Stock Take is a podcast by Intelligent Investor’s analyst team. Our team reflects on market movements, discusses stocks and current recommendations, offers value investing insights, and will even answer members’ questions. If you would like to submit a question to our analysts to be included for discussion in future episodes, please email us at firstname.lastname@example.org or add a comment below.
Host: Gaurav Sodhi
Guest: John Addis (JA)
Nick Cummings (NC)
The information in this podcast is current on the day of recording. It is general advice only and does not take your personal situation into account. It may not be suitable for you.
Welcome to Stock Take, my name’s Gaurav Sodhi, joining me today is John Addis. G’day, John.
JA: Morning, Gaurav.
Looking very nice where you are, you’re in the Melbourne at the moment, aren’t you?
JA: You haven’t seen my bottom half.
I never want to see your bottom half.
Let’s hope that sentence always stays true. Now, we’ve also got Nick. G’day, Nick. Welcome, think this is only your second, maybe your third, podcast and certainly your first using the video, so welcome aboard.
NC: Thanks, Gaurav, thanks for having me.
JA: I also want to make clear that that is not a fridge in the background of Nick’s… It’s not a beer fridge, right?
NC: It’s a cabinet.
JA: It’s a filing cabinet.
It does look a lot like a fridge though.
JA: A beer fridge, yeah.
A beer fridge, I didn’t want to say it but that’s what we all suspected.
JA: He’s getting ready for the Denmark game tomorrow, I think.
NC: The perks of working from home.
Taken over all our meetings now… I know nothing about that sport, I have zero interest in that game, I don’t get it. John, everyone falls over all the time and pretends they’re injured, it’s an embarrassing game to watch. I don’t even like watching with my son because he’s like, “Oh, why did they fall? Why did they fall?”
JA: This wasn’t on the running order, I don’t remember agreeing to discuss this.
To bash the world game.
JA: You’re right, that’s why they’re adding 10 or 15 minutes to injury time, because of all the time wasting that goes on with people rolling around on the floor. It doesn’t seem to be working at the moment though.
No, it’s worse than ever. Listen, let’s move to another disaster that’s probably worse than ever and that is crypto. John, we don’t talk about it very much in public, but privately I think we’ve all been…
JA: [Laughs] There’s a reason for that.
Well, yeah, I mean we’ve all been scathing about it, privately, and I think somewhat bamboozled by it, is probably the right word. You’ve probably done more work than anyone than the team on crypto, what’s your reaction…?
JA: Yeah, which isn’t saying much.
[Laughs] That’s probably true, actually, yeah. What’s your reaction though?
JA: Well, in total, we’ve written one story on crypto since this whole bubble blew up – well, inflated and then blew up, and that was really just to explain the technology behind it. I drew a parallel with the dot-com bubble. In retrospect, I think that this is probably a more obvious bubble than the dot-com bubble in our view and that’s why we didn’t write about it, because it did seem so obvious and it did seem a great way to lose a lot of money.
Despite the very many requests we got.
JA: We got loads of requests for it, absolutely loads, and you can see why, because lots of people were making a lot of money during that time. The story that I wrote was a result of me interviewing the son of a friend of mine who was, at the time, I think he was 20 and he had over $400,000 in the bank which he’d made on crypto and was absolutely adamant that he wasn’t really going to take any off the table, he was all in and all the way. And his cohort of friends, which my sons were in the same cohort, they all started trading the same thing, it just seemed to me like the most obvious bubble.
I think the parallel with the dot-com bubble is correct in terms of the market psychology, I’m just not sure that the technology itself is as useful as what I first thought and the ASX experience with their CHESS replacement suggests that, you know, maybe the real world uses aren’t as great as we thought, whereas in the dot-com bubble, the real world uses were fairly obvious, it was obvious, I think, at the time that the internet was going to be a big thing. Whether crypto’s going to be a big thing in the future, I still doubt, to be honest.
There’s a lot to unpack there. Let’s just stick with that comparison between crypto and the ’99 dot-com bubble. I actually think that understates the extent of the crypto bubble. The comparison I would use is with some of these historic bubbles that we all have read about.
JA: Biggest bubble since tulips.
Yep, tulips – all these manias that people write books about, I think crypto deserves a chapter in one of those books. I think this is going to go down as one of the most stunning manias and widely accepted, deeply held manias of the last 100 years. It’s incredible. I’m really proud that we had the sense and maybe the foolishness to avoid it and to see it for what it was. To me, that really comes down to reading a lot and recognising what a mania looks like and it books like Tulipmania and Panics, Crashes and – what’s that called? Manias, Panics and Crashes, I think it’s called.
JA: The Madness of Crowds.
The Madness of Crowds. If you have some sort of understanding of what’s come before it, I think you just make yourself less susceptible to future manias. So, this whole episode for me, is an advertisement for wide reading. It teaches you so much and I’m pleased – because I’m quite susceptible to manias…
JA: We all are.
15 years ago, I’m convinced I would have been into crypto, I’m convinced of it, and it was because of financial education reading that we all saw this very early for what it was. Nick, can I get a quick reaction from you before John deep-dives into why the tech is crap?
NC: Yeah, for me it seems like it’s just been an awful lot of garbage from the start, but also just so many different fraudulent things along the way and everyone sort of dismisses that as, oh that’s just someone else, and then there’s another big one with FTX. Quite a few years ago when Bitcoin was really starting to take off and the person on the news saying they were a trillionaire because they created a coin that had a trillion coins and they sold one to their friend for a dollar…
NC: I think that sort of sums it all up for me, it’s just – yeah…
JA: That wasn’t FTX, was it?
NC: No, it wasn’t, it was someone else.
