The Insanity of Australian House Prices

Traditionally house prices in Australia have equated to approximately five times average weekly ordinary times earnings (AWOTE) as published by the Australian Bureau of Statistics.

Currently house prices are anywhere from six to nine times AWOTE (depending on which city you look at).

The real estate listings in Australia are littered with houses that cost $1 million+ and we are not really talking about prime properties here. Very average houses that happen to be reasonably close to a city centre now command sale prices of $1 million+.

Those who have a vested interest in absurdly high property prices will come out with all sorts of nonsense to justify the prices being paid: limited supply, zoning restrictions, immigration etc.

The truth however (as always) has got to do with interest rates – cheap credit, similar to the cheap credit that was available in many other countries prior to the collapse of their housing markets.

The seeds of the housing bubble (as in the US) were sown after the dot com crash when the Reserve Bank of Australia (RBA) foolishly followed the US Federal Reserve in lowering interest rates to artificially low levels.

The fact that Australia had very few dot com companies, that the Australian share market declined by nowhere near what the US market did in that period and that Australia was not about to have a recession (like the US did) seemed to have been lost on the RBA.

The top officials at the RBA are paid a fortune in comparison to their US counterparts and yet they get it wrong as often as they get it right.

When people can borrow very cheaply, what do you think they are going to do? It’s not a trick question.

They are going to borrow more than they previously could have which then allows them to pay more for housing. There is of course no free lunch – house prices increase in proportion to the availability of credit. As Buffett famously said, when everyone watching a passing parade decides to stand on their tip toes, no one gets a better view.

As the Australian banks source approximately 40% of the funds they lend offshore, there is always the risk that they will at some stage be forced to act independently of the RBA in raising mortgage rates (as they have already done on a few notable occasions).

The RBA and many politicians will protest vehemently about that but it’s precisely their policies that have caused the problem: The RBA for keeping rates at artificially low levels for a prolonged period causing a borrowing binge and successive Australian Governments for discouraging savings through punitive tax policies, while at the same time encouraging speculation in the housing market by allowing ludicrous practices such as “negative gearing”.

This offshore funding dependence is why Moody’s recently downgraded the credit ratings of the big four Australian banks.

There are only two things than can happen to Australian house prices, they can collapse dramatically like they have done in the US, the UK, Ireland and Spain or they can go through a prolonged period (perhaps 10 years) of practically no price appreciation. I would favour the latter, but no one can rule out a price collapse.

What is absolutely clear to me is than anyone buying a house today in Australia (who doesn’t have to buy one) is not investing – they are taking a gamble for which they are more likely than not to pay dearly for down the track.

Yes, it’s not conventional wisdom, I know, but I’ve made a lot of money ignoring conventional wisdom (or what some fool at the Housing Industry Association is telling another fool in the media).

It is somewhat amusing to see people (who understand nothing of financial mathematics) who think that house prices can keep doubling every 7-8 years (as they have done in Australia over the past 7-8 years). This is simply not possible over long periods of time because the point will be reached where practically no one can afford a house – and that won’t happen, prices will correct before that point is reached.

No one can be certain when this party will come to an end and it might very well end with a whimper rather than a bang, but end it will.

The Royal Wolf Holdings IPO: One to Watch

Royal Wolf Holdings will list on the ASX on 31 May 2011. The lead manager and underwriter is Credit Suisse and the co managers are Commonwealth Securities and E.L. & C. Baillieu Stockbroking.

A number of institutional investors were falling over themselves to get stock in this company and I can see the reasons for their attraction.

Royal Wolf makes its money from leasing and selling portable containers. It has a large market share of this business in Australia and New Zealand.

While the business may sound boring, it’s precisely the type of business that investors such as myself like.

Why?

Because it’s a straight forward business that provides essential products that will never be made obsolescent by technology, the company earns attractive margins on its products, has good opportunities for growth, is a dominant player in its market and most importantly the IPO is reasonably priced. The estimated dividend yield will be quite acceptable too at about 4% (unfranked).

The other nice thing about Royal Wolf is that it has a very diverse client base, so there are no individual clients that account for significant amounts of revenue.

While Royal Wolf has the value of its lease container fleet at $103 million in its balance sheet, the independent valuation is actually $133.8 million. Conservative accounting is to be applauded.

The IPO price is $1.83 and I wouldn’t be too surprised to see it list at a premium to that price based on what I’m hearing regarding demand for the stock.

There haven’t been any Australian IPOs in the last three years that I have been interested in. Too many of the companies have been of average quality and the prices asked have generally been too high. Royal Wolf is different. It is a good quality company and the price is reasonable.

Only clients of the lead and co managers were invited to apply for shares.

Please note that as always, none of the above constitutes financial advice, as with any investment there are risks. You need to do your own research and consult appropriately qualified people for advice (where necessary).

Berkshire Hathaway is looking rather cheap

Currently, Berkshire A shares are trading at around $120,000 and the B shares are at approximately $80.

