The Madness of Crowds

By John Nicola CFP, CLU, CHF

IN THIS ISSUE: As we sort through what is essentially a bear market, it seems that 2006 has found some bullish trends in energy, gold and real estate – but how much of it is real and how much is simply the “madness of crowds”? In this edition of Tactics, John Nicola delves into an investment philosophy that helps investors rise above the bubbles and find consistency in a volatile environment.

Isaac Newton had a sense of both humility and vision when he wrote to his friend Robert Hooke in 1675. Forty-six years later he could have used both of those characteristics to avoid losing a small fortune (about $3,000,000 in $2006) in one of history’s most famous investment crashes – The South Sea Bubble.

Notwithstanding many additional investment catastrophes since then (the latest being the tech boom of the 1990’s), we investors have learned little from our collective experiences – which brings us to 2006.

The year started with a continuation of bull markets in gold, energy, real estate, income trusts, and emerging markets. Even plain old blue chip stocks roared back to equal or beat their previous highs reached in 2000. Over the three-year period ending March 2006, the average return of this group was in excess of 100%. Since then markets have fallen significantly, as shown in the table below. It seems volatility is the order of the day.

In addition to the above publicly traded markets, we all know that housing prices have risen dramatically (especially in Western Canada) and cap rates for commercial and retail real estate are at record lows (the lower the cap rate, the more an investor is paying for $1 of net income from the real estate).

While it is true that markets seemed to have recovered somewhat from these lows, it makes one wonder: Is this simply the pause that refreshes, or a dead cat bounce?

At the time of writing, most balanced funds and indices (Global and Canadian) have essentially broken even for 2006. With current government bond yields at less than 5% and equities that are not particularly cheap, what kind of returns can we expect going forward?

Over the last twelve years we have recommended to our clients a different investment portfolio approach that emphasizes:

  • Diversification through other asset classes such as real estate and mortgages.
  • Focus on the income that your portfolio generates. Most balanced funds and indices have net distributable income of about 2% after fees. (For most of our client profiles, we strive for at least twice that).
  • Increased tax efficiency through better corporate structures and more effective compensation strategies.

As of June 2006, our average Canadian dollar discretionary portfolio has returned 4.76% YTD after fees (for 258 client accounts with over $100,000 AUM as of Jan 1, 2006).

Building an investment portfolio that has good consistent returns (which we would define as being at least 4% above inflation) is a considerable challenge, and most investors do not achieve this goal.

Let’s examine three notions we use as steadfast guides to keep focused in these volatile times and how they affect long term returns. They are:

  1. Diversification amongst a very wide group of asset classes.
  2. When it comes to equities, dividends matter – especially over the long term and in secular bear markets.
  3. Most of the return from real estate comes from income vs. capital appreciation.

There are many examples of great investment results that are the antithesis of our points above. We all know individuals who have flipped condos for a nice windfall, or we have heard of junior mining gold stocks that have appreciated 1000% in the last three years. We will always be aware of these stories just as we will always hear about big winners whenever we visit a casino.

But in the end the house always wins. So it would seem obvious to try and invest as if we were the house.


Let’s look at two portfolios as examples. The first is a balanced portfolio split between Canadian & Global Bonds and Equities. In this case, we are using indices and results are after management fees.

Balanced Portfolio

(30% S&P Scotia Universe [Bonds]; 30% MSCI; 20% Lehman Bros. [Bonds])

Some observations about the above portfolio:

  • It is balanced – as long as we define “balanced” as being either a bond or stock and either Canadian or Global.
  • The return of 6% per year net of fees is only about 3% net of CPI – or below our long-term objective.
  • Between December of 2000 and December 2004 the portfolio broke even ($177,743 vs. $172,099). Would you as an investor have waited for years to allow this portfolio to work for you? What if you required an income from it?
  • The Standard Deviation (a standard measure of risk) of this portfolio is 7.71%. This means that 2/3rds of the time the annual return will be 7.71% over or under the average return of 7.03% before fees. The rest of the time the returns could be even higher or lower. The higher the Standard Deviation, the more risk you are taking in order to get a particular return.

Let’s look at another approach that involves a more diversified portfolio.

We will include other asset classes such as mortgages, real estate, hedge funds, precious metals, income trusts, and high-yield and foreign bonds, along with traditional equities and bonds (see pie chart below).

