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Why asset-turn could drive market valuations higher

Better productivity growth would challenge the consensus late-cycle hypothesis

Even with the sound on, you never hear television pundits talking about asset-turn. That is a shame because the ratio is key to understanding these annoyingly indecisive bond and equity markets. To be fair, it is not a widely known term. Worse, it could mean anything and is written inversely to how it is calculated (revenues divided by assets). Asset-turn is also hard to conceptualise.

Finance students may remember it as one of the three ratios the DuPont Corporation began multiplying together in the 1920s to derive return on equity (RoE) — the other two being leverage and net margin. While most people more or less get profitability and debt, the sales a company generates from its assets is less intuitive. Quickly now: is 0.9 or 0.6 the better number?

The reason the answer has not mattered much is that margin growth has been the primary driver of RoE and stock markets over the past 20 years. So successfully has profitability boosted returns that investors are most ignorant of the long-run decline in asset-turn. From a dollar of S&P 500 assets supporting one dollar of revenues in 1995, for example, half the turnover is made today.

In other words, assets have been expanding faster than sales. This is an ugly secret of the corporate world— in developed and developing countries alike. And it is doubly embarrassing when you consider the rise of tech companies with huge top lines and assets they could hide in a cupboard. Facebook’s asset-turn ratio is still 1 if the cash on balance sheet is excluded.

What happened was that buoyant profitability from declining interest rates, stagnant wages and global tax fiddles was squandered on wasteful investment. Hence the overcapacity in numerous industries and subdued inflation pressure. Indeed, applying the appropriate deflator to each type of spending, real capex as a percentage of output is at record highs in the US and Europe. Investors ignored such profligacy because returns on equity were sustained by margin growth.

Sounds bad. Actually, the asset-turn story could well drive market valuations significantly beyond the current expectations of investors. Since the second half of 2016, this ratio has begun to move higher almost everywhere. Perhaps worried that rising interest rates and nominal wages will make easy margins gains a thing of the past, companies are beginning to invest in ways that spur growth. It is no coincidence global activity picked up around the same time.

The missing link between asset-turn and the direction of capital markets is productivity. Output per worker has been below trend for so long investors barely think about it any more. In America it has barely broken 1.5 per cent year-on-year growth since 2011. But if companies spend faster and smarter, productivity should recover. There is a strong correlation between the two as ageing capital is replaced by more efficient stock.

Productivity could also jump as wages are rising in many developed markets. Historically, this has tended to lead productivity growth as companies are forced to innovate to boost returns per employee. In fact, anything that puts companies under pressure helps. For example, there is a close relationship between the dollar and productivity growth in the US. A rising currency hurts exporters and they compensate by raising productivity.

Output per worker is crucial to watch because it is central to economic growth as well a fixed income and equity markets due to its effect on inflation and margins. If employee wages rise faster than their productivity, the companies paying those wages have two choices. They can either pass on the extra costs to customers, thereby leading to rising inflation. Or they can absorb the hit, which results in lower profit margins — all else being equal.

This is an economic identity. It states that an increase in nominal wages must equal the sum of productivity improvements, price rises and changes to labour’s share of output (which is the inverse of profit margins). In other words, if productivity surprises to the upside, companies are no longer forced to make the choice outlined above. Nominal wages can rise without threatening the bond market through higher inflation or stock prices via lower margins.

Were productivity growth to accelerate, it would challenge the consensus late-cycle hypothesis, or at least delay it. Nominal wages could recover (as they are already in the US and elsewhere), which lifts aggregate demand and global output. But inflation would remain subdued and there would be no spike in interest rates, which is benign for fixed income markets. Likewise, margins can remain elevated or even rise if productivity grows fast enough — lending support to stretched equity market valuations.

It starts with asset-turn. Leave the talking heads on mute while you analyse the important stuff.

Key operators jostle for prime warehousing spots to slash delivery times

China’s ecommerce giants are fighting it out over everything from customer data to exclusive contracts with retailers.

Now that rivalry is spilling offline into logistics networks and warehousing, with key operators spending millions of dollars to secure prime warehouse locations to shave precious hours off delivery times. 

“The warehousing and logistics sector is really following growth in consumption,” said Stuart Ross, head of industrial at JLL in China. “Chinese consumers have taken online consumption to the greatest level in the world.” 