Book value per share (BVPS) at the end of the first quarter of 2011 was just over $97,000. Therefore the price-to-book ratio is approximately 1.24.

The average (year-end) price-to-book ratio over the period 2005-2010 was 1.44, this compares to 1.76 from 2000-2010 and 1.63 from 1985-2010.

Over the period 2005-2010, BVPS has increased at 9.9% compound, compared to 24% compound from 1990-2000. Even despite its size, Berkshire is still comfortably outperforming the S&P 500.

Realistically, I think that Berkshire will manage to return 8-9% compound for the next 3-4
years. Let’s assume 8% growth in BVPS. This would mean that the BVPS of Berkshire will be approximately $103,000 at year-end 2011, $111,000 at year-end 2012 and $120,000 at year-end 2013.

I also think that 1.44 times BVPS (the 2005-2010 average) is a realistic and not too demanding multiple for the actual stock price to trade at.

What does this give us?

It gives us an intrinsic value of approximately $148,000 for the A shares at year-end 2011, approximately $160,000 at year-end 2012 and $173,000 ($115 for the B shares) at year-end 2013.

If I’m correct here and Berkshire is trading at approximately $173,000 at year-end 2013, the compound return from now (at a current price of $120,000) will be about 15% - not bad at all.

The returns come from the ever increasing BVPS of Berkshire plus the movement in the price-to-book ratio to a more realistic 1.44.

What can go wrong?

You know the answer. Buffett is now 80 years old and no one knows how long he will remain as CEO of Berkshire (even he doesn’t know that). However, my analysis only goes to the end of 2013 which is just over 2.5 years away. I’m not looking beyond that and believe that it’s more likely than not that Buffett will still be at the helm at that time.

Even without Buffett, Berkshire will carry on with some wonderful businesses that generate vast amounts of cash (Buffett currently estimates normal earnings power of $12 billion after tax).

The majority of large American corporations trade at much more than 1.24 times BVPS and they do not have Buffett or the diversity of businesses that he has hand picked, and of course, he isn’t finished yet. You get my point.

I’ve recently bought Berkshire, so we will see how this pans out. Of course I’ve used Australian dollars to buy it and I bought at a point when the $A was trading at $1.10 to the $US. This adds another dimension to my investment which obviously US investors won’t have.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

The Volatile Australian Dollar

Alan Kohler wrote the following on 9th May 2011:

Don’t be misled by last week’s commodities crunch, the Australian dollar is heading higher – much higher. That’s partly because of the return of the carry trade.

On the same day, John Taylor (CEO and founder of FX Concepts) told the Australian Financial Review:

The Australian dollar is really high now – I thought it was going higher but now I’m not so sure. Things are going to turn… basically, the currency is going to come off the flame and things are going to start slowing down.

Kohler in his usual emphatic writing style is absolutely certain of an “explosive” Australian dollar. Of course he hasn’t done any research himself, he’s latched onto some thoughts of economist Tim Toohey on the $A/Yen carry trade.

Kohler is a journalist who has been wrong on many occasions previously but you wouldn’t know it from the way he writes. After all, he has grey hair, appears on TV, wears a suit and sounds plausible – enough for most people to believe him.

John Taylor on the other hand is a very experienced operator in the currency markets and has made many correct calls in the past. John Taylor doesn’t share the views of Kohler and Toohey.
Those of us who actually operate in markets, as opposed to writing about markets or living in economic ivory towers, will know instinctively why Taylor holds the view he does.

On any measure the $A is over-valued. The $A/Yen carry trade has been a factor, but the point that Kohler and Toohey miss is that playing the carry trade when the $A is at these levels (against most other major currencies) is a fool’s game. Why? Because:

1. The $A is trading at levels 40-50% above its long range valuation;
2. The $A is one of the most volatile currencies in the world - wild swings in value are normal (and dangerous for would be speculators);
3. The Reserve Bank of Australia is holding off on interest rate rises for as long as it possibly can (it really does worry about all those terribly over-leveraged “home owners” – but they won’t admit it);
4. There’s no point getting a few extra percentage points in interest if you end up ultimately losing a good part of your capital.

Of course, as is the case in any mature bull market, a large part of the price increase (just before the fall) is due to hedge funds and the like taking wild speculations with other people’s money, creating artificial demand, while trying to make some quick returns in an upwards trending market (i.e. collecting nickels in front of bulldozers).

All though much less of a factor, there are also all those individuals who are relatively new to markets and through CFDs are able to leverage their minimal capital 100-200 times and speculate in currencies. There will be some that have made easy money in recent times speculating on the $A/$US pair, but once again, they are picking up nickels in front of bulldozers. Just wait and see.

In any bull market you will always find those people who say “this time is different” as a means for justifying insane prices. However, things are never truly different – they just temporarily appear to be different before all of a sudden (and from seemingly nowhere), conditions return to their previous state.