25 January 2023
Happy new year to all readers. Please fasten your seatbelts for what is likely to be a rough ride, with a majority of leading economists forecasting a recession or at least a global economic slowdown.
The successive increases in interest rates by the US Fed inevitably impact on the rates at which our banks are borrowing in international markets and hence passing on to Australian borrowers. I also noticed that US car makers are experiencing a slump in sales. This is an indication of the US likely tipping into recession. The price of shipping containers from China to the west coast of the USA has plummeted—a sign of much lower demand, and another indicator of faltering economies. Much of the world will follow the US slowdown.
Is There a Big Australian Housing Shortage?
With high employment, our population spreads out. Youngsters leave home and share rental units creating a shortage. When unemployment rises and some lose their jobs or have hours reduced, many return to spare bedrooms at Mum and Dad’s. I recall that back in the 1980s ‘recession we had to have’, Australia went from a shortage of rental properties to a surplus, with prominent property economists wondering why the rental market had changed dramatically. The change revealed that demand for separate dwellings is a lot more elastic than was generally supposed. A big part of that elasticity is the vast number of spare bedrooms in the homes of older parents. Net immigration will create additional demand while a significant lift in unemployment would reduce demand.
Why There is a Shortage of Rental Housing
A big reason why there is a shortage of housing to rent is that government policies—particularly from state governments—has made investment in rental housing uneconomic and risky. There is significant stamp duty on property purchases, but none on purchase of shares, and substantial land tax on rental house investments but no equivalent tax on share ownership. There is a substantial risk of acquiring troublesome tenants and legislation generally favors tenant rights over landlord rights. Surveys of landlords indicate that this is a major concern. The net rental return on residential property is dismal. Wealthier investors are less likely to invest in residential rental property.
Most dentists and vets except those in small country towns find that their two best property investments are:
1. Their long-term family home, which is capital gains tax exempt, and
2. The practice premises
The rest of us are more likely to invest in upgrading our family home because of lifestyle benefits and its capital gains tax exempt status.
Typical geared investors in residential rental housing are those in secure government jobs such as school teachers, public servants and police because having secure employment banks consider them to be favored borrowers.
Invariably long-term family homes have better capital appreciation than tenanted rental houses because they tend to be better situated and better maintained. Most owners don’t modernize rental properties.
Misleading Home Price Appreciation Statistics
The real estate industry quotes median price statistics, but these can significantly overstate the actual price appreciation over time because they are simply based on sale prices. In areas where there has been a substantial amount of capital improvement such as extensions, modernized kitchens, bathrooms and ensuites compared to original obsolete styles, solar systems, security systems, automated garden watering systems etc., houses which were built many years ago now have much greater amenity than was originally the case. Naturally modernization has increased their value. However median price statistics simply reflect changes in selling prices of real estate titles by suburb and have no way of measuring the capital improvements. This includes demolition of small obsolete house and replacement with modern two-story dwellings with multi car garages and lots of modern features, all of which are buried in changes to median price statistics falsely represented as capital appreciation. This is part of the reason why rental houses perform poorly compared to median price movements.
In our street every original house has either been extended or demolished and rebuilt with multi car garages and greatly increased floor space including extra bedrooms and bathrooms. Originally, they did not have gas, Foxtel or NBN connection, nor did the originals built in the 1950s or earlier have ensuites, solar electricity etc. Any one studying house price movement in my suburb of Ivanhoe East over the past 70 years would come up with an enormously exaggerated view of price appreciation because the median price movement includes an enormous amount of capital investment over and above the original cost of home purchases.
Simplifying Self-Managed Superannuation Fund Investment
If you have substantial superannuation and/or have the ability to fund substantial contributions, particularly contributions as a couple, it is likely that you have an SMSF or are contemplating an SMSF. But you may be worried about the cost of investing/ investment advice. It is worth noting that two very long-standing investment funds, ARGO which publishes its top 20 investments by fund percentage and AFIC which publishes its top 25 investments by fund percentage excluding cash, are both heavily invested in the top 20 stocks listed on the ASX. Argo’s management expense ratio is 0.14 percent and AFIC’s is 0.16 percent. These are vastly lower than a range of other listed investment companies which came to the market in recent times and are a long way below the MERs of managed funds. I personally stopped investing in managed funds a great many years ago. Those who have sufficient superannuation to seriously consider an SMSF but are worried about investment could choose to invest in Argo and AFIC and achieve an approximate market level return in the long term.
