trade shock and the Federal Reserve has been more determined to stimulate growth than the RBA. 

Given that forecast EPS for the ASX200 has remained stagnant for the past five years, multiple expansion has driven the market higher, with the 12 month prospective PE lifting to 15x from 11.5x (see chart). 

A decomposition of forecast EPS shows that balance sheet growth has slowed, and that the profitability or ROE achieved on the net asset base has deteriorated to 12% (see chart).

On face value, the important role that multiple expansion has played in the past five years does not point to an optimistic outlook for stocks.  The PE ratio of 15x suggests that there is limited upside from further multiple expansion.  In other words, it appears that earnings expansion will need to drive the market higher going forward.

But when we turn our focus to dividends, the picture changes somewhat.  I am a firm believer that sector analysts over-estimate the control that a company's CEO has over a stock's performance because there are so many factors that shape a stock's returns that are beyond the CEO's control.  But there is one key variable that a CEO and CFO can control; payout policy.  Many companies have increasingly catered to investors' insatiable appetite for income in recent years by lifting payout ratios.

At a time when expected profitability has stagnated, forecast dividends have grown by over one-quarter in the past five years.  Consequently, the payout ratio for the ASX200 companies has lifted to a ten year high of 75% (see chart).  I believe that this forms an integral part of the quiet revolution in corporate governance, because companies disgorging cash to shareholders reduces the conflicts of interest that exist between shareholders and managers (see my post from last week). 

Some - including the RBA Governor - have bemoaned the absence of entrepreneurial risk taking among Australian companies and implored the corporate sector to invest for growth.  But at a time when the world economy is still awash with excess capacity and revenue conditions remain anaemic, why would companies invest in projects at or below their cost of capital?  Fortunately, the corporate sector has done the sensible thing and returned capital back to shareholders.

A focus on dividends helps to re-cast the market's rise in the past five years.  The 25% growth in expected dividends means that the aggregate DPS is now approaching the pre-crisis peak.  Compare this with forecast EPS, which remains 25% below its pre-crisis peak.  Indeed, dividend expansion has actually been the dominant driver of the higher market since the dividend multiple has remained broadly steady at around 20x (see chart).  In other words, the prospective dividend yield has hovered around 5%.

The key risk to the market in the near term therefore lies in bank sector dividends and the highly concentrated nature of dividends paid.  Dividend concentration has increased since 2007, with the top 10 dividend payers generating 60% of total dividends paid by ASX listed companies, up from 43% in 2007 (see chart).  As APRA continues to lift capital requirements, bankers will no doubt cry wolf that these measures will dilute their ROEs and reduce their ability to sustain current high payout ratios.  But in previous work I have published, I show that banks with more equity capital actually pay higher dividends because they are safer.  More generally, I believe that the aggregate payout ratio will continue to increase despite already being at a 10 year high of 75%, particularly as companies continue to find innovative ways to free up cash.

To more recent events - Good news for value stocks

Finally, in the past week, two stocks have bounced: Pacific Brands which revised its profit guidance higher, and Kathmandu, on that announcement that Briscoe, a NZ based retailer would be lodging a takeover offer.  In mid-June, I spoke to a number of portfolio managers about discretionary retailers and drew their attention to a chart for the stocks in their sector which plots their P/B ratios against their consensus ROE expectations.  At the time, there were three value traps that lay well below the regression line: KMD, PBG and MYR (see chart).

I have updated the chart (see below) and it is noteworthy that despite the fact that both KMD and PBG have re-rated since mid-June, they remain well below the line, suggesting that there could be more upside.  It also remains to be seen whether investors will now start to re-assess whether the risk-reward trade-off has improved for other stocks long considered to be value traps, notably MYR.  

A loss of trust and the Quiet Revolution in Corporate Governance

"Payouts to shareholders reduce the resources under manager's control, thereby reducing managers' power...Conflicts of interest between shareholders and managers are especially severe when the organisation generates substantial free cash flow.  The problem is how to motivate managers to disgorge the cash rather than invest it at or below the cost of capital... "

- Professor Michael Jensen, 1986, Agency costs of free cash flow, corporate finance and takeovers, American Economic Review

Commentators and analysts continue to be vocal critics of the insatiable appetite for income that investors have developed in recent years.  The argument goes that this trend has encouraged companies to return capital back to shareholders in the form of higher dividends and buy-backs, at the expense of investing for future growth.  Thus, companies are apparently foregoing valuable growth opportunities stemming from investors' short-termism.  Although record low interest rates has probably contributed to the 'reach for yield' in financial markets, this post argues that investors' loss of trust in CEOs' ability to undertake value accretive projects and acquisitions has had an important influence on corporate payout policies.  Moreover, the greater propensity for companies to return capital back to shareholders has been far more powerful in reducing the agency costs of free cash flow than the noise created by the bloated ESG industry.

Since the turn of the century, the finance industry has becoming increasingly noisy in extolling the virtues of good corporate governance thanks to a number of high profile governance failures, including (but not limited to) Enron, Parmalat, Tyco, WorldCom, Lehman Bros and closer to home, HIH Insurance.

Australian asset managers have led their world in their march to being good corporate citizens; the take up of the United Nations Principles of Responsible Investing is among the highest in the world.  The mainstreaming of environmental, governance and social factors (ESG) has meant that most active funds showcase their ability to incorporate ESG into their investment processes. 

Many ASX listed companies have catered to the greater investor appetite for good governance by appointing more independent board directors, lifting the level of disclosure in annual reports, adopting remuneration structures that are designed to align the interests of senior management and shareholders, establishing audit and remuneration committees, and separating the roles of chairperson and CEO.  CEOs are astute enough to give investors what they want, particularly if it involves a low cost, low effort box ticking exercise.  Little surprise then that there has been a pattern of inflation in governance scores over the past decade, but it is far from clear that the greater awareness of governance issues has properly addressed the classic agency conflict that arises from the separation of ownership and management of corporate assets. 

Despite the 'noisy' revolution in corporate governance (and ESG more generally), has the upheaval in governance practices led to improved company outcomes globally?  In their pioneering study published in 2003, Paul Gompers et al demonstrated a strong empirical link between governance and performance in the United States through the 1990s; stocks with strong shareholder rights strongly outperformed and had higher firm value, higher profits, stronger sales growth, lower capital expenditures and undertook fewer corporate acquisitions.  But a more recently published study in 2012 by Lucian Bebchuk et al shows that although well governed firms continued to exhibit superior operating performance from 2000-08, they did not outperform stocks with weak shareholder rights.  The authors attribute their finding to investor learning;  there was a greater awareness of, and attention paid to governance by investors, which meant that good governance was already impounded into stock prices.

Anecdotal evidence also casts doubt on the link between good governance and stock returns; firms with weak shareholder rights and few independent board directors continue to deliver strong stock returns, including Apple, Newscorp, Westfield and Harvey Norman to name a few.

In his pioneering study from almost three decades ago, Michael Jensen argued that the separation of ownership and management of corporate assets gives rise to more severe agency conflicts when a company generates strong free cash flow, because there is scope for the CEO and senior executives to use the free cash flow to expand the size of the firm at the expense of profitability and shareholder returns.  Returning cash to shareholders therefore imposes a powerful discipline on the CEO, "...making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital."

Australian firms have for a while now had a higher dividend payout ratio than their global peers thanks to the adoption of the imputation system in 1987, which eliminates the double taxation of corporate profits that are paid out as dividends since shareholders receive an imputation credit for the tax already paid on profits by the company.  The aggregate payout ratio started to lift from the 1980s.

But more recently, companies have increasingly resorted to returning cash to shareholders in preference to re-investment and acquisitions.  For starters, dividend concentration has risen; the top 10 dividend payers in Australia generate  60% of aggregate dividends paid by All Ordinaries companies, well above the 43% generated at the peak of the credit boom in 2007 (see chart). 

Second, the aggregate payout ratio has lifted in recent years, to its current level of 70%, above the median of 65% since 1990 and well above historical trends over the past forty years (see chart).  The payout ratio has exhibited a strong cyclical pattern since the early 1990s, with sharp rises associated with either a contraction or stagnation in earnings, while the aggregate dividend per share has exhibited far less variability, confirming that companies engage in dividend smoothing.

The sustained lift in the payout ratio represents the flip-side of the corporate sector's dormant animal spirits.  The RBA Governor, Mr Glenn Stevens, has bemoaned the lack of risk taking in corporate Australia and implored businesses to invest for future growth.  But more recently, Mr Stevens and the RBA have acknowledged that the hurdle rates used by companies to evaluate future projects has remained sticky despite the fact that 10 year government bond yields remain close to record lows.

The financial crisis continues to cast a long shadow

I believe that the insatiable appetite for income that investors have developed has arisen in large part to a loss of trust in CEOs' ability and willingness to undertake value accretive projects and acquisitions.  The poor track record of acquisition led growth through the credit boom of the mid-2000s has left investors justifiably cynical of CEOs' motives: RIO, BHP and QBE are just some that come to mind that have undermined investors' confidence.

Marrying payout and predictability

I have developed a score for a company's payout ratio based on past dividends paid and stock buy-backs undertaken (see chart below).  I use total assets rather than EPS as the scaling variable due to the volatility and cyclicality of EPS for some companies.  Stocks that rank strongly across this metric include CSL, COH and CAR. 

Separately, I have developed a proprietary composite indicator for a stock's earnings predictability based on five variables.  The chart below plots the earnings predictability score against the aggregate payout ratio.  The plot identifies a number of stocks with potentially unsustainably high payout ratios because their predictability scores fall below the median, notably JBH and MND.  Three stocks that appear to have scope to lift their payout ratios due to their strong earnings predictability include: ASX, SGP and AGK. 

