Residential property constitutes by far the largest asset class in Australia.
On average, property accounts for over two thirds of Australian households’ net worth.
If you include investment in the shares of banks, themselves heavily exposed to property, the average household has about 70 per cent of its net worth exposed to residential property.
Value investing
During market anomalies, we believe investors need to stick to their valuation convictions.
One of our key concerns in today’s markets is the high valuations in the Australian residential property market and domestic banking sectors and its impact on the wider economy.
We cannot forecast when some of these distortions may unravel, and we are not predicting an imminent fall in property prices.
We do, however, think that there are risks in the current level of residential and bank prices and it may be prudent to consider diversification should you be over-exposed.
Investors should consider areas of the market with sustainable yields or companies that make their earnings predominately overseas.
There is still yield available in the Australian market, even if you exclude banks, provided you know where to look.
Value investing has been described as an “uncomfortable” investment style, and this is most true at times of such market distortions.
Many investors are unable to withstand the emotional stress of standing alone against market distortions and therein lies the reason for the continuing effectiveness of this investment approach.
Recent Australian episodes of mispricing
American writer James Grant once said, "Successful investing is about having people agree with you... later”.
The Australian Recession – December 1990
During the 1990-1991 recession, the economic outlook was grim and by late 1990 many investors gave up on cyclical stocks and appeared to simply lose sight of the fact that recessions usually end.
News Corporation shares were available for around $2.
The Tech Boom – March 2000
By 1999-2000, the market’s mood was exuberant, especially towards technology stocks linked to the internet.
Large dispersions in returns appeared between sectors: Resources stocks, among others, were very cheap and BHP, for example, traded as low as $5 in the late 1990s.
The China Boom – June 2008
Chinese stocks and many resources stocks surged to all-time highs in early 2008.
By this time, BHP’s share price was trading near $50. At the time, valuations seemed to imply that commodity prices would stay high indefinitely.
Even as the financial crisis unfolded in the first half of 2008, many resource stocks continued to appreciate.
By the end of the March quarter of 2008, Fortescue Metals, for example, had risen over 90 per cent for the financial year to date.
This distortion eventually unwound, and Fortescue shares fell by 84 per cent in the second half of 2008.
Behavioral finance, banks and Australian housing
Why did some investors and the mining companies in 2011 believe the commodity price boom would never end?
In our view, investors were so focused on the strong demand numbers from China that they were unable to step back and see current events from a longer-term historical perspective.
Are we witnessing a similar failure now in relation to the prices of Aussie banks and houses?
Since 1997, Australian residential property prices have risen more than in any other nation.
By our calculations, ungeared capital city homes in Australia trade on a price/earnings (PE) multiple of around 62 times.
While a fully equity-funded residential home should perhaps attract a reasonably good PE, even high quality growth stocks don’t trade on even half that multiple.
The index weight of Australian domestic banks is over 30 per cent, a level not even reached during lending and property bubbles in markets overseas.
It seems reasonable that the value of a nation’s (listed) bank sector should bear some relationship to the value of its (listed) national economy.
Across the world this ratio is about 1:10; in Australia it is 1:2.
Why are Australian banks so highly valued? Put simply, Australian banks earn very high profits.
However, this is not necessarily because, in our view, they are better run, enjoy better margins, or use more advanced technology, but because there is a lot of debt in Australia.
This debt is effectively the top line of a bank’s profit and loss. The more debt, the more net interest and fee income.
Australian household gearing, previously much more conservative than in the United States, rose very rapidly between 1990 and 2008 and exceeded US debt levels.
US households have de-geared since 2008 while Australian households have not, and indeed the very latest data show new record highs in Australia.
The gap between the two nations has widened further.
What should investors do?
The risks are real, in our view, but we do not know when and how these distortions will be remedied.
However, in light of these valuations we think it is more likely that, in a decade hence, the distortion will be obvious, like so many others before it.
We believe actions that can be taken within the context of the Australian stock market to help to diversify away from this risk include:
Investing in genuinely defensive companies
Investors around the world have sought out stocks with sound yields and defensive earnings, focusing on the utility, infrastructure, health care, and telecommunications sectors.
However, in Australia, unlike in many other countries, this focus has included banks.
Given their gearing and exposure to the domestic economy, we have concerns in viewing local banks as defensive.
In our view, however, there are genuine defensives within the Australian market, in the sense that a sharp economic downturn would likely affect such companies less.
Investing in companies that earn revenues overseas
There are successful Australian companies that have expanded globally and now run competitive businesses offshore or export to other nations.
These companies can act as potential hedges to the Australian residential/bank exposure because we believe a decline in the Australian dollar, lower wage growth, and spare capacity in Australia would likely raise the value of these companies.
Just to be clear, we are not predicting an imminent crash in Australian property prices.
However, investors should be aware of the exposure that Australians have to this risk and that property and banks are more likely to be correlated in any downturn.
Philipp Hofflin is an Australian equities portfolio manager at Lazard Asset Management.
