Taxation Value of Equity Investments, Part 1

One thing that does not get nearly enough coverage when talking in terms of wealth creation is the important taxation differences between the various asset classes. People talk about the ‘safety’ of having your funds in cash. When it comes to people like self-funded retirees, with just enough asset coverage to see them out, cash is a valid investment position. For someone with a long-term investment horizon, say younger than 55, or older, but with substantial assets, say more than $2m, cash will likely be a significant anchor on your performance.

The reasons are many. The historically superior performance of shares versus cash is simply the one that gets the most attention. Capital gains legislation in Australia provides most of the other advantages. The immediate taxation of income versus the deferred taxation of gains (as with most other countries), but most especially, the 50% discount for capital gains held over 12 months. I can’t stress that advantage enough, particularly for long-term holding as the ‘untaxed’ gains in your portfolio compound, effectively using your future taxation obligations as ‘free-leverage’.

Example - assume you are in the 38c tax bracket (between $80k & $180k in earnings). If I told you that over the next 10 years, the average interest rates on term deposits available would be 10% and the average growth in equities over the same period would be 10% (6% growth & 4% in dividends). What would you do with the $10,000 you wish to invest? For most people, the steady increase of the term deposit would be attractive, because despite both seeming to get to the same end result, the equities would probably be more lumpy, perhaps (4% / 16% / -10% / 23% / 17%) and so on. Assuming they were smooth, the end result would look like this:

The difference you will agree is quite substantial, the cash/term deposit option (with the assumed 38c tax rate) naturally returns net – 6.2% per annum. The equities netted an annualised return of 7.865% despite what is ostensibly the same return. Obviously property can have similar capital growth benefits. Held for long enough (over 40 years or so), the dividend would eventually be a larger per annum payment than the 10% cash return, at that point your capital base (the funds column) would be over 2 & 1/3 times larger in the equities column than the cash.

There are of course other factors to consider, like capital gains & franking credits and so on. But the basic fact remains that an equity investment assumed over the long term to grow at the same rate as the equivalent cash investment will actually be considerably more valuable.

So, given that if the returns were expected to be exactly the same, equities would prove to be a substantially more lucrative investment, it is probably a more worthwhile comparison if we us their historic returns. For the 30 years from January 1 1980 to December 31 2009, the average cash rate was 7.24% (we’ll call it 7.25%) and the average return for the S&P/ASX200 (TR) was 12.47% (we’ll call it 12.5%) with approximately 4% of the growth in dividends, would look more like this:

I know I am not alone in making this prediction. There is a better than average prospect, given the spikes in commodity prices and the economic policies being undertaken by the two largest economies in the world that we could be in for substantial inflation over the next 10 or 15 years. There is no better protection for your net worth during such a time than having a substantial proportion of your net worth invested in a group of stocks with good pricing power. Tony Hansen – 24/11/10

Managed Funds

You will often hear me talk about the poor performance as a whole of the managed fund industry, after taking into account fees. Mathematically of course, over any given period, 50% of funds are going to out-perform and 50% will under-perform. Unfortunately, studies have shown that when fees and charges are added into that, over 80% of all managed funds fail to beat a basic benchmark.

I decided, rather than trust someone else’s ‘studies’; I would look into the matter myself. Here was what I discovered:

Comsec (EGP’s discount broker of choice) has a universe of managed funds for its clients to use. There are 560 in total; I downloaded all of these, including their MER (Management Expense Ratio) and their performance over 1, 3 & 5 years into a spreadsheet so that I could get the data into a workable form.

As an Australian investor, there is really only 2 sets of indices I think serve as a valid performance comparison of market performance, the S&P/ASX200 (TR) and the All Ordinaries Accumulation Index. These measure the majority of the Australian market by market capitalisation on a dividend reinvested basis. As at 12/11/2010, the 1, 3 & 5 year returns of the S&P/ASX200 (TR) were 4.58%, -7.57% & 5.35%. Bearing in mind that the bear market of 2007/2008 commenced 3 years 16 days ago (makes the 3 year figures look dreadful). These are the benchmarks I will use to evaluate the funds.

Of the 560 funds, only 354 have a 5 year or greater track record. Of this 354, there are only 37, or 10.45% that beat the benchmark. This of course means 89.55% of all funds managed in Australia over the last 5 years would have returned a better result by investing their funds directly in the ASX200.