The other revolution in corporate governance

It is a welcome development that CEOs with a track record of acquisitive growth no longer command a premium in the market for managerial talent.  Boards increasingly are looking for CEO candidates that have a track record of prudence and cost control, and that exhibit a willingness to abandon under-performing assets that in the past might have been seen to represent future growth options, but are increasingly now viewed as peripheral and distracting from the company's core focus.  This 'other' revolution in corporate governance will be the subject of a forthcoming report from Evidente.

Woolworths - Risk Reward Becomes More Compelling

Last month, Evidente published an open letter to the Woolworths CEO, Grant O'Brien, suggesting that a lack of corporate focus had contributed to the company's poor recent performance.  The rollout of Masters stores since 2011 had been a significant drag on the group's performance, with the company having little choice but to push out the timing of break-even expectations from what in hindsight was an unrealistically aggressive timetable. 

The slowdown in sales growth of Australian Food & Liquor segment evident in the past year suggests that the expansion into home improvement has distracted management from its core supermarket business and taken up a disproportionate amount of management time and effort.  Woolworths has effectively bucked the recent trend towards corporate focus; the demerger wave of recent years amounts to corporate Australia waving the white flag on corporate diversification and acknowledging that focussed firms typically produce superior returns to their shareholders.

In an encouraging sign at the investor strategy day in early May, Mr O'Brien announced that Woolworths would re-allocate capital away from the under-performing Masters and Big W businesses towards supermarkets, including for store refurbishment.  Whether this represents a harbinger of an exit from these businesses remains to be seen.  In what amounted to a mea culpa, Mr O'Brien admitted that in seeking to preserve high margins, the supermarkets division had effectively sacrificed sales growth and customer loyalty, and flagged a shift in strategy designed to neutralise the community perception of Coles' price leadership.

Despite my ongoing concerns about the ability for the senior executives to effectively manage a number of disparate and under-performing businesses in the near term, particularly Big W and home improvement, the following set of charts suggest that at current levels, analysts and investors have become unduly pessimistic about the company's prospects. 

First, multiple contraction - rather than earnings contraction - has accounted for the lion's share of the stock's underperformance in the past year.  The 12mth forward earnings multiple has declined to 14x from 17.5x (see top panel of the chart below).  The bottom panel confirms that a continued deterioration of the company's incremental ROE coincided with the roll-out of the Masters stores which commenced in 2011, coinciding with the start of Mr O'Brien's tenure as CEO. 

Second, the stock is now trading at 14x 12mth forward earnings, which is a discount to the ASX200 (16x).  This represents the first time Woolworths has traded at a discount (see chart).

Third, Woolworths is trading at a discount to its global food & grocery peers based on profitability adjusted price to book ratios.  Valuation theory says that there ought to be a positive and linear relationship between a stock's expected ROE and its P/B ratio, and the positive regression line in the chart below confirms this.  After having traded typically at or above the regression line in recent years, Woolworths is now trading at a 10% discount based on this metric.

As analysts have downgraded its ROE outlook, the stock has undergone a material de-rating, particularly in the past year.  The chart below highlights the extent of the de-rating, and shows that if the stock's profitability adjusted P/B ratio was in line with its peers, it would be trading on a book multiple of 3.8x.

Fourth, when benchmarked against the stocks in the ASX100, Woolworths also offers compelling value.  Its profitability adjusted P/B ratio is more than 20% below the regression line (see chart).  A closer inspection of valuation theory suggests that this discount is unlikely to persist.  The perpetuity earnings discount model says that a stock's P/B ratio is equal to its future expected ROE multiplied by the reciprocal of k - g (expected stock return minus future expected growth in EPS).  The CAPM dictates that the only source of variation across stocks' expected returns is in a stock's beta; high beta stocks ought to trade at a discount, other things being equal.  So a stock's book multiple might remain below the regression line in equilibrium if has a higher beta than its peers and/or lower EPS growth expectations.

Woolworths' risk and growth characteristics suggest that it should not remain below the regression line for an extended period.  The lion's share of the company's revenues are generated in segments that are considered to be defensive, and most analysts use betas of less than 1 when constructing their discount cash flow valuations. So controlling for expected future growth, Woolworths ought to trade on a premium based on profitability adjusted P/B ratios. 

Moreover, long-term consensus expectations suggest that sell-side analysts have become too pessimistic about the stock's future growth prospects.  The long term growth forecast for the stock has fallen to only 2%, well below the median estimate (see chart).  Over the sweep of the past five decades, household spending on food & liquor has broadly tracked growth in the economy of around 5.5%.  Concerns around management quality and the long-term viability of home improvement are valid but in my view, do not justify the stock trading at a discount to its large cap peers.

Fifth, parallels between Tesco and Woolworths are exaggerated.  The collapse in Tesco's share price in 2014 owes much to the lack of transparency of its financial accounts following an accounting scandal.  Moreover, prior to the scandal, the stock was priced for perfection, trading at a large premium to its global peers on a profitability adjusted price to book ratio (see chart).  As discussed above, Woolworths is trading well below the regression line at present.

An excessive pessimism

I continue to have concerns around the long-term viability of the Masters stores in their current format, the fact that the composition senior management appears to be in a state of flux thanks to a number of recent departures, and remain sceptical of the purported synergies between running a supermarkets business and a being big box hardware retailer.  But in my view, the share price is already impounding excessive pessimism.  At these levels, investors should neutralise their underweight bet in the stock and use any renewed price weakness to start building an overweight position. 

The Jamie Durie Index, Re-visited

Inspired by Robert Shiller’s best seller, Irrational Exuberance, I developed the Jamie Durie Index (JDI) over a decade ago, which represented the number of times the name ‘Jamie Durie’ appeared in newspapers and magazines.  Shiller’s book suggested that the media typically play an important role in propagating asset price booms.  Jamie Durie -host of top rating TV show, The Block - was the poster boy of Australia’s property market culture and the JDI was designed to measure the media attention and chatter surrounding property.  As it happened, the JDI correlated closely with the cycle in house prices, with both peaking in 2003.

At the time, Australian property was booming, stories of house price gains achieved in no time with an assist from plenty of debt dominated dinner party conversation, and Australia was rapidly becoming a nation of home renovators, inspired by Jamie Durie and shows like The Block.

Fast forward to 2015 and The Block has come a long way, having out-lived its original host.  In its initial form, it survived only two seasons.  After a six year absence, the Nine Network re-introduced the show in 2010, which has been hosted by Scott Cam ever since.  Despite the 20% lift in average home values in the past three years, The Block and other home renovation shows – including House Rules and Reno Rumble - haven’t hit the heights of a decade earlier.

The rise and rise of home renovation shows...

The recently appointed Treasury Secretary, Mr John Fraser, has weighed in on the debate about whether there is a bubble in property prices, suggesting that the plethora of home renovation television shows represents compelling evidence of over-investment in housing.  While there might be signs of a property market culture re-emerging, we need to tread carefully about drawing strong inferences about a property bubble for a number of reasons.

...but little sign of a speculative frenzy

First, a shift in consumer attitudes and tastes has contributed to the proliferation of home renovation shows.  For instance, the growing popularity of cooking shows, including Master Chef and My Kitchen Rules, together with the emergence of the celebrity chef, is largely due to the renewed interest in food and home cooking and a waning interest in processed foods.  Is anyone suggesting there is a bubble in home cooked food?

Second, the aggregate data doesn’t point to over-investment in housing, just yet.  Private sector dwelling investment has lifted to a little above 5% of GDP, but this remains well below prior peaks of around 6½% (see chart).

Third, despite the growing interest in home renovation shows, this has not yet translated into a lift in the share of their budgets that consumers devote to home renovations.  That much is obvious from the fact that the value of renovations declined to 1.8% of GDP in 2014, well below the peak of 2.7% of a decade ago and its lowest level in more than twenty years (see chart).  To put this in context, had the value of renovations accounted for 2.7% of GDP in 2014, this would have translated into a dollar value of $43 billion, well above the actual spending on renovations of $30 billion, representing a shortfall of over $10 billion.

The academic literature confirms that the level of home improvement activity provides a valuable insight into home owners' expectations of future price growth.  In a paper published in the Journal of Financial Economics, Harrison Hong and other researchers from Princeton show that in the United States, homeowners who are optimistic about future house prices are more likely to speculate on future price growth by renovating.

Fourth, increased liquidity, a pre-requisite for speculative bubbles according to Shiller, has been absent to date.  In fact, the annualised turnover rate of the stock of housing has declined to 4%, around half its level from a decade ago (see chart).  Normally, turnover rises with house prices because greater home equity encourages home-owners to trade up to more expensive homes and vendors who observe higher turnover infer that demand has picked up and lift their reserves.

The RBA speculates that various factors underpin muted housing turnover: the unusually low participation of owner-occupiers in housing market transactions and growing evidence that homeowners have become more reluctant to borrow against increases in net wealth to trade up homes.  Hardly ingredients of a property bubble.

Tipping point for a bubble has not been reached...yet

Despite the proliferation of home renovation shows on Australian television, signs of a re-emerging property market culture, and strong upswing in Sydney and Melbourne property prices, the modest level of renovation activity, low turnover in the housing stock and the fact that private sector dwelling investment is in line with historical norms suggests that the property market does not yet share the speculative elements that prevailed during the boom of the early 2000s.

