Past gives a clue for investors

The debates continue to rage over whether residential property is a better investment than shares or whether international equities are preferable to New Zealand shares. One of the chief problems in reaching any sensible conclusion is the lack of long-term historical data on the topic.

Mr X writes to Mary Holm boasting of his 10-year track record of residential property speculation in Howick but, a few weeks later, we hear of Mr and Mrs Y in Tokoroa whose rate of return is half that of Auckland investors.

Someone has made a killing in Australian shares while someone else lost their shirts on the Nasdaq.

Different time periods, gearing and exchange rates, to name but a few problems, make for difficult comparisons. Until now, perhaps.

In an interesting study, a former South African fund manager, Peter Urbani, now living here, has put together a detailed history of the performance of the major New Zealand and US asset classes, including local residential property, over the period 1928-2004.

What is particularly noteworthy is the apparent stellar performance of the latter asset class: maybe Mr and Mrs Average New Zealander's preoccupation with things residential hasn't been so silly after all.

Urbani's data is summarised in the table and shows the total return from owning the average home has only just underperformed the local sharemarket.

When one realises the cost of owning shares in terms of management fees will typically reduce returns by another 1 per cent to 2 per cent, residential property looks unbeatable. What is also interesting is the high historical return from bank deposits in New Zealand - 7 per cent a year since 1928. This risk-free return is better than that from many overseas sharemarkets and only 0.1 per cent a year below government bonds.

It is clear that compared with the US, where shares have outperformed cash by 7.8 per cent a year, there has been little incentive for local investors to take on more risk either by buying long-term bonds or shares.

Indeed, why bother when you can get 7 per cent from the bank? That more than anything may explain why local investors own so few shares.

New Zealand shares have also been volatile - they rose by 119 per cent in 1983, also a vintage year for white wines and surf around the Gisborne area. On the downside, the worst year in the 1928-2004 period was 1987, when share values halved.

A knowledge of the long-term performance of financial markets, as well as being interesting, can be useful in that it permits a historic perspective as to whether present valuations are higher or lower than average.

The current dividend yield of the sharemarket at around 7 per cent compares with a long-term average of about 5.5 per cent and highs and lows of 8 per cent and 2.2 per cent respectively.

On this basis anyway, NZ shares look reasonable value. On the other hand, 10-year government bonds yielding 5.7 per cent don't look so flash compared with their long-term average of 6.6 per cent and a high in 1985 of about 18 per cent.

At 9.6 per cent a year over the 1928-2004 period, New Zealand shares have underperformed those of the US, which averaged 11 per cent a year. But that doesn't necessarily make owning US Inc today more attractive than NZ Inc, as we need to understand whether the outperformance was due to faster growth in profits or just due to US stocks becoming more expensive.

Obviously, the latter conclusion would make US stocks less attractive.

So what's the story ... research by two US academics published in the Financial Analyst Journal in 2003 shows that much of the outperformance of the US sharemarket since 1926 has been due to a number of non-recurring events.

These include a dividend yield which was 5.5 per cent back in 1926 (now around 2.5 per cent) and the fact that the P/E ratio, the price investors will pay for a share relative to the company's earnings, has risen steadily.

Actual long-term earnings growth in the US has averaged only about 4 per cent a year or 1 per cent more than inflation. In contrast, back in 1928 the dividend yield of the local sharemarket was about 5 per cent, which is actually less than the yield today.

As New Zealand shares aren't as expensive as US stocks they haven't benefited from higher valuations to the same extent as those in the US. This arguably makes New Zealand shares a better prospect for the next 80 years.

Unfortunately, Urbani's performance figures won't end the debate on houses versus shares.

Some unknown component of property's 9.3 per cent per annum will be due to capital expenditure by homeowners adding an extra bedroom or remodelling the kitchen. This expenditure inflates prices and returns beyond what they would otherwise be, whereas sharemarket indices properly reflect the impact of new capital.

In any event, all this data is ancient history and, as we are constantly reminded by the regulatory authorities, past performance is no indication of the future.

So what returns can we reasonably expect over the next 80 years? Economics tells us that returns are equal to the initial dividend plus the rate at which profits grow. Behavioural finance, in turn, suggests that as perennial optimists we consistently overestimate this latter, variable growth.

Given that we can't be sure of growth but we know what dividends are, a strategy that focuses on assets with a high dividend is probably the safest bet.

On this basis, with residential property prices high and rents as a percentage of price, in Auckland and Tauranga anyway, averaging around 3 per cent to 4 per cent a year after costs, NZ shares with a 6 per cent to 7 per cent yield look to have a big head-start.

* Brent Sheather is a Whakatane-based financial adviser.