So, I think we all agree and I think most sensible people with an idea of history would agree that the coins themselves are part of the mania. John, you’ve been more open-minded about the underlying technology. Has all this episode changed the way you’re thinking about that? You sort of hinted that perhaps it has?
JA: Yeah, maybe. The idea is that – and this is why I think it attracted so many libertarians and so many people who were kind of early-20s, young males, who were kind of disenchanted with their financial prospects for their 20s and 30s. The idea that you could have this kind of libertarian free-range system where trust was not delivered by an independent third party, but was delivered systemically through clever programming, really. And instead of having one source of truth, you have multiple sources of truth and you use those multiple sources of truth to verify transactions. It’s quite an appealing idea to people who feel as though the system has failed them. I’m just not sure that that has real world commercial applications that are even widespread. There probably are some use cases, I think Dubai’s got its land registry on a blockchain, maybe the Ethereum network which seems to be quite useful with smart contracts, maybe that’s got some commercial applications. It just doesn’t seem that obvious to me. There are obviously problems with the energy consumption, like it’s hugely energy intensive and I think Ethereum have tried to work on that, so instead of doing proof of work, they’re doing proof of something else – I can’t remember what the term is – but it’s 90 per cent less energy intensive. But even so, it seems like a lot of work just to avoid a central source of truth, when central sources of truth have worked out quite well for society over the past few hundred years, they served us pretty well. They fail every now and again like all human systems fail, but generally they’ve done a pretty good job and I don’t really see the need to sort of abandon those sources of truth. So, I doubt whether this technology is going to change the world and the way that the internet has changed the world, maybe it will but it seems a question that’s open to doubt right now.
I suppose we’re about to see how much of the enthusiasm for crypto was built on the underlying technology and how much of it was more of a traditional financial bubble. It’s easy to be enthused when the coins are going up and you’ve made hundreds of thousands, millions of dollars, then it’s easy to say that the tech is valuable. But this is the real test, you know? I think we’re about to find out, John, and I think it’s right to raise questions and be more sceptical now, but we’re about to find out if there is a real use case for these technologies, which sound interesting but, like you, they’re just beyond me. I don’t quite get it and I don’t quite see the use case for it, although plenty of people do.
JA: If you take, say, the original use case of Bitcoin is kind of a gold replacement, limited supply, a store of value, that all makes a lot of sense. But that hasn’t worked in Bitcoin’s case, it hasn’t worked. That was a really good use case, I thought, for crypto and it doesn’t seem to have worked. In this environment, that should be going up, but it’s not. So, whether that emerges…
A store of value needs to be stable as well and the wild volatility of the price, I think it renders it useless.
JA: It does, and even the stable coins, which has clever maths behind them, they have failed. And I think the big tell in all of this is that some of the big crypto players who are still in there are now calling for regulation.
Yes, that’s right.
JA: I thought the whole point of this was not to have regulators involved. You know, if we need regulators to make this work, why don’t we just stick with the system that we’ve got?
My thoughts exactly. Nick, anything to add?
NC: No, just that a few of the large banks overseas and the ASX has just blown up a quarter of a billion dollars, I think, trying to build a similar technology as John alluded to. But there are players trying to do stuff with this technology, so there might be something there. As you said, as a medium of exchange, it’s hard to see that you’re going to go down and buy a coffee with Bitcoin.
Yeah. I guess Bitcoin has also been linked to other boom time behaviours that we’ve seen over the last 10 years or so and, John, among those is another one of your favourites and I think something that interests all of us, is the levitation of Tesla. That share price…
JA: Levitation! [Laughs]
[Laughs] That share price seems to defy all logic and most people are surprised by where it has gotten and where it stayed. Do you see it that way as well? Is Tesla the next dominant fall in the crash of 2022 or is there something different about Tesla that stands it apart?
JA: I think Tesla’s different, yeah. I’m not suggesting that we should all rush out and buy, I really don’t think that. We’ve got part two of that story coming out on Friday, but why don’t I make the bull case for Tesla and then you guys can have a crack at it?
We like destroying stuff, so, Nick, that would be perfect.
JA: Yeah, yeah, you’re both very good at pulling apart ideas. So, the bull case for Tesla is that the mission statement that Musk came out with when he started Tesla was that he wanted to radically transform the switch to renewable energy vehicles and transportation, so that’s predicated on becoming a big manufacturer. Key to that, was it’s an Apple kind of argument, which is the integration of hardware and software, which fundamentally delivers a much better user experience. That’s the first point to understand, is that I would think about Tesla in that way, as the integration of hardware and software. Traditional car manufacturers have just been terrible at software, absolutely appalling, and Tesla seems to have got that right and that gives it some distinct advantages in terms of self-driving and efficiency and user experience. So I think that is something that they have established a lead in.
The second point to understand, is that car manufacturing has traditionally been a horizontally integrated industry, so eats part of the way from equipment suppliers to car makers to logistics companies to dealerships, everybody takes their cut along the way. Tesla’s kind of inverted that and established a vertical integration model which allows it to deliver what seemed to be industry leading profit margins. So, Tesla’s now making more money per vehicle than some of the elite manufacturers like BMW and Mercedes. They’re really doing a very, very good job of that. They produced 300,000 vehicles last Q, so they made that big jump from zero to a million vehicles a year. I would suggest that is a harder thing to do than to go from one to five million a year.
Toyota, for example, makes about eight million vehicles a year, so if Tesla is to make that transition, accelerate the transition to EVs, it’s going to need to produce five-six million vehicles a year. To me, they look likely as though they could actually do that, they’ve integrated the supply chain as well, they’ve secured battery resources, they’ve established a great global brand and the thing is trading, I think, on a PER of around 70 now, which is half what it was. So, if you can go from a million vehicles a year to two or three million vehicles a year and maintain those margins that they’re currently making, then theoretically, they should actually increase as scale increases because there’s massive economies of scale in car making, that PER could come down very, very quickly. So, that, I think, is the bull case for Tesla.
