Thursday, April 29, 2010

Are we going into a double dip recession? How am I supposed to know?

Does it matter? Has the Easy Money been made? Whine, whine, and whine!

Ok, I’ll give you all the answers. And I will of course be correct until the day that I am wrong. So take it for what you think it is worth. But I don’t think we are going into a second recession. On the contrary, I am predicting a next high for the TSX to be... 18,000-19,000 and we will reach that in 3 to 4 years. After that we will crash to about 11,000 and everybody will say this is the worst they have ever seen and that the world is coming to an end. The bankers and politicians and the speculators should be shot and blablablablabla.

Look at the TSX graph below (B.T.W. the Dow doesn’t look that different). B.T.W do you know what B.T.W. means in Dutch? Yes of course, ‘Belasting Toegevoegde Waarde’! You didn’t know that? Well here you read it first! The B.T.W. in Holland is Canada’s G.S.T. Now that is funny! (for an investment geek like me).

So look at all those ‘Bubbles’! If you had a magnifying glass, you may recognize October 1987, the ‘Worst Crash Since The Great Depression’. Oh, and the previous Worst Recession Since The Last Depression’ was 1982. You need a Electron Scanning Microscope for that one! Ready for some math?
  1.  Take the value from the 1982 low, the 1987 high and the October 1987 low. 
  2.  Take the value from the 1987 low, the 2000 high (yes there was a recession then) and low.
  3.  Take the value from the 2000 low, the 2001 high and the 2003 low
  4. . Etc.
Now calculate the average stock market fall from the high and increase from the low. Here are my results based on the median. The big surprise was the consistency of the loss from peak to trough (around 45%) and the increased value from the trough to the subsequent peak (145%). Right now, we have recovered 72% or so from the 2008 low. Darn, this is so easy, you don’t even need high school for this.

So when you step back from the ‘The End of the World is Near’, things seem to be more predictable, as long as one sticks to generalities. Can you predict exactly when to sell before the next peak? If you listened to Peter Lynch, you know you can’t. But you sure can have an idea as to when you would like to start taking profits and when to have cash on hand for buying during the next downturn.

See you don't have to be dead on. Remember, Bulls and Bears do fine, but Pigs get slaughtered. Why, because of the pigs' greed and fear; they want to buy as cheap as they can and sell it for the most possible. In real life, that is not do-able and the pigs tend to miss the boat or worse. But you can buy at the right price and take some profits when things become 'frothy'. Never forget this is a game for the long haul and the investor who panics is most likely to lose.

Tuesday, April 27, 2010

Buying at the right price is my way of market timing.

When buying an investment, how do you know the price is right? This is the second toughest question for an investor, right after when to sell. So we have decided to buy into the stock market with the expectation of having a return between 6.5 and 7% plus inflation per year. That, according to Jeremy Siegel is the typical return on the stock market long term. But does that mean you are starting to buy right now?

Not necessarily. Here are a few things you want to check out:
1. Is the market trading near a 52-week high or a multi-year high?
2. Are we in an overall market up or down trend?
3. What is the average market dividend yield and how does it compare with short and 5 year interest rates?
4. What is the typical price to book value?
5. What is the P/E ratio on average and how does it compare with short and 5 year interest rates?

As long as the market seems to behave reasonable, i.e. there is no speculative frenzy with shares trading reasonably compared to interest rates (questions 1-5), it is fine to buy. Buy in such a market and hold for the long term, as discussed earlier, and you will do O.K.

If you do not understand the terms above, it would be advisable to study past postings on this blog and a number of books on stock market investing. A listing of books for beginning investors in the stock market goes beyond this post. However, if anything above does sound unfamiliar to you, do NOT invest in stocks until you know more.

As you may have noticed, we are not talking about individual stocks, buying such shares requires considerable knowledge of specific companies. Some people buy on tips from neighbours, friends or acquaintances, this often results in significant losses, so we don’t.

What about mutual funds? Many investment letters state that active managed stock portfolios such as mutual funds are a good way to invest in a diversified manner. But they also tell us that the management fees and commissions paid for those mutual funds are so high that the investment returns underperform the stock market.

