The Valor Blog.
Investment News and Views, Direct from Our Team.

“Delighting Moats” vs “Parasitic Moats”

I have recently reorganised my thoughts around moats.

One of the least discussed elements of a moat is its permanence. It is a quite subjective matter when evaluating the permanence of a moat. One way to attempt to bring some observations to the argument to reduce subjectivity is to look at the type of moat that a company has.

Is the company delighting its customers or is it a parasitic company that has a captive audience that can’t go anywhere else for its products or services.

The latter type of company can look impenetrable, however as soon as a customer has a better alternative they could leave.

A company such as a drug company might have a very wide moat on a certain drug, however they often raise the price to the point of extreme pain for the consumer (be that the end consumer of the government who subsidises it).

A bank might have a switching cost due to the difficulty of changing loans or accounts, however if they create too much pain for the consumer, or another new “easier” product is created by a fin-tech, the consumer could leave.

The local convenience store might have significantly higher prices than the supermarket 15 minutes away. If a supermarket starts up close to the convenience store, its business is crippled.

A company that delights its consumer is likely to have far more permanent customers.

People are “fans” of Apple. People are “obsessed” with Instagram. People are “addicted” to their double shot, half cream, caramel Frappuccino from Starbucks (or maybe thats just me).

Our portfolio is filled with “delighting moat” companies. A considerable percentage of the mistakes we have made over the years have included a number of “parasitic moat” businesses. Some “parasitic moat” businesses have their place and are acceptable businesses (at the correct price), however they are lower down the pecking order of companies we prefer to invest in.

We are loathed to sell a company that is widening its moat by delighting its consumers. We are quick to sell a company where a manager doesn’t understand what their competitive advantage is and is slowly eroding their moat.

What happens when Warren Dies?

Berkshire has been all about Warren since he took control of the struggling coat lining business.

One day Berkshire will be without its Warren. Whether this is in 10 years, 20 years or tomorrow is unknowable.

Due to our quite concentrated investment in Berkshire, I have received many questions by clients as to what will happen to Berkshire when Warren dies. Many are fearful that the stock will drop.

Whilst in the short term the stock may fall, we are not at all worried about Berkshire after Warren.

Funnily enough, Warrens death may actually be a catalyst for higher earnings per share over the next decade.

Berkshire has enormous spare cash resources. Any reasonable fall in Berkshire’s share price (greater that 15%) will very likely spur a huge buyback for Berkshire. A fall in the price of Berkshire will lead to a rise in the value per share thanks to the buyback.

As Warren often touts, if you own a truly wonderful company and they have the ability to buy back shares, you want the share price to go down not up so that the company can buy back shares at a lower value which will result in higher long-term returns.

Warren, I will shed a tear when you die. You have been a great teacher and role model. When you do, Berkshire will power on thanks to the powerhouse masterpiece that you have built.

Smart things and dumb things to do August 2017

Our latest edition of Smart things and dumb things to do has an increased list of dumb things to do as most markets around the world trade at higher prices and offer lower future returns. Investors who are expecting to live off assets and need a mid single digit after fee, after tax after inflation return are likely to be quite disappointed over the coming decade. Most markets are trading at gross future returns of around the low single digits, suggesting net returns after tax, inflation and costs of 0% or below.

 

Dumb things to do:

1. Aussie Property

2. Aussie Banks

3. China debt dependent industries

4. The vast majority of bonds, particularly the high yield space and long term government bonds.

5. Buying index’s that are at all time highs

6. Im going to mention Aussie Property again because it is such a dumb investment from here.

7. Leveraged infrastructure/ Leveraged Private Equity/ Leveraged “alternative investments”

Smart things to do:

1. Wonderful companies with high owners earnings yields, despite the general over priced nature of most markets.

2. Some cash

3. Some inflation linked and floating rate corporate bonds

 

Deeper explanations:

Dumb things to do:

1. Aussie Property. With the latest rises in Sydney and Melbourne, the time to invest in Aussie property has never been worse. The total property recently hit $7.1 Trillion for a $1.7 trillion economy. This ratio is around 4.17 times the economy. This is only the major cities. Add in the rest of Australia and we are approaching 4.5 times the economy in just property. This is insanity on a whole new level. Lets put this stupidity in perspective:

Country Property to GDP Ratio Real Price Falls Years to recover
USA (2006) 1.9 35% 12 (After inflation yet to recover)
Ireland (2007) 3.5 58% Still negative return
Hong Kong 1998 3.6 65% 10
Spain 2007 3.6 60% Still negative return
Japan 1989 3.8 75% Still negative return 28 years later
Australia 2017 4.4 ? ?