Back then people renovated to cash in on the soaring equity in their home so they could trade up to bigger places.  Now, the reality has set in that the transaction costs of moving are too high and households are more realistic about their expectations of capital growth.  If there does exist a tipping point for the emerging property market culture to morph into a speculative frenzy of over-investment, I believe that we are not there yet.

A less cautious consumer: Good news for discretionary retailers (finally!)

The March quarter capex survey revealed that animal spirits in the corporate sector remain dormant, with little prospect of a pick-up in non-mining investment in the near term.  The dollar value of capex for 2014/15  is set to come in at around $145 billion, 10% lower than a year earlier.  But the greater concern is that preliminary business expectations for capex in 2015/16 are comparable to those that prevailed for 2010/11.  If that year turns out to be a reliable guide, then capex is set to decline to $120 billion in 2015/16, representing an annual decline of over 15% (see chart).

Unprecedented upheaval in the corporate landscape

Faced with persistent revenue headwinds, the corporate sector faces little choice but to trim costs aggressively, restructure and lift efficiency to boost profitability and free cash flow, thus catering to investors' insatiable appetite for income.  In its recent strategy day, Woodside Petroleum was the latest in a long line of resources companies that announced a renewed focus on achieving a step down in its cost structure and lift in productivity.  It is already on that path, with capex 10% lower in 2014, and has a target of achieving a further 10-20% capex reduction by 2016.  While energy gentailer, AGL, announced at its strategy briefing this week that it would target asset sales of up to $1 billion by 2016.  Against the backdrop of the demerger wave of recent years and trend towards corporate focus, the upheaval in Australia's corporate landscape is unprecedented.

The consumer is key for reviving animal spirits

Richard Goyder, Wesfarmers' CEO, said recently that he would need to see sustained evidence of a strong pick-up in consumer spending before the company would commit to a ramping up of capital spending plans.  No doubt, this feeling is widespread amongst CEOs and CFOs across corporate Australia. 

The cautious consumer has held back investment intentions for some time now.  Since the financial crisis, the household saving ratio has hovered at or above 10%, representing its highest level in over two decades.  That is, households have been saving $10 for every $100 of gross disposable income earned since the financial crisis.  At face value, this doesn't seem high.  But to put this into perspective, the household sector saved less than $5 for every $100 of gross disposable income earned in the ten years to 2008 (see chart). 

Permanent income matters

Clearly, scared by the financial crisis and the related sharp drop in the present value of their human capital, households have taken on the task of balance sheet repair.  The persistent high level of job anxiety and proximity of the financial crisis has effectively seen households assign higher discount rates to their stream of future expected earnings.  As a result, they have been more reluctant to bring forward spending from the future to the present, so little wonder that the stock of personal credit remains below its pre-crisis peak.  Elevated political uncertainty of recent years hasn't helped consumer confidence either.

Signs of a less cautious consumer emerging

But some preliminary signs of a less cautious consumer are starting to emerge.  First, the saving rate has been on a modest downward trend since 2012, clearly helped by renewed strength in house prices, particularly across Sydney and Melbourne.  The introduction of macro-prudential measures by APRA, designed to curb the rapid growth in lending to the investor segment,  will probably moderate capital growth compared to recent years.  But the still high level of the saving ratio suggests that the medium term risks are skewed to the downside.  As the financial crisis becomes more distant, households will gradually assign lower discount rates to their future incomes, thus lifting their permanent income and encouraging them to borrow to bring forward consumption.

Second, the modest decline in the saving rate of recent years has been associated with a material pick-up in spending on durable goods, including household goods and clothing, footwear & personal accessories (see chart).  Department store sales are the only category among durable goods that has yet to participate in the recovery.

Third, there has been some renewed strength in consumer sentiment in recent months.  The inherent volatility of the series advises caution in extrapolating monthly movements into the future.  Nonetheless, the positive reaction to the Federal Budget delivered in mid-May and the strong showing in the polls by the Coalition has helped to reduce some of the political uncertainty that seems to have been a defining characteristic of Australia in recent years, particularly since the balance of power in the Senate has resided with a number of independent cross benchers.  With this Budget, the Government seems to have neutralised the bad news stemming from last year's Budget, where it spooked the electorate with talk of budget repair, hailed the end of the era of entitlement and failed to prosecute the case for the $7 Medicare co-payment.  Indeed, it is instructive that less than two weeks since the Budget was delivered, the ALP, the opposition party, has shifted the political debate to gay marriage.  Households have clearly welcomed the non-controversial budget as good news.  Consequently, I would expect that political uncertainty will continue to diminish and provide support to consumer sentiment in the near term.

The key risks to my view that the consumer will become less cautious relate to house prices, labour market slack and the already high level of household debt.  First, APRA's untested macro-prudential policies could provide a catalyst for renewed weakness in house prices.  Second, I have previously discussed the fact that considerable unemployment and under-employment in the labour market persists, which will cap wages, already growing at their slowest rate in the private sector for over a decade.  Third, the ratio of household debt to GDP in Australia remains high by global standards.  But this metric does not take into account the asset side of the household sector balance sheet.  Moreover, the ratio can be misleading because households consume out of their permanent income, not their current income. 

The maths of compounding suggests that even small declines in discount rates can have a powerful effect on boosting the present value of the household sector's human capital.  As this dynamic unfolds, households should gradually focus less on balance sheet repair and lift borrowing as their permanent income lifts.  A less cautious consumer is the key ingredient to a lift in revenue growth, revival in the corporate sector's entrepreneurial risk taking and a recovery in non-mining business investment.

Investment recommendation: Neutralise under-weight bets in discretionary retailers

After what has been a lost decade for the discretionary retailers, I believe that investors should now be starting to neutralise under-weight bets in the sector and gradually move overweight as more evidence of a less cautious consumer emerges.  Stock selection will be less important than getting the sector call right.  Nonetheless, a number of stocks stand out.  Based on a perpetuity earnings growth model, the following stocks offer the strongest upside: Echo Entertainment Group, GUD, Harvey Norman, Premier Investment, Retail Food Group and Super Retail Group.   

Despite the structural challenges facing department stores, there is some scope for catch-up for department store sales, suggesting upside risk to Myers.  See the table below for the full list of stocks.  Although some of the business models in addition to Myer face structural challenges, I believe that the market is under-estimating the powerful macro tailwind that a lift in the household sector's permanent income and present value of human capital will provide to the sector.

A new narrative for the Australian dollar (Update)

Two months ago, Evidente published a detailed report which suggested that contrary to the RBA's view that the currency remained over-valued, the Australian dollar was trading modestly below fair value of  80 US cents.  After what had been a strong period of out-performance from US dollar earners, I concluded that without the tailwind of A$ over-valuation - which prevailed through most of 2014 - their returns in the near term would be capped.  In this post, I provide an update of Evidente's A$ model and show that recent currency appreciation has been associated with under-performance from US$ earners.

Since the publication of the report on March 20th, the Australian dollar has confounded the expectations of futures markets, most market economists and the RBA, appreciating by around 3% against the US dollar.  The RBA's communications have become even more pointed about the persistently high A$.  In the statement accompanying the recent decision to cut the official interest rate by 25 basis points to 2%, the RBA Governor said that 'further depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices.'  The A$ has not followed the RBA script, depreciating against the US$ by only 30% from the peak in global commodity prices in 2011, well below the 50% fall in the RBA's Commodity Price Index (in US$ terms). 

Mr Stevens is right to highlight that the A$ deprecation has been modest compared to the decline in commodity prices in the past four years.  But over the sweep of the post float period, the A$ typically has not moved lock in step with swings in commodity prices.  For instance, the appreciation through the mid-2000s was muted given the size magnitude of the upswing in commodity prices.  In the five years to mid-2008, the A$ had appreciated by 40% against the US$, but the RBA’s Commodity Price index more than tripled in US$ terms over this period (see chart).  During this time, the RBA did not acknowledge publicly that the A$ remained substantially below its fundamental value.

Despite the modest lift in commodity prices in recent months, and the further easing of monetary policy in Australia in early May, Evidente's econometric model of the A$ points to fair value of around 79-80 US cents.   The key innovation of the model is that it utilises an interest rate differential variable based on a negative or shadow Federal Funds rate, developed by Leo Krippner at the RBNZ.  The modest under-valuation that prevailed at the time of publication of the original report has now dissipated and the A$ is trading in line with fair value (see chart).

After what had been an extraordinarily strong period of returns from US$ earners in the six months to April, the renewed A$ appreciation has been associated with under-performance from this basket in recent months (see chart). 

The table below provides the list of big-cap US dollar earners.  The basket is trading on a median 12 mth forward PE of 20x, which represents a 25% premium to the median estimate for the ASX100 and is slightly higher than historical norms.  The basket trades on a premium because offshore earners exhibit significantly higher long-term growth expectations and lower betas than the broader market.  Their low betas arise from the predominantly defensive nature of their cash flows and business models.  The three stocks that suffer from the highest level of analyst bearishness remain Cochlear, Treasury Wine Estates and Westfield, which each attract less than 20% of buy recommendations from sell-side analysts.

Lifting the lid on the Sage of Omaha's investment secrets

More than 40,000 people undertook the pilgrimage to Nebraska to attend Berkshire’s Hathaway’s AGM on May 2nd.  They had good reason to listen to the insights of Chairman, Warren Buffett, considered by many to be the greatest investor of modern times.  Berkshire Hathaway, the company he founded almost fifty years ago, has delivered to shareholders compound annual growth in returns of over 20 per cent over this time, handsomely beating the S&P500.

Some have taken Mr Buffett’s stellar track record as compelling evidence that active management can deliver consistently high returns over the long run.  Others attribute his success to luck; by chance, a small handful of funds will inevitably beat the benchmark over an extended period. 