For now, why not buy all stocks of the TSX300 instead? We could use an Exchange Traded Fund (ETF) which you can buy through your discount brokerage at a low commission and with minimal MER (Management expense ratio). OK we’re done! We buy it and let it sit for the next 200 years ‘et voila’ a greatly diversified investment portfolio has been created.

We could refine our strategy a bit. As discussed in earlier blogs, a significant proportion of profits is derived from dividends that are reinvested. Dividend paying companies are well established and because of their confidence in their future performance, they pay out part of their profits. Some of these company’s also buy back their own shares, something not yet discussed on this blog, but it often contributes to further profits for the investor. Personally, I prefer to invest in the largest company’s of the TSX, often called the TSX60 companies. Many pay dividends and are very well established. Currently, in my opinion, Canada is one of the best places in the world to invest, so let’s stick for now with Canadian stocks of the TSX60.

Rather than investing all our money at once, kind of gambling that today is the best day to buy; one can follow some specific buying strategies. One such strategy ensures that you don’t have to be too concerned about the buying price. It is called ‘Cost Averaging’ and consists of buying stocks in relatively small amounts at regular intervals, e.g. every month.

There are some considerations though! You may like to invest every month $50. However, you would have to pay the discount broker $9.99 commissions for each purchase. That is 25% commission; Ough! Answer: Join the Canadian Shareowners Association. They let you buy small amounts at one time for small commissions. Also they have a great dividend reinvestment program that allows small investors to buy with no commissions.

Or... you could invest once every two months then your commission is still $9.99 but now on $100 invested. This is still high (12.5%) but it is more reasonable. So, you get the concept: either save more or invest once every 6 months or so to get your commission rate down.

Say, you have every month $500 to invest.Then your commission of $9.99 represents just under 2%. Not cheap but as long as you don’t sell for a number of years it will become negligible. So say you invest $500 in January of year 1 in an ETF of the TSX60 which at that time trades at $19.00. You buy 500-9.99 divided by 19.00 = 25.79 shares. A month later you invest another $500 when the share price is $18.73 and after commission you buy another 26.16 shares. After three months you receive your first dividend, say $11.99 which you will reinvest in the fourth month together with your $500 contribution. At the then prevailing share price of $17.00 you buy another 29.53 shares. You keep on doing this for the next 5 years and although prices overall increase at 7% per year with an average dividend yield of 3%, prices are quite volatile varying by as much as 50%. .

So since you invest every month $500 or $500 plus dividend, you buy more shares when prices are low and less when prices are high. This technique, called 'cost averaging', allows you to invest without emotions, and you are purchase costs will average out over time. Based on my spreadsheet model and depending on the random market movements (with a 50% price volatility), your return on investment will range from 9.9% to 15.3 and typically be around 12%. If you did not re-invest the dividends but rather kept the cash, your return would be 0.4 to 0.7% lower. The graph below shows how the price movements may have been.

If the market price had been less volatile, say up or down 10% rather than 50%, your ROI would have been a lot less ranging from 5.4% to 5.9%. So with income averaging and investing every month $500 like clockwork in a volatile market (a high risk market as people may say) your return would have been easily double than when the stock market was nice and smooth and ‘predictable’. Even if your initial $500 purchase had been made at the peak of a bull market, you would have done fine – as long as you stuck with the plan and did not sell in a panic!

By investing $500 each month over a 5 year period, my average amount invested would have been $15,000 over 5 years. If I had invested that $15,000 at the absolute bottom of the market at once, my return would have been 28.6%. Which shows that the price at which you invest is important; but who can time that well?  Of course, you could have made several purchases spread out over the duration of a bear market instead.Your average purchase price would not have been as good as at the perfect bottom of the market, but chances are that you would have bought at a significant lower price than using the cost averaging method and your returns would probably have been well in the 20% per year range, which is something many real estate investors dream of.

So, market timing is a sure way to lose or under perform. Cost averaging in a volatile market will result in respectable ROIs. Buying at the perfect market bottom is impossible; but buying at a good price spread out over a significant portion of a bear market will result in achievable and very attractive results. That is what I mean when stating that you want to buy at the right price (not necessarily at the perfect price). Simple as this sounds, it takes a strong stomach to keep on buying in a bear market while seeing your net worth falling every day. But that is when you will make the best ROIs, provided you have cash.

