Don’t Buy the A-REITs

In today's Daily Reckoning, we take a look at what the hedge funds are buying (resource companies) and which corporate insiders are selling. And don't forget! It's GDP and industrial production week in China. What could that mean? Also, five time-bomb property investments to dump now.

If you didn't catch yesterday's episode, you missed maybe the single most important piece of advice ever published in the Daily Reckoning: do nothing. Or, to paraphrase Nassim Taleb, "Negative advice is vastly more important than positive advice." Knowing what not to do in a dangerous environment promotes your survival. Improving your quality of life comes later, if you're still alive.

Some examples? Don't touch a hot stove. Don't eat stuff that's been on the floor for longer than three seconds. Never start a land war on Asia. Don't sweat the petty things. Don't pet the sweaty things.

Even some of the most important laws for the organisation of a free but ordered society are negative laws. "Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the government for a redress of grievances."

In a leveraged financial world with insider trading, corruption, incompetent regulation, and industry advice not aligned with your own best interests, don't count on the "experts" to tell you what to do. But let's talk specifically about what not to do before what we talk about a smaller portfolio of assets that ARE worth risking your capital on.

Don't buy the A-REITs. That's pretty simple. The group is talking itself up again, and the press is following suit. Granted with an average dividend yield of 8.1%, and after taking losses and write downs of nearly $40 billion last year, the sector is deceptively attractive. It doesn't mind saying so itself.

"Australia stands out like a beacon because the yields here are much greater than other parts of the world," says AMP Capital Brookfield chief investment officer Kim Redding. He tells Bloomberg that, "If you like the Aussie dollar and you like yield, Australian LPTs would be a pretty good place to be."

The logic of the trade is that the A-REITS have taken their losses (mostly on foreign commercial real estate assets) and recapitalised through debt and equity markets that are no longer so tight. But if you're long the A-REITS, you're also assuming there won't be any further losses on a portfolio of Australian real estate assets, and that there won't be any more funding problems for the sector.

Those are two pretty big assumptions. And you know what they say about assumptions. Besides, if you wanted to speculate in the A-REITS, the time to buy them was 73% ago in March, when the S&P 200 A-REIT index was trading at 546. Now it's trading at 950. Over in the research and analysis wing of our new mansion/headquarters, Kris Sayce and Shae Smith are preparing a short report on "5 time bomb property investments to dump now." We'll keep you posted on the results.

That's what not to do. But what about doing something? We'll get to that in second. Just one more quick point about what not to do.

We often cop it from frustrated readers for being a sceptic and critic of fiscal stimulus and deficit spending, but with no constructive solutions to "all the problems" of our own. We are all talk and no action. All doubting Thomas and no economic Saviour. But that criticism is lame, and vastly discounts the innate resilience of free markets and free people to recover from financial decisions that did not work out.

Left unmolested by know-it-all bureaucratic busy-bodies, free markets and entrepreneurs are remarkably resilient and self-adjusting. Businesses make investments and hire people and then reckon up a profit or a loss. Loss-making investments are ditched and products or services that actually serve customer's needs are modified and amplified.

But when the government steps in to prop up loss-making enterprises (investment banks, money-centre banks, non-bank property lenders who can't self fund) it promotes and perpetuates bad investments. This ties up capital in ventures that don't generate jobs and misallocates society's resources (human and real). It's also a way for politicians to line the pockets of their friends and campaign contributors.

When we say the government should "do nothing," we mean it should allow bad businesses to fail. It should not prop up investments at artificial values and directly support bad corporate managers and risk takers, even if they are good friends from the country club.

If it allowed mistakes to be realised, the market and the economy would adjust quickly and get back to the business of business, rather than the business of maintaining a lousy status quo. And taxpayer money robbed from the capital markets would go, in the form of available savings, to small businesses in the trenches of the real economy creating real jobs.

