Are you covered?

If you add up all your income over your lifetime, it is likely that this is going to be your largest asset. Why is it then that you insure your car which may cost only tens of thousands over your income which is likely to be worth millions to you over your working career?

Sorry but this is crazy!

What would happen if you were unable to perform your job due to sickness or accident?

Would you be able to pay your mortgage? Would you be able to pay for your children's education? Would you be able to put food on the table?

These are fairly basic questions which unfortunately quite a few people can't answer with confidence.

If you require your income to keep coming in every month to provide the basic needs for your family and you dont have income protection, you are putting your family's well being at risk.

The great news is that it doesn't cost an arm and a leg to insure against these risks.

If you want to ensure your family is protected against the unthinkable then give us a call at Valor Private Wealth on 02 8013 5205 to create a wealth protection plan that gives you peace of mind.

Chinese overtaking the US?

There was a recent article which states that the OECD expects the Chinese economy to overtake the US by 2016. I generally have a great deal of respect for the OECD as they have a collection of above average independent thinkers. On this simple exercise of straight line extrapolation of future growth, I think they may be a little off.

Humans are terrible at predicting a change in trends. This is why very few economists predicted the GFC. The human brain loves symmetry and so most find it easier to just assume current trends will continue. Unfortunately things like reversion to the mean, valuations returning to normal, black swan events and unwinding of excesses in economic systems destroy most straight lines.

One day the Chinese economy may overtake the US, however I believe that day is still a way off.

The main reason the Chinese economy is growing at such high rates is because they are expanding their  building of empty apartments and offices by over 20% per year (to be fair, a small percentage of these apartments and offices are being used, maybe 25% or so). So this means that China will be building over 70% more empty apartments and offices by the year 2016.

Unlikely...

I have been to a number of Chinese cities to see with my own eyes the vast stretches of empty real estate. It has been fascinating to see this growth in empty offices and apartments. I first noticed it in 2008 at the Beijing Olympics and was perplexed as to why there were hundreds of office buildings in Beijing completely empty. At the time, I was not aware that this was the tip of the iceberg. As someone who gets paid to travel the world and observe from the front line what economies are doing, I find the Chinese economic "miracle"(experiment) truly fascinating.

What you see in this video is not an exaggeration, it is the norm in China. It worried me a few years ago when I realised the situation. It is far worse now, however it could continue to bubble away for a little longer.

China has a lot going for it over the long term. They have transitioned their economy out of the dark years of the 60's and 70's and brought hundreds of millions of people out of poverty over the last 40 years. I expect that over the next 40 years, their average incomes will continue to rise. This trend is unlikely to fix the damage from the previous administration, who overcooked the economy with too many unproductive assets. As described by Wen Jiabao, the Chinese economy truly is "unstable, unbalanced, uncoordinated and unsustainable". The only difference between now and 2007, when Wen first made this statement, is that  now there is a lot more debt!!!

So far I have been wrong in predicting the exact timing for the slowdown in China. I would have thought that being a command economy that they would pull in the reins and attempt an orderly slowdown. They began to tighten the reins early last year, but since then, they have pumped up enormous amounts of stimulus through the shadow banking system with wealth management products. This growth in off balance sheet debt is very worrying. With the current boom flourishing unabated, the eventual slowdown becomes far more painful.

Those punters buying the iron ore and coking coal miners are hoping that the OECD's straight line projection is correct. The Australian goldilocks economy is desperately clinging onto China's "treadmill to hell" policy of building its way out of its over building problem.

At some stage their SimCity experiment will have to address the issues as described by the game description on Wikipedia:

For the success of a city, players must manage its finances, environment, and quality of life for its residents.

So far the finances are looking very stretched, the environment is choking its residents and its people have to pay exorbitant multiples of average wage just to buy an apartment.

Only time will tell, however I would suggest there are far better investment thesis than betting on straight line projections of China's growth from this current point in time.

The biggest question I would love to have answered is how much a slowdown in China will spill over into the non-mining sectors of the Australian economy. The future is never clear, but at Valor Private Wealth, we are quite skeptical that the remainder of the Australian economy is immune to a Chinese slowdown. The latest run up in the banks share prices suggest that the rest of Australia is completely ignoring this risk.

The beautiful fact that investing is a "no strike called" game means you don't have to swing at every ball. So at Valor Private Wealth, we will sit this cycle of Chinese growth/slowdown out and let others take risks we think have poor upside for the significant downside risks ahead.

