This issue of The Churchouse Letter is freely available for all to read, if you would like to read more recent issues complete with up-to-date investment ideas, you can purchase your subscription here
In this Report:
- Any investment or asset class can be made to look good—if an appropriate time period of comparison is chosen.
- Introduction of bias by analysts, fund managers, bankers in making investment comparisons is part and parcel of the industry. Their audience needs to be aware of sources of bias. There are numerous means of making a sow’s ear look like a silk purse.
- Gold and real estate have more than their fair share of apparently biased, one-eyed zealots in the investment and analyst community.
- Both assets are touted as an inflation hedge—real estate has done a better job than gold in this respect.
- Gold is currently in a “golden era” (sic) and will likely remain so as a hedge against the stupidity of politicians and central bankers.
- Real estate typically takes years to recover from cyclical downturns, but buyers today in many western markets will probably be smiling a decade from now.
- Notwithstanding analytical biases, major asset classes such as real estate and gold can, and do, produce long periods of weak or negative returns. Watching an asset go down almost continually, as gold did for the 1980 – 2000 period, will test the patience of any self confessed “long term” investor.
- This all points to the case for frequent reappraisal of the case for holding assets such as gold, real estate, equities.
- Real estate stocks in China, Australia, New Zealand and Japan are cheap, and recovery in the first three markets will likely prove quicker than in Japan.
- China real estate stocks have been adversely affected by policy initiatives aimed at cooling a hot market fueled by huge injections of new bank lending in 2009. This has created uncertainty as to future real estate sales volumes and price trends.
- Many China property companies listed in Hong Kong are trading at single digit earnings multiples and will likely post earnings growth of around 20% and higher near term. They typically trade at 15% – 50% discounts to Net Asset Value (NAV).
- Australia and N.Z. propety trusts are suffering from weaker commercial property markets and in some cases, problems of debt refinancing. These problems are easing with property probably close to a cycle bottom.
Investment is Rarely, if Ever, an Exercise in Absolutes
Investors almost inevitably will judge their investments in relation to some other investment or benchmark. Hedge funds often claim to be “absolute return” vehicles, but even they will encourage comparison of their fund or portfolio against other funds or benchmarks.
The vast bulk of funds that are invested in the world’s capital markets are judged by their investors and their sponsors against how they perform relative to other investments or asset classes. A great many funds are unashamedly benchmarked against an assortment of indices – that is what you buy into when investing with such funds. But a great many are “closet” benchmark funds, even if they claim to be something else.
There is nothing particularly wrong with this, but perhaps investors should expect greater transparency from asset managers in what targets the manager is trying to achieve.
And of course every asset manager wants to look good against something. I cannot recall reviewing a fund pitch book or fund document that did not show the subject fund outperforming something or other.
These can occur in different ways.
- The “Find a Worse Performer” Bias.
The most obvious is to compare your fund or asset class against an index, a fund, an asset class that has done worse that the subject investment. These days with the literally thousands of indices that are out there, not to mention ETF’s (which are a quasi index) there is certainly no shortage of instruments to benchmark performance against. For example, MSCI, one of the leading index providers claims to produce 9,000 indices in real time, and that is just for equity markets. This does not include indices for fixed income instruments, commodities, gold, real estate, private equity, hedge funds.
- The “Find a relevant time” bias.
We have all seen the trick of comparing the subject fund or asset class to another over a certain period of time that makes the subject look good/better/best. An asset can be compared beginning from a date that was most convenient for the comparison. For example, the subject asset might have been in a cyclical slump at the beginning of the period, while the “benchmark” might have been in mid-cycle or even a peak. The recovering subject asset will likely look good against the benchmark that has had its day.
- “We are all dead in the long run”.
I find it fascinating how many people look at comparisons over a 50 or 100 year period. Compare for example the Dow from say 1900 to the present day against US government bonds, gold, the price of coal, steel – whatever. Should such a comparison guide my investment decision today? Probably not. Such comparisons may appeal to our intellectual senses, but are more a form of intellectual gymnastics than any real guide to investment decisions today. They are probably best suited to the textbooks of economic history and the machinations of stock market historians.
- “Like for like comparisons”.
One of the obvious flaws is comparing a subject asset against something that has been measured differently. Comparison of an investment which has received dividends or coupon payments and reinvested them against a benchmark that simply measures change in capital value of the asset in question is likely to exaggerate the performance of the former against the latter.
- “The different risk profile” comparison.
