Decisions fit for governments?
The recent discussions we have engaged in here – about governments being unwilling to borrow, and separately, how the balance of payments’ current deficit is ‘structural’ only because of a lack of long-term thinking – have generated enormous feedback from every corner of our great country. Interestingly and encouragingly, the issues are part of vernacular across all demographics and socio-economic groups.
At the heart of the issues however (and keep in mind the ‘heart’ has many chambers) is the question about whether the government is the right entity to make important capital allocation decisions.
If governments are popularly elected, they will inevitably make decisions based on popularity, but hard investment decisions with long-term economic, financial or social benefits and consequences cannot be decided on the votes likely to be won or lost.
Two examples are the recently resurfaced debate about high-speed rail and the NSW government’s contemplation of the sale of its NSW lotteries-duty cash stream.
One is a bad business that the government might like to buy and the other is one of the world’s best types of businesses to own – that the government might like to sell.
So my question is: can we and should we be relying on governments to make such serious capital allocation decisions?
Before sharing my thoughts on the businesses and their economics, a quick word from the world’s most successful investor and capital allocator, Warren Buffett:
“…companies that will perform the best are those that require little capital investment to facilitate inflationary growth and that have strong market positions that allow them to easily increase prices with inflation. That is, if there are relatively few competitors providing the same product to the market.”
What is an ideal business?
The best business to own is the one that generates high returns on capital and can invest that capital back into the business at equally high rates. For example, take a business with $100 million of equity that earns 20 per cent in one year, reinvests the $20 million profit and in the next year earns 20 per cent again, this time on $120 million. Such a business would be worth a great deal.
At Montgomery, we love businesses that can earn high rates on even more capital than they earn. That’s our very first prize.
Importantly, the very best businesses can maintain their earnings without continued reinvestment, whereas in the worst you have to keep pouring money into a money-losing business.
As an example, the best business might be the stream of legislated duties that come from a lottery. You don’t have to do any reinvestment. The owner of the business – in this case the government – will retain its earning power. Think about that for a moment. The NSW state government takes 23 cents of every dollar gambled on lotteries – about $330 million – which is about four times more than Tatts receives for running the lottery. For its 40 year right to operate the lottery, Tatts paid $850 million after $160 million of cash was transferred from NSW Lotteries to the government.
So that is the very first prize business, and the NSW government is proposing to sell it (perhaps it is simply front loading the receipt of the cash stream for a fixed rather than indefinite period).
Second prize are businesses that generate lots of money on existing capital, but can’t generate high returns on incremental capital. These businesses should pay out their profits to us at Montgomery, for example, allowing us to allocate those profits elsewhere – where we can achieve higher returns.
Warren Buffet talked about this at the 2003 Berkshire Annual General Meeting:
“So, what we do is take money and move it around into other businesses… our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It’s an enormous advantage.”
It’s an enormous advantage when the person at the helm knows how to allocate capital!
Some businesses generate profits but they are capital intensive, and the cash is required to be reinvested – not for growth but for maintenance. This is one of the worst kinds of businesses.
Charlie Munger noted this at the aforementioned Berkshire AGM:
“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested – there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.”
Its reputation precedes it…
The Australian government’s batting average when it comes to allocating capital has not been great. It’s the reason that we have relatively little to show for a decade-long resource boom, why we have ongoing budget deficits, and why there is no sovereign wealth fund (aside from the ‘future fund’ing of politician and bureaucrat superannuation).
A business that the government alternately promotes or rallies against is high-speed passenger rail.
When competing with cars and air travel, high-speed rail is uneconomic. In 2007, McKinsey noted that rail generates persistently low returns on invested capital, and Buffett, while being an investor in railroads, doesn’t like high-speed rail. In 2010, he was quoted thus:
“By its nature, it is non-economic when competing with auto and air. We [The US] don’t have point-to-point density to produce an economic return. If it gets done, unless heavily subsidized, it won’t meet test for private economics.”
And that’s the United States – with a population of 314 million people! Even over the Pacific, Warren Buffett suggests that the USA has insufficient population density for a fast train. Australia’s point-to-point density is even less.