Those who wish to be more hands on can use Argo and AFIC’s top 20/top 25 investments as lists to explore further by dialing up the ASX 200 then looking at the financial details of each company including recent annual reports to gain a further understanding of performance. There is no cheap substitute for lots of personal research.
We do not own Argo or AFIC, but we do own many of the shares in their top 20/25 stocks in our SMSF and/or investment portfolio.
Warning
Be careful to differentiate Argo and AFIC from certain other listed investment companies (LICs) which have vastly higher MERs.
Industry Super Funds Secret Valuation Gap
This issue has been bubbling along quietly but Karen Maley has summarized it nicely in the Australian Financial Review of 24/1/23.
Industry super funds are slow to revalue their exposure to unlisted assets including commercial property, infrastructure, venture capital and hedge funds. According to the AFR, the Property Council of Australia shows unlisted property funds recorded gains of nearly 19 percent in the first 9 months of 2022 in stark contrast to the nearly 20 percent drop in the valuation of stock market listed property funds. That is an overall 39 percent difference in value movements! Basic valuation technique indicates that with increasing interest rates that the capital value of commercial property, infrastructure, venture capital and hedge funds fall.
The tardiness of industry super funds in correcting values to market indicates that their assets are likely to be substantially overvalued. This is important because it favors those making withdrawals and devalues new contributions when inevitably at some point industry superannuation funds bring asset values into line with the market.
As interest rates are unlikely to return to the extreme low point that they reached before the US Federal Reserve and the Reserve Bank of Australia began increasing rates the pendulum is unlikely to restore these asset values to the point that they reached when interest rates reached their bottom. It is apparent that industry superannuation funds are resorting to a tactic of “extend and pretend”—i.e. turning a blind eye to a festering problem in the hope that it will somehow right itself.
Reportedly the regulator APRA is considering the issue but, if past performance is a guide, will be slow (too slow) to force industry superannuation funds to bring asset values to parity with the market.
Industry superannuation funds are suitable vehicles for those with small superannuation balances, particularly low-income earners who cannot afford contributions above compulsory employer amounts.
For those with significant balances and an ability to increase concessional superannuation contributions and possibly add non concessional contributions, it becomes progressively more advantageous to establish a self-managed superannuation funds particularly with two members who are in a long-term relationship. If a couple have superannuation benefits which with affordable superannuation contributions will total $500,000 or more in the year it is established, have realistic probability of making substantial annual contributions and have many years to anticipated retirement establishing an SMSF is a sound strategy. It will be beneficial at or above this level because professional superannuation administrators can provide a service well below what an industry super fund charges for an equivalent amount of money.
Investment cost can be reduced substantially by being hands on. For those who need the comfort of a stock broking adviser leading brokers will quote competitive brokerage rates if you have large amounts to invest and are able to indicate that you will be making regular substantial contributions. Those who wish to do their own research can use an online brokerage service. These are cheap but do have imperfections.
International Diversification?
Remember that leading stocks such as BHP, RioTinto, Macquarie Group, CSL, Woodside Energy, Reece etc. have substantial international businesses.
For those who want further international exposure the Blackrock S&P 500 exchange traded fund (ETF) ASX code IVV invests in the top 500 stocks listed on the New York Stock Exchange and NASDAQ. As many of these are huge international businesses, this fund represents an easy way to get international diversification with a low MER and saves the bother of separately investing in a range of ETFs covering various geographic parts of the world. Most ETFs have much lower MERs than managed funds.
We own the S&P 500 fund in our investment portfolio.
Bank Hybrid Investments
Bank hybrid investments issued by the big five Australian banks (i.e. ANZ, CBA, Macquarie Group, NAB and Westpac) represent a way of achieving a better return than bank term deposits at moderate risk. We own a selection of these in our SMSF including a mix of long and shorter term to maturity/rollover dated hybrids for each of the five major institutions. All can be purchased through the stock market. Usually at maturity the banks offer a no cost rollover to a replacement hybrid with the interest rate margin above the bank bill swap rate reflecting the prevailing long term interest rates at time of rollover. They are classified as low risk investments but are not immune from a bank failure, unlikely as that is. Analysis and understanding of the current interest rates and whether distributions are franked is vital research. Most hybrids pay franked distributions as a way of the banks utilizing their franking account credits. Before buying, spend time understanding their individual structures—including formula for making payments, whether fully franked, partially franked or unfranked and—hence calculate the grossed-up returns. Note that as interest rates rise, so does the bank bill swap rate between banks and since hybrids pay a specified interest margin above this rate so does their yield. The reverse would be the case in a falling interest environment. There appears to be negligible probability of interest rates going back to their lowest point of 18 months ago.
