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APM: Surging Sydney market shattering records

From Dr. Andrew Wilson of APM:

"The Sydney home auction market has unsurprisingly commenced August where it left off in July with yet another strong result. The weekend auction clearance rate of 81.3 percent was remarkably the fourth consecutive weekend result above 80 percent.
Sydney’s weekend auction market reached recorded highs over July with the clearance rate of 75.9 percent is the highest ever recorded for that month and the second highest ever – just behind the 78.3 percent recorded over April 2002.
A number of Sydney regions recorded their highest ever auction clearance rates over July. The best of the regions was the lower north shore with a clearance rate of 84.6 percent followed by the inner west with 82.4 percent, the city and east with 79.5 percent and the upper north shore with an auction clearance rate of 78.9 percent - all record highs.
The best regional result in Sydney this weekend was recorded by the lower north shore with an auction clearance rate of 87 percent. This was followed closely by the south with 86 percent, the inner west and the central coast each at 82 percent with the upper north shore at 81 percent.
Sydney’s weekend auction market can be expected to continue its record level mid-winter surge through August as indicated by the strong start to the month at the weekend. The real prospect of a cut in interest rates by the Reserve Bank this week will only add fuel to rising buyer activity and confidence, despite sobering economic forecasts."


RBA shows moderately increasing housing credit

From the Reserve Bank today:

"Housing credit increased by 0.4 per cent over May following an increase of 0.4 per cent over April. Over the year to May, housing credit rose by 4.5 per cent."

A lot of panicked articles doing the rounds today as the RP Data index shows colossal gains in June, particularly for Sydney where prices have apparently increased by 3% in the past month alone.

I wouldn't get too excited. Just like last month when prices were apparently falling.

It all just goes to show the silliness of relying one daily movements in one data source, with all the data collection issues it faces.

Over 12 months prices are up ~5.5% in Sydney and ~7% in Perth, and are only up marginally in other capital cities. 

But I haven't seen any indicators of prices surging at the levels being reported this month.

Keep an eye on the ABS credit growth figures over coming months.


APM: Sydney property market "hot"

From Australian Property Monitors:

"Another set of extraordinary results for Sydney’s hotter than hot home auction market was recorded at the weekend. The auction clearance rate of 80.8 percent was the third consecutive weekend of clearance rates above 80 percent. Auction clearance rates continue to track at levels not recorded for over ten years at this time of the year.
With auction clearance rates at their highest levels for years it’s no surprise that Sydney house prices are also growing at their fastest rates for years. The Sydney median house price increased by 2.7 percent over the June quarter which was the fastest rate of quarterly growth recorded since March 2010 during the previous house price boom.
With Sydney houses prices having increased by 6.7 percent over the 2013 financial year it’s also no surprise given almost historically low interest rates for both borrowers and depositors that investors are flooding into the Sydney housing market at record levels.
The best regional result in Sydney this weekend was recorded in the north west with an outstanding auction clearance rate of 93 percent. Another strong result was recorded by the consistently popular inner west region which despite providing clearly the highest number of auction listings at the weekend recorded an auction clearance rate of 90 percent.
With weekend auction clearance rates showing no signs of slowing down expect house prices to continue to surge with real the prospect that before years end, the median prices for Sydney houses to exceed $700,000 and the median price for Sydney units to exceed $500,000."
Most economists, 22 of 28 surveyed by Bloomberg, expect interest rates to be dropped again in August.
With auction clearance rates already at sky high levels in Sydney, the predictions of a slow decline in Sydney's housing market look to have been very wrong. 
While some new supply has hit the market in recent years, the population is growing at such a rate that the desirable stock is quickly absorbed, and Sydney properties have become among the fastest-selling in Australia.


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Will Australia fall into a recession?

Our economics teacher at school once said to us: "Don't be surprised if there's a recession when you leave school." He was a cantankerous old sod, and we just thought he was being antagonistic. Unfortunately, he then died, so the poor chap didn't stick around long enough to know whether his warning would come true.

What I now understand is that he was actually being realistic, rather than antagonistic. Recessions tend to come around surprisingly regularly in developed world economies, and perhaps the most surprising thing of all is...that we are still surprised when they arrive!

As it turned out, the US did fall into recession briefly in 1990-1, for after a period of high inflation and credit-driven expansion, the Fed jacked up interest rates, which capped growth. In 1990, there was an oil price shock, which, after the lending boom of the 1980s combined with a fall in consumer confidence, ended in a sharp fall in growth and a recession.

Fortunately it was a short-lived affair and growth returned thereafter.

Recessions aren't unusual

As Motley Fool once wisely said:

"There will be seven to ten recessions over the next 50 years. Don't act surprised when they come."

Australia hasn't had a recession now, for more than two decades. Famously, in November 1990, Paul Keating said:

"The [national] accounts do show that Australia is in a recession. The most important thing about that is that this is a recession that Australia had to have "

It's one of the most famous quotes in Australian economics, and implies that sometimes economies actually need to have a recession to clean up the excesses of the past. Of course, in an ideal world developed economies would continue with moderate growth in perpetuity, but it's not what seems to happen in practice.

