I didn’t want to write too much about central bankers today. As tempting as it is to discuss liquidity-driven markets and poor economic fundamentals in Europe, I’m starting to sound like a broken record.
What I really wanted to discuss was long-term wealth creation. There are always problems and risks in the market. Our job is to manage those risks. But our whole aim is wealth creation.
Unfortunately, as an Aussie (or Kiwi) investor, you’re on the back foot in this quest. That’s because our market has a lamentable number of options to buy quality, well-run companies. The Aussie share market has very few world-class companies. I’m talking about companies that have enduring competitive advantages…companies that generate high rates of return and compound those returns through reinvesting earnings.
Limited Options to Invest
A big reason for this is that the market is largely made up of resources and financials. Neither are great sectors to be in during a long bear market in credit.
Resources are great during a boom but they’re not the stocks you can just buy and forget about. They are capital intensive and subject to sharp moves in commodity prices.
And many industrial companies feed off the larger resource companies. Australia has many small engineering and contracting firms that are subject to the same vicious cycle as the resource companies.
Banks are inherently risky. For many, a 5 per cent fall in the value of their assets would wipe them out. With the Aussie residential property market finally starting to crack, I think asset values will come under pressure and bank share prices will fall. Bank of Queensland (it announced a write down and capital raising a couple of weeks back) is like the canary in the coal mine for the banking sector…so expect more write downs and capital raisings for our larger banks in the year ahead.
Whether the two-dimensional nature of the market is to blame or not, competition in Australia is not particularly robust. That’s why many companies fail when trying to expand offshore. Australia’s cosy duopolies don’t condition companies well for offshore expansion. And the local market is not large enough to provide years of unending growth for domestically focused companies.
In addition to all this, many companies are poorly managed from a capital management point of view. They raise capital (sell shares) at a low price and buy back shares at a high price. They listen to investment bankers, not shareholders.
This combination of factors makes it very difficult to construct a portfolio you don’t have to worry about. One where you don’t have to constantly monitor and stress about the effectiveness of the companies’ business models.
I’m talking about investing your capital in a collection of businesses – if bought at the right price – that will compound your wealth year after year. And if bought at the right price (that is, cheaply) you’ll stand a much better chance of beating the average market return over the next 5–10 years.
As I pointed out recently to subscribers of Sound Money. Sound Investments, I expect general equities to produce a long-term return of not much more than 5 per cent per annum over the 5–10 years.
However, a large exposure to precious metals could boost returns to around 7 per cent per annum.
Generating a 7 per cent per annum compound return means you could double your capital over the next 10 years.
How?
Let me tell you about the ‘Rule of 72‘
Investing Using The Rule of 72
Pick a number (let’s say 7) and divide 72 by that number. 72 divided by 7 = 10.3. That means if you can earn a compound return of 7 per cent per year, you will double your capital in 10.3 years.
Divide 72 by any number. The result will tell you how many years it will take for your investment to double.
I’m confident that by remaining patient, you will be able to achieve these returns over a longer time frame. I consider investment a marathon, not a sprint. Over time, the tortoise (you) will beat the hare (the index).
When you think about it, the formula for the tortoise to beat the hare is easy. The index represents the average performance of listed companies. There are a lot of poor companies in the index. If you have the patience and conviction to buy above average companies at a price that reflects an adequate risk/reward trade-off, over the long term you should do better than the average.
What companies do I consider ‘better than average’? Companies with attributes like competitive strength, quality of management and profitability. Unfortunately, very few of these companies meet the most important definition of a good investment – good value. But that can change. In fact it will change. It always does.
Greg Canavan
Editor, Sound Money. Sound Investments.
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2012-04-013 – Dr. Alex Cowie
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