Capital Dependent and Capital Independent

There are two types of businesses in this world.

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

You generally only want to own the latter.

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

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

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

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

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

We even go one step further...

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

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

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

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

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

Financial leverage, is simply borrowing money.

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

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

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

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

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

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

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

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

Why is this?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Lessons to be learned from Buffett's mistakes

In 2008, Warren Buffett invested in two Irish banks.

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

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

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

And Bank of Ireland:

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

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


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


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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

As Buffett said in 2008:

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

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

An interesting shift...

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

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

Platinum's "Illusions of Comfort" by Marc Lerner

Platinum’s “Illusions of Comfort”

Marc Lerner

At Valor Private Wealth, we take great interest in Kerr Neilson’s view as he has a wonderful track record at Platinum. We are happy to hold an allocation of our client’s money with his funds and in his business. In August 2012, Platinum wrote a report which in the face of Australia’s rising sharemarket, should be at the forefront of investor's minds.

The report charts the last two decades of booming economic growth in ‘the lucky country’ and the economic trends that have accompanied it. Rather than being used as an opportunity to reform government policy, this period has instead been used, largely, to increase the size of the government, particularly in the area of regulations. The report predicts it is likely this will end in “breaking-point” regulatory reform when the good times end, similarly to what happened in the early 1980s after the disastrous inflation of the 70s.

The report recounts how the boom in China led to a mining boom in Australia, which spread through the economy and into areas like housing through an overblown and subsidised financial sector. The good times will end, it predicts, when China slows down heavily, leading to a fall in commodity prices and a consequent rise in real wages (wages relative to the price of the output being sold). This will lead to rising unemployment, as those businesses still remaining afloat cut back on labour in the face of rising real costs. Whilst interest rates can, and likely will, be cut down further as a measure to stimulate the economy, this will not help with the structural problems of misallocated assets that the boom has resulted in. The report speculates that BHP’s recent announcement of $100 billion in investments over the next 8 years (more than it has had in capital expenditure in the last 20) could well prove to be a ‘peak bubble’ signal.

Overall, the report provides an interesting discussion of Australia’s recent economic past and the mistakes that have been made in it, as well as future challenges we will likely encounter. In the meantime, of course, the great Australian bull market will continue, with dividend yields being the main – if not only - motivation for buying shares relative to staying in cash. 

Mainstream views on China

It is a mainstream view now that China has to slow. The Australian government and Australian investors are the last to accept this fairly obvious coming slowdown.

China has to slow fixed asset investment at some stage...

Great article here from Andy Xie. The big China slowdown in fixed asset investment has to come at some stage. The question is whether they take their medicine now or get quite sick in the next few years...

Either way, those holding onto the hope that China can keep growing forever at their current growth rates, I think Andy sums it up quite well:

China's FAI is so vast that sustaining rapid growth would surely bankrupt the country soon. FAI has tripled in five years to the current level of 70 percent of GDP in nominal value. If it triples again, the amount would become bigger than the economy of the United States. There wouldn't be enough money in the whole world to fund it.

This is why I feel comfortable about not holding any of the Australian Miners.

How much this affects the Aussie banks is a less certain, however I would guess that West Australian, Northern Territory and other mining dependent property areas will have a reasonable amount of de-leveraging of their properties. Add this to a weak Victorian market and an already decimated Queensland market and the mainstay of the banks, that is property assets, is not looking overly promising. At the current elevated prices for the banks, I think there is significantly more risk than shareholders are factoring in.