Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

Invest in Sydney/Brisbane property markets, or for media/public speaking requests, email pete@allenwargent.com

Monday, 7 April 2014

Friction

Transaction costs

I've been having some fun over recent weeks re-reading Buffett's famous Letters to Shareholders, and today will touch on a subject he covered in his own inimitable style in Berkshire's 2005 missive: frictional costs in investing, frequently referred to elsewhere as transaction costs.

Long-term returns

Through the 20th century the Dow Jones industrials index increased from 66 to 11,497. Pretty impressive huh?


Source: stockcharts.com/freecharts

If compound growth tables are your thing you'll easily be able to calculate that this equates to annual return of a bit less than 5.5%. The maths isn't really all that important, but here it is: 

The index, which opened at 66 (let's call it 60), has doubled a little bit less than 7.5 times over 100 years to reach a level of around 11,000...so 100 years/7.5 times = 13.33. 

Then you simply use the "Rule of 72" to calculate the annual compounding growth rate: 72/13.3 = about 5.4% per annum (the actual figure is closer to 5.3%, but hey, that's near enough).

More importantly, what this shows is that US companies over the 20th century were tremendously successful!

Despite the Great Depression (1929), two World Wars (1914, 1939), the stock market unravelling by more than 22% during just one trade on Black Monday (1987) and heap of other bad stuff happening, becoming wealthy in the 20th century was fundamentally very easy.

All you had to do was own the index throughout the century and you would have scored an outstanding result, both in terms of the growing dividend income streams and the compounding capital growth.

Since this approach attracts neither transaction costs nor regular capital gains taxes liabilities, it is surely hard to beat as an approach for average investors. 

Buffettology - reductionism

Buffett is sometimes referred to as a "reductionist". He has the uncanny ability to take complex ideas and explain them in an exceptionally simple way using clever analogies that almost everyone can understand.

He asks us to consider, for the sake of argument, that one family owned all of the shares in the US index over the 20th century. The family would get very rich over the 100 years. Simple.

But then consider that - humans being what we are - each member of the family tries to "get ahead" of the others by trading shares just a little. Clearly, as a group they can become no wealthier, since the companies they own can create no more wealth in aggregate.

A group of stockbrokers will doubtless appear to help them trade shares (for a fee, of course). Since brokers generate their fees from the prevailing levels trading activity, they will be incentivised to encourage the members of the family to trade more frenetically.

Then, over time, more brokers - what Buffett would term "Helpers" - will appear to charge the family members fees for their stock tips, generating more frictional costs.

Remember, the family between them still owns all of corporate America, they are really only rearranging which member of the family owns which companies. The more the family trades, the less wealth they can earn.

Then more Helpers, in the guise of expert fund managers, come onto the scene, each professing to able to help the family members outperform the rest, and for a fee of perhaps 1-2% per annum will aim to help them do so.

Then financial planners and institutional consultants arrive to recommend which of the fund managers to use, although there's no guarantee, of course, that the financial planners the family members choose will be the right ones.

Not only are the family now struggling to pick the right stocks or the right stock-pickers, they are struggling to pick the right pickers of stock-pickers.

And all the while, each new layer of fees is chipping away at the net returns.

Perhaps the solution, then, is to pay more for the Helpers? And so "hedge funds" spring up promising higher returns, although in a sense, they are only really like fund managers in a new guise and with a smart-sounding new name. Oh, and these Helpers charge more - much more - in the form of results-contingent fees.

In aggregate the market can create no more wealth, yet the transaction fees keep on mounting. Instead of an aggregate return of 100%, the family may end up with a return of perhaps 80% thanks to frictional costs and capital gains taxes.

As a group they would, of course, be far better suited to inactivity - sitting in their rocking chairs and enjoying the gains mounting up - yet the constant bombardment of advertising and the ever-present urge to get ahead lead to a huge amount of nonsensical trading and speculating in the market.

Isaac Newton could, noted Buffett drily, have added a fourth law of motion: returns decrease as motion increases!