Researchers at AQR Capital, a US based hedge fund, have recently sought to understand the reasons for Berkshire Hathaway’s strong performance.  In their working paper, Buffett’s Alpha, Andrea Frazinni and his co-authors attribute the strong returns not to luck, but to reward for leveraged exposure to safe, quality stocks that are cheap.

Modern portfolio theory says that a stocks’ beta dictates its expected future returns.  This means that a high beta stock should yield high expected returns because it is very sensitive to fluctuations in the economic cycle.  For instance, mining firms, building material stocks and discretionary retailers are considered to have high betas since their profitability is largely tied to the fortunes of the economy.  According to theory, these sectors should yield higher returns than low beta or defensive sectors such as healthcare, consumer staples and telecommunications.

Investors with a strong risk appetite can juice up their portfolio returns by choosing to invest in predominantly high beta stocks.  Alternatively, leverage can also play an important role by allowing investors to amplify their returns.  Investors wanting to take on more risk can borrow and use the proceeds to gear up their exposure to the market.  Many retail investors engaged in this type of behaviour through margin lending for instance, during the credit boom in the lead up to 2008.

Contrary to theory, the overwhelming evidence compiled over the past three decades - led by Nobel prize winning economist Eugene Fama - has shown that high beta stocks have yielded worse returns than low beta stocks. Moreover, the assumption surrounding leverage comes unstuck in the real world.  Despite the rapid growth of hedge funds in recent decades, the lion's share of financial assets is still managed by institutional investors who are subject to leverage constraints; their mandates typically prevent them from borrowing or short-selling.

Betting against beta

In an environment where most institutional funds are subject to borrowing constraints, the obvious way to beat one’s peers is to gravitate towards high beta or risky stocks, especially those with supposedly strong growth prospects that easily capture investors’ imagination.  But crucially, these stocks become over-bought and expensive, and many fail to deliver on analysts' wildly optimistic growth expectations, which underpin their poor future returns.  Some high profile examples that fit this picture in Australia recently include: Woolworths, REA Group and Navitas.

Accounting for the tendency for high quality, defensive and cheap stocks to out-perform accounts for much of Mr Buffett’s performance over time.  Mr Buffett clearly identified many years ago that the ability and willingness to borrow heavily and bet against beta would yield remarkably strong returns.  The authors conclude that that the Sage of Omaha’s performance is not attributable to luck or chance, but rather the successful implementation of exposure to value and quality factors that have yielded strong returns over time.

Applying Buffett's Investing Principles to Australia

I have developed a number of screens for the ASX200 that represents proxies for Mr Buffett’s three preferred attributes: quality, safety and value.  Stocks need to attain a score better than the median across each of the categories to get into the long portfolio.  Three stocks that meet the criteria include: CSR, Echo Entertainment Group and IAG.  The full text report contains a full list of the thirteen stocks in the long portfolio and how they score across the quality, safety and value screens. 

Conversely, the short portfolio is composed of stocks that fail to meet the threshold across each of the three screens.  Three stocks in the short portfolio include: Oil Search, Premier Investment and Caltex.  The full text report contains a full list of the eleven stocks in the short portfolio.

A rate cut today, but what of tomorrow?

"Relevant considerations of late include the fact that output is below conventional estimates of ‘potential’, aggregate demand still seems on the soft side as resources investment falls sharply, and unemployment is elevated and above most estimates of ‘natural rates’ or ‘NAIRUs’. And inflation is forecast to be consistent with the 2–3 per cent target. So interest rates should be quite accommodative and the question of whether they should be reduced further has to be on the table." 

 - Glenn Stevens, RBA Governor, 21st April 2015

More policy easing appears to be imminent.  Interbank futures suggest there is a 70% probability of a 25 basis point rate cut at today's RBA Board meeting, while the overwhelming majority of market economists expect the RBA to ease policy today.

In December last year, in an interview to Fairfax journalists, Mr Stevens appeared to subtly acknowledge the case for more accommodative policy and laid the groundwork for a new communications strategy based on a positive narrative.  The RBA would want to avoid any further rate cuts being seen to reflect a weak economy, at a time when household and business confidence were (and still are) fragile.  Mr Stevens also indicated that the precipitous fall in energy prices would reduce inflation.

I believed that the benign inflation environment provided a cue for the RBA's positive narrative (see Evidente blog post, Money's too tight to mention, 12th December 2014) and expected that the RBA would ease policy at the February and May meetings, immediately following the release of quarterly CPI data (Australia is unique globally in having a quarterly CPI; most countries have monthly CPI readings).  The CPI release from last week confirmed that underlying inflation remains in the lower part of the RBA's 2-3% target range and that the inflation outlook does not pose an obstacle to lower interest rates.

The RBA's communications suggest that it is carefully calibrating monetary policy in the context of its policy of least regret, which assesses the likelihood and size of costs associated with making a policy error.  Most market economists, central bankers, prudential regulators and analysts are based in Sydney and Melbourne, where capital growth in housing has been strongest of late.  Moreover, the recent memory of sharp falls in house prices and the contagion effects across the United States, Europe and China is clearly influencing the RBA's cautious approach.  In seeking to contain the risks of speculative activity in housing, Mr Stevens is clearly wanting to avoid similar policy errors that he believes contributed to the credit boom and bust. 

But the RBA is also keen to contain the costs associated with growing unemployment and under-employment.  In a recent blog post (Beware of bubble talk for now - Part II, April 29th), I show that there is considerable slack in Australia's labour market: the unemployment rate of 6.1% is high amongst a group of developed countries, unemployment has remained above 6% for ten months, the longest stretch since 2003, the duration of unemployment has increased to a decade high, and the participation rate and employment to population remain low, which point to a strong discouraged worker effect.

It is telling that In the latest monetary policy minutes from April, the RBA acknowledges that labour market conditions are likely to remain subdued and that the economy is expected to operate with a degree of spare capacity for some time.  In the minds of the RBA, the more serious policy error at this juncture appears to be keeping policy unchanged.  Against this backdrop, market participants will need to become accustomed to more noise from the RBA and APRA about the use of macro-prudential to contain risks stemming from housing.  In terms of timing, the Board members also saw benefits in waiting for more data, including on inflation.

In the likely event that the central bank cuts the Overnight Cash Rate today to 2%, investors' focus will inevitably shift to what next?  Due the RBA's concerns about housing, I expect that the policy rate will remain on hold for the remainder of the year, because the central bank will want time to assess the impact of the two rate cuts.  My expectation is that the statement accompanying today's decision will therefore likely quell expectations of another rate cut in the near term, which will provide some support to the Australian dollar.

An open letter to Woolworths CEO, Grant O'Brien

Dear Mr O'Brien,

After what has been a difficult period for Woolworths - which has seen the market de-rate the stock following the recent downgrade to FY15 NPAT guidance -  a lot clearly rides on the upcoming investor strategy day on May 6th.  You have drawn attention to subdued trading conditions in Food & Liquor, evident from as early as August last year, and confirmed by the marked slowdown in sales growth in the supermarket and petrol divisions for the latest calendar year (see chart).

You have also highlighted that General Merchandise continues to be affected adversely by the Big W business transformation, hotel earnings have been impacted by the additional Victorian gaming tax, while the expected timing of break-even for the Masters rollout continues to be pushed back.

The market's verdict in the past six months has been unequivocal; the price of Woolworths shares have declined by 10-15%, while the market has risen by around 5%.  Over the sweep of the past four years -  which coincides with your tenure as CEO - the performance of Woolworths shares broadly tracked those of Wesfarmers up until six months ago, at which point your shares have strongly underperformed not just Wesfarmers but also the ASX100 ex-financials and resources (the peer group which is used to benchmark hurdle rates for your senior executives' Long Term Incentives) - see chart.  Unless you can turn around expectations at the strategy day and the remaining two months of the financial year, Woolworths is set to miss the threshold for the Total Shareholder Return hurdle rate for the second year running (but more on remuneration later).

Even against a peer group of large global food & grocery retailers, Woolworths has been amongst the group of stocks that has delivered negative excess returns or alpha in the past four years (see chart).

The significant downgrade to analysts' EPS forecasts that has occurred in recent months largely reflects a re-assessment of Woolworths' ROE prospects.  Analysts are now projecting the company to achieve an ROE of below 22% twelve months ahead, well below the 25% they had projected as recently as in October last year (see chart).  This continues a trend of deteriorating ROE prospects that date back to 2011, when brokers were forecasting Woolworths to deliver an ROE of over 30%.

The deterioration in the marginal ROE from 2011 coincides with the rollout of the Masters Home Improvement stores, to the point where the marginal ROE has recently turned negative (see chart). 

In 2011, the proposed expansion into home improvement would have seemed a sensible strategy.  Wesfarmers had demonstrated an ability to successfully manage hardware stores and supermarkets, while the free cash flows generated from Woolworths supermarkets would effectively fund the roll-out of the Masters stores.

But the expansion into home improvement has clearly pulled down the profitability of the broader group and has distracted your (and other senior executives') attention from Woolworths' core supermarkets business, which has probably contributed to the marked slowdown in sales growth from that segment in the past year.  Moreover, few in 2011 expected investors to develop an insatiable appetite for income, that would see many companies defer or abandon growth options completely to cater to this growing demand for dividends. 

At a time when Australia's corporate sector is undergoing a demerger wave, spinning off non-core business assets, Woolworths has bucked the trend towards corporate focus by expanding organically into home improvement, where the synergies between running supermarkets and hardware stores are questionable (despite Wesfarmers' success in managing Coles and Bunnings). 

