Fantastic article on Aussie Banks

A very well presented argument here on why our "safe" banks may not be as safe as everyone thinks.

Whilst I would not be betting that house prices are going to fall 10% to 15% next year as the Credit Suisse report suggests, I would also not bet against it happening. Regardless of what the housing experts say (those with vested interests in talking up house prices - Fairax, News and the very trustworthy real estate agents), houses are not cheap and there is a reasonable risk that there could be a correction.

With baby boomers de-leveraging over the coming years, there are significant headwinds for the housing sector and therefore the banking sector. For those that are believing that the housing corrections that have happened elsewhere around the world cant happen here because it is Australia, then I suggest you rethink you logic.

Our core scenario is that as interest rates continue to fall over the coming year or two, house prices will most likely stagnate. However, we also believe that there is a moderate probability that there could be a correction. It all depends on how high unemployment reaches in the next cycle. I suggest that you should not be investing significant amounts of money in companies that are based on continued low unemployment to maintain their current earnings.

As Buffett says:

"You only know who has been swimming naked when the tide goes out."

I would hazard a guess that we are closer to high tide than low tide in Australia...

Are all equities a good inflation hedge? By Marc Lerner

Are all equities a good inflation hedge?

Zero Hedge has reposted a UBS report entitled ‘Are equities a good inflation hedge?’ The report
investigates this question through a study of historical data of equity performance in various inflationary and deflationary price environments, and concludes:

Indeed, they [equities] provide an appropriate hedge to rising inflation only in a limited number of cases.

1. The trade has to be entered at a low level of inflation. If the trade is started above 4%, the
valuation loss due to declining P/E will dominate and make equities underperform.

2. If inflation increases only moderately. High-single-digit inflation would make the equity valuation
loss dominate other effects.

3. If the investor assumes that inflation will not decline. In that case, the trade would also generate
sub-inflation returns. So an equity hedge comes with increased portfolio risk in cases of deflation.

The main problem with the report’s approach in reaching these conclusions is that it does not attempt at all to focus on the effects price inflation – a sustained, general increase in prices - may have on individual businesses and their earnings. Whilst it does pose some interesting arguments on a macroeconomic level – for example, that higher inflation may lead to higher volatility and hence higher discount rates being applied to cash flows – and provide empirical data to support them, it only in passing mentions that “some price distortions can obviously affect corporate margins”, instead simply presenting the aggregate returns of stocks in general under inflationary and deflationary environments, as if all equities were homogenous. The report can’t see the trees for the forest. But if you are interested in the performance of specific companies in an inflationary environment, rather than a broad equity portfolio such as an index fund, this effect on margins is precisely the crucial issue, and well worth investigating further.

In the near term, the most likely source of price inflation is money printing from central banks, rather
than some other source, such as a supply shock. The effects of such monetary expansion are never even – prices will rise first wherever the new money enters the economy (relative to what they otherwise would have been – a relative price ‘increase’ can still be, in absolute terms, a decrease). If it is used to purchase government bonds, wherever the government spends the money will experience rising prices, if mortgage backed securities are purchased then rising house prices will result. By unevenly distributing the price increases in this manner, money printing can allow the early recipients of the money to benefit at the expense of the latter ones – by the time the money filters through to them, their costs have already increased correspondingly. Therefore, if it can be determined that a company’s output will be purchased directly by the new money flows before they spread through the economy to affect its costs, aggressive margin expansion and high returns to shareholders are likely to be the outcome. Finding such companies, however, is essentially a political question and hence a difficult one to answer accurately, unless you happen to be friends with Ben Bernanke.

More broadly, as the money does move through the economy and affect consumer prices as well as costs, the crucial question becomes whether or not a business can raise its prices to offset, and perhaps even outpace, the increase in its costs. The extent to which different businesses’ costs are affected depends, again, on the way the new money moves through the economy, and will differ in each case. For consumer businesses in particular, however, the question of whether prices can be raised to an appropriate degree takes on an especially interesting psychological dimension – will consumers be willing to pay higher prices? One consideration could be the extent to which the specific business’s customers themselves are in a position to benefit from the increased money flows earlier rather than later – if the business is one that caters to a particular, easily identifiable demographic. Another argument could be made, however, that the absolute value of the price increase is of importance – a 10% increase in the price of a Coke, for example, may not seem like much to most people in terms of the extra amount they have to pay, and hence not affect Coca-Cola’s ability to raise prices in tandem with inflation, whereas a 10% increase in the price of a house or a car could be seen as a serious cost-of-living increase, and hence such purchases may be delayed or cancelled until prices stabilize or fall.