We choose to avoid corporate bonds which come with higher risks than do bank hybrids.
Washington H Soul Pattinson (SOL)
Those with a desire to own a far more diversified portfolio of assets compared to Argo and AFIC and to include substantial bank of land for development, agriculture and coal mining investments can consider buying shares in Washington H Soul Pattinson (ASX code is SOL) which has existed as a listed Australian company since 1903 and in fact was founded as a pharmacy in 1872. It has produced steady growth and paid dividends every year since listing. Robert Milner’s family have a controlling shareholding and through SOLs shareholding allied with Milner’s own shares has effective control of Brickworks Ltd which in turn has a significant cross shareholding in SOL. While there have been periodic rumblings from those who would like to net out the cross share-holdings they have failed in attempts to force the issue and Robert Milner and son remain in control. In my opinion the overall business has long been conducted to a sound standard. During the 2022 financial it merged with Milton, in which it had been a long-term shareholder as had Robert Milner. There was a statutory non-cash write off of goodwill associated with the transaction. This did not impact dividends. Those interested in sourcing a long term SMSF investment can take a deep look at SOL.
We do not own shares in SOL but do regard it as a well-managed diversified investment company.
Back Dooring Accounting to India or Malaysia!
Accounting groups routinely have several accountants supporting each partner. Most of the work is done by them prior to approval by a partner who presents it to clients. Most clients are used to speaking with staff members of the firm in respect of accounting queries.
Accounting practices which have lost a number of staff has come up with a solution of sending client preparatory accounting work off shore! It is likely that clients will have misgivings about this given privacy issues!
How Do Banks Sometimes Pay More for Hybrid Investments than They Charge on Many Home Loans?
1. Their hybrid securities have a special status, being treated as tier one equity because under certain extreme circumstances they can be converted to bank shares. Banks are permitted by the regulator to lend a large multiple of their tier one equity theoretically around 10 or 11 times but they receive a special weighting for home lending which increases this multiple. The vast majority of the funds they lend come from various forms of deposit including wholesale borrowings and quite a lot of their deposits receive very little or no interest.
2. It enables them to lend a large multiple of the bank’s tier one capital. Their source of funds to lend is mainly made up of customers deposits augmented by wholesale borrowings. Ultra-cheap finance from the Reserve Bank of Australia, which enable the historically low interest rates on housing loans, is being withdrawn.
For example:
If a bank’s cost of capital, including hybrids, is say 5 percent but the overall cost to the bank of its deposits is say 2.5 percent and for every dollar of its capital costing 5 percent it can lend 12 dollars which include 11 dollars of borrowed funds at an average cost to the bank of 2.5 percent giving an overall cost of funds of 2.71 percent, there is a juicy overall margin to the bank’s lending at say 4.5 percent providing that they have strong credit control. The actual situation is vastly more complicated as other forms of bank lending, such as credit cards, small business overdrafts and hire purchase have greater degrees of risk but earn higher interest and fees for the banks than do home loans.
On a bank’s balance-sheet the loans it makes are bank assets and bank deposits are bank liabilities.
About This Newsletter
My reason for putting out this newsletter is to garner donations for the Delany Foundation, a registered charity which I support. I receive absolutely no personal financial reward nor am I obligated to recommend any financial services provider and hence my comments are fully independent. The Delany Foundation was established by the Patrician Brothers who provided me, a kid with parents struggling on a small uneconomic farm remote from a school bus route with a bursary to board at Holy Cross College for my secondary education.
I ceased to be covered by a financial services license after disposing of my equity in an accounting and financial services business on 30 June 2020. At that point I had passed the relevant exam and met the regulatory requirements including monthly study requirements. I have a BA and an MBA mostly including accounting, economic and finance electives. I had spent over 33 years providing business, strategic, financial and organizational advice to an extensive list of clients much of it as a founding director of an accounting and financial services business for the last 26 years prior to retirement.