Drawing on international evidence, few of the largest globally food & grocery retailers run hardware stores.  Evidente's proprietary index of corporate focus shows that Wesfarmers and Woolworths are among the least focussed food & grocery retailers globally (see chart).  Corporate focus is but one of a number of factors that govern performance; indeed focussed firms like Tesco and Sainsbury have delivered dreadful returns in recent years.  Nonetheless, the missteps associated with the Masters rollout, deterioration in group profitability and ongoing adverse impact of the business transformation of Big W are clearly distracting you and senior management from Woolworths' core supermarket business.

Structure of financial incentives helps to ameliorate agency costs

Having read the Woolworths remuneration report in detail, as well as those of your peers both in Australia and globally, the key hurdle rates contained in the Short Term and Long Term incentives appear to be reasonable.  Contrary to conventional wisdom, I do not believe that the sales targets that form part of the STIs have unduly distorted executives' behaviour to chase sales at the expense of profitability.  Among the STIs, the hurdle rate at the group level is NPAT growth, while the divisional hurdles include not just sales, but also profit, return on funds employed and cost of doing business.

If I was to quibble about the remuneration structure, it would be the gradual lowering of the EPS growth hurdles in recent years that form part of the LTIs, from 10%-15% in F09-F11 to 6%-8%.  But this is not unique to Woolworths; other companies have also lowered their EPS growth hurdles in the face of persistent revenue headwinds in recent years.

license to operate not to be taken for granted

You would no doubt be aware of the Four Corners program (Slaving Away) that went to air on May 5th, which showed damning evidence of exploitation of migrant workers in Australia's fresh food supply chain.  The allegations affect most of Australia's stores that sell fresh produce to the public, including Woolworths, Coles, Aldi, IGA and others.  Four Corners has posted to its website the written responses from each of these businesses, including Woolworths.  Although each of the supermarket chains deals with hundreds, possibly thousands of suppliers, the big supermarket chains need to be careful about managing their reputational risk, particularly as the community and governments have effectively conferred a license to operate to Woolworth, Coles and other supermarkets.  The sheer size of Woolworths and Coles suggest that they have more to gain from leading the charge and ensuring that their suppliers do not engage in worker exploitation.  Thus any detail at the investor strategy day around your proposed pipeline of cost savings in excess of $500 million and expected impact on suppliers will need to be carefully communicated and managed.

corporate focus will be rewarded

I believe that investors will reward Woolworths if at the investor strategy day you articulate a vision and future for the company that has a renewed focus on its core business of supermarkets.  You have previously demonstrated an ability and willingness to sell under-performing non-core businesses such as Dick Smith.  Perhaps your greatest legacy to the company you have worked at since a teenager will be to have the courage to admit to past failures and exit home improvement, while re-assessing the synergies that exist between general merchandise and supermarkets.   

Beware of bubble talk, for now (Part II)

In last week’s blog post, I discussed a wide ranging speech delivered by the RBA Governor in New York on April 21st (The world economy and Australia), in which he acknowledged that corporate Australia’s capital restraint of recent years reflected in part the fact that the cost of capital or hurdle rates used in capital budgeting decisions had remained sticky.  Despite the reduction in rates of return available on safe assets in Australia and globally, there has been an offsetting rise in the expected equity risk premium.  Sovereign bond yields globally have declined to record lows precisely because investors expect to be compensated more for taking on stock risk.

At times in the past year, having bemoaned the absence of entrepreneurial risk taking in Australia and implored businesses to invest for future growth, Mr Glenn Stevens’ comments provide the clearest indication yet that the RBA understands that animal spirits will be dormant for as long as the risk premium remains high.  The central bank's conduct of monetary policy over the course of this extended easing cycle suggests that it continues to under-estimate the power of monetary policy to influence the psychology of risk taking.  I concluded in last week's post that the risk premium would remain high and that multiples on low beta or defensive securities would remain elevated for as long as the capital discipline remains pervasive across corporate Australia.

A recurring question from portfolio managers that I spoke to last week related to the 'when' and 'what'; when will entrepreneurial risk appetite return and what range of indicators represent an accurate barometer of the risk premium?  I believe that the labour market provides fertile ground because new cost discipline has extended to a reluctance by businesses to hire in recent years.  Further, the labour force survey is a higher frequency and more up to date indicator than the capex survey compiled by the Australian Bureau of Statistics. 

The market understands the significance of labour market conditions at least for monetary policy deliberations; the implied probability of a rate cut at the RBA's May board meeting declined to 55% from over 75% immediately following the release of stronger than expected March employment data in mid-April (see chart).

But investors might have been premature in discounting the chances of another rate cut because a range of indicators point to still considerable slack in the labour market.  The persistent weakness in labour market conditions provides compelling evidence that the corporate sector's animal spirits remain dormant.

Record low wages growth

Growth in private sector wages has been moderated for over three years now, and the current annual rate of 2½% represents the slowest pace of growth on record, confirming that demand for labour remains subdued (see chart).

Strong discouraged worker effect, particularly among young people

The participation rate has stabilised at between 64½% and 65% in the past two years, but this remains at its lowest level since 2006 (see chart).  The low participation rate points to weak cyclical conditions which  discourage people from seeking jobs, and also reflects the demographics of ageing because older people typically have low rates of labour force participation.  The decade low level in the ratio of employment to working age population confirms that cyclical weakness in labour market conditions.

The discouraged worker effect seems to have been especially strong among young people (those between the ages of 15 and 24).  The participation rate among young people declined to a record low of 66% in 2014, down from 71% in 2008 (see chart).  Professor Jeff Borland, a labour market economist at the University of Melbourne, draws attention to the fact that the labour market for young people is particularly sensitive to cyclical conditions.  The number of young people looking for work tends to drop sharply during a downturn because hiring rates typically decline and young people account for a disproportionately high share of new hires.  Early signs of a revival in job prospects among young people have emerged in the past six months, although the participation rate of 67% remains low by historical standards.

Downward trend in average hours worked

Total hours worked has continued to grow, assisted by strong population growth, but average hours worked has been roughly stagnant now for two years and remains well below its level in 2006 (see chart).

Hiring intentions remain subdued

Forward looking measures of labour market conditions remain weak.  Both the level of job ads and job vacancies are below 1.3% of the labour force, suggesting that businesses remain cautious in their hiring intentions (see chart). 

Australia's unemployment rate is high by international standards

Australia's unemployment rate has remained above 6% for ten consecutive months, the longest stretch since 2003 (see chart).  In fact, the unemployment rate in Australia of 6.1% remains well above that of the United Kingdom, Japan, United States and New Zealand (see chart).

Unemployment duration continues to grow

People unemployed for more than 52 weeks has climbed to almost one-quarter of the total pool of unemployed, which represents the highest level since inception of the long-term unemployment ratio in 2001 (see chart).

The financial crisis and greater job insecurity

The Westpac/Melbourne Institute survey of unemployment expectations has increased by around 50% in the past four years to a level well above historical norms, confirming that one of the key legacies of the financial crisis is a heighted level of job anxiety (see chart).  Greater job insecurity might help to explain why households are saving the biggest slice of their incomes since the late 1980s and why the much anticipated re-bound in discretionary retail spending is yet to materialise.

THE RENEWED COST DISCPILINE: GOOD NEWS FOR SHAREHOLDERS, BAD NEWS FOR WORKERS

The persistent weakness in labour market conditions and renewed cost discipline are consistent with anecdotal evidence that the ASX200 companies continue to trim costs aggressively.  Hills Industries has announced that it 'continues to accelerate efforts to reduce group overheads and drive further structural efficiencies in its core business' , Woolworths has committed to a pipeline of cost savings in excess of $500m in its Australian Supermarkets division, and Myer has announced a strategic review under the leadership of its new CEO and is no longer proceeding with a store opening originally planned for Greenhills in NSW.

Anaemic revenue conditions continue to shape the corporate environment and the relentless focus on cost discipline.  The chart below illustrates the powerful revenue headwinds that corporate Australia has faced; forecast revenues from the ASX200 companies is at the same level that prevailed four years ago, at the peak of Australia's terms of trade boom.  Listed companies will therefore continue to seek ways to restructure, trim costs, and lift productivity to  boost profitability and cater to investors' insatiable appetite for income.  The fact that CEOs are focussing on the 'internals' or what they can control is a welcome development and a long way from chasing the pipedream of double digit revenue growth common to the credit boom years.

The renewed cost discipline is good news for shareholders but bad news for workers and job seekers.  Those waiting for an improvement in labour market conditions to signal a reduction in the risk premium associated with a revival in animal spirits will need to be patient, particularly as the RBA appears to be more concerned about the growing risks from speculative activity in housing than the costs of rising unemployment and under-employment. 

Beware of bubble talk, for now

In a wide ranging speech delivered overnight in New York, Glenn Stevens, provided more colour on his prior communications in which he has bemoaned the low level of entrepreneurial risk taking across Australia's corporate sector and implored businesses to invest for future growth prospects.

I have long argued that animal spirits remain dormant in Australia (and across most of the developed world) thanks to persistent revenue headwinds and high discount rates that companies are assigning to expected future cash flows for potential new projects.  Moreover, companies continue to cater to investors' insatiable appetite for income by lifting payout ratios.

At first glance, the persistence of a high cost of capital is difficult to reconcile with the risk free rate or yields on sovereign bonds being at record lows.  But Mr Stevens has acknowledged that lower returns on safe assets have not pulled down the cost of capital because there has been an offsetting rise in the equity risk premium.  The RBA Governor argues that the stability of earnings yields in the face of declining long term interest rates implies that the risk premium has lifted, reflecting more risk being assigned to future earnings and/or lower expected growth in future earnings (see chart).  Mr Stevens also highlights anecdotal evidence of stickiness in hurdle rates used by corporate Australia.