Australia is now the most likely contender of the biggest property bubble in global history. This is not a mantle we want to hold when the only other four bubbles that reached a level of around 20% below this point fell an average of 65%. Watch out below!

(Please note that the above figures are obtained from numerous sources and are averaged out. We have used  a number of investment banks, research institutions, country statistics bureaus and university papers to obtain these statistics . There is no single accurate source for property to GDP. They are all estimates. There are numerous property data companies in Australia who are often out by 10% or so from each other. We simply attempt to show an approximate amount. Whether Australia has 4 times the economy or 4.5 times the size of the economy in property is a mute point when the long term average is closer to 1.5 times. Anything over around 3 times the size of the economy is sheer stupidity)

Once again, we have no idea when the tide will turn. We do not short markets or predict timing. We simple look to avoid folly. The Australian Property market looks to be about the dumbest investment we have ever seen right now (tied with European Junk Bonds). With gross rental yields below 3% in the two largest cities and net rental yields in the 1% range, using the term “investor” for this asset is similar to calling someone in the 13f’s football team a talented player.

Just because an investment offers you no prospective future return above inflation, does not mean that speculative hype cannot drive the prices higher. We offer no short term view on the market, simply to say that there that history will view a net rental yield in the 1% range as an inappropriate return for the risk.

The falls in other property markets around Australia such as Perth, Darwin and Brisbane apartments, has made these investments less dumb, however we still see downside in these areas as they continue to trade well above long term averages.

2. Aussie Banks

Aussie banks continue to follow the property market. Whilst the banks are now counting around 25% of their loans as risk weighted assets, this still leaves 75% of their mortgage book with no capital. With some house prices in the western suburbs of Sydney hitting the mid $1million mark and people still borrowing 10 times gross wages, we are worried that this capital position will not be sufficient when the tide goes out. An example of a $1.35 million dollar loan against a $1.5 million house in the Western Suburbs is certainly not worth 100 cents in the dollar when long term prices are closer to 3.5 to 4.5 times wages which puts average house prices around the $450,000 mark. Whilst it is impossible to know the extent of the stupidity of the banks lending, we see a number of clients come to us with loan to income ratios that would be impossible to apply for in the vast majority of other countries. There is much subprime lending in Australia. It is simply called interest only loans to people at greater than 6 times gross wages.

With one of the highest proportion of interest only loans and mortgages of any banking system in the world, Australia has over cooked its banks and economy to a level that will only be revealed when the tide goes out. With a large dependence on overseas capital to sustain this bloated balance sheet, we have put ourselves in a precarious situation. Our reliance on the kindness of strangers makes us closer to a developing nation than a developed nation when looking at our financing.

 

3. China debt dependent industries

China borrowed around $5 trillion last year according to Jim Chanos. The reported figures and estimates from numerous sources vary, however one constant reigns true, they are borrowing at multiples of their economic growth. This is mathematically unsustainable. To quote Herbert Stein “If something cannot go on forever, it will stop”.

China’s debt growth has led to numerous “experts” and journalists claiming that China is now “stable”. I had to re-look up stable in the dictionary after these countless references to make sure I truly understood the meaning. Borrowing at 3 times the rate of your economic growth is anything but stable. It is enormously destabilising and the problems in China are continuing to worsen.

iron_ore_apr2015

When China is not borrowing at 3 times their economic growth, we are very comfortable that the exceptional period of commodity price strength since 2002 will likely appear an anomaly. At this point in time, prices will likely revert closer to their long term averages which is still a material fall from current prices.

Owning commodity based companies dependent on this debt growth will likely remain painful as it has since 2011.

4. Bonds

European junk bonds hit a low of 2.79% a few months ago. If you can’t work out how monumentally dumb this is, then you should never investing money. There are very scarce opportunities to create wealth in the bond market right now and the king of credit, Howard Marks has sounded his cautionary stance.

5.  Indexing

Indexing has become wildly popular of late, however we are at market levels where the future returns from stocks are likely to be less exciting than most are prepared for. Whilst Hussman funds invests in a way we do not think is rational, their market analysis on the general level of the market has some credibility. The latest report from Hussman suggests we are certainly near the upper levels of where the market will average over the long-term. Caution is warranted.

6. Aussie Property

How many warnings is enough?

