The craziest bond ever issued and looming recession worries

It’s time for a new episode of Stocks Neat, the podcast with nothing watered down.

In June’s episode of Stocks Neat, Gareth and I discuss a 100-year Austrian bond issued in 2017, before diving into the market commentary around a recession and how it might be different from others. And after Forager’s recent office move, we also chat about the concept of shared office spaces.

“There are some big lessons here for the rest of the asset pool, and some of them don’t feel like they’re getting the message on what’s happening in bonds,” says Gareth. “You’re also seeing it in parts of the equity market where the prices have gotten very realistic very quickly.”

Our whisky of choice this month is something a little more accessible than our previous tipples; Steve popped next door to Vintage Cellars to pick up Laphroaig’s Islay Single Malt Whisky. Tune in and join the team.


Disclaimer: Just a quick reminder, this podcast may contain general advice, but it doesn’t take into account your personal circumstances, needs, or objectives. The scenarios and stocks mentioned in this podcast are for illustrative purposes only, and do not constitute a recommendation to buy, hold, or sell any financial products. Read the relevant PDS, assess whether that information is appropriate for you, and consider speaking to a financial advisor before making investment decisions. Past performance is no indicator of future performance.

Steve: Hello, and welcome to episode seven of Stocks Neat, a Forger Funds podcast where we talk the world of stocks and try a few nice whiskeys. I’m Steve Johnson, Chief Investment Officer here at Forager, and I’m joined by our International Fund Portfolio Manager Gareth Brown. How are you Gareth?

Gareth: Hi Steve. Hi everyone.

Steve: Great to be here. I don’t know if you’ve noticed any difference in the recording sound, but we are in a new recording studio today, in a new office run by Hub Australia and we’re going to have a bit of a chat about the Hub model later, and what it means for shared offices.
We’re going to kick off though, talking about a very obscure part of the world, government bond markets, which has some important implications for our own world. And then what, if you believe the markets at the moment, is an almost certain and very deep coming recession in Australia. Gareth, we are drinking the Laphroaig 10-year whiskey today, which is a very common whiskey in the bottle shops, about a hundred bucks a bottle and probably one of the most famous peaty whiskeys, I’d say.

Gareth: Yeah, definitely on the west coast there, they make these very peaty, smoky whiskeys, and Laphroaig is definitely one of the marquee ones. And the 10 year is their signature.

Steve: So if you’ve got one to share with us, you can crack it open now, we’ll come back and chat about it a little bit later on.
Gareth I’ll let you kick off on this one. You lived in Austria for quite some time, married to an Austrian woman. So, it’s a country fairly close to your own heart. That’s not the relevance to this story that you’ve got to tell though, there’s been something very interesting going on over there.

Gareth: Yeah, so three years ago, no, five years ago, 2017, the Austrian government issued a hundred year bond. And I thought that was a really interesting thing. I hadn’t seen a lot of those over the years. There’s been a couple of perpetual bonds that governments have issued in the past, but this one had a yield to maturity of 2.1%. So, you would get, you know, you’d put your hundred dollars down, you’d get roughly 2.1, two euros, 10 cents each year. And then in a hundred years you get your hundred back. And so, you’d be yielding 2.1% annually to maturity. And I thought that was an astoundingly low rate at the time.

Steve: We were talking about it at the time, you know going that is just nuts. You buy something here taking a hundred years of risk around money printing and inflation and all sorts of, very, very typical Fiat currency problems.

Gareth: Three years later, 2020, just sort of a couple of months after the pandemic started, they issued another hundred-year bond. So, this goes out to the 2120, and it was at a yield maturity of 0.85%. So, you put a hundred euros down, you get 85 Euro cents annually for a hundred years, and then you get your hundred euros back after we’re all dead. Let’s face it.

The issue was it blew me away. The issue was eight times oversubscribed. I have no idea why the Austrian government just didn’t take every Euro that was offered to them. I’m sure they could find uses for that sort of capital, but it was a really interesting time, why would an investor buy a hundred-year security with such a skinny, skinny yield.

