The biggest thing that is going to affect Australia in the next few years...

With the Australian share market going up this week, I have come to the conclusion that investment "professionals" and punters do not read the news. Alan Kohler almost fell out of his chair when Patrick Chovanec spelled it out how bad it was in China this week.

I will try spell it out again:

China is borrowing at the rate of approximately 50% per annum to grow its economy at only 7.7% per annum. 

This is unsustainable!!!

Let me try this in another way to try get through to the world:

China increased credit by $1 trillion US dollars in the last 3 months!!!

I hope that is enough to get people realising how ridiculous the situation is getting. This is 2/3 of the worlds total credit growth in the last 3 months and China is only 1/8 of the world's economy.

But yet, people are going on blindly buying Australian banks as if this will not affect Australia. People believe that Perth, Darwin, Karratha and Gladstone house prices are going to be fine. They also have absolute faith that unemployment will never rise from its current levels. 

The Aussie dollar even went up in the last week!

Perhaps there was a mistake in the numbers by a factor of 10. Perhaps China only increased its credit by $100 billion US in the last 3 months and credit growth is only 5% per annum? That could be the reason for the share market and dollar rise.

I am fascinated by this lack of awareness at how unstable the Chinese economy is. The limits of their debt fuelled bubble in fixed asset investment are getting much closer. My guess is that they are now within a about a year of hitting the stops. The longer they allow it to bubble away at these rates, the more pain they create in the near future.

For those that need picture representation rather than numbers, please watch the 60 minutes video of a few months ago here. The head of Vanke, one of the biggest property developers in the world is a very respectable source and he is suggesting that all is not well in China's property bubble. 

This slowdown in China is going to be the biggest thing that is going to affect the Aussie economy in the next few years, and yet most are still oblivious to it!

Be fearful when others are greedy... Piggy banks...

"Be fearful when others are greedy and greedy when others are fearful." (Warren Buffett)

I have never seen people be more greedy with the Aussie banks than now.

When Risk Inverts...

One of Charlie Munger favourite sayings is "invert, always invert". Ben Bernanke has taken this phrase and inverted the worlds markets.

"Safe" assets may now actually be more risky than the "risky" assets.

With the worlds "safe" assets such as bonds and cash now offering yields that would make a pensioner cry and with "Helecopter Ben" throwing fuel on the fire, it looks at this present moment like risk has inverted. The safe assets are no longer safe and the "risky" assets such as shares and property are looking like better vehicles for your capital.

The world is becoming a very difficult place for investors. There are things you could not have dreamed of 5 years ago. I call them Alice in Wonderland style events such as negative bond yields. Government bond yields around the world are at or near their historic lows. In the case of places like the UK we are talking lows over a few hundred years. We are not in normal times.

The great unknown is inflation. Will it come back? Will it be mild? Will it be like the 70's? No one knows and I am not one to suggest I own a crystal ball.

The key to investing in these very weird times is to attempt to avoid the "return free risk" assets as described by Buffett and look to hold wonderful businesses which have pricing power to counter the effects of potential inflation.

Unfortunately many of these wonderful businesses are fully priced at present and so their inflation protection is becoming more limited.

If interest rates begin to rise in the US over the next few years, I would not want to be holding large amounts of long term bonds. This wont be great for many stocks, but companies with high returns on capital should still perform ok.

In Australia, we are on a bit of a different cycle. We are on the back end of the mining boom and the effect that will have on the rest of the economy is highly contentious at present. I am not convinced that we will sail through the next few years if our national income takes a hit due to a slowing China. Many are far more relaxed with our potential slowdown than I am, and this is being shown in the confidence in investing stocks levered to the economy such as bank stocks.

Interest rates may fall further to cushion the blow of a slowing China, but will this support our economy enough? There is actually a case that a large fall in interest rates in addition to ridiculous policies such as the first home buyers grant could cause a further housing bubble. This could end very horribly if the government allows this. I think this is unlikely, but not a zero chance. If this bubble does occur, the bank stocks will go significantly higher from here. Stranger things have happened. With some of the most expensive houses in the world based on some of the most eye watering mortgages, this would put our economy on the edge of collapse and closer to an Ireland style meltdown at some stage. I sincerely hope the government and reserve bank are not that short sighted to allow this housing bubble to inflate higher. (My guess is that they are more worried about growth rather than sustainable growth and this worries me).