The single best measure followup

For those that are expecting the Australian stock market to get back to its highs of 6800 in 2007  any time soon, I would suggest to once again use the Total Market Capitalisation (TMC) to Gross National Product (GNP) method. This would show that Australian markets were far more over priced than US markets in 2007 and therefore are unlikely to return soon to these overvalued levels.

In 2007 the Australian TMC to GNP came close to 140%. This is not far off to the all time high of approximately 145% of the tech bubble in the US. In 2007 the US TMC to GNP was around 110%. It took 13 years for the US markets to get back to their 2000 highs. Will Australia have the same issue with its 2007 highs? Only time will tell.

With the mining boom significantly boosting our GNP, there may be slower or even negative growth in our average incomes over the next few years. This is likely to have an impact on markets and so we are relatively cautious about the mid term outlook for Australian markets.

Single best measure

Warren Buffett outlaid his recommendation on how to think about whether markets are relatively expensive or cheap in 1999. He describes the stock market to GNP ratio as:

probably the best single measure of where valuations stand at any given moment

In Australia, we now stand the test of this measure as stock prices have risen significantly in the last six months to push the ratio up to just over 100% and now stands at approximately 103%. The periods where the ratio has been over 100% in the past have been the precursor to well below average returns in the preceding years.

Using these figures, it is possible to have an educated guess that the average investor will not return anywhere near the average stock market returns of the last 100 years over the next 5 to 10 years and so going forward, they should dampen their expectations.

Unfortunately animal spirits seem to have kicked in and when the good times are rolling, most don't think about rational measures of valuation and only think about the recent past in estimating their future returns.

The US stocks markets are also trading at elevated levels when compared to their GNP. See here for more details.

As Buffett always says:

Be fearful when others are greedy and greedy when others are fearful.

We suggest that investors be more fearful than greedy at this point in time.

There is one point to make. In any market there will be above average franchises that have the ability to make higher returns on their equity than the average business and so will do better than the total stock market as a whole. These businesses are those that display characteristics that give them higher earning power through competitive advantages that are durable. There are very few of these businesses and if you own a collection of them bought at rational prices, you have a reasonable chance to earn more than the average return.

This sounds easy in theory, but few have the temperament to follow this method. This method of buying companies with durable competitive advantages requires 3 things to be successful. First you have to be able to identify the long lasting protective moats of the businesses correctly. Second you have to buy them at reasonable prices and if they are not available below their fair worth then wait until they are and thirdly, you have to hold them for very long periods of time.

Most investors fail on the first point, so there is very little chance that they can truly outperform the average indicies over time. Many look at recent business growth as a competitive advantage. Often this growth is due to cyclical margin expansion rather than any competitive advantage. This is the rising tide theory where most companies seem to perform well. As Buffett says, "It is only when the tide goes out that you learn who has been swimming naked" and the truly wonderful companies show their enduring competitive advantages. At present, interest rates are at all time lows and the tide only seems to be going coming in, but at some stage over the next few years, interest rates are likely to rise and those investing in average and below average businesses are unlikely to return satisfactory results.

This theory applies to those buying low yielding real estate in Australia (mid to low single digits) using the past 20 years as a guideline for the next 20 years. Over the last 20 years, interest rates have generally trended in one direction - down. At some stage in the next 20 years, interest rates are likely to trend upwards. Those investing in properties with low yields may find they also achieve a less than satisfactory return when this reversal in rates occurs. I think this may be a few years off as Australia struggles with a slowing mining boom, but I would be very surprised if interest rates stay near emergency settings for decades. If average interest rates return nearer to 6-7% (more than double where they are now and closer to average) then I would suspect the current average property investor is unlikely to be returning above their cost of capital. This speculation of future capital gains is unlikely to prove overly profitable for many. Unfortunately this speculation of future gains is what a good many pre-retirees are banking their entire retirement on. They are making these bets either through highly geared property or through large holdings in Australian banks which are also addicted to above income loan growth which I believe is unlikely to persist indefinitely.

For those defined benefit and pension funds that are expecting greater than 7% returns (in a world of sub 3.5% bonds and greater than 100% market cap to GNP) for their calculations, I would suggest either find a Gretchen Tai or a Warren Buffett to manage your money to make this hurdle rate after fees and taxes going forward. If you are investing in businesses with large pension and defined benefit obligations, you may need to factor in some capital outlays by the businesses to top up their retirees funds.

There is currently a very strong "fear of missing out" syndrome that is beginning to pervade the markets. Those that get swept up in this phenomenon may over pay for their assets and have unsatisfactory results.  What looks to be an unattractive 4.5% return from a high yielding cash account may be better than the returns from overpaying for growth assets. Patience is a virtue with very high returns.