Often economic growth surges ahead at an irrational pace before reversing painfully.

The next Australian recession?

Will we be headed for recession in the near future? 

Personally, I believe the answer is 'probably not', but economic growth will very likely slide as the investment phase of the mining boom seems to have passed its peak. Despite the slowing economy to date, unemployment remains low at around 5.5% and GDP growth remains positive at 2.6%, although as noted this may well fall.

GDP quarterly growth rates

Graph: GDP growth rates, Volume measures, quarterly change

Source: ABS

The Reserve Bank forecasts that its stimulatory monetary policy (record low interest rates) will see GDP growth continuing through 2013 and 2014, and a return to 2.5% to 4% GDP growth through 2015, which would be a tremendous result if it actually eventuates.

Of course, there is a chance of recession. It nearly always pays to be wary when a commentator says with absolute cast-iron certainty that "this will happen" or "such-and-such will eventuate." The future is inherently uncertain and cannot be seen with such clarity.

If China suffers a major reversal and commodity prices fade, then Australia will be materially impacted, no question.

And of course, others will simply continue to predict a recession forever into the future. There's nothing unusual in that either; people are always predicting doom and gloom, and - given that we haven't had a recession for more than 20 years - one day they will again be right (and that's one thing I can predict with certainty!).

What would a recession mean for investors?

For share investors, if Australia sinks into recession share price valuations will naturally likely recede into single digit PE ratios. So you either need to have an investment plan which sees you selling your holdings before valuations fall that low again (timing the market), or you need to be employing a strategy which allows you to pick up more holdings when prices are once again low and shares are 'on sale'.

One unfortunate consequence of Australia not having had a recession for more than two decades is complacency with regards to property market commentary. Some commentators continue to talk about persisting very high levels of growth, but very high growth cannot continue forever, and if a genuine bubble forms then it is likely that it would eventually burst. 

Australia has avoided for recession for so long commentators often have little or no context for considering what happens to property markets in a genuine recession.

When Australia does again see recessionary times, you absolutely do not want to be holding properties which are in low demand, which often includes remote outer or fringe suburbs, and many regional centres. 

Such areas can perform reasonably enough when the market is on the up, for a "rising tide lifts all boats", but one reason that prices remain cheap is that when recessions do come along to clean up the excesses of the past, owners of illiquid property in low demand can experience a drawn out and devastatingly painful slow-motion deflation in prices.

Trust me, I've seen it happen to plenty of people before: I'm British.


Sydney auction boom continues

APM reports another stonking 81% auction clearance rate in the harbour city.

Extraordinary results which are commensurate with double digit price gains being recorded.

In contrast, Melbourne's auction clearance rate slipped to a reported 63%, as the winter months begin to cool the market.

As noted, this property market cycle could end up being Sydney going it alone.


AUD 95 cents

Will be interesting to see what happens to the dollar this week.

Futures markets are already pricing in a 55% chance of another rate cut in July.

So, if the Labour Force data is weak on Thursday...


The great delevering begins?

The great delivering begins?

Plenty of financial commentators were on hand to forecast a "housing bust" after the last great property boom in Australia. They were wrong and have incorrectly continued to make those predictions for years now.

But while there has been no major crash in capital city house prices, the aggregate weakness of the current property market upturn to date may represent compelling evidence that Australians could be slowly beginning to delever and are once again saving more.

Household Saving Ratio graph

Ultimately when dwelling prices-to-income ratios become high there are only really three ways in which affordability can improve without assistance from cheap borrowing rates.

Firstly there can be a major real estate market crash, as was seen in countries such as Ireland. Major crashes are often preceded by irrational market speculation until the market turns and a crash is triggered.

Secondly, there could be a mini-crash which is followed by weak markets and a slow recovery. This happened in parts of England situated away from London around half a decade ago, and prices are yet to fully recover in many regions such as in the north-east of the country.

And thirdly, prices can flatline or continue to rise but only in a weak fashion and slower than the rate of household income growth. There is a good argument to say that this is what has been playing out in Australia’s major capital cities, although, as is its way, Darwin has the potential to be an outlier.

Phase 1 – leveraging up (1993-2005)

Between 1993 and 2005, as interest rates fell and lending standards were deregulated, households geared up like never before. As noted recently by Luci Ellis of the RBA, household debt levels have broadly plateaued since 2005.

Household Finances graph

Phase 2 – slow melt begins? (2006-2009)

While prices in some areas remained strong, on a nationwide basis Australians stopped gearing up and price-to-income ratios eased a little.

Phase 3 – financial crisis and intervention (2009-2010)

As the subprime crisis took hold in the US and Lehman Brothers collapsed, a number of global real estate markets fell into turmoil. Australia avoided this, in part through intervention, as low interest rates stimulated the markets and other manipulative tools such as First Home Owners Grants were implemented. Prices jumped across Australia in a short but quite powerful mini-cycle.

Phase 4 – slow delevering continues? (2011-)

Property prices fell on a nationwide basis by around 7-8% through 2011 and the first part of 2012. But interest rates have been dropped to record lows and a property market recovery is well underway over a period of more than 12 months now, which is clearly evident in the increase in housing loan approvals.

