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.