And the only answer that makes any sense, is that you are worried about negative interest rates, which were in Europe at the time. Being a very, very long-term structural problem, you’re talking about decades of negative interest rates on the short-term side, decades of deflation. Then it makes sort of sense to be locking in nominally nothing instead of a minus, and that’s what’s important here, is you have an asset here that’s very, very long duration, you are very exposed to movements in interest rates. It’s going to hurt if they go up, and it’s going to make you a lot of money if they go down. The economist wrote a piece on the 2017 bond issuing in 2019, and they said, and the price had gone up a lot by then, but they said, something like, that you might experience problems at some time, but by the time you do, investors will be dead.

Here we are a few years later and there are problems in this market because those interest rates have started to normalize at a fairly rapid clip. And that’s where we are today.

Steve: We’ll, come to that in a moment, I guess, where the pricing of that bond is now, but I think it is important to recognize that not everyone who is trading these types of securities is thinking like you and I are, about is this good value if I hold it for the next a hundred years? They’re thinking, am I going to be able to sell it for a lower price? And you know, 10-year government bonds in Germany got to 0.5%. We were writing blogs five years ago saying, why would you do this at 0.5%? And they went to minus 0.5%. So, the person who bought that bond at 0.5% yield actually made a lot of money.

Gareth: And it was a strange time, you had life companies that were building vaults underground to store cash, because they didn’t want to have to experience negative interest rates.
It was a very bizarre time, right?

Steve: Yeah, so the era is over, at least for now, the year of negative interest rates.

Gareth: And it’s happened mildly quickly.

Steve: And the hundred-year bond rate in Austria is now what, 2.47%. So, that is now a 98-year bond and the yield to maturity on that has gone up to 2.47%.

Steve: We might be sitting at home thinking that’s skinny, 85 basis points to 2.5, I still wouldn’t want to buy it at 2.5, but also thinking that’s probably not that dramatic a change in the yield. It is.

Gareth: Yeah. So, in order for that yield expansion, so yield up, price down. The bonds are trading at 40 cents on the dollar. So, the hundred dollars that you put in two years ago, if you wanted to sell it on the market today, you get 40. So you’re down 60%. And this is amongst bond investors, which includes some of the most conservative investors in the whole risk spectrum. They’re down 60% on a government bond in two years.

Steve: Yeah, it’s extraordinary. Isn’t it? And to be honest with you, I sort of wish our government had been issuing the longest duration bonds they could as well. This is one of the great, I guess, wealth inequality fixes that you’re ever going to see in terms of a government issuing these bonds, not having to pay any interest really on it for a very long period of time. And the principal payment is so far down the track

Governments probably should have been taking more advantage of it than they were, but that concept is a really, really important one. So a hundred year bond is the most extreme form of bond that I’ve heard of in terms of term, but that concept there, that you have really extreme price sensitivity to changing yields. The term people need to get to know, and they’ll see it all over the place, is duration. It’s a long duration bond because all of the cash flows are a long way down the track.

Gareth: Long maturity. Minuscule coupon. They’re the two things that create that duration. You can have a bond, that’s say a 10% coupon, it pays you 10% every year. You get much more of your total cash flows in the early years than back in the late years. If that makes sense. But a bond like this, even at the end of a hundred years, you’ll have still not got a hundred euros worth of interest. You’ll have got 88 Euro or 85 Euros worth of interest. And then you get your hundred of principal.

So, the duration is way out there, you know, 60, 70 years. I’m not exactly sure what the number is, I haven’t done the maths on it. So it’s very, very sensitive to changes in interest rates. Interest rates up, price down or interest rate down, price up.

Steve: And the actual measure of duration is a straightforward relationship between those two things. You’ve got a bond that’s fallen 60% here on a 1.6% increase in rates. So it’s got a duration of something like 40, which is very, very, very long, but this actually has really important implications for equity markets, because we’ve seen some very, very violent moves in the longest duration equities as well because people are applying the same maths.
I guess we’ve got similar views about how stupid it was a few years ago, but they are applying that same logic to a lot of equities now as well.

