Here's how to pick returns

Robin and Tony have a problem, albeit a pleasant one: they have a freehold home in Tauranga worth $1 million, a section worth $250,000 with a $125,000 mortgage and $120,000 in the bank.

They wonder if they should:

1. Pay off the loan.

2. Borrow to put a house on the section and then rent it out.

3. Sell the section and invest the net proceeds and the cash in a balanced portfolio.

Obviously, there is no right or wrong answer but reaching any conclusion involves estimating the future returns of each alternative.

Getting an idea of what an investment will return is fundamental to making a good decision, but many people have different ideas as to just how this should be done.

A favourite and certainly easy method is to look at past performance and assume that the trend will continue. This is sometimes known as momentum investing and, while it is easier than other forms of analysis, there is no logical reason trends should continue.

Indeed, regulatory authorities around the world warn investors not to pay attention to historic returns as they are, in most cases, irrelevant.

More exotic ways of estimating returns include estimating the worth of a stock, bond or property investment using a computer model.

One thing is for certain: the high incidence of bad investments suggests forecasting returns is as much an art as a science.

The return on an asset is equal to the income you receive on it plus the movement in its price over the period. For a bank deposit, the calculation is pretty straightforward - you are quoted an interest rate and you get your money back so the return is equal to the interest rate.

For assets whose prices move around a bit, such as property or shares, you have to estimate what the income will be and what you can sell the asset for when you want to exit.

While estimating the income is reasonably easy, determining the price in 10 years can be really tricky.

Economics can help us out, though. The theory says that return (r) = dividend (d) + growth in profits (g).

Therefore, if you own a house in Tauranga and you expect the rent over one year will be 4 per cent of its value and that the rent will increase at the rate of inflation (3 per cent) the numbers for d + g = r are: 4 + 3 = 7 per cent.

The equation r = d + g is pretty simple to use (or I wouldn't be using it) but its relevance takes a bit of understanding.

What underlies the assumption behind it is that the value of the asset - a flat in this case - will increase or decrease as the rent rises or falls. This follows from an economic theory which simply says something is worth the cash profits it will produce over its life.

So if we know that historically rents in Tauranga or even nationally have risen at about the rate of inflation, and we know that most estimates of inflation are 2 to 3 per cent a year, then we have a fair idea that the return from that asset in the long run will be 4 + 3 = 7.

Of course, prices can go up or down randomly, tenants can default, floods can happen and so on, but at least the figure of 7 per cent gives a basis to compare a flat as an investment with bank deposits.

In the year ended March 2000, the technology sector of the United States stockmarket returned 48 per cent without the benefit of any dividends largely because people thought that the g component of r = d + g was going to grow at a fantastic rate for a good many years.

When analysts started winding down their estimates of g, prices duly collapsed.

The technology crash led many people to say the stockmarket was irrational, which may or may not have been right at the time.

However, it also points to the fact that g is difficult to forecast and prone to exaggeration and that d is a much more reliable component of r.

Today, the dividend of the US stockmarket overall isn't much better than it was in 2000 - only about 2 per cent - so investors must be expecting a good deal of dividend growth if they are to get to a 10 per cent return.

In practice, however, g usually doesn't even rise as fast in the long run as economic growth*.

So, realistically, with dividends only at 2 per cent, total returns from US shares may struggle to get past 6 to 7 per cent.

A cynical New Zealand investor, with the benefit of hindsight, might wonder how Americans could be so silly as to price an asset (technology stocks) to yield virtually zero.

Of course, you had to be there at the time, but one major difficulty with taking an alternative view in such a case is that maybe the zero yield on the Nasdaq correctly reflected the likelihood of strong profit growth in the future.

Taking a position away from the crowd is risky - some fund managers who couldn't see value in the Nasdaq lost their jobs when their performance didn't keep up with the indices. Of course, they were proved right eventually but I doubt that they got their jobs back.

Certainly NZ stockmarket valuations look much more sensible. Dividends are about 6 per cent so that even if profits just grow at the rate of inflation (2 to 3 per cent) a 10 per cent return looks possible.

Perhaps, however, we shouldn't be so smug as we may have a bubble in our own backyard: farm prices.

Anecdotal evidence suggests that the combined effect of the rapid rise in farm prices during the past five years or so and the strong dollar, which has depressed profits, means that cash earnings as a percentage of market price (a proxy for d) for many farms are now only around 2 per cent to 3 per cent.

More proof that farm prices may be sky high is shown by the NZ Rural Property Trust, which owns 30 or so dairy, sheep and beef farms valued at $2.61 a share yet is paying a dividend of only 3.5c a share - a yield of 1.3 per cent.

Admittedly, the trust is stuck with a high management fee but even if we add 1.5 per cent to this yield we struggle to get to 3 per cent.

So is the market crazy or are farm profits set to surge? Many industry observers and farmers shake their heads in disbelief at the disparity between prices and profits.

But, at the same time, they aren't falling over themselves to sell the family farm either, as the market - like that in tech stocks back in 2000 - could be right .

* Robert Arnott writing in the Journal of Portfolio Management's 30th anniversary issue, says earnings growth a share for US stocks in the 20th century averaged 4 per cent a year, of which 3 per cent was inflation.

* Brent Sheather is a Whakatane-based investment adviser.