Housing Loan Approvals graph

However, price gains to date have been significantly weaker than has been seen in previous cycles, which reflects the higher levels of household debt Australians are now carrying, and thus prices may fall in real terms over time.

The future downside of property markets (for example, when recessions hit, unemployment increases or when interest rates move higher) will likely be protected by the use of loose monetary policy where appropriate and perhaps the relaxing of foreign investor rules, although this will favour certain capital city markets disproportionately. Booming population growth in some cities will also underpin these same markets to some extent.

New trends

One of the trends which has been playing out globally is the increased impact of property investors on major real estate markets. Certainly in Australia, over the past two decades the level of investment mortgage debt has increased more than double the rate than that of the growth of mortgage debt for principal places of residence.

The proliferation of investors in part explains the strength of the Sydney and Melbourne markets in recent years.

The Brisbane and Adelaide markets have been significantly weaker over the past 5 years, and may be representative of the gradual delevering. Brisbane has very strong population growth which should keep the market buoyant enough. Notes the ABS:

"Between 2011 and 2012, the population of Greater Brisbane increased by 2.0% (43,300 people), which was the second fastest growth rate of the capital cities, behind Greater Perth (3.6%)."

Some commentators have been tipping Adelaide to outperform for the last 5 years, but it has not happened as the chart below shows. While the short-term is inherently uncertain, over the long run I believe Adelaide will be a weaker city market than, say, Sydney, due to Adelaide's weaker long-term population growth and dwelling supply meeting demand. Notes the ABS:

"At 30 June 2011, the estimated resident population of South Australia was 1.64 million people, which represented 7.3% of the total Australian population. In the ten years to June 2011, the state's population increased by 126,500 people, or 8.4%. This was the slowest growth of all states and territories, equal with Tasmania."

Dwelling Prices graph

The current property cycle continues, with all capital cities showing price gains, but Adelaide has been the worst performer of all the capital cities over the past 12 months. Prices in Adelaide remain all but flat in spite of record low interest rates. In contrast, Sydney has shown price gains of more than 8% and Perth more than 9% in this cycle, and Sydney's price gains look likely to continue. 

In summary, if you are expecting to benefit from households gearing up on mortgage debt ahead of the rate of income growth you are likely to be disappointed, because the great leveraging up took place years ago.

You may, however, move ahead, if you can anticipate the property markets and dwelling types which will be favoured by investors as well as homebuyers in the future. Broadly speaking, established medium-density dwellings and well-located houses in supply-constrained suburbs of the four major capital cities will likely be the best bet. 

These markets will be better protected in downturns too as as foreign investment rules are relaxed, with investors surging back to these markets each time a property market recovery is demonstrably underway.

Some say that promoting investing in suburbs close to the capital city centres is old-fashioned advice. Far from it - if you want to outperform the market in the future you need to be in the markets which will attract flows of domestic and international investment capital, because this may be one of the greatest drivers of future property price growth.

Why would price growth be stronger in remote regional centres, fringe/outer suburbs or small cities when the great leveraging up began two decades ago and finished in 2005? (it won't).


Investment risk - warts and all

In Australia, although the tabloids sometimes venture into unsavoury and intrusive reporting, we don't have the extreme gutter press that has plagued Britain over recent decades. 

Sometimes, of course, our press oversteps the mark, but nothing in comparison to UK newspapers such as the now-defunct News of the World, which was found to have pulled all kinds of despicable stunts including the appalling disruption of a high-profile murder investigation and numerous other odious practices.

Sometimes, it might legitimately be argued, tabloid exposés have served in the public interest, highlighted ill deeds which may otherwise may never have come to our attention. But equally, articles which exist only to defame often amount to nothing more than slurs and smears which serve little purpose.

Media sometimes sways in other direction, orchestrating what is known as 'puff piece' journalism. 

A puff piece documentary is one which exists only to "puff up" or exaggerate the positive angles of its subject, offering no balance and only subjective views. A puff piece might sometimes  be entertaining or reassuring, and pander to the ego of its subject, but tends to add little objective value in the manner that a 'warts and all' documentary might attempt to do.

Bias in investing

It's no coincidence that the greatest investors of the 20th century such as Benjamin Graham devoted a great deal of time to espousing the importance of forming an objective view of an investment, rather than being swayed by prejudice and bias.

In the preface to Graham's classic work The Intelligent Investor, Buffett says:

"What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework".

Buffett also said:

"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

Share market biases

There once was a time where everyday investors spoke to brokers only once or twice per year and took the advice of brokers as read. But the advent of online commentary has introduced an interesting new facet to the investing world, that being the airing of views of average investors.

Investors have always suffered from biases, as identified by Graham all those decades ago, but the online fraternity has perhaps shown them to be even more deeply ingrained than perhaps we ever believed. So many investors only want to hear positive news and views about their chosen investments as a means of validation.

Stock market forums demonstrate this perfectly. Take a look at chat forums discussing the merits of otherwise of speculative mining stocks. 