Buffett adds:
“If it is high speed, it can’t stop very often. It can’t spoke easily . . . the math gets to be staggering . . . it would be cheaper for society as a whole to give everyone a cab ride. It is tough in a country of 3mil[lion] square miles. It is hard to make the math work. If it becomes a huge project of government, then maybe it will work. But it won’t happen with money that wants a return.”
Qualified to decide?
Once again, it seems that the governments of Australia (State and Federal) may be poised to make precisely the wrong capital allocation decision, buying the low return business and selling – possibly to foreign owned pension funds – the very good business.
It is fascinating to see the daily debates about what the government should do and where they should invest or divest. The question that must come first and be answered, however, is:
Is the government currently qualified to make these massive strategic capital allocation decisions?
Of course government decisions shouldn’t all be made on numbers. And if a decision must be made on a social benefits basis, then the government should label it as such and it shouldn’t be questioned on the numbers. Imagine that.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Paul Whyte
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Scott W.
Agree with all you say apart from give it to the Chinese the high speed Chinese copies have already crashed and killed 10’s of people.
Give it to the Japanese they invented the Shinkansen and have now after 50 years yes half a century ago, have run x trillion passenger kilometres with zero fatalities.
If this was a purely financial decision, after all it’s a choice, fly, drive or train to Sydney (i live in Melb). Then of course it would be to fly, but the world is a subsidy. The trucks on the Hume Hwy drive for free down a road paid for by us.
Funny i don’t remember being asked to subsidise private companies driving down my highway. I want my share of the profits.
The choice of transport mode we choose is made by government not the people. If the Hume highway was crap then no one would drive down it, but we have spent probably $50 billion over 50 years making it 4 lanes the entire way.
What have we done with the rail line, nothing, it still runs on the tracks as if it is a steam train.
Amazingly the result is lots of trucks.
Governments conned by greedy business decided this result for us.
The HSR from Melb-Syd probably could be built for $32 billion but has been inflated by including expensive tunnels but then it did not sound expensive enough so they added Brisbane into it to make it sound really expensive.
Assuming correctly the public is to stupid to understand we are being conned.
$32 billion is the price floating around for Sydney’s second airport remember it needs transport to/from it as well.
The loser is the public.
Scott W
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Roger I suggest that in a small segment of Australia we could actually make good use of high speed rail. It is not as important how large the population, the important factor is their propensity to travel and the Melb-Syd route is in the top 4 world wide for passenger travel, in regardless of the total population we can qualify from a business case point of view that there is strong potential to fill the regular trains. Next point is that the airport in Sydney is flat chat and they could well use the extra capacity that would come from remove all the flights to/from Melbourne as would likely happen based on experience in Europe/UK where the travelers overwhelmingly shift to train travel due to the convenience of travel being point to point. There would also be a flow on boosting the urban rail system as a link up for the travelers wanting to hub into the departure point station. Environmental concerns may cancel out once you consider the concrete used in construction but as we evolve to cleaner power generation faster than Airlines are moving to a truly lower impact fuel it might still be ahead.
On the finance and capital allocation I suggest that the bulk of the project is outsourced too China. China have developed (borrowed) the current leading technology and engineering for high speed rail and they are also a great source of capital so instead of having the government borrow the money to pay people to do the job have the Chinese pay for it as well as build it. They can then have a buy back or partnership with the federal government through profit share and money saved by not building a new Sydney airport would go a long way to paying for it (along with savings by not building the geeks wet dream version of the NBN).
People would be unhappy about having the Chinese do the whole job BUT in reality it will never happen under the local direction, that is just being fanciful. Better to have someone actually do it and get the benefit of the infrastructure in under a decade as the Chinese would roll it out far quicker that the locals would take just to plan the project.
In terms of the lottery I agree the government are very short term thinkers, why give up a lifetime of income?
Roger Montgomery
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You’ve made some valid counter points. Nice work and thanks.
Dean Magee
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Great article Roger. As a Generation Y’er I’m probably going to bear the brunt of these poor decisions made by governments. There is little I can do though. Any attempt to influence government policy in our favour is often met with stiff resistance from the baby boomer generation. They make up a large portion of voters and often vote strongly as a group. Imagine the backlash if there were calls to remove negative gearing or to change the treatment of capital gains tax when assets are held for more than one year.
