Why this Australian invested in America

Kelly Choi
Sep 9, 2018 · 13 min read

I’ve been investing in the United States for a few years now. It was hard for me to pinpoint exactly why I picked the American market especially when there are over 100,000+ companies listed globally. But there are some compelling reasons to look abroad.

A reason I looked abroad could have been my contrarian nature. A few years ago, investing in Australia was a popular choice for foreigners. Interest rates were high relative to most countries. In 2010, when central policymakers in the developed countries were decreasing interest rates to all-time lows, Australia increased the interest rates to 4.75%. It wasn’t until November 2011, that the RBA started to cut rates. Back then, it drew attention from global investors. Do you remember the carry trade of 2011? Do you remember when AUDUSD pair traded at its peak at AUD/USD1.09?

Source: RBA, macrotrends.net

Ever since the first interest rate cut in November 2011, the RBA began its journey to cut rates. A total cut of 50bps in 2011, then 125bps in 2012, another 50bps in 2013, no cuts in 2014, then 50bps and 50 bps in 2015 and 2016 respectively. Since 2016, the cash rate sits at 1.50%.

As mortgages became affordable and real estate renovation shows dominated the Australian media airwaves, the property became the hot new asset and as we all know, property prices cannot fall. At the same time, wealth in China was increasing and with the rise of more Chinese millionaires, the new wealthy class was seeking Australian property to invest their new found wealth.

There could have been a slew of catalysts that indirectly triggered me to look elsewhere for investments. Perhaps it was the herd mentality that shaped my inability to take action; I didn’t want to be stampeded and crippled with the euphoria of record prices. (I have no idea how much home prices should be, nor will I try to forecast. But even in 2018 with housing prices deflating, paying a million for an unlivable house in Sydney’s inner west? Worth it?)

Source: realestate.com.au. Sale in the inner west of Sydney.

Investing in Australian equity

I’ve had minor success in investing in Australian equity but overall it was punishing. I came out learning a lot about portfolio construction and portfolio positioning. So, where to start looking for Australian equity you ask? Read Value.able by Roger Montgomery. The first screener I used was based on this book. There are other tools you that is much more available now such as https://simplywall.st/

The Australian market is a strange makeup. Over 50% of the market cap is concentrated in 3 sectors. The market capitalization of the ASX100 is approximately US$1.85trillion and the 3 largest sectors are the: Materials and Mining (24%), Banks (22%) and Real Estate (8%). Let’s take a look at these sectors in turn.

Source: Capital IQ. ASX100 by market capitalization.

Mining and Materials

Once upon a time, the mining sector in Australia was the market darling, with BHP and Rio Tinto leading the pack. The price of the stocks reflected a high rate of perpetual growth, how could there be a slowdown? With the benefit of hindsight, we now have a better understanding of how the mining sector was to be affected by the global economy. The GFC led to slower consumer spending in the United States, which reduced China’s exports. Fewer exports meant less manufacturing and production of consumable goods. This eventually resulted in less demand for raw materials coming from Australia. With the slowdown of the global economy, the Material and Mining sector suffered, and since it made up the majority of the ASX, the returns also suffered.

What makes up of the Material and Mining (M&M) sector you ask? M&M include iron ore, gold mining, aluminium, and coal mining. Australia is the “lucky” country as it is commodity-rich. However, a characteristic of commodities is that the product itself has no distinct differentiating features. Gold is gold, coal is coal, iron ore is iron ore. The commodity grades and the methods used to extract the commodity can differ, ultimately impacting operational expense.

A feature of the commodity business is the cyclical nature. Revenue, profitability and cash flow of commodity businesses are driven by the supply and demand of the raw materials, i.e. the volume sold multiplied by the price of the commodity.

Volume depends on the available mineral reserves in the mine site and factors that affect the production of the resource. The characteristics of a high-quality mineral/ore reserve is a deposit with a long life and where the mineral/ore resource is abundant and easily extractable. This is generally a good indicator that the mine can provide a reliable supply and stable production of the resource. On the other hand, if the mine life of the reserve is short, future production (and revenue) could be at risk as the mine depletes. Also, it’s good to have an understanding of the geographical location of the company’s mining assets. Are the mining assets located domestically or abroad? If the company’s mines are located abroad, does the country have a high political risk that may affect production or attract higher taxes?

Price — the other component to the revenue equation — is usually what causes earnings volatility. The commodity price and profitability of the resource company are generally correlated. Commodity prices are driven by macroeconomic and market factors that are difficult to forecast. For instance, crude oil prices are often driven by inventory levels and the supply of crude oil, high levels of inventory can drive down the price of crude oil, but at the same time, geopolitical risks could threaten the supply and ultimately drive up oil prices. Gold prices, on the other hand, can be driven by inflation expectations and exchange rates. Physical gold has a history of acting as an inflation hedge, particularly in times when the government is printing money.

