Housing corrections & shares

We talk a lot on MacroBusiness about an Australian housing bubble.  H&H, UE and DE are doing a sterling job of demonstrating Australian house prices are historically high by any meaningful measure.  Plenty of people – in fact most in the mainstream media and real estate industry – disagree with them, some vehemently so.

But this won’t be another blog about house prices (no truly, it won’t).  Nor is it a prediction. Rather, I want to discuss what  would happen to Australian equities if the eventuality of a correction and how you might best profit from it .

Given the recent MB debate on what constitutes a crash or correction, I’ll set the scene for this article by defining it in similar terms to the US correction between 2006 and 2009 of 11% per year for 3 years.

The Impact
The macroeconomic impact of a housing correction would be big.  The big 4 banks (CBA, Westpac, ANZ and NAB) have large volumes of mortgages on their books – CBA and Westpac account for just over half of the Australia’s mortgages.  Falling house prices would mean a drop in their capital bases (see Steve Keen’s exhaustive article here for more info) and as such a drop in the amount they can lend.  Overseas credit would most likely become more expensive too as international debt markets increase their risk premiums for Australia, however the supply itself would likely reduce as institutions lowered their exposure.  So whilst the RBA would drop interest rates, credit could remain expensive or be rationed as our banks find it more difficult to borrow offshore.

The resulting writedowns in bad debt and lack of mortgage lending would hurt the share prices of the Big 4 banks, which would see sharp falls in the major indices as the banks make up such a large proportion of the Australian market – 24% of the ASX200 and 20% of the entire equities market.  

A combination of reduced lending and low confidence would be felt strongly in retail spending, especially on discretionary items.  Even the non-discretionary parts of the economy (e.g. health, basic food stuffs) would be impacted as people tighten their belts.  The savings plans of the baby boomers would take a serious hit – not only because of dropping house prices but the subsequent losses to their superannuation portfolios.

Outside of the share market, federal and state government revenue would plunge with company profits and stamp duty and land taxes take a haircut. Conversely, welfare spending would rise as unemployment grew.

However, the pain would not be evenly spread in share market.  Some companies will be figuratively killed off, some will suffer badly and others will bear the brunt only to come out stronger due to reduced competition and improved cost efficiencies.

Which Companies will be In Trouble?
Obviously the banks would be in trouble as discussed above – CBA, ANZ, WBC, NAB, Suncorp, Bank of Qld, Bendigo, Rock Building Society and Wide Bay Australia would all be affected.  In the case of CBA, holding 26% of the nation’s mortgages during a housing downturn will have big impacts on capital ratios.  In fact at Empire Investing, we’ve already relegated the big 4 banks to non-investment grade.

Property developers and builders (those still left after the GFC) would be in big trouble as projects stop, houses and units go un-purchased, revenues dry up and asset values plummet.  This will impact the likes of Centro, Fleetwood, Mirvac, Stocklands, Sunland and any Real Estate Investment Trust (REIT).  Building supply companies would also see demand drop as projects dry up and people stop renovating houses that banks are foreclosing on – think Reece, James Hardie and the Bunnings side of Wesfarmers.

Most Australian consumers will reduce spending on anything that isn’t essential. Eating out, clothes and fashion, holidays, furniture, electronics, home renovations, home repairs, car services – pretty much anything not inside your food pantry or fridge.  Companies like Myer, David Jones, Oroton, Pacific Brands, Harvey Norman and JB HiFi will find conditions very difficult.

On the commercial front, Seek will feel the pressure of increasing unemployment as employers stop hiring and their Australian revenues diminish, though it would get some protection from ongoing expansion in the resource-associated industries.

Aside from the sectoral damage, any company with very low return on equity (i.e. marginal businesses) and/or high debt will be at risk of going under.  There may be a few rock-bottom capital raisings and share purchase plans to save the under-performers.  However, the new capital will just follow the old – from the investors pocket into the hands of the creditors and administrators.

Who’s (Relatively) Immune?
In a world where house prices drop but China still hoovers up our raw materials, the resources sector will likely sail on.  In fact, current operations will do even better as the AUD drops against the USD (in response to the RBA lowering rates amid the macroeconomic chaos), making commodities priced in USD more lucrative.  Engineering service companies tied to mining will also be OK, including Sedgman, Leighton’s, Monadelphous and Worley Parsons.

