How well and how quickly is the property market recovering from the global financial crisis? And which investments should we be considering, and when? - Shane McNally

PROCEED WITH CAUTION

ALL INDICATORS suggest we've missed a recession by inches and that the property market won't take the battering many expected just a few months ago. So is the worst of the global financial crisis over and is property still Australia's safest, strongest form of investment?

The general consensus is 'yes' on both counts - but with extreme caution. Property analysts generally agree the market is rebounding but rule out moving in for quick returns in favour of research and steady longer-term investments.

Markets in our two largest cities have performed strongly in the first half of the year,with RP Data figures showing Melbourne medians up 6.1 per cent from January to $443,811 and Sydney rising 5.2 per cent to $529,785. Brisbane went up 2.6 per cent to $432,101 while Adelaide rose marginally to $396,839 and Perth actually fell half a per cent to $466,052. The national median of $468,819 has brought the market back to within $520 of its February 2008 peak.

CAUTIOUS

WBP Property Group principal Greville Pabst says while the property market is beginning to move again, investors should guard against over-confidence because of a range of factors, including the likely increase in interest rates and uncertainty over unemployment levels.

"The last 12 months have witnessed the resurgence of the first homeowner, with this group now accounting for 30 per cent of the entire market," Pabst says. "Responsible for this change is decisive government policy that has seen the implementation and extension of generous grants to assist first time owners.

"There is concern, however, that this has created artificial demand (and) artificial increases in value at the lower end of the market.

"Notwithstanding, I don't believe there will be a huge burst in the bubble, but perhaps several years of deflation and minimal growth once incentives are scaled back. "There has been some improvement in the middle-tier market between one and two million (but) the very top end remains sluggish.

"Although markets have begun to show signs of recovery, property investors should remain cautious." Pabst says while the property market has almost returned to its high of February 2008, the recent collapse of several property and finance groups raises some questions about the sustainability of growth in residential property beyond first home owner incentives that expire in December.

"The situation is comparable to investment property that is underpinned by a rental guarantee," he says. "Is this income sustainable beyond the initial term?

"The second risk parameter is interest rates.Most pundits agree the cycle has bottomed and that future movement is likely to see an upward trend. If this prediction is correct many first homebuyers that have taken advantage of First Home Owner Grant incentives will hit hard times (and) considerable increase in the rate of unemployment will have significant implications for the property market."

Pabst urges investors to do their due diligence more than ever in a market that had unprecedented growth before the economic downturn.

"Australian real estate is one of the most expensive in the world," he says. "The UK, Europe and US have had major corrections in real estate markets while Australia has remained relatively well insulated. Property representing good value is becoming increasingly difficult to find (and) rising capital values will quickly erode yields. It is the time to exercise caution."

CONFIDENT

Property analyst Tim Lawless of RP Data believes the time is ripe for buying prime property in the middle-range suburbs and that current levels of affordability make the market an attractive option for small and large investors.

"Australia's home values have just recovered from the February 2008 peak, with 10 months of falls followed by five months of gains. I think we can safely say the market turned the corner in February 2009.

"We'd expect modest month-to-month improvements, slow and steady without any real growth after such a major economic downturn.

"Our market has been spectacular compared with the global market but it's very much diversified. Perth is still going backwards and Melbourne's going ahead strongly. The first homebuyers grants have been a big driver in the market but more importantly is the fact that we are back to 2001 levels of affordability.

"The markets that are really ripe for the picking now are the middle-ring suburbs in most cities. If you have the money, the inner suburban and coastal areas are where the opportunities are now."

SCEPTICAL

Economist and University of New South Wales lecturer Dr Nigel Stapledon is more sceptical about the state of the Australian property market, suggesting it will remain fairly static and ruling out sharp rises or falls in the immediate future. He advises investors to research the market and look for long-term gains.

"You can find data to suggest prices have gone up but there's a big question mark on that because of the temporary effect of the first homebuyers grant," he says.

"We've had all the benefits of a recession but we haven't had the cost of one yet.

"We've got the lower interest rates, the cash splash, the first homebuyers (grants) and going forward, we're either going to have a recession or, if not, you can bet your bottom dollar the Reserve Bank is going to lift those interest rates.

"The sharp drop in interest rates and the first homebuyers simply bring forward demand but I think there's a very heavy qualification over what's happening in the housing market at the moment.

"My view is that house prices won't do much in the medium term.

