M O NTG O M E RY IN V E S T ME NT M A NAGE M E NT

Stocks or Property: Where

to invest next?
Today, many investors in property and stocks face the prospect of inferior returns over the
coming years.

Principally, these are investors who have entered the overheated, over-geared apartment
market, and those whose equity portfolios are dominated by low growth, large cap
companies.

For these investors, there is now a rare opportunity to rotate into smaller, high quality
companies with bright prospects many of which have had their prices knocked down to
very compelling levels.

By Roger Montgomery

STOCK S O R PRO PE RTY: W HER E TO IN VES T N EX T ? PAGE 1

Let me state at the outset that I dont wish to impose any bias
I might have towards equities on anyone else. A quick read
through the list of the BRW Rich 200 List 2016 shows that
millions can be made from buying, subdividing and developing
property. And the rich lists also shows millions can be made from
developing a funds management business specialising in global
funds, index funds or hedge funds.
Most investors however are neither property developers nor fund
managers so this article is for passive equity investors and passive
property investors - those who purchase in the expectation of a
return either from the income their assets produce or from rising
market values or both.
Starting with property, East Coasters who believe property
cannot turn lower should really take a look at what is now being
experienced in Perth, Western Australia, right now.
The downturn in Perth is being described as the worst in 40
years, with 500 people leaving WA each month - according to
Bank-Wests chief economist Alan Langford - and geologists
with 10-years experience driving for Uber. Meanwhile, West
Australias state net debt has grown to $27 billion from $3.6
billion just eight years ago.
Corelogic notes that Perths median house price has fallen slightly and rising vacancies.
more than 10 per cent since 2014 and commercial vacancies are Developers are already experiencing aggregate downturns in
higher than at any time since 1995.
Living on the east coast of Australia you wouldnt know theres
a problem, but like beachgoers unaware of a tsunami hurtling
towards them, all of Australias leveraged property investors
might soon be engulfed in something far direr than they would
like to believe.
Property investors should be particularly concerned about the
combination of record prices and record debt because the
coexistence of these two factors have previously preceded crises.
Asset Price Inflation
We have written extensively about bubble-like conditions in
Australia and repeatedly warned investors to eschew leveraging
to buy property which will soon be in oversupply.
As Figures 1. and 2. reveal, Australia residential real estate is
some of the most expensive in the world on a House-price-to-
income ratio basis and yet supply is increasing rapidly further into
oversupply. These two conditions simply cannot coexist for long. At the same time, APRA has limited the growth rates at which
As iron ore bulls learned a few years ago, record forthcoming
supply is the death knell to record prices.
Figure 1. House Price to Income Ratio around the world
STOCK S O R PRO PE RTY: W H E R E TO IN VES T N EX T ?
Figure 2. Australian dwellings under construction
Much of the risk confronting property investors has its incubation
in the booming construction of residential apartments. Significant
oversupply is evident and we have written about it extensively at
www.rogermontgomery.com.
Our thesis is for falling prices, due to property developers being
forced to discount properties in order to sell their inventory to a
declining pool of buyers who in turn, are seeing declining rentals
off-the-plan purchase settlements. Banks have put entire suburbs
on black lists and are, refusing to extend loans to buyers who put
down deposits two or three years prior, expecting the loose credit
conditions to continue indefinitely.
Anecdotes of developers offering frequent flyer points, holidays
to Asia and ten-year rental guarantees are evidence that the
discounting has already begun. As the supply of unsold apartments
increases this discounting will become more aggressive and prices
will be lowered.
Banks arent funding loans like they used to, either because the
borrower is an investor, or their own valuations have been lowered
and the buyer cannot raise a higher deposit. Alternatively, if the
buyer is a foreign resident, the banks have shuttered lending to
those who have previously transferred money from their home
countries for a deposit but have since been unable to transfer the
balance.
lending to investors by banks can occur.
All of the above will simply mean developers cannot sell all their
forthcoming supply at current market prices. What they cannot
discount and sell, will remain untenanted, further limiting any
enthusiasm by future buyers until the excess supply is soaked up.
For those investors that can complete their purchases, rents will
need to be lowered, (assuming a tenant can be found) reducing
returns, and ipso factor, the enthusiasm of secondary buyers.
Property investors are already experiencing the impact of rising
supply on rental returns.
In Brisbane for example, where more than 5200 new apartments
have been constructed in the first nine months of 2016, renters are
moving from older suburban flats into the new apartments. As a
result, vacancies in Brisbanes middle suburbs those between 5
and 15 kilometers from the city - jumped to 4.5 per cent, from 2.3
per cent in the last quarter, while unoccupied units within 5km of
the city center rose from 3.4 per cent to 3.7 per cent.
PAGE 2
Vacancies put land lords who have borrowed to invest under companies meant large institutional fund managers those that
