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Cash is not so bad

Cash is not so bad

If you are of a certain vintage, you may have enjoyed watching the antics of Wylie.E.Coyote and his attempts to catch and eat Road Runner. In almost every episode there was a moment, commonly referred to the W.E Coyote moment, where the disingenuous coyote found himself momentarily suspended in thin air, invariably above a canyon, held up only by an initial failure to realize there was nothing underneath him.

Yield hungry, bank share investors found themselves in such a situation earlier this year. With term deposits yielding little and forced to move up the risk spectrum, investors purchased bank shares pushing them up while failing to realize that rising share prices need to be supported by earnings growth in order to be sustained. Without commensurate earnings growth, shares chased for yield would give up gains supported by nothing but thin air.

Banks need to retain profits in order to build capital against which they might lend. High dividend payout ratios must come at the expense of retained profits and when combined with the higher capital requirements and mortgage risk weighting ratios recommended by the Financial System Inquiry and imposed by APRA, growth for bank earnings was always going to be a little harder to come by in the future than in the past.

But while banks are part of, and related to, todays discussion, they aren’t the primary objective.

Banks have extended significant credit to buyers of residential real estate in Australia such that housing lending now accounts for around 40 per cent of banking industry assets and the proportion of total bank loans concentrated in mortgages is 60 per cent. This is double the aggregate value for US banks and triple that of UK banks.

To be fair, it is possible that the worst of a real estate bubble may have been avoided through APRA’s restriction of investor loan books to 10 per cent per annum, a rise in mortgage rates and requirements for more substantial deposits. But mitigating the worst of the excesses does not mean excesses don’t remain.

Lending for residential real estate investment has exploded higher in recent years. According to the ABS, investor lending in 2015 grew by double digits over the previous year, surpassing $13 billion, to a record high.

Now, don’t get me wrong, I do not think that any bursting of the property market will cause the economy to crash or that it will threaten the banking system. Nevertheless, a real estate correction, if it transpires, will see bank shares de-rated. In turn that might provide an opportunity to establish positions to produce excellent long term returns.

SO the question is whether the real estate market could be in any trouble. Anecdotal evidence and experience suggests the experience of 2015 is not sustainable. When full page ads for apartment developments number 36 in the weekend real estate lift-out, one needs to pause and reflect. When 80,000 apartments are under construction – and a high concentration being completed mid 2016 – and another 117,000 in the pipeline, at the same time that population growth is slowing (and going backwards in Perth along with already high vacancy rates), investors need to be careful about how and when they deploy any low yielding cash.

The last time I saw excess supply over already rising vacancy rates and falling rents was in 2010’s Chinese commercial property market. Fast-forward to 2015 and that market has fallen 50 per cent in just the last twelve months.

I am not suggesting falls of that magnitude are likely but irrespective of whether you are a share market or property market investor you need to be mindful of the risks.

Cash seems like a terrible investment right now and I can understand the pain it must cause those who rely on investment returns for their living expenses or to supplement their social security. But low positive returns might not look so bad when compared to the negative returns that might ensue if the apartment market corrects.

And one final thought; if an apartment correction transpires it is virtually impossible to imagine it could be contained to one dwelling type. For a significant proportion of home formers, they are indifferent to three bedroom houses or three bedroom apartments. If apartments are available at 10 or 15 per cent lower than hitherto prices, there will be less demand for the equivalent houses that have not fallen. Houses would then have to fall too.

Cash in 2016 may not be so bad after all.

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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11 Comments

  1. Thanks Roger for the reply,

    I was unsure if this is the best place to post a question about your book.(!)

    May I have the email contact that I should use?

    Cheers

    Toh

  2. Great article Roger!

    You mention that ‘for a significant proportion of home formers, they are indifferent to three bedroom houses or three bedroom apartments’

    It would be interesting to see what % of the existing apartment market (as well as new supplying coming on board) is 1/2 bedroom apartments vs 3.

    The theory being that different ‘pockets’ of the apartment market could have different demand/supply dynamics. Perhaps a glut of 1/2 bedders, but a scarcity of 3+ apartments suitable for family living.

    Have you come across any data sources that may better inform this view?

    Joe

  3. Hi Roger, with your bearish views on banks why does your fund still hold WBC and CBA? I don’t understand. Is there a difference of opinion amongst your investment team? Or a lack of better alternative stocks to invest in?

    • Hi Gav,

      A bearish view doesn’t mean that value cannot emerge. Remember one needs to establish a rate of growth to determine value. It could be that even at lower rates of growth (the bearish view) value is available.

  4. Dear Mr Montgomery,

    I have just finished reading the second edition of your extremely informative book and started my own folder of “Valuable Research”.

    I have a few questions that I will like to clarify regarding the approach in your valuation method but not sure how/where to best proceed with this.

    Please help.

    Kind regards,

    Toh

  5. Hi Roger,

    Apparently some apartments owners are now offering short periods (two weeks) of free rent as an inducement to lure renters.

    That does not sound like a “short supply” to me.

    regards
    Steve

  6. Thanks Roger for your usual well reasoned thoughts. I have appreciated your comments during 2015.
    With respect to cash holdings, do you think it worthwhile to “hedge” some cash into US dollars while waiting for an opportunity to deploy it?
    My reasoning is that firstly, some of the cash may be used to buy US assets in the future. Secondly, I have been reading that one exogenous risk is that emerging markets may have capital flight if US interest rates rise. Typically, if this happens, the AUD may be caught up in the currency depreciation against the USD.
    Merry Xmas to you and your team.

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