"I'm hearing a 10 per cent rise in real terms over the next couple of years but I'm not so sure about that.

"Some people think we have this period of steady prices and then a big jump followed by steady prices and another big jump. And they think we're about to get the next jump because it's a pattern but that's just not on. There has to be a reason.

"We had the late '80s boom and then a recession and flat prices until 1996 and then we had a big move until 2004. That was a product of prices catching up to a decline in interest rates.

"It can all be explained in terms of fundamentals. Prices overshot and now the market's stabilising and rents are going up which is helping restore the balance in terms of yield.

"What might underpin a sharp surge in prices? If we thought the variable rate was going to stay down at these levels, that might justify it, but no-one really believes that.

"The long-term interest rate market is significantly higher than the short-term, which tells you at some point interest rates are going to go higher so investors should be factoring that in.

"People are talking about sharp rises and sharp falls in the market but I don't think either is likely. Investors shouldn't be going for the quick buck."

SYDNEY

Property lecturer Cain Kennedy says the narrowing of the price gap between Sydney and the other capitals is making the harbour city an appealing option among investors who previously looked to Brisbane and Melbourne for more affordable purchases.

"The Sydney market's been doing it tough since 2003 compared with the other capitals but the gap has reduced and it's bringing the interest back, particularly in the inner suburbs," he says.

"The lower North Shore and the eastern suburbs are already starting to move and big numbers are attending auctions.

"From Maroubra to Coogee, Randwick and Bondi are doing very well and should continue to attract plenty of interest. Randwick is well placed close to the city and the beach while Coogee has the beach and the café lifestyle and I see a lot of interest in both areas in the short term.

"The property type is as important as the location in Sydney. It's what you buy and whether there's an oversupply to affect yields.

"Small blocks of apartments in those eastern suburbs will become sought after because there are often no longer zones for that sort of property."

MELBOURNE

Mark Armstrong of Property Planning Australia believes the inner suburbs have rebounded well and the overall market is on the way to a recovery after the slump of last year. He says demand within a 10-kilometre radius of the city is helping make Melbourne the healthiest property market in Australia.

"The Melbourne market's running pretty well true to form," he says. "The year started with first homebuyers jumping back in, there was enormous pressure put on that three to five hundred (thousand) price range in the inner suburbs and the outer suburban new estate areas. The prices are not going up a lot in the outer areas like Pakenham and Point Cook because of a lack of tenant demand, even though there was a strong demand for lower-priced housing among first homebuyers.

"Another name for tenant is first homebuyer so where there's a lot of tenants, you'll automatically see a lot of new homebuyers when property becomes affordable. First homebuyers tend to only compete in the market for a short period of time, they really lose steam quickly.

"We're seeing investors coming back in, with affordability at such a high point, interest rates down so much and rental yields bouncing back.

"I don't expect the outer suburbs to move much in the immediate future because there's an oversupply, volatile demand and low land values and you've also got demographic trends working against them. People with money will buy somewhere else because of desire.

"The 10-kilometre arc is where the Melbourne market is set to move. It's the desirable location close to infrastructure and lifestyle. Nothing's changed. The frequency of the cycle is getting quicker and quicker and compounding is taking hold in the inner suburbs. The cycles of market movement in the inner suburbs are shorter than in the outer suburbs and what we're seeing is a higher percentage of investor ownership in the inner suburbs."

BRISBANE

Property guru Terry Ryder says Brisbane's "trade-up" suburbs are likely to perform best in the next couple of years as those selling to the huge first homebuyers' market look to move closer to the city.

"The market's very segmented at the moment," he says. "The Brisbane pattern is the same as in most cities, where the outer suburbs are showing some price growth, the middle less and inner-city suburbs showing price reductions.

"In a normal cycle, the up-cycle starts in the centre and moves out but we have an opposite situation at the moment where the growth has started on the outer reaches and is likely to filter in.

"The first homebuyers grant is an influence but it's not the biggest influence. "The grant isn't just responsible for the increase in activity, it's also due to a sharp fall in interest rates and softer prices. In Brisbane, affordability rather than the grant is driving the market.

"The areas struggling most are the Gold Coast and Sunshine Coast. They have affordability problems and over supply problems.

"I don't see them rebounding any time soon. The areas that provide affordability are going quite well."