There are 536 funds that have been running for over 1 year. 148 of these or 27.61% have equalled or beaten the benchmark, proving only that it’s easier to beat the market in a single year than to do so on a sustained basis.

This brings me to my next point which is what might be termed ‘elimination bias’, whereby the worst performing funds are either closed, or wrapped into other products, so the manager can present a more successful ‘history’ in their PDS. This makes the 10.45% who beat the market over 5 years an even smaller figure because many of the other funds that make up the universe disappear through poor performance leading to unmarketability. Assume the universe should consist of 450 funds rather than the 354 remaining due to elimination bias (this is an assumed number as the true number removed is unknowable). Under this assumed circumstance, there are more like 8.22% out-performers.

The average MER for the 354 products with a 5 year history is 1.95%. The average MER of the 37 products which beat the benchmark was 1.80%. The 37 worst performing products had an MER of 2.02% (on average, if you’d have invested $100,000 in these funds 5 years ago, you’d now have the princely sum of $63,717 of capital remaining). This disproves, at least when it comes to fund management, the idea that you get what you pay for.

Similar results are found in the 1 year charts, the best performers charge below average fees and the worst performers charge the highest fees. When you look through the PDS of the higher performing products, invariably you discover a very low ‘annual charge’ and a higher ‘performance fee’ compared to the lower performers, which inevitably have higher annual fees and smaller performance fees.

The issue here is ‘alignment’. The more strongly the fund-managers interests are aligned with the unit-holders interests, generally the better the performance.

Some who look at this universe will state - but many of these are ‘world’ or ‘global’ products, the S&P/ASX200 (TR) is not a valid benchmark. To those people, I took the trouble of stripping out ‘global’, ‘world’, ‘commodities’, ‘gold’, ‘bond’ & ‘property’ products and was left with a universe of 232 Australian ‘equities’ facing products with a 5 year performance history. Care to predict the results?

26 out of the 232 products, 11.21% beat the indices. The out-performers charged below average fees. 4 out of 232 (1.72%) beat the index by more than 3% per annum over 5 years, and a single solitary 1 (0.43%) beat the benchmark by more than 5% per annum over the last 5 years.

There were 334 Australian ‘equities’ products with a 1 year performance history 86 of these, or 25.75%, out-performed the benchmark.

The conclusion – on an annualised basis, about ¼ of all fund managers will beat the index after fees are deducted, and generally less than 12% of fund managers will maintain index out-performance over a 5 year period, probably more like 7 or 8% when ‘elimination bias’ is factored in.

The solution - invest the proportion of your wealth you want exposed to equities one of two ways (or a combination of both) in either:

a) buy a low cost and liquid index fund such as SPDR 200 FUND ETF UNITS (trading on the ASX with ticker code STW), which after fees & costs has a tracking error over 5 years of less than 3% (about 0.5% per annum); or

b) find yourself a fund manager, who will charge you no fees, excepting in the event that a predetermined benchmark is beaten and who will have substantially all of their net worth exposed to the same investments as yours. Off the top of my head, I can think of EGP Fund No. 1 – Tony Hansen 17/11/10. (p.s. If you wish to see the list, e-mail us – eternalgrowthpartners@gmail.com and I will send it to you)

Beating the Indices

Our most satisfying result was calendar year 2008, a horrible year for investors globally, the S&P/ASX200 (TR) index declined by about 40%. I do not think it appropriate to quote an un-audited result here, but suffice to say that while our portfolio declined in value; it was nowhere near the quantum of the broader market. Any loss of capital is undesirable; however, if the cause of it enables you to accumulate significant positions in some seriously mis-priced issues then, in the longer term, it is not such a bad thing.

We were fortunate in that this attitude was handsomely (and rapidly) rewarded when the market bottomed in March 2009 and took off. Although the margin of victory over the benchmark in 2009 was not as wide, it came against an opponent (the S&P/ASX200 (TR) index) that had added about 35%. In years when the market advances so quickly, just keeping up is quite satisfactory.

When I think about benchmarks, I prefer to think in longer terms. On current values, the S&P/ASX200 (TR) dating back to 1980 has achieved returns in the order of 12.5% annualised. When you factor into that period, the 2 biggest market declines (1987 & 2008) since the great depression, that is pretty amazing, $1,000 invested in the indices (dividends reinvested) would be worth over $33,000 today, without doing anything more than being average. If, however, you managed to beat the market by a further 2.5% annually, your investment's current value would approximately double (about $66,000), add another 2.5% over the indices and your $1,000 would be over $125,000.

