Deflation and the Impact of Fees on Real Returns

Investment Perspective – September 2016

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

The Bad News

Deflation in my opinion has a strong hold over the global economy even though India and one or two other economies appear to be growing fast. It is likely India’s own internal economic activity is driving that growth rather than the global economy and their trading partners. 

Anyway, this means that the returns that we can expect on our investments may be lower over the next five to 10 years when compared to the last 20 to 30 years. This is partly because the liquidity bubble is maturing and that means asset prices are now expensive. Also economic growth in a deflationary environment tends to be slower.  

To be clear, there is still opportunity, especially if we can invest inside the market rather than across it, however, we may need to adjust our investment return / performance expectations – or be disappointed.

There Is Plenty of Evidence

There is plenty of evidence… looking first at the price to earnings ratio (P/E ratio).  P/E ratios on share markets around the world are above long-term averages. For example the price earnings ratio of the US share market sits at around 20. I mention the US market because, due to its size, it can be a driver of market direction and price movement for other markets as well, particularly in the short term.   

Anyway, for Value Investors investing in big business, a good P/E is about 10 although the long-term average is somewhere around 16.

Just look at house prices in New Zealand (it’s the same in a number of other countries too) and we see houses changing hands at five, seven and even 10 times the average wage. Historical data suggests that 2.5 to 3 times the average wage is more “normal”. At five times the average wage, houses are expensive when compared to historical norms. Obviously, at nine or 10 times, those houses are very expensive.

I am not suggesting a bubble about to burst or pending economic armageddon.  What I am boringly doing is stating the obvious (at least to me it is), which is that asset prices generally are expensive. This is a factor that I take into account with every recommendation… every investment.  

This is important because we take on more risk and it is harder to make money long term when we pay too much for our investments. Also, when prices are expensive they potentially have a long way to drop should circumstances change. Prices can’t / don’t defy the fundamentals forever. Whether it is a sharp, unexpected price correction or a long-term “stealth correction”, unfolding over many years, it matters how we are positioned. 

The Good News

Even with deflation taking hold around the world, we can still win as investors.

For example, with interest rates and inflation at one time 10% and 6% respectively, this looks like a 4.0% difference or gain. The 10% return would reduce down to around 7% after tax (depending on ones marginal tax rate). 

So 7% (after tax) less 6% inflation means we are ahead by around 1% in real terms.

This…

An important goal for us as investors is to protect the buying power of our money.  That’s what we all want (need).

In the current deflationary environment lets say we achieve a return of only 5%.  Take off tax at say 1.3% and we are down to 3.7%. With inflation running at say 0.4% we are actually ahead in real terms by 3.3%.

Yes but, what about the impact of fees though?  Ok, lets take a look at an example…

Return @ 5%                                      5.0%

Fees @ 1.5% (net)                             1.5%

Return after fees                              3.5%

Tax @ 25%                                          1.3%

Return after fees and tax                2.2%

Inflation @ 0.40%                              0.4%

Return after fees, tax, inflation     1.8%

The point here is that the lower nominal returns (returns before inflation) that are likely in the future don’t mean that we are not succeeding as investors in real terms (after inflation). 

Lower real returns are not necessarily the result of lower nominal returns.  

Lower nominal returns (the returns shown on your investment reports, based on price movement, before inflation) therefore do not necessarily mean that you are making less money – that might sound strange… but there it is.

EDITORS TIP: Protecting the buying power of our capital and making real returns is more likely when we invest for growth, long term, in productive assets (quality businesses that grow).

Most people worry about capital loss and volatility. Smart investors think about protecting the buying power of their capital. To protect our capital from losing real buying power we just need to invest for growth (and be tolerant about pricing volatility along the way).  

“Predicting rain does not count, building arcs does.“

Warren Buffett