The Death of the Yield Hog? Central banks barking up the wrong tree

This week we look at nothing new. The lofty valuations we are seeing in the tech space are neither new or unprecedented in a historic context. A paradigm shift like this is simply an opportunity to achieve out sized returns. Just look at the trains...

​We would like to begin this weeks article with a story. It is the story of a little organisation called the Interstate Commerce Commission or ICC for short. The ICC was created in the late 1800’s under the Cleveland presidency to regulate the railroads and transportation of goods across and between the US states. 

The period between the 1870’s and early 20th Century in the United States was characterised by massive changes both economically and on a societal level. Within the space of a few decades the nation moved from primarily subsistence agriculture toward rapid industrialisation and underwent massive changes to its demography. States and local governments, which were the primary locus of control in that age, found it increasingly hard to grapple with and regulate a society in a constant state of flux. The advent of the railroads and the technological advancements taking place cannot be understated, especially at that point in a country where the federal government consisted primarily of frontier forces (in terms of the armed forces) and revenues were basically limited to customs duties and tariffs. 

The technological advancements that the railroads and later on mass-production represented shaped and tested both the institutional capacity and political systems of the day. With new institutions being created and a rationalisation of the hitherto disparate and a primarily political bureaucracy. On an economic front, the railroads created a massive opportunity with a large influx of capital flowing into the system. In just two decades between 1870 to 1890, the rail mileage across the US almost trebled. This created a new class of entrepreneurs (i.e. Railroad Barons) and triggered massive changes in the political landscape with overt lobbying and corruption becoming rampant. This change also created significant shifts in economic thinking - when regulation was understood within an economic context and new concepts such as marginal cost and externalities were introduced - and led eventually to the creation of a federal commission to act as arbiter and, eventually, to regulate the prices of railroads and even trucking later on. 

From its humble origins as a political mechanism and tool to support the party machines of the day where appointment was primarily done through patronage and quid pro quo, the ICC eventually came to be increasingly technocratic. Eventually the ICC became a cornerstone of the interstate commerce system until its dissolution in 1996. 

So, what does the creation of regulatory frameworks in the late 18th century have to do with investing today? 

We see many parallels between the trajectory of the US economy in the late 18th century to now in the information age, as we like to call it. While much has been said about the Facebook-Cambridge Analytica scandal, the place of large technological behemoths and the income inequality that these changes have seemingly created, we would like to take a step back and question whether this is intrinsically different from the past. Yes, the technologies themselves are quite different, but are there parallels between then and now? Most certainly. 

If we think of the creation of the World Wide Web as the first revolution, the innovations taking place today from the gig economy to artificial intelligence to virtual reality are going to have profound implications for the societies we live in and, more specifically, how capital markets function. Think of a company like Microsoft with a return on equity in the high double digits despite having a market capitalization of over a trillion dollars or a company like Uber which was able to go from 0 to 60 billion in the space of a decade. These are profound changes that cannot be quantified in any substantive manner despite our wanting to do so. You would be hard pressed to have found someone who even in the late 1990’s in the middle of the dotcom bubble who could have foreseen the shape or form of where this was going. We would go so far as to say that even Tim Benners-Lee couldn’t have foreseen the trajectory we are on, nor can we say with certainty where this is going to lead. 

From an investment perspective we do think that these changes, what Kuhn might have referred to as the latest paradigm shift, should get us to rethink how we use traditional metrics (i.e. DCF or P/E). We are not suggesting that we dispense with all expected norms or reason but it might just pay to be a little more flexible. This brings us to the next question and the real reason we are writing this article. That is, our frustration with the sheer amount of pessimism out there with regards to valuations and the market. 

As we have suggested previously, we are late in the cycle and, yes, markets are trading at a decent premium to their historic valuations (10% on average depending on where you look) but couldn’t there mayhaps be a reason behind the madness of it all? 

As big tech consolidates and drives forth in the commercialisation of new to market innovations, we think that this will create new sectors and opportunities for growth in what should otherwise be a stretched business cycle. This is no doubt helped on by a central bank policy focused on being ‘data-driven’ or post-hoc rather than pre-emptive. 

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​The death of the Yield Hog? Central Banks barking up the wrong tree.

From a yield perspective, we have seen central banks around the world distort markets to such unprecedented levels that there has been an almost flagrant bullying of investors into risk assets in the form of equities. We have also previously spoken of demographics and how that has contributed to the distortion of traditional valuations. But here is the real kicker, policy initiatives at central banks seem to constantly look for underlying inflation with their institutional capacity being quite limited in dealing with the flux in the underlying economy. 

For one thing, major technological innovations are, in a majority of cases, disinflationary. So, when inflation is not working or reacting as expected in a traditional base case scenario, how do you tackle it using the same (interest rate policy) tools? With technological innovation already creating income disparities and massive changes in the structure of underlying employment, the major central banks have tended to exacerbate it by pushing up asset valuations to even higher levels.

So, we can say that a significant factor behind high valuations is central bank policy but the flip side is a simple question: will this change? Our bets are no, despite this seeming like the perennial kicking of the can down the road. So the new base case is, technological innovation that is disinflationary and central banks essentially being ever closer to zero bound (not likely to change since inflation is not anywhere on the horizon in the near term). 

So from an equities perspective, it might just pay to stay invested with the caveat of course that we will continue to have volatility as a lot of hot money (as opposed to patient money) continues to run around in search of yield. From a thematic perspective, we continue to look for opportunities which have significant catalysts in the form of technological innovation and companies that specifically chose to take the opportunity that low cost of capital creates by REINVESTING IN THE BUSINESS. For us it makes more sense in this environment to target businesses that also have a good return on equity (and ROIC) trimming positions where there is a lot of what we like to call bad debt. 

Looking into the history of the railroads, we see a number of lessons we can learn. The influx of capital chasing that particular thematic also was analogous to our times. But so too were the bankruptcies and when the regulatory/political environment did catch up, guess who unfortunately got caught up in it? You guessed it, the ones with significant amounts of leverage and the smaller players were eaten up to create the modern utilities landscape dominated by larger players. 

We think that there will be significant parallels when we look to some of the thematic investment choices we make. Just as we saw significant intervention in railroads and later on in healthcare, we will continue to see more intervention and consolidation when it comes to technology or some of the innovation based plays. This also creates opportunities on its own, for example, one of our bigger holdings domestically is PointsBet (PBH.ASX) which we see as having a first mover advantage in a heavily regulated market which means that, once market share is gained, it can than prime itself for acquisition or throw up barriers for new entrants. Think about how much harder it is for me to decide to start a bank in Australia or a Railroad company in the US as opposed to a hundred years ago when the sectors were relatively less regulated. 

From a broader economic perspective, while we have given up on predicting the turns and frenzies that characterise cycles, we think that there still remains a case to be optimistic as capital owners (as opposed to wage earners). Much of the significant innovation of this century (as previously alluded to in sectors ranging from AI to VR) is still in its infancy and we will see disruptions in the existing market structures and potentially elongate the business cycle as they maintain their ROE’s (at the cost of labour’s share of AD). We feel the biggest risks will  play out in the regulatory, political and broader societal spheres as participants catch up and adapt to these new changes.