While Warren Buffett’s recent investment in IAG Limited suggests that parts of the Australian equity market represent a growth opportunity, it also exposed how inefficient the Australian capital market has become. In this context, efficiency is not measured by price movement or price performance; rather it is measured by the ability, capacity or willingness of Australian capital to invest in or fund Australian business growth. In other words, the capacity of Australian capital to be patient and focused on the long term. When large Australian companies structure capital raising deals with offshore entities on favourable terms to the other party, then questions are raised.
Buffett’s investment in IAG created memories of his outstanding investments in Goldman Sachs and GE at the height of the GFC. Back then, he structured capital by way of high yielding redeemable, convertible notes with attaching warrants that ensured him a minimum return of 10% per annum. He did not cap his upside; indeed, it was magnified by the attached warrants. His downside was protected by redemption rights and so the investments had the best of everything.
While the IAG investment may not be as good as his GFC deals, it is worth noting that his investment in IAG was not done at a time of crisis. Despite this, it looks a remarkably good deal for Berkshire Hathaway and a fairly average one for IAG. While it did raise capital for IAG, it also created the presumptions that IAG needed to supplement its capital, stabilise its underwriting risk and take the volatility out of its returns. IAG needed support and Buffett was there to provide it. That poses this question – Why didn’t or couldn’t the Australian capital markets, with our abundant availability of long term capital, supply the capital that IAG needed? Further, given that Buffett’s great cash investment cow is the free float and cash generated by his insurance arm, then why hasn’t IAG been able to do the same?
Buffett took a direct 3.5% stake in IAG by way of subscription of a $500 million equity investment which secured the rights to 20% of IAG’s underwriting business. In doing so, Buffett secured entitlements as a minority shareholder that no other shareholder is entitled to. That is clever, because it elevated Buffett above all other IAG shareholders in terms of potential returns. However, there will be a cost to other IAG shareholders through dilution, and it is hard to see how they will improve their potential returns by doing this deal.
In the course of time, the relative benefits of the transaction will become transparent, but we doubt that Buffett will increase his stake in IAG except in exceptional circumstances. Outside his portfolio investments, Buffett is opportunistic. He wields the power given to him by his company investment structure (Berkshire Hathaway has a market capitalisation of US$350 billion) that ensures that he has permanent or non-withdrawable capital. This allows Berkshire to offer stable capital to its investee companies and they have it so long as they can generate a satisfactory return on that capital. A further benefit is that Berkshire shareholders do not seek dividends and so Berkshire benefits from the power of compounding returns and its capital continues to balloon.
This leads to an important observation. The media coverage of the Buffett/IAG deal made much of an interview where Buffett intimated that in time he may make a few more investments in Australia to access the growth opportunities in Asia. That is a sensible portfolio strategy, but we think the opportunities are limited and simply don’t rate when compared to direct investments in Asia, or investing via the powerful US multinationals. Further, if Buffett makes a large strategic investment, he will do so on terms highly favourable to himself. For instance, we doubt that he would strategically invest in Australian banks in normal times, but he certainly would be attracted to them if Australia lurched into recession and bank equity was offered at significant discounts.
We suspect that Buffett will construct some portfolio investments in Australia utilising the free float granted to him by the IAG deal. That will be normal risk management and we expect he will pick the eyes out of the limited growth opportunities that Australia currently offers.
Berkshire is akin to a US Future Fund, but it has no defined liabilities to meet. Its beneficiaries (shareholders) can come and go as they please. The investment methodology is value based with no concern for indexes and a clear focus on long term returns. Today, Berkshire has over $50 billion of liquidity as it scans the world for opportunities, but it retains the bulk of its capital invested in US companies. Its investment in IAG makes business sense, investment sense and is opportunistic. Unfortunately, Australian capital is not as mobile or clever as Buffett and too often it defaults to a lazy strategy.
A Super time-bomb
The Buffett/IAG transaction may give the impression that Australia is short of capital. That is far from the truth; the chart below shows just how much investible capital the Australian household sector has.
Figure 1. Household Wealth and Liabilities
Sources. ABS; RBA
Australia’s annual household income (wages, rents, investment income, etc) approximates $1 trillion per annum, and from this we can glean the following observations as at December 2014.
First, Australian mortgage debt is approximately $1.6 trillion. As a sector, this household debt is levered against $5 trillion in dwellings. This leverage looks low in total, but it is noteworthy that 60% of house owners do not have a mortgage. Leverage is high for those with mortgages and these young households do not have much investable capital or savings.