Nick, I’ll let you go first, where do you see holes in that argument, or are there any or do you agree?
JA: I’m just going to leave now and come back in about 20 minutes, alright?
NC: Well, I might start with governance. I think part of the bull case is Elon Musk and how much he’s a visionary leader and done amazing already, as John described, upending the car industry. But there’s another side of that too and I mean, this is a company that has been fined $20 million dollars from the SEC for faking a takeover offer on Twitter. It’s a company who renamed their CFO, ‘The Master of Coin’.
[Laughs] I tell you what, he’s got a good sense of humour though, Elon, doesn’t he?
NC: He does.
I appreciate that about him, he’s a funny guy.
NC: He does. The other one too, they earn – and I think John alluded to it – they earn close to 30 per cent gross margins on their vehicles and that’s much higher than any other car company, I think double some other car companies or even triple…
JA: Yeah, it is.
NC: And that’s because they own a lot of that supply chain. But if someone came in and really tried to have a go at it, maybe it’s too far gone now, but it’s always been a capital intensive industry and it’s still at – for Tesla, they have to spend billions of dollars rolling out these – I think they call them gigafactories or these large factories where they produce tens of thousands of vehicles. So, I guess, if you look at some of the history of some of the biggest businesses at the moment, like the Googles and Microsofts of the world, they’re typically capital light businesses, capital intense businesses that are pretty hard and people usually come back in. Whether that continues, it’s hard to know. The other one risk is 25 per cent of the sales come from China and a lot of the manufacturing comes from China now, I think about a third of the manufacturing, so there is that US-China risk because it is still a US company.
It’s interesting though, right? So we’re not talking about a big blow up, we’re talking about very traditional conventional operating risks that apply to, I’d say, almost any car maker. It’s a different argument now than what it was, say, five years ago, where I think myself included would have argued that Tesla was a time bomb waiting to go off and that really hasn’t been the case. I think what everyone has missed is just how different and unique EV design and manufacture is to traditional design and manufacture. As a car guy, I actually am not a fan of EVs, I don’t like them, I don’t like driving them.
I am incredibly sceptical about the environmental benefit – not just sceptical, I think that actually everyone’s got this wrong, no one quite appreciates how mineral intensive the batteries are, they only last for a short time and you have to replace the whole thing all over again, the ability to recycle those minerals is really difficult and it’s not clear that we have those sheer resources to convert the entire global fleet over. Then, at the end of the day, after you finish driving in your boring, silent, soul-less car, you’ve got to plug it into the power grid where fossil fuels recharge it. It doesn’t work, I don’t understand why we think this is the salvation for climate change.
If the problem you’re confronting is there is too much pollution, there are too much carbon emissions, the stupidest idea I can think of is let’s just replace emissions at the tailpipe with emission at the generator site and put a mineral intensive, energy intensive battery in the place of a mechanical engine, it makes no sense. Why not make the cars smaller, lighter and more efficient?
JA: That’s true.
Why not work on the generation side, you know, cleaning up the generation, rather than cleaning up the engine? We’re solving the wrong problem. But that being said…
JA: Let me take that on.
Yeah, go on, John.
JA: So there’s two things I think you raised. Firstly, this point about China is absolutely correct. Tesla could be really wrapped up in a trade war in the same way that Apple can be and that could completely stuff the growth prospects of that company so I think we have to accept that as a risk. Just in terms of the governance issues, which is basically a nice way of saying that Elon’s a nutter, I would say that that is a feature, not a bug…
JA: And I think you have to be kind of mad to think that you can do the kind of things that he’s done. Like, the idea of building a rocket that goes up into our atmosphere and then comes back down and lands in one piece…
Now, that is genuinely extraordinary.
JA: That is an astonishing thing to think that he could solve or he could build a business that solves that problem. So I think people are getting way too carried away with all this Twitter stuff, Twitter is quantifiably different. In terms of programming, in terms of engineering problems, it’s really not an issue at all. Twitter’s problem is its users and how those users collaborate and interact on Twitter is an entirely different problem to what Telstra is trying to solve, is an entirely different problem to Space X. So, I don’t think Musk is at all suited to solving the problems at Twitter, but I think he is suited to solving engineering based problems at Space X and Tesla.
You can look at all of his stuff about the kitchen sink and putting Trump back on and all of that kind of stuff, but I don’t think that’s the issue, I think that those two businesses that he’s already established, and SolarCity, have shown that once he’s established the principles, he does actually build a workforce that is quite loyal and wants to solve those problems and will do almost anything to work on those things because they are so interesting to them and they’re prepared to forgive him all of his sort of personality traits that might otherwise wind people up.
It was the same at Apple with Steve Jobs, who was also kind of weird, like he spent six weeks eating carrots and his skin went orange. These tend not to be normal kind of people, they are on the edge and that’s why they do this interesting stuff. So, I’m prepared to give him, not a pass, because some of the stuff he does is quite mad, but if you’re thinking about investing in Tesla, which I’m not, I would separate Musk and the reporting and the stuff that he’s getting involved in in Twitter from the other businesses that he’s doing because he’s built a new car industry and is producing now one million vehicles a year from nothing.