On market bubbles and contrarian investing

On the REIN forum several posters were looking down on the masses fearing a Canadian Real Estate crash as economists such as David Rosenberg have pointed out in recent days. Here is my take:

The issue is that Canada's housing market has many segments and those segments can be further subdivided into many areas. Nobody is going to be an expert in all of those different local market segments. It sounds to me, and it really is 'sound' because I don't invest in many of these markets, that condominium complexes and other real estate market segments are 'frothy' in areas around Vancouver and Toronto where a large portion of our Canadian population lives. These two (and maybe also include Montreal and Ottawa) comprise a large portion of what we call euphemistically the 'Canadian Real Estate Market'.

But other markets such as luxury condominiums in Canmore are still severely depressed although possibly stabilizing. Calgary's condominium market is also hard hit and may fall even a bit more over the coming months, while in Edmonton things appear to turn around for the better.

Regarding the statement that the masses are always wrong, that is incorrect. Even the masses may see the obvious. The difficulty with contrarian investing is that you don't go against the masses out of principle or by definition. It is more about anticipating the unexpected which may prove to be the most profitable.

Yes, the market may be 'frothy' in the opinion of many, but that does not mean the obvious crash is nearby. The market may go up a bit longer, it may go sideways for a long time instead of crashing or... certain local market segments may crash while others will do fine or even excellent. In fact, as a contrarian you may want to say, "Things will likely be different than the masses expect, the question remains where will the most profitable opportunities occur?" That is something not even the contrarians can answer with certainty.

Reality is that the investor should be aware of trends, because it may help identify opportunities, but the true key point is to buy assets at the right price with enough price cushion and cash flow to get by the rough spots. Something that is again a lot more difficult to do than say.

Wednesday, April 21, 2010

Head Fake?

Why were my RRSP returns so anaemic over the last decade or two?

RRSP or Registered Retirement Savings Plans are the best thing other than apple pie, or so we are led to believe. Well, I have an RRSP and its returns have been not very exciting. My Quicken files haven’t been corrupted since 2003 and my return was 4.33% per year. Not counting tepid performance for the many years before that.

I always paid the maximum or near maximum contributions, but the RRSP was always the poorest performer in my portfolio with 2008 being the exception. For two decades interest rates have been declining, and although I made some disastrous forays into the stock market (Nortel and Air Canada), the bulk of the RRSP was focussed on interest income. If it wasn’t for a long term investment in Vermillion Oil & Gas with an annual return of 17.85% starting in 1998 for around $7.50, the portfolio would have performed even more dismal.

One of the big financial events over the last decade has been the falling income tax rates, here in Alberta from 52% or so to as low as 38% last year. The other major event was the falling inflation rate and with that falling government deficits which like a never-ending reinforcement cycle resulted in falling interest rates. All these events are now coming to an end. I don’t foresee a return to the high interest rates of the early 1980s but similarities with the 1970-1980 decades are uncanny.

So, I made this little spreadsheet showing falling interest rates which were typically 10% in year 1 (assuming 7% inflation) and at 0% in year 10 with an inflation rate of 1.2%. I assumed the declines of both inflation and interest rates were gradual. I did the same for the income tax rate (See table I below). I made each year a $1000 contribution to my RRSP which resulted in a tax refund that varied depending on the prevailing income tax rate and the net investment increased accordingly.

Table 1 – After Tax Real Returns on Annual RRSP contribution of $1000.00

For example, in year 1, the $1000 contribution resulted in a refund of $520 and the net investment was $480. The $1000 earned 10% interest or $100. When withdrawn in the next year, at a lower tax rate, that was an after tax return of $49.56. After deducting that year’s inflation my return on $480 actually invested would have been 3.3%. In year 10 that return would have been -1.2%.

