Million-Mile View Of Investment Value

Imagine we’re on an intergalactic spaceship traveling far away from Earth. It’s a quiet day. There are no meteor storms or alien encounters to contend with. We’re sitting in the Solar Lounge discussing a topic of great interest to both of us — the root elements of investment value. Our dialogue is as follows:

What defines investment value? Is it the return of an investment over time? We contemplate this and decide that return cannot be a good definition of value because inflation causes prices to rise, which is not an increase in real value. Then inflation gains are taxed by governments, which reduces real value.

Is investment value the real return less taxes over time? Perhaps, but it appears we’re missing something. Let’s take a step back and look at this question more broadly.

We agree that inflation and taxes must be discounted out when determining long-term value. We also agree that risk and return are joined at the hip; the greater the perceived investment risk in the short term, the higher the expected return in the long term.

It also appears universally true that taking risk tends to be rewarded by the government through a lower tax rate. Interest income on taxable bonds is paid as ordinary income while capital gains and dividends are taxed at a lower rate.

I recalled reading a study from 2013 by Elroy Dimson and Christophe Spaenjers entitled The Investment Performance of Art and Other Collectibles. This study interested me because the authors measured very-long-term investment returns for several asset classes. Their data spanned 112 years, from 1900 to 2012, well beyond the life expectancy of an individual at the time. Taxes were not part of their analysis.

Dimson and Spaenjers show that owning small slices of multiple businesses through the stock market is riskier and more rewarding than lending money for an income stream or stashing money in Treasury bills, gold and collectables. They also showed that the volatility of asset class annual returns was directly related to the long-term return, adding more evidence to the theory that risk and return are related.

Figure 1 illustrated the long-term relationship between risk and return graphically. The corrosive effects of costs and taxes were not included. Also, the currency used in the study is British pounds, which has no effect on the point. I combined the three collectable categories, (Art,Stamps and Musical Instruments) in the figure using equal weight.

Figure 1: The long-term relationship between asset class risk and return 1900-2012

Source: Chart created by Rick Ferri; Data Source:  Elroy Dimson and Christophe Spaenjers, “The Investment Performance of Art and Other Collectibles.”

Our conversation turns to the interpretation of the data in Figure 1. First, we looked at each asset class individually to see what explains their risk and return characteristics. Second, we stepped back and looked at the data in its totality in an attempt to draw conclusions.

Over the period 1900-2012, art, stamps and musical instruments (violins) have appreciated at an average annual rate of 2.4%-2.8% in real returns. Collectibles have enjoyed higher annualized real returns than government bonds (1.5%), bills (0.9%) and gold (1.1%); however, their return was lower than equities (5.2%).

UK Treasury bills: Treasury bills issued by HM Treasury have 1-month, 3-month, 6-month and 12-month maturities. Treasury bills are considered a “risk-free” asset in that the probability of not being paid back is supposed to be risk-free. Since there is no perceived risk, there is a low expected real return before tax, and there is no expected real return after tax.

UK Government bonds: The value of bonds comes from the cash flow they generate and the terminal, or par, value. UK government bonds (or Gilts) used by Dimson and Spaenjers were long-term maturities. This created a meaningful volatility to term-risk, which is the price change that occurs when interest rates fluctuate. Significant excess volatility occurred during WWI, which had a major economic impact on the UK. This excess volatility did not occur in the US during the same period. Thus, it can be argued that the Standard Deviation of UK bonds as illustrated in Figure 1 is higher than it would have been otherwise.

Gold: The obsession with gold has existed for thousands of years. Reliable pricing data exists going back to ancient times. Gold does not pay interest or dividends and does not multiply. One ounce of gold does not become two ounces if left in a safe place. Thus, its value is derived solely from supply and demand. Figure 1 shows a real return of 1.1% from 1900 through 2012. All this real return was earned during a short period from 2008 to 2012. Prices have fallen about 20% since and I fully expect they will fall further as memories of the financial crisis fade, demand slackens and more gold is mined. Over the very long term, the price tracks the inflation rate.

Collectibles: The real return derived value of collectibles is an interesting study. Unlike gold, where more can be mined, there is only a limited supply of Rembrandts. This rarity value is reflected in prices over time. The price of collectibles tends to roughly reflect the global growth in GDP per capita. As more people have more money, standard of living increases and the price of collectibles goes up accordingly.

Dimson’s and Spaenjers’s report states that short-term return trends can vary substantially across the different types of collectibles. There’s also important differences in transaction costs between assets. Some transaction costs can be very high. Then there is the issue of illiquidity and related costs such as expenses related to storage, insurance, etc. Taxes are another matter to consider.

Equities: The value of equity is calculated based on the cumulated expectation of all future cash flows and the riskiness of those cash flows not occurring. Companies have four choices after earning money. They can reinvest to earn more money, pay cash dividends, buy back stock, or sit on the cash. It’s common for most large companies to do all four in the normal course of business. With the exception of sitting on cash, all of these activities add value to an investor.

In the long term, the real return expected from equities is the GDP per capita growth rate, plus cash dividends and stock buybacks. Currently, GDP is about 2%, cash dividends are also 2% and buybacks add even more value to equities. I’m expecting a 5% real return from US equities before taxes. This estimate is from the Portfolio Solutions’ 30-Year Market Forecast for Investment Planning (2014 Edition). Taxes on equity investments tend to be more favorable than bond or bill investments. Governments reward us for taking economic risk.

My friend, what have we learned from this simple asset class analysis?

  1. The inflation rate exists in all asset class returns and taxes must be paid also.
  2. Gold has no real return in the long term, assuming changes in supply and demand cancel each other out over time. This doesn’t include paying income taxes, which makes gold unattractive as an inflation hedge.
  3. Presuming a 28% tax on collectables, 25% tax on bonds and bills, and 20% tax on equity, Treasury bills have a small return above inflation, but no real return after taxes. At times, the after-tax return is negative. On the other hand, government bonds have higher real return before taxes and a slight expected real return after taxes. However, long-term bonds tend to have uncompensated risk.  They have historically fluctuated in price due to government decision making. From 1926-2013, the Sharpe ratio for 5-year Treasury bonds is 0.41 whereas the Sharpe ratio for long-term US Treasury bonds is 0.24.
  4. Collectibles are fun and might yield a real return after transaction costs. The expected long-term return is about the same as the global GDP per capita. However, taxes and expenses may take away a large portion of the return. Dimson and Spaenjers suggest that “enjoyment value” should be a major factor when considering this asset class.
  5. This leaves us with equities, the only “true” investment in this study (real estate would be another one). The real return from equity is a result of earnings growth that results from long-term economic growth, and the payment of cash dividends or stock buybacks as a result of that earnings growth. Governments are more tax-friendly to equity investors.

It’s almost time to take a galactic nap, so let’s sum up our conversation. We agree that cash is trash in the long term, and that bonds do work for safety of principal and income over time. We also like gold and collectibles — not for their investment value but because because they can provide emotional value in addition to monetary gain. When looking for real long-term return value in the public markets, we agree that there really isn’t anything that matches equity. These are facts we spacemen can agree on.

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