Wednesday, December 07, 2005

Markets and the theory of relativity

Nobody likes to pay much attention to the bond markets. Nevermind that it is the biggest, most complex and most ubiquitous financial trade in the world. It is just so boring, arcane and, well, completely lacking in sex appeal. What really gets the heart throbbing, the pulse pumping and the business news journos jumping is stocks and real estate and art collectibles and the like. Not for them or your average day trader is the world of coupons and mere interest. Nope, the eyes of the investment crowd is on the high-octane world of equities where capital grows, ownership crows and money flows.

Which is rather odd when you really think it through, because the benchmark against which all else is ultimately valued is the boring old bond rate. It doesn't matter whether you're using the rocket science of the Black-Scholes nobel prize winning model for figuring out the value of options or the mundane model the Fed uses to value the stock market, the keystone is the risk-free proxy of the plane-jane bond rate.

The concept is simple enough, really: if, accounting for the risk, I can make more money with an investment option than the bond rate (the interest you get on your ownership of the bond), then I should pursue the riskier investment option. But if, accounting for the risk, the bond pays me the same or more, then I just shouldn't bother with the riskier investment and should content myself with loaning my money at the bond rate of interest.

Now, ALL corporations need money in some kind of financing form. This is because they can (theoretically) make more money from operating the business than from simply selling it and putting the proceeds in the bank; if they can get an additional $100 and earn $15 with that, it pays them to find some way to get that additional $100 at a cost up to something less than $15. They can either borrow it (and pay interest) or convince investors to give it to them. Businesses don't usually share their wealth-making enterprises, but they will do so if it is cheaper for them to do that than it is to borrow the money in the first place - or if that is their only viable option if the business is too risky for lenders to touch. Thus it is that, in the usual course of events, corporations clamor for capital from the markets rather than borrowings from the banks. It's all relative, you see.

When a corporation borrows money they are dealing with professional lenders, who are often regulated by central banks, and who take a great deal of effort to understand and protect against the risk of their loan. They expect a return OF their investment as well as a return ON their investment and security to boot. But that's all they expect. Equity investors have stars in their eyes and expect that, in spite of the unsecured risk, they will get all that and more; they're betting on capital growth, too, which doesn't cost the corporation anything out of pocket. So corporations can generally get their financing money from investors cheaper than from lenders because the investors are expecting the total growth rate to beat the bond rate.

So it says something about the state of affairs when a company determines that it is cheaper for them to borrow money than to convince investors to invest in them. It suggests investors may not be so easy with their money because the expected total return from capital is not as great as the return from bond interest. It suggests investors are unwilling to count on the expected growth. It suggests the cost of capital - and the value put on it - is too high.

The Herald's Alan Kohler tells us we are in one of those times when corporations are finding it more condusive to their own needs to borrow than go to the capital markets.

"ONE of the most powerful themes in global capital at the moment is called "de-equitisation", the shrinking of equity markets as companies return capital to shareholders and replace it with debt. In the 1980s it was called borrowing and brought many to grief by 1990; now it's de-equitisation.

The UK equity market has shrunk by 3.8 per cent this year. Across Europe, sharemarkets have contracted by 1.2 per cent. This is an astonishing turnaround for markets that grew by 5 to 10 per cent a year for two decades during the 1980s and 1990s. In the US the size of the equity market has been flat this year after a decade of averaging 5 per cent annual growth. The capitalisation of the Australian sharemarket has grown 14 per cent this year, down from 20 per cent growth last year....

The global shift from equity to debt is caused by the simple fact that their relative costs have undergone a dramatic reversal. Bond yields and [shares] earnings yields have essentially switched over the past five years - broadly speaking, from 7 per cent and 5 per cent, to 5 per cent and 7 per cent. At the same time, corporations have found themselves with the strongest balance sheets for a decade and well able to justify more debt. The case to de-equitise has been compelling.
I have been in the camp, along with the likes of John Bollinger and Richard Arms (well, not in the same camp as those gifted ones, but lets just say I find what they say more valuable than what others may suggest, and if I were to find myself in their camp I'd surely be the camp cook's kitchen slave), who believe that, at least in the US, the stock markets are in a cyclical consolidation phase that will last several more years before another major bull market asserts itself.

