Yield Chasers beware

Market price and intrinsic value often follow very different paths – sometimes for extended periods – but eventually they meet. (Warren Buffett)

Those that are chasing yield regardless of the intrinsic value of the companies they are investing in may start to believe their own hype, but at some stage the intrinsic value will catch up on them.

Some companies are barely growing and yet their shares are growing at 50% a year. Something doesn't feel right.

A company which is growing at low single digits should trade at a relatively low multiple of its earnings. Many of these companies are trading at mid to high teen multiples and some are even in the low 20 times their earnings. Add in the fact that many of these higher yielding companies have quite high debt and you have to lower their intrinsic value further.

These companies have diverged significantly from their intrinsic value and may stay there for a while, but eventually those holding them will have their capital withered back to fair value.

The rising tide has lifted all boats. Beware the belief that your boat can fly.

At Valor Private Wealth, we are finding it very difficult to find companies that are trading at or below fair value at present. We would still prefer to own 4% cash than own a company which is double our estimate of its intrinsic value (of which there are plenty). There are still a few gems out there, but they are becoming a rare find.

Our total stock market to our economy is around 110%. Be more fearful whenever this ratio is greater than around 90%. Be even more fearful when our economy has a higher probability of retreating at some stage in the next few years due to a slowdown in China.

Actively seeking rational opposing views

I always read as much as I can on views that oppose my own.

This article is one of them. Unfortunately the points it brings up about China being different actually enforce my belief that the real estate bubble is unsustainable.

"Use it or lose it" as a policy to force developers to build regardless of the economic viability is a very dangerous policy. This major point from Keith reinforces the idea that the current building in China is "unsustainable and uncoordinated".

In China, you have to build, even if it means the buildings lie empty. And when it’s time for people to move in, they’ll see if the building’s held up over time. If it’s not, they’ll knock it down and, many times, build a new one.”

If Australia had a policy of "you have to build", then I would expect our economy would be growing at 8% for the next decade too. We could rewrite the rules of economics and continue to build empty apartments for ever, eternally creating wealth and never having a downturn. Someone would have to rewrite Keynes "General theory of employment, interest and money" and state that endless stimulus can grow the economy at high single digits for ever regardless of overcapacity.

The biggest question is how all this mania will end. One area I possibly agree with this article is that China is different in the way it can handle the crisis. They can bail out their banks and local governments, however this will likely still result in less building at some stage and this is where I worry for Australia. China as an economy will likely be fine, but investors will probably lose out. Australia will also be ok, but we will probably be sending less dirt up north at lower prices in the next couple of years and this will slow our economy. There is no crystal ball, only rational allocation of capital. Allocating capital to mining and banking which are both reliant on metrics that are at multiples of their century long after inflation averages is not overly rational.

"You only know who has been swimming naked when the tide goes out" (Warren Buffett). Our best estimates is that the "building empty buildings" tide in China is ready to go out at some stage in the next year or two.

(P.S. Im still looking for some rational opposing views)

Aussie Dollar cheer squad may hurt our economy...

The Australian economy is likely to slow over the next year or two as the mining boom fades and it is articles like this one which may deepen the slowdown.

During the last Asian crisis, Australia did not have a recession. A large part of the reason for this is the great Australian safety net - our floating exchange rate.

In 1998 during the Asian Crisis, the Aussie Dollar dropped from around 80c to around 50c. In the GFC, the dollar dropped from around 93c to around 63c. This time around, we may not be so lucky as we are one of the few remaining AAA rated countries in the world and our dollar may not be the perfect shock absorber it has been in the past. This could hurt our slowing economy.

Our opinion is that the slowdown in China has the makings of a much bigger crisis than the 1998 crisis and the dollar would need to fall further to cushion the economy. If this does not happen, then the dollar sensitive industries like tourism, manufacturing, agriculture and even mining are going to have some very stiff headwinds. This could be quite painful.

We do not know exactly what is going to happen, but with the Aussie Dollar cheer squad still out in force and limited places for pension and insurance companies to invest to keep their average credit ratings up, the probabilities of the Aussie staying higher for longer and further damaging our economy is increasing.

Those that believe that the Aussie banks are the ultimate investment should perhaps factor into their thinking the possibility that our unemployment starts to rise higher than many are predicting due to the higher Aussie dollar.

At Valor Private Wealth, we would feel uncomfortable holding the Australian banks at even half their current prices if this possibility eventuates.

Is the budget good for the Australian economy?

Australia is a two trick pony. Mining and housing.

The government obviously has no control over the revenue raiser, but they do have a bit of control over the second lever - housing.

