All aboard the yield bubble?

‘We concluded that by almost any affordability metric, Australia had the largest housing bubble on the planet.’

The words of David Hurwitz of SC Fundamental, a large US-based hedge fund, neatly explain why he’s shorting Commonwealth Bank. He’s not alone, either. Jim Grant of Grant’s Interest Rate Observer recently recommended shorting Westpac and Bank of Queensland.

Grant’s colleague Evan Lorenz warns that, ‘Houses in the major Australian markets are priced at an average of 6.5 times median household income, compared to 3.1 times in the United States today and 4.6 times in the zany year of 2006. [Yet] In all my calls to Australia no one was willing to venture a bearish view on the Aussie housing market outside of a few suburbs in Queensland.’

Maybe he’s calling the wrong people. Share Advisor’s Leith van Onselen in A property price bubble? expressed similar concerns. Even the banks themselves are cautious. The Age reports that UBS and Deutsche Bank, hardly organisations known for talking down share prices, called the sector ‘overpriced’.

High bank PERs

Bank investors have received about three years of average gains in the past year or so. Low interest rates and a lucrative oligopoly have fundamentally changed perceptions of the sector. Two decades ago, banks were low growth utilities trading on price-earnings ratios of 9-12. Now the big four trade on PERs of up to 16.

Where local investors see stability, oligopoly profits and a government guarantee in the event of trouble, their international counterparts worry about consumer debt and property market exposure. Who’s right?

Having recently increased the portfolio limits for each of the big banks from 5% to 8%, and to 20% for the banking industry as a whole, up from 10% respectively (see Table 1), members might think we side with the locals.

That would be to misunderstand us. Safety is not king: Why stocks will win explained how lower interest rates have made shares relatively more attractive. For stocks like Woolworths, Carsales, ResMed, CSL, the big four banks, and NewsCorp, we’ve been happy to pay a bit more for quality and growth. That partly explains why we’ve increased the portfolio limits for these stocks.

The other factor is that, in accordance with our new approach described in The Simpsons' guide to Buy, Sell, Hold, portfolio limits now only indicate the riskiness of a business; for valuation purposes, the recommendation guide is the tool you should use, specifically the Buy, Sell and Hold prices. Bear in mind these are just a guide, as your tolerance for risk could be quite different from the average.

So we haven’t dispensed with valuations in favour of climbing aboard the yield bubble. There are other pointers. The model Growth Portfolio doesn’t own any bank stocks, nor do any of your analysts.

The model Income Portfolio has a conservative 8% total bank stake, split between Westpac and Commonwealth. I’d recommend that if your bank holdings breach our recommended portfolio weightings, you trim them to meet the limits set out in Table 1.

Other blue chips stocks have followed the banks in their upward march. Table 2 shows how some long-admired stocks – those with recurring revenue streams, bulletproof balance sheets, strong market positions and decent management – have performed since December 2011. While we've just selected stocks that we've recommended for simplicity, this trend is obvious across the market for high yielding stocks such as Telstra and those in the A-REIT sector.

Our high-quality focus since the GFC has also seen the model Income and Growth portfolios deliver compound returns of 6.9% and 22.6% respectively since 31 December 2008. All good then?

Not quite. Current valuations mean we’re unlikely to produce these sorts of returns over the next year or two. With interest rates barely registering and high quality companies fully priced, this is the challenge: either accept lower returns or wait patiently for valuations to fall (assuming you don’t swap investing for speculation).

In our model portfolios, we’re opting for the latter. Expect to see their cash holdings increase with rising prices.

The times call for a different kind of bravado from that needed in 2009. During the GFC going against the crowd meant buying cheap stocks. In 2013 it means selling or trimming holdings in long-term compounders like the big banks, and foregoing the opportunity to make money in the short term.

As explained in The buy and sell strategy, better to buy low, sell high and pay the tax. The member that failed to sell Centro Properties at over $10 because he didn’t want to incur a CGT liability learnt that lesson the hard way. To spur you into action, let’s wander among the bell ringers.

Commercial property bubble?

Fund manager John Hussman claims the S&P 500 is overvalued, saying ‘the ratio of equity market value to GDP has demonstrated a 90% correlation with subsequent 10-year total returns on the S&P 500 and the present level is associated with projected annual total returns on the S&P 500 of just over 3% annually.’ Yep, 3% p.a. for the next decade.

Cromwell Property Group chief executive Weightman recently warned of a commercial real estate bubble; ‘If it plays out like 1988, you will see prices bid up to the wazoo and a complete flop in property values.’ Is that why the Lowy family recently sold its entire $664m stake in Westfield Retail Trust at a 10% discount to book value?

Is it time to sell the lot? No. Local interest rates could go lower, supporting the valuations of high dividend, high quality stocks. China could also muddle along for several years yet. It’s a dilemma, especially for income investors.

Our approach is to find companies that will provide satisfactory returns over the long-term no matter what. Stocks such as CSL, NewsCorp and ResMed are growth stocks that shouldn’t be impacted too much by economic headwinds. Others such as ALE Property Group and Bunnings Warehouse Property Trust will continue to pay distributions throughout. See What’s a satisfactory return parts 1 and 2 for more stocks of this ilk.

These stocks are no longer cheap. But they should provide high single digit returns over the long term at the very least. That’s far superior to cash.

Many high quality businesses also boast overseas exposure, which could help protect earnings and dividends if the Australian economy stumbles and the Aussie dollar falls (see Will the Australian dollar ever fall?).

It’s not too late to diversify overseas, either by investing directly yourself or through a managed or index fund, ETF or even LICs if they’re trading at a discount to net tangible assets after factoring in fees (A clean sweep of LICs shows you how to value them and what to look out for).

Two special reports

In our recent interview with Jack Lowenstein of Morphic (which will shortly appear on our website) he said it was a great time to invest in Australia over the past 20 years and that now could be a great time to invest overseas. In June, we’ll provide an update to the stocks first reviewed in Ripe for the picking: Overseas stocks to buy so you know where to look. Owning some foreign currency could also help diversify your portfolio as you wait for cheaper stock prices, although you’re unlikely to get any interest.

Despite high valuations, a portfolio packed with companies delivering reliable earnings, preferably purchased at cheap prices, will do well over time. Our model portfolios and current Buy list are there to help guide you to them.

Regardless of the economy’s state, many stocks will reach record highs in the years to come and we’re looking out for them. Work has commenced on two special reports to be released in early July: one uncovering small cap opportunities, the other top picks from Australia’s best fund managers. These reports will be filled with stock ideas, a demonstration of how focusing on unloved businesses rather than indexes remains the secret to building genuine wealth.

So, forget the yield bubble, adjust your portfolio accordingly, and remember that valuations always matter, most pertinently at a time when they appear not to.