This guest post discussing Value Investing in Australia was submitted by The Broken Leg Investment Letter subscriber Xavier Hill. The thoughts and opinions expressed here are those of the author and may not reflect those of anybody else at Broken Leg Investing. Article image (Creative Commons) by vagawi, edited by Broken Leg Investing.
Nearly all value-oriented investors know that the finance industry is riddled with scams and hidden fees that are collected, whatever the investment’s performance. However, a little-known provision in the Australian Constitution has recently been exploited, causing a full-blown Royal Commission to investigate Australia’s finance industry. How bad can the situation be? Well, however bad you thought it was – it is worse.
For nearly a decade, various commentators and politicians in Australia have been calling for a Royal Commission into Australia’s finance and banking sector. These calls have always been suppressed, thanks to the enormous power that the sector wields within the Australian economy. Financials make up an incredible 46% of the Australian Securities Exchange (ASX), which makes it very hard for value investing in Australia as there are so few deep value businesses on the ASX. It also means that financials dominate the Australian economy allowing it to hide all manner of scams that no one wanted to lay bare.
As the scandals began to mount, the calls became louder, to the point that a significant minority of Australia’s parliament wanted a Royal Commission to look into the sector. This minority could never mount the numbers for it to pass Parliament – until a little-known section in the Australian constitution, which requires any member of Parliament to not be, or be eligible to be, a citizen of another country was exploited.
An eccentric lawyer in Perth had been campaigning for this matter to be heard by the Australian High Court, and when it was, it turned out that his interpretation of the Australian Constitution was correct. All of a sudden, Australia’s parliament was thrown into chaos as MP after MP was forced out and a bi-election for their seats held. This threw the balance of power in the Parliament and allowed the minority to pass a Royal Commission – the highest commission of inquiry available – into Australia’s finance sector.
Laughing at the Regulator Leads to Opportunities for Value Investing in Australia
Like most Western nations, Australia has seen its fair share of corporate scandals (for instance, Google “storm financial”) that saw unsuspecting retail investors lose their life savings. These scandals open up opportunities for value investing in Australia by depressing prices shotgun-style, offering substantial returns for the smart investor.
Australia has a unique banking system that allows the four major banks in the country (Commonwealth, Westpac, NAB and ANZ) to operate as a near oligopoly. By law, none of the banks can merge with another, yet their size makes it difficult for smaller regional banks to compete. Their size also means they are too big to fail, and their loan book is underwritten by the Australian government, which reduces their lending costs.
The banks’ ubiquitousness meant that from the late ’90s, it made sense for them to expand their offerings from not just banking but also into financial planning, insurance, and developing financial products for their massive retail customer base. As the banking sector grew not just in size but also in the scope of the services they offered, the financial regulator ASIC (Australian Securities and Investment Commission) failed to keep up.
Now, the revelations out of this royal commission have been explosive:
- Banks employed financial advisors charging people 10 years after they had died.
- Countless mortgage brokers falsifying documents to restate a person’s income and living expenses.
- Banks pushing people into high-risk, high-fee products without their consent.
- Commonwealth Bank – Australia’s largest bank – laundered money for terrorist groups.
- Commonwealth Bank also charged $118 million to customers for services it never provided.
- An introduction scheme whereby borrowers were given a discount if they referred another person seeking to borrow money to the bank.
Despite all these revelations, perhaps the most telling moment was when an executive from AMP, a large Australian financial services company, was interrogated on the witness stand and confronted with the number of times AMP had lied to the ASIC. As the QC (Queen’s Counsel – the head prosecuting lawyer, if you like) ran through the breaches, he got to 17 times AMP had lied. At this point, the AMP executive laughed and said it was actually 18.
This was a telling moment because it goes to the heart of what the finance industry thinks not just of its customers, but of the toothless regulator. Despite fraud on a grand scale, they can still afford to laugh, because the money is all other people’s. It is not theirs, they never earned it, they do a poor job managing it, and they believe they are immune from prosecution due to the size of their organizations. AMP executives, as well as other shady financiers, are likely to face criminal charges as a result of the Royal Commission’s findings, but while I remain skeptical of that result, I do believe this creates opportunities for value investing in Australia to grow.
The Fallout and How It Affects Value Investing in Australia
The royal commission is still ongoing, but already the inquiry is impacting banks and home real estate borrowers as banks tighten their lending requirements. As for AMP …
AMP Share Price (Source: AMP Class Action)
Buying financials that are too close to government, are reliant on convincing retail clients to pay fees for poor service and have opaque loan books are where deep value investors generally stay clear. The fallout of the royal commission means Australian financials will be cheaper and under more scrutiny than ever before.
