After years of great domestic returns, Australian investors should surely now be asking have things changed and whether they have enough foreign share exposure.
The more one travels, the more one’s perspective changes; one discovers locally generated myths that to an outsider are clearly aberrant and yet locals treat them as a certainty. When discussing investments with Australians, how often does one hear about the benefits of owning property or the dangers of investing abroad on account of exchange rate (movements)? Fortunately, there are periodic reality checks and importantly, following the GFC, there is now greater circumspection as to the merits of negative gearing. Hitherto it was all about the positive attributes of leveraging an investment but now the cost of the bet going the other way is better understood.
So often it has been our experience that imperfections in the pricing of share investments arise from two human behavioural biases. They are interlinked and relate to over-emphasising the recent experience and extrapolating the current into the distant future. These short cuts are a way many of us try to deal with the overload of information and they give us a simple method for dealing with seemingly complex systems.
Why they are so damaging is that the narrative can carry huge conviction but if not married to the appropriate price, it has no worth. When assessing risk one is evaluating potential gain/loss weighted against its likelihood. A way of saying this is that a low probability of an event encourages us to either ignore it or to see it as being cancelled out by the potential gain. Remember though that a total wipe out is just that, and to define outcomes without a view of the very worst case will be to underestimate risk. This leads us to the essence of this article.
Australian investors seem to have a predilection for Australian property and Australian-based listed companies. This faith has built over the years on account of a protracted period of population growth and prosperity: 21 years without any annual contractions of the economy. It has been further reinforced by the falling cost and freer access to borrowings. A relatively strong labour market which has contributed to annual rises in real wages has further enhanced this feeling of well-being and Australians have responded by taking on progressively more debt. In the late 1970s, debt to personal income was 40%, by 2013 it had risen to 150%. As Mr George Soros will tell you, the notion of reflexivity is built on participants mutually reinforcing a trend, until they don’t. Disturbance at the point of self-organised criticality can be triggered by a surprise event that invariably seems trivial in relation to the damage done.
Far from gaining comfort from a long-established trend, it is wise to progressively raise one’s scepticism as the trend ages and matures. How does one know a trend is ageing? Simply by observing crowd behaviour to identify when the crowd no longer expresses doubt about the trend despite changing momentum of its underlying drivers.
In the residential property market the experience has been delightful for those well-entrenched. We all know the case for property but seldom are the gains expressed in compound returns and seldom are holding costs and repairs/embellishments fully accounted for. Most point to the gains in tens of thousands of dollars, which in most cases has been augmented by considerable mortgage leverage which they would never dream of applying to a long-term portfolio of shares.
This same comfort seems to apply to Australian-based listed companies. It is well-founded and perhaps a lot more justifiable than their faith in residential property. However, the listed sector has become increasingly skewed to the major banks/insurers and the big two miners. These now account respectively for 45% and 17% of the entire market’s capitalisation.
When we look at valuations on the cyclical adjusted profits, the case is perhaps justifiable but against similar opportunities abroad, in most cases, valuations here look uninteresting.
Looking at the Australian banks separately, relative valuations are at a 30 year high and typically 80% more expensive than a portfolio of world banks! What would happen to their profitability if the government asked them to hold more capital?
Lastly, after a great innings that has been fuelled by the Chinese miracle, surely now is the time to be questioning the underlying drivers of the Australian dollar. The terms of trade have in all probability completed a huge bull market and in a world with less reserve intervention, there are perhaps fewer Central Banks looking to place their surplus funds in the Australian currency.
It is a fact that the function of markets is to ration the allocation of money. For the majority of participants, precedent rules their thinking but the smart money systematically analyses what is changing rather than simply relying on the historic trend.
Over the last 20 years to December 2013, Australian equities have been superb, giving an aggregate compound gross return of 8.7% pa, according to the 2014 long-term investment report (ASX, Russell Investments). Residential property across the country has averaged 9.9% pa over the same period while international shares have delivered 8% pa. The Platinum International Fund has outperformed all these markers… but that is not the message.
The key take-away is that after years of great domestic returns, Australian investors should surely now be asking, have things changed and whether they have enough foreign share exposure.
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