Gareth: I just think there’s some big lessons here for the rest of the asset pool of the world. And some of them don’t feel like they’ve gotten the message yet about what’s happening in bonds. And you’re also seeing it elsewhere in parts of the equity market. The prices have gotten very realistic very quickly.

Steve: Maybe we’ll start with where it has repriced pretty quickly. And they’re good examples I think of stocks to think about as having long duration. Well, think about any of these high growth companies where you’re not expecting to get any cash flow back anytime soon. That’s the first piece of a high duration investment. And then the second piece is all of your value is going to come a long time down the track and you can think about a Shopify, an Uber to some extent. There’s a lot of really good, listed companies out there. Even a Xero here in Australia. You know, it’s a business that has not ever paid a dividend. They don’t have any intention of paying a dividend anytime soon. The business is growing really, really nicely. But that share price has gone from $150 down to $85 or $90, simply from people applying this sort of logic to it. Nobody’s putting any different cash flows into the model. No, they’re just saying, okay, I’m going to use an interest rate of 4% here instead of an interest rate of 1%.

Gareth: That’s sort of interesting, isn’t it? Because you sit here and think stock prices are down 70% in some of these, or more in some of those long duration equities, and you’re thinking, okay, people are getting more realistic on the cash flows themselves, but that sort of discount rate change that we’ve seen in the Austrian hundred-year government bond explains 60% points of the fall. Right. It’s not like necessarily the equity markets have really reigned in the cash flow expectations that they had 12 months ago.

Steve: No, I would say if anything, those numbers have probably gone up as some of these companies start to show a little bit more restraint around how much they’re prepared to spend. So it’s going to be very interesting to see that unfold further. Obviously, we’ve had some pretty big moves in particular parts of the market. You’ve seen those share prices come down a long way. There are other parts that I don’t think have really started to accept this reality at all yet. And they might be sitting there thinking, well, we’re not tech companies, so it doesn’t affect us. But, there’s some other asset classes that have only known declining interest rates for a long time.

Gareth: So yesterday, Aussie FinTwit, financial Twitter in the Australian community, was really running hot talking about the results from Vicinity Centres. Sorry, this is not a full result yet, this is a trading update. They own half the Chadstone Shopping Centre in Melbourne. It’s a Gandel entity, I guess you would say, they own a bunch of other shopping centres around the country. And they released a statement titled Full Year 22 Earnings Guidance and Property Valuations Update. So, this was on the 20th of June. I’ll read the offending paragraph in full. Vicinity also announced preliminary 30 June 22 asset valuations, which indicate a 245 million uplift in book value for the six months to 30, June 22, and a modest tightening of the weighted average capitalization rate from 5.35 to 5.31

Steve: You said tightening means down, not up?

Gareth: Yes. Yield down, price up, a little bit. Right? A lowering of the capitalization rate and an uplift valuation in this market, like that’s an astounding thing. Now I’m not a valuer of shopping centres. But I guess the thing that most clearly puts this into perspective is you look at the Australian long bond. So the ten-year, the government long bond last year, sorry, 12 months ago, 30 June, 2021 that had a yield to maturity of about 1.4%.

Steve: So, if I take that property centre, they were saying.

Gareth: Sorry, this is the Australian government bond I’m talking about, 1.4%.

Steve: Yeah, so you take that discount rate that they were applying which was five and a half.

Gareth: 395 basis points over the government.

Steve: So, 3.95% premium. You would want to get paid to own a shopping centre over the government.

Gareth: Yeah. There are costs coming out, sub the capitalization rate. So it’s not really, but then you’ve got debt you can apply. But anyhow, just at 1.4%. Here we are almost 12 months later, the Australian government 10-year bond now has a yield of 4.1%. So it has risen, what are we at, nearly 300 basis points in a year, that’s a massive expansion, right? What’s happened at Vicinity’s capitalization rate. It’s gone down slightly.