So that’s the governance issues, yes, there’s a problem with him, but I think that’s part and parcel of the problems he’s trying to solve. Now, in terms of your point, Gaurav, about this being the wrong way to solve emissions, there’s obviously a lot of truth to that. There’s no point plugging – well, there is a point, but it’s not as good to have an electric vehicle and plug it into a coal fired power station, effectively. But all the machinery is there for users not to have to do that and I never thought I’d be on a podcast where I’d talk about my brother, who once flew to Stockholm to look at a set of taps, but he is absolutely obsessive about being emissions free. He lives in the UK, he’s got a load of solar panels on his roof and he’s got two electric vehicles and he now thinks with three more panels he can be completely off-grid, having done what we call a thermal upgrade on the house, with a battery, with two electric cars and all of these solar panels. Now, you can buy all of that stuff from Tesla, you know, they’re setting up in a way where you can effectively go off-grid and not use any power from the electricity network at all just with batteries and panels. And my brother’s proof that you can do that now, it’s not cheap to do but the people who are buying Tesla cars are probably the audience that can do it if they want to.
So, I think this is a proof of concept thing and nobody’s saying that Musk on his own is going to solve this, nobody on their own is going to solve this issue, but the faster we get to a point where there are more electric vehicles on the road, the more likely we are to build an electricity network that is cleaner, far cleaner than what it is now, I think. Because once you get an electric car, if you’re buying it for environmental reasons, you don’t want to be using coal fired power, you want other sources. So, I think it creates its own demand to help with that transition.
Toyota, of course, has a large EV program, but they’ve actually been working on hydrogen cars for about 20 years and…
JA: They’ve just released the first one, haven’t they?
Yeah, the Mirai, and apparently it gets reasonable reviews. It’s a completely different approach to solving that problem and I guess we haven’t really seen – the traditional competition, generally you get a new industry and the incumbents fight, there’s new entrants that are fighting – we haven’t really seen an effective tussle in EVs. The traditional car makers, they’re not going to be there, it’s not them because they can’t get their head around the complete difference in design and manufacturer when it comes to EVs and engine cars. I’ve seen most designs for EVs, they just take their traditional platforms and then instead of putting an engine in, they’ve got a battery under the hood, which is just pretty silly really, it’s a silly way to do it.
JA: But isn’t VW building its own…?
Yeah. So, even now, take VW, for example, they’ve stopped doing that and they’ve now got specifically designed platforms for EVs, which do some of the stuff that Teslas have been doing for sort of 10 years. But even then, they outsource somewhere between 80 and 40 per cent of their software to third parties, so they’re not really doing the software integration. All the traditional auto companies are trying to hire developers and do the software thing. But they’re not doing it to the extent that Tesla has done it from the beginning and it’s not clear that they’re doing it very effectively.
We’re just starting to see the emergence of true Tesla competitors, you know, and companies like Lucid who start from the very beginning as an EV business and have fully integrated software and hardware, those products are amazing and we’ll have to wait for them to sort of challenge Tesla to see how durable that business really is. But look, I’m actually really impressed with Tesla as well. I’m not going to poke too many holes in it. I think how they’ve mastered the economics has been amazing and they’ve just been really good at recognising how to take advantage of a completely new technology in the way that the traditional car makers have completely missed.
JA: All the existing car manufacturers face now what Clay Christensen called ‘the innovator’s dilemma’.
The innovator’s dilemma, that’s it, yeah.
JA: They have to re-engineer their entire thought processes and approach to making cars that have served them well for 100 years and in so doing, they have to sacrifice what they’re currently making from their current vehicles in order to just take the risk of being a good competitor to Tesla and maybe some of the other EV companies. There’s so much sort of legacy thinking in these industries that I think you’re right, they’re going to struggle to do it well. But there’s a kind of survival imperative I think down the track for them as well.
Yeah, no, it’s an interesting case study.
JA: What do you think of the competitive response, Nick? Do you feel as though some of these companies are going to be able to make this transition? Like, VW seems to be doing something, Hyundai seems to be making progress as well, they’re all talking about EVs, is that going to crunch Tesla’s margins down the track or do you think that maybe they’ve already secured their spot and now it’s just a case of taking market share off everybody?
NC: I mean, potentially I think you’ve sort of alluded to it too that Apple only sell, I think, one in five smartphones around the world, but they take 95 per cent of the profits, so you can see maybe a similar situation like that taking place. Some of Tesla’s margins are their own doing. Like, for all Elon Musk’s governance and bravado, there’s a reason they spend no sales and marketing dollars, because he’s always in the news, you know, trying to save boys in a cave in Thailand…
JA: Doing a humanitarian piece but actually calling them paedophiles…
NC: Yeah, exactly. So, compared to other car companies that actually have billions of dollars in sales and marketing budgets, Tesla has nothing which is quite remarkable that they’ve been able to do that. But yeah, I think one of the biggest threats – and this is longer, longer-term and whether we can do it is a huge question, but autonomous vehicles, it can really change the whole industry, where there is a world where we don’t own cars anymore because cars are 95 per cent idled and they sit parked and we don’t need as many. I think Tesla’s obviously touting its own autonomous vehicle technology, but there are other players in that as well. I think that’s a legitimate threat further down the track, but in between, I think you’re going to have this sort of electric vehicle transition and it looks like they’re by far and away ahead.
JA: One other threat, though – and you spoke of this, Gaurav – is that this is kind of like the aviation industry in those early days, where you can see that this is going to be big but you don’t know in which direction it’s going to travel. You know, you’re going to have single engine aircraft, you’re going to have multiple engine aircraft, there’s going to be bi-planed and mono-winged… You don’t really know, it’s possible that Tesla is kind of too early – and this is where the difference with Apple is, the parallel kind of breaks down, Apple likes being second or third and watching everybody else stuff it up and then comes in something that actually solves that problem. Tesla has been first and that means they have to commit to technologies that might not be the ones that we really want long-term, and hydrogen is a good example of that.
