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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...