So we are talking about a 395 basis point premium to Australian government bonds 12 months ago. That is now 121 basis points. So they’ve just said here, the valuations are not going down. It’s just that the premium to the government bonds have compacted dramatically. Whew, you said I’m not an expert on shopping centre evaluations. It may reflect what’s going on in the market, but it feels like a bit of a fairy land to me.

And I think that fairy land is not restricted to shopping centres. I think there are a lot of assets where people have been applying lower and lower discount rates to the cash flows to justify higher and higher prices. Toll roads, utilities, even electricity companies. I think a lot of these businesses, and we’re going to come to it in a moment, people worrying about recession, but I think people are going well I want defensive businesses and cash flows, so I’m going to buy those. But there is a lot of interest rate risk here.

You know, when I was working at Macquarie, buying Sydney airport, back in 2003, we were valuing that business at seven- and eight-times EBITDA because interest rates were five and debt was costing us seven and eight, and investors wanted twelves and thirteens on their equity, and now you’ve got IFM taking over Sydney airport paying three times that multiple on the basis that they can use cheap debt. And the right rate of return for a Superfund here is maybe a six or seven which I assume they’re using. Whew. And, and that whole space has always had me very, very worried. The superfunds never really, you know, they sit there and say, oh, your money’s down 5% this year, but three quarters of it’s unlisted. And they get to put their, whatever valuation they want in the model.

Gareth: I just think it’s like, we talk about whether we want these safe assets, because it’s a tough time, but you can now buy a government bond and earn 4%, more than 4%. You couldn’t do that 12 months ago. It didn’t offer you that shelter.

Now, you can lose money on a government bond, but if you lose on the Aussie 10 year from here, you’re going to lose more on your Vicinity share holding is my feeling.

Steve: Why don’t we pour a whiskey Gareth after that very technical conversation, people at home or out on their walks might want to stop in at the pub or pour themselves a whiskey after that conversation as well.

We’re going to get even more economics in this next little session. I’ll give a quick example to kick things off here. We own Seven West Media in our Australian Shares Fund, the owner of Channel Seven and The West Australian, the main newspaper over in WA. We bought that stock at sort of three times earnings, when the share price was 40 cents in August of last year. They’ve had a couple of really good results. They’ve generated a bunch of cash flow. They’ve repaid a huge amount of debt and de-levered the balance sheet. And, the overall advertising market here in Australia has been growing quite nicely out of the COVID downturn as well.
And the share price hit a high of 80 cents, I think, but traded sort of between 65 and 75 for a fairly significant amount of time. Then in April, they came out and upgraded their guidance for the full year, said we’re expecting to make more money than we’re anticipating. It translates, they gave EBITDA guidance of sort of pre lots of things, earnings guidance, but it translates to about 180 million of profit for the year. And the share price has been absolutely whacked. It’s all the way down from 75 back to 35 cents this morning. We’re recording this podcast on the 21st of June, shortest day of the year. And that share price is more than halved over three months. And the explanation. If, and it’s not hard to find, you can read broker reports saying advertising downturn is around the corner, we’re about to have a recession and this is the most cyclical exposed business. Therefore, just sell the stock and it’s been absolutely hammered.

Gareth: And the way you put it is that. Revenue falling 10 or 15%, it can halve earnings. Right? That’s sort of what the magnitude we’re talking about.

Steve: That’s right. And it is a structurally, it’s a free to air TV station. So, I think there are long term structural challenges there that we probably won’t get into today. But those challenges were the same three months ago as they are now. But the stock market has become absolutely convinced that we’re going to have a recession, that it’s going to be a very deep and very lasting one because I mean, you can lose a year of earnings here and you’re still going to be fine.

Gareth: It’s sort of strange, isn’t it, you buy this thing at 80 cents, you know the future’s cyclical, the recession arrives, and you know that, or you think that earnings are going to halve, but it’s going to halve for a period of time, whatever that is, and then rebound. Is halving the stock price the right response to having earnings depressed for a period of time?

