Eureka's Week: the truth about money, the correction, blockchain, retail

The truth about money | Eureka's Week | The correction | China and commodities | Blockchain | Retail | Readings & viewings | Last week | Next week

Last night

Dow Jones, down 0.33%
S&P 500, down 0.33%
Nasdaq, down 0.92%
Aust. dollar, US73.9c

Paul Clitheroe

The truth about money

In my first column a few weeks ago I looked at the key principles of money and investing. Our very sophisticated financial system tends to place a shroud of complexity around investment and it is very easy to get dragged into a huge amount of chatter and noise, which can incapacitate our ability to take action. Very sensibly, we don't want to get key investment decisions wrong and the huge amount of noise about investment often obliterates the really important stuff, the simple truths about money. These have been unchanged for thousands of years, I call them the “gravity of money”. Like gravity, you can do what you like, but over any extended period it will win. Thirty five years of working in the “money” industry, communicating money issues and also worrying about my own money has certainly taught me not to ignore fundamental principles.

People do love to chat about money and over the last few decades people have chatted to me about their money concerns and asked me questions in planes, trains, walking through the city, on talk back radio, emails and so on. But they nearly always ask the wrong questions. On Wednesday I was at a charity golf day with some old University college friends in Moree. It was a great day, with a large amount of money raised for Variety, the children's charity. In the golf club bar after the game, sure enough, a few locals did want to chat about money.

As you would expect in a rural export region, the value of the Aussie dollar against the US dollar always comes up. Of course, like everyone else who bothers to take the faintest notice of “experts” predicting our exchange rate, it is bleedingly obvious that the chances of anyone getting this consistently anywhere near correct are about zero. In fact if you take the usual “start of the year” predictions by experts and check a year later, you'll realise you may as well put various exchange rates on a dart board and chuck a dart at it.

As you can imagine, Moree farmers contemplating whether to hedge this year's crop or not (it looks like being another good season) found this particularly unhelpful. But at least it is the truth. Anyway, then the questions fell into the usual pattern. Do I have a “hot” share tip?, what is the best investment property or shares?, will super be any good after the politicians finish with it?

And so on.

What is missing is a key truth about money, which you know. Firstly, wealth is created by spending less than you earn and secondly this surplus income is directed towards sensible assets. Unlike markets going up and down, which they always will and you have absolutely no control over this, spending less than you earn is totally in your control. It really makes me chuckle when in a more appropriate location than a bar, such as an office meeting, someone starts out by telling me how much they earn. This is of little interest to me. Wealth is only created by the gap between earning and spending. I am constantly astonished by people wanting to talk about investment and wealth creation who, whether working or in retirement, do not have their cash flow control as an absolute priority.

So I really don't give a twopenny toss about trying to answer questions such as “is property better than shares”, because this is a second stage question. The first stage is to control what you can control. Your cash flow. Sure, I am then happy to have a chat about property vs shares, but I don't much care which you buy. If you have surplus assets or are generating surplus cash flow, this is quite a fun conversation. The truth about property and shares is not easy to find. Most people talking about this are trying to flog you either property or shares. In a world full of expert opinion, commentary and more statistics than you can point a stick at it is pretty easy to make a case than either is better. It also easy to bring out selective statistics and show property is terrible, or shares are a disaster.

Back to the truth, and this is that both of these assets have done very well for investors over long periods of time. Personally, I hold both property and shares. Australia's population is projected by the ABS to grow to some 40 million in the next few decades, their range is 36.8 to 48.3 million in 35 years. I figure these people will prefer not to sleep in a cave, and we don't have a heap of available land with access to jobs, schools, health and so on. So despite some experts proclaiming the crash in values to come and others the next boom, my cut through is more basic. I just reckon if I own well located property in central locations with loads of public transport and decent coffee and I hang onto it for at least a decade or two, it will be fine.

I am sure you must be mightily impressed by my sophisticated analysis, but when it comes to property it seems to me the supply and demand is a pretty good principle. If you can convince me our population will drop to say 20 million, easy, I am a seller. But I can't see the evidence.

And so it goes with shares. For heaven's sake, a share is just our piece of a business. We don't need to be Albert Einstein here, our growing population and the new 90 million people (births over deaths) living on our planet each year add to demand. And the nice thing with shares is that in this modern world we can own a bunch of them in Australia and globally and give ourselves exposure to growth sectors around the planet. Take a look at the InvestSMART website – investing in shares, infrastructure and so on here or globally can be done very efficiently and cheaply.

