Warren Buffett is seen by many as the world’s top value investor, and his long-term performance is certainly impressive. But is Buffett really a value investor anymore? The likes of Tesco (even after the recent slump) and IBM hardly hit the classic definition of a value stock.

If you want to learn from a modern-day value investor, a better bet is Seth Klarman. Klarman doesn’t have Buffett’s profile, but he has produced annual returns of around 20% a year for nearly 30 years, simply by buying stuff that’s cheap.

Better yet, unlike your average hedge fund or private equity manager, this performance has been largely achieved without using any borrowed money (leveraging) or by betting on falling asset prices (known as shorting).

Who is Seth Klarman?

Klarman started his investment career working under top value investors Max Heine and Michael Price. After working with them for two years, he went to Harvard University to study for an MBA. On graduating in the early 1980s, he set up his company, the Baupost Group, in Boston, initially looking after the funds of wealthy families.

Apart from his investment performance, Klarman is famous for writing a book on value investing: Margin of Safety – Risk Averse Value Investing Strategies for the Thoughtful Investor. Published in 1991, the book is now out of print, but second hand copies can be found on Amazon for £1,000 or more.

Having realised that the book is giving away some of his competitive edge, it is not surprising that Klarman has no plans for a second edition.

Nine Lessons to Learn from Seth Klarman

So what do we know about how Klarman invests? Here are some insights into his approach.

What’s your advantage over others?

The investment markets are crowded. Thousands of professional investors spend their days trying to find the next big thing, but they can’t all win. In order to get ahead you need to do something or know something that others don’t. This is not easy. Are you really smarter than the crowd?

Buy what others are selling

Going against the crowd can be profitable. People often sell assets due to temporary, short-term factors. This offers opportunities for investors who can take a longer view. Examples of such situations are litigation, fraud, financial distress and ejection from an index.

Go where others don’t

Look at lots of different asset classes. For example:

• Opportunities often exist in ‘spin offs’ – smaller businesses sold by bigger companies. Professional investors often sell holdings in these companies because they are too small and this temporarily depresses their value, spelling a buying opportunity.

• Research bonds in bankrupt companies: often these bonds sell for a fraction of what they are worth. If the company is turned around, investors can make massive gains. There are often similar opportunities in distressed property.

• Don’t confine yourself to domestic markets. Foreign markets are often less crowded and can be subject to levels of political and regulatory uncertainty that present opportunities. In the preface to the sixth edition of Benjamin Graham and David Dodd’s book, Security Analysis’, Klarman uses the example of South Korea in the early 2000s where investor pessimism saw multinational companies selling for as low as one or two times their annual cash flow. Smart investors made a killing buying these stocks.

Focus on risk before you start thinking about returns

Research shows the pain of losing 50% of your money far outweighs the pleasure to be had from making a 50% return. To be successful as an investor you must focus your research on the risks of a company’s business model and its industry. Remember that the first rule of investment is not to lose money. Also remember – and this is particularly pertinent to technology companies – that today’s good business may not be tomorrow’s winner.

You are buying a stake in a business, not a piece of paper

Investment success comes from buying the cash flows of businesses for less than they are worth. These cash flows come from the real world, not punting numbers on a computer screen. So focus on free cash flow rather than profits. And look at balance sheets to see risks like too much debt or big pension fund liabilities.

Know when to sell

Value investors start selling when assets are 10-20% below what they think they are worth. Owning fully valued assets is a form of speculation – you are betting on someone paying more than they are worth, not on the market recognising the true value of the assets.

Don’t invest with borrowed money

The ability to sleep well at night is more important than a few more percentage gains.

Don’t rely on the market to provide your investment returns

If bond coupons or stock dividends (paid out by companies) can provide a large chunk of your returns, you are less reliant on fickle and volatile markets for capital gains. Buying bonds below their redemption value is another good strategy.

Don’t be afraid to do nothing

Always hold cash when cheap assets are scarce. Be prepared to wait.

Klarman’s value investing style clearly depends as much on investor psychology as on hard numbers.

However, there is no doubt that most of what he does works well. Considering the nine points noted above before you take the plunge into any asset in the future will almost certainly make you a better investor.

Phil Oakley

Contributing Editor, MoneyWeek (UK)

via moneymorning.com.au

The 1920-21 depression in the United States was as sharp as it was short. In just three years, production shrunk by a third before rebounding smartly. The drop was almost as savage as that of the Great Depression. Yet the policy response was totally different.