Even the penny dreadfuls which have seen 90% or more of their market cap obliterated by capital raisings and other dilutions can see a positive comment met with a chorus of 'thumbs up' responses and favourable comments. Meanwhile anyone daring to point out the shocking performance of a stock versus the wider resources index, the failings of executive management or any kind of dismal outlook at all is met with widespread derision and dismissed out of hand.

Investors love to hear positive news about their prospects, but will only become intelligent investors in the mould of a Graham or a Buffett if they can learn to adopt a balanced view while considering the risks and failings of investment selections as well as the positive aspects.

Property prejudices

Nowhere are these prejudices better illustrated than in the world of Aussie real estate. Market commentators are quickly and conveniently carved up between bears and bulls. Market crash advocates highlight only negative angles, whereas so-called 'perma-bulls' persist with viewpoints which imply that prices only ever head north. Neither adds much value, because their viewpoints have already been jaundiced before pen is put to paper (or fingers are put to the keyboard).

Biases in real estate are often swayed by ownership status, of course. Those of bullish tendencies of are often property owners or work in the real estate industry, while those who only look at downside risk tend to be renters who want prices to crash so that they can buy (sometimes proving to have been latent bulls once they clamber aboard the property ladder) and sometimes they are those who stand to gain in some way from promoting the idea of a market crash. 

There is little value added in promoting only one side of an argument. In fact, if there is no balance in reporting, then it adds nothing.

Overall, I've been 'optimistic' (if that's the right word for appreciating dwelling prices) about the Sydney housing market since around 2006 because I felt that appropriate dwelling construction in the popular suburbs close to the city would fail to match the rapidly growing demand.

But that's not to say I'll always remain that way, and I can equally name any number of markets including many fringe city suburbs, holiday locations and regional markets (and even some capital cities) where I consider the risks to be unduly high and not worthy of investment at this stage in the cycle. 

And besides, continuing to remain optimistic when evidence starts points in another direction introduces an increased likelihood of looking like a prize goose.

Sometimes, I've just been plain wrong (a whole other subject for another day: commentators who never admit to being wrong), and I've admittedly been taken aback by the resilience of Melbourne's dwelling prices in the last 12 months or so, with prices gaining a surprising 7.5% since their trough according to RP Data. I'd felt that the best case scenario would be something close to flat prices in that time, and a base case would have included a small drop in prices.

Residential real estate is not a pure investment asset class, and ultimately markets which experience jobs growth will see growing demand, whereas those markets which are heavily reliant on one or two industries must entail a higher risk. It's approaching madness to suggest that certain remote markets where people often live through necessity rather than choice are going to outperform income growth after a decade-and-a-half boom in household leverage.

That's why I felt that parts of the south coast of NSW was a risky selection nominated by yield-focussed investors in 2010 due to its heavy reliance one one industry. In my opinion at the time, it was a poor risk-adjusted bet because of the possibility of redundancies in exporting industries in an era of a rapidly rebounding Australian dollar and thus it proved. Regional markets which are heavily reliant on the automotive industry will likely now face stiff headwinds too.


Is Australia's cost of living spiralling out of control?

I've heard it said fairly often over the last few years that the cost of living in Australia is a "dead set joke". We've certainly become a high cost country, although having visited Britain over the past month I can attest that the costs of some goods are worse elsewhere.

Is the cost of living in Australia spiralling out of control? 

Ask a macro-economist and they will tell you: "Definitely not". They would say that we as Australians are collectively suffering from Fisher's Money Illusion and highlight that since 2003 the poorest fifth of households are $42 better off and the richest fifth $576. The 'Money Illusion' concept dictates that we instinctively focus on nominal price increases rather than real price movements after accounting for inflation.

The latest round of inflation data lends support to this argument, showing inflation to be tracking comfortably in the middle of the targeted 2-3% range, which is well below the 3%+ wages growth reported for the past 12 months.

Source: ASX

I suspect however, that if you asked the average ex-mining single-income earner outside of Western Australia, they would tell you that their wages are not growing and that the cost of living has outpaced incomes.

The ABS is an independent body and has no reason to distort results deliberately, rather the reality is that looking at average figures gives you an average result. 

Wages growth has been weak for some time now in retail trade, real estate services and healthcare, for example, while it has been considerably stronger in mining, wholesale trade and, to a lesser extent construction.

As we might expect, wages growth has been very strong in Western Australia, with very high wages being paid to those completing the construction of new mining projects, but wages growth has been consistently notably weaker in South Australia than in other states for some years now.

Naturally the CPI figures show that the cost of some goods has increased more than for others. We might expect to see the weaker Aussie dollar introducing a new bout of inflation in the coming quarters. 

Don't forget that yesterdays figures are retrospective and some of the figures relate back to what was happening at the beginning of April. Petrol prices, for example, will be reported as significantly higher next quarter, barring surprises.

Good news?

The good news for Australians is that personal wealth has increased considerably over the past year.

Stock markets have been flying, with valuations moving up by close to 20%, which correspondingly has increased the value of pension pots. Property market prices have increased strongly in most capital cities which benefits owners, although not renters (rents were reported as having increased by 1.1% this quarter).


The stark reality is that developed economies have a policy of promoting inflationary economies and it is important to have a financial plan to protect yourself from the silent thief.