Any suggestions on how to save my future?
Charlie Dalziell
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It’s precisely the uneconomic (or social benefit) projects the government should be funding. Schools, hospitals, sewerage systems, roads. I could not for the life of me understand why the government spent so much time trying to convince us that the NBN was a commercially viable project. Everyone knew the numbers they came up with were fiction but they insisted of producing them anyway. The NBN will be a very low returning project that should stay in Government hands providing a vital infrastructure service to the community.
Roger Montgomery
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Exactly Charlie.
Andrew Legget
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Is the government currently qualified to make capital allocation decisions? The evidence states no, however they should be as they have a whole department set up for this type of thing.
I can’t help but wonder, are they letting good decisions regarding the allocation of its finances go because of improper reasoning about “losing votes”.
Take the 2nd airport in Sydney, the government already owns the land and has for some time. However, now both sides of politics want to go down a more expensive route and no doubt delaying it even more, the only real reason i can see is that (having first hand experience of the areas around badgerys creek) they are worried about losing the votes of this growing, affluent and often swinging voter base.
So thinking about it, i think the government is qualified to make these decisions but are unwilling to because of the desire to win the “game” of politics.
Dennis Bergmans
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Career politicians cannot govern a country. I very much dislike the idea of a some union lawyers making the decisions for the country. Sure, a lawyer may be able to write legislation, but do they make effective long term decisions (per your point above – capital allocation decisions) before they write the legislation?
Moreover, career politicians make decisions on areas they know nothing about. Where is the party representation for the teachers? the doctors? the small business operators? the engineers? etc etc. How many times are the ministers shuffled around so they never really get to understand the part of the economy they have been put in charge of?
Both political parties are as bad as each other.
Grahame Lucas
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You are so right
Anything to get into Government and anything to stay there
Craig Brown
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If getting a financial return was the only outcome to consider in analysing public transport projects then L.A. here we come. Having said that, the fast train down the east coast is a dumb idea. If (and its a BIG IF) we were to go down the fast train path, then surely connecting Sydney, Melbourne and Brisbane with the larger regional towns would make more sense. Do we want to build a train for tourists or for business people, workers, students and families? Do we want to improve the lives of the people who live here or the people who visit here?
I liked your idea last week Roger about borrowing at current rates to fund infrastructure spending. Public transport in and around our big cities must surely be not far from the top of the priority list. Driving into Melbourne for work is soul destroying some days, which is why I mostly take the train, but cancellations are common, you often have to stand, and that little 5 minute rest each train takes between Footscray and North Melbourne, then another one between North Melbourne and Spencer St…grrrr.
(Do I presume its only Passenger Rail Buffett thinks is uneconomic? Otherwise that $25 Billion he spent 3 years ago on BNSF seems an odd decision.)
If our government aren’t up to the task of capital allocation, god help us if we let our business leaders do the job.
Richard Goyder paid $22M for a 3.5% earnings yield with Coles, missed his bonus triggers, then had his board adjust his incentives so he was certain not to miss again. As one journalist put it, “Thanks for coming Wesfarmers shareholders”. And I quote RG from a recent interview: “I will never apologise for being successful”. If you were a shareholder in 2006 your shares are now worth the same, ear less per share, and you’ve been diluted some 150%. Oh, and your equity, now 8 times greater, is earning 8%. No please, don’t apologise, just make sure you’re there when my house goes to auction.
Marius Kloppers and Tom Albanese threw billions at pet projects only to have those billions written off. What’s that saying about all of man’s troubles stemming from not being able to sit quietly in a room? I hope BHP and RIO can find their successors something to keep them busy on the operational side.
And to end this piece of commentary, (and to strengthen the argument you posit here) I just saw Greg Hunt, the Liberal’s Environment Spokesman being sliced up by Tony Jones on Lateline. The new government coming our way in September might not be the improvement people are hoping for. (Leave the NBN alone Malcolm. Let us have just one piece of world class infrastructure. It may just pay off).
bedtime