7. Leveraged illiquid assets

There is a very large proportion of the pension and superannuation market that is trending into “alternative assets”. With these assets providing less volatility due to not being quoted daily on a market, it is understandable that it attracts large amounts of capital. Unfortunately the popularity can also lead to higher prices for assets due to higher competition. Interest rates around the world look like they might have bottomed. Margin contraction from having high leverage for a relatively low yielding asset in a rising interest rate environment may prove far less attractive than it has been in the falling interest rate environment from the last few decades. Be very careful of infrastructure, private equity and alternative investments that have shown high returns from leveraged bets on illiquid assets.

Smart things to do:

1. Wonderful companies with high owners earning yields

Despite the general loftiness of the market, there are still attractive investments that offer solid returns. These investments are as rare as hens teeth, however they are still available. In a 2% to 4% owners earning yielding world, we continue to find investments in the high single digits and even double digit owners earning yields. For this reason, we are not recommending that investors go to 100% cash as may be assumed from our general cautious tone from this blog. We are actually quite excited about the prospective returns from the collection of great companies that we own. Yes there will be volatility in the share prices, however if you are getting paid 9% a year in owners earnings and the share price drops 20%, then we are excited to buy more of that business at an 11.25% owners earning yield. If you were only getting 3% owners earning yield and the share price drops 20% then a 3.75% return remains similarly unexciting.

2. Cash

We continue to hold cash as an option to buy assets at more attractive prices at some point in the future. For Australians, having some cash outside of Australia is still a rational allocation.

3. Inflation linked and floating rate notes

In Australia, we have some insurmountable household debt problems. Due to this high debt, households have little left over to spend on other areas of the economy leading to lower inflation and wage growth. If history repeats, rhymes or comes half way to where every other housing bubble eventually settled, then we are in for some very difficult times. There is no need to despair. We will hopefully avoid being the next Argentina or South Africa as the Aussie dollar will likely take some of the pain. A large fall in our currency will likely cause an increase in tradable goods inflation. The bank bill swap rate may also rise due to difficulty in funding our problematic banking asset excesses. In this environment, inflation linked and floating rate notes may provide some protection. Sadly this is a very small part of the market.

Final Note:

I truly believe that we are in one of the more difficult environments to be an investor. The prospective low returns in almost every asset class leads to most investors stretching themselves and taking risks they are unaware of. The calm that is upon markets may be hoodwinking investors into a false sense of confidence.

Quick stats of companies that we own…

Berkshire is trading with an 11% owners earning yield. Berkshire collects this capital and will likely grow the share price at around this level for many years to come.

Google is growing at 24%. Whilst this growth rate is likely to slow over time, it still has enormous growth in emerging markets through Android mobile phone platform dominance.

Managed Accounts is growing at 62%. Managed discretionary accounts growth is in its infancy with single digit billions under management compared to wrap platforms with funds under management of hundreds of billions.  The transition from wraps to managed discretionary management has many years to run.

Rolls-Royce is likely to conservatively have more than double the earnings from here in the next few years as the cash-flows of the A350 start to grow. Rolls-Royce is continuing to gain market share over GE in the long-haul engine market. The difficulties from their oil and gas segment are now mostly behind them.

Wells Fargo will continue to gather deposits despite challenges to their procedures. They remain the superior bank in the US with deposits exceeding loans, something very few can claim.

TPG is continuing to steal market share from their more expensive competitors. Their competitors are having difficulty whilst TPG grew at 11% last year.

OFX has likely passed the worst of its restructuring. This is a very high return on equity business. They are lower cost than the banks by a large margin and will continue to offer far cheaper international payments and great service. They had some below average management who overspent  and we believe with a new direction they can once again regain their growth.

Capilano will continue to sell more honey at higher prices over the years as they dominate the Australian market and increase their international sales. Their China sales grew at 87% last year and are set to become a major part of their growth over time.

H&R Block has been a difficult investment with management overpaying for their initial share buyback. This unforced error has been outweighed by continuing to purchase shares at far lower prices. The value of the business to shareholders is now increasing with these buybacks. They still have 25% of the size of the business in planned buybacks. They are increasing their dividend.

These businesses as a whole will continue to provide solid returns for shareholders over the coming years despite a generally difficult investment environment due to high valuations.

Some will have temporary difficulty. Others will do better than we hope. We have no foresight of short-term returns, however we are very comfortable that we are positioned well for your investment period, regardless of the market being at elevated levels.

Kyle Bass on China

https://www.bloomberg.com/news/videos/2017-01-25/kyle-bass-border-tax-to-pay-for-trump-s-tax-cuts

This link has some valuable insights into the Chinese economy and the effect Trump may have on it (amongst other subjects) from hedge fund investor Kyle Bass.

To buy, or not to buy?

