Now is generally not the time to bet big. Whilst the market is not overly greedy at present (not 2000 levels), there is certainly a distinct lack of fear around.
We are on the bearish side of agnostic on the market.
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.”
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:
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:
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.
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:
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.
Berkshire Hathaway Update
Berkshire Hathaway released its second quarter results on Friday. The numbers were within our expectations. Valor is extremely concentrated in Berkshire Hathaway, making up around a third of our clients portfolios on average. With around 80 different businesses under the banner, there is significant diversification within the stock. We believe that Berkshire is the best company in the world by a very large margin. It makes sense to have a far larger position in Berkshire than any other business due to the extraordinary cash that it generates.
Here are the numbers in summary:
Cash from operations for 6 months: $15.3 Billion giving us a yearly figure estimate of around $33 Billion (assuming railroad freight recovers somewhat and no major insurance losses)
Cash in the bank (Short term Treasuries): $61.8 Billion
Look through cash flows from listed equities on top of dividends (approximately): $6billion
Maintenance capital expenditure (approximately): $6billion
Market Cap: $360 Billion
Owners earnings yield of approximately: $33/($360-$62) = 11%
This is extremely rough and not meant to be accurate to more than a few billion or so. Whether you are getting a 10% or 12% yield is immaterial and not able to be calculated accurately anyway. Even Buffett doesn’t know what cash-flow will come from insurance, railroad, Precision Cast Parts or energy earnings in the next 12 months to any degree of accuracy. The key point is that you are getting roughly an 11% owners earning yield, not a 1.5% yield from a government bond (let alone a negative yield which is very common).
Those that are investing in the lowest government bond yields in economic history may be patting themselves on the back for good guess work for the last 12 months performance, however the next decade may be far less kind.
If you view Berkshire with a book value focus (still rational, although becoming far less relevant over time), we calculate that the book value at the end of the second quarter was $107.30 for the “B” shares. This gives a buyback figure that Warren would be “delighted” to repurchase at 120% of book value of around $128.80. This was the figure for 30th June and if you calculate that growing at around 11% per annum, then the figure for August is very close to $130.
So you have the worlds best company with an approximate 11% owners earning yield with roughly an 11% downside before the buyback price. This is why we are so comfortable with our very large holding.
If the share price dropped to the rough $130 buyback price, we would not be concerned as it would be very beneficial to our holdings over time. If this doesn’t happen, the increasing gap between the book value and growth in cash-flows leads us to expect that over the next few years, it is likely that Buffett increases the buyback to a higher percentage of book value. In a low return world with most other stocks offering such poor value, Buffett might be looking at his own stock and thinking that buying back at a slightly increased number is the best use for the cash. Perhaps he has another elephant in his sights that we don’t know about?
The RBA just lost control of the Australian Economy
On Tuesday the 2nd of August, the RBA lowered interest rates from 1.75% to 1.5%. Then the most unexpected moves by the banks indicated that what the RBA does from here has very little meaning.
After the 0.25% drop, the banks put their deposit rates up by 0.5 to 0.85%. This increase in funding cost for the banks after only passing on 0.13% cut to rates is the equivalent of a roughly 25% fall in their net interest margins of 2%.
The banks have effectively just lowered profits for mortgages by around 25%. If you own bank shares in Australia, I would be reviewing the quality of those temporary “juicy” dividends. For the yield addicted retirees, this news is the blow that they can’t afford. (See European banks for what is more likely than not from here)
Tuesday was the crack in the San Andreas Fault, that is the extremely leveraged Australian property market.
The proverbial straw that breaks the camels back can’t be far away with much greater risks to our economy that any time in the last few decades thanks to China’s monstrous $35 trillion debt bubble.
The property market has not corrected over the last few years as we expected. This does not mean that we are going to be permanently wrong on the eventual outcome. It means that when it eventually rolls over, the correction will be larger than it otherwise needed to be. Most estimates for falls in prices are not even close to what has happened in history to every property bubble of this magnitude. There are no exceptions.
Read about Japan in 1989, Hong Kong in 1998 and Ireland in 2007 as these bubbles are the only bubbles that have ever reached these lofty heights of above 3.5 times the size of the economy.
We are now atop a $6.5 trillion property market for a $1.6 trillion economy, possibly the largest in world history, with no effective interest rate bullets left in the reserve bank chamber.
“Be fearful when others are greedy and greedy when others are fearful” (Warren Buffett). Australia is likely the greediest property market that has ever existed. Discussions on the topic engulf dinner party conversations and Uber ride discussions (formerly the taxi driver bubble test). Whilst we cannot know exactly when it will become very ugly, we can know that we should be more fearful than any time in the history of property markets (and act accordingly by selling all related assets that are solely dependent on higher household debt levels.)
