Mailbag: incl. Do you eat your own cooking? March 3, 2024

28:32But new businesses aren't allowed to do that. In terms of what does it mean? Yes, it absolutely means that. So it means you have to trust the executives and the directors implicitly because they can do whatever they want. Now, they also have a lot of their own money tied up in this thing. So there's some value there. But yeah, honestly, if Rob Milner and the board wanted to screw me over, they could do it tomorrow. And that could be done in a way that couldn't be done in another company, probably. Now, there are still laws that require directors to act in the best interest of all shareholders, for example.

28:59So if I were to sell Pats to go into the Bitcoin mining business and they chose not to and 60 % of the shareholders wanted it but couldn't quite get a majority vote, then yeah, they could use that casting vote for a whole lot of different things. So yes, it's a risk, absolutely. I actually also think it's a benefit because we've also had, by the way, other perpetual and Mark Carnegie. Mark Carnegie is actually a good guy. I was on the other side of him on this one. They wanted to kind of break this cross-sheholding up because they said the businesses are worth more separately. In other words, they could break them up, sell off the assets, make a bit more money out of it by making the breakup work.

29:31Now, that's exactly what Solpats wanted to stop. And frankly, their 30-plus year history of market-beating performance is more than enough for me to say, you know what, I'm happy to let them keep doing it. And if they were broken up earlier and sold off earlier or people had done other things with them, would it be better or worse off? Don't know. So there's an ideology and a philosophy there and there's a pragmatism there. I tend to be pretty pragmatic as a matter of course rather than ideological, although I probably could be a bit of both depending on the mood. So, yeah, but you're absolutely right.

30:00Yes, yes. A vote against them would be practically impossible. And so that's why it stopped. But again, if you know what you buy, here's the other thing, by the way, would you rather that or a badly managed companies where lots of short-term fund managers who just want a result the next two months so that we don't, you know, so that things don't go, you know, I'm trying to think of a proverbial nice way to describe that without using the phrase. Go badly, let's say that. But, you know, sometimes the theory, what does Yogi Berra say? In theory, there's no difference between theory and practice, but in practice there is.

30:36I'm very, very happy. But you're absolutely right, mate. Your objection or at least your observation is true. Ram? Yeah. About every three years, I go, oh, yeah, the cross shareholding. How does that work again? Yeah, that's also true. And then I figure it out. And then three years later, I go, oh, yeah. How does that work again? Yeah, because it is, I owe 50 % of something that owns 50 % of me. So then that just, it's this recursive kind of, it just, my brain melts. And, you know, you can work it out. I forget. I'm at that point of the cycle again where it's like, I completely forget how it works.

31:16Yeah. Because, yeah, I mean, it's not so much from a will I be screwed over perspective, but just like when trying to value the company. I'm buying a company that owns 50 % of that company that happens to own 50 % of me. so how much am I what do I own here yeah do you have a I don't want to put you on the spot but do you have a quick and easy explanation as to how that maths works no there's no easy way to do it there's two ways you can do it you can uh you can value them both together effectively and I cross out the you kind of it's almost the algebra you kind of you cross out the the thing on both sides of the equation yeah so that's one way you can do it the other way you can do it is the shareholding is you you assume that it is the shareholding is separate from the operations So you're sharing the income with a shareholder.

31:59So take Solpats, for example. 40 % of Solpats are owned by Brickworks, roughly. You take out the shareholding for a second and just say, right, Solpats makes this much money from its own business, gets this much money from Brickworks. So that's its total income on a P &L basis. And then it shares that with all the shareholders, 40 % of whom happen to be Brickworks shareholders. Right. And so Brickworks gets a dividend flow or a share of the earnings from that. So you can do it either way. It's still messy. It's a bit hard to get your head around, but that's how I've done it anyway. Yeah. I'll ask you again in three years.

32:28Greg, second question. Also, regarding the difference between Harvey Norman and JB Hi-Fi, you've mentioned before they have very different price to earnings ratios, despite their similarities. Could this be related to the fact that as a franchisor, Harvey Norman generates a proportion of its revenue as rent and not retail sales? While they operate in the same industry, the way the company gets its revenue, as opposed to revenue of the franchisee business, is very different, isn't it? Thanks for your insights, Greg. Yeah, absolutely. You go first, mate. Yeah, yeah. I mean, yeah, they are. They're very different.