Steve: I mean, the only situation in which that is true is where those structural issues are so serious that you’re not going to have a business left at the end of the recession.

Gareth: But it sounds like they’re responding to cyclical rather than structural in the last three months?

Absolutely. No doubt. Like I said, those issues were there and across the retail space, we don’t own the stock, but there’s a company called Adairs, the share price is $4.50 down to $1.50. JBHIFI, even a really good example. I think 50, mid $50 share price down to $39, $38 this morning.

Lots and lots and lots of stocks that are exposed to the economy have been sold off very aggressively. And I think it’s a really interesting environment that we are in, this whole momentum driven nature of the market, or maybe narrative driven is a better way of putting it, there’s just no reference to what the right price is for the future. It’s just, well, this is going to happen, and therefore, I don’t want to own the stock, or I do want to own the stock.

Gareth: So you’ve got one stock that we’ve talked about earlier. No change in the discount rate that’s being applied to it, no expected change in the revenue and earnings, or somehow the price ends up staying the same or near abouts, or at least the valuations, the directors apply.

Then you’ve got another stock where recession’s coming and they just completely take the clippers to it because revenue’s going to be down and maybe the discount multiple, the discount rate, sorry, has gone up. And it’s a bit indiscriminate.

Steve: And I think there is a lot of pulling out the playbook from the 2008/09 recession that’s happening here that is not necessarily going to be the right playbook for this next recession.
I mean, you and I were sort of finishing school the last time Australia had a recession of this type that is driven by inflation and driven by the central bank having to raise interest rates that slows down economic activity. So there is not a lot of experience around it, but I do think it can be quite a different type of recession from what I would call a balance sheet recession that we had in the financial crisis, which we know take a long, long time to repair because you need to just slowly earn your way out of that balance sheet crisis. What we have here is a demand overheating problem that the central bank is raising interest rates to try slowdown that excess demand.

Gareth: And typically some fairly unique supply problem as well. At least we have seen that. They might be normalizing.

Steve: Yeah, well, it’s been exacerbated by wars in Ukraine and Russia and oil prices high. I think it’s getting hard to say what’s temporary and, and what’s become permanent here, but either way I think central banks are saying we’re going to try and slow the demand down by putting interest rates up. And it’d be stupid to say you know what’s going to happen, economics is a very, very complicated thing, but I can see a lot of, there’s a range of different scenarios here that vary from it’s a really bad problem to, we had a recession where nominal GDP didn’t even go down potentially.

You know, when they’re talking about recession, it’s inflation adjusted. And I feel like a lot of these businesses have the balance sheet to survive it for sure and certain, and may not perform anywhere near as badly as people are thinking.

Gareth: Definitely learned some lessons from that last balance sheet downturn, in terms of how a lot of companies are financed in Australia. They just don’t have the bad balance sheets that we saw in the mid 2000’s.

Steve: Well, that’s probably not exclusively true.

Gareth: Some sectors of the market.

Steve: And the consumer here in Australia is one of the more highly leveraged consumers in the world. There’s been a lot of talk about this internally, we’re probably wasting time talk to be honest with you. But are interest rates going to go to 4% or 5% here in Australia? I think with the amount of household debt that we have, it’s going to bite much earlier, and sooner than in the US.

Gareth: Just the structure of interest rates, I’m sure most of you’re aware of, but most people in the US, and even in Europe now, take 30 year mortgages with a fixed rate. You have the option to walk away and refinance if rates go down. But when they go up the average mortgage holder, or even a very new one, doesn’t cop an interest rate rise. Whereas we, every borrower, sort of cops an interest rate rise, and especially the people in the first that have borrowed in the last few years, some of them are on fixed rates, but short term fixed rates. So they might not hit that step right now. They might hit it in a year, or two or maybe three, but at some point their mortgage costs are going up quite a lot.

Steve: And you and I both have, you know, fixed rate mortgages at very low rates, and I think as that horizon starts to approach people do start to adjust their behaviour before they even get there. So, okay, I go to a mortgage calculator, punch in today’s rate and say, this is what my mortgage payment needs to be. And I start thinking, what does my lifestyle need to be to fit that in? I think there can be less stress about that than a lot of the fear mongers think at the moment, but there is no doubt that it’s going to crimp people’s capacity to spend money on a wide variety of things.