Lower interest rates in Europe are delaying the inevitable, however with the 230,000 housing starts in Australia with a need for less than half this number, a very Irish type scenario is developing quickly. The oversupply is already leading to zero or no rental growth and will continue to get worse over the coming year. At some point in time, investors will face lower rents, higher vacancy rates and falling prices.
Roger Bannister and negative rates
The world has survived another great depression over the last 8 years due to ever decreasing interest rates. The question is how low can they go?
We believe that there is a hard floor on negative rates. There is a point that rates cant go any further negative because savers just refuse to hand over cash at some negative rate. This might be -1.5% or -2%. We don’t know and until savers start to flee on mass the number is unknown.
The Roger Bannister effect then grips savers. Before Roger Bannister broke the 4 minute mile in 1954, it was widely believed that it was impossible to run the distance in that time. After his run, numerous runners achieved this feat. It was Roger’s achievement that allowed people to follow his lead. We believe that once it is seen to be achievable of removing cash from banks, then a snowball effect will follow.
What we expect to happen is an innovative business will come and offer to store cash at a better rate than the bank. At this point in time there will be a bank run and exodus of long-term government bonds. This is the point of no return for the world.
Sweeden is ground zero for negative rates. They have the lowest rate of negative 1%. There will come a time where the rates cant go further negative and the day that happens is the day the world realizes the true lowest possible rate. Central banks can do what they please, however the faith will be lost in their abilities.
The problem is the worlds central banks have promised that lower rates will stay lower for longer and that this scenario will allow the world to recover. This is a promise they can’t keep.
Pension funds and insurance companies have been fine in a world of ever decreasing bond yields. Their bond portfolios have been making sufficient capital gains to meet their hurdle requirements, which are around the 6-7% mark. There are some that are higher, which is fantasyland and there are a few rational ones that have dropped their hurdle rates to closer to 3.5%. Unfortunately in a world of negative and zero rates, they are all unsustainable over the medium to long term.
The day that yields truly stop falling or going further negative is the day the world becomes unfunded. Pension liabilities around the world become a burden that almost no company can afford.
The question is:
When do yields find their floor? That is the day you want to avoid all investments dependent on 7% hurdle rates. The vast majority of the worlds pension funds and insurance companies have liabilities have no way of ever being repaid.
This is the day the negative interest rates experiment gets put back in the category of experiments that failed horribly. Possibly the largest failure in history.
Some ideas on how to fix Australia
Australia faces some of our darkest years in the very near future. Our household debt is the highest in the world. We have the greatest reliance on China of any western nation going into a Chinese debt crisis.
The current government and opposition are as useless as a one legged man in an ass kicking competition. They are looking solely at the next month of political point scoring and have no policies to tackle the coming crisis from the largest debt bubbles in the world, ours and China’s.
At Valor, we are positioned so that we will make considerable gains from a very difficult economic situation in Australia in the coming years. We hope it doesn’t get as bad as we think it might for the sake of many of our family and friends who are not positioned correctly, however our clients are set to capitilise on this coming crisis.
There are a few actions that the newly elected government can do to lessen the blow of what is coming. We are realists and with Malcolm Turnbull selling his soul to the right end of the Liberal party to become leader means will do none of the following. Bill Shorten has also shown no sign that he has any inkling of how to manage Australia’s coming crisis.
There needs to be a political party established that has no agenda other than to make rational decisions for the greater good over a very long term period. If we could dream up this theoretical party and structure it correctly, it would consist of leaders with real life experience who have not compromised their morals to get to the political position they have achieved. Malcolm Turnbull initially showed promise in this department, however has obviously been muzzled by the party.
Lets call this fanciful party the “rational party”. They are not beholden to powerful bodies such as the property council or the unions. They simply act in a manner that is rational. This does not exist in politics. There is no one in any position of influence who is not themselves under the influence. Some of the independent senators have made fewer compromises, however they are not in a position to drive policy, rather they can only vote to influence the balance of power.
What could the rational party suggest as a way to fix our formerly great country:
Tax empty houses
Make the home part of pension asset test
Ban borrowing in Super
Ban negative gearing that doesn’t become positively geared within 3 years.
Re-capitalise banks before the crash
Build a capital based society and encourage innovation (currently rent seeking asset based society)
(This list is not exhaustive and is just a few ideas that would put us on a more sustainable path)
Tax empty houses. Drive through Zetland in Sydney or Docklands in Melbourne at 8pm on a Monday night and you will see a very large proportion of the apartments with no lights on. There is a wide range of estimates of how many apartments are empty, however a simple vacancy tax will fix any housing issues in Australia. The mayor of Vancouver recently announced this very rational measure. Why should an Australian working class family, who is doing all the right things, be put in a compromising position of enormous debt or inability to buy a house simply because we allow foreign buyers to launder their money through our property market. Their dirty money sits in apartments and houses that are left vacant, wasting resources in our country. It is simply immoral and easily fixed. Increasing taxes on all property would also be rational, as it would reduce speculation.