Of course, in real life, I would have earned over the entire 10 year period a lot more (see table II). A one-time contribution of $1000 would have again been an actual investment of $480. After 10 years of falling interest rates, it would have resulted in a $1623.75 RRSP balance, which when withdrawn today would have been worth $1006.72 on an after tax basis. Within the RRSP the return would have been 4.97% (very close to my real life performance since 2003) and on an after tax basis (with an actual investment of $480) the return was 7.69%. So what did inflation do?

Well the purchase value of $480 year 1 dollars declined to $315.22 and the real inflation corrected return was: $1066.34 and after tax that would have been: $449.31. So when everything has been said and done,  my $480 initial invested money would have been worth on an after tax and after inflation basis: $449.31, I lost close to $40 in purchasing power. In real life, since 2003 my return inside the RRSP was 4.33% so I guess I did do even worse. Well, at least I still have all my marbles, or do I?

To add insult to injury, I will confess I invested a lot of my RRSP money in Canada Government Bonds. They got my money for years for free!. Ah, well at least I didn’t invest in Canada SAVINGS Bonds!!!!

Table 2. Performance of One-time $1000 RRSP contribution (see rates and years as Table I)

Tuesday, April 20, 2010

I just came back from my annual visit with the accountant - just as pleasant as visiting the dentist, but this time....

This is not always a good time of the year, when the tax man cometh.

So I went to my accountant to pick up my tax returns. After many years, I finally have to pay something that not blows me out of this world. Partially because my semi-retiree finances have finally stabilized. (I better find something new to get me in trouble.)

But not only that, my tax return print out declared I have room to make a sizeable RRSP contribution. I thought that I would have virtually no room to make contributions since I don't earn employment income any longer. My accountant explained to me that rental income also qualifies for determining your RRSP contributions.

So here is another advantage you may want to tell your retired JV investors about. Rental Income creates RRSP contribution room! Hope this is a useful tidbit. But before sticking out your neck, confirm this with your accountant.

Saturday, April 17, 2010

What is better stocks or real estate?

First of all, real estate is not necessarily a better investment than the stock market or bonds and visa versa. It all depends on the specific investment opportunity. People should invest in all these asset or investment classes. When one class is doing poorly another may perform better. Also, what all these investments have in common is that they are long term investments.

One should not advocate day trading or flipping houses in general. This is risky speculation rather than investing. I cannot tell you why others invest in real estate or stocks, however, for me, the reason to invest in all these investment classes is obvious: risk mitigation or as many would call it: diversification. You just don't want to put all your eggs in one basket.

Real estate investments have different characteristics than stock investing. For starters there is more work and control involved. Even for passive JV investors, the involvement with a real estate JV is more than with most stock investments and so are the risks. Some of the different investment characteristics.

Real estate lets you leverage your investment because it is less volatile. In fact you can control the volatility of your investment by determining your amount of leverage (LTV). The higher the LTV the higher the risk that your equity in the investment goes up and down as an amplified response to changes in the property value. Also, the amount of leverage is an important tool in determining the ratio of cash flow, mortgage pay down and appreciation components of your return on investment.

When investing in stocks, the opposite happens. First of all you are not in control - for all practical purposes you just rent out your money. On the other hand the investment is very liquid, you can sell it typically in a matter of hours and days. Share prices are more volatile and therefore the risk of using leverage is much higher and can result in financial disaster. Why is this? Well simple - the business you invest in is already leveraged - i.e. corporate debt. Both real estate and stock market investments are leveraged. But in the case of real estate the investor is the borrower and he/she is liable for repayment, while in the stock market the corporate loans are secured against the corporation and the corporation is liable for the loan.

So a true diversified investor does use both paper securities and real estate for purposes of asset allocation. Is Gold better than stocks? Are options better than bonds? Are commodities the place to be? It does not matter; in a properly allocated portfolio you want them all - provided you take the time to understand these investment classes.

This is key; many of us are lazy and only go into real estate or we only go into stocks. Well in doing so we are limiting ourselves and our potential to profit. Also, we increase our investment risk. This is fine; it is entirely your decision. But, you are also responsible for the outcome. Not your realtor, not your financial planner, not your banker or mortgage broker, not your lawyer or the stock broker, it is YOU who is responsible for your investment performance. You are the captain of your investment ship, all others just advice (poorly or wisely).

