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Tuesday, May 31, 2005

ValueRant: Colours to the Mast...

Note - from June 24th 2009, this blog has migrated from Blogger to a self-hosted version. Click here to go straight there.

I've often been accused of bias against News Corp (or New Corpse, as I prefer), but I seriously don't think the charge can be sustained. Besides, it's not like it makes a damn bit of difference... thankfully there's no hint of any bias the other way (i.e., against me stemming from New Corpse) - otherwise I would be in Gitmo. One of the primary pleasures of being insignificant is that your blatherings are ignored by people who could do you genuine harm if they felt like it.

I've been 'down' on NCP (now NWS) as an investment since NCP was in the mid-20's (equivalent to NWS at about $45), purely on the basis that it is a shell. Any fool can build a megabusiness by acquiring revenue streams for $1.20-$5 per dollar; that's "anti-Buffettology", and Warwick Fairfax showed that eventually your luck runs out. Thus far, Murdoch's luck has held, but that doesn't make him a good manager.

Think back to when that little Texas bank funded that famous 'lifeline' debt renewal; if that bank had been within its legally-mandated reserve requirements, there would be no such thing as News Corp today. The names Rupert Murdoch would join Warwick Fairfax, Alan Bond, Laurie Connell, George Herscu, Christopher Skase, Rodney Adler and Jodee Rich in the list of mug punters who went to the well once too often. Imagine - the guy who gets the most fawning coverage on earth would be vying for the title of the country's most spectacular business failure. So I'm prepared to give the guy credit for luck... but not for anything else (he's done little else since then, except dig faster).

Anyhow - that's by way of preamble. It's meant to help explain why I exclude News Corp from every market-wide analysis that I do. As far as I'm concerned, it's so laden with difficulties that it's not part of what I consider the 'investable universe', although I did say at one stage that NCP was worth $7.04 (it got as low as $8). With Fox News ratings having halved in the last 6 months, even $7.04 might prove embarrassingly optimistic.

OK - on to the main show. Why I think the Australian market is primed for a significant slide (or at the very least, why it will provide sub-standard returns over the next 20 years - a time when the Government requires it to provide supernormal returns in order to fund all the Superannuants from the demographic hump currently in the 55-60 age range).

First, Some Background

The crux of the issue is the slide of the 'investment community' towards the Dark Side - that is where people buy stocks (and latterly, property) on the basis that there will be a bigger idiot later on who will buy it off them for higher prices.

{Sorry for the Star Wars reference - like NCP, it is the most overhyped, unsubtle and epistemologically empty set of tripe since the New Testament. Lots of neat CGI in the 'first' three, and they're watchable... but sheesh, enough already.}

Still, the Dark Side metaphor is apt here; the herd always has less difficulty buying stocks on momentum rather than for any embedded value. The herd is a comfortable place to be. You see the same behaviours everywhere - women are far more likely to en-blonden their hair colour than to 'go dark'; short men drive big cars; politicians 'emote' over any corpse they can get their hands on. Everyone is prepared to swim with the current (and retire on a diet of Snappy Tom and Pal).

Swimming against the current is psychologically gruelling for a while - but once you get used to it; it's a snap. Ask George Soros, Marc Faber or Warren Buffett. Swimming upstream in the investment world reaps huge dividends.

And dividends is the entire point. (Neat segué, don't you think?).

You will often have heard the sell-side crapola about how stocks are the highest-returning asset class 'over the long run'. What is seldom disclosed is that about 65% of the much-touted 'long run' return on stocks is derived from dividends, and reinvestment of those dividends.

When dividend yields are high (i.e., stock valuations are low) the herd is scared of stocks. When dividend yields are low, stocks have been charging like a herd of Wildebeest, and the herd thinks that greener pastures lie ahead. That's why the herd's retirement diet includes a lot of 'plain brand' stuff (plus the aforementioned dogfood). They get their hopes conflated with investment rationality - and that is encouraged by government and 'the Street'.

Listed equities are (by and large) shares in companies that have already done most of their expansion-phase growing. Risk is higher in the expansion stage, but returns more than compensate (venture capitalism is like options trading - if one in five ideas gets traction, the venture capitalist gets rich). Companies are listed as a way for venture -capitalists to exit a venture - and also as a much lower-cost way of raising capital when compared to debt. Companies do not become listed in order to do the pubic a favour.

The 'mature company' hypothesis is the primary reason that earnings growth for listed equity should not be expected to exceed GDP growth (except perhaps in the first quarter out of a trough); most of the genuinely dynamic growth in mid-expansion happens in unlisted equity.

So, think of a world in which everything is 'about average' for the post-1929 situation. Earnings are growing at about the same rate as GDP (6%-7% nominal at best over any significant period of time), and yields are about 5%. Those numbers, you might take note, are roughly the average.