Marc Lerner

These are a few of our favourite things - Google (By our star recruit Marc Lerner)

Our newest recruit Marc Lerner has given an excellent summary on why we are very happy to hold a reasonable allocation of our client's portfolios in Google:


Despite the seeming complexity of the various services it provides – Gmail,
Youtube, and a search engine that is synonymous with finding something on the
internet, in terms of revenue Google is, quite simply, an advertising company,
with advertising accounting for 96% of revenue in 2011. There are two primary
types of advertising businesses the company runs – advertising on Google
websites – for example, the plain text ads on Google search or Youtube ads
before a video, and advertising on Google Network Members’ sites – a network
of affiliate websites that hosts ads relevant to their content contracted through
Google. The former is a far more profitable business model than the latter, as in
the latter Google has to pay a large proportion of its revenue from advertisers
directly on to the Network Members, although interestingly the second model,
by tying the major cost directly to revenues in a variable manner (if advertising
revenue drops, so do the payments to Network Members), in the case of an
economic downturn could help in mitigating the severity of margin contraction,
which has some value in what is essentially a cyclical business. The ads on
Google sites are, however, a larger part of revenue and have been growing faster,
so the more profitable segment of the company is overtaking the less profitable
one.

In a world where the Internet as a source of information is fast taking over
traditional forms of media – newspapers, television and books – Google has
created a near-monopoly in its strongest generator of advertising revenue,
Google Search. The nearest competitor, Microsoft’s Bing, has a market share
that fluctuates around 14-16%, with Yahoo posting similar figures. Neither has
anything like Google’s – a high of 66.8% of the market in June 2012. Nor is either
likely to increase to any extent that rivals Google – at most, possibly taking share
from each other is all these two can reasonably hope for. After all, when you
need to find something online, what do you do? You Google it.

A current challenge that Google is facing is drawing advertising revenue from the
increasing use of smart phones and tablets, rather than traditional computers, to
access the internet. Because of the physical and technological limitations of such
products, this is a difficult task - for example on a mobile screen there are no text
ads on a Google search, presumably simply because there is not enough space.
The extent to which Google can innovate new ways to generate revenue from
this technological space will have a significant impact on the growth it can attain
in future years. However, even if such innovation, which Google is pursuing
aggressively, provides only disappointing results, the core business will likely
continue unaffected insofar as the convenience of using a computer or laptop
ensures that they will never be fully replaced by mobile devices.

Longer-term, there is some risk in online advertising that – legally or illegally –
ad blocking programs that block ads such as Google’s become very widely used.
These already exist – for example here is a free ad blocking extension to Google
Chrome, which claims to be the “world’s most popular browser extension” and
“used by millions of users worldwide”. Most of Google’s advertising revenues
only get paid on a cost-per-click basis, so if this became truly popular as the
general population becomes increasingly tech-savvy, the effect could be very
serious on Google and its Network Members’ revenue, or its costs insofar as
counteractive technology may need to be developed. Leaving this possibility
aside, however, the position that Google has as a search engine ensures it will
have a competitive “moat” around it for years to come.

Marc Lerner

Coin flippers come out to play...

Its that time of the year again when the coin flippers come out of their shell and make ridiculous predictions for the various share market indexes for the next 12 months. Shane Oliver and John Abernethy have both predicted 10% to 15% returns for the market.

I call them coin flippers because the probability of guessing where the index will be in 12 months is not much better than a 50/50 coin toss.

This practice is about as useful as dart board investing. The answer is that no-one knows where the Dow Jones is going to be at the end of 2013 or whether the All Ordinaries is going to be higher or lower.

Shane Oliver's famous call in 2007 that the Australian market would reach 8000 in the next year was a fantastic example of coin flipping.

The regular offenders of the coin flipping calls are the brokerage houses. Once again, it all comes down to incentives. How do these guys get paid? They get paid when you buy and sell shares. If you keep your shares they dont get paid as much, so it is in their interests (not yours) to attempt to make you buy and sell regularly.

There are a large group of people who like to move in an out of the share market as if they know what is going to happen in the next 12 months. This is a very good way to miss out on some of the best returns available.

If stocks you own are over valued, it may be wise to trim your position, but it is not wise to be buying and selling in and out of the market on a regular basis because of a gut feel.

There are sectors of the market we believe are at greater risk than others and for those of you who are able to invest your superannuation with discretion, you have the ability to reduce risk by avoiding these sectors. Mining and housing related sectors of the Australian share market are likely to have greater headwinds over the coming years. We caution those over exposed to these sectors.

A better practice is to ignore the markets and invest in wonderful businesses and hold them for extremely long periods of time. Always keep some powder dry to add to your positions if markets offer irrationally cheap but high return and sustainable businesses.

At Valor Private Wealth, we would like to make a prediction that the share markets in free markets (not "roach motel" markets like China) will gradually grow over the very long term and continue to create wealth as they have for the last century. There will be market corrections one in every 4 or 5 years on average and your portfolios will fluctuate. It is not these market fluctuations that you should worry about, but the long term growth in the value of the businesses you invest in.

Limits to Proctor and Gambles price gouging?

This article here about the "shaving guru" is an obvious example that the cost of the every day razor is getting out of hand.

Proctor and Gamble who owns Gillette have marked up the price of the every day mans de-bearding tool to ridiculous levels and it is driving customers to look for alternatives.