Now, on to doing something with your share portfolio. We'd like to draw your attention to the bidding war taking place for two separate Aussie resource firms, Polaris Metals (ASX: POL) and Rey Resources (ASX:REY). Mind you we haven't recommended them in Diggers and Drillers, nor are we recommending them here.

But our point about them today is that both are the types of investments you might make if you were building a portfolio of risk assets where the low-probability, high-magnitude event (the Black Swan) that the firm is aiming for is massively positive, and not cataclysmically destructive.

Polaris is mostly an iron ore play. Its chief project is the Yilgarn iron ore project in Western Australia. It reckons it has a 42 million tonne resource at an average ore grade of 58% iron. The bonus is that three of the five tenements have been drilled before and the entire project is close to both rail and port infrastructure, which significantly lowers the capital costs of getting it off the ground.

Polaris finds itself in the middle of a bidding war between Singapore-based Lion-Asia resources and former D&D pick, Perth-based Mineral Resources (ASX:MIN...It's a former pick, by the way, because we sold it at a profit.) Both bids take into account that Polaris is an exploration play. But both bids obviously place a premium on high-grade, low-cost iron ore deposits in WA that are close to infrastructure and not already owned by BHP, Rio Tinto, and Fortescue.

The long-term insight here is that even though contract iron ore prices are headed down this year and perhaps next, Asian steel-makers (especially the smaller ones) are still looking to lock up long-term access to Aussie ore...and they're willing to pay for it. If you find the right exploration asset as a small-cap resource investor, you can ride the share up as the bidding war does its work.

Rey Resources is sitting on another bulk commodity asset (thermal coal) that's facing a down-year in contract price terms but many years of higher prices, thanks to demand from India and China. Rey has been presented with duelling bids from Crosby Capital, which values Rey's coal tenements at around $35.5 million, and India-based Gujarat NRE Minerals.

Rey owns exploration licenses on areas highly prospective for thermal coal. Thermal coal is coal burned in power plants to make electricity. By the way, China and India are going to burn Australian coal no matter what kind of Emissions Trading Scheme the government conjures up. Rey reckons it has a 500-million tonne coal resource. And that alone-a mineral deposit of a highly-valued commodity headed up in price over the long-term-is attracting interest.

Details of both companies and all four bids aside, this is clearly the kind of high-risk worth investigating, and, from time to time, taking. Because these are exploration assets and because the value of the underlying commodities changes, valuing the mineral deposits and the companies is like shooting at a moving target. But the important investment point is that the target is moving up.

Speaking of Chinese and Indian demand for Australian coal and iron ore, third quarter Chinese GDP figures come out this week. Look out! Will it be 9% again? Odds are it will be. China's official statisticians also release figures on retail sales and industrial production this week.

Like all statistical releases from major economies, we are highly distrustful of official numbers. But the numbers do have an effect on market sentiment. And a bullish lead from China will contribute to the idea that the recovery (especially here in Australia) is taking hold and will sprint ahead in 2010. This could send the All Ords over 5,000 in short order.

But a word of caution: the insiders are selling. Barron's reports that's insiders at Leucadia National (NYSE:LUK) $47 million worth of shares in the last month. Leucadia is a bit of a poor man's Berkshire Hathaway. It's a holding company run by professional investors with an eye for value. Barron's reports that chairmen Ian Cumming, who owns 10% of the company, sold about 850,000 shares for nearly $22 million on October 13th.

There a variety of reasons insiders sell. Just because an insider is selling doesn't mean he's bearish on his own stock or that he thinks his shares are overvalued. But if they're optimistic and things are going well, how many business owners sell their equity?

Some reader mail. Send your comments, questions and disparaging remarks to dr@dailyreckoning.com.au

Dear DR,

Larry

--Hi DR,

Bob B.

We'll look into Bob.

--Hello DR,

Graham D.

Great question Graham. Investors have been trying to play the expected appreciation in the Yuan for ten years. But it hasn't happened yet. More on this subject this week. This is one of those major asset allocation decisions that, if you get right, can make you look like a genius.

Dan Denning
for The Daily Reckoning Australia

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