The big question is where will unemployment get to in the next few years? If the Australian dollar holds up then our agriculture, tourism and manufacturing sectors will continue to be under pressure and I think unemployment will rise higher than many are expecting. This could be quite painful for Australia.

The safe assets such as cash and bonds in Australia are not necessarily risky yet. They are still offering moderate yields and if cash rates go down, bonds could provide some moderate capital appreciation. This is a medium term play rather than a long term holding.

In Australia, risk is yet to invert. This risky assets such as shares and property are still (very) risky, however elsewhere in the world, the safe assets are offering virtually no return, but are looking risky if inflation returns or interest rates rise.

Never tell your mate his wife is ugly!!!

After writing the last post about the Aussie banks, one of my colleagues suggested that I write an apology to all the bank share lovers in Australia that I may have offended.

The recent price rise of CBA and Westpac of 45% after they announced virtually no profit increase shows how much Aussies love their banks. We have the most loved banks in the world (our banks are about 2 to 3 times more expensive than our global peers) and so I should not bag something which is so endeared. So I have come to the conclusion that I am not going to win any friends by telling people about the risks of these institutions and I should officially apologise for suggesting that they have any downside.

Dear Bank Share Lovers,

I sincerely apologise for suggesting that your wife (the banks) may be ugly. I find it very endearing that you believe a 5% dividend yield is good enough for you and that you do not see the ugly side of your wife (the banks).

I truly hope that your wife's stunning beauty never fades (that Australian house prices remain some of the most expensive in the entire world and that Australia manages to never again have another recession). I wish you luck with your wife for the rest of your marriage (and hope that unemployment remains below 6% for the rest of your time invested in the banks).

I also wish that Santa grants your wish of your wife winning the Miss World title (Australian mortgage debt to GDP growing higher than its current level to be the true world title holder - were not far off the record!!! Come on Aussie come on!!!)

Although the divorce rate around the world (bank problems) is close to 50%, I honestly believe that your relationship with your wife (bank) is different and cannot fail.

I sincerely wish you the best of luck in your relationship and I apologise for any words that I said otherwise.

Sincerely,

Rob Shears

How much will a slowing China affect our banks?

It is a fairly obvious link between a slowing China and our mining companies.

China slows, they use less iron ore, coking coal, thermal coal, copper etc. Our miners are directly affected. The recent weakness in their share prices is reflecting this and I think this is just the tip of the iceberg.

But will a slowdown in China affect our banks?

Our banks are basically leveraged bets on the house prices. Westpac and CBA are 2/3 home loans and so it all depends on house prices.

I think that mining boom towns and cities such as Karatha, Darwin and Perth are likely to have fairly large haircuts on their very elevated house prices over the next few years, but how much this flows into other property areas is difficult to predict.

As the mining boom slows, interest rates will probably fall further. This will cushion many borrowers, but what happens if the Australian dollar does not fall with our terms of trade? Australia's AAA status is not really under threat for a few years because of our low government debt. This "least worst" position means there is a chance that the Australian dollar could remain elevated and may not cushion the fall in the terms of trade. The counter cyclical areas to the mining boom such as tourism, agriculture and manufacturing sectors may continue to struggle. If this happens unemployment rises may be higher than many are predicting. This will put pressure on borrowers and flow through to banks.

So should the banks prices be going up as the news out of China is suggesting they are running out of steam? I think it is extremely irrational to think that our banks are safe if the mining boom is finishing in the next few years.

The banks may be ok, but then again they may not. I do not believe they are offering enough returns to factor in the quite large downside that may eventuate if Australia's unemployment rises quickly following the end of the mining boom.

The probability that the banks are ok investments in my opinion is a 50/50 bet. These are terrible odds for investors and at Valor Private Wealth, we look to find investments where we believe we have much higher odds of being right over the long term.

Gold vs investing

There is a very large difference between an investor and a speculator. An investor, through thorough research invests because he or she has a high probability of earning an acceptable income greater than cash or government bonds over the life of that investment.

A speculator simply guesses on a higher price in the future. 

Gold has no income, anyone who calls themselves an investor in gold is really a speculator.

