Recent Data and other Reports we’ve been Reading

by Marc Lerner

Several of the big names in the hedge-fund community have recently written letters mentioning their views on China and the impacts its slowing could have on Australia. In his latest letter, Kyle Bass says that Chinese growth “appears to be stumbling dramatically” and that the scale and pace of credit expansion in China over the last 5 years is “truly staggering”, with the rate of credit growth now 3 times total credit system growth the US had at the peak of the bubble in 2006. He discusses the view his fund now holds that a limit has been reached in terms of how much credit expansion in China can now filter through into real economic growth and wealth creation, as the newer debt is being used to maintain balance sheets rather in an environment of slowing growth than into productive new investments. He also says that a significant slowdown in China would have “devastating” impacts on marketplaces leveraged to a continually booming China such as Brazil and Australia.

Hugh Hendry, a well-known Scottish manager who has previously discussed his views on China (similar to Bass’), mentions in his latest letter that his fund has been investing with the view that the Reserve Bank of Australia (along with that of South Korea, another economy heavily leveraged to China) will continue to cut short-term interest rates aggressively, faced with “ rapidly deteriorating domestic consumption and international trade activity”.

In other news relevant to the thesis of a slowing China (and consequently Australia), there have been recent reports of sharply falling rents in mining towns in Western Australia as mining investment slows. In Karratha rents have fallen for seven quarters in a row, falling almost $500 a week, while in Port Hedland and South Hedland, the number of properties available for rent rose 37 percent during the June quarter. At Valor Private Wealth, we think this trend is likely to continue and worsen, although its severity may be reduced if the dollar falls sharply and far enough that Australian manufacturing, agriculture and tourism are able to make a strong rebound, so that those in the mining industry who have heavily geared themselves into properties in WA can continue to pay off their loans as they find jobs in these other industries. If the dollar stays high, it will mean those whose incomes come from the mining boom will have trouble finding work as the mining investment boom unwinds, with potentially negative implications for the banks who have lent to them, and the housing market throughout the rest of the country (through flow-on effects such as reduced lending elsewhere by the banks and negative effects on the rest of the economy of the end of the mining boom).

In contrast to this depressing trend, a new report has found that Google – one of our largest holdings for our clients – now accounts for 25% of all consumer Internet traffic in North America, up from about 6% three years ago. Whilst this report draws on only some Internet Service Providers (ISPs) and thus only represents an estimate of total traffic, the figure is nonetheless very, very impressive. We are very happy to hold our client’s money in growing, global leaders rather than focussing purely on local mining and banking stocks leveraged to an entirely unsustainable, credit-driven fixed asset investment boom in China.

"Be Fearful when others are greedy..."

CBA is hitting all time highs as seen in this article here.

With TV shows like The Block Sky High also hitting all time highs, I am very suspect of rational thought being used in the property and banking sectors. Paying $1.5 million for a three bedroom apartment when there are plenty of apartments just around the corner in Docklands doesn't seem overly rational. The net yield on these prices has to be in the very low single digits. Unless you think that these apartments are going to be $3 million in 10 years, then you are unlikely to enjoy acceptable returns. When you can buy a nice terrace in numerous areas around the corner for a cheaper price, then the limit on the upside is obvious.

A significant slowdown in China which is becoming more likely, leaves those who are leveraged into property, banking and mining exposed. If the Australian dollar falls low enough and fast enough then Australia and its property, banking and mining markets may be ok. Whilst we are expecting significant falls in the dollar, we are uncertain of its trajectory and therefore this is not a bet that we are willing to take and I certainly would not leverage into this slowdown. Unfortunately we are a distinct minority. The majority of Australians are leveraged into this slowdown in property and hold quite large exposures of banks and miners either directly or through their super.

"You only know who has been swimming naked when the tide goes out" (Warren Buffett). It looks as though we are much closer to high tide than low tide.

Anecdotal evidence is weak when used alone, however when attached to empirical evidence, it can be handy addition to your investment arsenal. Over the last month or two, the number of people I know who have been suggesting that now is the best time to invest in the property market is hitting an all time high. Every one of these "property moguls" has vested interests in attempting to mould my investment strategy. They all have one way bets on the property market. A moderate fall in the market combined with rising unemployment would likely completely wipe away most, if not all of their wealth (and probably lead to negative equity). They may be correct, however when you have a greater than zero chance of completely destroying your wealth, I am highly unlikely to get excited about buying anything. The fact that there is significant confidence in highly leveraged property owners makes me far more cautious.

For those that are overexposed, the recent price rises may be a good time to review your portfolios. Sadly most are completely oblivious to what is likely to happen and many are at risk of being significantly poorer over the next few years.

Buying a family home with low leverage is an emotional decision and has nothing to do with investing. To keep a roof over ones head and look after your family is very rational. Buying with higher leverage makes this less rational. Buying an investment property with extreme leverage and losing money on it in the faint hope of capital gains is just dumb!

We will buy very large amounts of property in Australia when yields are much higher than they currently are (at least 50% higher). If this does not happen, we will avoid this sector as we do with any investment that has limited upside and significant downside.

If you believe that the current interest rate settings around the globe are permanent, then property is likely to be a reasonable investment. If interest rates ever rise, then the prices currently being paid are likely to look rather foolish.

Why we are allergic to bonds at present

Whilst this Bloomberg article was regarding how cheap stocks were, we inverted the view to show how expensive bonds are.

With potential rising US interest rates at some stage over the next few years, stocks are not spectacularly cheap, however bonds are spectacularly overpriced!

Be moderately cautious with stocks and run for the hills with bonds.

Why Google may win the TV war

This new device is likely to disrupt the worlds current TV market:

http://blogs.wsj.com/digits/2013/07/24/googles-new-35-chromecast-device-streams-to-tvs/

I really would not want to be owning a free to air or even a non-sports based pay TV station with the online TV revolution that is coming.

I have been testing out the available devices for watching TV online and so far I think that Amazon and Google are leading the race. Apple is not far behind in terms of technology, however they are behind on the content and are more expensive at present.

Whilst we are generally not "technology" investors as trends change faster that you change your underwear, we do keep a very close eye on what is happening for structural changes to entire industries so that we avoid losing money in other sectors. 

A rare gem

A rare gem from the Business Spectator is here

Patrick Chovanec on China

Here is another great interview on China's problems.

Jim Chanos Interview

As expected, not much changed in this interview from Jim Chanos. China keeps bubbling away and is actually getting worse...

There are some very entertaining articles about whether to invest in Banks or Miners in the media. Is Australia so narrow minded that this is all the choice we have?

The situation in China is deteriorating. When the mainstream media are starting to talk about the problems, you know it is coming to an end.  I think it is wise to avoid owning any more than a small percentage of your wealth in assets that are based on the continued boom in China and Australia's unprecedented prosperity.

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.

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.

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.