financial stress. focus generally, and by necessity, on the big cap stocks fuelled a
And lest you think the vacancies will ease, another 13,000 boom in the prices of smaller high-quality growth companies, as
apartments will be completed in inner-city Brisbane over the next they migrated down the market capitalisation spectrum, looking
18 months and 16,000 in Melbournes inner suburbs in two years. to boost their returns. High quality, mid and small capitalised
company shares, those with bright prospects and economics,
The impact on returns to investors will be inescapable. benefitted.
Couple all of the above with the recent news that property doyens, More recently, the perceived prospects of the banks and resource
John Gandel, John Symonds, Rob Millner and Harry Triguboff companies have improved and those same institutions, who found
have all sold or are trying to sell significant properties or their themselves underweight, were forced to sell down their holdings in
property businesses, then you have what amounts to a warning. smaller, high quality growth companies to fund their purchases of
Expanding Debt Fuels Property Boom the banks, BHP, RIO et al.
When rapid asset price rises, particularly property, are As those large institutional funds unwound their positions over the
accompanied by an equally rapid expansion of debt, the toxicity last few months, we have witnessed corrections, if not crashes, in
of any subsequent pullback is accentuated and borrowing binges the share prices of smaller high-quality, high-growth companies.
always precede a crisis. ISentia has declined more than 30 per cent as has APN Outdoor
and Vita Group. Healthscope has fallen 32 per cent from a high
Prior to the GFC, for example, the rise in asset prices in the
of $3.14 to a low of $2.15, REA Group and Carsales are down 27
US was being fuelled by a relentless increase in the ratio of
per cent and 28 per cent respectively from their highs.
household-debt-to-GDP. This ratio had been stable at 80
per cent of personal income until 1993 before jumping to As an aside, our inability to identify good value earlier in the year
120 per cent in 2003 and 130 per cent in 2006. In Australia resulted in building cash to around 30 per cent, in aggregate,
today, household-debt-to-GDP is rising inexorably and now sits of the value of Montgomerys domestic funds. This places
at 126 per cent. Montgomery in the enviable position of being able to take
advantage of lower prices, and in some cases, the first opportunity
Figure 3. Household Debt to GDP. Australia
to acquire value in a long time.
An investigation of the recent declines in our universe produces
some interesting and encouraging observations.
Perhaps the most interesting of those observations is that
companies that score highest on our quality matrix have been the
very worst performers. Conversely, some of the very lowest quality
companies those with no track record of adding shareholder
value over the longer-term have been the best share price
performers. This cannot last and the eventual reversal of these
trends will deliver more reassuring results. It is worth remembering
the economist Herb Stein, who once observed; if something
Now, many commentators, including the Reserve Bank of cannot go on forever, it must stop.
Australias Governor, also note that Australian households enjoy As you know we are obsessed with quality simply because, over
record cash balances. The only problem however is that the the long-run, we know that quality is a material positive contributor
people with the cash are not the same people with the debt. to returns.
Over two decades, Australias household debt has increased We maintain a database covering the entire ASX300, scoring every
more rapidly than household income. In 1990 household debt business in terms of its pricing power, barriers to entry, industry
to income was 56%, by 2002 it had reached 125%. By April of structure, switching costs, and a myriad of other factors. This
2014 it reached 177%. And according to the OECD it now sits at allows us to calculate an aggregate quality score for every business
206% we may be interested in and, using that, we can sort the market in
And private credit card usage is also rising spectacularly. order from best to worst. Our objective is to rank businesses by
Australians have simply taken on more debt, typically to chase the sustainability of their propensity to create shareholder value by
more expensive houses, and have less money to pay for it all. investing incremental capital at rates of return above the cost of
capital. The underlying rationale for this is reasonably self-evident.
When interest rates on mortgages do increase, borrowers will
Over long periods of time, a business that has the ability to create
have more debt to service and less capacity to repay.
genuine value for its shareholders should be able to generate good
Irrespective of whether the path of returns is violent or smooth, investment returns by the accumulation of that value.
passive property investors are likely to experience low returns for
Importantly, however, this is a long-term dynamic. Value creation
some time.
only reveals itself over a number of years and as the business
Equities reports growing shareholder equity while sustaining a high return
Over the last year or two, a lack of growth in the banks (credit on that growing equity. Over shorter periods of time, the share
growth expected to slow given maturing residential development prices for good businesses can decline and the prices for inferior
as well as record mortgage and credit card debt) and resource businesses can surge, and we believe we are currently witnessing
just such a period.