Different asset classes can have very different inherent risk profiles. Technology stocks for example are likely to have very much greater risk attached to them than say Government bonds. Nevertheless, it is surprising how frequently one sees comparisons of investments that have inherently different risk profiles.
Bias through Knowledge……..
Most analysts and asset managers have developed expertise in a particular area, or if very experienced maybe in several different areas. Their views are likely to be shaped by significant knowledge of their subject, gleaned perhaps after many years of experience, perhaps in the industry itself or as an analyst, consultant.
This almost single minded focus on a single small part of the investment universe can lead to a natural tendency of bias towards that asset class. It is certainly not necessarily so, but I for one can attest to having dealt with people who are very knowledgeable in their subject and maintain a perennially rosy view of the asset class, despite the inevitable ups and downs of the economy and markets.
…… is hopefully better than bias through ignorance.
Let’s not even get into the bias that springs from a weak and flawed knowledge base. Being in the property sector, I perhaps see more than my fair share of undeterred champions of real estate, despite having little real depth of understanding, knowledge or analytical skills of the subject at all. Luckily this happens more at the sales end of the real estate industry, and in the so-called “financial advisory” parts of the business and not really in the equity business.
Bias More Common in Certain Asset Classes – Gold and Real Estate Stand Out
There are particular asset classes that seem to bring out the bias in spades, more so than for other asset classes. Yes, there are the equity guys, who are one-eyed about this asset class, like there are sports fans who are one-eyed about Chelsea, the Yankees, the All Blacks. The same can be said of some hard core bond investors. And there are the aficionados of particular industry sectors, the tech guys who see the next killer application around every corner. The bio tech folks who find miracle cures in every new drug. There are the small cap/micro cap folks who constantly parade their favourite picks that went up 300% in 3 months, while quietly forgetting the 10 others that dogged terribly.
Gold Brings out Evangelical Zeal!
But there are a few asset classes that really bring out the zealots. Gold probably ranks at the top of the list. Some gold champions bring an almost evangelical fervour to the subject. For a product that produces no income return, and has really few functional uses (jewelry could be made from many other materials), it is remarkable how much enthusiasm the yellow metal can produce. The investment arguments for gold seem to centre on its apparent quality as a hedge against inflation, and its role as a hedge against the potential vagaries of man-made money.
The gold-bugs may have a point. But I am less than convinced.
A great deal comes down to that “relevant time” bias.
Just take a look at the attached charts which make a simple comparison of gold price vs the Dow – a comparison many pundits on both sides of the fence choose to use from time to time. The first chart (see Figure 2) plots gold vs Dow going back to 1968 – when a large proportion of today’s investors and fund managers were not even born! The other charts plot the same data from a different starting point, 1981, and gives a startlingly different result (see Figure 3 – 5).
The yellow metal enthusiasts will point to how gold has appreciated by around 30 times over the period from 1968, while the Dow is up only about 12 times over this period. Quite true. But if we take 1980/81 as our start point, what we might call the “post inflation” era, up to 2010, the Dow has massively outperformed gold, surging by around 11 times, while gold has a little more than doubled over the same (see Figure 3).
Taking an even shorter time frame, say from post dotcom boom to the present time the relative performance is massively reversed with gold surging about fourfold, and the Dow essentially flat (see Figure 5).
The truth is that gold has produced its magic in relatively short bursts over the past 40 years, with a very long, painful period of dire performance. Holding gold in preference to stocks for the 20 year period from 1980 to 2000 must have tested the patience of even the most zealous gold bugs.
Gold as Inflation Hedge – A Dubious Case
The case of gold as a hedge against inflation is a dubious one. For example, the decade of the 1970’s was a period of high inflation in the US and most other western countries. Gold performed very strongly during that period, leading some credence to the gold/inflation hedge argument. But think again, perhaps gold’s resurgence in that period was due to the first oil crisis of 1973 than anything else.
But looking at gold vs the Dow from 1981 (see Figure 6) – the Volcker induced “end of inflation” era – to the present time gold has not only massively underperformed stocks, but even in this era of lower inflation, has not outstripped the US Consumer Price Index.
But then of course the gold pundits would probably choose to illustrate their point by adopting say the period from 2000 to the present, conveniently dismissing the previous 20 years of history!
A chart that took my eye recently in the Financial Times (August 7th/8th) also made a powerful point about gold vs other core investments such as equities, bonds, bills (see Figure 7). This work was undertaken by Christophe Spaenjers (Tilburg University) and Elroy Dimson (London Business School) and takes 1900 as the base date and charts the performance of gold, UK equities, bonds and bills in sterling terms. This demonstrates that if my great grandfather, a sheepfarmer in NZ had managed to acquire a kilo of gold to pass down the generations (a pretty doubtful scenario in those days), it would have produced an annual real return of about 0.8% per annum. However, if he had been able to pass on a UK equity index fund or a UK bond fund, the annual real returns would have been 5.3% and 1.4% respectively, both much higher than the return from gold.