Observations about the more diversified portfolio:

  • The net return is 1.8% per year more than the previous “balanced portfolio” and, based on $100,000 being invested, results in about $36,000 more in value ($233,000 vs. $197,000). This also works out to about 4.8% more than the CPI (at the high end of our objective of 4-5% over the CPI).
  • The Standard Deviation is less than half of the traditional balanced portfolio at 3.57%. In fact, this portfolio has no years with negative returns over this period of time.

Being in balanced funds may feel like an effective way to generate steady returns with low volatility, but true diversification requires a broader array of assets and, as we shall see next, a focus on cash flow as well.

Dividends Matter

 So now let’s turn our minds to the impact of dividends on equity returns. There have been numerous studies on this topic. A study by The International Bank Credit Analyst (chart on back page) examined ten different countries and determined what percentage of total returns from stocks was created by dividends between 1975 and 2005. The average is about 2/3rds – i.e.: 2/3rds of one’s total return was due to dividends vs. capital gains.

Given that the average blue chip North American stock pays a current dividend of less than 2%, how will stocks perform overall if that dividend yield makes up 2/3rds of our future returns?

Since 1900 there have been 4 significant secular bear markets: 1906-1924, 1929-1950, 1968-1981 and 2000-ongoing. In each case, the net capital gain on equities for the entire market (S&P 500) was close to zero. In order to make any return at all, one had to rely on dividends.

Some points to ponder:

  • From 1871 to 2006 the total return from the S&P 500 was about 8.85%, and of this the average dividend contribution was 4.23%.
  • In the first three bear markets, total returns were not unreasonable (5-6% annually) because dividend yields were much higher then than they are now. Note that since January 2000 the total return for the S&P 500 is still negative at about -1% per year – and that number is before fees and the impact of an appreciating Canadian dollar. If those factors are taken into account, then after six years the total return in Canadian dollars is about -4% annually. Of course, this is the first time dividend yields have ever dipped this low.
  • Dividends are far less volatile than capital gains when it comes to equities. Since 1972 there have been 9 years when stock prices have had a negative annual return (about 25% of the time) and many of those drops were well in excess of 10% (the worst being 30% in 1974). However, in that same time frame dividends have only dropped twice (6% of the time) and those reductions were minor (6% and 0.62% in 2000 and 2001).

Return from Real Estate:

Over the last few years, prices for both housing and commercial real estate have risen dramatically. They have been driven by a number of factors including:

  • Lower interest rates make the cost of owning more affordable.
  • Cap rates on commercial and multi-family residential real estate have dropped as a result of lower mortgage rates and an increased appetite for good quality assets from institutional investors (especially pension funds).
  • Global investors who have a large surplus of US Dollars are looking to reinvest those funds in what they feel are “safe assets” in areas such as North America and Europe.

Real estate has been a solid asset class for many years. However, actual returns for real estate over the long-term are similar to common shares. Most investors probably feel they have done better with real estate than with stocks, but likely there are simple explanations for that:

  • Real estate lends itself to leverage, provided that the income (rents) from it can fund the cost of financing. This means that investors must pay attention to the income from the real estate (same as dividends on equities). Investors would get the same results over time if they leveraged common stocks that paid consistent and growing dividends.
  • It is difficult and expensive to sell real estate in tough markets, whereas stocks are generally easy to liquidate. Many real estate investors have waited through long down markets to eventually sell for a profit when buyers returned. Real estate often forces a good discipline on investors.

Our rule of thumb for acquiring income producing real estate for clients is that the property must show a net income after all expenses of 2%+ more than the cost of financing. This, of course, is only one of many factors, but if we have done our proper due diligence, then this “income spread” could mean the difference between a positive cash flow return and having to support financing out of other assets.

We are not sure that the “Madness of Crowds” has returned, but the last three years look suspiciously like many prior bubbles. Markets are rarely rational, because in the end they represent the collective decisions of investors who are inconveniently emotional beings. Star Trek’s character Spock said it best: “Logic is the beginning of wisdom, not the end.”

Logic is how we start the process of building a strong investment portfolio, but ongoing due diligence and discipline is how we ensure it continues to perform. So despite the investment bubbles that burgeon and deflate around us, we can stand on the shoulders of giants and peek just above the maddened crowds if we have kept our focus on the three issues we’ve explored in this newsletter: diversification, dividends and positive cash flow from real estate.