Even the very specific battery technologies, I mean the chemistry is always changing and evolving and it’s not clear which battery chemistry is going to take the lead, but they’ve sunk capital in these gigafactories and they’re stuck. Like, if the battery chemistry evolves and gets better, they’re stuck with a technology. I think that’s a risk for them as well.
JA: Yeah, well in order to make the future, you have to commit to some kind of technology, you have to commit otherwise you’re not going to be able to get to a million cars a year. But in so doing, because you’re so early into it, it potentially closes off other avenues that might be more successful for the industry at large.
Yep. Let’s close off Tesla at that point, we’ve had a big conversation, we better talk about some Aussie stocks. But, John, looking forward to that part two, that’s coming out this week, is that right?
JA: Yeah, on Friday, yeah.
Okay, so it should be out by Friday, nice one. Nick, let’s go to you for a moment, you’ve picked up some of the businesses on the ASX and as the last one through the door at I-I, you’ve been stuck with the companies that are too complicated or too hard or too uninteresting…
JA: Or too expensive.
Or too expensive for the rest of us to take a look at, but that’s actually saddled you with some really interesting stocks and you’ve started writing them up. I was particularly interested in Goodman Group, which is a company that I feel as though we have missed over the years.
JA: I think that’s understating it.
It is, I’m trying to be understated here, John. [Laughs] Not only has it done really well in terms of share price, but the way that business has been built up, the way it’s run, the way it dominates its niche, certainly in Australia, it has all the hallmarks of a business that we genuinely like to get to know and want to invest in. After taking a close look at it, do you agree this is the sort of business that we want to take a more active interest in?
NC: Yeah, absolutely. So, we’ve kicked it off with a hold recommendation. I think the business quality is almost unquestionable, they’ve done a really good job out of the GFC where they almost did go broke. They’ve reduced debt on the balance sheet and really transitioned the model to less of a real estate investment trust and more towards a global fund manager or even private equity like business, focusing on industry property.
Let’s just break down the business model, because I think this is quite unique and confusing. It’s classified as a REIT, but as you say, it’s not really a REIT, it’s more of a fund manager. Just explain to us how a REIT morphs into a fund manager? What are these activities that Goodman does and how does it make so much money?
NC: So, there’s three prongs to the model. There’s rental income, which is your traditional real estate investment trust, earning money from properties, earning rent from tenants; then there’s fund management and development, and they’re sort of in the same boat together. So, what Goodman does, is they’ll put up typically one-fifth of the capital and go to big overseas, generally pension funds like The Canadian Pension Board, there’s a Chinese pension fund as well involved, and create these partnerships in each geography and go and buy logistics properties or industrial properties.
Then they’ll charge the partnership a management fee, the same as a Magellan would earn a management fee, they’ll charge the partnership performance fees on any outperformance above agreed upon benchmark, which are mainly kept private. For example, the New Zealand partnership is the only one that’s listed, so their hurdle rate or their performance fee that they’ve got to beat is the New Zealand REIT Index, essentially, or Property Index. Then they’ll go and use the capital that partners provide to not only buy properties, but buy land and develop it, or they’ll dispose of assets, it’s this entire model around industrial property and they sort of take a clip in every little corner. So, if they’re developing a project, they’ll charge the partnership a project management fee, they’ll take a fee on any excess returns they might earn. So they’re very similar to Macquarie, there’s just fees on fees on fees throughout these partnerships. And there’s been a huge desire for the capital to find more investment in property over the last, I guess, decade, with interest rates going so low that the Canadian Pension Fund’s got to meet requirements and they’ve got to find returns somewhere and industrial property’s been a huge winner, as has all property, but where Goodman focuses a lot is industrial, it’s almost entirely industrial.
So, compared to office and retail which has maybe suffered over the last – particularly since COVID, industrial’s taken off because the demand’s mainly coming from e-commerce players that need to be in sort of consumer centric locations in major cities, close to the consumer.
One thing I never really got my head around, Nick, is just the extent of the fees, and you mentioned Macquarie, I’d say that’s another business that’s always surprised me just how much fees they can extract from a deal. It has been sustainable for Macquarie, is it sustainable for Goodman? Do you think their partners are always going to be willing to pay those fees because the developments are that profitable?
NC: Well, I think that’s it, these partnerships have been earning 15 to 20 per cent returns…
NC: Yeah, and for a number of years. So at the moment, they are happy to pay it, but it’s one thing I think we mentioned in the article too that can turn, particularly in a recession like it did in the GFC, is that development profits can really fall because they just don’t complete as much work, they don’t start any new projects, the work in progress falls and developments now make up 50 per cent of the profits, so that’s probably why we’re not a buy on the stock, is because that number can really fall if things get tight.
John, did you want to say something?
JA: I don’t know much about Goodman, but it just seems to be extraordinary, the amount of money it can make for what it really does. Is it that hard to build big boxes? Where’s the skill in that? Or is it all just financial engineering?
NC: There is some financial engineering there as well. Two of the things that Goodman have that, I guess, a lot of other managers around the world don’t have is, one, they have a global presence. So, a lot of the competitors are more local, even Prologis in the US is mainly a US business with partnerships in the US, they do have some outside. But Goodman are one of the only companies that actually specialise in industrial property and have done for two decades in almost every continent on earth, apart from Africa. And so, the feature to these big pension funds, is they can go to just one manager and get global exposure.