Source: Financial Times, “Ingot we trust for that element of insurance”, Christophe Spaeniers and Elroy Dimson, August 7/August 8, 2010.
Core Reason to Hold Gold – as Insurance against Politicians and Central Bankers
I certainly do not wish to be branded as a gold basher – I am not that for a moment. However, the case for holding gold as a hedge against inflation is dubious. Far more important I believe is its hedge against the stupidity of man – particularly its politicians and central bankers. And today’s environment is right up there in the long term risk stakes associated with actions of these groups of policy makers.
Now the bubble has burst, the debt has to be repaid, and the temptation for politicians will clearly be to inflate the debt away over the coming decade. This will likely be accompanied by debasement of the currency.
Hence the attractions of something that cannot be debased by politicians and central bankers – gold.
More on the “Relevant Time Bias”
Our bar charts shown in Figure 8 make the point on comparisons based on choice of time period quite nicely. Here we look at gold vs some key indices (including some Asian indices, based on the premise that we are Asia focused in our work). These charts plot the compound annual returns of the asset classes, starting from 1980 (again, a start date that could be claimed is biased!).
We also choose certain big events in markets as possibly appropriate points from which to base comparisons.
- The “Post Inflation” era that began in 1980/81.
- The “Post 1987 Market Crash” era.
- For Asian reference, the “Post Asian Financial Crisis” era.
- The “Post Dotcom Bubble” era.
- The “Post Subprime Crisis” era.
The longer term comparison over the 30 years from 1980 to the present shows gold as a distinctly mediocre investment – posting a compound annual return of around 2.1% p.a. vs 8.2% and 7.5% p.a. for the US and Hong Kong equity markets respectively.
Following the 1987 stock market crash which started in the US, gold’s performance has improved relative to equities, beating commodities and the US long bond substantially, but lagging equities (US, Singapore, Hong Kong). Gold has substantially beaten the Japanese equity market, over the 1987—2010 period.
More recent comparisons over the past decade or so casts gold in a very much more flattering light, as equity markets have been clobbered by the dotcom bust, and the global financial crisis that started in 2007.
Real Estate Zealots can be Even More One-Eyed than Gold Bugs!
Real estate is the other major asset class that has its serious devotees, almost to the exclusion of all else. Unfortunately many of the real diehards of real estate bring their bias not through knowledge but all too frequently from lack of real knowledge. Real estate is central to all our lives. How many dinner parties have you attended when the subject of property prices does not come up. Certainly in Asia it is almost as inevitable as night follows day.
Real estate’s zealots are probably much larger in numbers than even the gold bugs, driven largely by the fact that about 70% of households in most developed countries (and increasingly also in less developed countries) are home owners. And a great many homeowners have second homes, or investment properties, probably way more so than have investments in gold funds or gold bullion. This widespread ownership of real estate means that just about everyone has some information about what the asset class is doing and has some kind of opinion on the subject.
The “You never lose money owning property” nonsense!
I wish I had taken $5 for every time I have heard someone proclaim that old mantra “You will always make money owning real estate”, or “You will never lose money in real estate”. What is surprising is how often such verbiage spills from the lips of professionals in the industry – and by that I don’t just mean your friendly real estate agent!
Perhaps one can be forgiven this lapse in the real estate industry more than other asset classes. For example, average house prices in the US had never shown a downturn in nominal terms since data began to be collected in the 1950’s (see Figure 10). The overall trend in the US was inexorably upwards, never negative. Certain regions and cities might have seen downturns, but never across the nation as a whole.
That is until this current financial crisis when the average house price across the nation has fallen by more than 30% according to the Case Shiller index (see Figure 11). This has come as a huge shock to a nation fed with the notion of never-ending upside in house prices.
…… until now!
London also seems to produce more than its share of biased, blinkered punters in that city’s real estate market. Being regaled by London property lovers vehemently claiming that London real estate always goes up, never loses money, has been a pretty frequent event for many of us over the past 20 years or so. And as much as I believe there are very sound fundamentals that make London a relatively strong real estate play, to say that it is a one way street up is to ignore the facts. Tell that to folks who bought new apartments in London in the late 1980’s partly encouraged by the Chancellor of the Exchequer’s tax breaks for home buyers, only to see values fall as much as 40% in some locations in the first few years of the 1990’s. A very large number of buyers were under water on that trade for as much as a decade.