There is no rational reference for the price of gold. It could be $200 per ounce or it could be $10,000. The price of gold is determined by the greater fool theory. Someone dumber than you is expected to pay a higher price than you did. This can turn out to be highly profitable for a very long period as has been over the last 10 years, but you usually run out of fools. 

The cost of digging gold out of the ground can be as low as a few hundred dollars for the best mines up to the more recent very marginal mines of well over $1000 per ounce. The reference point for gold should usually average somewhere around just above the marginal cost of the lowest cost producers.

Over the very long term, gold has sat at around $400 to $600 per ounce in todays money. There are two exceptions. The late 70's and the most recent bubble. 

As I said, there is no definite reference for gold, but those that are betting that it should remain at multiples above its 100 year average are taking what I consider a fairly dumb bet. 

Just like house prices in Australia, they can remain irrational for very long periods of time, however when there are fewer greater fools, they return to more rational levels. This can take many years. The trick to becoming wealthy is to attempt to avoid betting on the irrational assets and wait for the irregular but very obvious bargains which come around every few years. The bubbles are less obvious when they are in full force, but the more astute investor waits until the phrase:

"You will never make money investing in ..... ever again"

These are my favourite words. They can be in the form of quotes such as "The death of Equities" (1982) or more recently "You will never make money in US property in our generation" (at a period when you could buy $50,000 houses with 20% rental yields trading at half their replacement cost). Gold is nowhere near the "never make money again" stage. If it got below the $400 to $600 an ounce, I may look at "speculating" on a few gold miners, but until then, it still looks to be well into bubble territory to me. 

China GDP big miss

BHP and RIO are getting smashed today thanks to a big miss from China's GDP numbers.

The problem is that with China's credit expanding at the ridiculous rate of around 4-5% a month and fixed asset investment still growing at over 20% per year, this GDP miss is not yet the beginning of a China Slowdown. They are still building empty apartments and offices and there is no sign of this slowing down at present. It has to at some stage, but it has not yet started.

Unbelievable Chinese credit growth

According to this article in Bloomberg, China's aggregate credit grew by 2.54 Trillion Yuan in March.

Surely this is wrong. This means that in a 51.9 Trillion Yuan economy, they borrowed 4.8% of their GDP in one month!!!

Australia's credit growth is maxing out after our property bubble of the last 15 years. Our credit growth is closer to 4% per year. China's is around 4% per month!!!

Those that are betting on China to keep expanding their credit at this rate for their investments to work out are in my opinion not being overly rational.

There are many out there that believe China can stimulate the economy if it begins a downturn. 4% per month credit growth is one of the biggest stimulus packages the world has ever seen. How can they stimulate more from here?

At Valor, we look to remove the irrational movements in markets such as these from our clients portfolios. At some stage in the next few years, China will be growing their credit at a much slower rate and those that have portfolios dependent on this continued unsustainable growth are likely to have less than acceptable returns on their investments.

Call me a skeptic...

In 2008, I traveled to the Beijing Olympics. The Olympics are supposed to be a showcase event for a nation. The Beijing games were empty. There was no food available to buy and the transport was a disaster.

In Australia, the games were shown to be a giant success. For those on the ground, it was obvious that this was not the case.

For many of the events we went to, the crowd were compacted into one quarter of the stadium and the cameras were focused so that the other three quarters of the empty stadium did not make the news. This was at events which were supposedly sold out!

So when I see videos like this one, I am just thinking that the propaganda machine is is full swing again.

Whilst many are great believers of the Chinese economic miracle, having been to China dozens of times, I am far more skeptical about the true growth of the economy. In the 15 years I have been travelling there, there has been truly impressive advances in many areas, but unfortunately the more recent growth in the last 5 years appears to be very uneconomical with countless empty apartments, offices, roads and railways.

This "building for the sake of building" growth is unsustainable at its current rate and either the government acknowledges this and attempts a gentle slowdown now (which is unlikely to be gentle) or they risk a forced much greater slowdown in a few years which could be far more painful.

Mining boom from another perspective..

This Bloomberg article is trying to suggest that Australia is feeling the pain of the mining boom. I thought Australia was having some of the best economic conditions in the world?

I would think that the pain of not having the mining boom is going to be significantly greater at some stage in the future.