Gareth: But I mean, what you’re talking about there is potentially they go a bit aggressive if they go to 4%, then they can unwind it. The inverse is also true. Once the RBA recognizes a mistake, if we get to that point, they cut the rates. The flow through effect to those borrowers is pretty quick and to a large pool of them. So it’s a tool that’s a little bit more responsive than what most central bankers are working with. Because they hit a bigger part of the population quicker.

Steve: The other thing I’m quite enthusiastic about is that there are so many moving pieces of the demand equation, still, that I think we can have a pretty poor macro environment and some sectors still doing very well, because people want to spend money on certain types of things that they haven’t been able to spend money on for years. I’m really conservative about the durable goods side of things. People have been buying lounges and televisions.

Gareth: Everything that had a massive boost in COVID.

Steve: Yeah. A lot of people are now saying, okay, I’ll put in 2019 levels of profitability. I’d be thinking 2019 and knock something off it because it’s going lower than that for some of those businesses

Gareth: Couple of those standouts that are looking different to that – travel. Definitely. Where we have, I think, a uniquely price insensitive travel market at the moment. We have a lot of people, everyone’s been stuck at home for two and a half years, they want to get out. The prices have gone up. People are paying it. They’re finding a way to pay it. They’re not spending that money at Harvey Norman. They’re now going to go and spend it going to Europe or to Fiji or wherever it is. And automobile’s, cars will probably be relatively price insensitive for a while. We’ve had a massive supply shock where there’s a big pool of unsatisfied demand. You might see automobiles, sellers having unusual pricing power for a couple of years, but they do right now and it might sustain for a little bit.

Steve: All right. How about we try this whiskey? It’s been sitting there and enticing me for the last 20 minutes. Smell it first. A lot of people, and again, if you’re new to your whiskey, I probably wouldn’t start with a really peaty one, because it might turn you off. And I think even a lot of people that do like their whiskeys won’t like the peaty ones, at least to begin with.
Can you explain what that even means and maybe start with the smell of it first, because you can really, I’m not great at picking the different flavours and tastes it’s giving.

Gareth: It’s not subtle.

Steve: You’re not going to miss this one.

Gareth: It’s like getting punched in the face by a smoke machine.

Steve: I was out at my parents’ farm on the weekend. I took my godson and his family out for the long-weekend, and we had a bonfire outside. And that smell that you have on your clothes when you’ve been sitting around a bonfire all night. Exactly what the whiskey smells like.

Gareth: The next day smell, not necessarily while you’re sitting there.
So, this whiskey’s been made in Islay. That’s the name of the island off the west coast. All the west coast whiskeys have, or nearly all of them, as far as I’m aware, have a very peaty, smoky profile. So the Highland whiskeys are much less smoky and they have big peat reserves on all these islands. So, Talisker from the Isle of Sky, all the Islay whiskeys, like Auchentoshan, Lagavulin, Laphroaig, have very smoky profile. Laphroaig, so they’ve been making this whiskey for 100, no two hundred and seven years on Islay. It’s been unchanged for about 75 apparently.
So they get the barley and they cold smoke at first. So that is, you’re making smoke and you’re piping it through pipes to cool it down. And you are imparting smoke flavour into the barley without cooking it. So, it’s the exact same process.

Steve: So normally that flavour would come from the cooking, the heat that’s used for cooking, would bring some of that flavour into the whiskey. Whereas here, you’re saying cold smoked and hot smoked. So they’re doing both.

Gareth: We’ll get to it. Cold smoking process is how you would prep smoked salmon, for example. That’s why it still retains the colour that you get from the fish.

Steve: The colour that you injected the fish with if you farm them.

Gareth: Yeah, unless you buy the wild stuff from Alaska mate, but it’s the same process. And then they hot smoke it over the peat. So, you get peat, which is sort of, let’s say immature coal almost.