ADELAIDE

Wayne Smith says the Adelaide market doesn't know which way to move but he has confidence it will grow strongly in the long term. The Adelaide valuer says there's little interest in the high end of town and the strong growth in lower priced housing slowed dramatically once the Federal Government announced an extension in the First Home Owner Grant.

"The low end slowed because people who were rushing to get into the market suddenly knew they had a bit of time so I'd expect that to come back in a few months," he says.

"The Adelaide market's come back since December and a lot of people are indecisive but I think it might be a very good time to buy for well-researched investors.

"I think they can buy with confidence in the long term, even though I'd admit I'm not sure where the Adelaide market's going to move in the short term. "The top end is dead and the big issue affecting the Adelaide middle and lower markets is the tightening up of the lending criteria.

"You have to jump through more hoops now to get a loan and that means even those who want to buy in the middle and lower market can't always do so. "If I was looking for specific areas for investment, I'd revisit the transport corridors.

"There's been a lot of attention from government on improving Adelaide's transport and I think the suburbs along the corridors and the transport hubs are set to really grow in the next few years."

© Australian Property Investor magazine - www.apimagazine.com.au. Reproduced with permission.

This information is of a general nature only and does not constitute professional advice. You must seek professional advice in relation to your particular circumstances before acting. Please read our warning and disclaimer.

A look at the Australian Sharemarket in 2009 - Julia Lee

With less than 5 weeks to go before the end of the year, let's have a look at the winners, losers in 2009 and what to expect in 2010.

The Australian sharemarket is tracking for a yearly gain of 27%.

The best sector has been the second largest sector on the Aussie market; the materials sector. The materials sector is tracking for a yearly gain of 42%. It's not surprising given copper has seen a rise of 140%, oil prices a rise of 98% and gold prices hitting all time record highs during the year. The two biggest companies in this sector are BHP Billiton and Rio Tinto but saw vastly different returns. BHP Billiton has gained 37% while Rio Tinto has gained a massive 137%.

In second place is the smallest sector on our sharemarket which is the information technology sector. This sector is tracking for a gain of 41% and has been helped by the three largest companies in this sector. Computershare has gained 36%, IRESS has gained 58% with these two companies helped along by the improvement in sharemarket conditions in 2009. SMS Management has had a whopping year with a gain of more than 200%. Still all three of these companies are simply recovering from what was the Global Financial Crisis and none of these shares are yet trading higher than pre-GFC levels.

Not all sectors performed well. Four areas lost ground in 2009 and they are the telecom sector, utilities, property and healthcare sectors. The worst by far was the telecom sector with a loss of 10%. Losses in this sector have been driven by Telstra which makes up most of this sector and is down 10.7% year to date so far. Telstra shares have been punished with the NBN process and plans weighing on its share price.

Most of the blue chips on the Australian market managed gains with 14 out of 20 of our largest companies recording gains.

Only 6 out of 20 managed losses. The biggest loss in this group was from QBE Insurance. This company is considered a great quality business by most analysts but the high Australian dollar is bad news for its profit. The high Australian dollar and exposure to offshore earnings has also been bad news for Brambles, CSL and Westfield which saw declines of between 5-10% during the year. The best gain was from Rio Tinto with a rise of 137% followed by Commonwealth Bank with a gain of 80% and Wesfarmers with a gain of 71%.

2009 is a year that can be characterised by one word and that's "recovery". It looks like that recovery process with continue in 2010. In particular, China will be a key for the Australian sharemarket given that it is a large driver of commodity prices. The other theme is going to be around the Australian dollar which is still near 15 month highs. A high Australian dollar is great news for importers like our retailers but bad news for companies with offshore earnings. Valuations now seem reasonable and investors will be watching for an improvement in earnings to support cheaper valuations.

All in all, while the recovery of 27% in 2009 has been welcome news for shareholders, for the market to return to pre-GFC levels, we still need to see a rise of 43% from where the market currently is. Let the recovery continue!

Happy trading!

Julia Lee - Equities Analyst - Bell Direct

To buy or sell shares from as little as $15 per trade, go to www.belldirect.com.au  

Bell Direct does not provide investment advice. This information is general information only. You should consider your own financial situation, particular needs and investment objectives before acting.

Update on the Gold Market - Expectations of further USD weakness continues to underpin investor demand for Gold - Peter McGuire

The price of gold has surged in recent weeks with November firmly on track to be the third straight monthly gain.

At the time of writing, COMEX gold futures are up $151/oz or 14.5 percent in November - an average gain of $12.60 for each of the twelve trading sessions so far this month.

