Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 122

Companies crying wolf

“Greed, for lack of a better word is good. Greed is right, Greed works. Greed clarifies, cuts through and captures the essence of evolutionary spirit.” - Gordon Gecko in Wall Street

These inimitable words from Gordon Gecko, portrayed adroitly by Michael Douglas in Wall Street, captures the process of creative destruction of the market perfectly. The market will reward companies it thinks will allocate capital well and similarly punishes those who don’t. It tries to anticipate the future and thus the changes in future returns on capital before they happen.

Can managers think counter-cyclically?

Good news travels fast and bad news travels slowly. So too is the case with management teams who get good news from the troops quickly and bad news slowly. If all we did was listen to management’s current views on their businesses we would miss changes to future returns. If you had listened to the mining CEOs two years ago, things could not have been better, they were racing to expand capacity, Chinese demand for everything was insatiable and the backlog for capital equipment orders was at record highs. Just as the last capacity addition was being announced, prices for most commodities started to fall and have continued to slide since.

Whilst demand is not in the hands of commodity producers, supply certainly is and disciplined managers would start to think about reducing capacity to restore over supplied markets back to a balance rather than simply focussing on their own marginal costs – which continually signals for them to produce more. Their future is collectively in their hands but so long as they continue to act as if they have no impact on market prices it won’t be. The same dynamics play out in all commodity style businesses and it is without doubt the managers who can think counter-cyclically will make more money for their investors than those that run with the pack. Sure running with the pack is fun, it’s contagious, why heck you might even let off a wolf cry or two but why don’t MBA courses have titles like “How to operate against the cycle (and ignore the Board’s imperative)” or “How to buy your competitors when they are on their knees due to overzealous expansion?”.

Excess executive compensation

Allied to this issue are current practices in executive compensation. On this front we have been vocal recently in voting down packages for management teams where we feel our investors’ interests haven’t been properly represented. Managers have several things under their control including operational excellence and capital allocation. Those two drivers, above all, will help to determine how their businesses and ultimately how their share price will perform. Often however, an executive team will inherit an overly optimistic share price through no fault of their own and in spite of producing decent operational performance and the prudent use of capital their shares will still decline or underperform peers. The converse is also true. Thus it seems to us utterly silly to include TSR (total shareholder return) as a key metric for executive performance measurement. Most senior executives have a relatively short tenure at the top (3-5 years seems to see most CEO’s out) and it would be close to a fluke if the beginning of their tenure were to coincide with a perfectly valued share price. Installing KPIs which reflect how operations should best be run into performance packages as well as return on capital improvements seem a far better way to us to align shareholders’ interests with the things management can actually control. Knowing you will be judged on the capital you deploy, might slow down or even encourage management teams to think against the grain and thus better position their companies to profit from the cycle rather than be purged by it. More of a lone wolf howl than a wolf pack yap!

No free cash flow in many resource companies

Two of the critical issues we focus on in small cap investing are return on capital and cashflow generation. To use a crude medical analogy, cashflow is the lifeblood of a business and return on capital is the skeletal muscle. It is the interaction of these two primal financial forces that is the key to generating shareholder wealth. Layer over that capital allocation (which we have spoken of many times before as one of, if not, THE key skill required by senior executives) and valuation and you have the lingua franca of a good investment process. Applying this to smaller companies means that we end up very underweight some sectors.

We often get asked what we think of gold companies for instance. This was a sector that not long ago comprised almost 10% of the Small Ordinaries Index. Whilst we struggle to have much of a sensible view on gold per se, we do have a strong view on the underlying business economics. Unlike most commodities which are in some sense used or at least hard to recycle, gold is stored or worn or sometimes used in high end electronics which require a strong resistance to corrosion. The high value of gold ensures that a large proportion of the ‘used’ gold makes its way back into the system via recycling. The production of gold however is a virtually futile exercise from an investor’s point of view. The average mine in Australia is currently mining grades at around 1gram per tonne of ore. Most mines, in addition, require the removal of several tonnes of overburden to get to the one tonne of ore in which the 1 gram of gold is contained. That’s a lot of dirt moving merely to get to the tonne of ore which you then have to grind, float and process in order to extract the tiny fleck of a valuable substance known as gold. To make matters worse, of the twelve gold companies listed in the Small Ordinaries Index very few have produced free cashflow (the lifeblood remember) in any of the last five years. Only one has produced free cashflow in aggregate over five years – that honour goes to Alacer Gold. Alacer however is busy stashing cash for, you guessed it, a new US$600 million plant to enable them to process more complex ore!

Small gold companies are not alone. A quick glance down the 11 small oil companies in the Small Ordinaries Index produces an even more exceptional result. Once again there have been individual years when a few have produced free cashflow in individual years but none have produced free cashflow in aggregate over the past five years. Those years haven’t seen bad oil prices either so it will be interesting to see how many shareholders will be keen to continue to give these companies money with the prevailing oil prices. Whilst it goes against the grain a little to highlight these two sectors when commodity prices and their share prices are down, the economics and capital allocation decisions within the sector leave a lot to be desired.

Outlook

As we head into the results season we would expect there to be a higher than usual degree of volatility within the small companies universe. A combination of what we feel is a fairly broad-based move to trend and momentum investing has pushed a number of stocks away from levels we would see as fair value in both directions. We witnessed some examples of ‘snap backs’ over July 2015 with holdings in Webjet, Pacific Brands and Sedgman all jumping between 16% and 45% within a few days of positive trading updates. On the other side of the coin, several of the mainstream media names declined aggressively on reasonably modest earnings downgrades. We think our universe will remain a stock pickers market where adherence to the disciplines of cashflow and capital allocation will ultimately out as winning attributes.

 

Marcus Burns is a Senior Portfolio Manager, Australian Smaller Companies at Schroder Investment Management Australia Ltd. Opinions, estimates and projections in this article constitute the current judgement of the author. They do not necessarily reflect the opinions of any member of the Schroders Group. This document should not be relied on as containing any investment, accounting, legal or tax advice.

 


 

Leave a Comment:


RELATED ARTICLES

Why the ASX 200 has gone nowhere in 16 years

Why central banks are becoming impotent

Two great examples of why company management matters

banner

Most viewed in recent weeks

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Property

Coalition's super for housing plan is better than it looks

Housing affordability is shaping up as a major topic as we head toward the next federal election. The Coalition's proposal to allow home buyers to dip into their superannuation has merit, though misses one key feature.

Planning

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Retirement

More people want to delay retirement and continue working

A new survey suggests that most people aged 50 or over don't intend to stop work completely when they reach retirement age. And a significant proportion of those who delay retirement do so for non-financial reasons.

Economy

US debt, the weak AUD and the role of super funds

The more the US needs capital and funding, the higher its currency goes. For Australia, this has become a significant problem as the US draws our capital to sustain its growth, putting pressure on our economy and the Aussie dollar.

Investment strategies

America eats the world

As the S&P 500 rips to new highs, the US now accounts for a staggering two-thirds of the world equity index. This looks at how America came to dwarf other markets, and what could change to slow or halt its momentum.

Gold

What's next for gold?

Despite a recent pullback, gold has been one of the best performing assets this year. What are the key factors behind the rise and what's needed for the bull market in the yellow metal to continue?

Taxation

Consulting on the side? Don't fall into these tax traps

Consultants must be aware of the risks of Personal Service Income rules applying to their income. Especially if they want to split their income or work through a company.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.