So do you buy shares or property? Clearly, I don't care as long as you invest in decent quality assets. But what I really care about is that you control what you can control first. Your cash flow. Yes, if you own mainly shares, I'd be thinking about diversifying into property. If you owned mainly property, I'd be thinking about diversifying into shares. If you hate property because it is too labour intensive, buy shares. If you hate shares because you can see prices going up and down every day (property does this as well, but you can't see it!), don't buy them.

My final thought here is also a truth. Be cynical about the ”research” provided by anyone or any organisation that profits from selling either shares or property. But I do think if you take a look at any independent research you will see that over long periods both asset typeshave generated returns well above inflation.  

Next week we'll have a chat about leverage and risk. There are plenty of untruths to uncover here!

- Paul Clitheroe

Eureka's Week

The correction

The Australian market has now reversed about five per cent of the 13 per cent rally that began in mid-February, thanks to a bout of risk-aversion prompted by fears of Brexit.

Let's leave to one side whether that risk aversion is justified (I don't think it is) – what it has done is return a bit of value back to the market. The price earnings ratio based on one-year forward consensus earnings estimates has dropped from 16 to 15 – slightly better but still above the long term average of 14.7.

The problem is that the already expensive defensive sectors, such as utilities and consumer durables, have done best in the past week or two, and actually become more expensive.

Most of the correction has been focused on resources and other cyclicals, so that the P/E dispersion (the gap between the highest and lowest valuation stocks) is higher than it's been since 2008.

One of the more significant trends lately has been a shift by yield investors from banks to real estate investment trusts (REITs) which has seen a big rise in their relative valuation, so that it is now well above average.

Source: UBS

That doesn't mean there will be a correction the other way, either in REITs falling or banks rising, and in fact it's more likely that defensive yield investments are likely to remain well bid for a while – for as long as markets are risk averse and interest rates are super low.

On the surface, banks are starting to look decent value, but they have got their own problems, of course, and have been lagging REITs because of concerns about capital requirements and rising provisions.

Normally the fact the 10-year bond yield fell to 1.99 per cent on Thursday and is currently two per cent – a record low – would give a valuation boost to equities and property (all assets are valued by adding a risk premium to the “risk-free rate” and discounting future cash flows by the answer – the lower discount rate, the higher the valuation).

But these are not normal times, and the fact that cash and bond interest rates are so low is raising concerns about economic growth and earnings, so that the resulting reductions in profit forecasts are offsetting the impact of lower discount rates on valuations.

That's the problem with the current market: equities are not cheap and bond yields are pointing to something both weird and worrying.

As I wrote last week, I can't get my head around negative bond yields, or negative cash rates for that matter, and as an investor I don't like it one bit. It's possible that at some point the share market reacts by having another big burst of “risk-on” and possibly even a bull market, but it's also possible that Bill Gross is right and it's a supernova about to explode.

I just don't know because these conditions are unprecedented. Then again, it's always “different this time”, so as investors we have to keep calm and carry on and try to earn a decent return.

In the current weird environment that means returning to first principles: finding well run companies in growing industries, and stick with them until something changes. It's not rocket surgery, as they say, but nor is it easy.

China and commodities

Chinese data out earlier this week has raised some questions marks around the sustainability of the rally in commodity prices this year.

Industrial production was unchanged, as was electricity production, and fixed asset investment was weak. Longer term, the picture is of an economy that just keeps grinding lower:

China's industrial production, fixed asset investment and electricity production 

I suppose China and the rest of the world will take what they can get growth-wise, but with an economy as leveraged as China's is now, you're always worried when growth falls short.

At the very least, demand for iron ore and coal is likely to soften in the months ahead which should keep commodity prices subdued.

This is being exacerbated by the risk-aversion coming out next week's UK referendum (on Thursday June 23) and the fears about Brexit, which will also probably get worse before it gets better.

Blockchain

We hear a lot about disruptive technologies that is usually broad-ranging and fairly unspecific, except for those being disrupted. But here's something specific, and quite interesting.

ASX Ltd is testing the use of Blockchain to replace its CHESS settlement system, which could be very good for ASX but not very good for Computershare.

Blockchain is the technology that makes Bitcoin work and looks like being much more important in the long term than the “crypto-currency” invented in 2008 by someone hiding behind the pseudonym, Satoshi Nakamoto (an Australian named Craig Wright claims to be him, but not many believe him).

