Now is the time for investors to stray from the herd

I wrote the following paragraphs in an article the Sydney Morning Herald published in October 2013, under the headline Chinese investors say g’day:

“On a recent Sunday, a Honolulu matron answered the door of her stately home to find three Japanese businessmen who offered her $300,000 for it on the spot; they wanted it as a vacation centre for their Hiroshima workers. When she refused, the group’s spokesman replied: ‘Ah, I understand. The $300,000 was merely for the house. The grounds we can discuss later.’ Similar, if less startling, offers are being made all over Hawaii these days, as Japanese businessmen step up their efforts to buy control of hotels, shops, travel agencies, land and private estates.”

This was the opening paragraph of an article published in Time magazine on July 2, 1973 with the headline “Business: The Japanese Invade Hawaii”. Despite this situation being so remarkable as to warrant an article in Time, this was only the beginning of a massive influx of Japanese investment in America’s island state. Low interest rates in Japan and a weaker US dollar had virtually halved the price of buying US real estate for Japanese investors.

But the Hawaiian property bubble popped in 1990 and by 1995 the Los Angeles Times had reported that Japanese investors had lost as much as $US6 billion as a result, with average prices in Kahala dropping 38 per cent in five years.

Early warning

The idea of the article was to warn about the similarities between Australia’s property market and the Hawaiian property market decades before.

Since then, the Chinese have only ramped up their buying of Australian property. The story of the Japanese impact on Hawaii during an unprecedented period of prosperity looks eerily like China’s impact on Australia today. It’s not just Australian property that’s coveted, however, but our resources, resources companies and technology.

Our reliance on economic growth and stability in China is worrying when considered against our mortgage debt levels. While some worry about the eventual impact of less Chinese interest in our property market, I’m more concerned about locals paying current prices without potentially being able to afford principal repayments.

Foreign buyers are helping set the marginal price for property. While they may be able to afford higher prices, many local buyers are stretching too far to keep up.

If prices were to stop rising, or worse, start falling, investors with interest-only loans are hardly going to keep properties that cost them money. Given rental yields are now about 3 per cent before large costs, such as strata fees for apartments, it wouldn’t take much for highly leveraged property investors to rush the exits.

If I said you should buy a stock trading on 31 times earnings, offering a taxable 2.5 per cent dividend yield with little to no growth, and you had to buy it using borrowed money for, say, 50-80 per cent of the purchase price, you’d wonder how I ever got a job in funds management. But without ongoing capital gains, which must stop eventually, given they requires ever higher debt levels, this is what many Australians are prepared to invest their life savings in for an all-or-nothing bet on housing.

Capitalising on China

Rather than compete with Chinese buyers for property in Australia, we’re invested in a couple of Chinese internet stocks that are part of a small group of businesses that look set to dominate their respective industries for decades to come.

JD.com is like the Amazon of China, where its delivery times are usually measured in hours, not several days like its major rival Alibaba. It’s also serious about eliminating fake goods being sold on its websites, which is a big issue for Alibaba. Buying items from JD.com is not only quicker, but comes with more trust.

We also own Baidu, which is the Google of China after Google was effectively shut down in the country many years ago. Baidu’s growth has come to a standstill recently, following a regulatory clamp down on medical services advertising, after a university student died following receiving experimental treatment that he discovered from an advertisement on one of Baidu’s websites. More stringent vetting of advertisers should produce a more sustainable business, despite the short-term impact on profits. Paying a price-to-earnings multiple of 12 times, based on depressed earnings, also provides a large margin of safety.

Quoting recently from the Australian Financial Review, “Far to the west of Sydney’s glittering harbour, construction cranes are rising up in the once-downtrodden suburb of Auburn, an emblem of Australia’s housing boom. Citibank recently named the area among those most in danger of a supply glut, with rents already falling or stagnating in [such] places, a possible precursor to a fall.

“ ‘Inquiries are still strong, though perhaps not quite as hot as a year ago, when I thought I’d need a ticket-line counter for people coming in. Look at the expensive cars around – the money is there,’ ” said real-estate broker Themy Panagiotidis.

It bears mentioning that 90 per cent of cars sold in Australia reportedly attract some form of finance. While asset values can swing wildly, debt usually remains solid as a rock.

It was 15 years before the Hawaiian property market crashed following the initial article in Time magazine. While it’s impossible to time swings in sentiment consistently, now seems a sensible time to reduce debt and look for value in unpopular spots, rather than paying huge premiums for what’s most popular. As contrarian investor Jim Rogers put it more succinctly, “Nearly every time I have strayed from the herd, I’ve made a lot of money.”

By Nathan Bell, Head of Research at Peters MacGregor Capital Management.

Disclosure: Peters MacGregor Capital Management Limited holds a financial interest in Baidu and JD.com through various mandates where it acts as investment manager.