Infrastructure is horribly lacking in the entirety of Australia. Whilst Melbourne may have a superior tram system that is better than most, it is still far behind the wonderful networks of the worlds truly great cities such as London, Paris, New York, Hong Kong, Singapore and Tokyo. A congestion tax such as in London would be wise to discourage single drivers entering the city causing inefficient usage of roads. This congestion tax must be implemented along side a significant increase in public transport.
There are multi millionaires in Australia who are receiving the full pension. This is insane. Hard working Australians are paying for the rich peoples retirement, simply because that person put all their money into a house rather than superannuation. There are even a number of Australians who are wasting their super as fast as possible to get the full pension. Some of these people live in $2 million to $10 million dollar houses! A simple fix is to have the family home counted in the assets test. If someone wants to stay in the home, that is their prerogative, however it is a choice that they must pay for if they have the ability to. A struggling nurse or policeman who works all night just to pay tax so that these multimillionaires can life comfortably in their mansions is just not fair. If these rich 1%ers want the pension and to stay in their house, the government can have the pension deducted against their home as a growing debt owed to the government. On death, the government sells the house and any remaining asset value becomes part of the estate. This way essential members of society such as teachers, nurses or policemen are not working to pay tax for another person’s extreme wealth.
Borrowing inside super is just dumb. Those that are leveraged into housing for the coming crash are going to wipe out their retirement assets and be a burden on society. This should not be allowed. Their greed will be your increased taxes to pay for their folly. There are also some who are leveraging into banks using warrants. This should also be banned. There should be no leverage in retirement assets because when the tide goes out, those that were greedy become dependent on those that were cautious. This is just not fair.
There should be no tax deductions for investing in property for any period beyond 3 years. There is a rough 3-year test for businesses to become profitable before the ATO deems a business a hobby, so why shouldn’t this apply to property. Anyone who is putting money into property with the current rental yields is likely to have rental losses for a decade. This is tax evasion! This is illegal, yet currently not being enforced because “everyone is doing it”. Why should the rest of society pay for a speculator who never intends to make an income profit in any meaningful time frame? Capital gains are not considered an income profit. The current tax code makes it clear that it is tax avoidance if you never intend on making an income profit from an investment and attempt to claim losses against your personal income. This needs to be enforced with a very strict 3-year rule. This 3-year rule would be a better outcome than the current proposal by Labor to completely ban negative gearing over 10 years.
The Australian banks, at first glance, look ok with their capital ratios when compared to the rest of the world. The only problem is that these capital ratios require assets to be fairly valued. A house in Atlanta for $100,00 is probably at or below fair value. A house in Blacktown for $1,000,000 is probably a very long way from what could be considered fair value. When an Australian bank has lent $900,000 for a $1,000,000 house in Blacktown, it puts that $900,000 in its accounts as an asset. There is no way that this $900,000 “asset” can be honestly used as a comparison to a $90,000 loan against a $100,000 house in Atlanta. Australian banks are horribly undercapitalised when using what should be fair value for their assets. When the tide goes out, the “assets” the banks hold will prove wildly over stated and tax payers will have to foot the bill for the banks stupidity. This is not fair. What needs to happen now is that banks must recapitilise to closer to double their current capital to survive the coming debt crisis. The banks have been earning 15% to 20% returns on their very leveraged equity. Reducing this leverage will make banks less profitable and thus the bankers bonuses will pay for any future losses, not your taxes.
In the US, people look to start businesses to create wealth. In Australia, people look to borrow as much as they can to buy assets that they hope someone else will buy off them at a higher price – the greater fool theory. Australia has hollowed out our economy from this rent seeker attitude. We have very few internationally competitive businesses. We have an enormous number of rent seeking dependent businesses based on selling second hand houses to each other. Too many of our intelligent people go into mortgage broking, real estate sales and banking. We have the largest property to economy ratio of any nation in history. In other words, there has never been a society in history more dependent on rising property values than Australia. This is an utter failure by our country because it will not last and when it turns, there is nothing of note to pick up the slack. We have to restructure society so that there is far less incentive to enter the rent seeking leveraged unproductive asset sales game and enormous incentive to improve society through capital investment into productive businesses. This is done through grants and taxes. Malcolm Turnbull has started this concept, however the amount of $1 billion he proposes is a drop in the ocean compared to the trillions of dollars that has gone into reshuffling second had property. His innovation grants need to be expanded 100 fold to have any impact.
We are supremely confident that none of the above measures will be enacted in the short to medium term where they are desperately needed because they are too rational and politically unpopular. Thus we remain very worried about Australia’s next few decades of falling income into rising debts. Australia could not be in a more precarious situation for the coming years. We will likely never be as worried as we currently are for our nations wealth.
Those that still have excess property or a family home with debt that is greater than 4 times gross wages, please speak to your adviser as soon as possible to properly prepare for what is coming.