US dollar weakness continues to underpin the rally in gold prices. Overnight the US dollar Index (a measure of the dollar's value relative to a basket of major currencies) declined to its lowest level since August 2008 (see chart below). A falling dollar increases the purchasing power of other currencies, thereby exerting upward pressure on the USD-denominated gold price.

Chart: COMEX near-month gold futures (Light Blue) versus the US Dollar Index (Dark Blue)

Investment demand for gold has strengthened in response to the current environment of low interest rates, expansionary fiscal policy and quantitative easing. These policies, while averting Great Depression 2.0, have sparked growing concern over potential dollar debasement and price inflation.

Adding to the downward pressure on the dollar has been the steady improvement in investor risk appetite. As the financial crisis took hold, the dollar temporarily benefited from financial deleveraging and a spike in risk aversion. But as financial markets have returned to more normal conditions, abating risk aversion has added to the downward pressure on the dollar.

The recent announcement that India's central bank had purchased 200 tonnes of bullion from the IMF was a strong indication of the growing appeal of gold as a strategic low-risk asset. Since that announcement earlier this month, Sri Lanka, Russia and Mauritus have also announced official sector purchases of gold. The Reserve Bank of India's transaction, made at the prevailing market price between October 19 to 30, was the largest seen since the mid-1980s and made a significant positive impact on market psychology.

Why are central banks showing so much interest in buying gold when it is trading at a record high nominal price? The buying interest suggests an expectation that the US dollar will extend its decline. Gold's inverse relationship with the dollar means that by increasing their gold holdings, central banks are insuring against further decline in the greenback.

Where to for the USD and the gold price?

The Federal Reserve stated in the minutes of their latest FOMC meeting that they expect US unemployment will come down only very gradually (over 9 percent at the end of 2010, over 8 percent a the end of 2011 and around 7 percent at the end of 2012). Over this period they also expect inflationary pressures to remain consistently below the Fed's target. These are not forecasts that suggest the tightening cycle will begin any time soon. For good reason, the Fed has chosen a weaker dollar over higher rates and they look likely to maintain this stance into next year. If the Fed were to begin the tightening cycle in the near future it would be comparable to taking away the punch bowl before the party had even started (to steal a metaphor from economist Paul Krugman).

In our view the Fed will move to tighten only when there are robust signs of positive growth in the real economy. In the meantime the bleeding of the dollar decline may only be stemmed by the undoing of the Fed's quantitative easing policy which is likely sometime in 2010. Until such time, further dollar weakness is foreseeable and accordingly, the outlook for gold prices remains biased to the upside.

Peter McGuire - Managing Director - CWA Global Markets    www.cwa.net.au
Peter is a regular commodities commentator on Bloomberg Television and CNBC and appears widely in the Australian financial press.

How long will it take your Portfolio to hit an all time high? - Jamie Nemtsas

What a contrast!

Remember back to the start of this year. The talk on the street was of a global depression with unemployment rates to match, record low interest rates, governments borrowing heavily to prop up economies, property prices potentially falling up to 50% and markets not recovering for up to 10 years.

Now today, near the exact opposite environment. Confidence has returned to pre Global Financial Crisis (GFC) highs, the Australian market has recovered by over 50% and most diversified portfolios have increased by at least 30% since lows reached in March 2009.

This sounds great, however your current portfolio balance will still be lower than its all time high. The all time high in most portfolios coincided with the peak in the ASX, on or around the 10th of November 2007. The question from most investors is "how long will it take to get back to this high?" Historically, it takes around 5 years for markets to go from high to new high. Using this as a guide it would be around November 2012, or three years from now. The obvious question here, and given the more bullish environment, is "if the market has recovered around 50% in 8 months then surely it will not take another 3 years to get to a new high from here?"

Well we are sorry to say it probably will, as the rapid rise cannot continue at this pace, mainly due to at least 2 major headwinds the economy faces. 1. Interest rates, and 2. Taxes. The market will need to be over 6,850 points in November 2012 to record a new high. This is actually very interesting because at that time, this new high will be on the Investing Times Long Term Trend line, meaning that at this point the market would be relatively fairly priced.

Headwind No. 1 - interest rates

Interest rates are the key to economies and financial markets. Interest rates fell by nearly 50% in the GFC, however we all now need to concern ourselves with increasing interest rates. Not only do they reduce the disposable income of most households, but they do the same for companies (reducing cash flow and earnings) and property investors (reducing cash flow).