Tuesday, April 13, 2010

Godfried’s 10th forecast of the year - The major investment themes of this Decade are becoming increasingly clear

  1. Oil prices will continue their uptrend after the interruption of the 2008-2009 Great Recession
  2. Gas will be the truly best investment opportunity of this decade
  3. Demographics will strongly influence the labour market:
    • a. Babyboomers will work longer for social and economic reasons creating a highly competitive market for experienced workers.
    • b. Echoboomers and younger generations will benefit from Babyboomer attrition and the corporate needs to have a continuous experience range in their labour force.
      • Educated workers will be in high demand.
      • Surprisingly workers with a craft will be in high demand as well
      • Blue collar labour and new immigrants will find better employment opportunities in N. America when high transportation expenses and the increasing affluence of emerging market workers will make manufacturing close to population centres more competitiva
  4. Inflation is a conundrum. Babyboomers will have higher savings reducing credit demand. With less people in younger generations the demand for ever more education moneys will abate. Immigrants with basic education are cheaper than promoting higher birth numbers. Although healthcare costs will escalate, the Babyboomers are the wealthiest generation in history – a two-tiered healthcare system where upper middleclass and wealthy retirees pay for their own healthcare while the less affluents will be the only population group for which provincial health care provides is nearly unavoidable.
  5. Higher energy prices in the past were considered the result of inflation and an over-heated economy. This caused central bankers to raise interest rates, which in turn caused increased government deficits. This time, we have hopefully learned. If interest rates are tied to core inflation rather than energy and commodity prices, in spite of massive government debt, interest rates hopefully do not reach the excessive heights of the 1980s.
  6. Return of Manufacturing to the major population centres of Eastern Canada
  7. Increasing wealth and population in Western Canada will be centered around Calgary and Edmonton. With the bulk of oil&gas company headquarters established in Calgary and the centre of industrial services in Edmonton, these are the two economic power houses of the West. Vancouver will wilt because of the absence of oil&gas company head quarters and because of its high lifestyle costs and expectations. Vancouver is no longer competitive.
  8. China and India will cater increasingly towards their more affluent and growing middle class. Their economic growth will moderate to the 6 to 8% range, in particular due to decreasing exports. North America will benefit from abundant and relative cheap gas prices (when compared to oil). The tendency of oil companies to pay for ever higher land sale prices and extraction methods will make oil less profitable than gas in spite of ever increasing oil prices.
  9. Saskatchewan will likely recover from the set-back of the fertilizer price crash. It will benefit from uranium, potash and to a lesser degree from increased oil prices. Its economy will become increasingly dependent on commodities, while the absence of major population centres and corporate head quarters will prevent economic diversification and limit population growth.
  10. Ontario’s manufacturing will recover but it will be economically outdone by Alberta which will become the economic powerhouse of Canada with Calgary taking over as the most hated city of Canada and The magnet for immigration.

Dissenting opinions please.

Thursday, April 8, 2010

Is this the right time to buy?

How many times do I hear this question and throw up my hands in desperation. Market Timers! Speculators! Some make money, most lose it. To pick a market top or a bottom is nearly impossible and to do it consistently is even more difficult.

It doesn’t matter whether you invest in the stock market or in real estate. Market timing is a money losing game. Even if you time the market perfectly and you pick the bottom, next thing you know is that you picked the wrong stock or in your excitement of having picked a bottom dead on, you paid too much for the property because you were afraid of losing out. Statistics have shown over and over again that very few people call a market top or bottom correctly. If people like Warren Buffett, John Templeton or Peter Lynch don’t bother because they know they can’t then why do so many less skilled investors try to time their investments?

Really, how many gurus have consistently forecast market tops and bottoms? None, except for liars! Guess what successful investors don’t even bother. What they are concerned about is buying an investment at the right price! Here is why.

According to Jeremy Siegel’s data in his 2005 book: The Future for Investors, inflation for the last 200 years or so averaged in the U.S. 4.2%. The Bank of Canada states that the average inflation rate in Canada for over the last 40 years was 4.6%. So what does that tell you? Yes! Over the long term prices do not go down but up!