Capital Dependent and Capital Independent

There are two types of businesses in this world.

There are companies that are capital dependent and companies that are capital independent.

You generally only want to own the latter.

Its a bit like the story of two brothers. One who worked hard and supported himself through his wage and the other who had great dreams and many crazy business ideas, but floundered and went back to his parents for cash every few years because his income and cash had depleted. If you had the choice of investing in the hard working brother or the flounderer, it is an obvious choice. In the investing world, you have the same choice, buy unfortunately many people want to back the dreamer rather than the steady hard worker.

Most companies require capital over time. Some companies like airlines and start up mining companies consume capital like a herion junky. Even companies that are considered great companies can sometimes be capital dependent in difficult times.

During the GFC, numerous capital dependent companies were required to raise capital when their share prices were very low. They permanently destroyed capital.

Then there are wonderful companies like Berkshire Hathaway that always has a cash buffer and is capital independent. Warren Buffett was the saviour of numerous companies during the GFC throwing them a lifeline in their time of need when capital was sparse.

For most of the time the average investor doesn't think about the capital dependency of a business. At Valor Private Wealth, it is paramount in our thinking.

We even go one step further...

If you own a capital independent company and you are a long term shareholder, then you actually want the share price of the business you own to go down. If this happens, the management who has spare cash up their sleeves can buy back shares and permanently increase your share of the company. This paradox is very far from the minds of those who value their shares by the popularity contest undertaken daily by the 1% of speculators who trade in their company every day.

Unfortunately in this short term world, some of our clients who dont understand our very long term views would feel uneasy because the share price of their businesses have gone down. We spend copious amounts of time attempting to educate our clients that owning wonderful businesses which have excess capital are even better when the share price dips and management buy back shares to increase your piece of pie in the company.

At present, two of our largest holdings, Coke (KO) (not the Australian subsidiary) and Berkshire Hathaway both have stated buyback plans. If the share price of these two wonderful businesses were to decline in the short term, we would be very happy with the outcome because it would allow Muhtar Kent and Warren Buffett to buy back shares and increase our effective holding in the business.

Converse to this are companies like the Australian banks. Although at this point in time, it looks as though the Australian banks are unlikely to need capital, I am not so sure this is a permanent situation. The Australian banks capital is leveraged off very high house prices. I would not blink if the situation arose where mining focused towns and cities had significant house price falls combined with continued weak conditions in Queensland and Victoria. In this situation, the banks may be forced to review their capital positions. This may not happen this year or even next year, but it is not a zero probability. If the Australian banks are required to raise significant capital in more difficult times, there could be permanent destruction of shareholders wealth.

A factor that affects the capital dependency of a company is the financial or operational leverage of a the business.

Financial leverage, is simply borrowing money.

Operational leverage is where a business can experience wild swings in its profit margins due to fixed costs and external factors which it has little control. This margin expansion and contraction can be very profitable for the enterprising investor who invests in a contrarian manner, however it can present problems when the good times are up for those not aware of its magnified downside.

Mining companies, manufacturing businesses and airlines are examples of businesses which can have operational leverage.

If you invest in operationally and financially leveraged companies, then you are generally investing in companies which are likely to be capital dependent at some stage in the future. It might be many years away, but if that company is required to raise equity during more difficult times, then you can permanently wipe away significant wealth.

A company such as Fortescue Metals runs this risk. It has both operational leverage and considerable financial leverage.

At Valor Private Wealth, we believe in finding businesses which we believe have a very low probability of ever requiring to raise capital. For those that don't think about companies from this perspective, then you run the risk of potentially having greater losses during more difficult times.

Unfortunately over 70% of the Australian market is what we consider operationally leveraged. Add this to many being financially leveraged and it narrows your focus on wonderful businesses which can grow your wealth without the risk of capital dependency.

Its not what you earn, but how much you save and return on your passive income

Unfortunately there is a common misconception that high income earners are wealthy. This belief is often far from the truth.

Why is this?

The main reason is because high income earners are also often high spenders.

Many of my clients are like me, airline pilots. Airline pilots earn above average, but they also spend above average. The amount the typical airline pilot saves is close to nothing as they buy bigger houses, spend more on holidays and send their children to better schools.

The belief that they are wealthier than they actually are is common and hence they save little.

This paradigm is also common for doctors, lawyers and many high paying executives.

