The Path Of Real Money and Wealth

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The big corporate news to come out of the Australian Share Market yesterday was the David Jones takeover offer by South African retailer Woolworths. They’ve offered a hefty $4 a share for the struggling retailer, which is about 23.5 times 2014 forecast earnings. Clearly, the South African’s think they can boost earnings with a new strategy. Let’s hope they’re right.

The Financial Review says that if the deal goes ahead, ‘It would be the biggest retail transaction since Wesfarmers bought the Coles Group in 2007.

Uh oh…2007 didn’t turn out to be the best year to make a large, overvalued, debt-funded acquisition, did it?

Here’s Wesfarmers’ share price since…

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As you can see, the shares spiked on the news (mid-2007) as debt-funded acquisitions were all the rage back then. But then the market reconsidered and volatility ensued. After all, Wesfarmers paid a very full price for Coles and the economic environment — when you thought about it for more than five minutes — was very uncertain. A bit like today.

Before long, the GFC hit, Wesfarmers had to issue a massive amount of equity (at a very low price) to pay down debt (because debt was no longer cool) and the share price has struggled ever since. Nearly seven years later, shareholders are only just back to where they were before the Coles acquisition.

Notwithstanding the fact the Coles is a much better run company now than seven years ago, Wesfarmers’ shareholders would have been just as well off without it. In 2007, Wesfarmers generated a 25% return on equity (ROE) and rightly received a share price premium rating because of this reputation for generating superior long term returns.

But because of the high price paid for Coles (and the huge amount of goodwill it added to Wesfarmers’ balance sheet) ROE plunged into single digits following the acquisition and is forecast to hit only 9% in 2014.

The message? The price you pay for an asset makes all the difference to your future returns. It’s a message well-worth listening to as these highly leveraged global asset markets morph into melt-up mode.     

But we digress. It’s now 2014 and Woolworths (the South African brand) is making a similarly expensive bid for a similarly underperforming iconic Australian retail brand. Luckily for Woolworths it can look forward to increased consumer spending because over the past 12 months Australia has grown much wealthier from increased house prices.

Ahhh, there’s that word again…wealth. We’ve been discussing the topic a bit this week. In this day and age, it seems that wealth is pretty easy to come by. Overnight, the US Federal Reserve magically created billions of dollars in additional ‘wealth’ by releasing minutes of its last meeting. These minutes indicated that the Fed was in no hurry to raise rates (is that actually new news?) and so markets surged (again).

Likewise, the Woolworths bid helped create more wealth in Australia yesterday by pushing the ASX 200 up to a new marginal, post 2008 high. But is that true wealth? What is true wealth and how do you keep it once you’ve got it?

Vern Gowdie will have a crack at answering those questions tomorrow in a special report heading your way. In the meantime, we’ll give it a shot too.

Real wealth comes in two main ways. If you’re an income earner, you accumulate wealth slowly by consuming less than you produce. You then have a number of choices about where to ‘store’ or ‘grow’ this wealth. You can leverage it up (put it at risk) by investing in shares or property, or you can be more conservative by putting your wealth in gold, cash, or lend it to governments or corporations (fixed interest).

The other way you can grow wealth is to start a business. This is the best way to grow genuine wealth. Except in the first two, five, or 10 years it may seem like you’re not generating any wealth at all. And you certainly don’t feel wealthy when you’re reinvesting ever spare dollar back into your business.

But this is how wealth grows; by producing more than you consume (it’s the same for a business as it is for an individual) and then reinvesting that excess production back into the business. If the business generates good returns on investment, over the years that compounding effect will generate profits for the business owners.

Once the business becomes established, capitalising the profits provides a business value, which represents the real wealth that has been created by the owners over the years.

In the stock market, investors guess at the ‘real wealth’ of a business every day. Sometimes those guesses are optimistic and sometimes they are pessimistic. In other words, real wealth in the equity market fluctuates.

And it is only as secure as the foundation it is built on. Unfortunately, the foundation of our financial system is extremely fragile, which is why wealth can disappear as easily as it appears in publicly traded markets. This makes the project of retaining wealth (once you have fought hard to obtain it) an extremely difficult one.

Which is why Vern is passionate about his family wealth project. He grew his money and wealth by building a business over many years. Upon realising the value of the business, he found himself wondering how to protect it from the vagaries of the stock market and debt fuelled asset markets in general.

The result is a refreshingly different way of thinking about long term wealth creation. Stay tuned for Vern’s report tomorrow.


Greg Canavan+
for The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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