For those who missed this cute statistic:

Ever heard about GDP or Gross Domestic Product? Every month, every quarter, every year, we measure the GROWTH in GDP. Sometimes GDP declines (in recessions and depressions) mostly it goes up. If the economy grows over time, typically as measured in terms of GDP, then corporate profits increase accordingly. So why would the stock market then decline over the long term? Or why would housing values fall over the long term?

Housing and stocks are known to be protectors against inflation and of course their value increases with overall economic growth. Housing typically goes up in value when employment rises, when wages increase and... when the population increases. There are very few countries in the world, if not none, where there is no inflation, where there is no economic growth and where the economy does not grow over the long haul.

Investors, buyers of stocks or of real estate and numerous others may get caught up in euphoria and overpay for products or investments. But when matters get too out-of-whack or too disconnected with economic reality and/or demographics, we get corrections, recessions and sometimes even depressions. Over the long term, however, everything goes up.

Somewhere in the next 50 years or so, growth of world population may cease. Many countries have policies in place to rein in population growth and immigration because they fear that the economy cannot sustain a good quality of life for so many people. There is truth in that. Look at developing countries such as Egypt where economic growth fell behind population growth and the misery that can bring. Yet, in history overall, large increases in world population coincides with an increase of innovations.

Basically, the idea is that population growth may require lifestyle adjustments forcing, e.g. new sources of energy. For example, coal in the Renaissance and Industrial Revolution became a major environmental disaster – remember the smog and acid rains in an over-populated London during the adventures of Sherlock Holmes? It was soon replaced by electricity, oil and gas which with a growing population were more sustainable forms of energy. Fears of Climate Change, wrong or right, pollution concerns, oil tankers broken up during major marine disasters, the disappearance of cheap oil and gas are cause for the current revolution in energy technologies. Population increases force often big innovations. Not only that, the number of geniuses will increase along with the growth in population and that leads to ever more new discoveries.

Innovation and its relative ‘creative destruction’ create economic growth, and even if the world population growth momentarily comes to a halt, I am sure, innovation and discovery will continue to increase our productivity and thus our economic growth for eons to come. Who knows what will happen, what the consequence would be of the discovery of interstellar travel. In my mind, we, mankind, and our economy will forever grow!

This growth will not be homogeneous. There will be ups and downs around our average growth. But unless we create a true ‘End of the World’ disaster, mankind will prosper. So whether it is real estate or stocks or bonds or investments in general, the overall long term picture will be the one shown below. Stop whining and be happy! Let economists and other ‘chickenlittles’ worry, they seem to like it. We are more humble and only have the dream of becoming rich.

So now, that we are all believers in long term economic growth and the idea that we have economic ups and downs lining this overall growth pattern it should be easy to grasp why market timing does not work! Look at the graph; let it become part of your subconscious sense of reality. For this you don’t even need a law of attraction, it is so basic! Jeremy Siegel came up with an inflation corrected average stock market return based on data from the last 200 years of 6.5 to 7%! If you look backwards to the Great Depression and beyond, does the stock market graph not look exactly like the picture above?

So, say you bought a stock during the downturn labelled ‘Red A’ on the graph and you didn’t sell at the high ‘Blue A’. Your profits were cut in half if not more during downturn ‘Red B’. But guess what, if you wanted to buy more of that stock during down turn ‘Red B’ at the same price as at the low of down turn ‘Red A’, you may have to wait a long time if not forever because the average stock is typically not to go that low again!

So you bought on market high ‘Blue A’ and you kept your stocks or property during Red B. Guess what, by the time you are at the next market high ‘Blue B’ you are profitable again. And if you waited even longer and experienced downturns ‘Red C’ and ‘D’ you would despite market setbacks still be profitable. Now add a bit of dividends or when dealing with real estate add your mortgage pay-down and positive cash flow! You see the beauty of this scheme?