Over 10 years ago, a good friend of mine gave me a brilliant book called "The Millionaire Next Door" by Thomas Stanley and William Danko. This book changed by life and made me realise the basic concept:

Its not what you earn but what you save that leads to truly independent wealth.

High income earners who are also high spenders are usually not wealthy. They drive fancy european cars, but the cars are on lease. They have beautiful houses, but the houses are mostly owned by the bank.

My wealthiest clients are those that spend the least. Some of my clients save over half their income and have become truly wealthy. When I go to their houses, they have modest furniture, they live in modest neighbor hoods, and they drive second hand cars. Once they get past the first 15 to 20 years of spending less than they earn, they get to a point of margin expansion on their savings income versus their expenses. This is where their savings income begin to grow rapidly when compared to their expenditure and they often cant spend all of the excess income from their savings.

There is one point I would like to add. If you save significant amounts of money, earning high returns on your savings can make you spectacularly wealthy over the long term.

The problem is that many high income earners don't save any money. The typical strategy is to build up some equity in their house and then use this equity to buy loss making (negatively geared) property speculating that it will go up in value.

This speculation of capital gains has been a good bet over the last 15 years, but I am not certain that it will work in the same fashion going forward over the next 15 years.

The latest ABS statistics show that "investors" are growing in the home loan market. I strongly recommend the ABS to review their term "investors" as most of these investors are speculators. Speculators who are prepared to lose money on an asset in the hope that it will go up in value to cover those losses and then also hope the assets goes up further in value to actually make money. According to this article, 63% of property owners lose money. If you aim lose money on an investment in the hope it will go up in value one day, you are a speculator not an investor.

A far superior strategy over the long term is to spend significantly less than what you earn and slowly add to a growing portfolio of wonderful businesses (and property if it doesn't lose you money every year). This strategy requires a concept called "patience" which most Australians have forgotten about. The "need it now" strategy has put most Australians on the back foot when it comes to saving and investing.

Debt can be wonderful when asset prices are rising (the last 15 years), but when asset prices fall and if you are no longer able to make repayments, you can wipe away significant chunks of your paper wealth. If you dont have much equity, you can get to a situation of negative equity. Speak to property owners on the Gold Coast for a lesson in this phenomenon. Apart from the Gold Coast, this de-leveraging effect has not happened in Australia for a very long time, but it has happened many times throughout history and around the world. With Aussies geared to the hilt, just be a bit more cautious than usual.

Lessons to be learned from Buffett's mistakes

In 2008, Warren Buffett invested in two Irish banks.

He describes his investments in his 2008 Annual letter to shareholders quite frankly:

I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

Buffett invested in AIB and Bank of Ireland. What he did not expect was the banks to continue to lose significantly more over the coming years. The charts are below:

And Bank of Ireland:

Whilst the property bubble in Ireland was characterised by greater oversupply of houses, there are some characteristics that can be juxtaposed against Australian banks.

1. High national mortgage debt to GDP
2. Prized high return on equity
3. Prized dividends
4. Strong bank fundamentals
5. Belief that population growth propped up housing markets.
6. Government believed there was no downturn coming due to the strength of their economy due to associated neighboring countries economies


1. Ireland had mortgage debt to GDP of only 60% in at the end of 2006. Australia has mortgage debt to GDP of 90%. What happens if our GDP starts to decline due to a slowing China?


2. The return on Equity in 2007 was a very healthy 21.8%. This is similar to the Australian banks return of 17.3% for CBA, 14.9% for WBC, 14.9% for ANZ and laggard NAB with 11.9% (thanks to the UK bad bank).

3. From the Chairmans letter we see a statement regarding dividends that would sound familiar to Australian bank investors:

This outcome continues AIB's proud record of growing its total dividend every year since 1993. 

It is reported that the dividends are the reason our banks are rapidly increasing in price. Relying on this metric did not turn out too well for the Irish bank shareholders.

4. Strong bank fundamentals were common for the Irish banks.

The net interest margin is similar to our banks at 2.14% for AIB and 1.77% for Bank of Ireland. NAB at 2.3%, CBA 2.2%, ANZ at 2.2% and WBC at 2.1%.

The profit growth in a slowing economy as people continue to borrow more despite a looming slowdown. AIB grew at 14.9% in 2007. Bank of Ireland grew at 22%


Many financial experts brag about Australia's prudent lending practices. Whilst our regulation is amongst the highest standard in the world, lending prudence is dependent on the valuations of the assets they lend against. A 80% LVR (considered fairly conservative) against an asset which is 40% overvalued is the equivalent to a 112% LVR on the fair value of the asset. Whilst the fair value of an asset is not a fixed number, I would suggest that house prices are highly unlikely to be considered by most as undervalued and very few would even consider them fair value. How far overvalued they are is highly contentious, however the fact that there is considerable debate suggests that they are likely over valued.