33:01And I often rail at these sort of industry classifications and how they're sort of practically applied because there are two companies that can be very similar at a surface level but just so fundamentally different in structure and where their earnings and stuff come from. So, yeah, they are both – where they are similar, the similarity that matters, I guess, is that they are largely discretionary retailers. you're going to be somewhat cyclical against the the economic cycle and the rest of it but under the hood yeah very different businesses very different businesses and i think i think greg you actually make the right point i don't i don't know i've ever intended to suggest that arbitrarily worth more or less because of that but actually to ram's point you're very very very good point that is the difference that is the point is these things are different and so dot dot dot and And really thinking that through is fascinatingly important.

33:52I'll make a simpler one because I'm not trying to avoid the J.B. Harvey one, but Meyer and DJs at one point were trading on the same PE or very, very close to it. And yet Meyer had a whole lot of leases, owned almost no property. DJs owned two really large and valuable CBD stores, one in Sydney and one in Melbourne. Now, on one hand, the cost of that shareholding isn't necessarily that dissimilar, right? Because we've talked about opportunity cost a million times. They could rent that building out to somebody else and get an income stream from it. They could sell it and pay rent instead. And if you paid rent, your profit would be lower.

34:29So again, the E would be different, but your asset base would be different. Now, it's not to say either one of those is necessarily better or worse. it's just thinking through the reality of hang on how is that how is that true and what does it actually mean does it mean that coles and sorry coles does it mean that uh djs and myer are equally being valued by the market on one hand yes as a multiple of earnings but what about as a proportion of the balance sheet or what about the assets they hold the quality of those assets or the defensiveness of the business and i think the the key point here and again this is why i love the question you ask is that's exactly the question you should ask is don't just look at the pe and say two companies with a PE of 13 are the same, they may have different industries, different growth prospects, different profitability, different futures.

35:13They may have different balance sheets. They may have different obligations. That's exactly why, again, you've absolutely nailed it, mate, because this is exactly why you should be looking past just single numbers and saying, well, a PE of 13 isn't the same for everybody. What if, dot, dot, dot. Is it a cyclical business? Is it a super, super, super acyclical business? You know, toll road or something that does have no security at all okay that matters where is it in the cycle um how exposes it to recessions or economic booms those are exactly the right sorts of questions so i'm gonna i'm just gonna say yes yes they are very different and that yes that's exactly why and yes that's why you should you should think more carefully as you are about the way we think about um about managing that in particular yeah and just the very high level view um would be that by doing the sale and lease back, as it's called, like sell your property and then just lease it back off someone else, let them run all of that kind of stuff, is that you've now got a bunch of equity that you can invest potentially to get some really good returns on.

36:15You have a less lazy balance sheet. You may have, as a result of it, a far better return on equity, the profit that you're making, but in proportion to the net assets of the business. If you've got the property, well, you may be less efficient, for want of a better term, but you are far more robust in terms of the hard assets that underpin what you actually own. There's a good deal more sort of a backstop in terms of value held on the balance sheet. illiquid though it may be it is real value whereas in these other enterprises all of the value is in is in the operating characteristics of the business not in not in not in what it sort of holds in its balance sheet so there's no right answer it just it depends on what you want to what you prefer and i would like all else being equal with a very very attractive business model and competent management team yeah i'd probably go towards just just lease what you need and put everything you can into generating very high rates of return on invested capital would be this quote-unquote sophisticated answer.

37:26But I still have a huge amount of sympathy for those that err towards the conservative side of things, even if it means that they are leaving a little bit of money on the table. Because it's kind of like an umbrella. You don't need it until you really need it. That's right. Exactly. Yes. And it's not, I think you can, that's the advantage of Harvey Norman, right? Like it's just, it's got that property there as a backing. So it's, you know, is it better or worse? It's a personal decision. Yeah. Those that are, those that have less capital on the balance sheet will do much, much, much better in the good times.

37:57Yeah. But they come at a much more threat and risk in the bad times. You know what I love, mate? We get some great questions from really great, I'll say simple questions or beginner questions for people who don't know and want to know and I love that. And also I love the fact that a lot of our listeners who've been around the block a couple of times have thought through some of this stuff and kind of going, hey what about so here's one from bernard mate which again is just a really really thoughtful question this got andrew i've learned from you fellas that companies with strong balance sheets can profit when a here we go when a downturn in the economy happens as this is the time when cashed up companies get the chance to buy cash starved companies for a knockdown price quick break here mate um woolworths bought the one-hour delivery company milk run after it went broke now I don't know whether it'll do well or not.