Even Hong Kong, arguably the most volatile property market in the world, has its proponents who see property investment as a sure-fire bet. Not so at all. A great deal depends on the entry point. A buyer of a flat in the exuberant times of 1997, around the time of the handover of sovereignty to China, would have been in negative return territory until the last few months, and would have endured years of negative equity, in a market where down payments have been typically 30% of purchase price. In the post Asian financial crisis, from mid 1997 to mid 2003, average residential property prices in Hong Kong fell by about 65%, similar to the 70% fall in the 3 years leading up to the signing of the Sino-British agreement in September 1984.
Most other Asian property markets have endured substantial downturns in the past 30 years. But most have been less volatile than Hong Kong. However even the “clean, green Singapore machine” has suffered bouts of average price declines of more than 30%. A buyer of an apartment in Singapore in 1996 would have waited a decade to see his apartment achieve its original price again (see Figure 12).
Real Estate has Proven a More Reliable Inflation Hedge than Gold
Like the gold aficionados, real estate pundits cite real estate’s role as a hedge against inflation. This actually has more substance than gold’s claim as the ideal inflation hedge.
Figures 12 – 15 plot average house price indices for a range of markets in both nominal and real terms. In all markets except Japan house prices have at least kept pace with inflation, or substantially beaten it over the long term periods for which we have the data.
Interestingly, for both the US and UK residential property prices really only produced real returns in the post late 1990’s/ 2000 period. Prior to that house prices basically only kept pace with inflation. For Australia and New Zealand real returns did occur during the 1990’s but became supercharged in the post 2000 period.
Inflation hedge, maybe, but real estate still can have long down periods. A one way street to riches it certainly is not!
The Japan story is very much a tale of two eras. The decade of the 1980’s was a boom period for Japanese house prices in both nominal and real terms, but has been nothing short of disastrous ever since, falling by around 47% in real terms since the peak in 1990/91.
What this analysis ignores, however, is the potential rental returns that an investor in hard property stands to receive. This can typically be in the range of 4% – 8% of the original purchase price, and typically can rise over the course of time. The first apartment I ever bought in London, 25 years later received an annual rental 20% greater than the total price paid for the unit 25 years earlier!
Also, typically most real estate buyers may use some debt for their purchase. Thus, while the total property price may or may not keep pace with inflation, the return on equity for the investor may well prove significantly higher than the inflation rate. Most other asset classes do not have the potential to be bought and held long term using debt in quite the same way that applies to real estate investments.
Real Estate Stocks Way More Volatile than the Underlying Assets
If property assets are a more reliable hedge against inflation than gold, or some other asset classes, then how do real estate stocks fare? Figure 16 plots the returns for the listed real estate sector in various markets over certain periods since 1980. The general picture is similar for the broader stock market indices.
But property stocks have traditionally proved much more volatile than the property assets underpinning them. Realisation of this and an ability to call the real estate cycles even part way right can be a recipe for outsized returns.
Over the 30 year period shown in the data here, property stocks in the major markets of Asia (Hong Kong, Singapore, Japan, Australia) have produced annual compound returns of 5% – 7% per annum vs 2.1% for gold.
But taking the onset of the Asian financial crisis as the investment review starting point, gold has very significantly outperformed all property stock indices in our universe here. Property stocks have been dismal places to be since the start of the current global financial crisis in 2007, with all markets showing negative annual returns of 8% to almost 30%.
Any Piece of Mutton can be Made to Look Like Lamb!
When all is said and done, the truth is that just about anyone can produce charts or statistics that make any asset class look attractive or better than others by choosing an “appropriate” time period for comparison, with other devices such as comparing apples and oranges commonly used. Comparing assets with totally different risk profiles is also common – government bonds against equity indices for example.
How many times have we heard investors espouse that they are “in it for the long run”. Well, how long is LONG? Five years, ten, 30, fifty, 100 years?
Sitting on an asset for 20 years while it goes down almost continuously like gold did for the 1980 – 2000 period, will test the patience of any self-confessed “long term” investor. Buyers of real estate in markets such as Hong Kong and Singapore in 1996/97 waited a decade to see a return to their original purchase price, and most buyers of residential real estate in Japan in 1990 have still not seen their asset achieve its price level of 20 years ago.
The truth is that any asset class can endure very long periods of down performance, negative returns, but within such long periods they might enjoy shorter bursts of good absolute or relative performance.