This leads me to question how much growth is left in these big brand consumer product companies like Proctor and Gamble. Is there a limit to their growth?

At what point do these companies price themselves out of the market? I still use Gillette, however I would gladly swap for something that does a similar job for less.

Are any of my readers looking for alternatives? Are you brand loyal regardless of the increased costs?

Does Buffett Style investing work in Australia?

Warren Buffett has said it is far better to "buy a wonderful company at a fair price than a fair company at a wonderful price". He also likes to say his "favourite holding period is forever".

But does this work in Australia?

Australia doesn't have a plethora of global world beating franchises. Our best brands don't come anywhere near making the top 100. Billabong and Qantas are probably our two most recognised global brands and these have not been fantastic investments over the last decade. In the Brand Directory for 2012, we have some brands that have value, but they are not world beating brands, they are local franchises.

So are there any companies in Australia that would tempt Buffett? Yes, but not many.

Buffett generally doesn't invest in cyclical businesses, so this rules out the mining companies.

He likes to invest in a few banks, so maybe some of our banks might make his portfolio. However at their current prices, I would be very surprised if he decided to buy Commonwealth bank trading at 2.4 times book value when he can buy Wells Fargo at 1.2 times book value or Bank of America at 0.5 times book value.

Buffett has been buying more of the US banks recently, but most of his purchases have been after significant pain the the mortgage market. Something we haven't seen here in Australia (yet).

He likes to invest in insurance companies, so would QBE make the list? With QBE's highly geared structure, I would think that Buffett would throw it into the too hard basket.

IAG might pop up on his radar, but they have had a less than stellar record over the last 10 years so it is also unlikely.

Buffett has always liked newspapers since his days as a delivery boy, but with Fairfax destroying capital at an alarming rate, it is probably not a worthy investment. Newscorp is one of the stocks that may be on his radar as the formidable Rupert continually surprises his competitors.

Buffett doesn't invest in telco's so everyones favourite - Telstra, is not going to make the cut.

So with the miners ruled out, the banks likely over priced, the telcos too uncertain and our insurance companies having been poorly run, what is left?

He might like a piece of ARB. The market leading 4 wheel drive company that has grown its shareholders funds well into the double digits for the last decade, however that is looking a bit overpriced at the moment.

Fleetwood is up Buffetts alley. He owns an amazing caravan business in the US. I would guess that Buffett would be worrying about a slowdown in mining affecting Fleetwood's manufactured housing business.

Having invested in financial reporting at rating companies like Moody's, Buffett may take a look at Iress which has a slightly different business, but still a moderately strong moat. Iress has also had a very good run of late and is not looking like it would fit in Buffett's discounted cash flow mental models at present.

Buffett doesn't mind an investment in oil and gas. His Conoco Phillips investment has been one of his worst performers, but he hasn't sold all of it. A company like Origin energy might tickle his fancy with its current price falls, but with the US shale gas revolution and potential LNG exports out of the US, the upside on Australian high cost gas producers might be less than many predict.

Buffett has previously invested in Sanofi-Aventis, so would CSL get some research time? I would think it would. CSL appears to be kicking some goals at present, however with new management in place and a very high valuation, Buffett would probably leave it for another time.

Woolworths is a wonderful business that Buffett would also probably invest in, however his recent purchases in Walmart at 10 times earnings and Tesco at 8 times earnings make investing in  Woolworths at 20 times earnings an unlikely prospect.

Buffett recently bought Burlington railway. So would QR be on his radar? It might, however with Burlington earning twice the return on equity and significantly lower debt that QR does, he would probably let that one slide.

So if Buffett was located in Australia, he would have a difficult time using his investment philosophy to fill a portfolio of Australian stocks.

Michael Pettis article

Another fantastic article on China's difficult road ahead from Michael Pettis.

At Valor Private Wealth, we have not seen any evidence that China is doing anything more than talk about reforms in their economy.

Building empty buildings and infrastructure is not the panacea for all growth problems. It is extremely difficult to turn the ship around and reduce fixed asset investment and at the same time increase consumer spending.

We still believe we are in the eye of the storm in China's fixed asset slowdown. At some stage the debt binge becomes unmanageable and the party ends. And this has been one hell of a party!!!

Many mainstream journalists and fund managers are buying back into the story that China will resume 8% plus growth for decades on end. We dont believe the hype and are still very worried that there is more pain to come.

More Chinese Accounting issues

The SEC are working hard but are hitting road blocks and seem to be having difficulty in dealing with the Chinese when looking into the accounting issues of a number of companies. The Chinese are further blocking access to many of these companies documents and not playing fair.

It astounds me that people are still investing in these Chinese foreign listed entities. The level of accounting irregularities is perverse and yet professional investors are still putting their money into the black hole of Chinese foreign listed entities.

When trust fails in markets, the systems can break down. The Chinese need to ensure they dont break the trust of western investors.

It will be interesting to see the outcome of the coming months of SEC probing.