“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.