The second feature, again, it’s not that no one else can do this, but they’ve been really good at designing properties. I think in the article, we had the Interlink property in Hong Kong which is 24 storeys, 15 storeys are accessible by trucks, and it’s not that no one else could do this, but there seems to be actually a bit of IP in that design work and they’ve also been ahead of the game in providing or developing environmentally friendly buildings and buildings are one of the main contributors to emissions, so tenants like Amazon which is, I think, 8 per cent of income, really want that because they’ve got their own ESG aims that they need to hit or they’ve mentioned them in their annual reports before net zero by a certain year and their building footprints are a big part of that. They’re probably the two things I’d say that Goodman has done better than the competition, but it’s not that no one else can do this, they’ve just been the best. The other one is just the returns, which have just been outstanding, so there’s no real reason to leave at the moment.
It reminds me a little bit, I guess, of Westfield, in the sense that anyone can build a shopping centre, it’s not impossible, but they did it a little bit better and because they did it a little bit better, the rewards they got were a lot, lot better. I think that’s true in this industry as well, that a little bit of improvement can lead to drastically out scaled outperformance as well. I’m familiar with Goodman because they’re a joint venture partner for a business I cover, Brickworks, and Brickworks management is constantly singing the praises of Goodman, saying that the location of the properties is really, really important because when you have, essentially, a logistics warehouse, it has to straddle main roads, it has to be close to customers, being close to port and rail resources are really important as well.
There’s only a limited supply of that sort of property and once you build up a handful of warehouses, all the trucks and all the logistics already lead to that area, so you end up sort of creating your own network. I think locking up a lot of good property and owning those networks already is a huge advantage for Goodman and it makes it much, much harder for someone else to come in and try and compete.
NC: Yeah, I guess that’s all correct. The other one I would say, probably going back to the previous question, is they also have long-dated capital which is a real difference compared to Magellan, let’s say. So, because it’s property and its illiquid, let’s say the Canadian Pension Board – they can’t just sell all their stakes tomorrow, this is locked in for several years and so, essentially, by locking in these partners, the assets grow, they just build and they’ve got pre-commitments just like private equity has pre-commitments from capital partners. So, they have a contract that they need to contribute x, y, z each year and that sort of just continues to grow. Then, over time, particularly where interest rates fall, valuations go up, so it just feeds into this whole model and then they allocate more money because that’s where the returns are and that’s pretty much what’s happened since the GFC.
As you said, they have had a lot of these properties in the best locations, they’ve also de-risked the balance sheet by selling all the worst properties. All the worst properties they held on their balance sheet, they’ve just got rid of and really focusing on just the properties with the best logistics networks and the best access to roads, ports, infrastructure, as you said.
JA: There was a friend of mine who works in industrial property saying that your point about the locations that Goodman has got is pretty accurate and that a lot of the increase in the cap rate and that effect on valuation is being offset by rental growth because they do own all of the best – not all of them, but the best properties. And if you’re looking at land that is close to the customer, you’re normally looking at inner-city land or land that’s in short supply and a lot of that has already gone in many of the major cities and you end up building 16-storey warehouses in Hong Kong and there’s only so many of those that you can do. So, they do seem to have carved out a niche for themselves, where these high value urban locations are really desired by tenants.
Just to play devil’s advocate for a second, the three of us, I think, are in agreement that this is a high quality business, it’s one we’re interested in, but another way of approaching Goodman is to consider that a lot of its success came post the GFC in an environment where interest rates have collapsed. They’ve been zero for 10 years, unprecedented and in that environment, if a property business can’t make bucketloads of money, especially one with huge development profits, there’s something wrong. So, I think we ought to be a bit more cautious – it’s an argument to be a bit more cautious in a rising rate environment, where the development pool is potentially smaller or less profitable and the business gets tested in a way it really hasn’t been tested over the last 10 or even 15 years. Is that probably a bit harsh?
NC: No, I think that’s 100 per cent right. I mean, if you look at it compared to just your typical real estate investment trust, the revaluations that’ve come through are just an accounting sort of entry, it doesn’t really matter, it doesn’t come through in cash flow, but this is different with Goodman. When a partnership re-values a property, they charge an asset management fee of about 75 basis points based on that revalued value, so if it goes down, if it goes the other way, then the assets under management falls and the actual earnings for Goodman fall as well, the actual cash earnings, and the same with the development business.
So, over the last 10 years or since 2011, they started with $12 billion assets under management, now I think it’s close to $80 billion, but if you just take the $70 billion that they had under management at the end of last financial year, half of that gain or a little bit over half that gain has come from revaluation of property, which is capitalisation rates falling anywhere from 9 per cent to 4 per cent of what they are today. So, a lot of Goodman’s gains have come from the revaluation of property and earnings that have flowed through. Then on top of that, they’ve just been in the best area of property which has been industrial property, because e-commerce has taken off over the last decade.
So they’ve definitely benefitted and importantly, the income statement, the cash flow statement, as well as the balance sheet has benefitted. It’s not just a revaluation like a typical real estate investment trust. I think you’ve talked about it before with Brickworks, that they say, “Oh, those profits may reverse at some stage.”
Yep, completely different view. That’s probably the single most important point to understand about the business and you’re right, Brickworks is a great example because the management who I really rate at Brickworks, all the way throughout the boom they gave warning that, “Look, we’ve got these revaluations coming through, they’re not real profits, we don’t count them as real profits…” and they said that as the asset prices were rising and they’re saying the same things now as asset prices are falling. They’re saying that, look, those weren’t real profits, they didn’t benefit us and so they’re not going to hurt us on the way down. I completely agree with that, I think that’s true, that’s accounting treatment affecting the bottom line, but your point’s well made.
Goodman is completely different, you’ve actually got real cash flows coming from their accounting treatment, so things are going to get really nasty if they can’t compensate for that falling FUM if they can’t do something to offset that, then profits are going to fall.