I am fairly confident that the current prices for houses in mining towns and cities are not sustainable and that when the tide goes out, this will cause pain to those who have borrowed or lent heavily into this area.

My rough estimate is that approximately 15-20% of Australia's housing is related to mining and the flow on effects of mining. This is likely to make a dent to the banks profits and equity when we are no longer experiencing such lofty conditions.

Apple and the story of the DVD player

Most people love to invest in the latest and greatest tech fad, but as many pervious high flying tech giants such as Palm, Sony Walkman, Blackberry and Nokia have shown time and time again, it is a very difficult way to make money.

Those who bought Apple in the early to mid 2000's have had tremendous success.

However for this success to continue, Apple needs to reinvent the way we lead our digital lives again. This unfortunately is unlikely without Steve Jobs.

The more likely scenario is that Apple goes the way of the DVD player. When DVD players were first introduced, they were selling for $800 a pop. These days you can pick one up from ALDI for less than $30.

As HP has shown with its latest release tablet, the price wars have well and truly begun, but are probably only just getting started. How cheap will iPhone and Ipad competitors get? $100? $50?

The problem Apple is facing is that their competitors have caught up very quickly and are actually selling better phones. The Samsung Galaxy phones really are better than the Apple ones (and I am a very loyal Apple consumer). With the price of a competing phones less than half the price of an Apple device, I am sorry to say that I will be switching over.

This cost differential is going to continue to eat away at Apple's margins. If Apple goes from making a few hundred dollars of margin to a few dozen dollars of margin, then their profits are going to take a dive. There are not enough consumers in China and India to buy Apple products at multiples of the price of their Android competitors to offset the margin contraction.

With enormous amounts of cash, there is a price to pay for Apple, but that price is significantly lower than it is currently trading at.

Apple is set to follow the story of the DVD player over the next few years...

On a purely observational point, I noted that the Apple stores that I have visited in LA and New York in recent days have been significantly less crowded than previous years. Interesting...

Debt in operationally leveraged economies

I love articles like this that state that China's debt build up is not yet a problem. They argue that because total credit is only 180% of GDP (debatable), that they can continue borrowing significantly more before it becomes a serious problem. It is true that China may continue to bubble away for a little longer, but I firmly believe that it is highly unlikely they will make it until 2018 as this article suggests before the situation gets out of hand.

The key to why China cannot sustain the same level of debt as the US is operational leverage.

Many of the best companies in the US have relatively higher and more stable margins than their competitors around the world. Coke, Johnson and Johnson, Proctor and Gamble, Google and many of the other large US companies are far less susceptible to fluctuating economics because they display more stable sales and margins. China is the opposite of this. It is the ultimate operationally leveraged economy.

China actually has numerous industries that deliberately lose money such as solar, steel production and much of their fixed asset growth purely to satisfy top line GDP growth. Not only are most of China's industries marginal, their margins are contracting due to rising wages. During the US downturn, wages have stagnated and even been reduced in Chapter 11 proceedings. I would be surprised if during a Chinese downturn the rise of the workers wages were allowed to stagnate or even fall. There is a new wave of expectation from the factory workers as they realise their power to negotiate higher wages. This trend is likely to put a great deal of pressure on margins and the economy.

Operationally leveraged businesses and economies cannot handle as much financial leverage as their higher margin counterparts.

I have no idea when China will face the music. I believe it would be prudent for them to face the facts and reduce their uneconomic growth now rather than in a few years time.  I am quite certain that when they do, they are likely to face a more pronounced slowdown than many are expecting due to the operational and financial leverage built into their system.

The Chinese leaders know the pain that will be caused by a slowing economy due to the operational leverage which is why they are yet to do much about it. There is a great deal of rhetoric about rebalancing the economy, but the imbalances continue to become greater every year. Fixed asset investment in ventures that will never cover the cost of capital and supporting loss making businesses is a dead end street, but the leaders have shown no clear sign of taking the tough measures to reverse the situation.