The problem is that this budget has tightened the belts of those who already have their backs to the wall.

The increase in the Medicare Levy and the cuts in the Family Tax Benefit are effectively a pay cut for those who have very large mortgages - the middle income Australian families. These mortgages are extreme and if you include credit card debt are actually larger than the entire Australian economy. Small cuts in the take home pay for this group is a leveraged step down for the economy.

My first impression of this budget is that it is going to increase the slowdown in the Australian economy as it puts pressure on the elephant in the room - the third of Australians who have borrowed too much.

With the mining boom in its twilight days, there was only one sector of the economy that was being propped up - housing. The ridiculous rally in the bank shares is testament to this. This budget puts further pressure on this sector and is not overly good news.

On top of this the pensioners and babyboomers downsizing of housing is likely to add to pressure on the middle end of the housing market. The ability to downsize your house and add $200,000 to your financial assets without affecting your pension is likely to see further pressure on what was already looking to be a rush for the exits in houses in the middle end of the spectrum. Four out of five of clients who I speak to about retirement have stated they would like to downsize at some stage in the next five years. Many of these people cannot retire unless they downsize. They are forced sellers! This has the ability to create an oversupply of houses in the middle end of the market at some stage. With the banks hanging on to every percentage point of growth in the mortgage market, this may again reduce borrowing going forward.

The next few years are going to be very interesting. I feel very comfortable to sit on the sidelines with the miners and banks and only invest my client's money in areas which are not at the top of their cycle and could have a long way down.

Mining Capex Dwindling

by Marc Lerner

In the past few months, there have been several indicators of the falling amount of capital expenditure in the mining sector in Australia, the best of which is the ANZ major projects update, which forecasts reductions in the potential project pipeline of about $115 billion compared to ANZ’s previous forecast in July 2012 for total major projects in the country, a large part of the fall being attributable to mining and energy project delays or cancellations. There have also been several secondary indicators of the slowdown of the sector - two examples being poor results from mining equipment manufacturers such as Caterpillar and earnings guidance reductions and job cuts at the mining consultancy firm Coffey.

All of this, of course, only charts the supply response of the Australian mining industry to weaker commodity prices so far. What might happen to demand from China, and hence these prices going forward, is a whole other issue.

The CAPM versus Rational Investing

by Marc Lerner

Finance students the world around are taught, as the method of finding the required rate of return of an asset appropriate for its risk, a model called the Capital Asset Pricing Model (CAPM). The key factor in determining the risk and hence required return of an asset in the CAPM is beta, a number that describes the volatility of the asset’s returns relative to the volatility of the market as a whole. A beta greater than one indicates that the stock is more volatile than the market, and a beta less than one indicates it is less volatile. As long as the beta is above zero, however, it means the asset still generally moves in the same direction as the market. This figure, beta, is fed into the model, which is then touted as taking into account – supposedly – all of the risk of the asset.

There are several problems with the CAPM that make it an irrational model to rely upon. Firstly, it equates risk with volatility, which, to a long-term value investor, is not accurate. Depending on your situation in life, the degree of volatility you can bear will undeniably be different – a university graduate who can expect a rising income for many years should be happier with far more volatility than a retiree who might need all their savings at a moment’s notice for a medical emergency. However, the truly key risk to a rational investor planning to hold shares over the long term is not the risk of volatile stock prices in the short term, but operational risk – the risk of the company being incompetently run, having demand for its products stop, being overtaken by competition or any of the myriad of other bad things that can happen to the business itself, which bears no direct relation to the volatility of the stock price, although there may be some level of correlation between the two. Temporary volatility in a downward direction, in fact, can be great if you want to buy businesses for as cheap as possible (or have the business you own shares in buy back its stock as cheaply as possible, if it has the cash to do so). A further complicating factor is the CAPM’s use of not just plain volatility, but volatility relative to the market as a whole – but this is only a concern for you if you are already invested in an index fund, rather than focused on picking out the best business you can find at the cheapest prices.

On top of this, the CAPM simply uses past data and projects it into the future, assuming no changes will occur between the two. But the future can, and often is, different from the past in fundamental way. Did the future of Apple change fundamentally with the entry of Samsung and all the other current competitors into the smartphone space? Would the future of Microsoft change fundamentally if Bill Gates were to return to working full-time for the company? The answers are obvious, not only for the operational risk of the company, but likely even for the volatility of the stock prices.