Only if you panic during down turns or if you are forced to sell because you were over-leveraged or plain out of cash, then you would have suffered losses. These are some quotes from Peter Lynch, world renowned stock market investor:

The only thing I know about predicting markets is that every time I get promoted, the market goes down. Obviously you don’t have to be able to predict the stock market to make money in stocks, or else I wouldn’t have made any money. I’ve sat right here at my Quotron through some of the most terrible drops, and I couldn’t have figured out the drop beforehand if my life depended on it. In the middle of 1987 I didn’t warn anybody, and least of all myself, about the imminent 1000-point decline”

“I wasn’t the only one who failed to issue a warning. In fact, if ignorance loves company, then I was very comfortably surrounded by a large and impressive mob of seers, prognosticators, and other experts who failed to see it too. “If you must forecast,” an intelligent forecaster once said, “then forecast often”.”

So how do you invest? Quite simple, you buy when the PRICE is right not when the price is perfect! Make estimates of income streams, cash flow, profits. Look at how much you have to pay for said profits and how that price compares with other investments. For example, company ‘A’ earns 1 dollar per share which can be bought for $10. In the same industry, you can buy $1 earnings from another company for $100 per share. What is the better deal? If interest rates are 5%, you earn 50 cents for every $10 invested. How does that compare to shares of company ‘A’? In real estate you can make $1 profit for every $7 dollars invested. So which is the better investmen real estate or company 'A't? What is a good price?

Of course, you want to incorporate other factors than just return on investment in your decision. In particular, determine how risky an investment is. Being able to determine risk is why it is so important to compare apples with apples and not with oranges. That is why it is so important to understand an investment thoroughly! If you don’t, then do just like Warren Buffett, walk away.

Comparing Apples and Oranges - Follow Up

Thanks for the input from all of you.

I did this comparison so as to get a better understanding how real estate and other investment classes compare in terms of financial performance. It finally dawned on me, that many such comparisons are not correct and that the above results get closer to reality.

When dealing with real estate, a major issue is the division of strict investment returns versus returns on the work you do. As said before, investing in my opinion represents the return on your money, i.e. your money works for you.

Real estate investing has two components of income: return on the money invested, but also compensation for the work done, whether this is done by a rental manager, a renovator or by the real estate 'investor'. To truly compare investment returns you should look at what a passive JV makes, because he/she is the only true investor dealing with return on money invested. So here, one can compare with the performance of other investment classes.

When looking at 'normal investment returns', Return on Investment is not often used; a better basis for comparison is the 'time value of money calculation' and the there from derived compound rate if return, yes the same one used for many GIC investments.

The other issue when comparing investment returns is risk/reward. Stock market returns are looked upon by many successful investors as long term investments. Jeremy Siegel is a big proponent of this. But many others as well. Over the long term (last 200 years), after inflation stocks returned 6.5 to 7% and including inflation around 11.2%. In terms of risk, I came across the following, very interesting statistics - Time (horizon) of investment and the probability of Loss in the Stock Market (W.J. Bernstein):

Time horizon     Probability of Loss

One hour                      49.58%

One Day                       48.80%

One Week                   47.36%

One Month                 44.51%

One Year                   30.85%

Ten Years                  0.59%

100 Years                 0%

Stock markets are obviously volatile hence many perceive it riskier. But over the long term, as you can see it is one of the most profitable ways of investing and yes, returns of the last decade on average were poor, but the table above shows that it might have been even a loss. This does not make these poor investments. And I can tell you that my stock market returns over the last ten years were a lot higher than I ever made in real estate.

When investing in stocks, your liability is restricted to the money invested. Even a passive JV investor, using leverage, can lose a lot more than the money invested. On top of that, there are operational risks as several investors in Grand Prairie experienced. The 'finder' may turn out not to be very experienced; JV investors may have a fallout and the JV collapses, the rental market turns sour. Then there are liabilities, environmental liabilities, safety liabilities. Do I have to go on?

So the risk, even for a passive JV investor is considerably higher than investing in the stock market. Hence the returns need to be better to compensate for that. The expectation by some budding JV investors here on this forum, that a not guaranteed return of 8.8% should be adequate is, in my opinion' ludicrous. But a friend or relative may go for it because he/she knows the budding investor personally and is full of trust and love. But a true investor would likely not go for that.

