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.