Naturally readers should take other relevant advice and are encouraged to do as much of their own research as possible.
Good Reading
The best book about finance that I have ever read was The Bold Riders, by Trevor Sykes. It details the financial misdeeds and misjudgements of Australia’s 1980s entrepreneurs, many of whom ended up bankrupt, in jail or in exile. During the period, Trevor Sykes was not taken seriously when he pointed out their serious weaknesses, particularly Alan Bond who was eventually bankrupted and jailed. Copies are available on Amazon. I treasure my copy as it contains many lessons. Sykes wrote a weekly column in the Australian Financial Review under the pen name Pierpont and regularly exposed financial scams many related to dodgy mining companies often conducted by dubious characters he referred to as ‘old friends’. To be so labelled by Trevor Sykes invariably was a kiss of death to market scammers. Sykes was the author of a number of books and had a huge knowledge of the history of mining in Australia.
The best regular writing on investment is Warren Buffett’s annual letter to Berkshire Hathaway shareholders. It is available on the internet. The first 50 years of Warren Buffett’s annual letters to Berkshire Hathaway investors are available in book form at Amazon.
Financial Success for Dentists
Financial Success for Dentists: Rules for How to Approach Your Dental Career sets out the key strategies which make dentists successful. It is specifically written for those dentists and dental specialists owning their own practices and for those aspiring to own practices. Among the topics included:
· Understand key practice valuation criteria.
· Learn how some dentists inadvertently reduce the value of their practice by $500,000
· Avoid long term errors when purchasing your practice.
There are many accountants, financial advisers, marketing consultants, web site designers and practice advisers who give advice from their particular disciplinary experience, but very few have the wider breadth of experience to define for their clients the key rules to follow to optimize their practice and their long-term financial outcomes. An otherwise competent financial adviser may have little understanding of what makes one practice much more successful than another. Many accountants have detailed knowledge of the taxation rules but cannot identify if a dental client has broached invisible barriers to practice growth or a threat to practice goodwill value.
I spent 33 years examining dental practice financial outcomes and reviewing the key strategies and decisions which separated successful Australian dental practices and practice owners from the less successful and this led to relevant conclusions and advice to dental practice owners.
A complete and comprehensive career guide for mature and aspiring dentists.
Based on real life situations and a lifetime of dealing with dental practice ownership outcomes this book is worthy of Text Book status for every dental teaching school.
—Merv Saultry, Founder Dental Innovations Network
To Obtain a Copy:
· Go to the Delany Foundation website at http://www.delanyfoundation.org.au
· Click on the Donations tab and make a donation of minimum $60. This is easiest by Mastercard or Visa.
· Email graham.george.middleton@gmail.com confirming that your donation has been made, as well as your name and mail address
· A copy of the book will be mailed directly to you
All production costs and mail costs are met by me personally, so all money donated goes to the Delany Foundation which contributes toward the running of schools in Ghana, Kenya and Papua New Guinea. Naturally donations above $60 are welcome.
The donation to obtain this publication will be the most cost-effective practice advice most dentists will ever receive.
Please Pass On
If you like these newsletters, please pass them on to colleagues. Past newsletters and articles in Australasian Dental magazine on business issues are at grahammiddleton.com. I can be contacted directly at graham.george.middleton@gmail.com
Independence And Disclosure
I am not a representative of any accounting practice, financial planning firm, business or marketing consultancy. I spent 33 years as a business and financial adviser to mainly dental, medical and veterinary specialist and general practitioners. Since I retired as a director of a financial services group, of which I had been a founder, on 30 June 2020, I am no longer licensed as an investment adviser. Readers should treat the above as general advice and take professional advice as required.
General Advice
I sold my interest in a financial services and accounting group on 30 June 2020 and have no intention of starting another financial services business. I own, via my family superannuation fund and investment portfolio, some of the stocks mentioned in this newsletter. My website is now available at grahammiddleton.com.
Those who find my newsletters of value to them are asked to consider making a donation to the Delany Foundation, a registered charity which assists schools in Papua New Guinea, Ghana and Kenya. Delany Foundation c/- Holy Cross College, 517 Victoria Road Ryde NSW 2112.
Best wishes to all readers
Graham Middleton
