Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory & buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

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Sunday, 6 January 2013

5 things investors should know about Modigliani and Miller

Modigliani and Miller
Modigliani-Miller Theorem was one of those things I was taught at accounting college - today I'll look at what investors can learn from the idea.
Modigliani and Miller’s theory was also known as the capital structure irrelevance principle for the simple reason that it stated that, subject to a range of assumptions, it is irrelevant how a company is financed (i.e whether it raises debt or equity, and its dividend policy remains unimportant).
The assumptions included that companies don’t have bankruptcy costs, no taxes are assumed and it is held that markets are always efficient. 

In other words, in a hypothetical world - that does not exist - capital structure isn’t important.
However the theorem is useful when it is practically applied and particularly when one attempts to quantify the impact of each of the assumptions.
The tax shield
Interest on corporate debt attracts tax deductions and therefore it can be beneficial for companies to use debt rather than equity when it can source debt at a reasonable cost. 

In fact, taking the theory to its ultimate conclusion you might think that taking on as much debt as possible should lead to maximum profitability and shareholder value.
However, as we saw through the financial crisis, debt is only beneficial if it can be serviced; using too much leverage or "gearing" can result in bankruptcy. 

Plus, if too much debt is taken on by a company, a country or an individual, it invariably begins to cost more to compensate for the risk.
Thus a moderate level of debt should be used in order to leverage returns, but the gearing level or debt-to-equity ratio should never be taken too high.
Investors too have used moderate debt to increase their wealth safely and securely: it is a time-proven method of so doing.
That’s WACC
Major companies often calculate their Weighted Average Cost of Capital (WACC), being the cost of its debt and equity weighted by how much of each it has on its balance sheet.
Thinking about this practically - take the example of a mining company which determines its cost of capital to be 8 percent - it should not pursue a project unless it believes that the returns will comfortably exceed its cost of capital or WACC.
Too often, self-interested executives pursue sub-optimal projects in order to justify drawing their healthy remuneration. 

They undertake mergers and acquisitions which notionally add profit to the bottom line but achieve few synergies or real benefits. This is sometimes known as “buying profit”.
A bigger profit is of no use to a shareholder if it is ultimately spread across more ordinary shares.
What management should really be doing is seeking projects which increase the return on the capital it has employed. 

Therefore a rational management calculates an estimated Net Present Value (NPV) for a project and should aim to increase not only Earnings Per Share (EPS) but also its Return on Equity (ROE) and Return on Capital Employed (ROCE).
What does all this mean for investors?
What does it mean for investors?
Firstly, it’s not enough to buy shares in companies with growing profits. 

You need to seek out companies with managements which have goals that are congruent with adding shareholder value. 

If a company cannot re-invest its capital to add shareholder value, rationally it should return funds to shareholders through the payment of dividends.
Be wary of managements who seem more interested in their own remuneration than adding shareholder value.
5 other things investors can learn from Modigliani and Miller
1 – Debt should be used moderately
Using debt to magnify returns is a sensible idea and successful companies (yes, even Berkshire Hathaway and BHP Billiton) will do so moderately.
I’ve come full circle with regards to margin loans for share investment. I started out using them moderately as I learned the game, thereafter I used them more aggressively, but found that margin calls and retaining a worthy cash buffer can be a problem.
Today, I have come back to my original belief that the use of moderate margin loans in share investment makes sense, provided you have the fortitude to keep a reasonable cash buffer (or low loan-to-value ratio) and stick to a long-term and ‘long only’ strategy.
It might sound odd that a pro-property investor suggests that debt should be used moderately. But the loan-to-value ratio (LVR) on my UK property portfolio, for example, is under 50%. The LVR on my Australian property portfolio is a little higher, but I am steadily reducing it.
Remember Modigliani and Miller – yes, a higher debt-to-equity ratio magnifies returns, but at what cost? 

The cost is risk. 

It was common for promoters of UK “property clubs” to talk of “being 'worth' 2 million” in property up until around 2007. 

But since the were often promoting investing in far-flung towns and remote locations using 100% mortgages, the only thing they are likely to be worth today is being lynched by angry investors who were duped into doing the same.
I will add two properties to my portfolio over the next few months but I will look to use cash rather than drawing equity and will use 25-50 percent deposits (one in London, partly as a long-term currency play, and one in Australia). 

Of course I could be more aggressive in order to leverage up and chase greater returns…but don’t forget that I am, after all, an accountant. After years of boring-but-safe and risk-averse investment I will remain disinclined to take on greater risk.
Today I saw reference to the story of Mark Goldberg, a one-time recruitment magnate who made £40 million before blowing the lot in 8 months after he bought into his beloved Crystal Palace Football Club. You hear that kind of story often - you just need to substitute the name, the industry and the type of new venture.
Investors would be far wiser to “stick to the knitting” and stay with a safe but secure long-term buy-and-hold strategy in quality, proven assets.
2 – Debt must only be used if it is serviceable
A property investor might have a goal of a portfolio of $5 million in value. But if this achieved by buying one very expensive house that returns a rental yield of 1-2 percent then the investor will probably become insolvent very quickly.
I don’t suggest that investors chase yields too keenly, for yield is a poor indicator of the quality of an investment and it is capital growth that creates wealth. 

However, investors should also avoid properties which generate a large negative cash-flow.
3 – In the real world companies go bankrupt
Take a look at the list of top companies from a few decades ago. 

It’s amazing, isn’t it? Where did they all go? 

Some were acquired or merged with each other. Others become insolvent or went into liquidation.

Average investors tend to think that they are great at picking individual companies to invest in. Generally they aren’t and it is wise diversify.  

A good way to do this might be through buying into a low-cost Listed Investment Company (LIC) or an index fund.
4 – In the real world markets are frequently inefficient
In The Intelligent Investor, Ben Graham clearly states that no matter which asset class you choose to invest in, you should buy only quality assets when sentiment is low, and buy at a large margin of safety or below intrinsic value.
5 – In the real world there is tax
From 1985 to 1987 there was a good deal of change within Australia’s tax system. 

Without going over too much old ground here, Keating removed the iniquitous double taxation on dividends (thus there are now franking credits on certain qualifying dividends) but introduced a capital gains tax. 

The so-termed "negative gearing" rules were also quarantined then fairly quickly re-introduced.
In short, the upshot is that today there are two wonderfully tax-efficient ways to compound your wealth without giving too much of it back to the tax office:
i)              Over time, continue to buy into a diversified LIC which buys a well-diversified range of shares in the quality dividend-paying industrials index (but is not weighted towards the resources index which pays relatively weaker dividends and must eventually be set for a downturn in any case). Never sell and you will receive a stream of tax efficient dividends and not attract capital gains tax; and

ii)             Over time, continue to acquire quality prime-location investment property and thus benefit from depreciation allowances and negative gearing tax benefits. Never sell these either.

The Wrap

Used wisely and moderately at a level which can be comfortably serviced, debt can be used to help your business and investments 

However, debt can magnify both gains and losses so it should only be used on projects which will return greater benefit than the cost of the debt, and at a level which can be managed.