The battle over logistics and warehousing has paralleled the broad competition among Alibaba, Tencent and JD.com to dominate China’s ecommerce market, which churned out revenue of Rmb7.18tn ($1tn) last year, according to the commerce ministry. 

That competition has fuelled heated demand for premium warehousing space, one of the few links in the logistics chain not handled in-house by the ecommerce companies given the high upfront capital costs of owning property.

China is projected to have 52m square metres of high-quality warehousing space by the end of this year, according to JLL — though a fraction of the US’s nearly 900m sq m, that was entirely built up in just 15 years, according to Mr Ross. Efficient networks around warehousing hubs were crucial to processing the 40bn parcels the state postal service said were delivered in China last year. 

At the heart of the logistics battle is the race by ecommerce giants to capture the best warehousing spots by anticipating pockets of consumer demand before competitors. 

“It’s all about getting closer to the consumer. From a long-term point of view, this is a very crucial time for any of the players who try to play in the new retail field,” said Tianbing Zhang, head of Deloitte China’s consumer practice. 

The warehousing demand has enriched third-party logistics operators such as Best Logistics, one of Alibaba’s key partners, and courier delivery company SF Express. Revenue for third-party logistics providers was $159bn in 2015, three times that in 2007, according to JLL. In 2016, local businesses spent Rmb11.1tn ($1.6tn) on logistics, with a third of that going to storage alone. 

Transport accounts for 40-50 per cent of the cost of logistics, so reducing the distance from warehouse to consumer is crucial, says Victor Mok, a co-president at Global Logistics Properties, China’s largest warehousing operator, which manages around 30m sq m of space in the country. 

GLP so far has focused on China’s biggest cities — Beijing, Shanghai and Shenzhen — but logistics operators increasingly are following online consumption into smaller, inland locales. 

Investment in warehouses has slowed, though, as big cities have begun limiting the amount of land allotted for industrial use to control urban sprawl. Investment peaked in 2015 with a jump of 28 per cent from the year before, slowing to 5 per cent in 2016 and just 4 per cent in 2017.

In the past two years, six key Chinese cities including Beijing, Guangzhou and Shanghai have shortened land leases for warehouses from 50 to 30 years and slashed the percentage of land allocated to industrial purposes.

In contrast, some inland cities such as Wuhan are dealing with warehousing oversupply.

“There’s been a forced development and repositioning of the facilities in the marketplace by the government,” said Mr Ross. “China has the largest road network in the world. It’s also got the largest rail network. Those infrastructure improvements, as well as development of scores of new airports and seaports, have enabled this industry sector to really thrive.” 

As it has grown, the logistics warehouse sector has attracted private equity, insurance companies and sovereign wealth funds seeking stable returns. Most recently GLP was taken private for $11.6bn by a consortium that included Hopu and Hillhouse Capital, and set up a Rmb10bn warehouse fund with China Life.

“In last five years or so, there has been more than $25bn of investment with a focus on the logistics sector,” said Mr Ross. “We’re really at an apex point now where logistics is the hottest real-estate sector in the country.”

China’s ecommerce groups are moving to consolidate their logistics operations. Last September, Alibaba invested $800m to increase its holding in logistics platform Cainiao to a controlling stake.

Recent confusing moves may be part of a realistic shift away from the grand vision

There are three possible explanations for what has been happening in Saudi Arabia over the past few weeks. Confusing moves include the fall in oil production in July, when it was supposed to be rising in line with public commitments. The long-promised IPO of the state oil company Aramco has been postponed indefinitely and meanwhile Aramco is reluctantly preparing to buy the state-controlled chemicals business Sabic.

An unnecessary conflict has opened up in response to some mild Canadian comments on Saudi’s human rights record. And the Public Investment Fund, the country’s sovereign wealth fund, may or may not have committed to provide the funds to help Elon Musk take Tesla private.

The first explanation for all this is that because of illness or some other incapacity neither King Salman nor his son, Crown Prince Mohammed bin Salman, are in full control, leaving the individual agencies that run the country without clear leadership.

The second is that MbS — as the crown prince is commonly known — has decided to accelerate his ambitious Vision 2030 plan, adopted in 2016.