I calculated using a typical two bedroom apartment in Calgary with low cap rates and high appreciation that the passive JV investor may walk away with a 14% return. And by massaging the numbers using a cap rate of around 6% and appreciation more typical for Canadian properties on average, the compounded return would be 15%.

This is definitely better than 11.2% for the stock market. However, when adding in the higher risk level and the liquidity of the investment, I gather that most investors would be reluctant to do a JV unless the 'finder' has a lot of real estate experience.

As to only investing in the real estate because the investor feels that he/she is not knowledgeable in the stock market that is completely justified. But... such an investor accepts the higher risk levels by not being diversified.  Someone only investing in Alberta Real Estate would count on the fortunes of the oil industry and maybe a few other local industries. Calgary's economy seems to be more diversified than 10 or 20 years ago. But, I would not count on it.

Investing is all about risk management and asset allocation. In other words: "not putting your eggs in one basket". Having said that, a number of investors (Bill Gates) have become very rich sticking with a portfolio that was not very diversified (Microsoft).

Monday, April 5, 2010

Comparing ‘apples and oranges’ - The real thing

 Please note mistake in table: Berkshire-Hathaway's performance of 9.46% was from 1996 until today - NOT since inception.

Well, here is the real comparison (as I see it) between real estate investments and other investments. All data is expressed as compounded rate of return. The rate based on the compound interest equation:
FV=PV x (1+rate)^ yr
FV= Future Value; PV= Present Value; rate= Compounded annual rate of return; yr= investment time in years.

Numbers are derived from the extensive stock market analysis by Jeremy Siegel (The Future for Investors, published in 2005). There is also comparison data based on the performance of Warren Buffett’s Berkshire Hathaway and John Templeton’s Growth Fund from inception in 1954 to today.

Jeremy Siegel compared long term (200 years) stock market performance with that of various asset classes and the second best asset class was U.S. Government Bonds which had over the last 80 years an average nominal annual return of 7.9%. All these rates include inflation

In a REIN forum post by Thomas Beyer commenting on the first posting titled “Comparing ‘apples and oranges’” stated that real estate returns comprise two components:
1. Return on Time (or labor) investment
2. Return on Capital investment

The Return on Time Investment is basically work compensation, while Return on Capital Investment represents the rent paid for the use of capital. We consider the latter the true return on investment as it represents money working for you rather than you working for money.

A real estate investor can buy a property, rent it out and manage the rental operation, use leverage (a mortgage) to enhance his/her profits and after a number of years the property can be sold (hopefully) at a profit. This is the most basic form of real estate investing (apart from owning your own residence). In this scenario, profits represent a combined return on work and on capital.

The same real estate investor (Finder) may use a partner to provide the capital and financing portion of the transaction. The Finder of such a Real Estate Joint Venture (JV) provides the expertise in locating an appropriate property, finds passive investing partners, arranges for the acquisition, and organizes the financing. The Finder also manages of the property and is responsible for the accounting. In return, the profits of the JV are split on a 50/50 basis.

The question arises as to what the returns of such a JV operation are and how they compare with the return of the other investment classes? The author ran two JV scenarios using a typical Calgary two-bedroom apartment bought at a low capitalization rate (2.6%) and a second property more typical for an average Canadian property at a cap rate of 6.5%. Calgary is known for its low cap rates when compared with the average Canadian property, but the rate of appreciation is typically higher to offset this. In Calgary over the last 33 years, the property appreciation was 8.1% per year, while the average Canadian property appreciated at a rate of 6.4%.

The Basic Real Estate Scenario, run over a 5 year period, with an initial Loan-to-Value ratio of 75% and a mortgage rate of 2.25% resulted in a 23% return for the Calgary property and 25% for the average Canadian property. It should be noted that these are total returns combining both return on time and capital invested.

For the Finder of a 50/50 JV, the return on capital is infinite, since no capital was provided. For the passive investor, the annual compound rate return was 14% in Calgary and 15% for the average Canadian Property. This compares to an annual S&P500 return of 11.9% for a stock market investor.

These numbers show why it is so difficult for starting JV investors to attract capital from passive investors other than friends and immediate family. Finder investors with an extensive successful and consistent track record are more likely to attract investment capital.