Over time owners of property are likely to fare better than renters. Those who own quality share portfolios consisting of profitable, dividend-paying companies which which can grow returns on equity will see their income and wealth outpace inflation. Others will look to A-REITS or farmland as assets which can represent an inflation hedge.

A point I raised back in 2011 when I wrote my book was that with a growing awareness of and concern about the impact of pollution on the environment, any leniency which Australian governments had towards the taxing of petrol in past will disappear. My suggestions included owning properties in locations close to key transport hubs and links and to find ways to avoid driving.

This may be already unfolding: petrol prices are now at their highest level since 2008, with no signs of the increases abating. 

I also expect to see the prices of alcohol and tobacco (smokes +3% in this quarter alone) increase over time too due to the related costs of healthcare.


Trade surplus - 5th month in a row

It looks like today will be a good news day.

Another indicator that the June national accounts might not be so weak as touted, Australia recording a 5th consecutive month of trade surplus according to the ABS:

  • "In seasonally adjusted terms, the balance on goods and services was a surplus of $602m in June 2013, an increase of $95m (19%) on the surplus in May 2013"
The balance on goods and services:

Graph: This graph shows the Balance on Goods and Services for the Trend and Seasonally adjusted series

Source: ABS


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New home sales keep on climbing...

And now for some brighter news. 

New home sales climbed again in May (+1.6%) after their increase in April (+3.6%).

The increase in the month was driven by both increases in sales of new houses (+0.9%) and new units (+5.7%).

New home sales hit record lows in September 2012, but have bounced by some 23% since that time. 

As you can see from the figures above, it has been mainly units which are driving the growth, as might be expected.

Source: HIA

As ever, the stats are not smooth across the states.

New home sales which have been strong in Western Australia, are now tapering off, but New South Wales, Victoria and South Australia are picking up the slack.

Detached house sales were up most in NSW (+8.8%), South Australia (+6.9%) and Victoria (+4.3%) but fell in Western Australia (-2.2%) and Queensland (-10.3%).

Overall, promising signs but still much work to be done to bring new home sales back up to the levels seen in 2011 as part of Australia's 'Great Rebalancing' of the economy.


"UK homeowners are making £60 a day"

Crumbs, you know Britain is gonna have a good ol' crack at reinflating its housing market when you see headlines like this starting to appear in the usually sober Daily Telegraph.



Stock selection for today's defensive investor

Picking your own stocks

Regular readers will know that for most average investors, I'd suggest not trying to be too clever wiht picking your own stocks and instead investing consistently and regularly into a diversified Listed Investment Company with heavy exposure to industrials and financials.

Most people don't, though, and they prefer to pick their own stocks. Nothing wrong with that in itself, of course. The trouble is, people often ask me if I like 'XYZ' stock, and when I ask them why they like it, the answers are usually one of the below (or at least, something along similar lines):
  • "I just like 'the look' of the company..."
  • "The price has fallen 25% and I reckon it will bounce."
  • "My mate down the pub tipped XYZ as the next 10 bagger..."
To be frank, if you aren't going to carry out any worthwhile analysis into whether a company's financials stack up, you might as well stop pretending that you are investing and call it what it is: gambling or guessing. The share price should be the last of the criteria to look at - not the first!

I'd still suggest that if you're a monthly salary earner the most sensible way to invest is to write yourself a signed contract which says that you will pay a regular amount into a well-diversified LIC with a low management expense ratio each month or each quarter for as long as you possibly can. When the market is low, buy harder, and focus on the growing dividend streams.

Still, that's not to say you shouldn't invest in individual stocks too. But with the market going on a tremendous surge in the year through to May, how might you invest defensively now that the market is more expensive today?

Well, let's go right back to the doyen of value investing himself, Mr. Benjamin Graham. In the most recently updated version of his classic investment book The Intelligent Investor, which Buffett described as by far the best book on investment ever written, Graham includes a chapter on stock selection for the enterprising investor and  a chapter on stock selection for the defensive investor.

Graham suggests 7 criteria for defensive stock selection. Let's take a look and then apply to Australia's stock market of today.

1 - Adequate size of the enterprise

In Graham's last version of The Intelligent Investor, he refers to business with a turnover of "at least $100 million" for industrial companies or "$50 million for a public utility". That would make for a relatively small business today.

Smaller companies can show great growth potential, but that is not the point of the discussion here, where we are seeking solid, defensive investments. Today, an enterprise of an "adequate size" might refer to a company with a market capitalisation of at least a couple of billion dollars.

2 - Sufficiently strong financial position

Graham suggests current assets should be at least twice current liabilities, which we would call a 'two-to-one' current ratio. We should also remember from the financial crisis (when leveraged companies such as Centro were hugely exposed) the dangers of high levels of debt and interest cover ratios.

For this reason, Graham suggests that long-term debt should not exceed the net current assets (and for a public utility debt should not exceed twice the stock equity at book value).

3 - Earnings stability

Graham insists on some earnings (profits after tax) for each of the past ten years.

4 - Dividend record

Uninterrupted payments for the past 20 years.

5 - Earnings growth

Graham speaks of a minimum increase of at least one-third in per share earnings in the past 10 years using three year averages at the beginning and end.