Actually anyone who has borrowed money, or has a leveraged balance sheet will be impacted negatively. We are certain the Reserve Bank will not finish with just two rate rises. Evidence of this is everywhere. Take, for example, the fact that you can get around 7% pa if you invest in a term deposit with one of the big 4 banks for 5 years. We all know that the banks like making profits, so they must be pretty sure they can get, on average, say 1.5% more than what they give you by lending it out to a mortgage holder. Rates are going up!

So let's say interest rates rise until the average household is paying 7.5% pa. That rate is about 36% higher than the 5.5% we're paying. In other words, interest costs will be 36% more each year. This cost will need to be serviced from somewhere, and that likely 'somewhere' is disposable income. Corporate profits will be constrained and property investors will use more cash flow to service loans. These scenarios will all suck money out of the economy and this slows growth.

Of course rising interest rates are not all bad. The flip side is they are positive for cash / fixed interest investors; a relatively risk free 7% pa return is a great thing to anchor your portfolio.

Headwind No. 2 - taxes

The other way that our economy has been saved is through the use of massive government stimulus, which is nearly all borrowed money. This will leave the Australian government with a substantial debt. The only real way the Australian government can pay off debt is to increase taxes, and increasing taxes is essentially another headwind to a recovering economy.

The Henry Report is out around Christmas, so hold onto your hat as this is touted as being a substantial review of how and how much tax is levied in Australia over the next ten years.

We all hope that the market recovers quicker than in 3 years time, however active portfolio management should mean that a new high for most properly managed portfolios should come much sooner than the market's new high!

Jamie Nemtsas - Partner - Lachlan Partners

Visit the Investing Times online - www.investingtimes.com.au 
This article is an extract from the November 2009 issue of Investing Times newsletter.

To order a complimentary copy of the subscribing to the Investing Times Newsletter email susan@investingtimes.com.au or phone 1300 131 526.

Plan an integrated long-term strategy to deliver realistic growth - Laura Menschik

Last month we covered the issue of "Personal Risk Insurance - Preparing for the Worst", but financial planning for Senior Executives is not just about worst case scenarios and protecting what you have - people quite naturally want to grow their wealth.

If you would like to find out more about how to best position yourself for the brightest financial future we invite you to order a copy of WLM's free White Paper on "Financial Planning for Senior Executives".

The key is to plan and implement an integrated long-term strategy to deliver strong but realistic growth, with an acceptable level of risk. Areas to consider include:

• Superannuation; including Self-Managed Super Funds and salary sacrificing.
  
• Savings plans.
  
• Gearing strategies - negative, positive or neutral.
  
• Investment bonds; such as education or insurance bonds. These can be used for purposes such as saving for childrens' school or university fees. They are held for at least 10 years and taxed at the corporate tax rate, and do not need to be reported on the client's tax return. Additional investments of up to 125% on the previous year can be made.
  
• Structured Products (100% Gearing with protection) - these are designed to grow capital and offer the investor access to commodities and other less accessible markets, while mitigating risk.
  

Gearing to Invest - A Risk Worth Taking?

Almost all of us borrow to invest at some point in our lives - for example, buying a family home. However, borrowing to invest in equities or other investments is viewed with far more suspicion. But for people with the right risk profile, and with sufficient disposable income, gearing can be a key to wealth accumulation.

Unlike a mortgage, gearing offers tax relief which may be particularly attractive to those paying the highest rate of income tax, as it can almost halve the cost of interest. When gearing into an income producing investment, current tax legislation allows that the interest cost associated with the borrowing may be offset against income received, i.e. tax deductible. This effectively allows you to fund the interest payments from pre-tax income.

Why gear?

Essentially gearing an investment can increase the return to the investor. But it is not that simple. Gearing also increases losses from poor investments and can increase other risks.

There are other reasons for the gearing of investments:

• Borrowing enables an asset, such as an investment property or a business, to be purchased without having to wait until the whole of the purchase price has been saved; and/or
  
• Borrowing enables a better and/or more attractive property or business to be purchased, or a larger investment to be made, which may give a better investment return or be cheaper to administer.
  

Another positive gearing strategy is to lower the proportion of the investment that is borrowed, contributing some of your own funds. This makes a positive yield much more attainable - for example, by only borrowing 50% of a share investment, it only needs to yield 3% per annum. This strategy tends to appeal more to people with a lower income who are subject to lower marginal tax rates.

