The Royal Road To Riches

The week witnessed a wonderful juxtaposition: the indictment for insider trading of one of the most successful ever hedge funds, SAC Capital, while retail investors returned to stock markets in droves as they neared or reached record highs. We’re not going to add to commentary on the extraordinary tale of greed and excess at SAC but instead focus on a broader, less mentioned lesson for investors from this episode. That is, SAC founder Steve Cohen didn’t amass the majority of his US$10 billion fortune from being a stock market guru or alleged market manipulator, though these clearly played a part. He principally made his money from the exorbitant fees that he charged his clients. It’s a lesson that investors should heed as the so-called animal spirits return and many start to dream of stock market riches again.

The stock market can certainly play a part in generating wealth but simple maths dictates that it’s highly unlikely to make you rich enough to retire early. What can then? Property? This seems unlikely, given the low yields on offer, particularly in my neighbourhood of Asia. Bonds? Certainly not, given the pathetic yields across almost all types and maturities.

The real road to riches can instead found through earning income rather than investing in assets. By this, I mean earning through excelling at your workplace or, more likely, starting a business of your own (like Cohen did). Some may view this as stating the obvious but it’s a point worth reiterating at a time when so many are intent on trying to ride the next asset bubble.

Animal spirits return

The SAC Capital case really has it all. A charismatic founder who achieved unimaginable wealth and subsequently developed a penchant for buying obscenely priced (or just obscene?) pieces of art.  He seemingly achieved this wealth by generating 30% returns per annum since 1992, a track record that very few have matched. But, alas, the fund is alleged to have taken many shortcuts to achieving these great returns.

The SAC soap opera hasn’t stopped retail investors (that’s your average investors as opposed to institutional investors) from piling into stock markets though. That’s particularly the case in the U.S., where net equity inflows have turned strongly positive after being negative for much of the past four years. That’s come at the expense of both bond and cash inflows. Interestingly, while retail investors have been buyers of the U.S. stock market, institutional investors have been heavy sellers.


Meanwhile, the picture in Asia hasn’t been as bullish. In China and Hong Kong, volumes remain reasonably tepid as many retail investors remain on the sidelines. In Japan, money is starting to flow into the stock market, though bonds have seen few signs of money exiting despite some of the obvious risks from the government’s inflationary policies. And in South-East Asia, retail investors remain upbeat, even after taking a beating in recent months (though the region was the best performing of any in the four years prior).

It isn’t hard to figure out why investors are coming back to stock markets. The recent bond market take-down has helped. As has the share markets continuing uptick towards or through record highs.

Then there’s the central bank “puts” underpinning the markets. The U.S has the “Bernanke put”, referring to the prospects for more money printing on any stock market correction. Europe has its own “Draghi put”.

Now Asia has jumped on board too. You have the “Abe put” where the Japanese central bank is printing money to buy stocks directly (that isn’t a misprint) and Japanese government officials are apt to talk up the local stock market on any down days.

And even China, a horrific market over the past few years, has caught a bid due to the so-called “Li Keqiang put”, referring to the Chinese Premier’s pledge to keep China’s GDP growth rate above 7%. Markets like the pledge because it signals more stimulus is on the way if there’s a further economic correction. No matter that additional stimulus is the last thing that the Chinese economy needs right now.

Some number crunching

With the return of the retail investor, it’s unsurprising that Asia Confidential has started to receive a bunch of mail of late suggesting sure-fire ways to get rich from the stock market. They’re making a comeback after a five year absence!

Many of them are quite well written and persuasive (there’s something to be said for some copywriting lessons). And all of them emphasise that the stock market is the best way to become wealthy and they have the “secret tips” to guarantee that you get there.

While these may be exaggerated examples by the unscrupulous operators, their central premise that stock markets are the best means to attain wealth is a widely-held notion. It’s promoted by the financial industry and academics (“Stocks For The Long Run” and so forth). And the demi-god status of hedge fund managers and Warren Buffett is testament to the phenomenon.

As stock markets near or push through to record highs and many investors pile in, it’s worthwhile remembering though that the whole premise pushed by these people is a complete load of hogwash.

Let’s crunch some numbers to demonstrate why. It’s widely reported that the S&P 500 has produced a total return (index gain plus dividends) of close to 9% over the past 50 years. This number is far from fool-proof as it includes only those companies that have survived and excludes those which haven’t – so-called survivorship bias. Not to mention that the past 50 years have been a glorious period for the U.S that’s highly unlikely to be repeated. By way of contrast, global indice returns have been about 2% below the U.S. during that same period.

But let’s go by the aggressive assumption that you might be able to earn 9% total returns per year from the stock market over the next 20 years. We’ll also assume that you invest a portion of your savings, say US$50,000 – a reasonable amount for someone on an average wage.

Earning 9% each year will double your money every eight years (the rule of 72 gets you there: divide 72 by the returns achieved). Over 20 years then, the original US$50,000 at 9% returns would turn into US$280,221, a nice gain of more than US$231,000, or a bit over 4.5x your original investment.