NC: John’s point that he’s made about industrial property is absolutely correct as well. Even though most people expect capitalisation rates to rise, so from 4 per cent to maybe 5 or 6, rental growth in their properties is offsetting a lot of valuation fall. Some of their properties in the US, Goodman have said they’re 40 per cent under-rented or they can increase rents about 40 per cent. So, yeah, the two main inputs in valuation for them are the actual capitalisation rate and the rental levels. So, there should be some offset even if capitalisation rates do rise.
That’s why it’s so hard.
I mean, the valuation is so difficult, the reason I think we haven’t upgraded, I don’t think on the team actually owns Goodman is because you have these two very powerful forces working in opposing directions. I mean, we don’t really know which way this is going to land. It could be potentially very bad or it could be quite favourable, it’s just hard.
JA: What’s a disaster scenario for this business, Nick?
NC: I think the disaster scenario is literally what happened in the GFC, you come in over-leveraged into a massive property bubble and they had the one for one rights issue at 40 cents to save the business. The stock absolutely collapsed, I think it fell 95 per cent plus, that’s the disaster scenario. I think in this case, unless we get some extremely high interest rate, which there’ll be many disasters in that case, that’s off the table this time, just because the balance sheet’s been repaired. It used to be about 50 per cent debt to equity, it’s now 8 per cent, if you include the partnership stakes then it’s about 19 per cent. So it’s just a different ball game in terms of how leveraged they are.
Probably the worst scenario I can envision is just those development profits really fall and then some of the valuations – I think the rental side of the business, they’ve got 99 per cent occupancy, the rental side of the business which is about 25 per cent of earnings, should continue to grow earnings. I mean, I don’t think Amazon’s pulling out of any warehouses they’ve got just yet and most of the other customers are big, like Australia Post, like industrial businesses or logistics business. It’d be just on the development side of earnings and potentially the assets under management or the FUM side of earnings as well.
The fact that there’s a founder there just provides so much comfort, doesn’t it? And a founder that’s actually shown himself to be quite sensible. 0
NC: Yeah, absolutely, and it’s not just the founder… The Founder, Greg Goodman, he owns, I think, a stake worth about $800 million dollars, but all the senior executives own stock. I think the six people they have in their key management personnel report in the annual report, they’ve been there for 10 or 15 years plus, all of them. The business had 6 per cent employee turnover last year, which is extraordinarily low. So, I think it’s a culture that he’s built from the top, but it goes all the way through and most people own shares in the business that work for them.
JA: Nick, I’ve got an uncomfortable question for you. We clearly missed this, why do you think we missed it?
NC: That is an uncomfortable question. [Laughs]
NC: I think Witcomb was the analyst for most of it.
JA: Yeah, he was, but I just wonder whether because of the experience that we collectively went through Goodman with stopped us from seeing what it became after that catastrophic event.
NC: Yeah, I think that’s part of it, for sure. I think the other thing, to really envision back then what Goodman is today, you would have had to predict that e-commerce was going to be as big as it is today, which a lot of people didn’t. I mean, we take it for granted how big Amazon is or something like today, but a lot of people didn’t predict that in maybe 2010, 2011. The other thing you had to predict was that capitalisation rates were going to fall from 9 per cent to 4 per cent and interest rates were going to be zero, like at a central bank level. All those things have helped not only property companies, but in particular, Goodman Group because of the things we spoke about before of the revaluations and that sort of thing, so I think it was pretty hard to see. Maybe the thing was just to back Greg Goodman and they still kept a lot of the partnership assets under management, the tenants – the actual occupancy of the buildings never, I think, fell below 94 or 93 per cent, so their buildings were occupied. So there was legit business underneath, but there was risks back then too that they needed to de-leverage the balance sheet and I guess they did quite aggressively.
I think you’re being quite kind there, Nick. I think we were all aware that the shopping thing was taking off and I think John’s point is quite right, I mean we saw this thing go almost bust and to back it after watching it fall 95 per cent is really hard. I actually had a similar experience with Lynas. Lynas, the rare earth miner, used to be an absolute basket case, poorly managed and they couldn’t get the chemistry right. I saw that thing struggle and almost go under multiple times. When new management came in and sorted that business out, I was very late to see it because I was scarred by what I’d seen about the business earlier, it just leaves you with this lingering scepticism.
I don’t think anyone minds being wrong in this industry, I mean, we’re all wrong sometimes, it doesn’t bother me one bit, but to be wrong on the same stock, that would hurt and I think we try and avoid that a lot.
JA: Wrong on the same stock twice.
Twice, yeah, you don’t want that.
JA: That’s hard. It’s funny, isn’t it, because there’s this argument for experience which I fully support, but there is a way that experience also takes your view, you know, the way that history forces you to see things in a particular way or suggests that you see things in a particular way when the future might look very different from the past, it’s just hard to see.
I completely agree. Hey listen, we better move on from this and quickly finish up on our last segment, which I actually just planned to have a quick word about AGMs, which for the first time I’ve been attending more regularly this year, made a huge effort to get to a lot of AGMs, or at least listen to them and read the transcripts after the fact…
JA: I thought you’d put on a bit of weight.
All those sandwiches. It is tempting… It’s actually great, I used to think, oh, what a waste, all these sandwiches and just go over the food, but you’re sitting there for one and a half or two hours, the sandwiches are just a delight when they come out afterwards, it’s so nice. And some companies bring out some really good stuff. New Hope, which I expected to be really stingy and bring out nothing and maybe a bit of chips. I mean, I actually bought my lunch beforehand because I was telling the guys that, “New Hope’s not going to provide any lunch, they’re not going to give you anything to eat, this is the Milners, come on!” And they put a fantastic spread…
JA: Their food and beverage budget must be pretty awesome nowadays.