I have previously argued that long term interest rates are low precisely because the equity risk premium has shifted up (see the blog post from 26 November 2014 - Low interest rates are here to stay but don't expect stocks to re-rate).  That is, investors have gravitated towards safe assets as they have perceived a still high level of risk in the world.  From a capital budgeting perspective, the risk free rate is low due to factors that are restraining corporate investment: low expected earnings growth and a high expected risk premium.  Consequently, stock multiples should not get an assist from a lower risk free rate given a higher ERP and lower growth prospects.

A behavioural perspective on the risk premium and cost of capital

The common misconception that record low interest rates should be associated with a re-rating of stocks stems from the availability heuristic that is a cornerstone of behavioural finance.  Events that are memorable, directly observable and have a high valency are more likely to resonate with us.  The risk free rate is directly observable on a daily basis, so our familiarity with low long term interest rates informs our mental framing of the cost of capital.  But the equity risk premium is not directly observable, and so we are likely to neglect it as a source of variation in the cost of capital.  Just because the ERP cannot be directly observed, does not mean that it should be ignored.  

In fact, from the perspective of monetary policy, the ERP is a key channel in which a central bank can influence the psychology of risk taking.  If a central bank is seeking to revive animal spirits in the corporate sector, it must do so by reducing the expected equity risk premium (as well as lifting expectations of revenue growth).

If the lift in the risk premium has broadly offset lower returns on safe assets, then the effect on the multiple of the market ought to be neutral.  But this masks important sources of cross variation between high and low beta stocks.  High beta stocks are associated with greater sensitivity of their cost of capital to shifts in the risk premium.  For instance, a lift in the risk premium from 4% to 5% causes a high beta stock's cost of equity to rise by 150 basis points, while the cost of capital for a low beta stock rises by less than 50 basis points (see chart). 

While not shown here, mathematically, the percentage increase in the multiple of a high beta stock exceeds that of a low beta stock in an environment where the risk premium is rising, other things being equal.  Moreover, it is reasonable to think that low beta stocks have experienced a larger compression of their betas in recent years than their high beta counterparts, as investors have assigned lower risk to the future earnings of defensive stocks. 

Indeed, the pattern confirms that the defensive sectors in the Australian market are trading at a premium (based on dividend multiples) to their 10 year median estimates, while cyclical sectors are trading at or below their historical medians (see chart).  While lower expected earnings growth has contributed to this trend, we believe that the higher equity risk premium has played an important role in driving a wedge in the multiples between high and low beta stocks.

Beware of bubble talk, for now

It might be tempting to think that either defensive stocks or high yielding stocks with strong and sustainable sources of competitive advantage are exhibiting bubble like valuations.  But shifts in the risk premium and cost of capital matter for portfolio construction, and our analysis suggests that they have contributed to the relative rise in valuations for low beta or defensive stocks.  I expect those high valuations to persist while the corporate sector's animal spirits remain dormant.  The unwinding of the defensive trade will eventually happen abruptly, but that remains way off as long as output remains below potential, there is deficient aggregate demand, unemployment is well above the natural rate, and inflation remains subdued.

Who's Afraid of Deflation?

Concerns about deflation - the phenomenon of falling prices of goods and services - in the wake of the financial crisis, have provided the intellectual cornerstone for central banks around the world - led by the Federal Reserve - to embrace unconventional policy measures, notably forward guidance and large scale asset purchases or quantitative easing.

The deflation aversion has greatly influenced policymakers in the United States, thanks to the legacy of the Great Depression and the fact that the former Governor of the Federal Reserve, Ben Bernanke, remains a leading authority on this episode.  Most economic historians attribute the depth and long duration of the Great Depression to excessively tight monetary policy pursued by the newly formed Federal Reserve at the time.  More recently, central bankers have also been keen to avoid the decade long deflation that has afflicted Japan.

The Bank of International Settlements has recently examined the historical record of deflation and output growth (The costs of deflation: A historical perspective).  The analysis is based on a newly developed dataset of 38 economies covering 140 years.  Their key findings are as follows.

1. There is only a very weak link between deflation of goods and services and growth in output.  On face value, the finding suggests that deflation is not particularly costly.

2. There is a stronger link between asset price deflations - particularly falling property prices - and output growth.

3. The modern day pre-occupation with deflation stems from the Great Depression, where deflation was associated with significant output losses.

4. Japan's deflation in recent decades might reflect the rapid ageing of the country's population.  When controlling for the demographics of ageing, Japan's economic performance has been comparable to the United States since the turn of the century. 

5. The BIS study concludes that policy makers should not necessarily be afraid of deflation in goods and services, but should be vigilant in monitoring and responding to asset price deflation, particularly persistent declines in property prices.

Based on a simple demand-supply framework, it is self-evident that not all deflationary episodes are pernicious.  Falling prices of goods and services can reflect a demand shock, a supply shock or a combination of the two.  The diagram below show that bad deflation is associated with lower demand (ie. lower prices and output), while good deflation is associated with a positive supply shock (ie. lower prices and higher output).  Bad deflation is contractionary while good deflation is expansionary.  This framework downplays the causal role of deflation; rather, it interprets deflationary episodes as symptomatic of unexpected shifts in demand and supply.

A positive supply side shock might reflects factors which lift a country's productivity growth or supply of inputs, such as innovation, technological change and permanent tax cuts which induce greater workforce participation.  The results of the BIS study - that goods and services deflation does not appear to be costly on average over the sweep of the past 140 years - suggests that positive supply side shocks have played an important role in underpinning deflationary episodes in the past. 

With the exception of Japan, few countries have experienced persistent deflation in recent decades.  But many countries have undergone a period of disinflation in goods and services - a moderation in the rate of price growth - since the financial crisis.  During this time, prices of goods and services in advanced economies have expanded at a compound annual rate of well below 2% compared to growth of 2-3% during the credit boom (see chart). 

The Great Disinflation - A Demand Contraction

The fact that growth in real GDP has also slowed markedly since the financial crisis confirms that a contraction in demand has underpinned the Great Disinflation.  Moreover, house prices remain below their prior peak in the United States and many advanced economies which offers compelling evidence of an adverse and persistent demand shock (see chart).  The finding of the BIS study that property price deflations have historically been associated with significantly weaker output growth probably reflects the fact that lower house prices undermine aggregate demand by reducing wealth and collateral values.  Thus falling house prices combined with deflation or disinflation of goods and services represents a clear signal of an adverse demand shock that central banks should remain vigilant towards.

Contrary to the conclusions of the BIS study, I am sceptical that Japan's rapidly ageing population has caused or contributed to its persistent deflation in recent decades.  It is widely accepted that ageing is associated with a negative demand shock which other things being equal, should be deflationary.  But a smaller working age population is also associated with a contraction in supply, which should be inflationary.  In my view, Japan's deflation stems from a shortfall in aggregate demand related to the tight stance of monetary policy (up until recently) and an unwillingness of successive governments to let zombie banks die.  The more aggressive stimulus adopted by the Bank of Japan under its new Governor is therefore a welcome development.

Revival of animal spirits crucial to the outlook

Central banks have been justified in resorting to unconventional policy measures to address growing deflationary risks associated with the shortfall in aggregate demand since the financial crisis.  The series of synchronised policy easings by many of the world's central banks through January and February should be viewed through this prism.  For too long since the financial crisis, some central bankers and many commentators have under-estimated the power of monetary policy.  Even if the equilibrium global interest rate has declined - as argued by Ben Bernanke in his recent blog post - monetary policy still has an important role to play in boosting the psychology of risk taking in the corporate and household sectors.  

US employment growth moderates, buying the Fed and growth investors more time

The March non-farm payrolls release confirmed that employment in the United States continues to expand but at a more moderate pace over the past three months.  The US economy added a net 600k jobs in the March quarter down from 970k jobs in the December quarter (see chart). The unemployment rate remained steady at 5.5%, well below it peak of 10% and its lowest level in six years. 

The decline in the labour force participation rate - the percentage of the civilian population either in employment or actively looking for work - from a peak of over 66% in 2007 to its current level of  63% - has assisted the fall in the unemployment rate.   An understanding of the mechanics of the unemployment rate helps to shed light on how lower workforce participation has contributed to a lower unemployment rate (see graphic). 

Assuming a participation rate  of 66% - the average of the credit boom - translates into a counterfactual unemployment rate of over 10%.  Of course, this scenario assumes that total employment remains unchanged from its current level of 148.3 million, which is unrealistic because greater labour force participation would be associated with stronger labour market conditions and higher employment.  This does not invalidate the counterfactual exercise, but does highlight just how sensitive the unemployment rate is to changes in the participation rate.

How much of the post-2007 decline in the participation rate is structural is important to gauge the amount of slack in the US labour market and the future course of monetary policy.  The ageing of the baby boom generation has helped to underpin lower workforce participation, because older people have lower participation rates than prime age workers (see chart).  A recently published IMF study suggests that at least half of the three percentage rise in the participation rate post-2007 is irreversible, thanks mainly to the demographics of ageing.  

A participation rate of 64.5% for instance, produces an unemployment rate of 8%, providing further evidence that there is plenty more labour market slack than implied by the current unemployment rate of 5.5% and sheds light on why US inflation pressures remain dormant despite the decline in the unemployment rate.  The Phillips curve, which formalises the short-run inverse relationship between inflation and unemployment, has flattened considerably since the financial crisis, and confirms that core inflation has become less responsive to changes in the unemployment rate (see chart).