38:39Milk Run was flush with cash and trying to take on the big guys. When the cash dries up, Milk Run goes broke. Will you say, yep, we'll have that. Thank you very much. Now, again, whether it's an example or not in time is an open question, but this is exactly what Bernard's talking about. Hey, maybe there's value in it just by taking it and sweeping it under the rug, right? Yeah, there is that too. Okay. Bernard goes on, quote, this got me thinking about the so-called bank of mum and dad and Australian property. Then in square brackets, I like the square brackets too, but he says, start limbering up, rant, as we see you making your way back to the fence.

39:09In square brackets. I'm in middle age, says Bernard, and very few of my friends and family have bought property to live in without the help from the bank of mum and dad. This is in contrast to my mum and dad and the parents of my friends who are able to buy their own homes without any help from their family and usually with only one pay packet back in the late 70s. My thinking is, aren't the families who have a healthy bank of mum and dad just like strong companies who have healthy balance sheets and therefore won't these families simply buy up the houses that go on sale when and or if there is a major downturn in Australian property prices.

39:49Oh, interesting. As homes have become and maybe always were financialized products, isn't this simply a transfer of assets from the unlucky and or not so well-heeled to the very lucky and rich? Isn't this how capitalism works? The strong eat the weak, so to speak. I'm not saying this is okay or that it should or shouldn't be this way, but simply that it seems this is the way financial systems work when there is little will to correct distortions and rules are in place that seem to exacerbate those distortions. Or will the whole thing collapse if property prices go south, no matter how much money the bank of mum and dad has?

40:25Fool on, straw away, love your work, he says. He then says, as a long-term listener, I've reflected that much of what you two talk about does come to pass in the long run. and that the buy to hold know what you own and why and don't pay too much approach seems to work over the very long term thanks to you fellas and the motley fool in general i'm beating the asx 200 since 2019 but as you two point out i have barely underperformed the market at times two lord please grant me patience now he says another thought i'll hold that one for a second it's an interesting question mate the bank of mom and dad as the proxy for the healthy balance sheet.

41:05What do you think, Matt? Is this the way things are going to go absent any corrective action? I mean, it's definitely a structural advantage. If the folks have some money that they can lend you, you've got an edge over those that don't, 100%. I mean, I don't think you can argue that point. I don't know that in any, let's not try and predict, but just sort of go through various scenarios. So just under the, for whatever reason, we do see a meaningful sort of pullback. Will that just mean that all of the cashed up people rush in and buy it? I'm not so sure. And the reason is, is that there's a distinction between those that have strong balance sheets because they've got millions of dollars in cash sitting in the bank, or go back to our earlier point that the bank has a liability to repay should they ever demand their money back, versus money, quote unquote, that is represented in the equity value of your property.

41:58So play it through and think about it this way. So let's say, I don't know, property falls 30%. Now the bank of mum and dad is really, in most cases, just the equity that mum and dad have in their home. And now they've got, like everyone else, they've got 30 % less of it. They're probably finding themselves in a much more difficult lending environment too because all of a sudden the lender is going to be, whoa, pulling their heads back in again. This is really scary. We're going to really up our game here. So I don't necessarily think so. This is what's so dangerous about leveraged speculative bubbles, which is the Australian property market in my humble opinion.

42:36Because when it unwinds, it's debt on debt on debt, turtles on turtles on sort of turtles. So you buy your house, I don't know,$500 ,000 back in the day. You put$200 ,000 into it. Let's say you just keep that there as an interest only and then the house is worth a million dollars all of a sudden. I mean, all that money, quote unquote, has kind of just really appeared out of nowhere. But what we have found is, and this is what's been the driving force of much of the price appreciation, is that rather than just saying, well, that's really nice. Because if I sell, I'm out on the street and I have to buy it back.