5. The ridiculous population growth theory. The higher the population growth, the higher that house prices can be sustained. Ireland had about the same population growth during the run up to their property peak at around 2%. Australia is not dissimilar to Ireland in our population growth.

6. Ireland was dependent on its neighboring countries for economic growth. Australia is also dependent on China, Japan and Asia to continue their mercantilism. I would tend to agree more with Hugh Hendry that this Asian export dominance has its limits.

There is one big difference between Ireland and Australia. Australia maintains its own currency and so can devalue it if we have a significant decline in our economy. This is proving to be difficult for the RBA at present, however there is a point if interest rates fall low enough that overseas buyers lose interest in our debt and cash. This loss of interest may be fairly sudden with a corresponding fall in the Australian Dollar and is one of the reasons we have a larger than usual exposure to international assets at present for our clients.

The problem with Australian bank share holders is that they have not invested $200 million of a 200 billion portfolio as Buffett did. This equates to 0.1%. Australian investors have invested 30%, 40% and even over 50% of their portfolios. This is basically a bet that Australian mortgages will continue to increase at a rate above wages for an indefinite period and there will be no unemployment rise for the foreseeable future.

Numerous Aussie SMSF's have not only put a very sizable chunk of their retirement assets into bank shares, they have also become yield obsessed and have dived into the bank hybrids. These investments are more equity than debt and I have seen portfolios with 35% bank shares and 20% hybrids. The holders of these portfolios believed that they were being conservative. They could not have been further from the truth. By using the experiences from Ireland and numerous other nations, it is possible to imagine a scenario where these "conservative investors" lose significant amounts of capital.
I must stress that I think that the Australian property market is more likely to have a slower grind rather than a crash. I believe that we will experience flatlining or gradually declining prices over the coming years. The potential for a crash is not a negligible probability and is definitely not something to be completely ruled out. With one of the highest mortgage debt's in the world, the potential for significant increases in house prices is a low probability. Limited upside, significant potential downside. Not what you want when you invest.

Dont ask your barber if you need a haircut. Also be wary of anyone who has a vested interest in propping up the property market. Fairfax, Newscorp, property developers, realestate agents and those who have debt to their eyeballs have a vested interest in keeping the property market bubbling. They may right and the market may keep rising, but it is never wise to put much emphasis on those talking their own book.

Realestate.com.au (REA group) has a larger market cap that Fairfax. Spruiking the property market is a very profitable game. Dont think for a second that the big newspaper companies are not trying to keep the excitement in the market.

The whole point of this blog is that a bank is based on its equity. If the equity is based on an underlying asset that is significantly overvalued, then falling asset prices can destroy the small amounts of equity that the banks hold.

Those blindly obsessed with yield have very little idea of the risks they are taking.

If you disagree with the notion that Australian house prices are overvalued, then by all means invest in bank shares, but I still recommend you limit your exposure to 1% to 2% per bank and a maximum of 10% total. This maximum of around 10% of a total portfolio includes bank hybrids and indirect holdings through index funds and managed funds. Personally I believe that Australia still has more headwinds than tailwinds over the next few years and with the baby boomers retiring I think that there is far more downside than most have factored in.

Predicting macro economics is an inexact science. I have my views, however over the last 6 months, I have been wrong. We are still making money for our clients, however we have been expecting a greater slowdown in China than has yet happened. We are still expecting further pain at some stage. If we are correct and China's miracle economy is proved a poor model, (building empty buildings and infrastructure) then Australia is likely to have a less than stelar outlook. At this point in time, Western Australian, Northern Territory, Queensland may show some increased mortgage pain. Add this to Victoria's current over supply predicament and we have a recipe for poor returns for our banks.

As Buffett said in 2008:

Beware the investment activity that produces applause; the great moves are usually greeted by yawns.

Nothing in investing in certain. I spend all my time attempting to find investments that have limited downside and significant upside. I think the Aussie banks offer the opposite to what I am looking to invest for clients.

An interesting shift...

An interesting article here about the changing manufacturing landscape for the US to Mexico. This trend will be interesting to watch as China's wages rise rapidly and the one child policy reduces the number of young workers available.

China needs to step up the quality curve for manufacturing quickly. Being the worlds cheap factory has its limits.