General Commentary

Global markets are going through a rough ride. Not in my entire investing lifetime have I witnessed such wild vicissitudes in equity markets. While this is probably more of a reflection of my youth rather than anything else, it is still interesting times where our equanimity and rational thought are being tested.

We are experiencing  multifaceted problems in major economies such as China, Greece, America and Australia. Domestically, it is in my view that we have been shielded away from the GFC given our commodity boom. However, it has been apparent for an extended time that the good times are disappearing. The downturn in mining is having a multitudinous effect on our economy. For example, it is having adverse impacts on income, tax revenue and jobs.

Recent studies have shown that wage inflation is going nowhere. Our real incomes, as consumers aren’t appreciating. So what implications may this have? Well, for one, I believe that consumer demand will be weak and this is what I think we are seeing now with the most recent reporting season. A common theme among many companies is that growth in revenue is not transparent. While cost cutting has been a theme for some time, as well as restructuring, we are seeing the implications when these measures are exhausted – margins are contracting. Importers are even more vulnerable to gross margin contraction as the lower $A (predominantly driven by the rapid decline in the demand for Australian commodities) lifts their costs of goods sold.

To overcome this problem, many companies, both domestically and internationally are turning to M&A activity to boost revenues rather than anything else. And boy is the time ripe for that! In this low interest rate environment, companies are definitely taking advantage of cheap credit to help pick up the slack. However, what happens when interest rates begin to rise- especially in the US?

Given the aforementioned, I believe it’s fairly evident that the Australian market is in a tough time for the foreseeable future. Given the lust for yield as a result of the historically low interest rates globally, riskier assets are appreciating while global economic growth is decelerating. Moreover, benefits from the RBA rate cuts are having fewer impacts with each subsequent cut.

I believe the reasons mentioned above are key to the issues Australian companies are facing, namely revenue growth and margin contraction. By extension, I would argue that profitability will be sub-par in at least the near term. Moreover, as I mentioned earlier, the lust for yield have pushed these exact companies to prices which may be unjustifiable. Do you see the spiral effect I’m trying to achieve here? The low interest rate environment is evident of a weak economy; however, this is pushing investors into riskier assets – such as shares. These companies, given the weak economy and lack of consumer demand aren’t delivering. This problem is enhanced by the premium some investors are willing to pay to own a piece of a company which is able to pay dividends. So what’s the outcome? Investors are paying more and more for less and less. Not only that, but they are increasingly becoming vulnerable to stocks de-rating - which has become more apparent with some companies which have come out in the FY15 reporting season. Over the long term, it sometimes pays to arrest our inherent rapacious actions which may do more worse than good.

A prevalent theme of the FY14 reporting season was a lack of EPS growth on a broad level. Interest rates we’re still historically low back then and investors demanded dividends. As a result of the latter overpowering the former, (on a broad scale) payout ratios unambiguously rose at the cost of investing for future growth. As the labour market continues to weaken it will be interesting to see where the growth will come from. I believe technology will no doubt have a big role in this.

Despite the relatively bearish atmosphere i may be depicting, I wholeheartedly believe that the astute manager can still generate outsized returns in this environment. Why? Because if history is any guide, then it is definitely possible. Returns may not be as easy as they were previously, but this is only a guess at best. Unfortunately, i wasn't blessed as a Seer and so i cannot detect what the future holds.