6 - Moderate Price-Earnings ratio

Fashions come and go to some extent relating to PE ratios, but Graham suggests a PE ratio of not more than 15.

7 - Moderate ratio of price to assets

The current share price, says Graham, should not be more than 1.5 times book value (note: strip out intangibles such as franchises and licences).

Using these criteria in today's Aussie stock market?

There has been much recent talk of a "bank bubble" in Australia. With the banks paying very strong dividends and generating giant profits, share prices went roaring upwards from late 2011 before experiencing quite a sharp correction through May. So, let's take a look at how Graham might have analysed the bank stocks from a defensive investor's perspective.

Naturally, all of Australia's 'Big 4' major banks meet the size criteria, being of large market capitalisation - Commonwealth Bank (CBA) has a market capitalisation of around an incredible $108,000 million! And they have consistently increased profits and paid strong dividends, thus meeting these criteria also.

CBA's 2012 Annual Report (page 7) shows the Groups Return on Assets and cash net profit after tax (NPAT) moving upwards very strongly. And CBA's full year dividend has increased from 224 cents per share at June 2008 to 334 cents per share for June 2012. Magic.

Earnings stability for the banking sector has been reasonable and the sector presently has low 'Beta' values. So far, so good.

Strong financial position?

Let's take a look at the balance sheets from the Commonwealth Bank (CBA) 2012 Annual Report.

Whoa! Take a look at the liabilities: deposits and other public borrowings of $437,655 million as compared to net assets of only $41,572 million? High leverage.

The top half of the balance sheet (the bank's assets) show loans due of more than $525,682 million which the notes to the accounts show overwhelmingly relate to home loans in Australia ($320,570 million) and overseas home loans ($30,063 million) such as in NZ.

So the banks are unusual beasts with massive exposure to residential property. Naturally mortgages are issued are usually secured against property worth more than the loan but with a net asset position of only $40 billion against home loans of $350 billion, CBA has exposure to loans going bad. Of most concern would presumably be some of the 100% LVR loans which were being dished out before the financial crisis.

On the plus side, unlike physical residential property, bank stocks are liquid. You can choose to sell up at any time, which is not always so easy to do with an illiquid asset such as a house.

Of course, the banks undertake all manner of risk management solutions, capital adequacy and stress tests, but the transparency and disclosure thereof is questionable. New rules will gradually come into place, commencing with the regulatory standard BASEL III in coming years.

So, would Graham dare to venture into the banks as highly leveraged as they are? Well, he might because the banks are seen as "too big to fail" and receive an implied guarantee from the Government and have the potential to earn great profits. However, at today's prices, as I'll explore in more detail below, the banks do not meet the criteria for defensive investors.


With regards to earnings growth, Graham talks of a benchmark of one-third growth in per share earnings over ten years, which implies growth of less than 3% per annum. Times change and I would suggest that today this hurdle is probably too low. I'd want to see growth of 50%, thereby closer to 4% per annum. No matter, for the purpose of this discussion, the banks can score a pass here.

Graham suggests PE ratios of not more than 15. Commonwealth Bank (CBA) has experienced a correction of close to 10% in recent weeks pulling back from above $74 per share to $65 per share, and as I write this has a PE ratio of 14, which is reasonable under Graham's criteria, with the other major banks trading at lower PE ratios than this.

Incidentally, for defensive investors, I wouldn't recommend the practice of using next year's forecast earnings to calculate the so-called "forward PE ratio". Why? Because it makes more sense to use known actual numbers than forecast future ones which are often wildly inaccurate! Detailed research by David Dreman in the US showed that forecast earnings 'miss' by more than 15% more than half of the time!

Price-to-book value issues?

But what about the price-to-book ratio? Well, here's where Graham would have a problem with some of Australia's major banks as defensive investments, as the price-to-book valuations are all higher than 1.5. CBA has is trading at a price-to-book of somewhere just over 2.5 (market cap of more than $100 billion, net assets at the 2012 full year reporting date of somewhere just above $40 billion as noted above).

Westpac (WBC) has a PE ratio of 13 and price-to-book of 2. And ANZ clocks in at PE of 12 and price-to-book of 1.9. Only NAB is close to meeting Graham's criteria at a price-to-book of 1.6 and a PE of 12 (NAB today has a market cap of $69 billion and its 2012 Annual Report shows net assets of a shade under $44 billion).

Is it sometimes OK to pay more?

Graham suggests that a PE ratio of lower than 15 can sometimes justify a correspondingly higher price-to-book (he suggests that the product of the PE multiplier and the price-to-book should not exceed 22.5 - i.e. 15 multiplied by 1.5).

Take a look at CBA with this in mind with its PE of 14 and a price-to-book of 2.5, giving a total of more than 30. That's way too expensive for a defensive investor in Graham's eyes.

On these criteria at least, WBC looks a little overvalued, while ANZ looks reasonable. NAB, which has been less in favour with investors, could be a goer, with its significantly lower price-to-book of 1.6, although a defensive investor would still be very wary of a banking sector correction. 

Here is where the judgement call comes in...