The government of Woodrow Wilson, followed by Warren Harding, cut spending and then cut it some more. The Federal Reserve raised interest rates right up to 1920. This is precisely the opposite of the policy prescriptions recommended today by most economists – which is to spend more and cut rates.

So were Wilson and Harding right, or lucky? And do the early 1920s hold any lessons for today?

A Devastating US Economic Collapse

During World War I, US government spending ballooned, financed by borrowing and by a compliant Federal Reserve. During the war, the Fed was, in the words of New York Federal Reserve Governor Benjamin Strong: “[the Treasury's] agent and servant”.

By 1919, the war was over, but inflation had surged to an annual rate of 27%. In response, the Wilson administration slashed spending. By November 1919, the federal budget was balanced, with federal spending down an astonishing – by 2012 standards – 75% from its peak.

The Fed had only been established in 1913, so the post-war inflation of 1919-20 was the first test of the new system. Under Governor William P Harding, they set about their inflation-busting task with vigour. The various Federal Reserve banks raised interest rates by 244 basis points over the course of eight months, with rates peaking at 7% in June 1920.

The Fed’s aggressive tightening seems to have yanked the economy to a halt. Output peaked in January 1920 when the Fed raised rates by 1.25% – still the sharpest single rise in the entire history of the system. Employment and output fell slowly at first, then collapsed in the summer after the final rate rise in June 1920.

The word collapse is overused – but it’s entirely appropriate in this case. Production dropped by a third in just over a year. Wholesale prices more than halved. Indeed, the price collapse was probably the biggest the US has seen in its entire history. And the fall in output was second only to the Great Depression.

This severe deflation, combined with high nominal interest rates, meant that real (adjusted for inflation) interest rates were exceptionally high. This led to widespread bankruptcies – farmers who’d borrowed to expand their output in response to high food prices during the war and the inflation which followed found they could no longer keep up with interest payments, as high real rates combined with falling prices for their output made the debts unbearable.

Yet the terrible years of 1920-21 aren’t burned into folk memory in the way that the Great Depression is. Why not? The reason that the 1920-21 depression wasn’t ‘Great’, with a capital ‘G’, is that it was short. The economy went from sickening free-fall to rampant roaring ’20s growth without pausing at the bottom.

And that sudden recovery is what’s sparked so much interest in 1921 today.

The Austrians vs. The Monetarists

These crashes are meat and drink to economists. They don’t have labs in which they can simulate all the variables that go into a real-life economy. So big, unusual events like the 1920-21 depression are the only way to put their theories to the test.

But there’s a lot more at stake here than the pride of a few obscure academics. How we understand and digest these big stories will determine how – and whether – we’ll find a way out of the depression begun in 2008.

And as with everything in economics, there’s a lively debate over this story. In this case, we have the Austrians in one corner, and the monetarists in the other.

For Austrian economists like Robert P Murphy, it’s “almost a laboratory experiment showcasing the flaws of both the Keynesian and monetarist prescriptions”. The recession “purged the rottenness out of the system”, says Murphy, setting the scene for the strong decade of growth that followed. Prices fell in 1921, and then markets cleared – once prices had fallen far enough, demand picked up.

So, then, is liquidation and price discovery the cure for sick economies? Do we ‘earn’ a rebound with a firm crash?

Well, there’s certainly no way to spin this as a Keynesian story. Harding succeeded Wilson as president, and enthusiastically continued where his predecessor left off. He oversaw a further fall in government spending throughout the worst of the depression.

But what about monetary policy? Monetarists (who argue that most booms and recessions we see in the real economy are a result of changes in the price or quantity of money – for example, changes in interest rates) would argue that the economic collapse tracked the Fed’s tightening in 1919 and 1920, and then seemed to relent when the Fed cut rates in mid-1921.

But management of monetary policy can only explain half of the monetarist theory. The other half is the demand for loans in the economy. Monetarists would argue that the economy was ‘running hot’ in 1919, just as was the case years later in 1980.

In other words, demand was high – and it’s easier to hold spending down by tightening monetary policy and imposing fiscal austerity than it is to boost spending when the economy is ‘running cold’. When there is strong demand for loans, a rate-cut from 7% to 4% can massively stimulate the economy. Without sufficient demand, 4% interest rates can be high enough to kill off spending entirely.