But I've been uneasy with that because, at its base, it is a conclusion arrived at by looking at the average lenghts of bull and bear cycles over the last 100 years and is nothing more than reliance on a continuation of that pattern. What Kohler's column does for me is provide some fundamental underpinning to that belief. It suggests a reason to expect the markets to continue to consolidate. It suggests to me that we cannot even think about a new bull run until relative equity to bond values revert to the equity-favoured relationship over bonds, and in the course of things, I'd expect that to take a while to develop and thrash out.

Kohler hints that relativity of bonds and equities in Australia may not be so divergent because of somewhat unique characteristics of the equity market here, which, apart from risk premium, give equity investors near parity of return as bond investors. He points out:
"Australia has a couple of extra wrinkles to the global theme: much higher dividend payout ratios than elsewhere, plus an obsession with "capital management" among investment funds, which is code for giving capital back to them.

Compulsory superannuation in this country has created a glut of capital - a torrent of cash looking for double-digit investment returns. Yet the one constant in investor presentations in Australia these days is capital management: managers of all listed companies are under enormous and constant pressure to give back capital.

Most of them succumb, no matter what their own ambitions for investing the capital might be, because their salaries are tied to sharemarket value (or rather "total shareholder return") and they can't afford a collapse in the share price because they might get sacked and find that the short-term bonuses with which they depart are not what they would like.

Capital management is the fastest way for a chief executive to get a share price up and keep investors happy; investing the capital in the business to make money over the long term - which is what he or she is there for - is more risky and less likely to result in a short term kick in the share price.

Why are Australian funds so obsessed with capital management? I've been asking fund managers this and apart from the constant pressure on them for short-term performance - which they pass on to those running the companies - there is a deep, lingering distrust of corporate empire-building.

There's nothing especially new about this but you might have thought the huge successes of Australian companies expanding offshore over the past five years would have wiped out the bad taste of the bumbling adventurism of the past. Companies like CSL, Computershare, Macquarie Bank, BHP Billiton, Ansell, Cochlear and so on have created a completely new paradigm for global expansion by Australian businesses.

The other Australian wrinkle to the global theme of de-equitisation is the high dividend payout ratio in this country. AMP's Shane Oliver highlighted this recently when he showed that Australia's average payout ratio (dividend as a percentage of earnings) is 64 per cent, compared to a global average of 39 per cent and even less in the US (34 per cent) and Japan (31 per cent).

Oliver says that of the 12.4 per cent average annual return from Australian shares in the 105 years since 1900, just over half has been due to dividends, providing a stable anchor for investment returns. He used the stats to argue that high dividends tend to produce better company returns because they indicate that the reported earnings are real - that is, they have actual cash flow backing them, which Oliver says is especially relevant after Enron and HIH etc.

In their hearts, institutional investors like Shane Oliver's employer no doubt think the cash is better in their hands than in those of overpaid, over-ambitious CEOs. The trouble is that this is forcing managers to take on more debt. The global trend towards "de-equitisation" we are now seeing has haunting echoes of the great gearing up of the world's balance sheets that occurred during the 1980s, driven by Kohlberg Kravis Roberts, Michael Milken, Alan Bond, Christopher Skase and the rest.

That whooshing sound you can hear is the debt-to-equity pendulum swinging past."
Franking credits on dividends and tax-free return of capital arrangements in Australia tend to give equity investors here an advantage over equity investors elsewhere, but even so, if the large Australian corporations, most of whom have overseas connections making them part of the wider global markets, can borrow cheaper than their cost of capital, the Australian share market will not be immune from the swinging pendulum of relative debt-equity values.


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