Australia's banks have historically been seen as rock-solid investments, partly because they effectively receive an implicit guarantee from the Government as they are seen as "too big to fail". For this reason, analysts deem it appropriate to value banks such as CBA  at way over twice the book value, even in today's uncertain climes.

Graham's insistence for defensive investors on relatively low PE ratios and price-to-book ratios is often seen as unfashionable today, with many analysts suggesting that companies with growth prospects justify an expensive share price and should be bought regardless.


So, there you have it. Going back to the time-honoured principles of defensive value investing, the major banks such as CBA, ANZ and WBC do not qualify as defensive investments.

I hold shares in all of them and some of the smaller banks (both directly and indirectly through LICs because I focus on the growing dividend streams) but must acknowledge that at today's share prices a correction could potentially be quite sharp. If that does eventuate and prices fall sharply I would be looking to buy more.

However, if you have an investment plan that sees you worrying about a share prices falling in the short term (CBA is trading at a premium to its book value which is 40% too high for Graham's defensive investor criteria and he'd prefer to see it trading in the $40-$50 range) then other stocks offer a more defensive investment strategy.


Disclaimer: I don't advise on individual shares to buy or sell. Each individual investor has a different financial profile, so consult a licensed professional before committing to any investment decisions.


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Suckers rally?

Source: kitco


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Retail sales on the road to nowhere...

A weak result for the month of June, with retail sales failing to show growth for the month of the quarter on a seasonally adjusted basis.

Although there are whispers that July and August may show a better result, weak retail sales in June missed expectations and should temper optimism about the GDP result for June.

Aussie dollar sank to a new low of 88.49 cents earlier, the weakening of the currency continuing to be great news.

Shares were flat. 

Stand by for an interest rate cut.

Graph: Monthly Turnover, Current Prices, Trend Estimate

Source: ABS


Unemployment to tick up today?

Labour Force data out at 11.30am.

Expecting to see unemployment tick up today from last month's surprise 5.5%, perhaps even to 5.7%.

The April figures showed 50,100 jobs added (+0.4%) but if ABS past history is anything to go by we'll see a chunk of those figures wound back in May.

Such is the way of ABS employment figures...


UK heatwave continues...

The UK heatwave continues this week with temperatures hitting a sticky 33.7 degrees. 

Great chance for Australia to take charge of the third Test Match today with the pitch turning sharply.

As a National Trust member and a certified history nerd, I've been to visit a few of England's finer pieces of real estate over the last month...and couple of churches, including the outstanding York Minster.

If you can guess more than one of these below, very good...more than two of these and I'd be ridiculously impressed. 

You can pick up British country piles for surprisingly cheap purchase prices due to the painful ongoing costs of maintaining an estate.

If rumours on the BBC website are to be believed, James Bond star Daniel Craig (and presumably his wife Rachel Weisz) is reportedly about to pick up the recently sold Dalby Hall estate in Lincolnshire (asking price £12 million), which has seemingly been on the market since approximately the dawn of time.

Craig would be joining an illustrious list of famous Lincolnshire residents, including, erm, former World's Strongest Man Geoff Capes, and, um...I'm sure there are more...

1 - Hampton Court Palace - built by Henry VIII for Cardinal Wolsey in 1514

2 - Cricket ground at Belton House, Grantham, built by the Brownlow family, 1685

3 - Gardens - also at Belton House

4 - Waddesdon Manor, Bucks - one of the 40 Rothschild residences, built as a French-style chateau by Baron Ferdinand de Rothschild in 1874

5 - Church of St. Mary & All Saints aka. the 'Crooked Spire', Chesterfield, the spire was added in 1362

6 - Chatsworth House, Peak District, Derbyshire - occupied by Duke of Devonshire's Cavendish family since 1649


Property Update: Population growth underpinning the capital city markets

Read my latest Property Update article here.


Let's play darts!

After nearly two full weeks of hot, sticky weather, Britain has officially moved into heatwave Category 3 territory - it was 32.2 degrees in parts yesterday.

If Britain is supposed to be heading for a triple dip recession, then nobody seems to have told those in the populous south-east of England - the pubs and restaurants seem to be more packed than I've ever seen them. With the long, warm evenings, establishments are packed out with people indulging in the usual British traditions: drinking warm, bitter ale with twigs in the bottom, playing darts, sitting in beer gardens.

I've always enjoyed a good game of darts. Although the configuration of numbers on the board appears to be random, the layout was actually designed in the 19th century with a view to punishing inaccuracy. Thus the high numbers such as the 20 are immediately surrounded by low numbers (1 and 5). Similarly if you look down to hit the 19 as a fall-back shot, you'll instead introduce the risk of hitting a 3 or 7.

Darts is so popular in Britain that it regularly features in TV scheduling. Back in the 1980s there was even a really naff primetime quiz show with a darts theme (ITV's Bullseye) which culminated in two players - a darts player and a non-darts player who was supposedly good at things like spelling and trivia - needing to score "101 or more in 6 darts to win'Bully's special prize", which for some reason was nearly always a speedboat (weird really, as the competitors were usually portly, red-faced chaps from pubs in places like Leeds and Sheffield, not exactly places known for their glistening coastlines or playboy yachtsmen).