The third is that, on the contrary, the leadership of the country — a much wider collective body based on the core royal family but extending to key officials and diplomats — is pulling back from Vision 2030 and reverting to a more traditional, cautious approach designed above all to ensure that the House of Saud remains in control.

The first of these explanations is much rumoured in the market but there is little substance to it. The crown prince has been known to behave erratically before.

The second seems unlikely given the failure of the Saudi government to deliver on any of the major plans announced in 2016. There has been no diversification of the economy, and the country remains as dependent on oil as ever. There has been no work on Neom , the $500bn city to be built in the north-west of the country.

Perhaps even more important: there is no spare money. The oil price increase has helped but the benefit has been limited by production cuts and the slowdown in the economy, which shrank last year by 0.7 per cent. Unemployment has risen to 12.7 per cent. The only advance delivered by the reforms to date is that a few highly privileged women are now able to drive cars.

The third possibility is the most likely, although reversion to traditional norms is certainly not complete.

The clearest evidence for this conclusion is the Aramco/Sabic deal, which raises money by borrowing rather than risking any sale of assets or loss of control: Aramco borrows the funds for the purchase, then hands the money over to the government, as Sabic’s owner. A messy Aramco IPO is avoided, saving the face that would be lost if the company were valued at $800bn or $900bn rather than the $2tn plus sought by MbS. The radical idea of making Aramco a genuinely independent company is put aside.

In the oil market, too, Saudi appears to have reverted to the role of swing producer, keeping prices within a range around $70 a barrel. With output elsewhere (for instance in Kuwait) higher than expected, the Saudis balancing the market by producing a little less would explain the unexpectedly low July numbers.

There is also a new degree of realism when it comes to natural gas, as shown by the acceptance last week of the need for major imports.

The new approach goes beyond energy. The policy of shrinking the number of people employed by the public sector — one of the key proposals in Vision 2030 — appears to have been reversed, with talk of another 500,000 jobs being created to reduce unemployment.

The spat with Canada suggests that internal security and repression of opposition is more important than human rights or improving the country’s image internationally. (The number of executions in the kingdom this year is 73.)

When it comes to Tesla , the explanation may lie in the US rather than Saudi Arabia. The prospective deal has been announced by Mr Musk but not endorsed by any Saudi official. The key question must be: who stood to gain from the idea that the Saudis were about to invest in Tesla?

The reversion to traditional behaviour has some way to run. The next likely step is a pause in the Yemen conflict, which has exposed the weakness of the Saudi military. It has become obvious that Saudi Arabia is in no position to take on Iran in a series of conflicts across the region.

Beyond that would come an end to the pointless disputes with Qatar and Canada and a return to the pragmatic policies adopted under the late King Abdullah.

Saudi is a complex society, with a leadership much more sophisticated and realistic than many in the west imagine. The last three years have been an aberration, a personality cult alien to the culture of a conservative society intent on its own preservation. 

Reform was much needed, and still is, but it was never going to come through grand visions. Reversion to tradition will not be easy, and it will not solve all the country’s problems, but it may deliver a little more stability to the region and to the oil market.

Electric cars: the race to replace cobalt

Carmakers want new batteries that are not dependent on metals from the Democratic Republic of Congo

In a laboratory on an industrial park an hour’s drive outside Boston, Tufts professor Michael Zimmerman is hoping a material he invented in his basement can help solve a crisis facing the electric car industry — which has inadvertently tied its fortunes to one of the poorest and least stable countries in the world.

In between his teaching, Mr Zimmerman runs start-up Ionic Materials, whose battery material could mark the future for the car industry as it races to go electric after a century of producing petrol cars. His hope is that his homegrown prototype could pave the way for a new generation of batteries that does not use cobalt, a silver-grey metal, over 60 per cent of which is mined in the Democratic Republic of Congo.

Backed by highly respected computer scientist and investor Bill Joy, who spent years searching for the perfect battery, Ionic counts the Renault Nissan Mitsubishi alliance, Hyundai and French oil company Total as its shareholders.

“The world wants to electrify vehicles,” Mr Zimmerman says in his office across the car park from a shopping mall. “I’ve never seen such a massive industry say I want to completely switch technologies. Every single company, government and country — they all want to do it worldwide. There’s a worldwide race.”