Another characteristic of the mining business is its high fixed costs. The business is capital intensive and outlays large sums of money to build, develop and procure equipment. To fund these activities, a company can raise money by issuing more equity or if they are creditworthy — through bank borrowings. A company that decides to expand during a time where commodity prices begin to fall for an extended period, could ultimately be detrimental to the investor.

As you can already tell, the earnings, cash flow and profitability can be tricky to predict since it’s driven by so many market forces. Having a good understanding of macroeconomic factors would certainly help when investing in this arena. There is a plethora of information on the mining sector, where experts can give a better and more detailed analysis than myself. For me, a long-term investor, holding a concentrated position in this sector is risky. There could be opportunities outside this sector.

Australian Banking

Now to Australia’s second largest sector: Banks. Banks have a relativity ‘simple’ money-making model. Traditionally, banks are conservative and operate to serve the customers financial needs. The main source of income comes from the spread between the lending rate and the inter-company bank borrowing rate. They offer financial services such as home loans, business loans, credit cards, and insurance etc. To better serve the customer, banks have to be ‘innovative’ by adapting to new technologies, but the core business is to act as a financial intermediary.

Over the past few years, the Australian banking sector had grown their assets with retailers taking out residential mortgages to fund real estate purchases. Naturally, revenue in the form of interest income increased as more mortgages were taken out. The growth in revenue came from the growth in assets. To take an example, have a look at CBA’s balance sheet in 2018: 75% of the Assets were made up of ‘Loans’. Of these ‘Loans’, ~67% is made up of ‘Home loans’. Basically, 50% of CBA’s total assets are made up of residential mortgages.

Source: CapitalIQ, Total Assets from 2011–2017 Q4 Balances
YoY growth from 2011- 2017 Q4 Balances

Compared to most businesses, the profit margin is… how should I put it? “It’s very nice”. With a net profit margin of 30+%, they are not a loss-making business. Reiterating, banks are financial intermediaries; they earn a spread between the lending rates and the cost of funding of the bank. If the banks’ cost of funding increases, they will pass the increase onto the customer’s lending rates.

Source: CaptialIQ, Revenue and Income 2011–2017 Q4 TTM

From 2011 — 2016, the Australian Bank sector benefited from economic tailwinds. The profitability of the banks was propelled by the real estate boom and foreign investments. With higher profitability, record cash profits and nowhere to reinvest the cash, the banks distributed its earnings back to shareholders. In an economic environment where interest rates were at an all-time low, a bank dividend yield of 5–7% — with relatively strong earnings and stable track record of dividend payments — became an attractive alternative.

Banks are Profitable and Assets are growing — what’s wrong with that?

As assets continue to grow, the quality of the bank’s balance sheet can be questionable. This would come down to the type of assets the banks underwrite. Continuing with the example of CBA’s balance sheet, if half of the growth in assets is driven by residential mortgages, the quality of the assets can erode as the real estate market softens. In addition, future growth of the banking sector is likely to stall as the government tightens foreign investment by raising taxes. Already, there are signs of the real estate market softening — evidenced by lower residential clearance rates — since the introduction of new taxes to foreign investors in 2017.

Another headwind could be tougher bank regulations. Financial institutions are heavily regulated to reduce moral hazard and to mitigate systematic risk. In 2017, news had surfaced of some Australian banks involved with fraud and irresponsible lending practices. This would eventually prompt the Royal Commission to conduct an inquiry into the misconduct of Australia’s financial sector. The Royal Commission is currently gathering information on the matter. If there is enough evidence against the institutions, this would cause more them more headaches. With tighter regulations, the cost of compliance would also increase — further chipping away at the profitability.

Globally, Australia has one of the highest levels of household debt (second to Switzerland). With the high levels of household debt, low disposable income and weakening savings rate, future economic growth in Australia is likely to slow. Since the GFC, the United States has tightened bank regulation in order to strengthen the financial system. Currently whilst the American economy is on the mend and is poised to raise interest rates, Australia continues to be dovish. Raising interest rates in a country where the economic fundamentals are weak, could prove to be crippling.

Despite the headwinds facing Australian banks, adding bank stocks to a portfolio is ubiquitous, especially for a dividend style investment strategy. To make use of this strategy most effectively, the investor should be mindful of the price paid for the stock. The question is — does it make sense to add Australian banks?

Australian REITs

In the financial market, real estate investments can be split into two types: Equity REITs and Mortgage REITs. Here, I’ll focus on the equity type.
Equity REITs can be in the form of commercial property (office buildings, industrial complexes, retail, and shopping malls) or residential property (multiple home living and apartment complexes). One main benefits of REITs are leveraging the company’s expertise in managing and developing the property.