Steve: This is plant that’s decomposed. It would become coal if you left it there for a few million years.

Gareth: Hundreds of years old, but not hundreds of millions years old. They light a fire and then they hot smoke the barley to dry it basically. And then you turn it into mash and then you ferment it into alcohol, put it into a barrel for 10 years, and this is the end product. But all that smoke is created at the beginning of the process.

Steve: Yeah. And it’s a really, really noticeable taste. I really like the smoky ones. I find if I haven’t had one for a few months, it takes me a couple of nights in a row or a couple of drinks to really start enjoying it and appreciating again, because it’s such a strong taste, but this is a very strong one, and one of my favourites.

Gareth: So smoky flavour, and then, I don’t know how to say this without making it sound off, putting detergent. Do you get that at all? Just right there in that mid note and then a sort of a sweet finish, which you sort of don’t expect with all that smoke at the start. There’s a bit of saltiness there as well.

Steve: Yeah. The word Tamika used when we had Chloe on was pungent. Maybe you get that detergent.

Gareth: Sort of. It’s almost like the mouth feel of it rather than the taste. I used to be a huge fan of those, Islay whiskeys. I don’t drink them as often anymore, but there’s usually one in the collection. Very nice.

Steve: Very nice. I touched on this earlier today, but we are recording this podcast in a fully soundproofed podcasting studio at Hub Australia. They’ve got a brand new office in the Brookfield Place building above Wynyard, which is a really cool building to start with. And they’ve done an amazing job here with the offices.

We got kicked out of our old office. We’ve been doing the shared office thing for three years I think, wasn’t it?

Gareth: Really? Since we left Pitt street?

Steve: It’s pre-COVID, so.

Gareth: No, no. We moved in there, we moved into the last office in October 2020.

Steve: Oh, okay. So, we were in a Victory Office, shared office. We have our own office space to describe it and your own desks and everything. And we can lock the door, but you share the kitchen, you share meeting rooms, you share a front reception with a whole bunch of businesses. So these companies will lease the floor, they’ll kit it out with everything, and then they’ll sublease space. You effectively pay rent and then you don’t pay for much else. So, your internet is included. The meeting rooms, a certain number of meeting rooms are included. This podcast studio, for example, is included.
Alex Shevelev was sitting at work a few weeks ago and it was about six o’clock at night, and one of the Victory Office’s people walked in and said you’ve gotta leave, we’ve not been paying our rent and we’ve been kicked out and you’ve gotta leave and don’t come back.

Gareth: So, sorry, this is not us not paying our rent. This is our landlord not paying the rent to the ultimate property owner.

Steve: Correct. So, we had been paying our rent, but it hadn’t been handed onto the landlord.
So we got kicked out and we’re all back working at home again, like COVID once more. Fortunately, we’ve had a lot of practice at that, but we had actually looked at Hub when we looked at Victory and it’s a brush of fresh air coming to this place.

Gareth: That whiskey’s kicking in. Isn’t it?

Steve: That’s right.

Gareth: It is a very different experience. I mean, we kind of liked when we first moved into the Victory Office, some elements of it. But it got a bit difficult and the financial strain on the business, on their business, was becoming very obvious.

Steve: The share price, it’s a listed company Victory Office’s, the share price has gone from $2 to two and a half cents. So that puts the financial strains into context.

Gareth: And just to put that in context, they own these assets through special purpose vehicles. So they blow up one at a time and our one branch blew up. And it took a bit of work to get us moved over here, but it’s a much, much better office and we are going to be much more comfortable here.

Steve: Yeah, and I find it really interesting, and I’m a bit like this with a lot of architecture. If you ask me to design something, I’m pretty hopeless at laying out what is going to look amazing, but when I see it, I know what I really like. And I know what I don’t like. And there is something about the aesthetics of what they’ve done here that’s really, really, really good. The spaces are great. They’ve got these little phone booths you can go and make phone calls in, the offices are nice and light and airy. Just things like black walls in our old office, and these are white walls, it just makes you feel more open.