The list of Ionic’s backers reflects the increasing concerns among carmakers over current battery technology and its reliance on the DRC. Cobalt supply is dominated by a handful of mining companies, including Switzerland-based Glencore, or mined by hand and sold to Chinese traders in the country. Child labour is common, according to human rights groups.

Mike Zimmerman, Tufts professor, whose start-up, Ionic Materials, is looking at how to make batteries safer and use less cobalt © Tony Luong/Redux/ Eyevine

In other words, the product that is the shining hope of the new economy is — for the timebeing — highly dependent on some of the most-criticised practices of the old industrial economy.

For many experts, the battery will reign supreme in this century — just as oil did in the last. Batteries power our everyday digital lives, from our iPhones to our laptops. But they are also key for electric cars to replace petrol-powered vehicles and for some types of renewable energy. Without them, it will be much harder for the world to end its addiction to fossil fuels and limit the impact of climate change.

But batteries are complicated to produce and contain a delicate mix of chemistries that have to meet a demanding list of performance requirements. Customers expect fast charging, a long battery life and safety — and in conditions ranging from the cold winters to the heat of the Arizona desert.

Without a major shift in battery technology, cobalt demand is set to more than double over the next decade — with the share from the DRC set to rise to over 70 per cent. Gleb Yushin, a professor at the School of Materials and Engineering at Georgia Institute of Technology, puts it more bluntly: the rollout of electric cars will stall within a decade, he says, unless there is a battery breakthrough.

“There will be no EV industry without DRC cobalt,” says Caspar Rawles, who tracks the market for London-based consultancy Benchmark Mineral Intelligence. “Without the DRC, this ramp up in EVs won’t happen.”

Mr Zimmerman started thinking about batteries about five or six years ago, just as electric cars were starting to gain traction and the first Teslas were becoming popular. Back then, cobalt was a niche metal mainly used in jet engines and smartphones.

Since then sales of battery electric vehicles and plug-in hybrid vehicles have grown from about 6,000 cars in 2010 to 1m cars sold last year, or about 1 per cent of annual sales. There will be a further 340m electric vehicles (including passenger cars, trucks and buses) produced between now and 2030, according to analysts at McKinsey.

That has led to an explosion of battery factories with little historical precedent. The number of “gigafactories” under construction, named for the gigawatt hours of batteries they can produce each year, has increased tenfold over the past eight years to 41, according to Benchmark Mineral Intelligence. Simon Moores, the founder of the company, says the battery is destined to become the “oil barrel of the 21st century.”

Discovered by 96-year-old American professor John Goodenough while he was at Oxford university in 1980, the lithium-ion battery was a pivotal moment for 20th century science and technology, paving the way for portable electronic devices from camcorders to smartphones. It has also become the standard choice for electric cars, which use hundreds of battery cells placed together in battery packs that can weigh up to 600kg.

Cobalt mining in Congo, where over 60 per cent of the mineral is excavated © AFP

But since Sony commercialised the lithium-ion technology in 1991 there have been few substantial improvements upon the current technology, Mr Zimmerman says. He believes the battery that powers our world may now have reached its limit.

“Everyone wants their smartphone to last longer and their car battery to not blow up,” he says. “My belief is that lithium-ion batteries are at a dead end right now, there’s really no further improvements that can be made with the current technology.”

Assembled together into battery packs, which look like metal briefcases, battery cells rely on four main parts: a positive and negative electrode, a separator and a liquid electrolyte. The positive electrode, or cathode, is coated in a carefully processed metal oxide slurry that in most cars includes lithium, cobalt, nickel, and manganese. When the battery is charged, the lithium ions flow to the anode, the negative electrode, which is normally made of graphite; on discharging they flow back to the cathode, generating a flow of electrons and electricity.

Cobalt is essential for stopping the battery from overheating and the stability it brings to the battery materials also allows users to charge and discharge their car over many years. But it’s also the most expensive of the metals used — hindering the ability of carmakers to lower the cost of electric cars to compete against their petrol counterparts. Analysts at Liberum reckon that the cost of cobalt in a kilogramme of battery cathode material is about $12, compared with $8 for lithium and $5 for nickel. Metals account for about 25 per cent of the battery cost, they estimate. While new sources of cobalt are being developed in Idaho, Alaska and Australia, they are not due to produce metal until after 2020.