Usually what happened was the non-darts player, in order to appear confident and professional, would aim for the 20 and score very poorly by hitting a succession of 1s and 5s. Occasionally, though, you'd see an amateur contestant swallow their pride and aim for the left side of the board, where there is something of a safe haven of higher numbers 16, 8, 11, 14, 9, 12 - and as a result, they often did quite well. 

I guess the victorious contestants just used to sell the speedboat.

Parrallels with investment

It's a bit like this in the stock markets sometimes. Beginner investors seem to show a disproportionate level of interest in the 'penny dreadful stocks' - often speculative mining exploration companies with no track record of generating revenues or profits and with shares prices of just a few cents. They hope that they will strike it rich when the mining company finds the modern equivalent of Lasseter's Reef and see the share price quadrupling quickly, but usually what happens is that the company runs low on cash and needs to raise more capital, thus diluting away the little existing value in the company's share price.

In darts terms, you've aimed for a 20 and got a 5. Or worse, if the company becomes insolvent, you may even have aimed for a 20 and hit the dreaded 1 - you've lost you're entire investment.

Investing in larger, profitable companies with a proven track record (or, better still, a portfolio of them) is a bit more like aiming for the left hand side of the dart board. Commonwealth Bank's share price was never going to quadruple overnight, yet it has represented a tremendous income-producing and compounding investment over the years. Ditto Westfield. A bit like the cautious darts player, in some years you might have hit a 16 or a 14, and in others perhaps only an 11, but over time, you would have profited very handsomely.

The buy-and-hold approach isn't the only strategy which can work in the stock market. Plenty aim to time the market, a strategy which requires the effective use of sell-stops to limit downside risk.

Property darts

Around the turn of the century in Australia there was a theory doing the rounds that it was "impossible" to forecast where property prices would show growth, so instead property investors should just find a property located virtually anywhere which generated a positive cash flow, and simply hope for capital growth over time. Gratifyingly, you don't hear that viewpoint too often any more.

So many unlikely parts of Australia have been tipped as potentially hot regions for property price capital growth over the years that it does feel sometimes like those tipping them are throwing darts at a map of Australia blindfold.


Positive cashflow investor Margaret Lomas once said that all investors are likely to have at least one 'lemon' in their portfolio - it's all a part of the learning process. It's definitely true that the best investors are those who resolve to learn from their mistakes over the years and do better next time around.

Being a 'boring-but-safe' investor over the years in Sydney's inner 5km ring suburbs, and city suburbs around London, I've never had a 'lemon' in my portfolio, glad to say, though of course some properties will always perform better than others. 

What I do have, though, is a property which I bough in Sydney's eastern suburbs years ago which to this day I remain convinced I could have negotiated to pay $10,000-$15,000 less for. It's common for agents to say: "Don't worry, over the long-term $15,000 is nothing!". That may or may not be true, but I can tell you it still very much irks me that I could potentially have one of my mortgages with a lower balance. 

Getting it right

As the statistics show that most investors for various reasons do not go on to own very large property portfolios, this makes it doubly important to attempt to 'get it right' first time. If you are only going to own a handful of properties in your lifetime, it's crucial that you attempt to choose them wisely rather than simply learning from painful mistakes the hard way.

Something we have seen increasingly in recent times is a region being tipped as a 'hot investment market', only for commentators to completely reverse their viewpoint within a year or two due to cancelled or mothballed mining projects, median rental prices collapsing by a third or spirally vacancy rates. This is of no use whatsoever to property investors - you can't buy and sell property so quickly and expect to regularly finish with a good result.

Expect to see more of this in coming years as the Baby Boomer generation starts to think a little differently about real estate as an asset class. Many have been conditioned to believe that property prices only ever go up, which clearly isn't the case. With household debt levels running to record high levels by 2005, property prices in some regions could remain flat or falling for many years, and plenty already have.

This is one aspect in which property investment differs from share market strategies. While you might decide to dispose of a poor share market investment quickly at a moderate loss, this is far harder to do in the property sphere, for various reasons. 

Real estate is a more illiquid asset class (particularly out in the regions where demand can be lower), it has high transaction costs (such as stamp duty and legal fees) which makes trading properties frequently tremendously inefficient, and the use of leverage means that an asset which falls in value by, say, 20%, can leave the investor facing negative equity and devastating losses.

Ultimately, you can't disaggregate a property market from its local economy, which is why I'll always be discinclined to head to the regions where employment and economic activity is necessarily focussed on one or two key industries. As noted above, for buy-and hold investors (as opposed to property flippers and renovators) property is far better viewed as a 20-30 year investment than it is as 12 month investment. 

With the migration of the British population to the south-east of England, property prices are continuing to break through all-time highs. In Australia, while nobody knows what will happen to property prices in Sydney's inner 5km in the next 12 or 24 months - although it's been forecast that prices will move upwards to new record heights given the sky-high auction clearance rates and properties selling incredibly quickly at present - with the population of the city set to increase to 7 million people by 2050, I reckon it will do alright over the life of a mortgage.

Definitely a better investment than a speedboat.