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

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.