43:13So it's sort of like this. It's more just a notional equity value, which basically means I've got added collateral as determined by the lender to lend to me. And so I've taken that money and I've rolled it into another house and the equity has expanded there and I've taken that equity. So when it does roll back potentially, you'll see all of these sort of TikTokers out there talking about their 15 investment properties. And I did it all before 25 just by stacking shelves on Woolies. It's like, yeah, the only way you did that is by going very much up to the eyeballs in debt. And you don't have a, like, you might have a huge pile of assets on your balance sheet, but the liabilities almost match it.

43:47And the slightest fall in asset value wipes you out completely. And all of those properties are going to mean absolutely sweet nothing when it comes time for you to try and be opportunistic and buy on a big dip. So I think structurally there's challenges with that assumption. And it's why I think a more healthily structured housing market would be one that was more underpinned by the utility value or by the cash flow value that it gets from rent. There was something, I think it was in the, maybe the telly or somewhere the other day, it was on Twitter. They're talking about the percentage of investment properties negatively geared in various suburbs.

44:22And my suburb was mentioned, so I took particular note of it. But they're all really high. It was 90%. Right. You know, it was sort of 90%. So again, these people, I'm sure, walk around saying, well, I've got this much dollars in property. But what they're not selling you is that it's got equally amount in debt. And in fact, the property is generating such pathetic cash flow that I can't even cover my interest payments. I'm happy with that for some bizarre reason I'm designing it that way. But, you know, on any kind of pullback, I don't have the dry – like we said before with the companies that have the dry powder to take advantage of difficult times.

44:53The dry powder won't be there because the dry powder was never there to begin with. It kind of like was materialized through a higher valuation estimate by the market at large and underpinned by a massive pile of debt. So when these things unwind, that's why they can unwind a lot faster, sharper and more scarily than people tend to assume. Right, because leverage works both ways. Yep. Bernard, I kind of agree with you, Ram, for the most part. I think, Bernard, the difference, I suppose, between the bank of mum and dad and general investment property is important. and in the sense that we're talking about the bank of mom and dad is helping people into their first homes or their own homes not first homes their own homes as owner occupiers right so i want to buy a unit i borrow some money off the off the folks and they help me into that unit or house and then i own it and that's my house um that if there's only one if it's an owner occupied property it doesn't change the dynamics of the market meaningfully across the market in other words we're not creating more investment properties relative to under occupied properties We're pushing the price up.

45:51But if I sell my house to some other first home buyer who's using the bank of mum and dad, they're going to be buying my house. There's no change to the dynamic of the number of owner occupiers. The price goes up, as I said, but it doesn't change the number. It's a little bit different to businesses buying other businesses where they are trying to effectively act as investors, where they would buy the second and third income streams, i.e. always buying milk run or something else. With actual cash in most cases. But also they're buying it as an investment property. So if the bank in my dad is helping people buy investment properties, then Bernard, you're absolutely right.

46:23If there is the use of existing capital to buy more properties that they're not otherwise living in, then yes, the rich end up with more properties overall rather than just pushing the price up of those properties. So it depends on, think about monopoly, how many houses, how many hotels on each street. If we're just simply changing from owner-occupier to another owner-occupier, then it doesn't really change the dynamic of the market from that perspective in terms of the rich hoarding more of the properties. Now, there is a little bit of a, and probably longer than we've got, and probably they're set up a bit differently, but there is a way in which you will see property in general, occupied property, be more likely to be owned by those who have family wealth because they can bid more highly and therefore take more than their share.

47:08So that's absolutely true. That's very true. But it's very green in the objection. At this point in time, that's the only people who are buying property to live in. right, is those that have access to that. Because if you don't and you're under 35, unless you're an MBA all-star or a surgeon or a QC or something, that is absolutely the case. You must have that access to buy a house. Particularly in certain CBDs in certain parts of the country, but yes. Look, maybe not in Coober Pedy, right? But I think while that is true and you will get much more affordable housing in the regions, they don't have the same employment opportunities and pay the same amount as well.

47:46So it's sort of, I think that that's, when you look at when majority of us live or aspire to live for better or worse, it's kind of true, right? Correct. So just make that point, we don't have to speculate about that anymore. We're here, we're here now. Yep. So that's, so in terms of, it depends on what outcome I think you'll kind of point to, Bernard. Again, that's price rather than kind of accumulation or, you know, if you're about the rich kind of buying more and more properties, fees, I don't think that's happening on an unoccupied level. They're just bidding up more for it. So they're more able to get to the property rather than buy up more than one.