Gareth: Good cafés.

Steve: Got a barista making coffees, you pay for them, but you can go and sit in a nice lounge area and read whatever you want to read for a while. It’s just been fantastic. I’ve been really enjoying coming into the office. I’ve also been watching WeCrashed on Apple, which is a documentary. Well, how would you describe it?

Gareth: I haven’t watched it, so I don’t know.

Steve: Anne Hathaway is in it. It’s got a bunch of really high profile, Jared Leto. So it’s not documentary, it’s not a doco, but it’s a recreation. It’s based on real events. And I have a friend who’s done a lot of work in Silicon Valley, knows someone who used to work there and said, it’s very, very realistic. Even the actual personality types are very realistic about what was going on, and I mean, that whole thing was a disaster. You wrote a blog about it. How many years ago was that?

Gareth: My first one was in 2015, March, I think. I mean they were raising money at that point with a valuation of 10 billion dollars, which ultimately they thought they could get to a 40 something billion valuation.

Steve: They were about to IPO at $47 billion.

Gareth: And then the market said no.

Steve: And then the market said no, and it all came unstuck. He walked away, the founder of the business, Adam Newman, walked away with billions of dollars of wealth anyway, they paid him a fortune to hang around. But it was sort of a very public example of the excess at the time around the valuations of these things. SoftBank.

Gareth: Sort of blew up a little earlier than most of the things that followed too.

Steve: Yeah, there was a first round, I guess, of sort of tech blow up, that then took off again because of COVID, the valuations and then has come unstuck again more recently. But it really was a poster child for just the craziness of.

Gareth: And it was my original thing, which was seven years ago, was really focused on the valuation. It’s one of the egregiously overpriced things that I’ve seen in my years in markets. I wasn’t quite aware of the craziness until that started emerging years later.

Steve: Lots of drugs and alcohol and all sorts of crazy inappropriate things happening at a corporate level. And then also almost expecting the tenants to sort of behave in the same way. But just coming here, he was really onto something with the concept of giving businesses the benefits that you get in some large corporates these days, really nice office space without needing to pay that crazy sort of rent. And this is a much more professional version here, but I think they have actually embraced a lot of the things that WeWork was doing around making it an enjoyable place to come and work and hang out and bring people for meetings.
And I’m really, really bullish about the concept, would love to invest in the business. And I think it’s harder than most people think to get it right. As we’ve seen with Victory, it’s one of those qualitative things that you look at and you go, okay, why can’t someone else just rent an office and do the same things?
I think it’s hard to get those qualitative things right. And I think this business is going to do really well. A lot of our former cotenants in Victory are in the same building as us. So they they’ve had a pretty big benefit from that. But, if you’re a client and come to one of our evening roadshow events, or maybe something down the track, we’ll probably try and hold something in the office. You can come in and check it out and have a look around.

Gareth: And the only thing I’d add to that, you know, my issue with valuation of WeWork is that other companies could do it. You know, it’s not easy to replicate Uber and take it on. Of course, DiDi’s had a good go at it, but you know, Spotify’s probably the same sort of situation. Most of them have network effects that are pretty powerful. Shared office space, I can imagine 10 companies doing that very well. Globally. And it just changes the pricing power dynamic over time. But I think one this is that it can be a very big business. You get it right. You can be a very big business. It’s always going to be a fairly slim margin, but WeWork was an early example of that.

Steve: Fantastic Gareth, we will wrap it up there. Tamika’s going to be on to us for running over time, as it is. Thank you for tuning into this episode as always send us an email, follow us on Twitter, send us a message if there is anything you’d like us to discuss in future. Hopefully you found the sound quality in our new studio good, and thank you very much for tuning in.

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Steve Johnson
Founder & Chief Investment Officer

Steve began Forager Funds in 2009, and now manages approximately $350m across two funds. Offering a listed Australian Shares Fund (FOR) and an unlisted International Shares Fund, Steve focuses on long-term investing in undervalued companies.

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