[Laughs] Yes, that’s right. They had a great spread and it was very good. My point is, really, I wanted to get your ideas about this as well. I credit my friend, Greg Hoffman, for getting me to more AGMs, he’s been saying for quite some time that if you go to one, you might not get that much out of it, but if you start going to several you start recognising things and you start seeing things that you don’t always get to see, and it’s the only time we get unguarded access to management. When you ring up the management as an analyst and want to have a chat, I find that completely useless because they’re on script and they don’t help you out. But over a sandwich at an AGM and you’re wearing jeans, that can be different. Is that your experience as well? John, maybe you go first.
JA: The one that I remember from AGMs, it was actually Greg at Brambles and Brambles had lost, I don’t know how many pallets it was, but it was a lot and it impacted their results and they were denying that they’d lost them, they said, “We just don’t know where they are, but they are somewhere but they’re not lost.” And I think Greg went up and had a chat with the CEO and the Chair at the time, he said, “Of course they’re F’ing lost.” So there was this public and personal persona that were quite different and he just couldn’t bring himself to come out and say what everybody knew, because that wasn’t the company line. So you do get instances like that.
I think, for me – and I was hoping to go to the Lovisa AGM last week, but I was bloody sick – but, often you see the dynamic between the management teams in real life, how they interact, how often they interrupt each other, who uses ‘I’ a lot, do they talk in the ‘we’, the collective, or the singular? You know, is the CFO sitting there sort of cowering before the CEO, worried that he’s going to say something out of place, all of that kind of stuff…
The relationship between the Chairman and the management, the board and the management, you get to see that relationship which is crucial, absolutely crucial…
JA: That’s right.
And that’s the only time you’ll see that. Sorry, go on, John.
JA: Well, this is the soft side of analysis, you know, in most cases it’s probably not that pertinent, but there are situations where, especially in growing businesses, where the management I think is really critical, they’re not just sort of custodians of a monopoly asset, they’re actually trying to build something. That dynamic between the various members of the management team is really, really important and you only really get to see that face to face to AGMs, so I think that in itself is a good reason to go.
Nick, what about you?
NC: Yeah, I haven’t been to a lot, but I think your point on getting management and the board when they’re unguarded is extremely important. I mean, you can sit in front of your computer and read the transcripts from an AGM, but it’s not the same as going and actually meeting these people face to face. That dynamic between the board and the management is another good point. I mean, how many boards have we seen over the years that just don’t care? Yeah, you’ve seen it with AMP and then you’ve seen, as you said, with New Hope and Lovisa’s another good one, that the board actually cares, they’re invested as well a lot of the time, particularly a lot of the time, the Chairman, and how they incentivise management is another big one because a lot of the time the board really, I think, just doesn’t care, they’re just there to get a pay check.
I think for me, what I realised, it’s a good chance to understand the people running the business – I’m not pretending I can read their body language or get to know them after a 30-minute chat, but you do pickup bits and pieces. An example from the New Hope meeting, a group of friends and I went over before to Muswellbrook and we’re having dinner at a pub in Muswellbrook and the entire New Hope executive team and a bunch of other people were at the pub and they were having dinner as well…
JA: And had been for the last three days, probably… [Laughs]
[Laughs] We bumped into the same people so many times over the course of the couple of days, it was quite funny. A random lady just came up to me and said, “Geez, we’ve seen you boys everywhere, where are you going? Why are you following me around?” It’s just a small place and we’re walking around and we just kept on bumping into the same people. But what I noticed, was that Rob Milner, his son and the CEO and the CFO, the four most senior people in that business, were the last ones to leave that night when everyone else had gone, and those four individuals cleaned up after themselves.
They brought all the plates and everything, big armfuls of everything and brought it to the counter and had a chat to the people who were at the pub, they clearly knew each other reasonably well. And you know, this is a billionaire, a bona fide billionaire cleaning up after himself and having a chat to the staff. It’s probably not a big deal, but it tells you, you know, the fact that he cleans up after himself makes me feel a bit better about operating a mine and cleaning up after himself on the mine site.
JA: Yeah, what would that say about rehabilitation of their mine sites? Like, could you make the argument that their rehabilitation is better than anybody else’s in the industry?
Look, I think it’s a long bow to link those two together, but it gives you an insight into the kind of people who are running that business and it’s no coincidence, I would say, that your point is 100 per cent correct, New Hope actually has maybe the best record of mine rehabilitation in all of Australian mining. They’ve rehabilitated several coal sites and now they’re actually operating farms on those sites and they own cattle on the former mine site. When you see pictures of it – I’ve never gone in person to see the rehabilitated sites, something I want to do one day, but pictures of it, you would never know there was a mine there, it looks just like a farm and there are very few miners who leave the ground untouched the way New Hope do.
And I don’t think it’s a coincidence that the sort of people who clean up after themselves and think of their own identity with humility, do that in their professional life as well.
So, there you go, go to the AGM and get to the pub, I think that’s the lesson from today’s podcast.
JA: That sounds like a full life to me.
That does, doesn’t it? AGM and pubs, the meaning of life right there. [Laughs]
Listen, we better get some other stuff done as well. It was nice chatting to both of you. Nick, great to have you today, we’re going to have to grab you on for some other stocks as well, so don’t go too far, we’ll see you soon. Thanks, Nick.
NC: Thanks, guys, thanks for having me.
And, John, huge treat to have you, we don’t get to speak to you often enough, but I’m really glad for your time today, thanks.
JA: No, that was good, I really enjoyed it, and enjoy the game tomorrow, Nick.
NC: Oh, yeah, thank you, will do.
Soccer stuff, goodness me.
All right, for everyone else, despite the soccer, thanks for listening.
JA: All right, see you.
END OF TRANSCRIPT