A cobalt mine in Mutanda in the Democratic Republic of Congo. Cobalt demand is set to more than double over the next decade — with the share from the DRC set to rise to over 70% © Bloomberg

Mr Zimmerman, a materials scientist, started to look at a relatively unexplored area of research — the electrolyte, which is generally what catches fire in batteries. If a solid material instead of a liquid were used, so the theory goes, the batteries could be safer and lighter. It could also allow carmakers to reduce the amount of cobalt in the cathode, or even, he says, eliminate it entirely.

The first electrically conductive solid was discovered in the 1830s by British scientist Michael Faraday, but it had never worked in a battery at room temperature. Working in his basement Mr Zimmerman created a polymer material that could do just that. “It was a really ugly piece of plastic in a roll with little pinholes in it everywhere, but you had to say wow,” recalls Bill Joy, who was searching for a solid state battery technology while at venture capital firm Kleiner Perkins & Caulfield. “This is just amazing that it demonstrated feasibility of a property that had been sought for so long.”

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Carmakers from Toyota to Mercedes-Benz and Dyson in the UK are working on so-called solid state batteries like Mr Zimmerman’s and there were about $400m of investments in the technology in the first half of the year, according to consultancy Wood Mackenzie. They forecast such batteries will make up the majority of electric car technology by 2030 but will not enter the market until 2025.

“There are still a number of challenging problems in order for an all solid state battery to be a commercially viable proposition,” says Peter Bruce, a professor in the department of materials at Oxford university. “But they are now being addressed.”

Ionic is one of a number of start-ups who are hoping to commercialise the next battery breakthrough. It is a field that has seen its fair share of failures, such as the bankruptcy of Pittsburgh-based saltwater battery company Aquion Energy, which raised money from Bill Gates and Kleiner Perkins, in March last year.

In the meantime battery companies are racing to reduce the amount of cobalt they use with conventional technology. Yoshio Ito, the head of Panasonic’s automotive business, which supplies Tesla, told reporters in Tokyo last month that it aims to further halve the use of cobalt in Tesla’s EVs in two to three years. Tesla has said the company was “aiming to achieve close to zero usage of cobalt in the near future”.

Most carmakers are moving towards batteries that use more nickel and as much as 75 per cent less cobalt. These products are expected to pick up market share over the next few years.

Venkat Viswanathan, a professor at Carnegie Mellon University, says cobalt can be reduced using liquid electrolyte chemistries. “Ionic Materials is one pathway to making low cobalt cathodes but a liquid electrolyte pathway is also something that many battery makers are working on and have feasible solutions,” he says.

A battery to be installed on an electric car at a BYD assembly line in Shenzhen, China © Reuters

Still, even with a shift to lower cobalt batteries, demand for cobalt is still expected to more than double by 2025, according to Wood Mackenzie. “Zero cobalt is hard, low is possible, [but] zero is very tricky at this point,” Mr Viswanathan says.

For his part, Mr Zimmerman says the low-cobalt batteries still come with a considerable fire risk that will require expensive monitoring technology.

In his small study he plays videos on his laptop of nails going into the latest low-cobalt cathodes with liquid electrolytes, which he calls the “nail penetration test”. There’s smoke, fire and “bad things about to happen”, he says, as we watch the cells catch fire in a metal chamber. In such fires toxic gases are produced that require fire crews to wear specialist clothes. “It’s just fundamentally unsafe,” he says.

“The cobalt is expensive — and it gets mined from unethical sources in the Congo, so people want to put less cobalt in,” Mr Zimmerman adds. “When you put less cobalt in, the voltage of the cathode goes up and the current liquid electrolytes can’t work at that higher voltage. But our polymer can.” Ionic says it has tested its polymer material with cathodes that have either little cobalt or none at all and is working with companies to commercialise the technology. If successful, it says it could find its way into batteries within a few years and into electric cars a few years after that.

Two views of the VW I.D. concept car, showing the size of the battery pack needed © Company

Mr Joy, who co-founded Sun Microsystems and wrote some of the founding code of the internet, says such technologies are critical to addressing climate change. The current mix of materials has been “stretched to the limit”, he says.