For most people, their residential home is their main exposure to the real estate market. Individual investors may also purchase residential real estate to earn passive income or for capital appreciation. However, there are pros and cons to investing in the residential real estate. For most investors, the main advantages are: tax shields, and using leverage to capitalise on potential capital appreciation. The disadvantages can be the burden of illiquidity, maintenance of the property, dealing with tenants, and outlaying a large sum of money.

REITs can offer the investor an alternative vehicle to get into the real estate sector without investing a large amount of cash. So why would one want to invest in REITs? Again, it’s similar to the two reasons given for residential real estate investing: cash flow and capital appreciation from the real estate where the Average-Joe can’t invest. Other advantages that are often overlooked are liquidity and diversification. Since equity REITs are in the form of tradable shares, the investor can enter and withdraw from the investment at any time. Investing in REITs will also offer you geographical and asset class diversification instead of your investment concentrated in one asset.

Now, how do REITs work? A company is established to invest in the property. In order to make investments, the company seeks equity investors who will give them money in exchange for shares of the corporation. Furthermore, if an established company has a good credit history, the business can go to the debt market to borrow money to fund property purchases or property development. Once funding is secured, the company will then go out and purchase and/or develop the property. When the property is ready for use, the business will either charge rent to tenants or sell the newly renovated property to retailers (residential REITs). The company will then distribute the income back to the shareholders after deducting their operating expenses.

For REITs investing, the investor should look for stable dividends and assess the quality and type of assets that the company owns. Gaining an understanding of the type of REITs is important because some REITs are more cyclical than others. For instance, certain residential REITs could be riskier now than it was a few years ago — especially with the slowdown of Australian residential housing. Compared this to a commercial REIT that manages office buildings where they may not have experienced the same growth a few years ago, but offer a stable rental income. To hone in on the point further, compare this to a commercial retail REIT, where the REIT develops shopping centres but faces uncertainty to due to online retailing.

Another feature of REITs that the investor should beware of is how much leverage the company uses and whether this is a sensible amount for the company. The profitability of REITs is affected by the cost of funding. The past few years, popular sources for funding have been from the U.S. market because of the low-interest rates. If the cost of funding increases, a REIT that is highly leveraged could reduce the returns back to shareholders.

For most people, adding REITs in their portfolios would not be appropriate since a majority of their assets are already tied to their residential home. Depending on the investor’s portfolio strategy and time horizon, this sector could actually be an interesting play because of the benefits mentioned above. There is one more thing to note, institutional investors (such as your superannuation fund) make up the majority of shareholders for REITs. This can be a blessing because it’s likely that the average Australian would have exposure to this sector through their superannuation fund. However, for the active investor, this might not be so good. If the institutions decide to rebalance the portfolio or pulls out of the position, this could adversely affect the price due to the volume they are selling.

There are many good businesses in Australia in these sectors ran by excellent leaders and good people. However, with housing prices and household debt at an all-time high, a weakening Aussie dollar and limited opportunity set of global brands, it’s time to look elsewhere.

Investing in the United States of America

The opportunity set in America is A LOT bigger. The S&P 100 is approximately USD$18.41 trillion compared to Australia’s ASX 100 at USD$1.85 trillion. The top 10 companies by market capitalization in the United States alone make up USD$5.8 trillion. That’s three times the size of the ASX 100. Companies listed on the NYSE and NASDAQ also have global names with global product lines, reaching more customers and users.

Source: Capital IQ, data from Aug 2018

Not only do the companies listed in the United States have global reach, but the Software and Technology sector makes up almost 30% of the market. Unless you have been living under a rock, you should by now realise that the Software and Technology industry have changed the way we operate professionally and personally. Companies want more real-time data to make optimal decisions and engage their workers, whilst social media influencers can create their own content and create their own brand instead of waiting for their talent to be ‘discovered’. These are exciting times. These are the game-changers.

Source: Capital IQ, Market capitalisation for S&P100, data from Aug18.

In summary, as our society changes and evolves, the way our society interact, work and behave will ultimately change with competing technologies. There’s no doubt in my mind that Technology has benefited our lives for the better and it will continue to improve our quality of living.

Also, just to be clear, I’m not advocating what companies you should buy or sell. The purpose here was to highlight that the opportunity set for investment outside of Australia is larger and it’s worth considering investment options elsewhere given Australia’s concentrated sectors on Material and Mining, Banking and Real Estate. With the AUDUSD forecasted to weaken and higher tariffs for foreign investments, sluggish growth numbers coming from China and interest rates rising in the United States, how would you have positioned yourself?

Disclosure:

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The research is for informational purposes only. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but I do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.

Thanks to Michael Hutton

Kelly Choi

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