The flatter slope reflects 1) the fact that the unemployment rate has become a less reliable barometer for labour market conditions due to structurally lower labour force participation; and 2) inflation expectations remain well anchored.  The flatter Phillips curve suggests that further cyclical improvement in the labour market might not lead to inflation moving back towards the Federal Reserve's 2% objective, giving the central bank scope to remain patient in it approach to normalising monetary policy. 

In fact, since mid-2011, the core CPI has decelerated to an annualised rate of 1.5%, well below the Fed's target and down from 2.8% at a time when the unemployment rate has declined by over three percentage points (see chart).  So much for the prevailing conventional wisdom that the large pool of long-term unemployed would give rise to inflationary pressures at high rates of unemployment due to hysteresis effects (ie. de-skilling).

Discount rate shocks: A key risk for growth investors

Deliberations of the Federal Open Market Committee about the much anticipated timing of lift-off of the Federal Funds rate might seem far removed from the day to day decisions and portfolio returns of growth investors.  But an analysis of the performance of stocks around the taper 'tantrum' in May 2013 reveals the sensitivity of premium rated growth stocks to the future course of monetary policy.  In his testimony to Congress on 22 May 2013, Ben Bernanke flagged that he expected the Fed to start to slow or taper the pace of bond buying later in the year, conditional on continuing good economic news.  Yields on 10-year Australian Commonwealth Government Securities jumped by around 20 basis points and the ASX200 fell by 5% during that week.

The chart below reveals that premium rated growth stocks were among the worst performing stocks in the ASX200.  In fact, the four stocks that yielded the lowest returns were all high PE, high growth stocks: CTD, DMP, IIN and REA.  Many of these and the other premium rated growth stocks in the list are low beta or defensive, so the strong under-performance probably reflects the long duration attributes of high growth stocks.  The taper tantrum highlights that the implied discount rates that investors apply to the expected future cash flow of these stocks are clearly vulnerable to any sudden and unexpected increases in the risk free rate. 

Since the taper tantrum, Australian 10 year government bond yields have declined by around 100 basis points to 2.3%.  The associated fall in expectations of the risk free rate has probably been a tailwind in the out-performance of premium rated growth stocks; the list of stocks in the chart above have produced a median return of 44% since then, well above the ASX200 (30%). 

Good news for growth investors (for now)

The lesson for growth investors is that discount rate shocks represent a key risk for their portfolio performance because of the long duration attributes of growth stocks.  But the good news is this; the recent moderation of US employment growth, still considerable slack in the US labour market, and little prospect that core inflation will move back to the Fed Reserve's 2% objective anytime soon, should buy more time for not just the Fed but also growth investors.

Taxing Times

The Government release of Re:think, its tax discussion paper, is a welcome development, designed to kick-start the conversation with the community on a range of reform options designed to achieve a simpler and streamlined tax system capable of meeting the growing needs of an ageing population. 

In this post, I discuss some of the areas raised in Re:think which are of greatest interest to equity investors: how important income and consumption taxes are to Australia's tax take in a global context, the prospect of the growing drag from bracket creep on household disposable incomes (discretionary retailers), the outlook for the GST (supermarket retailers), the efficacy and viability of the dividend imputation system (high yielders with predominantly domestically oriented operations), the sustainability of the concessional tax treatment of superannuation (asset managers), and the risk associated with companies that have low effective tax rates.

The great divergence

Although Re-think does not consider the outlook for government spending, the conversation about the viability of Australia's tax system cannot be disentangled from trends in expenditures.  After growing in line with government outlays during the credit boom, tax revenue dropped sharply during the financial crisis and although it has recovered since then, it hasn't kept up with the path of government spending (see chart). 

Australia's ageing population will make it increasingly difficult for governments to reduce the growth in their spending.  The burden will thus fall on governments to reform the tax system to reduce its sensitivity to the economic cycle so that downturns are not associated with a large and persistent divergence between spending and tax revenue.  The federal Government collects around 80% of Australia's total tax revenue, mainly from taxes levied on individuals and companies, while state and territory governments collect 15% of tax revenue, largely through payroll taxes and stamp duties (see chart).

Australia's aggregate tax burden - 27% of GDP - is low by the standards of other developed economies, which reflects the overall size of government and the fact that Australia is one of the few countries that does not levy specific social security taxes.  Much of the media reaction to Re:think has been around Australia's excessive reliance on corporate and personal income tax, and what this might mean for the politically sensitive Australia's Goods & Services Tax.  Income tax levied on individuals accounts for 40% of total tax revenue and corporate taxes account for another 20%.  The combined contribution from these two sources is second only to Denmark (see chart). 

But the heavy reliance on corporate and personal income tax reflects Australia's low consumption tax take and the  fact that Australia does not levy a social security tax.  Social security contributions across the OECD represent a significant source of revenue, accounting for one quarter of tax revenue in developed countries.   Australia's consumption taxes generate around 27% of total tax revenue, below the OECD average of 32% (see chart).

The GST - Politically Hot Potato

The GST is Australia's main consumption tax which applies a rate of 10% to a range of goods and services. The rate is around half of the OECD average and the base is narrow, applying to only 47 of the consumption basket (see chart). 

The GST base has narrowed over time because Australians are increasingly spending a bigger slice of their budgets on health and education that are exempt from the GST (see chart).  Going forward, Australia's ageing population will likely further reduce the GST base.  Fresh food is also GST exempt.  Any efforts to broaden the base to capture fresh food would clearly have negative implications for food retailers Woolworths and Wesfarmers, although the effect on profitability would be partly ameliorated by government efforts to compensate low income earners.

But Re:think acknowledges that GST reform is a politically hot potato.  The Commonwealth Government collects the GST on behalf of the states and territories and all the revenue raised by the GST is provided to the states and territories.  Thus any change to the rate or base would require unanimous support of the state and territory governments.  Comments from the Prime Minister and Treasurer today confirm that any efforts to reform the GST would also be conditional on broad political consensus for change.  If the Shadow Treasurer's - Chris Bowen's - comments on the 730 Report tonight are any guide, support from the ALP is not forthcoming at this time (nor any time soon).

Bracket creep - A drag on discretionary retailers

Australia's tax system is progressive because higher marginal tax rates are levied at higher income levels.  Because the tax or income thresholds are not indexed, they remain fixed and do not keep up with inflation or wages.  So over time, income earners will find that they face higher marginal tax rates as their salaries grow beyond the tax thresholds.  This effectively leads to bracket creep which erodes the value of tax cuts.  At present, the second highest marginal rate of 37% is levied at gross incomes of $80,000 pa, while the top marginal rate of 45% applies to gross incomes above $180,000. 

Currently, average full time weekly earnings is around $75,000 which is associated with a marginal rate of 32.5% for each dollar earned above $37,000.  Based on the government's estimates, a full time employee is projected to move into the second highest tax bracket of 37% by 2016-17 (see chart).  In the absence of cuts to marginal rates or adjustments to income tax thresholds, bracket creep promises to be a drag on discretionary spending at a time when profitability for the discretionary retailers is little changed from a decade ago.

Target - Savings in superannuation?

Among saving vehicles, bank deposits attract the highest marginal tax rate followed next by foreign shares and property, while superannuation attracts the lowest tax rate because contributions are taxed at a flat concessional rate of 15% out of pre-tax income (see chart).  The flat concessional rate, when combined with the progressive income tax system, produces regressive outcomes.  That is, high income earners effectively receive the largest tax benefit from the superannuation system.  The discussion paper acknowledges the problems of distribution and fairness that the superannuation system gives rise to.

Thanks to the growing concerns of rising income inequality across many developed countries - including Australia - there is a growing risk that the tax breaks that Australia's superannuation system offers the wealthy will increasingly come under intense scrutiny, particularly from a government with little philosophical attachment to a system of forced saving.  While such changes would carry negative implications for Australian based asset managers, ironically they would be expected to be met with stiff opposition from the ALP, which was the party that launched superannuation in the early 1990s. 

But any measures designed to reduce the size and scope of superannuation tax concessions accruing to high earners and the wealthy would likely garner support from the cross benchers in the Senate.  Stocks that would be most adversely impacted are the pure play asset managers (BTT, MFG, PPT, PMC) and the major banks, all of which have significant wealth management operations.

Dividend imputation - Not in the firing line thanks to an ageing population

Any proposed changes to Australia's dividend imputation system is likely to arouse interest amongst institutional investors, particularly at a time when high yielding stocks with defensive cash flows have delivered strong performance for over three consecutive years.  The discussion paper draws attention to the costs to tax revenue associated with a full imputation system, which Australia has had in place since 1987.

But Re:think also addresses some of the key advantages of imputation.  First, it ensures that there is no double taxation of income earned by Australian shares owned by Australian resident shareholders.  Second, it supports the integrity of the business tax system because imputation does not encourage Australian companies to avoid tax; tax avoidance by Australian companies reduces their ability to pay unfranked dividends.  Third, imputation imposes an important source of discipline on CEOs since it encourages companies to pay out dividends rather than retain profits and discourages forays offshore, which have tended to be value destructive on balance over the sweep of the past three decades. 

Given the demographics of ageing, I doubt that this or any future government will tamper with the tax treatment of corporate payout that effectively encourages companies to cater to the growing influence of those approaching retirement age, and their preference for dividends over capital growth.

Regulatory risk surrounding corporate income tax set to grow

Corporate income tax is levied at a rate of 30% on all taxable income earned by companies, which is higher than the OECD average of 25% (see chart).  Re:think discusses the mobility of capital and the fact that Australia's relatively high corporate tax rate potentially deters foreign investment in Australia.