Anyway, Blockchain is what's called a distributed ledger. All parties to a transaction have the same copies of all trading records, and any changes have to be agreed upon by a majority of nodes before it is digitally encrypted and “chained” to the nodes, forming part of the transaction history.

It's a sort of a “social media”, or consensus method of conducting business. Chaining the records makes tracing ownership history very simple, and fraud is difficult because the consensus approach means all nodes have to change simultaneously.

There are two types of Blockchain: permissioned and permissionless. Bitcoin is permissionless, which means that it happens between strangers. Permissioned is where transactions are happening between parties known to each other using preset protocols. That's what ASX is looking at introducing.

According to Morgan Stanley, it's currently doing a proof-of-concept programme, and plans to make a decision either way in mid 2017. If it goes ahead, the new system will run in parallel with CHESS for 12 months, before full adoption in 2018.

Computershare's registry business is based on the existing settlement systems for global stock markets, and 36 per cent of its total revenue comes from this division.

About seven per cent of this comes from Australia, which is most immediately at risk. The US, which contributes 40 per cent of Computershare's registry revenue, is also experimenting with Blockchain, so if it works that's only a matter of time as well.

And what's not well known is how important the registry business is to the rest of Computershare's other revenue streams, such as business services and employee share plans.

As for ASX, Blockchain should defend its clearing monopoly and reduce costs, and possibly create some opportunities, like growing data & analytic services and expanding services provided to the equity markets – as well as go beyond equities.

Retail

Two interesting things happened this week: I went into a Uniqlo store and I sat next to a Wesfarmers executive at a dinner.

Uniqlo is a Japanese-owned chain and it's an extraordinary store: packed with stock, well-laid out and cheap, and the clothes are pretty good. I'd previously been in an H&M store, which is also very good, and although I haven't been inside a Zara shop yet, apparently it's pretty good too.

The Wesfarmers executive confirmed to me that those three chains are squeezing the life out of Target in much the same way as Aldi and Costco are squeezing Coles (and Woolies).

As a direct result of the competition from Uniqlo, H&M and Zara, the head of K-Mart, Guy Russo, as well as some self-inflicted miseries, has been put in charge of Target with the task of cutting the size of the business down by about half. That is, its retail floor space and revenue will be halved, and the hope is that the business will be profitable at that point (it's losing money now).

According to a recent report from Macquarie Wealth Management, Uniqlo, H&M ad Zara reported $460 million in sales in 2015, from a standing start three years before. Actually H&M and Uniqlo didn't exist in Australian 2013, only Zara did.

They now have 36 stores between them and plans to continue rapidly rolling new stores out.

They are also taking market share off Myer and David Jones, which is ironic since the fear about those has always been that online retailers would drain their revenue. Turns out it's other, better, shops.

Readings & viewings

Stephen Colbert discusses Donald Trump's reaction to Orlando shootings. Funny, devastating.
 
The message of the terrorist is, “I matter. My cause matters. My hatred matters. My ability to act matters.” We respond by saying, “Yes, you matter.”
 
The NRA's slippery slope in gun control ends in paradise.
 
Fantastic interview on Radio national's Religion and Ethics Report with Raheel Raza, Pakistani Canadian writer, about the Orlando shooting.
 
Container ships doubled in size between 1955 and 1975, then quadrupled again by 1995. The latest mega-carriers are too big for most ports, and shipowners are building ever bigger ships in a sort of arms race, hoping to drive rivals out of business. A crash looms.
 
The golden rule of investing, with Roger Montgomery and Steve Johnson.
 
Globalisation is fraying. Look under the Elephant Trunk.
 
Stunning piece from Ambrose Evans-Pritchard: why I'll be voting for Brexit.
 
Brexit will be a gentle process.
 
Unlike life and the universe, Europe has no simple answer.
 
This is remarkable: an entire spoof issue of the New Yorker magazine.
 
How do you hedge against a Trump Presidency (traders are asking themselves).
 
LinkedIn, which was bought by Microsoft this week, is “an Escher staircase masquerading as a career ladder”.
 
What's going on in an animal's mind?
 
Why humans sing.
 
Barrie Cassidy on the hoax of pork barrelling.
 
The problem with reinforced concrete (it doesn't last long).

Last week 

Shane Oliver, AMP