Other asset classes - timing the market

We've been talking about how average investors might approach shares above, the clear implication being that most of us would achieve a better result by investing in a low-cost index fund, steadily adding to our holdings over time.

Naturally enough, similar principles apply in other asset classes, and go some way to explaining why so many budding property investors never go on to achieve the results that they want. 

Suppose the future average growth rate of the property market is 4.5% - which is much, much lower than the growth rates we have seen in the past - yet an aspiring investor thinks he can beat the market by investing in a "regional hotspot" or mining town which attains a capital growth rate of 5% for an entire decade.

For the sake of argument the investor uses a $100,000 deposit to buy a $500,000 house, uses an interest only loan, and incurs closing costs on the purchase of $25,000 (click chart). 


Ignoring the impact of any holding costs for a moment, the investor who can achieve such a growth rate will have built equity of more than $400,000 at the end of year 10.

However, when they come to sell the house, they will incur estate agent fees and capital gains taxes which might easily add up to more than $60,000 of their gains to be paid out. 

Because of the risk employed (the use of signicant leverage) the net return on the initial capital employed of $125,000 might end up being over 10% per annum. In real terms (after an assumed inflation rate of 2.5% per annum is stripped out) the investor might have doubled their initial capital employed over a decade.

Time in the market

Just as in the share markets where the most remarkable tales of wealth often seem to involve old ladies who dropped $10,000 into the share market seven decades ago and simply left it there, so it is in property.

Strange though it may seem, the most dramatic gains are often recorded by the elderly, who bought a house decades ago and "stayed in their rocking chairs", as Buffett might say. Inactivity becomes their greatest ally.

Back in 2008, a ramshackle beachfront house which was built in the 1920s by a chap called George Dodd was sold by his granddaughter for $5 million - that was down in Wollongong on the New South Wales south coast. I remember it going up for sale very well: a terrible house in a superb location. As the family's place of residence, it would have attracted no capital gains tax either - now that's a smart way to avoid frictional costs!

Take another scenario where a $100,000 deposit and an interest only loan is again used to buy a $500,000 property, which achieves a lower capital growth rate of 4.5%, but is held instead for 36 years (click chart).


Impressive equity of more than $2 million is built over that timescale, with year 35 being significant in that the nominal capital growth achieved in that year is even greater than the initial deposit of $100,000. That is the power of compound interest at work.

Thanks to the high capital growth rates experienced in the 1990s, I've experienced a similar outcome myself in much less than 35 years...well under half the time, in fact.

These are some simple theoretical examples, but they demonstrate the power of compound interest where it is allowed to run unimpeded by transaction costs and capital gains taxes. Property investors who elect to pull out some of their equity to invest in other assets (rather than selling their investments) generally finish far ahead of those who try to be clever by skipping in and out of the market. 

More pertinently, timing the market in real estate is devilishly difficult, and perhaps most will fail to get ahead at all using such an approach.

The $64 billion question

Perhaps no-one on earth understands the power of compound interest as it implies to investment better than Buffett himself, which is what allowed him to turn a relatively small initial float into a net worth of more than $64 billion. 

Even when his tranches of Coca-Cola shares were periodically over-valued, Buffett remained disinclined to sell them.

Lest anyone thinks that one man generating such incredible wealth is obscene, note that Buffett and Bill Gates through their Giving Pledge brainchild, will facilitate what will by a long stretch be the greatest private charitable giving in the history of the planet.

More than 90 billionaires quickly signed the Giving Pledge (including Australians Andrew and Nicola Forrest), whereby they will each donate at least 50% of their net worth to charitable causes. Buffett himself will give away 99% of his wealth, a huge chunk of it being gifted to the Bill and Melinda Gates Foundation.

Each and everyone one of these billionaires understands the dual power of leverage and compounding growth, which is why, one suspects, so many of them are to focus on giving to causes which incorporate education, which can be one of the greatest compounding forces of all.