Despite the high corporate tax rate, Australian resident shareholders effectively pay a lower tax rate on their dividends than other country shareholders thanks to imputation.  Moreover, it is not entirely clear just how much of a deterrant to foreign investment is associated with Australia's high corporate tax rate.  After all, the corporate tax rate levied in the United States is amongst the highest in the OECD at close to 40%.

Indeed, there is a case for lifting the corporate tax rate.  First, after peaking at a record high of 25% during the credit boom, the corporate tax take as a share of economy wide profits has fallen to 17.5%, below its long run median (see chart).  Second, the mining boom saw a reduction in effective tax rates due to the growing depreciation and amortisation expenses associated with the construction of mining and LNG projects.  The size of this effect is already diminishing however, as mining and energy companies have increasingly deferred or permanently shelved new investment projects.  Third, the politics of growing income inequality across most developed countries - which has found a credible voice in French economist Thomas Piketty - means that a lift in the corporate tax rate is politically more feasible than other alternatives. 

Beyond a lift in the corporate tax rate, a number of companies with low effective tax rates would be exposed to measures that seek to raise the corporate tax burden, including: CGF, FXJ, QBE, COH, IPL, SEK and CSR (a full list of exposed stocks is available on request).  Infrastructure companies - some of which receive a net tax benefit due to their large depreciation and amortisation charges - should be insulated because governments are unlikely to implement reforms that discourage infrastructure investment. 

The yield trade and the RBA's easing bias: More than meets the eye

The RBA confounded market expectations and left the overnight cash rate (OCR) unchanged at 2.25% at the March meeting, but adopted an explicit easing bias which would have appeased the market somewhat.  Its reluctance to cut rates in consecutive meetings stems from its desire to have more time to assess the impact of its decision to ease policy in February. 

Clearly, it wasn't persuaded to cut again by the unambiguously weak data flow since the February meeting, including the labour force survey and capital spending intentions.

In previous posts (notably, 17th December 2014, Money's Too Tight Too Mention) I suggested that February and May represented the most likely months for policy easing because in an interview in mid-December to the Fairfax press, Glenn Stevens laid the groundwork for lower rates based on a positive narrative.  He was keen to ensure that the markets would not interpret a shift to ease policy as reflecting weak demand, at a time when business and consumer sentiment were still fragile.  A reading of the interview suggested that the slide in oil prices and low inflation would form an integral part of the RBA's positive narrative.

The case for further policy easing has been compelling for some time.  The RBA's patience with the non-mining business sector has been wearing thin for a while.  Through 2014, the RBA implored businesses to invest for growth rather than remain fixated on their costs and internals.  The new normal of capital and cost discipline embraced across the corporate sector has dampened capital spending, to the point where now that the ratio of capex to assets has declined to 1.75%, well below the historical median of 2.2% (see chart).  

The RBA had clearly under-estimated the pervasiveness of this newly entrenched discipline.  Persistent revenue headwinds, a loss of trust in ability of CEOs  to undertake value accretive investments and acquisitions, and investors' insatiable appetite for income has meant that companies increasingly are focussing on trimming operating costs, deferring capex and restructuring to boost profitability.  CEOs with a track record of acquisition led growth no longer command a premium in the market for managerial talent. 

The Agency Costs of Free Cash Flow Have Fallen Considerably

It is a welcome development for shareholders that CEOs are now focussing on what they can control  rather than chasing the pipedream of double digit revenue growth.  Shareholders are exerting a tremendous discipline on companies to return surplus cash flow and in so doing, the agency costs of free cash flow have fallen considerably.  The interim reporting season confirmed that companies continue to lift payout ratios where feasible and more are undertaking buybacks.

But the flipside of the new normal of capital and cost discipline has been sluggish growth.  The economy has effectively been stuck in a nominal recession for three years now, coinciding with the negative terms of trade shock.  The December quarter National Accounts due for release today should confirm that the terms of trade has declined by over 30% from its 2011 peak and that the nominal economy has expanded by less than 4%pa over this time, representing the weakest period of growth since the deep recession of the early 1990s. 

Inflation does not represent an obstacle to lower interest rates.  Growth in unit labour costs - productivity adjusted wages growth - remains weak, private sector nominal wages are growing at their slowest rate on record, there is little sign that the depreciation of the Australian dollar has flowed through to higher prices of tradeable goods, inflation expectations are well anchored, the slide in oil prices pose a downside risk to headline inflation, and there is still considerable slack in the labour market .

Contrary to the RBA's view, it is the role of monetary policy to revive animal spirits, which have been dormant for three years now.  Also contrary to recent statements from Mr Stevens, policy easing at lower interest rates can be just as effective at boosting expectations of growth as policy easing at higher rates.   To the best of my knowledge, there is no theoretical support for the assertion that monetary policy is less potent at lower interest rates.  Further, the large scale asset purchases and forward guidance adopted by the US Federal Reserve, Bank of Japan and other central banks since the financial crisis offers ample evidence that the zero lower bound does not render monetary policy impotent.  Mr Stevens continues to under-estimate the power of monetary policy to revive growth and reduce unemployment.

The Yield Trade: More Than Meets the Eye

Many will interpret the RBA's adoption of an explicit easing bias as a harbinger for further out-performance of high yielding stocks.  At a time when term deposit rates continue to fall, the lure of high yielding stocks - particularly those accompanied by high levels of franking - is compelling.  But on closer inspection, high yielders have endured a period of under-performance in recent years.  Since the end of 2013, the low yielders have delivered an average portfolio return of 24%, well above the ASX200 (16%) and the highest yielding stocks (6%) - see chart.

Valuation theory sheds some light on the poor performance of high yielders at a time when interest rates have declined.  A stock's dividend yield equals the expected discount rate (k) minus expected dividend growth  into perpetuity (g).  Holding g constant, valuation theory says that high yielders ought to be associated with higher risk and higher betas than low yielders.  It so happens that risk assets have fared worse than safe assets in recent years, at a time when investors have eschewed risk from their portfolios; emerging market equities for instance have underperformed and sovereign bond yields around the world have declined to record lows.  Thus, the shift towards safe assets has undermined the performance of high yielders.

Aside from what valuation theory says about the riskiness of high yielders, the pattern of price performance also suggests that investors perceive these stocks as riskier.  The average price performance over the past six months among the high yielders is -11%, well below the low yielders (+1%).  For investors seeking to invest in high yielding stocks with strong price momentum outside of the banks, utilities and REITs, only three candidates meet these criteria: CCL, IFL and JBH.  In a forthcoming report, Evidente will showcase a systematic approach for investors to measure and identify stocks with sustainably high yields.

Tame inflation data and the bond market signal that the yield trade is yet to run its course

As with most macroeconomic releases, there was something for everyone in today’s December quarter CPI.  For the doves, the precipitous fall in petrol prices has pulled down the headline CPI which is around 1.6% higher than a year ago.  For the hawks, the various measures of core or underlying inflation came in stronger than expected, growing by 0.66% in the quarter.  Nonetheless, on a year on year basis, they remain close to the bottom end of the Reserve Bank’s inflation target range of 2-3%.

For the hawks, the inflation data might not offer a compelling reason for the central bank to cut interest rates.  Unlike many other advanced economies, core inflation has not undershot the bank’s inflation target and the fall in the $A/$US cross rate will lead to inflationary pressures in tradeables in coming quarters.  The hawks would also point to concerns that the RBA Governor has expressed about further stimulus stoking speculative activity in housing.

For doves, such as Evidente, the inflation data does not pose an obstacle to further policy easing for an economy that has been stuck in a nominal recession since 2011.  Animal spirits remain dormant and labour market conditions continue to deteriorate.  Record low growth in private sector wages and households’ heightened concerns surrounding job security – which have lifted by 50% in the past three years - point to considerable slack in the labour market (see chart).

Valuations of the yield trade are not exactly stretched

The yield trade has delivered stellar returns for quite some time now.  A portfolio of high yielding stocks with strong earnings predictability or stability has produced a compound annual return of 23% in the past three years, well above the ASX200 return of 15%.  Investors who have been on the right side of the trade are understandably anxious about the prospect that it unwinds against the backdrop of a cyclical re-bound.

But my quantitative analysis suggests that valuations of the yield trade are far from stretched.  The basket is trading on a PE of 15 based on 12 month forecast earnings, which represents a 3% premium to the ASX200.  But at times over the past three years, the basket has traded at significantly higher premiums (see chart).

Record low bond yields are not a harbinger for a cyclical re-bound

Investors concerned about the prospect of a strong cyclical re-bound would be well advised to interpret what the bond market is telling us.  10 year government bond yields have fallen recently to close to a record low of 3%.  This is the lowest level since mid-2012, a period which coincided with the RBA embarking on a series of rate cuts (see chart).  Clearly, bond investors are not pinning their hopes of a strong cyclical rebound anytime soon, nor are they expecting a resurgence in inflation.

The clock ticks on the global yield trade

Given the ECB’s announcement last week to expand and extend its program of large scale asset purchases, the world’s three major central banks are now aligned in their determination to address the shortfall in aggregate demand, reduce the slack in their labour markets, and boost expectations of inflation and nominal GDP.  The clock is therefore ticking on the global yield trade.  But it will be a while before the synchronised actions from the world’s major central banks successfully revive the dormant animal spirits in the corporate and household sectors.

Key action point: For Australia, the tame CPI print, record low bond yields and the fact that valuations of high yielding stocks with strong earnings stability are not stretched, suggest that the yield trade has yet to run its course.