Asset Allocation

In early 2017 we identified debt and the unsustainably high property prices as the key risks to the Australian economy. In particular we were concerned about the unwinding of the wealth effect as investors began to feel the pinch of a weaker property market. We believed this would manifest itself through poorer consumer sentiment and consequent drop in spending.

Some readers may recall we wrote an article in April 2017 discussing our conversation with our Uber driver and his views on property. At the time our driver explained that he was working double shifts in an effort to get on the property investment ladder.  When we questioned his thinking and wondered aloud if he was concerned about the sustainability of high prices, he laughed us off secure in his belief that property prices can never go down.

Following mountains of anecdotal evidence suggesting that the music was about to stop, we began the process of reorganising our portfolio away from housing (including the financial institutions that fund it), building, and consumer discretionary stocks.

We began to look for counter cyclical businesses, businesses with international earnings, and businesses whose products were driven by non-discretionary consumption.

Our Current View

Property prices are retreating.  The peak to trough price fall in Sydney thus far is 9.5% and as great as anything we’ve seen since the Paul Keating recession we had to have in 1989-1991 (-9.6%).

There are some key differences between then and now:

  • In 1990, the country found itself in a recession. It was a weakening of economic activity coupled with higher interest rates that saw property prices fall in the early 90’s. Debt to household incomes ratios were significantly lower than today, and lending continued to grow as the economy recovered. At present, there is no recession in Australia.
  • Today’s prices have been driven to record levels by soft lending criteria, and the banking system’s willingness to rely on fuzzy personal expenditure numbers. The recent pull back is being driven by a return to responsible lending standards, and more traditional loan to value ratios.  If a recession does eventuate, we’d expect property price falls to accelerate.

Debt continues to remain a concern

Australia’s consumer debt to GDP ratio is the highest it has been in recent memory, and significantly higher than global peers.

A confluence of falling housing prices and risky loans due for refinancing at the same time that global interest rates are moving higher is a worry. In particular, interest only “liar loans” are a serious cause for concern.

To shelter ourselves from the risk, our portfolio is positioned away from domestic consumption, property, building, and the domestic economy in general.  There are plenty of opportunities for investment. There is no need to hope that the economy will continue to be driven by borrowed money.

Cash Converters (ASX:CCV) business tends to be counter cyclical. Demand for small loans tends to increase during difficult economic times. This is especially the case when the major banks pull back from lending.

iSelect (ASX:ISU) provides a platform for customers to select the best deals on insurance (and a number of other similar products). Currently recovering from a profit downgrade, the major competitor has become the major shareholder. Look out for potential corporate activity in 2019.

Litigation Capital Management (ASX:LCA) has traditionally funded litigation claims (such as class actions). The company is branching out to participate in corporate litigation, opening a significant new market. Historically, litigation claims have increased during turbulent times.

Paradigm Biopharmaceuticals (ASX:PAR) owns a drug that is effectively treating osteoarthritis. The company has begun treating patients with their drug in Australia (with limited access in the USA) and is awaiting the green light from the FDA to expedite their commercial entry into the US market.

Paladin (ASX:PDN) is the most advanced and largest Australian listed uranium producer. Global demand for nuclear energy continues to grow at a rapid pace (currently over 10% of global electricity is generated via nuclear energy), while production has fallen away. This year promises to be a key period in uranium re-pricing as US utilities look to lock in new long-term contracts.

Looking Forward

Falling property prices have entered the mainstream consciousness.  News programs that once featured home renovation and house flipping shows now caution that property prices are falling and could fall further.

Yet few analysts are talking about it in the context of its effect on consumers ability to maintain and fund our record-breaking debt levels. The “wealth effect” that saw people feel richer and spend more as property prices moved higher is now beginning to unwind.

Serviceability of loans is a concern with more far reaching consequences than shorter term consumer sentiment/consumer psychology.

Where investors were previously able to disregard the fact that they had borrowed more than they could afford to pay back, they remained comforted by the knowledge that there was always someone willing to pay more for their property in the future. Living with the strain of high interest repayments was worth the effort given that a greater capital gain was certain the longer they could hold on.

What happens when the prospect of finding a buyer at a higher price point for an investment property dissipates?

We don’t have the answer, but our sense is that if this situation begins to play out en-masse, a resolution will require some significant government intervention, or some significant investor pain.

Where the opportunity lies

The last two years has seen growth stocks outperform value investing. 

Positive consumer sentiment determined that companies with the promise of a bright future thrived even in the absence of making good on that promise.  Conversely, good quality stable businesses were seen as boring.  The prospect of investing in them at a time that growth was the rage seemed like an opportunity cost too great to bear.

As perception re-aligns, we anticipate that investors will rush back to value.  After all, there is safety in owning a business for cents on the dollar.  This may be particularly true as expensive growth businesses find themselves being valued on actual earnings rather than prospective earnings.

Our view has always been that we would like to own wonderful businesses and purchase them at attractive prices.

As we begin to see an unwinding of irrational (exuberant) investing, we expect many high-quality companies to be sold at unreasonably discounted prices. Our ongoing challenge is to continue to identify those quality businesses and to recognise the value in their prices.

We look forward to 2019, with our eyes wide open.



Comments

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Aleksandar Bogdanovic

Firstly, thank you for sharing your stance and thoughts. Considering your writting is unsual and unconventional- positively- I would be useful for everyone if you call-in more often.

Bill Edlinger

Good article Mr Goldberg. Was the 1990 recession the Keating "recession we had to have" ? From memory house prices dropped circa 20%