Recently, we’ve come across a few articles discussing Berkshire’s enormous stockpile of cash (over $70 billion; increasing at around $1.5 billion each month). Some authors are suggesting that Berkshire should “hurry up and buy something already”. While it would seem obvious why Buffett needs little guidance from bloggers and amateur investors regarding the rational allocation of his capital, one individual in the comment section elaborated with some agreeable food for thought:

 

“With all due respect, it is always confounding to read advisories to Warren Buffett with respect to what he should be doing. The world is open for new ideas and I am certain that Mr. Buffett is constantly searching for such ideas. However, I doubt whether, “Buy something, already” is constructive counsel in any way. Berkshire can afford to defer overpaying for “opportunities” until the right one is available. If one doesn’t trust Berkshire to do this one should sell their stock because they are not likely to yield their bedrock investing discipline because a potentially overheated market is interfering with the occasional opportunity that Mr. Buffett seeks.
My own working hypothesis is that there is no one in the world better situated to be receiving and researching business opportunities than Berkshire. The fact that Mr Buffett will not alter his standards represents a continuing learning experience that all of us should embrace. I don’t understand the criticism or hortatory arguments that would suggest that Berkshire is not constantly looking for acquisitions or other opportunities on a daily or hourly basis. That contradicts decades of experience that we have had to observe Warren from afar. Lets never forget the principal axiom of medicine and investing, “Do no Harm.” Thanks for the opportunity to comment.”

*Mark Ross

 

The concerned investor raises some strong points that even those with a basic knowledge of Buffett’s track record would agree with. Only time will tell whether Mr. Ross is correct in his brief analysis of a 2016 Berkshire Hathaway. We believe that he will be.

East Coast Australian Property 10 times more expensive than Berkshire

We find ourselves in one of the most extraordinary economic times. Interest rates are negative for around 30% of the world’s government debt. This means that governments are getting paid to borrow money. This has never happened before in history.

For those of you that can’t get your head around this concept of being paid to borrow, you are not alone. Charlie Munger, Warren Buffett’s business partner, and one of the wisest people alive today, referred to interest rates in his comment:

Anybody who is intelligent who is not confused doesn’t understand the situation very well

One thing we can be sure of is that low and negative interest rates have pushed up asset prices to levels that are at or near some of the biggest bubbles in economic history. House prices in Australia are one area that has seen cheap debt flood the market and the net economic rent from these assets has never been lower.

The gross rental yields in Sydney and Melbourne are now below 3%. http://www.macrobusiness.com.au/2016/09/core-logic-rental-yields-plumb-another-record-low/. For those that are not finance experts, the gross yield is before costs that are required to maintain that property. For those of you that are “property experts”, the gross yield is before costs that are required to maintain the property (Most of the property experts don’t understand the economics of what they do). This means the net rental yield is likely now in the 1% range for many properties. We have found a number of properties that we estimate have a net rental yield of around 1.3%.

We find this 1.3% number quite amusing. Not only is it below cash returns, however it is approximately 10 times more expensive than our largest holding Berkshire Hathaway.

Here is Berkshire Hathaway’s cash flow report from last year:

berkshire-2015-10-k-cashflow

We adjust the cash flows for around $6 billion in maintenance capital expenditure and the readjust the cash flows for the $6billion in earnings that Berkshire earns from listed business, yet only includes the dividends not the whole cash flow. We also have projected around 10% growth for next year and our number comes out at around $36 billion per annum. This equates to around $3 billion per month. That is right, Berkshire has owners earnings at around $3 billion a month.

We then look at Berkshire’s cash and with the cancellation of the Mars/Wrigley deal, we estimate that Berkshire has around $80 billion in cash. For a market capitalisation of $355 billion, this means that Berkshire has the following metrics:

Owners Earnings: $36 Billion

Market Cap: $355 Billion

Cash: $80 billion

Owners earning yield : $36 bil/ ($355 Bil – $80 bil) = 13%

So rational investors have a decent choice here. They can buy an east coast Australian property and receive 1.3% owners earning yield or they can buy Berkshire Hathaway at 1/10th the price and receive a 13% owners earning yield.

One of these investments will likely be very difficult over the coming years and one will likely be the gift that keeps giving.

 

 

Buying the W&C 75 rather than the S&P 500

The W&C 75 (Warren and Charlie 75 group of companies) has been tracking fairly closely to the S&P 500 over the last 2 years:

screenshot BRK

 

There is one slight difference. Earnings for one of them is growing, and earnings for one of them is not.

It is likely that the similar results of the last few years may diverge over the next few years.