Deep Value Investing in Australia Is More important Than Ever
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”
– Warren Buffett
Trust is so difficult to find in the financial world that the only person you can really trust is yourself. I am sure regulators are good people doing their best, but it is very difficult for the regulator to prosecute powerful financial institutions. Litigation is an expensive and time-consuming process. With the Royal Commission uncovering scandals in the Australian banking industry, now is the time to switch from blind faith to deep value investing in Australia.
Deep value investing means taking advantage of crisis rather than falling victim to it (or to mass euphoria which then collapses). It is far better that the retail investor be the judge of what investments are fraudulent, as the regulator is the last to find out. If you invest according to deep value principles, you are buying businesses with strong fundamentals, and if you do it through a cheap and reliable brokerage service, then your fees are low. It means you completely avoid any of the scams the banking industry has waiting for you. Of course, the company you buy could itself still be committing fraud; however, thanks to the helpful brokenleginvesting.com you are amongst the best placed to avoid them.
Housing the Root of the Problem — Value Investing in Australia Is the Solution
“When you combine ignorance and leverage, you get some pretty interesting results.”
– Warren Buffett
What is clear is that at the core of the skulduggery within the Australian financial system and the 2008 and 2009 crisis is real estate. Real estate is the most unique of markets. It sees mostly ignorant people leverage heavily with money lent to them by an often-ignorant mortgage broker to buy an asset from a real estate agent who themselves is often uneducated. The real estate industry is like an extreme version of Buffett’s quote.
Of course, Australia is known as a land of extremes, so naturally Australia has by far the highest ratio of household debt to GDP in the Anglosphere, as you can see below:
Figure 2 - Household debt to GDP across the anglosphere (Source: www.macrobusiness.com.au)
The above chart should be scary to anyone with exposure to Australian banks or real estate. It proves what the commentators like to euphemistically describe as Australia’s “relaxed” lending standards.
This chart is what makes the Royal Commission so scary for the Australian economy. In an effort to root out fraud, lending standards tighten, credit tightens, housing prices drop, and financials – which is the biggest sector of the Australian economy – suffer. This makes now an ideal time for deep value investing in Australia by avoiding overpriced investments and seeking safety in conservatively financed stocks trading well below fair value. Of course, the resulting bank stock crisis form the Royal Commission will help smart investors find great stocks in due course.
The Royal Commission is revealing the symbiotic relationship between banks and their financial planning business. Often, a bank’s financial planners encourage their victims – I mean, clients – to leverage through their bank-issued mortgage and invest in housing. A condition of the mortgage many times will be that the client needs to take out life and income insurance, which the bank too conveniently sells. Because of the Royal Commission, calls for banks to sell off this section of their business continue to grow, and it’s widely predicted that the banks will have to heed these calls sooner rather than later.
I have long avoided buying a house, though recently I was forced to as the lease agreement ran out on my old house. There were no decent rentals, so I had to buy – but I paid cash, and I am going into it with open eyes. I have long been the odd one out at barbeques and dinner parties, where everyone talks about real estate and how you can add $100K to your house by renovating a bathroom. Never will I forget being told by a friend in finance how irresponsible I was being for not buying a house. He said, “Xavier, the demand for real estate is infinite because everyone has to live somewhere.” This may or may not be true, but what I definitely know is that the price of real estate is totally reliant on credit and that credit is finite. I also know the housing market is teaming with more ignorance and more leverage than the stock market.
I have been out of sync with my friends on the state of Australian housing since I was at school nearly 20 years ago. Back then, I could not figure out why, but it just seemed way overpriced. Deep value investing has helped me understand how mispriced and how dependent on ignorance the Australian real estate market is. I also suspected widespread fraud and poor regulation, yet I never knew it would be so bad that Australian financial institutions were prepared to laugh at the regulator in open court.
Deep value investing in Australia has allowed me to avoid this impending disaster. For nearly 20 years, rather than plowing money into paying interest on my mortgage (a word which, incidentally, includes as its route “morte” ...death), I’ve been buying dirt cheap stocks and stacking up a fortune. It’s allowed me to just hand over a stack of cash when I was finally forced into home ownership last year. How many financially-strapped home-owning Aussies can say that? Value investing in Australia has, ironically, allowed me to sleep easy, just like an ignorant leveraged Aussie homeowner.
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