“What happened with Sony inventing the lithium-ion . . . well, we ended up with things that get rechargeability,” he says. “But they gave up safety and cost. Not only safety and cost but also abundance because there isn’t physically enough cobalt to electrify the world.”

Beverage and snacks group looks to continue health-conscious strategy for growth

PepsiCo has agreed to buy SodaStream, the Israeli maker of home fizzy drink dispensers, for $3.2bn, just weeks after the US consumer group announced that its chief executive Indra Nooyi would step down later this year. 

The acquisition of the health-conscious soda maker is a clear indication that Pepsi’s incoming chief executive, Ramon Laguarta, plans to continue developing the company in a similar direction as his predecessor. 

SodaStream fits with Pepsi’s broader strategy under Ms Nooyi’s 12-year leadership, during which she switched the company’s focus from sugary sodas to healthier snacks and beverages. 

SodaStream, which fashions itself as a health and wellness alternative to cola drinks, would complement Pepsi’s healthier options, which include the flavoured sparkling water brand Bubly and the fruit and vegetable snacks maker Bare Foods. 

“SodaStream is highly complementary and incremental to our business, adding to our growing water portfolio, while catalysing our ability to offer personalised in-home beverage solutions around the world,” said Mr Laguarta. 

Pepsi has agreed to pay shareholders of Nasdaq-listed SodaStream $144 per share in cash, a 32 per cent premium to the company’s 30-day volume weighted average price. The transaction, which needs to be approved by SodaStream shareholders, is expected to close by January 2019.

Global food and beverage companies have been carrying out a series of calibrated deals in recent years as they try to reposition their portfolios as health conscious consumers opt for fewer sugary drinks.

Pepsi’s deal comes days after its main rival Coca-Cola agreed to buy a minority stake in BodyArmor, a sports drink maker backed by US basketball star Kobe Bryant. Coca-Cola’s move comes as it has struggled over the years to loosen the hold of Pepsi’s sports drink business Gatorade. 

SodaStream will continue to be led by its current chief executive, Daniel Birnbaum, as Pepsi aims to expand the Israeli company by giving it access to its strong global distribution, research and development firepower and marketing expertise.

“The intent is to maintain the business as a standalone unit, keep the growth, maintain the culture and not stifle the organisation with corporate types of restrictions,” Mr Birnbaum told the Financial Times.

SodaStream has grown strongly in parts of Europe and Asia in recent years but lagged in the US, where its fizzy drink dispensers have less than 2 per cent market penetration.

Its shares jumped this month after it reported that net income in the second quarter rose 82 per cent to $26m compared with $14m a year ago, and revised upwards its growth projections for the year.

In the beverage market, Coca-Cola and Pepsi also face new competition from consumer group JAB Holding, a Luxembourg-based investment vehicle backed by the Reimann family. As part of an international buying spree, JAB bought the Keurig Green Mountain coffee business, which is best known for its single-serve brewing machines, in December 2015 for $13.9bn. 

A major shareholder in Keurig at the time, Coca-Cola agreed to sell its entire stake. JAB subsequently discontinued Keurig’s cold brewing system that allowed consumers to make their own sodas from pods including those produced by Coca-Cola.

In January 2018, JAB struck a $18.7bn deal to acquire Dr Pepper Snapple and combined it with Keurig to create a beverage group with nearly $11bn in annual revenue.

Most Asian equities gained on Monday as traders held out hopes about developments in the trade war and ahead of a meeting of central bankers later in the week that may throw up clues on the outlook for markets.

Japan’s shares fell, while stocks rose in Hong Kong in thin volumes in most of Asia. The dollar steadied and the 10-year Treasury yield was little changed. The offshore yuan was stable after signs China may be propping up the currency just as it prepares to restart trade negotiations with the U.S., while the yuan traded onshore strengthened.

Nikkei -0.21% Hang Seng +0.63% CSI -0.49% Shanghai -0.46% Shenzen -1.35%

Eur$ 1.1418 CNH 6.8448 CNY 6.8533 JPY 110.60 GBP 1.2736 CHF 6.0365 RUB 67.2024 TRY 6.0360 WTI$65.65 -0.38%

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