Non-discretionary stocks should fare well (at least compared to the rest of the market).  Healthcare stocks with high ROE and good products will do well – especially those with large offshore revenues that would benefit from the lower AUD.  Cochlear, Celestis and CSL would fall into this category.

Basic food stuff suppliers would remain solid (even the jobless need to eat) so Woolworths should remain a safe harbour.  Coca-Cola Amatil would be safe, despite moderate debt levels, offset by increasing revenue from Asia and a timeless, tasty product. These two companies also have great return on equity (ROE) and dominant market positions – bulwarks that will be required during a house crash tsunami.  In our opinion Wesfarmers (owner of Coles) would take a hit owing to its Bunnings arm.

On the fast food front, Dominos should fare well because its product (pizza) is well liked and a very cheap way to feed a family.  As Michelin Hat restaurants and funky cafes go out of business, Dominoes, Pizza Hut and MacDonald’s will be the beneficiaries of a new culinary frugality.

One final refuge may be those companies that profit from tough economic times.  Cash Converters would see a big upswing in business as people resort to hocking possessions to pay the bills.  In a similar light, FSA Group, the largest debt consolidation and personal bankruptcy firm in the country, may also see an upswing in debt arrangements as people and businesses go to the wall (although FSA’s sub-prime loan division would likely suffer).  Failing that, convincing your local loan shark to list publically may also be a good play.

Where would the opportunities be?
Enough of the doom and gloom – where are the silver linings? What can we do to insulate ourselves, or even profit from, a housing correction?

Well, that will be subject of tomorrow’s article.  So stay tuned..

Until then, I’d like to hear your views on what a decent housing correction would do to Australian listed shares.

Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has interests in some of the businesses discussed in this article.  The article is not to be taken as investment advice and the views expressed are opinions only.  Readers should seek advice from someone who claims to be qualified before allocating capital in any investment.

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  1. i also think ORG would be a nice safe harbour. it may suffer in short term if housing bubble/QE 2 commodity inflation falls but its amazing business with scale, deep cash and hard assets and significant economic moat. people still need utilities too. my portfolio is heavily weighted toward ORG and WOW.

    • I’d agree on the need for utilities even during a downturn Leon, but none of the listed utilities companies produce the ROEs we look for.

      ORG has averaged about 6% over the last 4 years whilst their net debt levels are pretty high at $2.9B (vs FY10 NPAT of $0.6B).

      We’d only invest if it traded at a very, very significant discount to value (i.e. well south of $10).

  2. Great article. This is a world-wide phenomenon. Let’s not forget the world-wide derivatives market which some estimate to be around 1.4 quadrillion dollars.

    The Australian banking system has an estimated 14 trillion dollar exposure to this market and this calculates to over $670,000 per person in Australia!

  3. “H&H, UE and DE are doing a sterling job of demonstrating Australian house prices are historically high by any meaningful measure.”

    They have done no such thing. The very best and most meaningful measure of housing affordability is one which measures the cost of repayments for a leveraged buyer compared to their income. That current measure is NOT historically high. It was much higher in the years around 1989 and 2007.

    • Howdy Sarah. I know you disagree with the bubble thesis, but the aim of my article is to discuss the impact a hypothetical housing correction would have on Australian shares.

      Let’s leave the bubble/no bubble debate for articles on housing.

      • Q

        don’t know if you and the other bloggers are familiar with LVRG group.


        They have another interesting measure when it comes to housing. They argue that if turnover(sales) in any given year is greater than 19% it means there is a bubble in housing. According to them $327 billion of Australian property changed hands in 2010, roughly 25% of GDP. They argue when turnover returns below 19% recession follows withing two years.

        They argue 29.1% or $805 billion of gains from 1999-2010 are in a bubble and need to be deleveraged. They argue a drop in turnover will set the conditions for Australia’s first recession in two decades.

        —-> It will be interesting to see what % turnover figure they will have for 2011.

    • “cost of repayments for a leveraged buyer compared to their income.”

