Financial Thoughts

My IM Canada race report is drafted and I'm giving myself a few more days to mull it over. As promised, it will be live by September 10th.

I have a few hours this morning before my taxi comes to take me to the airport so I thought that I'd address a question that I received this week.

I enjoyed your continued comments on finances and economy. At about the same time you posted being "overweight cash" I was doing about the same... ...I would love to hear your thoughts on the blog about the subprime situation and the US housing market if you're looking for suggestions from the viewing public ;)

For background and continued info on the sub-prime situation, check out this website. John is a great analyst when it comes to explaining the background as well as the specifics. My gut feel is that the sub-prime situation was merely a trigger that resulted in a (beneficial) repricing of global risk. Things were totally out of control in terms of liquidity and lending. My personal view is that the "powers that be" should let a lot of people lose a lot of money -- investors should not be bailed out when they make crappy investment decisions. People need to lose money.

That said... I'm reading the Lex Column this morning (on the back of my FT) and notice their chart on three-month interbank rates. It is a look at what's happened to Sterling, Dollar and Euro interbank lending rates over the last six months. If you can punch that up on your Bloomberg then it's worth checking out. This is the rate that banks lend to each other.

I combine that chart with a discussion that I had with a senior banker this week. He was telling me that there are rumours about some medium sized institutions that are expected to need to merge with a stronger partner. That's a quaint British way of saying that they expect a few medium-sized banks to go bust if they don't get taken over.

I flip elsewhere in my paper and note that the last month saw record levels of capital raised by the strongest financial institutions (to strengthen their balance sheets). Elsewhere, my old boss is talking about the regulatory authorities being ill-equipped to handle the nature of the crisis.

So there is a real financial crisis happening right now. To date, the stock market, real economy and general public haven't focused on this issue. Given the magnitude of what I see happening, I can't see how it won't hit the real economy. Massive amounts of liquidity are being removed from the global financial system and the cost of capital is increasing.

That's my view on the macro picture.

On the micro picture -- life remains good for everyone that I come across. Unless you are a realtor, housebuilder, mortgage broker or specialist investment banker -- you will have been insulated from the crisis.

In Scotland, we've seen 5% capital growth in our property portfolio (YTD) and have been able to achieve returns much greater than that by creating value through project design; enhanced planning and "financial engineering". The team here are experts at getting the most out of difficult refurbishment projects in prime locations.

Consistently moving around the world, what most strikes me is the value that the United States offers relative to Europe (generally) and the UK (specifically). Europe is an expensive place to live and do business.

I'm writing this piece inside a two-bedroom flat at the edge of the New Town of Edinburgh. It is a converted warehouse, rather than the traditional buildings that make up most of our portfolio. This flat is valued at US$565,000 and I'd expect to see it get close to US$600,000 in an open market sale. At market value, you'd be looking at a gross yield of 4% and I wouldn't bet on you receiving much capital growth over the next three years. Smart financial buyers have been priced out of this market (they weren't really participants up here anyhow).

What's all this mean? Not much of change from what I was concerned about in 2004. I saw that we had to shift our business strategy to one that is based around value-creation, rather than asset-inflation. Personally, I reduced exposure "too early" and my partner made a quick paper profit on my holdings. However, together we created our new business and I "made" far more by helping him create something new -- than kicking back and letting him (and our team) do all the work on an established business.

At some stage, I'll talk about exits, sales and the strategic nature of working with entrepreneurs. I'm very happy about how things turned out. Selling to a CEO (& very close friend) was highly educational -- I'm glad that we're consistently on the same side of the table now. Personally, I prefer to sell early and for a bit less than full price.

So that's what I'm seeing out there right now. No real change in my outlook from last time.

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In portfolio terms...

Asset Allocation is 75% USD and 25% GBP
Forecast Capital Growth is 5% USD and 95% GBP
Forecast Income is 20% USD and 80% GBP
Forecast Expenses are 50% USD and 50% GBP

Breaking my portfolio down I'm 50% cash equivalents and 50% property related. The property investments are split 50:50 between the US and the UK. Our US property investments have a negative yield (we live in our house). My UK property investments have a high (but indirect) yield as they are tied to my advisory income.

All my portfolio leverage (up and down) sits in the UK property component of my portfolio. I hold cash as a hedge against this volatility. If we saw a major crash in global property markets then my UK holding would be hit. It is important to me to avoid dilution through the trough of the next property downturn.

It all sounds pretty complicated! More simply... a house in Boulder; a financial advisory business; a UK property developer; and cash. One major client in Scotland and personal expenses dominated by US taxes and a UK-domiciled consulting team.

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In reading through I didn't address your question on the US housing market. I think that the market will continue to fall over the next 12-18 months. If I wanted to enter the market then I'd start looking in January next year. I think that you'll have a lot of scared vendors early next year -- there is a wall of ARM debt that is going to adjust in the spring.

The only reason that I'd buy would be to have a primary family residence -- I expect that the terms on "buying for investment" will greatly improve over the next 12 months. I also expect that vacation locations will see better values when over-leveraged buyers are forced to unload properties.

Given the "yield gap" on most properties, I see little capital upside and the potential to get smoked by an adverse yield-shift (for the last ten years we've been benefiting from a favorable yield-shift). If that happens then there will be some great buying opportunities but we'll all be scared (witless) about putting money into a falling market.

Cheers,
g