Margin Lending Facilities

Margin Lending can be a powerful tool for more rapid growth and wealth accumulation. However, it is a strategy that can carry risk. A good financial advisor can help you by conducting a risk assessment, and assisting you in structuring and protecting your assets.

A margin loan is secured against a portfolio of cash, shares or managed funds. The loan can be used for investments such as shares or managed funds. You can usually borrow between 40% to 70% of the value of the investment, but the amount varies account to the lender's assessment of the risk of the investment.

By enhancing your portfolio with a margin loan, you can benefit from:

• Increased dividends
  
• Greater access to franking credits
  
• Increased capital growth
  
• Opportunities to participate in floats and capital raisings
  
• The ability to make payments on instalment receipts
  

It can also enable you to diversify and balance your existing portfolio by investing in new sectors without compromising your existing investments.

Margin loans can enable you to reap the tax benefits of negative gearing, and give you access to additional franking credits. Rather than limiting yourself to geared property investments, you can access a variety of investment types.

The Risk of a Margin Call

A margin call occurs when the value of your investment drops below an agreed level . It requires you to give the lender more money to re-establish the original Loan-to-Value Ratio (LVR). It is therefore advisable to ensure that you gear 'conservatively' or have access to some kind of 'emergency fund' to prepare for this eventuality, to avoid either defaulting on the loan or losing money by being forced to withdraw a deposit or investment prematurely. Needless to say, a sudden and dramatic drop in the value of your investment could have devastating consequences if you are not prepared. Many investors learnt this at an appalling cost to their wealth in late 2008.

There are a number of other precautions you can take to reduce the risk of a margin call:

• Using an equity loan against property rather than a margin loan
  
• Adopting lower gearing levels than the maximum permitted
  
• Not capitalising interest
  
• Regularly using income from the securities to reduce the loan balance
  

It is interesting to note that borrowing to buy a property to live in or as an investment, or to buy a business, is widely accepted as normal practice, whereas borrowing to buy part of a business (i.e. shares or share trusts) is seen as risky. In fact the principle is the same in each case.

Negative Gearing

An investment is said to be negatively geared if the interest payable on the borrowing exceeds the income (dividends, rent or interest) received from the investment (after expenses), giving a negative cash flow.

The fundamental rule is that gearing (or negative gearing) an investment is profitable (and hence makes sense) only if:

• The return from the investment, including both income and capital gains, after tax and expenses, is expected to exceed the cost of borrowing, after tax and all expenses; and
  
• The gain from the whole arrangement is expected to be large enough to make it worthwhile.
  

Purely deferring income tax to a later year, or reducing income tax now in return for taxable capital gains later, does not, on its own, justify negative gearing. It can only be justified if the amount of tax payable later will be lower (because the taxpayer will be on a lower marginal tax rate), or if the taxpayer can get a significant benefit from the delay in payment and the whole arrangement makes enough money to make it worthwhile.

The negative cash flow is usually a tax deduction against other taxable income.

Positive Gearing

A positive gearing strategy is where the income received from the investment exceeds the costs, including interest on the loan. It is aimed at providing cashflow, as opposed to capital growth. However, in the case of residential property investment, this can be difficult to achieve. The Australian Bureau of Statistics (ABS Cat. 8711) tells us that in 1995-96, only around 15% of investment properties funded by a mortgage made a profit. Even unmortgaged properties did not necessarily deliver, with only 60% making a profit. Investments that generate higher income also tend to have higher risk.

In the share market, positive gearing requires your dividend income and franking credits to exceed the cash cost of servicing your loan. If you were to borrow the entire amount for a $100,000 share portfolio at an interest rate of 8.5 per cent, your interest bill will be about $8500 a year. Therefore, your investment would need to yield more than 8.5%, which is ambitious even among top Australian equities, which rarely yield more than 5%.

Equities with unusually high yields don't always mean they are good to invest in. They may represent a bad investment, possibly indicating poor growth prospects or a falling share price.

Any gearing strategy should be coordinated with your risk profile, cash flow, tax implications and personal understanding and comfort level.

If you are considering a gearing strategy, or need to re-evaluate one already in place, you should seek advice from professionals who are able to independently assist in this area to ensure suitability to your personal circumstances.

