Australian Investment: Shares or Property?

It is the ultimate contest in the field of Australian investment. Which is better, shares or property?

Both have their cheer squads. And both can easily pull out a pile of statistics and charts "proving" their argument is right and their opponents are wrong.

Our view is that it is a nonsense argument. The fact is, they are both wrong. And furthermore, the race for spruikers on each side to outperform each other is partly behind the bubbles in both markets.

In reality you shouldn't compare shares against property. They are both completely different types of investments. They are not comparable. In a normal, undistorted free-market they would each provide a different set of returns based on growth and income.

Unfortunately, both markets have become so distorted by taxbreaks and leverage that it is almost impossible to know what the true rate of return on either asset should be. All anyone can do is guess. But one thing we know for sure, an asset value cannot consistantly achieve double digit gains year after year.

Even a small cap company will return to modest growth after its initial spurt.

On the one hand you have the share spruikers. Those that claim the only way to invest in shares is to buy them and hold them forever. This case is most frequently argued by those with a vested interest. That is fund managers and financial advisers.

The more money you give them and the longer they hold it, the more money they make for... themselves.

You've seen the chart from Vanguard showing returns of three million percent from buying and holding shares. That's if you happened to buy your portfolio in 1898 and held it through to today. Happy 101st birthday to you if you have.

But for many investors, after a year and a half of pain they are taking the decision to exit the stock market, perhaps forever.

The trouble is, now is exactly the wrong time to get out of the stock market. Instead, what most investors should be doing is taking a look at their portfolio and - in the words of fund managers - rebalancing it.

You see, for years fund managers have brain washed the investing public into believing buy and hold is the only strategy. That you should split your assets between blue chip shares, cash, fixed interest and listed property.

Except, they've got it all wrong. That's the formula to make average and below average returns. If you're happy with that then go for it. If you're only after 3% per annum then you shouldn't invest in something providing 10%, because you'll take a bigger hit if things turn out wrong. But if you want to make above average returns you have to play the market differently to the fund managers.

Don't get me wrong, this isn't all about getting one-up on Wall Street, Collins Street or Martin Place. And it isn't about earning more than your neighbour or your work colleagues. This is about getting a better return on your investments. I wrote recently that the 'rule' about diversification was just fund manager spin. There is a simple reason why that's true, and I'll get to it shortly.

As an investor, you want your investments to do one of two things: grow, or provide an income. Sometimes you get lucky and you can have a bit of both. But not usually. In fact, if any investment offers growth and income in the one investment then take a second look to make sure you aren't being conned. Those investments are out there, for instance, a small company we tipped in the Australian Small Cap Investigator last October looked too good to be true with a 9% yield and the potential to more than double in price. So I checked the figures again, and the numbers did stack up.

Let me make one thing clear. I'm not saying that investing in small cap shares is better than investing in property. They are different investments with different returns. In other words, you should match your investment based on the returns you want rather than trying to get higher returns from an investment that can't provide it.

In order to understand investing we need to take a step back and see how an economy works. In very simple terms you can split businesses into two areas - companies that make things (products), and companies that provide a service.

You then have entities that buy those products or services. They are either other businesses or individual consumers. (We'll leave government out of this to keep it simple - if only we could do that for real!)

Over time some companies will do better than other companies. It could be for a variety of different reasons - a better product, a cheaper product, better marketing, etc. Also some companies will fail and go out of business.

But new companies will emerge. They may fill the gap of the failed companies by copying their technology. Or, as frequently happens, a new company will improve on an existing product or service. This may (but not always) increase demand for their product and allow the company to grow.

The existing companies will then have two choices. To either adapt their own business to follow suit or stick to what they have been doing. Either way, it is a decision that could either ruin the company or allow it to remain in business to grow further or at least maintain its market share.

Over time new companies will replace the old, get taken over by the old, or they will take over the old companies themselves.

And that's how you can achieve above average returns. Sure, it does mean taking on more risk - the fund managers have got that much right - but without risk there is little reward. And if you want higher returns you need to understand there is higher risk.