48:22You will get some who have a lot more money and are using that to buy up more properties. That's absolutely happening. I don't know that it's likely a very large impact on, as Ram says, most of the people with multiple properties just leveraging up stupidly rather than genuinely doing it. Now, I've got to say, and this is kind of a slight tangent, but not really, my bigger concern is kind of the extension of your point, Bernard, which is actually multi-generational. If I can pay my house off and then I can either buy or help my kid buy their own home, they don't have to pay the mortgage or the rent so they can afford to then invest more money.

48:54And if you kind of play this through the generations, this is why taxation is important. Frankly, we should be talking about inheritance taxes, which again will annoy a large portion of our listenership. If I get mortgage free and then I help my kids get mortgage free and they help their kids get mortgage free, and that expands over and over again. Think about a different family who aren't mortgage-free, who can't help their kids, those kids either never buy or buy a cheaper property, they can't help their kids. And so if you kind of flow that through any meaningful way and you think about the composition of society and the proportion of that and what that does, we talked about on Friday, but owning capital in the context of AI disruption, I don't even think AI disruption is the key one here.

49:34I think it's just the intergenerational inequity that's being promulgated by the society that we're in. And I don't think that's necessarily a bad thing in terms of the, let me finish, it's not a bad thing in terms of the incentives that creates because we like the incentives of capitalism. We like the outcomes you get when you incentivize people to do well. What we also need to make sure as a society is that we don't let that become so distorted that we end up with effectively a feudal society. And I think that's my biggest concern. If you let that roll out and if you put self-interest aside, people say, oh, that's fine.

50:08I want to give some of my kids because I've worked hard and they should get it. and I don't blame them for that view. But as you've said many, many times around, if you designed a system and then had to be assigned a random place in that system, I don't know whether generational inherited inequality, I think of all the inequalities, I think inherited inequality is probably the most pernicious because once the structure of society is such that you can't get out of that, you're back in a class system where you'd have no choice to escape the class in which you are born. I think that's pretty ugly.

50:39Yeah. I guess what I worry about too is that this drive for ever increasing acquisition of property comes from a really noble place. I want to make sure that I look after myself and my family and build wealth for the long term. What's wrong with that? I'm trying to do that too. Correct. So, you know, I get all of that. I just, I think that we have pulled every rabbit out of the hat. Let's go through them, right? Back in our parents' day, dad's income was assessed. Mum wasn't even on the radar, right? Thankfully, that changed. Okay, so now every party of the – both parties in a partnership have to work, right?

51:19And then we had to have – Women's liberation, women's enslavement effectively because they've gone from I now have the choice to work to actually don't have a choice not to work anymore. You've got to work. You need to if you want to buy a house. You've got to work, right? Yeah. And then, okay, well, let's reduce the APRA lending standards. Okay, we've done that. Reduce buffers. Okay, let's add more government stimulus on top of this. Yep, let's add some tax breaks. Okay, yeah, we've done that. Okay, let's turn the taps on with immigration. Let's just like plow, you know, three Canberra's worth into the country every year.

51:46Okay, well, boom, we've done that. Interest rates have actually gone to zero. Oh, maybe we can intergenerationally tap equity. Okay, yeah, that'll really work because there's a whole bunch of, okay, yeah, brilliant. Okay, let's do that. Let's have 20-year, no, 35-year mortgage. Actually, there's 50-year mortgages out there. Okay, we're going to do 50-year mortgage. You are getting to a point where it's just like if you want to look at it structurally, for this thing to continue at this current pace, new money has to come in. As I've said before, everyone loves to talk about the property ladder.

52:19The ladder only moves up if there's people jumping on the bottom rung and pushing everyone up. And when no one can get on the bottom rung despite every single incentive and, you know, enabled to do that. I mean, that's a genuine question. What next? What's the next trick that we have to make sure that this party going? Like, yes, there will always be a demand for housing. And yes, it will always be a very desirable thing. And people will always try and do it. But to imagine that I'm saying, you know, that this$2 million fibro two-bedroom house on a 300 square meter block in Blankstown is going to continue to double every seven years.

