Price is what you pay, value is what you get. However, the former doesn’t necessarily guarantee the latter, writes Marcus Burns.
As money managers we clearly have a vested interest in trying to persuade clients to save more of their money and preferably invest a large chunk of that in our funds.
Therefore, having declared our interest at the outset, I bravely push on to consider spending “today” versus investing for some future benefit.
Most of us broadly have some idea of the power of compounding – Einstein even called it the eighth wonder of the world. Small initial amounts, invested even at relatively modest rates will, over time, compound into seemingly enormous amounts of cash.
We all remember the story of that clever Dutchman, Peter Minuit, who bought Manhattan for $24 worth of axes, kettles and beads from the Lenape Indians in 1626. Since none of us are 387 years old I’ll consider a more recent example.
Consider the case of an early forty something male tempted to spend some of his money on a …oh I don’t know, a Porsche. Let’s pick a 928 which was considered a pretty sexy car in 1987.
Back then a new Porsche 928 cost an impressive $211,856 in dollars of the day.
This sum would have bought you almost two median-priced houses in Sydney (1.75 houses to be exact) or a reasonable chunk of stock in the All Ordinaries.
What was the underlying value of these “investments” over time?
Today your Porsche 928, if kept in reasonably good condition, would be worth around $20,000.
Sorry Mr Porsche.
The median value of a Sydney property has increased to $642,000 so your 1.75 properties could be worth $1.12 million.
If we include rental from the property returns that figure could now be an impressive $2.25 million (see Table 1).
In case you think I’ve picked a high returning asset class to compare with the poor old Porsche, I’ve included a parcel of shares in BHP (current value approximately $5.4 million; compound return 13.8 per cent per annum, based on the same initial investment amount of $211,856) and a parcel of shares in NAB (current value $4.5 million; compound return 13.0 per cent per annum) shares over the same time frame – which have actually done better than the median Sydney property.
Recently, the original Adam West 1966 Batmobile was sold at auction for an impressive US$4.2 million – apparently the atomic turbine engine and rocket launchers aren’t real – but notwithstanding this rather large let-down, the car sold well at auction.
That car was purchased for US$15,000 in 1966 and the recent sale price represented a compound rate of return of 12.7 per cent per annum over 47 years.
So not ALL cars are bad investments. Just make sure they are one-of-a-kind, black with bat fins!
Two points from this bear further discussion. The first is that small differences in compounding rates add up to large differences over time.
A difference of just 3 per cent per annum over the 25-year period results in a total return figure which is twice as large (look at the Sydney median property price with rental return ($1.2 million) versus just the capital appreciation figure ($640,000).
The second point to bear in mind is that this is the reason we look for sustainably high return on invested capital (ROIC) businesses in which to invest money.
A company’s ROIC is a proxy for its ability to re-employ retained capital.
It directly drives a company’s earnings growth rates which drives the share price performance.
Whilst this is only an approximate estimate of what a company can earn into the future, we’d rather have a portfolio of high-ROIC businesses than low-ROIC businesses.
I have laboured the point that investing in stocks on the basis of yield is a highly flawed strategy in our opinion – especially over the long term.
In fact we would rather be invested in a business that could reinvest ALL of its earnings at high incremental rates of return than one which paid out a handsome dividend – precisely because of this benefit of compounding.
It is also for this reason that Warren Buffett hasn’t paid a single dividend since 1965 and rumour has it still drives a 1987 Cadillac.
Outlook
With markets having rallied significantly towards the back end of 2012 and early 2013, stocks don’t represent as compelling value as they did last year.
Our portfolio tilt has shifted more towards cyclical stocks as we have found, from a bottom-up basis, better value in these sectors.
With many investors heavily invested in cash, bonds and corporate credit, we suspect equities might do well as money is re-weighted into so-called “risk” assets like equities.
Although from a bottom-up basis we are finding absolute value more difficult to find at the moment, we suspect equity represents a far better place to invest money than very low yielding government bonds where the risk of capital loss from repricing and credit deterioration should be a very real concern.
Marcus Burns is senior portfolio manager, Australian smaller companies at Schroders.