So like Paul Volcker’s 1981 war on inflation, the 1920-21 depression was deep and short. And it was both brought on by, and cured by, changes in monetary policy.

What Can 1921 Teach Us Today?

Whether 1921 has any relevance today hinges on this question of demand.

In economics, demand is an elusive, theoretical thing – like dark matter. And in the same way that physicists use dark matter to plug holes in their equations, economists need demand to reconcile their theories to reality. For more mainstream economists, the dark matter of demand explains why Fed loosening in 1921 and 1982 created instant growth, but the same trick failed in 1930 and 2009.

Sceptical Austrians don’t rely on such sleights of hand. For Austrians, the economy prospers when markets clear, and markets clear when prices are allowed to adjust. Many see the 1920-21 deflation as a savage ordeal. But for Austrians, that ordeal was necessary to clear markets and it led to years of plenty. And Austrians would argue today that if we’d had a similar collapse post-2008, and had allowed asset prices to find a natural clearing level, rather than bailing out the banks and slashing interest rates, we’d be in a much better state today.

But given that the Fed shows no sign at all of tightening monetary policy any time soon, it doesn’t look like we’ll be getting a chance to test the William P Harding / Warren Harding solution, regardless of how well it might have worked in the ’20s.

Sean Keyes
Contributing Editor, MoneyWeek (UK)

ANZ Bank has announced it will increase interest rates on its variable mortgage and small business lending by 0.06%.

It also announced a drop to its 3-year fixed rate mortgage package to 0.15%.

Boy will this create a stir!

Effective February 17, ANZ’s new standard variable mortgage rate will be 7.36% per year.

New small business rates are also effective from 17 February 17. ANZ and Westpac now have the highest variable mortgage rates of the big four.

CBA‘s standard variable rate is 7.31%, and NAB‘s is 7.22%.

The bank blamed the rates it has to pay on deposits and higher wholesale funding costs for increasing the variable rate following the RBA leaving rates unchanged earlier this week.

ANZ CEO Australia Philip Chronican says the decision may leave some people “frustrated and even angry but believe Australia needs safe, well-run commercial banks that aren’t a burden on taxpayers and that can continue to lend”.

Damian Smith, RateCity’s CEO said this was potentially risky by the fourth-largest lender of owner-occupied home loans in Australia.

“RateCity estimates that there are approximately 400,000 variable rate home loan customers with ANZ who will be affected by this rate rise (not including those with a business loan).

“While the rate rise will only add marginally to most of these customers’ monthly repayments – around  $12 per month for a $300,000 mortgage or $24 per month for a $600,000 mortgage, for example – it still sends a signal that the big four banks will push up rates by more than the Reserve Bank cash rate in future.

Only by comparing and switching to a better deal will borrowers be able to stop this “rate creep”.

“The rate increase will add an extra $2.36 million in interest revenue per month for ANZ or $28.3 million per year. ANZ is relying on customer inertia to allow this and future increases, but borrowers should remember that it would only take around 2,500 of ANZ’s variable rate customers to switch in order to make ANZ worse off” said Smith.

via propertyupdate.com.au

At least twice a week I get recommendations in my inbox to invest in US property and for the last 2 years I’ve been writing blogs explaining why I would avoid investing in the US at present.

I recently wrote an article explaining how the American property markets are sinking.

Today I’d like to share with you something I received in an email that’s the best (and simplest) explanation I’ve seen on what’s going on in the US economy.

Look at it this way…

- U.S. tax revenue…….    $2,170,000,000,000

- Federal budget……….    $3,820,000,000,000

- New debt………………    $1,650,000,000,000

- National debt………….  $14,271,000,000,000

- Recent budget cut…….       $38,500,000,000

 

Now, let’s remove 8 zeros and pretend this is a household budget…

- Annual family income…………………..   $21,700

- Money the family spent…………………   $38,200

- New debt on credit card………………..    $16,500

- Outstanding balance on credit card…  $142,710

- Total budget cuts………………………….         $385

This put things in perspective, doesn’t it?

Not the ideal household budget is it?

Just to make things clear… I have long term confidence in the US and its level of entrepreneurship and the American economy will eventually rebound. It is expected that the number of millionaires in the US will almost double in numbers by 2020.