As John Bogle has aptly demonstrated though, these kind of returns usually substantially overstate things. They don’t include taxes, brokerage and buy/sell spreads. Often investors use fund managers to achieve the returns and these managers charge +1% per annum and often much more for management fees and performance fees. It also assumes that investors have the fortitude to hold something for 20 years. The reality is most investors buy and sell stocks at the wrong times by letting their emotions influence decision making.

But the larger point is that even if you assume that an average investor can achieve 9% returns from the stock market each, that won’t translate into substantial wealth. And by that I mean enough wealth that you’ll never have to work again.

To achieve extraordinary wealth in stock markets, you either have to be an extraordinary investor, use substantial leverage perhaps in addition to that, have a longer investment period (say 40 years for the numbers to compound), have significant upfront capital to invest or just be plain lucky.

And by the way, the opt-cited case of Warren Buffett achieving his US$53 billion fortune from the stock market is a myth. He achieved the vast majority of his wealth via buying whole businesses, particularly insurance companies which gave him essentially free money with which to invest.

In sum, it’s absolutely true that the stock market can help people build wealth. But there’s only a small chance that it’ll ever make you really rich.

To some, the above analysis may seem both simple and obvious. But it’s the kind of analysis which seems to get forgotten as a bull market takes off, or matures, depending on your viewpoint.

Property, bonds instead?

If stocks aren’t going to get you to an early retirement, which other assets may be able to do the trick? Property is the go-to for many investors. That’s particularly the case in Asia, where many segments of real estate hardly missed a beat during 2008 and are now well above pre-crisis highs.

The real estate bull market has resulted in low rental yields and therefore likely low prospective returns. For instance, in many key Asian cities such Hong Kong, Singapore and Australia, residential real estate is yielding close to 4%. At these levels, if you minus taxes, entry and exit costs, maintenance costs and inflation, you’ll be lucky to get any real return in the short or long term. Put another way, you’re paying 25x pre-tax earnings at these rental yields (100 multiplied by 4%) compared with the less than 10x pre-tax earnings of stock markets in Asia ex-Japan.

Yes, this calculation doesn’t include any capital gains. Any conservative forecast shouldn’t include prospective capital gains though, in my view. And given residential property prices compared to income levels are at extreme levels in these cities, any capital gains certainly shouldn’t be counted on.

Other property segments offer better yields. You can get 5-8% on industrial, retail commercial segments in many of these cities. Relative to residential, they seem to offer more value.

On this note, I recently read a good interview with a highly successful entrepreneur and global real estate investor, Nathan Kirsh. In the interview, Kirsh states his preferences for commercial and industrial real estate over residential and retail. Residential being unattractive on relative price terms and retail being least preferred due to the ongoing impact on tenants from internet sales. On these points, Asia Confidential agrees.

The larger point is that across all segments of real estate, even if you take on reasonable debt in any transaction (say 50:50 debt/equity), achieving +12% when taking taxes, interest and costs into account, isn’t an easy task. Don’t get me wrong, these kind of returns are highly attractive to billionaires such as Kirsh. But for an average investor, these type of returns aren’t going to prove transformative. If you’re after low risk, steady returns however, then they could well suit your needs of course.

What about bonds then? For the long term investor, this asset class is the least attractive of those mentioned so far. That’s even though I’m reasonably bullish on the prospects for bonds in the short-to-medium term as deflationary forces overwhelm the extraordinary policies of the world’s central bankers (see this previous post for more). The pitifully low yields guarantee low future returns, even in a deflationary scenario. One of my favourite investment writers, Jim Grant, has described bonds as offering “return-free risk” versus the traditional “risk-free return” and he’s largely right about that.

How to get on a Forbes list then?

By now you’re probably thinking, “you seem to be negative on everything, so where in the heck am I supposed to make some real money?”. And to that I’m going to give you a seemingly simple and boring answer: you’re going to have to work for it. This might be a quaint notion in an age where instant wealth is everything but hear me out anyway.

The first way to earn substantial wealth is by excelling in your workplace. That means climbing your way into a senior position or senior positions above hundreds and possibly thousands of others. It’s certainly possible, though the odds are reasonably long. And the odds that you’ll achieve outstanding wealth via this method are even longer still.

The second way is this author’s preferred route down the royal road to riches: to own a business yourself. This way has been method since time immemorial and remains the case today. If you doubt that, have a read of any Forbes billionaire list. As for what types of businesses may get you there, I’ll leave that up to you to think about.

Some readers may think all of the above is talking my own book, being a business owner myself. Keep in mind though this newsletter focuses primarily on stocks and therefore talking them down, or setting realistic goals as I’d prefer to term it, isn’t exactly in my best interests.

Take the article then for what it’s meant to be: an independent and objective point of view. And if any of you are now starting to plough into stock markets in the hope of becoming the next Warren Buffett or Li Ka-shing (hopefully not the next Steve Cohen), I hope it gives a different perspective to the self-interested advice that you’ll get from much of the stock broking and financial advisor industries.

This post was originally published at Asia Confidential:


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