      If housing falls just a modest 3% pa for a few years leveraged buyers would be brought to their knees Sarah. Rent cannot go much higher than it already is and it would need to go into the stratosphere for leveraged buyers just to break even in a market environment where you have a few years of negative growth.

    • Sarah

      ‘The very best and most meaningful measure of housing affordability is one which measures the cost of repayments for a leveraged buyer compared to their income’

      No, you have been misinformed.

      Repayments are not the best measure, you are confusing stocks with flows.

      A person has around 35-40 years of meaningful income producing years.

      The difference between allocating 7 years income to the purchase of a house (including interest), to 14+ years income to the purchase of a houses is the real cost to an individual.

      The disparity ultimately ends up in the withdrawal of spending in other areas of the economy, be these services or productive enterprises.

      The stock is the price.

      The flow is the ratio of price to income (cost / years), this is a first derivative. (d.x / d.t)

      The rate of flow is the interest rate (d^2.x / d.t^2), this is a second derivative, near meaningless except in snapshot analysis.

      Expressed would be two loans;

      i) 100% of my income with 10% interest rates
      ii) 10% of my income with 100% interest rates.

      In both scenarios 10% of my income is my interest obligation.

      However once this interest obligation is met, the real cost is borne.

      In the first scenario, the cost of acquisition is still over one years of my remaining income.

      In the second scenario, the cost of acquisition is 1.3 months income.

      Second derivatives used to express cost are meaningless.

    • Houses are VERY expensive, historically and otherwise. Don’t tell me 2 incomes for 30 years to pay off a crappy house in the ‘burbs is cheaper than 1989 when my parents bought our 3br house in S.E Melbourne – it cost $140k (expensive by those days standards in that area), and SINGLE incomes were about $30k.

      Today we’re buying $500k houses with SINGLE incomes of ~$55k.

      Its WAY WAY over priced, and if you don’t admit to this, then go back to selling your realestate. It will bite you in the arse one day soon.

  4. Thanks QCE

    My thinking is it is also worthwhile to look at the shareholdings. In saying this I am probably looking at companies that are below the radar as far as Empire is concerned.
    I’ve invested in a couple of resource companies that have a very ‘scattered’ shareholding with no major institutional investors. As such the shareholders are M&D’s. I’m guessing, in the circumstances outlined such shares will take a heavy hit even though they may produce good results.

    • Hi Flawse

      Interesting comment on the M&D holders. When it comes to shareholdings we like to see the management of the company with large shareholdings – produces the right kinds of incentives when the people at the top lose their shirt if the company goes bust.

  5. Q. i agree, on your ORG valuation. fair value is around 9-10 bucks as you say putting their P/E around 12 or so. much more reasonable. but this price could occur as housing bubble unfolds and depresses the index.

  6. I presume everyone on here has read “The Big Short”.

    It’s not necessarily money for jam – the market can stay irrational longer than you can stay solvent.

    Pity the hedge fund operators in the USA who cut their losses and bailed out after shorting the market for 12 months or more; and ONE WEEK LATER Lehman Bros folded up……

    • Phil, all four banks are on a tear at the moment, with the consensus crowd pushing for how cheap they are and how record net profits are about to be posted again (I too am long the banks in my trading account)

      Great time to set up a “big short” if you dare….

      • Perhaps…perhaps…perhaps…

        ASX is going to 100 lot puts in May, which is interesting to say the least.

        Hopefully volume and liquidity will increase as our ETO market is not that good in comparison to the US and EU.

        I still am waiting for the property CFD’s but I dont think they will happen anytime soon.

  7. The mortgage insurers (in particular QBE)would probably be in trouble as well. Suprise suprise, Fairfax may also come under pressure, since a large chunk of their revenue growth over the past few years has been real-estate advertising related.

    just a guess.

  8. michael francis

    Gerry Harvey on the radio today. Closing down his megastore at Westfield’s Southland. 2 months ago he shut down his Mentone store, 5 km down the road.
    Business apparently not good in affluent Melbourne.
    Looks like Gerry might have a date with “Chapter 11” as they say in the States.

  9. Mining stock outperformance is predicated on continued China growth. Indications are that China is slowing down. Although M2 in China has grown 16% despite credit cuts, this is likely temporary. Why? Inflation is around 10%. This will force yuan appreciations and cut jobs in export industries.