And while there is not “one” US property market, most are in the doldrums, especially the low end ones that are being promoted to Australian property investors.

After considering cash flow, capital growth, tax implications, financing options, the currency risk and all other factors, investing back home has a better chance of being more a profitable, more predictable and more manageable option. 

via propertyupdate.com.au

1. Don’t see a budget as being about what you can’t have, but instead, working out what you can afford.

2. Don’t deprive yourself completely. Factor in the odd treat, otherwise you will never stick to your budget.

3. Don’t use ATMs, or only use them once a week.

4. Leave your credit card at home; the less temptation, the better.

5. Only shop when you have to.

6. Shop during sales, especially for major purchases.

7. If you see something you want, look at your budget first. If you can, save the money rather than use credit.

8. Pay your bills on time. You can save hundreds of dollars a year in charges.

9. Go back through your bills and work out where you can cut costs.

10. Don’t be afraid to ask for a discount.

There have been several short reports for public consumption of late, discussing off-the-plan buying.  Most have been masquerading as buyer tips or advice, but they take a very pro-developer side of things.

Now, without wanting to peeve too many of our developer clients – we have helped, after all, over 550 new residential developments (nearly all of which involved pre-selling) come to fruition over the past 15 years – below are my thoughts as to what a buyer should be asking when considering buying a dwelling before it has started construction.

I haven’t bothered to comment on the obvious here – stamp duty concessions; building depreciation; potential for growth before settlement (don’t we all wish!); time to sell your house or other investments or even the need to match the dwelling type to demographic/economic demand – but have touched on some less covered ground.

There can be great benefits to buying off the plan, but inherent in such purchases is risk.

One of the biggest risks is that the project is cancelled – or that the completion date will be delayed for lengthy periods of time, during which you may be required to commence paying fees without the ability to live in or rent out the property.

Another risk is that the development will not be built to a high enough standard to reflect the price you paid.

A third risk – which applies to investors – is that your property won’t attract the actual rent and yield you were told it would.

It is important to do your own homework in order to limit your risks – ascertain information regarding the property you are interested in and comparable sales/rents in the area.   It is also important to seek legal advice regarding the terms of any contract.  Okay, now that the basic caveats are out of the way, here we go.

Risk 1 – the building is late or doesn’t happen

Right off the bat, a buyer should question the number of sales being reported.  A fast sales rate, with only a few remaining for sale, is one of the oldest spruiks in the book – it’s project marketing 101.

It used to be that a new off-the-plan dwelling sale was only reported as “sold” when a contract went unconditional, the full deposit was paid and all the necessary documentation was signed by both parties.  Too often today a “sale” is reported, based on a holding deposit only – sometimes as little as $1,000.

One service my business conducts is “mystery shopping”.  We send buyers to new projects to critique sales techniques and to ascertain the real sales status.  Often, and increasingly of late, our mystery shoppers have been able to purchase “sold” stock.  Sometimes up to a third of the sales claimed to be made had not really occurred at all.

In addition to challenging the number of reported sales, a buyer should also ask if the proposed project has all the necessary development and building approvals to go ahead.

Another good thing to query relates to multiple sales being made to the same buyer.  Also, ask if any sales have been made internally i.e. to people directly associated with the development; and whether any of the reported sales actually reflect unsold stock taken off the market.

A buyer should also question the time period for the reported sales.  Often developers will “soft” launch their new project to interested buyer groups many months before going to the open market.  Many of the sales might have been made during this period, yet the sales spruiking is often based on the public launch date.  Don’t always believe the “50 sales made in the first two weeks” or similar headlines.  Fifty sales might have been made but our experience is that they took many months, if not up to a year, to make.

Finally, in relation to this first risk, a buyer should ask about the financial conditions needed to be met before start of construction.  And although somewhat obvious, too few ask about the exact planned start and finishing dates.

Risk 2 – building standard

First and foremost, make sure you know the answers to these questions:  Who is the developer and/or builder?  What are their track records?  Have they developed/built buildings before, and do they have any history of being sued over defects?

Also important is to check that the three-Fs (fixtures, fittings and finishings) in the display and printed material are guaranteed.  Beware of glossy leaflets with annotations along the lines of “artist impression” and “subject to change or availability”.

