The head of Australian equities at Schroders Investment Management, Martin Conlon, has argued that good investment analysis looks first at the ungeared cashflows of companies. The industry’s favoured valuation yardstick, the price/ earnings ratio, was unreliable because it introduced leveraged profits into the process. The importance of finding the true source of cashflows was demonstrated during the Telstra floats, in which investors – Conlon included – bought the cashflows generated by a 90-year-old copper network, which turned out to be near the end of its useful life.

This should have taught professional investors to investigate the sources of company cashflows and calculate the leverage being applied to them, and then assess whether the price being offered was justified. “You can’t be a sensible investor when your first step is looking at the price.” He questioned why investors bought gold (despite the near-zero official interest rates of most developed countries) and art, since neither generated cash flows. Investing in these relied on the ‘greater fool theory’ for returns. Rehashing one of his views from late 2008, Conlon said that volatility was not a reliable measure of risk, which instead came from inaccurately tracking the sources of cashflows, misjudging the leverage within them, and then paying inappropriate prices for assets.

“Once we understand this, we can really move forward from the GFC and the things that caused mistakes.” Reiterating a classic Schroders view, he said the evolution of domestic funds management products – from balanced funds to today’s product divisions between market cap, sector and style – had benefited manufacturers more than customers. This fragmentation of funds management businesses decreased economies of scale, while increasing fees and portfolio complexity, he said. “At the moment we’re tasked with reducing fees. How do we do that?

We’d say that you need to reduce complexity.” At the superannuation fund level, investors’ fascination with unlisted assets and niche investment styles, such as value, growth and ESG equity funds, distracted them from the crucial determinant of a company’s value: its cashflows. Conlon said the rationale for investing in unlisted assets should be to access better ungeared cashflows. “It’s hard to believe that Kathmandu and Myer are generating different cashflows at a better yield…private equity is great at using that leverage part to change the return profile.” Conlon had some words of warning for Frontier Investment Consulting in its push to set cost-recovery base fees for managers and pay them for outperformance. “It’s about what you incentivise managers to do,” he said. “People will move further out the risk curve to get paid.” Before pushing for flat-fee mandates, investors should predetermine the amount of leverage managers can use.

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