In September 2015, Howard Marks wrote a memo entitled, ‘It’s Not Easy’, a reflection on Charlie Munger’s famous aphorism about investing, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” The memo reflected upon the requirement for second level thinking in order to be a successful investor.
“The first-level thinker simply looks for the highest-quality company, the best product, the fastest earnings growth, or the lowest p/e ratio. He’s ignorant of the very existence of a second level at which to think, and of the need to pursue it.”
Given the substantial aggregate IQ devoted to identifying value in the market, most opportunities are seized upon quickly and priced such that the prospect is eliminated. Anyone who believes investing with consistent success is easy can miss “substantial nuance and complexity”.
Good investing is not only about good IQs
However, I believe successful investing is not merely a race to the prize between the highest IQ’s. Indeed Charlie Munger’s business partner, Warren Buffett, stated investing is not a game where the highest IQ wins.
Many extremely bright people require hard evidence, quantitative proof if you will, before making a decision. They argue that anything less is a guess. Sadly for this line of reasoning, the speed of repricing is so rapid in financial markets that waiting for the robin to sing renders spring over.
This is where second level thinking comes in. As Howard Marks wrote: “You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently.”
This article is about how Howard Marks’s memo topic might be applied to today’s equity markets.
Second level thinking in today’s market
Consider for a moment the widely-held view that banks are the place to invest. Since 29 February 2016 to the time of writing, CBA has risen 17%, NAB 26%, ANZ 34% and Westpac 12%, driving much of the gains in the S&P/ASX200 over the last year.
Late 2016 one analyst wrote: “The last Aussie banks results season once again confirmed no collapse in the housing market, no rampant rise of bad debts, resilient NIM’s and no cuts in dividends or imminent capital raises to rebut the bear thesis coupled with attractive valuations and double digit ROE’s.”
What about that second level thinking? Does a rear view mirror – that which has already occurred – aid in the navigation of what lies ahead?
Knowing that humans suffer from representativeness – a belief that the past is a good sample to use to identify what the future holds – is it any surprise that we are notoriously bad at predicting turning points?
Given that bank updates are at best a distillation of the last three months, what can they offer about turning points other than that they have passed?
As Howard Marks observed, first level thinking says, “It’s a good company; let’s buy the stock.” Second level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
Bank share pricing is factoring in a scenario that does not have a high chance of transpiring, and while there is little hard evidence today that the banks are suffering from any headwinds, any sailor knows the ripples and wind lines on the water are a better sign of what’s to come.
Australia’s mortgage debt and household debt-to-GDP ratios are the highest in the world, and with credit card debt also at a record, consumers – who are also leveraged apartment investors – can least afford increases in their mortgage interest rates now.
And yet the prospect of imminently higher mortgage rates is real. The correlation between 3 year bonds and mortgage rates is high and while Australian 3 year AA-rated corporate bond yields have been declining since 2012, they have been rising recently. Mortgage rates are showing early signs of rising.
Of course, as long as highly-geared investors keep their jobs, they can attempt to raise rents and offset any increase in interest rates on their mortgages. Sadly, rents are unlikely to go anywhere but down. Last year in Cuffelinks, I described the situation for landlords in Brisbane:
“For the nine months to September 2016, just over 5200 apartments were completed within 5 kilometres of the Brisbane CBD. During the same period of time, owners of apartments 5 to 15 kilometres from the CBD experienced a doubling of vacancy rates from 2.3% to 4.7%. So think about that: just 5200 apartments caused a doubling of vacancy rates. What might happen when the 13,000 apartments currently under construction and due for completion in the next 14 months hit the market?”
The yield on an apartment with no tenant is zero so landlords will compete by offering lower rents. Any landlord that doesn’t follow suit will lose their yield too. The outlook for many leveraged apartment investors will be lower yields. Investor appetite for apartments will be turned on its head in due course, putting further pressure on credit growth for banks.
Short-term problems will hit banks
Bank earnings over recent years have also been aided by the writing back of provisions for bad and doubtful debts. These provisions will need to be rebuilt and just in time for a peak in the property market. The October 2016 apartment approvals dropped by 23% and given approvals lead to commencements, commencements to construction and construction to completion, a drop in approvals today will mean lower construction activity and associated employment soon.
Much of the above, along with record credit card debt, and APRA’s requirement that the banks increase their Common Tier 1 equity and reduce their mortgage risk weighting ratios, will conspire to render the banks’ collective prospects less attractive than in the past.
I am not talking about the prospects for the next two decades, which are terrific given the Australian population will almost double, ensuring the banks will be much more valuable. I am looking at the next few years.
Using consensus forecast numbers for 2016, we believe current bank share prices are factoring in 4.5-5.5% EPS growth into perpetuity from FY18 assuming the marginal ROE is in line with the ROTE generated in FY16 (with adjustments for ANZ and NAB to reflect a shift in mix away from Asia and divestments respectively). So even if we adopt a benign regulatory outlook and no need to increase capital intensity from current levels, the banks need to grow earnings in line with nominal GDP growth into perpetuity to be fair value.
The recent share price performance of banks reflects first level thinking about their aggregate business performance to date. Second level thinking considers the cyclical headwinds to the loan book growth, non-interest income growth, the lower than mid-cycle level of bad and doubtful debt provisions that need to be extrapolated into perpetuity.
If successful investing requires second level thinking, then successful investing may also require caution towards the dominant position of banks in an investor’s portfolio.
Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is general information and does not consider the circumstances of any individual.