In such a case, reinvesting dividends works like magic: without any growth in price-earnings multiples (i.e., where stock prices increase exactly in line with retained earnings), in Year 10 you have $1.65 per $1 initial investment... which works out to a 5.8% annualised rate of return... almost 20% higher than the initial dividend rate. In a world where there's underlying inflation (as a result of the sort of monetary mismanagement we've endured since WW1) this virtually ensures a rising real portfolio value... but notice you don't get to take any money out.

It's possible to alter those outcomes - by altering the rate of growth of the company's earnings, by altering the payout ratio, by assuming some discount for dividend reinvestment... that's just called sensitivity analysis and any good analyst will do precisely that and will report the sensitivity of valuations to changes in assumptions. I'm not doing that here, because it doesn't change anything - whatever assumption you make to try and 'sass up' the outcomes, there's always a second-round effect on the broader economy that undermines the result.

But the underlying reality is that for long-term investment, the return on investment is critically dependent on the ability of the investee company to generate cash flow to the investor, and the ability of the investor to re-invest that cash sensibly. That's the only way to generate portfolio returns that don't rely on 'multiple expansion''.

Multiple expansion is shorthand for saying that some other investor will be prepared to pay more per dollar's worth of cash flow at the end of your investment horizon, than you were prepared to pay at the start of your planning horizon. In short, you're relying on someone dumber than you.

A lot of the time, people think of the 'multiple' as being the price-earnings ratio. In times where dividend payout ratios are stable, the PE can be a useful tool, because there's an implicit shorthand relationship between dividends and earnings - namely, that future dividends will just be a fairly-constant proportion of (growing) future earnings.

But here's the problem; when payout ratios are declining, the nexus between earnings and dividends is broken. Earnings growth does not translate into increased flows of cash to investors. That's why it's best to focus on dividend yield rather than earnings yield... plus, a company can't fudge its dividends for more than a year or so, whereas 'one off' expenses seem to help explain any slowdown in earnings growth - year in. year out.

There can be sensible reasons for a decline in so-called 'free cash flows to equity' - an increased retention of earnings to fund a capital expansion, for example. In such a case, investors would rationally require that the rate of return on the capital expansion should exceed the company's existing returns on capital (because otherwise the company should distribute the dividends and give shareholders the option of reinvesting in the stock). They should also expect that any reduction in the payout ratio would be temporary.

OK - that forms pretty much the 'bedrock' of any sensible investment methodology. Now let's see what has actually happened. In what follows I will try to be careful about what was known at each point in time - I'll be assuming, for example, that earnings as at December 2002 were not known until March 2003 at the earliest.

Then, Some Data...

Since the end of 2002 (which coincides - roughly - with the recent 5-year low in the major ASX indices), aggregate earnings on the ASX20 ex NCP - the biggest stocks in the market, excluding the bloated New Corpse - have grown at about 23% annualised. That's just nifty.

What about dividends? Well, you might be surprised to know that the dividend yield on the index has fallen from 4.28% to 2.16% - which translates to a fall in aggregate dividends (i.e., the actual total of dollars paid out in dividends) of 68%. The payout ratio has declined from 69% (arguably, a little too high) to just under 36%.

So, free cash distributed to equity has declined substantially; if that retention of distributable cash was justified, you would expect the earnings yield to be rising (indicating that the retained earnings were being deployed in activities that had a higher realised return than they would have had if they were distributed).

Thanks for playing, but the answer is 'nuh-uh'.

As far as the 'crudest' form of earnings yield is concerned, the market has actually gone backwards - the earnings per dollar of market cap (the inverse of the PE) has decreased by 3% in that time. You might argue that such a slight decline is 'just noise'.

But bear in mind that any number that's not a significant increase in profits per dollar deployed, is bad. Managements are retaining more dollars in retained profits as time passes. Also, it makes sense to try to adjust for the increased leverage being deployed: debt has increased slower than equity, but it has still increased. Equity has increased as a result of retained profits, and debt has also increased - a double increase in funds employed. The actual marginal return on funds employed - the profit per share in addition to what would have been realised with no additional leverage and only 'normal' rates of profit-retention - is negative.

Note: since NCP made a massive loss in the latter half of 2002 as a result of stupid foreseeable idiotic acquisitions at the height of the dotcom/media bubble, excluding their management serves to bias earnings growth downward. BUT... that is more than made up for by the reduction in the initial price-earnings ratio and increase in the starting dividend yield.

So while the market capitalisation of the 'Top20 ex NCP" has grown by about 35%, cash returns to investors have been heading in exactly the opposite direction. In fact since the start of 1998, dividends on the Top 20 have grown by only 14% in total, whereas marketcap has grown by nearly 83%. For those who can do the sums, that's about a 70% decline in dividend yield in about 7 years.