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performance
high quality low quality
As shown in the above chart, the businesses with our very highest
quality scores (at the left of the chart) have delivered the worst
returns since August 1, 2016. Meanwhile the strongest returns
have been found towards the low end of the quality scale, on the
right hand side.
Poor Quality Wins
Sims Metal Management (SGM) is a metal recycler with a market
capitalisation of around $2.5 billion and a company that can be
found at the lower end of our quality scale.
For the last 8 years SGM has reported a return on equity below its
estimated cost of equity, and therefore has destroyed shareholder
value.
As you know we believe the market is a weighing machine
in the long run and so, unsurprisingly, SGMs share price is
considerably lower than it was in early 2009, despite the fact that
the market has recovered strongly since the GFC.
In the short run however the market is a voting machine and since
August SGMs share price has soared, rising by some 50%.
Investors who own SGM may look like wise investors, however
unless SGM has acquired the ability to create long-term
shareholder value, the markets recent fetish will eventually tire.
High Quality Loses
One high quality company to have sold off dramatically
was private hospital operator Healthscope, following an
announcement of a slowing in admissions. There are few sectors
in Australia with as clearly obvious bright prospects as healthcare.
An ageing population, as well as a generation of baby boomers
who took up aerobics and jogging for the first time, almost
ensures a growing conga-line of hospital visits, also known
as separations and elective surgeries. And while the quarterly
numbers show variability, the trend over the last two decades is
clear and uninterrupted. When the market treats that which is
temporary, as permanent, investor have the opportunity to make
outsized gains over the long run.
Another company to suffer at the hands of short termism is
mobile phone retailer Vita Group. Founded in 1995 by Maxine
Horne and David McMahon, under the Fone Zone banner, the
pair were the first to establish a mobile phone retailer inside
shopping centres. Helped along by the rapid growth in mobile
phone demand, Fone Zone grew to 123 stores in a decade.
When it listed in November 2005, Fone Zone was the largest
independent handset and accessories retailer in Australia.
STOCK S O R PROPE RTY: W H E R E TO IN VES T N EX T ?
In FY09 Vita strengthened its relationship with Telstra by securing
the master license for Telstras retail stores of which there were
103 by the end of FY16.
Since 2010 revenue has grown from less than $100 million to
more than $600 million in FY16 and EBITDA has grown more
than ten-fold over the same period, from circa $6 million to more
than $60 million.
We have met few company leaders with the same intense passion,
drive and success in retail than that which we have seen in
Maxine Horne. The systems and process for driving individual
store and individual sales representative performance is not
something we have come across anywhere else and we believe
that growth over the next two to four years is obvious provided
Maxine sticks around.
In the short-term however the market has reacted to news of
a renegotiation of remuneration terms between Telstra and its
licensees. The market appears to have adopted a pessimistic
view of these negotiations - contributing to a 50 per cent decline
in the share price - even though the company has reassured the
market that these negotiations are regular, that Vitagroup is on
favourable terms with Telstra, and that the company will make
up for any lost margin through shifting product mix and opening
additional stores.
At the higher-quality end of the market, businesses with a
demonstrated capacity to create value have been going
backwards in price even though, in most cases, the ability of
these businesses to create future value remains intact, and over
the long-run, the economics of these businesses will continue to
work their compounding effect on share prices.
Seen in this light, the most rational response to seems clear. The
faddish and benchmark-aware approach to investing of larger
institutions who found themselves underweight rising bank and
resource companies means materially better value is now on offer
in the high-quality part of the market and it is time to put some
cash to work. Encouragingly, we are seeing this approach being
adopted by quite a number of individual clients and their advisers.
Equity Portfolios Concentrated In The Wrong Stocks
Many equity investors have their portfolios concentrated in high
yielding companies with little or no growth. When a company
pays 100 per cent of its earnings as a dividend, the yield might
look attractive today but 0 per cent of earnings is being retained
for future growth. If there is no earnings growth, then the
dividends wont grow. If the dividends dont grow, investors lose
purchasing power.
Again we point to a good example of this; Telstra. $100,000
invested in Telstra in 2005 at a yield of 5.97 per cent produced
$5,970 of income for the investor. Fast forward to December 31,
2015 (a year ago) and that $100,000 had grown to $117,000
and the dividend grew to just $6,508. The income growth has
not kept up with inflation. Whatever restaurant you were enjoying
in 2005, the prices wont be the same in 2015.
Many people think those big cap blue chips are safe but what
could be riskier than being guaranteed to have less purchasing
power in the future?
PAGE 4
Contrast Telstra with a $100,000 investment in 2005 in M2
Telecommunications. Unlike Telstra, M2 was able to retain a
large proportion of its annual profits and generate very high
returns on that incremental capital. When high quality growth
companies behave this way wealth is created and purchasing
power is preserved and grown. While the yield for M2 in 2005
was only 3.19 per cent, producing $3,190 of income in 2005,
by 2015 the $100,000 investment had grown to more than
$3 million and the annual dividend had grown from $3,190 to
$98,970 a yield of almost 100 per cent per year.
M2 has now been taken over but the question to ponder is;
was M2 an income stock or a growth stock? The answer is
that it was neither and it was both. It was simply a high quality
company.
High quality companies have been smashed in todays market
presenting a rare opportunity. Meanwhile investors are
concentrating their investments in overpriced, overgeared
apartments and large cap stocks with little or no growth.