The reliance on volatility relative to the market and focus on past data can combine in the CAPM to form a theory of risk that is imperfect at best and absurd at worst. Imagine if tomorrow the price of Coca-Cola shares halved on no news, while the market stayed exactly where it is. This is, of course, very unlikely, but unless you assume markets are perfectly rational (which the CAPM does) it is not, in principle, impossible. According to the CAPM, the beta of the stock – its volatility relative to the market – just drastically increased, and it became a far riskier investment. But rationally, is it now more or less risky to buy? The answer is obvious.

Looking back on our mistakes...

If you can not analyse your mistakes, you are unlikely to learn from them to avoid them in the future.

Whilst our portfolios have outperformed our peers by quite a substantial margin since Valor Private Wealth began investing for clients, we still like to look back to see if we could improve.

Our returns over the last 2 years are around 30% (every client is individually managed and has varying returns). This compares to the ASX 200 returns of only around 7% and the average super fund return of only 11%. We have achieved these returns with an average of 40% to 50% cash over their period. We are very happy with this performance and our clients are too.

Our biggest mistakes over the last few years:

1. Being slightly underinvested when we knew there were great opportunities
2. Austal
3. Harvey Norman

1. Slightly underinvested

At Valor, we like to invest slowly over time. If a client comes to us, our preference is to attempt to fully invest them over a period of a few years when great companies come to prices that are attractive. We believe our direct investment approach is superior to buying someone else's capital gains in a managed fund. This conservative approach should protect clients capital in the event of a significant downturn, however if market shoot up as they have in the last few years, we may end up slightly underinvested.

Luckily many of the stocks we have picked have gone up significantly more than the market and so our returns have looked quite attractive, but our error of omission has meant we could have done slightly better. With returns that are around double the average returns of our competitors superfunds, our clients are not complaining, but we are here to attempt to continue to improve.

Our investment in some of our highest conviction stocks could have been higher. When Google was at $580 a share, we knew it was a bargain, but we held our position to 6%.

When Berkshire was trading at $69 when we bought it, we only bought 8% of our clients money.

When Walmart was trading at $52 we only invested 5% of our clients money.

These three stocks were trading at significant discounts to their worth at the time. We were quite aware of this and yet we were not greedy enough. We should have bought roughly twice the amounts in each company at the prices they were trading at. When the market offers such dominant companies in their fields at these prices again, we aim to have greater courage for our clients.

Our view that China is to slow significantly has led us to be more cautious than usual, however we should have invested more in the companies we believe to do well regardless of this impending slowdown.

2. Austal

Austal was a failure in conservative analysis. A ship building business that is building advanced warships is likely to have cost overruns. This is a simple fact and we did not have enough foresight to factor this into our models.

Our analysis that Austal was going to triple its earnings was correct, however it took an extra year than we forecasted and that was enough for Austal to get behind the curve.

We have talked about capital dependent and capital independent companies in this blog. Austal is a perfect example of buying a capital dependent company and paying the price. We will look to avoid this folly in the future.

Austal eventually had to raise capital at horribly low prices to sure up its debt. They cut our piece of the pie in half. This capital raising could not have come at a worse time. If they had Twiggy Forrest to do their banking negotiations, they would likely have been able to convince their bankers that in the next 6 months their cashflow would be more than sufficient to start paying down large portions of its debt.

We still believe Austal has a reasonable future as it continues to build better ships than its competitors. Unfortunately, we are unable to trust management to manage the capital in a manner that is likely to benefit shareholders over the long term.

3. Harvey Norman

Most people are unaware that Harvey Norman is basically a property company. It has over $2 billion worth of property. When we purchased Harvey Norman, we were buying as an asset play. What we did not consider was the noose that was around Harvey Norman's neck.

Our expectation was that Harvey Norman would continue to improve its online offering to stem sales declines. We eventually realised that this was unlikely as an online store would shoot itself in the foot by killing its franchisees.

We then came to view a large part of Harvey Normans property holdings as liabilities not assets. They were not able to increase online sales for fear of destroying its franchisee model and so other online stores would continually eat away at any large scale buying advantage Harvey Norman previously had.

I think that Harvey Norman will survive beyond most of its competitors, but we are not interested in buying companies that merely survive. We are interested in buying companies that thrive and eat away at their competitors.

One thing is guaranteed - we will unfortunately make mistakes in the future. If investing was an exact science, there would be no mistakes, but yet there would also not be the ability to find underpriced wonderful businesses. Our ability to keep our mistakes to very small positions is important. Harvey Norman and Austal were very small parts of our portfolio's so the losses were very low single digits. The companies we have large positions in such as Berkshire Hathaway, Google and Walmart have all done exceptionally well.

Looking forward, we are finding it very difficult to find reasonably priced companies. Overconfidence is the nemesis of a value investor and we prefer when there is more fear in the world so that we can buy at more rational prices.