That's the problem with the recent trend in the property market. We're not saying it isn't a good investment and property investors haven't done well over the last twenty years or more. What I am saying is valuations have got "out of whack" with reality. Property values have increased for all the wrong reasons. Thanks to property spruikers, negative gearing, and the belief that property values always rise, the reality has become lost amongst the dream.

Think about it, throughout time, housing has been built and bought as somewhere to live. Or built and bought by a landlord for someone else to live in - whether its a nineteenth century industrialist building terraced houses for factory workers, or country gents building cottages for labourers, or even modern day landlords building well-appointed units in Docklands.

But, do you see the difference? Industrialists didn't build thousands of terraced houses in the north of England because they thought the price would rise allowing them to sell them off at a profit. They built them because they needed people to work in factories. People would only move from the countryside to the cities if they had somewhere to live.

What better way to indenture the workers than giving them a house in return for working in the factory. If they play up or complain then they're out of a job and a house.

The point is, property was not the investment for the industrialist. Property was merely a way of securing labour that could work in the factory to manufacture the products. That was how the industrialist made his money. Owning the land and houses was a bonus, and a liability.

Suddenly things changed. More and more people started owning their own homes, which meant that more and more people wanted to own their own home. The banks realised there was good money to be made in lending money against property - providing they didn't lend too much of course.

But once the floodgates are opened it takes a lot of effort to close them again. The banks were willing to increase the amount of money they loaned. Property owners now wanted to buy a beach house to complement their home. "If the rich can do it, why can't I?"

And then before you knew it, everyone wanted to be a property developer. Units, townhouses and apartments were springing up everywhere. The promise of easy money was too hard to refuse. And don't worry about rental income being high enough to cover the mortgage, because negative gearing means you can get away with undercutting yourself.

In fact, why not make the rental income so cheap that it's cheaper to rent than buy!

Besides, property investors aren't interested in the income, it's the capital gains that count. Because property prices always rise.

There is little doubt that property values have risen very healthily. If you'd bought a block of land in the 1970s or 1980s you would have made many times your money on the investment. So why shouldn't that be the case now? Why shouldn't a property bought today increase in value by the same amount over the next twenty years?

Well, that brings us right back to productivity. When you buy shares in a small company you are buying the rights to share in its current and future profits. It is making something that has a demand in the market, and that will be used by the end user. The company can keep making the product until a better product emerges and the business starts to decline.

However, when you buy a property, sure there may be a demand for it now, but what about when a better property becomes

available, will it be in such high demand then? Will it not also start to decline?

What is the productive output of a house that causes it to continue rising in value?

Take a look at the chart below...

Source: http://www.debtdeflation.com/blogs/

It displays the growth in property prices in Australia since 1890. Now, we don't need to go back that far, so let's take the period from the early 1970s. Since then, the house price index has risen from just over 100, to more than 350 today. And that's removing the impact of inflation.

But the real spike doesn't start to kick in until the 1990s. That's when the credit bubble really started to take off. Can we really believe that the credit excesses will cut the stock market in half yet leave the property market almost completely unscathed? Even though property has been just as leveraged as shares.

Yet that is what the property spruikers claim.

But for some investors and the economy, things could just be about to get a whole lot worse. Because just as the stock market is cruising around the lows - in our opinion - the property market is still close to a record high.

Lured by the belief that property prices always rise, many investors are closing the door on the stock market and opening the door on the property market. And they're doing so at exactly the wrong time. Not only are property prices near record highs but interest rates are at record lows.

That is a recipe for disaster once interest rates start rising again. In the recent Australian Small Cap Investigator newsletter I took the decision to tip a property trust as a short term punt. That's because I believe we are approaching a short term "Super Spike" in the property market as demand and supply converge.

It won't last for long. Soon interest rates will rise, government subsidies to prop up the property sector will run out and the glut of over-priced and over-appointed new property developments will be awash over the economy. Hopefully, just before that happens I'll tell Australian Small Cap Investigator subscribers to bail out of the property trust as soon as they can.

Meanwhile, while all this is happening, many - but not all - small companies will continue producing, servicing and making money. That's why it is the worst possible time to leave the stock market and buy property.

Remember, the saying is "buy low, sell high." Buying low is not something that could be said for the property market at the moment.

Kris Sayce
for The Daily Reckoning Australia

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