Laura Menschik
Director and Authorised Representative
WLM Financial Services Pty Ltd.
CERTIFIED FINANCIAL PLANNER TM - SMSF SPECIALIST ADVISER TM
Fellow of the Financial Planning Association of Australia Limited

WLM provides wealth and lifestyle management services in a professional and personalised manner, by qualified advisers, on a fee-for-service basis. WLM is independently owned by its Directors. Visit WLM Financial Services online wlm.com.au

The Japanese Experience of the Past 20 Years  -  Andrew Page

They say that one should avoid speaking of politics and religion in polite conversation. Ostensibly this is because people hold such strong opinions on these topics, and understandably avoidance is a wise course of action if one wishes to avoid confrontation. To this list I would add investment philosophy, as this too is a highly polarising topic which seems to engender very strong emotions.

As an advocate of the long term approach I am certainly well aware of this, particularly in an age where most are more concerned with speculation and short term gains. Nevertheless, I believe the best one can do is take an evidence based approach and let the facts speak for themselves. To that end, this week I want to tackle one of the most credible arguments against long term investing: the Japanese experience. While many criticisms against long term investing are easily dismissed, the performance of the Japanese market over the past 20 years is much more difficult to ignore: since 1989 the Japanese market has dropped by approximately 69%.

Clearly this seems to be a terrible outcome for long term investors, but we need to not only contextualise this performance but also understand that long term investing, contrary to popular belief, involves far more than simply 'buy and hold'. If we acknowledge this and introduce even some very basic investment techniques the result is one which may surprise you.

In a very small minority

Before we get into specifics, the first point to make is that the Japanese market is the only example of a major industrialised nation to exhibit such poor long term performance over the past couple of decades. I would argue if the long term approach has been successful in the vast majority of cases, it can hardly be labelled as ineffective. If you had a technical indicator that was correct even 70% of the time it would be considered very powerful indeed. The fact is that if the long term investing approach was completely ineffective, you would imagine that there would be a long list of examples of its failure, not just a small handful.

(I won't discuss the other oft quoted examples, such as the oil crisis of the 70's or the '87 crash as none are as severe as the Japanese example and furthermore the arguments I will discuss here are equally relevant .)

Inflation, or the lack of

Rather than just chalk up the performance of the Japanese market as the exception that proves the rule, I would go a step further and suggest that things aren't nearly as bad as they appear. For starters Japan has barely seen any inflation over the past 20 years, and indeed suffered substantial deflation during the 'lost decade'. As most would know, inflation acts to reduce the spending power of money. The flip side of course is that deflation will increase the value of the currency. So whereas the true or 'real' value of money has decreased for most other nations, in Japan it has essentially remained the same.

This means that in real terms the decrease in market value is substantially less than would have otherwise been the case in an inflationary environment. More importantly, it means that if indeed any gains were made over the period, they would not have been lessened by inflation. And as we shall see, gains were indeed possible.

Measuring from the peak

A much more important factor is that we are almost exactly 20 years on from the absolute height of the Japanese market. The 20 years preceding the 1989 top saw the Japanese market rise a staggering 1588% as it underwent a massive transformation to become the second largest economy in the world. Towards the end of this time, fantastic bubbles developed in asset markets which significantly over inflated prices. The point is that if you buy at the height of a bubble, especially one as staggeringly large as in Japan, it will always take you a long time to recoup your losses (especially if you just sit on your hands and wait). Clearly, it doesn't make sense to only choose the summit of market bubbles as the starting point for measuring performance.

If instead you missed the absolute high, which the majority of consistent long term buyers would have, the situation becomes much less disappointing. If you had invested only 3 years after the high you would now be sitting at 33% loss. Of course that's still pretty poor, but nevertheless it is a significant improvement. Move further away from the market peak and the picture continues to improve. Indeed, you could even nominate a number of periods over the past few decades which would have led to attractive long term gains.

As you can see, a retrospective approach will allow you to paint the picture as you choose. With the benefit of hindsight you can make even the Japanese market seem reasonably rewarding! I acknowledge this, but I want to ensure that readers understand that the reverse is true; that is, by choosing the very top of the largest asset bubble in the modern era you can easily make things seem absolutely terrible.

Don't set and forget

Another point to acknowledge is that the long term investor does not simply buy a bunch of shares at some specific point and then sit on them indefinitely. As income is saved, investors add to positions and build their portfolios. This has the unintended (yet beneficial) effect of dollar cost averaging. I have already written extensively on this, but I do want to remind readers that I don't advocate dollar cost averaging as a strategy in and of itself. Rather it is an unavoidable consequence of continuing to build a portfolio. A consequence that helps smooth out volatility and reduce the reliance on timing.