Those that believe in the current Chinese economic model are not comprehending the magnitude by which China is over building. Simple mathematical calculations will quickly discover that continuing the current growth rate in the number of apartments they are building in the next five years is roughly enough to house half of China with a second apartment. Use the same calculation for the number of offices they are building and the over building is expected to produce more than two offices for every man woman and child. These projections are simply not based on sustainable economics. Perhaps they have rewritten the laws of economics, but if that is the case then Australia should just give Harry Trigaboff an unending line of credit and get started building ghost cities in Alice Springs.

For all of the worlds analysts, few are focused on margin expansion and contraction, but yet it is these two forces which magnify booms and busts. Straight line projections do very little to truly analyse the economic fundamentals and where they are in their cycles. When you are close to the top of a cycle and there is potential for margin contraction in the economy and businesses, the floor (if there is one) is often a lot lower than most expect. When you throw financial leverage into the operational leverage fire, look elsewhere for your investments.

Great Interview of Jim Chanos...

Great interview of Jim Chanos here.

It really makes you think of the consequences that allowing the greed of the bankers to get out of hand could have in the future.

Jim really is a great historian and independent thinker. The world needs people like this.

Many short sellers get a bad wrap, but without them there would be few checks and balances on the morally bankrupt.

These are a few of our favourite things - Peters MacGregor, Platinum Capital, Magellan Flagship Fund

Peters MacGregor (PET), Platinum Capital (PMC) and Magellan Flagship Fund (MFF) has been a core holding for our clients. They made up approximately 12% of our clients money (for an aggressive client). Our returns on these investments have been quite satisfying over the last few years.

The story behind these stocks is simple. We bought a underlying portfolio of wonderful companies at a 20-35% discount to their value. This portfolio was managed by three managers who have proved they can return more than the market over time.

If I said you could buy a dollar for 70c, you would be quite silly if you turned down my offer. This is exactly how I saw the discounts that PET, PMC and MFF were trading at. The market was being silly.

Most people who invest naively believe the market is always right. If something is trading at a 30% discount, then there must be a reason that so many people are selling their stock at such crazy prices. Often the market is right, but for the educated investor, these short term market inefficiencies are wonderful ways of making money. The key is to be patient and wait for the right moments.

Unfortunately there will always be a large group who just dont get the concept of buying something for less than what it is worth. You can try convince some people until you are blue in the face, but for a reason that I will never understand, they like paying more than what something is worth.

Whilst it is not guaranteed that investing in listed fund that their discount will narrow, it is comforting that you are buying the underlying companies at a discount and so your share of the earnings is effectively higher than you could purchase directly from the market.

We certainly are not recommending buying these companies now there is no discount to their assets.

Often a valuation on a company is not as simple as looking at its net assets and working out a simple discount as was in the case with the listed funds above, but there are enough opportunities that are quite obvious to allow a hard working investor to allocate capital over time.

Google was a very obvious value play when we bought it around the $580 mark. At the time, if you took out the cash from the price, it was trading at 12 times earnings. Lets invert that to an earnings yield so the property minded Australians can understand. This equates to a 8.3% earnings yield (rental yield). So if you were to compare that to a typical investment property of $500,000 in one of the major cities, it would be a rent of $800 per week. Thats right $800 bucks a week for a $500,000 apartment. There are not too many of those around. But then it gets interesting. Google is growing in the order of 23% per year. Thats right, your $800 per week for your $500,000 apartment is growing at a rate of 23% per year. It is for this reason I find it difficult to get excited about people buying apartments for $500,000 renting out for just over half this amount and likely to grow at best in the low single digits.

At Valor Private Wealth, we like to keep things simple. If we can get 4.7% in long term cash then we think it is certifiably mad to buy a risky asset that is likely to return less than this. In fact, we believe it is crazy to buy an asset which is likely to return less than a reasonable "margin of safety" over this amount. We generally use a 9% hurdle rate and a 10 year time horizon for investment. That is, if we don't believe that our asset is going to return greater than 9% per year to its owners over the next 10 years, then we much prefer the Australian government backed cash return of 4.7%.

Using this metric, we find it fascinating watching the hords of people paying high prices that will eventually equate to mid to low single digit returns on their assets. Sometimes they know something that we don't, but usually it is just human 'greed' kicking in. In Australia, most of the investments we analyse are at prices that we equate to mid to low single digit returns going forward. Globally, there are still enough opportunities to make above our 9% hurdle rate, but as the markets rise, these opportunities are becoming more scarce.