52:56It just stretches credulity in a very logical and mathematical sense. that it's sort of like, I feel as though it's a kind of problem that will sort itself out in time. And that those that have tried to sort of hoover everything up and suck it from themselves, maybe you can do that if you've got incredible cash flows. And then it's actually being able to, you've done that in a way that's very sensibly structured. But I just suspect a lot of people have done that just again through debt. And I'll make the point again, it goes both ways and it unwind very quickly. I think that's true on a per person or per house basis, Ram, but I also think that is a subset.

53:37I know you're talking about the investors who expect more than that. I know it's been something you've been right about for a long time. Only every single person I ever speak to. Well, my biggest concern, though, is those who acquire assets for cash and then can keep going from there. I mean, you're a different story. Yeah, that's the group I think is more potentially damaging for societal cohesion because that's the group that's just and you know it's capital as you to your point it's capitalism 101 it's literally i'm buying more shares i'm reinvesting those dividends in more shares right now the the property version of that over time does exactly the same thing well those who can afford who can afford to do and even if the the gains that you're talking about having you know going away because we're not we're not keeping adding fuel to the fire doesn't mean the fire goes out it just means it stays at the current level and those with the cash and the ability to do it who don't have to borrow or who can borrow less because they've already got the cash they become the buyer of choice because they're the only ones who can afford it yeah and then that that does tend to at some point and it might be a couple of generations a few generations away but it compounds itself to the point where you know i'm hoping to leave money to my kids and they will get a better start than the neighbor who doesn't have money to their kids yeah and so they leave money to their kids now you know in three generations some kid will be a you know a hopeless junkie or something he'll blow it all and that's fine but everyone else will do okay and you know if if i'm able to and allowed to continue to roll an inheritance out then at some point the kid that's born literally with the silver spoon the gap between the silver spoons and the not silver spoons even aside from the speculation that you talk about and you're absolutely right it's not that you're not right i think the the implication for the bank of mum and dad uh that bernard talks about is that at some point the cash buyer becomes the dominant buyer and then can start to accumulate in large numbers.

55:17I agree with that. My thesis or my proposition, I suppose, is that I would speculate, and I have the data in front of me, that the vast majority of people who have been acquiring property have been acquiring on equity. Incomes haven't gone up tenfold, right? Right. You know, asset prices expanded, and all of a sudden you had collateral that you could lend against that you never could have before. And that collateral is just, you know, an IOU to the bank. And that's what you've said. The bank literally created new money. When you bought the house, they deposited that into the vendor's bank deposit.

55:50It didn't exist before. Now it does. It's matched off against your IOU liability. And that's just been pushed in and in and in and in. And it's just sort of on a cash. Yeah, there's a bunch of people just sitting around with all the money in the world that can just go in there. It doesn't really matter what happens to asset values. I can buy it at a set price. And I can rationalize it against some like reasonable kind of cash flows. I 100 % agree. I just don't I don't know how many people in Australia have are in that position versus those that are just you know very big landlords because they've they've they've just leveraged the whole way through that's that's the more dangerous part I think that's true my time we did wrap up but I want to finish with Bernard's PS he says PS I do hope you to keep these pod machine rants going well into your dotage I can just see you two now as your avatars sit on battery operated rocking chairs beards flowing to the floor as Brant shakes takes his fist at how expensive Australian property still is and laments that he still can't buy a vegan sausage roll with Bitcoin, while Dr.

56:46Calm savyly sighs and reflects on the sprawling housing estate he built on his once rural property, marvelling at how many zeros his bank account has in it. So going to happen. It's so... That is such the vision of the future. I'm not sure that's something we want to necessarily look for, but let's hope that things are net out nicely. So, mate, that is all we've got time for. A fascinating conversation as ever. If you have questions for us or comments, info at fool.com.au is the way you can get hold of us. You can follow Ram on Twitter, as you should, at Sage underscore Simien or at Strawman Invest, if you want to follow strawman.com and you should.

57:24Jump on at TMF Scott P on Twitter and Insta or Scott Phillips Money on Facebook. And until Friday afternoon, when I'm sure Ram will join me again for some more Motley Fool Money goodness, And maybe an announcement or maybe not about something that might come in the future. I don't know. Can't say too much. Can't say too much. Until then, Fool on. Cheers. The Motley Fool and people appearing in this program may have positions in the companies mentioned. General advice only. Please speak to your financial professional to understand how it may pertain to your situation. Subscribe to the free newsletter at fool.com.au forward slash listener.

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