Summary
Passive investors in property appear to be entering a period of inferior returns. Equity investors who
have focused their portfolios on high yielding, large-cap, low-growth companies would be wise to
consider the merit of holding companies whose only appeal is a high yield. Even if interest rates stay
where they are, inflation will still erode the purchasing power of the income being generated. What
could be riskier than being assured to have less purchasing power in the future than one has today.
And if interest rates rise?
With the prices of high quality companies - those with bright prospects for generating future growth
in income having fallen significantly, it might now be worth considering whether its the right time to
reduce exposure to property and low-growth large-caps, and increase exposure to high quality small
and mid-cap companies or those managed funds that are obsessed with long-term quality growth.

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Important Information
This document has been prepared by Montgomery Investment Management Pty Ltd
(ABN73139161 701) (AFSL 354 564) (Montgomery).
The information provided in this document does not take into account your investment objectives,
financial situation or particular needs. You should consider your own investment objectives,
financial situation and particular needs before acting upon any information provided and consider
seeking advice from a financial advisor if necessary.
Future investment performance can vary from past performance. You should not base an
investment decision simply on past performance. Past performance is not an indicator of future
performance. Investment returns reviewed in this document are not guaranteed, and the value of
an investment may rise or fall.
This document is based on information obtained from sources believed to be reliable as at the
time of compilation. However, no warranty is made as to the accuracy, reliability or completeness
of this information. Recipients should not regard this document as asubstitute for the exercise
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