Ask, too, whether the construction will merely meet Australian standards.  These standards are, in the main, inadequate for the realities of modern urban living; and in particular, for those residing in large apartment complexes.  You are better off paying for higher than the prescribed building standard. 

Risk 3 – rent and return

Paramount questions when building an off-the-plan apartment or townhouse are: Who will manage the complex?  What is their track record?  And under what circumstances could these arrangements change?

Sometimes the management rights are sold early in the piece.  That is okay, as selling the rights to manage a complex forms an integral part of a developer’s income stream.  But you should be told who they are and make sure that you have full voting rights at the first AGM.

Whilst many buyers ask how much the body corporate fees are; like they do with council rates; too few ask for a breakdown of the body corporate costs.  Nor do they ask about cost projections.

Also, make sure that your view – for which you will pay a premium – is unlikely to be blocked by any future development.  And also ask an independent agent for their opinion on the suggested rent.

In most cases, you will receive honest and satisfactory answers to these questions.  But in those rare examples that you don’t, our experience is that it might be best to move on.

via matusikmissive.wordpress.com

According to The Economist, Australian house prices are more overvalued than the US housing market at its peak.

According to the economic journal, there are two ways to track valuations: price-to-rent ratio and price-to-earnings ratio.  Just as a share price reflects a company’s future profits, house prices should reflect expected return.  If both measures are well above their long-term averages, then the property market is overvalued.

Australian house prices, The Economist says, are 53% overvalued relative to rental return and 38% overvalued relative to income. Australia, today, has more household debt than America at its housing-market peak, which leaves it – again according to The Economist – more vulnerable to a credit crunch, higher mortgage rates or a recession which drives up unemployment.  Either of which, The Economist says, could send house prices tumbling.

What balderdash!

I am not referring to the premise that a credit crunch, higher interest rates or rising unemployment would have a negative impact on the housing market, but rather the two measures used by The Economist to measure housing value.

According to our most recent Matusik Snapshot (Matusik Snapshot 499 – House price update) – how could you not subscribe ? (Snapshot Subscription form 24 issues $100) – Australian housing is becoming quite affordable again.  Falling end prices, coupled with falling interest rates and rising household incomes, have now made housing across Australia – and especially in Queensland, Western Australia, South Australia and Tasmania – much more affordable. For example, it now only takes 30% of household income to buy the median priced dwelling in Brisbane, even less in Perth, Adelaide and Hobart.

Prices are starting to get to the point where people will start buying again.  That doesn’t mean that prices will necessarily rise quickly, but they are unlikely to crash as strongly suggested by The Economist.

The Economist’s other housing value measure – the ratio of average house prices to average rents model – is seriously flawed.

There are several logical reasons why our house price to rent ratio is high; the sum of which dismisses The Economist’s claim.

Now, as recently outlined, the value of investment property (that is, stock held by investors) should be determined by its return (i.e. rent) but not owner-resident or even secondary homes.  Why?

Close to 70% of Australia’s dwellings are held by owner-residents, of which half are owned outright.  A third of Australia’s dwellings are held by investors and are rented out.  We can sell our principal place of residence tax-free.  Investment property is subject to capital gains tax.

In addition, two-thirds of the Australian housing dollar is spent on renovations, a trend which has accelerated since the introduction of GST on new dwellings about a decade ago. We estimate that close to 80% of this renovation money is spent on owner-occupied homes.

In contrast, very little is spent on improving investment dwellings.  Improvements to Australian investment property are done to increase the rental return, not necessarily the sales price.

Given the current tax laws, it makes good economic sense for owner-residents to improve their homes.  Hence, there is a large difference between the price of owner-occupied homes and investment property across Australia.  Many rental properties sell for prices in the mid-to-high $400,000s.  Most owner-occupied properties sell for much more, with close to 70% selling for prices over $500,000 and near to 40% selling for amounts in excess of $600,000.

Owner-residents generally prefer detached houses over attached stock.  The reverse is true for investors.  Attached stock is, more often than not, cheaper than detached housing.  More renters live in attached stock than detached product.  This further exacerbates the reason why end prices – when pooled together – far exceed rents in this country.

So there is little wonder that the average price of Australian houses is much more than the average rent.  Our rental stock is inferior – for the most part – to the dwelling stock held by owner-residents.  A simple drive around any of our cities will illustrate such.

A house of horrors it is not!

via stocktrader.co.nz