These metrics are based on the ASX20 ex NCP/NWS, but the same logic (and the quantitative changes) applies to wider indices as well. The investment merit of the market as whole is poor. On a longer-term basis, the market (as measured by the indices) is not the place to have your money - which in turn means that the major fund managers are to be avoided like the plague since their portfolio size makes them de facto indexers.

There will always be listed companies which have investment merit of their own - there is always a place for selective investment in common stocks. Over the next 5 years or so, however, it's likely that selective investment will produce sub-standard returns unless market risk is hedged away when the speculative merit turns sour (i.e., even good companies will get dragged down by revaluation momentum).

And Finally, Some Wiggles and Squiggles...

Not the Wiggles (gack!), nor Mr Squiggle ("It's upside-down, Miss Jane").

It's all very well to understand that the valuation metrics for the market are squishy at best - they reflect a market which has morphed from a means of purchasing discounted free cash flows, to something indistinguishable from the TAB. The investment merit argument has lost a great deal of steam.

That still doesn't give us much idea of timing (but it certainly does indicate that you should only be 'long beta' when the market is significantly short-term oversold). In the absence of investment merit, a market may still have speculative merit.

There's been a bit of a sea-change in the use of technical analysis in the last few years. Previously, folks who considered themselves "analytical' would scoff at those who tried to divine the future through the examination of wiggly lines. I remember sitting in the West End Caf' at Monash, guffawing at something or other we had read in a magazine, feeling smug and educated and being supercilious towards trading in general and technical analysis in particular. "Mug Punters...", we thought, armed only with honours degrees and the ability to do algebra. "Charting ... what a con." Everyone was an idiot except us (that goes without saying).

But really, there was a lot of implicit technical analysis that went on already; people would think a company was good value, but had 'run a bit far'. Stocks that were declining - but obviously not going out of business based on a fundamental reading of the company - were considered to have 'fallen as far as they're likely to".

Add to that, the fact that the moment you dig into the finance literature, you discover that stock analysts as a group have always significantly overestimated future earnings growth (by 30% on average since 1992). Since you can't buy the past at a discount, analysts as a group were of bugger-all use to an investment outlook. Most of their output is generated with one eye on maintaining good relations with the company (either for access to briefings, or for access to the company for the analyst firm's investment banking arm)... most of what's left over is biased to the upside because the ticket clippers own most analysts.

I've said it before - if you think you invest based on fundamentals, never get your analysis from a firm with a brokerage arm.

But I digress... we were talking about wiggles and squiggles.

The wiggles are looking ominous; taken in conjunction with the market fundamentals, and with what I consider a disinterested reading of the global economy, the time to be getting your affairs in order (and reducing your exposure to assets with solely speculative merit) is now.

As folks should be aware by now, I favour the simpler approaches to chart-based analysis. If I can't understand the conceptual basis for a charting methodology quickly, I tend to bin it; furthermore, there is a sense in which adding further layers of technical analytics yields diminishing returns.

So anyhow - I use moving averages to provide some indication of underlying trend, and two oscillators (Williams' %R and the Commodity Channel Index) to give me a reading on whether the trend is getting stale. Once the trend is stale, I look for divergences. I also use some very basic Elliott Wave analysis to try and figure out if the 'staleness' coincides with any potential 'measurable' turning points based on an 'enthusiastic amateur' Elliott Wave count (see here for an example). I'm not going to do that here, because the Australian market has already completed a 'throwover' from a sensible Elliott Target at 4150-4200.

Check out the chart below; it is a cutout from a weekly chart of the ASX200. (You will need to click on it in order to view the entire chart properly... it's pretty large)

What I've marked on the chart (labelled D1 and D2) are two prior points in time at which valid 'divergences' have been triggered - where the index makes a lower swing low (or a higher swing high) but the new high (low) is not confirmed by any of:

  • volume;
  • breadth; or
  • the CCI.
Note also - D2 is also pretty much the 38.2% retracement of a move that I date from August 2004.

As you can see, requiring all three to fail-to-confirm is a pretty high hurdle. Suffice it to say that the Australian market appears to be forming another divergence on daily charts, which is a microcosm of what appears to be happening on the weekly chart. The signs on the weekly are still weak, but if they develop as I suspect, the recent swing high is going to stand out much like the March 2002 low does (that was the last valid weekly divergence, and it was a corker).

For the moment, all that it means is that intraday biases should be on the short side - looking to short SPI futures on any intraday early strength, particularly after mid-week, and also looking for medium-term shorting opportunities on daily charts (i.e., don't look to buy oversold until there's another buy-side divergence... for now the sensible bias is to sell overbought). At some stage there will be a very serious leg down (D1-to-D2 is an 'a-b-c' in a larger 'A-B-C'...) which will enable a longer-lived bounce from about 3750-3700. Then a further decline as the world descends into a maelstrom...