Second, the total financial assets of Australian households are estimated at about $3.5 trillion. Of this, some $2 trillion is in super, with the remaining $1.5 trillion outside super. Frankly, this non- super financial asset class is likely to be seriously understated. Individuals and private companies commonly understate the true value of their investable assets as a means of minimising tax. We guess that the understatement could be hundreds of billions of dollars, with a large portion in property held at historic cost.
Third, the value of Australian residential assets now exceeds $5 trillion. The recent surge in Sydney property values (up 13.1% over the last year) supports this contention as does the announcement of a spike in stamp duty receipts by the NSW Government.
Finally, this leads to the observation that the net worth of Australian households is lifting towards $ 7 trillion. This net wealth appears to be split 50% in residential property, 30% in Superannuation, and 20% in non-super property, equity-type investments and personal assets.
The above leads us to the conclusion that Australia does not have a serious government debt problem if measured against the capacity to internally fund it. Indeed, there is no shortage of household capital that could be utilised by the government to restructure its debt or fund government-sponsored investment initiatives. Total Commonwealth and State debt is $500 billion. About $100 billion of this is held by Australian banks on their capital accounts. The other $400 billion represents a mere 20% of super assets, or just 10% of household financial assets.
Remarkably, despite an ageing population, Australian households hold less than $50 billion of Australian government debt. This is probably because Governments do not make it easy or attractive for households to invest in bonds. The great bulk of our bonds are held by non-residents; Australian governments pay approximately $10 billion per annum in interest to foreign entities, when we clearly do not need to. If Australia properly integrated bonds into the financial system and offered tax incentives or government-backed annuities, then the true benefits of a burgeoning super asset sector could be achieved. The current account could quickly be balanced and interest payments recycled through the Australian economy.
The following chart plots the expected growth in total super assets for the next few decades. In 2020, Australia is expected to have $3 trillion in super assets of which about $400 billion will be in pension mode. By 2020, SMSF assets are expected to approximate $1 trillion. What is unknown is the future size of the Australian equity market, although it appears safe to assume that the equity market will not grow as fast as Superannuation assets.
Figure 2. Australia’s projected superannuation assets, 2012 – 2033
Source. Deloitte Actuaries & Consultants
Therefore, we can anticipate problems for the management of superannuation assets in Australia. The asset classes available domestically are unlikely to be big enough to cope with the investment flows. Importantly, this observation is focused upon super and ignores non-super financial investments. The investment problem is therefore bigger than many suspect.
There is a national and social imperative to build a savings regime to support public pensions and create an element of self-funded retirement. However, the success of this scheme will not be measured by its mere size. Its success will be driven by the investment of these funds into growing local businesses, national commonwealth projects, social infrastructure and international growth opportunities with a focus on our high-growth region and major trading partners.
The problem that is fast emerging is this: private and public enterprise is not creating enough investment opportunity to deploy the available and growing capital flows. The excess capital is actually causing a depletion in returns, and this is evident in the Australian equity market where the price index now sits below its level of eight years ago.
In response, the “default” option for major superannuation funds is the increasing use of indexing. Super funds are invested based on the size of the company and with no Buffett-style requirement for returns. Concurrently, the big index funds moderately enhance their poor long term index returns by reducing their management fees through lending stock. The generation of stock lending fees, and precisely who is involved in Australia, remains a great mystery. However, in an article this week (where Clime was featured), the AFR’s Chanticleer noted that the Australian equity market was possibly the most easily shorted market in the world. The ability to access stock to short was described as easy by a large local hedge fund.
So where does this stock come from? Overseas and local index fund managers. Have Australian fund managers sought approval from their clients and beneficiaries to lend their stock? Certainly not openly; perhaps it is in the small print of their contracts.
Where does this lead investors?
There seems reason to expect that the mediocre returns and excessive volatility of Australian equities will continue. The growth in indexing and hedge funds will ensure this. Today, the Australian economy and our equity market is confronted with an overvalued currency and corporate mediocrity created by 24 years of continuous economic growth. Earnings growth expectations for the Australian market in 2015/16 are slumping towards low single digits and it has been there for the last 6 years.
In the longer term, as Australian super assets balloon at a faster rate than the Australian economy, there will be massive allocation of funds offshore. This will be measured in the hundreds of billions of dollars. Australia’s Future Fund has already allocated over 50% of its assets offshore and they are a bellwether of the future.
Self-directed and self-managed super funds should beware the above trends and issues. The allocation to offshore assets needs to be reviewed, and in most cases, increased, with the re-allocation back to Australia only when it has properly adjusted its economy, devalued its currency and devised a growth strategy.
Clearly we cannot invest like Warren Buffett, he is one of a kind. But we can learn from him. Australian investors will need to be patient, ignore the index and be willing to deploy capital where the best opportunities lie – and those opportunities may well be far from home.
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