    Interest rates via trusts to property developers are in the region of 15%. In a falling property price environment, further loans are not sustainable.

    Add stockpiled copper, iron and other base metals to the equation, and we have the perfect storm of falling commodity prices. Believe this is most likely to occur by calendar year end.

    So, there is not likely to be a “safe haven” in equities. Cash would seem a better alternative, at least until bond yields spike.

    Just my two cents.

  10. I have been following this for a while and I think the best way to play it is international assets unhedged. I am in equities currently, but moving to fixed income would make sense soon.

    My thesis is that 1) China has a hiccup 2) Australian economy receives a nasty shock that leads to confidence falling, unemployment rising and 3) bubble deflating and popping which makes the process accelerate. In this scenario I disagree that you want to be in resources. I think you want to be well clear. Also the mining services guys will be hit worse than the miners. I pretty much think the whole ASX market will be very weak as a result because banks and resources are the barbells.

    So my strategy to profit is to be o/s using the high AUD. When my thesis above plays out the AUD will fall hard and fast giving me buying power to swoop. Problem with O/S equities is that the whole global economy is leveraged to China. So fixed income is probably best, or stablish equities like Global Healthcare etc.


  11. Lloydie & Daniel have picked out the rather large elephant I avoided in my post. If the China story stops then I think Australian will be in some deep trouble. In fact it’d be the perfect catalyst for a housing correction. In which case the miners and their engineering suppliers would also take a hit.

  12. It would be wrong to think all property/REITS will be similalry affected. For example Australian Education Trust (AEU)has a current SP of 82c, a genuine NTA of $1.19 and a projected distribution of 8.8cpa.

    Yes, it’s property backed but the revenue stream comes from the owners of busineses (childminding centres @ over 350 of them) who have average leases terms of 10+ years and where the revenue is tied to CPI.

    This is a classic scenario where you cannot judge a business on a ROCE basis, rather it must be viewed on a ROI basis. Check it out.

    • Hi PP

      Right you are – each company/trust will be different, but the general thrust is that REITs would be vulnerable during a property downturn.

      With regards to AEU, we’ll want to see a few years of operations post-ABC Learnings debacle before committing. It’s NTA is only as genuine as the valuations behind the properties. With 4% drops in freehold valuations and 11% drops in leasehold valuations in FY10, combined with a HYFY11 loss of $1.6M, Empire will be staying clear for a while yet.

  13. HI Q

    I was wondering what your thoughts are on a company called m2 communications MTU. I like it has a v.good roe. What do you think of it?

    • Hi Randy

      We had filed MTU under “high intangibles, non-investment grade” since 2009, until your comment prompted me to take another look. On the face of it their intangibles seem to have come down since 2009, debt is low and ROE is very impressive.

      I like their numbers a lot more now, so I’m adding it to our review list. As long as there were no big intangible write downs over the last couple of years (indicating they overpaid for past acquisitions), then it may end up on the Empire Index. The NBN will be a big factor in their risk profile.

      So at first (or second) glance, MTU’s current numbers indicate it’s a good company.

  14. Greetings to you all on the other side of the world!

    I’m glad to read your local views as in my private asset allocation I am kind of heavily biased towards down-under: international Aussie corporate bonds and your excellent mining companies (big ones as investments and small ones as option-substitutes) make a significant part of it. Together with Brazil bonds this is my chance to diversify away from my domestic “sick” currency named EUR. Since I did this some 3 years ago I am quite happy (as a EUR-based investor). Question is of course when to get out. I am worried to see your incredible increase in housing prices (both letting rates and house prices) but it might be justified in a country with a healthy optimism. As long as China and Southeast Asia is catching up with Europe and US in living standard, education and industrial production, Australia will benefit from this trend. However, as a regular visitor in down-under I have noticed over the last 5 years how inflation is diminishing the purchasing-value of my AUD-investments. So 6% on a term-deposit account in one of your 4 big banks looks like a reasonable risk-adjusted alternative – even after the expiration of the state guarantee. So living in your wonderful country (good currency, good yield level for bonds, good mining companies and some good value stocks), into what foreign countries/currencies would Australians diversify?

    Regards from Germany,