The sound performance of the indices, without the stress of individual stock selection is the reason that I recommend index investments to the vast majority of investors seeking exposure to the share market. Provided you take a long view and accumulate steadily a significant holding, you will build a handsome asset.

If you think for a moment the next 30 years will not be as good as the last, I think you will be proven wrong by a good margin. Provided we (as a country) make no substantial economic missteps, we are poised on the brink of a period of massive economic growth. I would happily bet that if you reset the benchmark – the S&P/ASX200 (TR) to 1000 on December 31 2009 (as it was at December 31 1979), that it would be at least at the 33,000 it is currently by 2040.

However, being as good as ‘average’ has always struck me as not being quite good enough. It would be much more satisfying to beat the market by a handsome margin. A 10 year record of beating the market by 5% per annum would place you firmly in the top 1% of investors over such a period, and as pointed out above, in a period of ‘normal’ market performance, would lead to the creation of substantial wealth.

The purpose of the informal/un-marketed commencement of EPG fund No. 1 is in order to establish, under an auditable reporting format, the formalisation of our investing track record, to - we hope - create the type of performance record that will serve as its own advertisement for the reasons you would want to invest. I am very excited about the market at the moment, in my view the whole market is quite cheap, meaning (I expect) over the medium term, gains will be better than their historic average. Better still, if we can beat that by a few points, we will stand our long-term wealth position in excellent stead. Tony Hansen 10/11/2010.

Efficient Market Hypothesis

Over the next few months, while we get all the regulatory loose ends tied off prior to our July 1^st 2011 ‘informal’ launch of EGP Fund No. 1, I will periodically post some information to direct our investors to the philosophical foundation of my investment choices and beliefs.

I am an unashamed fan of Warren Buffett as an investor, as I am of a great many other ‘super-investors’. I have reviewed extensively Buffett’s career and writings and would encourage anyone with a genuine interest in wealth creation to do the same.

Academics frequently posit that it is impossible for an individual to beat the benchmark consistently over a period, due to all known information being rapidly reflected in stock prices. The link below (authored by Buffett) is easily the best counter to that argument, and has never been successfully explained by efficient market theorists.

http://www.tilsonfunds.com/superinvestors.pdf

The most fascinating aspect of investment to me is the idea of competing against the ‘collective intelligence’ of the market. I am by nature an enormously competitive individual; the S&P/ASX200 (TR) index is the yardstick by which I measure the collective result of the market. Consistent out-performance of this benchmark can mean only one thing in my view; the accumulation of substantial wealth.

Whilst, like most people who have had a considerable measure of success in outperforming the stock-market, I am reluctant to attribute any of my success to ‘luck’, I would freely acknowledge that the idea of the market being relatively efficient is not completely baseless. The information instantaneously available to individual and professional investors alike means that the quantum of the discrepancy is significantly smaller than it has ever been in the past. The incredible reach of globalisation - the internet and telecommunications means information is disseminated swiftly and seamlessly to an audience with a great and growing capacity to interpret that information and quantify its impact on the current and future prospects of businesses.

That is to say markets are much more efficient than they were in the 1950’s or 1960’s, but they are not, and never will be, perfectly efficient. The likelihood of any investor ever creating anything like the returns of the Buffett partnership, which between 1957 and 1969 outperformed the Dow by 22.1% p.a. annualised, is close to zero in my opinion.

It is my belief, through in-depth analysis, I could outperform the S&P/ASX200 (TR), even investing only in ASX50 companies (the 50 largest in Australia). At the moment, I think BHP and RIO both represent very good value and will perform better than the indices and most other stocks in the ASX50; I find it difficult to separate the two at current prices. I would rank the big 4 banks in 2 classes CBA & WBC representing better value than ANZ & NAB. That said, I would be unlikely to invest in any of these given the substantially more favourable valuations to be found in the smaller companies.

The smaller the business, the greater the likelihood of the market mis-pricing the enterprise value. Companies worth less than $1b are most frequently mis-priced, and until the day I am managing truly substantial sums of money, I will spend most of my analytic time and effort outside of the ASX100 stocks – Tony Hansen 03/11/10