Consider the example where an investor has the terrible misfortune of investing $2000 into the Japanese market at the absolute high of the 1989 boom. However, if this investor continues to add an additional $2000 each and every year after this their return on investment comes in at -32%. Again, that's nothing to get excited about, but it does represent a substantial improvement on an otherwise near 70% loss.

Dividends make a BIG difference

Of course to this point, while we have significantly reduced our losses we are nevertheless well and truly in the red. What we have failed to do of course is include dividends and the power of compounding. Consider the difference between the Topix and Topix accumulation index (which factors in the effect of dividend reinvestment):

As you can see, even a seemingly low dividend yield of approximately 3.5% pa can lead to a substantial difference over the long term. Again we still remain in the red, but the losses have nearly halved when dividends have been reinvested. However when you combine the effects of regular additional contributions with dividend reinvestment, something truly remarkable happens.

To continue with our previous example, let's say that you invest $2000 into the Japanese market at the very height of the bubble. However this time you not only continue to add an additional $2000 each year, but you also reinvest your dividends. Amazingly, even though the Topix index has declined by close to 70% in that time, in this example you are today down only 3.6% on your invested funds! And all of this in a virtually inflation free environment! Essentially, although you have failed to grow your capital, you have nevertheless managed to preserve your wealth, something that you achieved in the worst market of the modern era with nothing more advanced than investing in an index, reinvesting dividends and making regular contributions. Personally, I find that quite amazing.

The GFC

What is also amazing is that you have to remember that the Japanese market not only suffered truly horrendous losses following the 1989 high, but of course was also affected by the Global Financial Crisis (in fact, it was hit harder than the US and Australian markets, declining by close to 60% between 2007 and early 2009). As you can see in the chart above, prior to the GFC the portfolio was actually doing very well indeed; at its height enjoying a healthy 69% return on invested funds. Again, this is truly remarkable when you consider that the initial investment was made at the height of the market in 1989.

Diversify to increase gains

Additionally, one should also consider the value of diversification into other asset classes and off shore markets. Diversification is usually seen as something that will reduce risk at the cost of also reducing gains, which is indeed often the case. However, if what you diversify into performs better than your existing assets you will actually see a better overall performance. Now of course the point of this article is to discuss the Japanese experience, but the fact is that diversifying across markets and asset classes is what one should do anyway as part of a sensible investment strategy. In this case, it is something that would have significantly improved performance.  It can very clearly be demonstrated that Japanese investors could have seen attractive returns by simply investing a portion of their funds offshore.

More than Buy and Hold

The final point to make, and one that is usually overlooked by cynics, is that long term investing does not necessarily mean simply buy and hold, and it does not infer that you must be resign yourself to achieving the market average. As a long term investor I regularly review my positions, reweight my portfolio and employ risk mitigation techniques. Furthermore, as I have previously shown, a focus on dividend paying industrial style businesses has historically led to a significant outperformance of the broader market indices. Had we conducted the previous example using a diversified mix of the better Japanese stocks we would have actually seen a very attractive return over the same period. For example over the past 20 years shares in Canon have seen a near five-fold increase in value.

Summary

So it is really undeniable that a well managed portfolio of quality industrial style stocks, with dividends reinvested, regular additional contributions, and with even a small amount of funds diversified into offshore markets, would have actually led to very reasonable long term returns, and all in an inflation free environment. And that's even accounting for the fact that you initiated the investment strategy at one of the worst possible points in history. Truly remarkable.

So in conclusion, cynics should be careful not to quote the Japanese market as an example of why long term investing doesn't work. It has undoubtedly been a difficult period for Japanese investors and clearly things could have been much better, but that doesn't mean we should completely discount an otherwise very powerful and successful investment philosophy. Simply referring to a long term chart of the Nikkei or Topix as 'proof' that long term investing doesn't work is overly simplistic and ignores the most basic principles of sensible investing.

Andrew Page -  Media & eLearning Manager - Hubb Financial Group

Download HUBB's free scanning & charting software at www.hubbinvestor.com

All recommendations are provided without consideration of any specific reader's investment objectives, financial situation or particular needs. Those acting upon such recommendations do so entirely at their own risk.

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