The one singular characteristic of todays capital market environment that has been the most perplexing and frustrating has been the complete lack of concern for what “might” happen. As we have discussed, low rates and the absolute manic focus on additional yield at whatever cost, has produced an almost universal catatonic state. Nothing is more indicative of this than the markets complete lack of attention to the potential for reflation/inflation. We forgive the equity markets for their lack of focus as they have the attention span of a six year old, but it is curious that the Treasury Market continues to remain oblivious to what are emerging signs that pricing pressures are already upon us. Slack in the labor market, spare capacity, and seasonal one-off factors are only some of the reasons given as to why we should ignore what are clearly clouds on the inflationary horizon. Perception is reality however, and the reality of low long term rates will remain until the broadly held mis-perception on inflation/reflation changes. The argument is also made that inflation/pricing pressure will never come to bear primarily because we would have already seen it if it were going to take hold. Our feeling is that all of the liquidity sloshing around has flowed into the easiest parts of the capital markets (debt and equity markets), next up are the hard asset/commodities markets which will in turn lead to overall broad price increases, which will then ultimately flow through to wages. We have never seen the kind of uncharted, unfettered Central Bank action that we have most recently experienced, so rest assured that when this inflationary cycle unfolds it will most likely not look like anything we have seen before. Buy Stuff
The recent lawsuit by prominent hedge fund investor David Einhorn highlights the struggle to prioritize corporate cash in a low rate/no rate world. Mr. Einhorn is imploring Apple to return some of its burgeoning cash stockpile to investors via a preferred dividend. His focus is to return some cash to investors via a significant dividend, but also to boost the value of the preferred shares as yield hungry investors presumably would bid up the shares above what would be a normal earnings multiple. Apple, for its part, has resisted such a proposal as it prefers to keep a comfortable stash of cash to maintain ultimate flexibility. This type of dynamic is currently being played out in the commodities world as well, as companies are being forced by shareholders and boards to shelve or severely cutback their highly aggressive growth plans. Quite frankly, the decision to hold cash at a tech company versus a mining company is quite similar. Both are interested in growth, but only if that growth is additive. Market history would suggest that the good times in neither tech nor mining coincided with bright decisions on the capex or acquisition front. However, if you think about it, they face similar fates if they fail to grow with tech companies simply becoming irrelevant, and mining companies risk becoming self liquidating entities as reserves dwindle.
Analysts at Citi recently wrote an excellent note on this point when describing the valuation of Rio Tinto. They stated that Rio Tinto traditionally has traded at a 30% discount to NPV. In essence, they maintain, for every $1 of NPV created by the company, shareholders have been rewarded with 70 cents of value. These analysts suggest that the market is essentially telling Rio Tinto that they do not allocate capital efficiently by not using the correct cost of capital. The thrust of the report therefore is that miners like Rio should use a much higher hurdle rate for projects than they have in the past, and if these rates cannot be met they should return cash to shareholders.